Subject: 322 Homework

Dr. Lowery,

I had a quick question on homework problem 15.19 in the old book. How do we adjust the values for inflation?

Joe

Joe:

Just like when you had a problem with a geometric gradient, and realized we hadn’t done a problem like that, you dug around and finally on page 356 in the old book (page 388 in the new book) found a nifty equation that would do the job for you. Same thing here.

In this case you look around for the word inflation, and find it on page 417 in the old book (460 in the new book) and see “Inflation-Adjusted (Real) Rate of Return”

Sounds like what we need, including example problems.

He gives you a table of income, then a table including depreciation, taxable income, tax to be paid, and what’s left for you, not including inflation. In your homework problem he just goes ahead and gives you the final numbers.

You then can solve for the “nominal” rate of return, excluding inflation, by trial and error or by putting the following numbers in Excel:

Year Amount

0 -$1000

1 $299

2 $332

3 $365

4 $398

5 $431

Then go to the bottom of that string of numbers, type in =IRR(A2:A7) and Excel will tell you the answer, excluding inflation.

Your only problem is that the money listed as income several years down the road is worth less (worth less, not worthless) due to inflation.

-$1000 = $1000

+$299 = +$299/(1.03) = $285 i.e. the $299 dollars that the person will hand you at the end of year 1 will only buy $285 worth of stuff.

+$332 = +$332/(1.03)^2 = $301 because you got hit with two years of inflation.

Etc.

To get the after-inflation IRR you again use trial and error to solve it, or put it in Excel.

L^3

Lee L. Lowery, Jr., PhD, P.E. <><

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Zachry Department of Civil Engineering

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