3798 words - 16 pages

I.1 Adjusting for Inflation and Taxes

Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 1 / 28

What is Inflation?

Definition

Inflation is defined as the rate at which prices increase.

Inflation is typically measured by the Consumer Price Index (CPI).

The CPI measures the rate of increase of the price of a bundle of goods that

a “typical” consumer purchases.

If the cost last year was $1000 and the cost this year is $1020, then the rate

of the inflation was 2%

Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 2 / 28

Inflation over the last decade in the US

6 6

CPI-U 12-Month Changes, 2002 to Present

Percent Percent

3

4

5

6

3

4

5

6

All Items

0

1

2

0

1

2

-3

-2

-1

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-3

-2

-1All Items Less

Food and Energy

4

CPI Detailed Report-December 2012

The Bureau of Labor Statistics now publishes numerous CPIs that differ by region

and “type” of person to which they apply.

Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 3 / 28

Where does inflation show up in business decisions

Cash flow projections

Annual growth rate is often projected based on historical “real” growth rate

scaled by expected inflation

Contracts (e.g., wages or benefits)

Colas = Cost of Living Adjustments (often based on CPI)

e.g., how much wages increase so that our employees are not worse off?

Financial Planning

People care about purchasing power. You need to take into account inflation

in order to achieve desired purchasing power.

e.g., How much can you consume more in real terms if you get an MBA?

Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 4 / 28

Nominal versus Real Terms

When dealing with inflation there are three relations to keep in mind:

1. Nominal versus real cash flows

C realt =

Cnomt

(1 + i)t

2. Nominal versus real interest rates

1 + r real =

1 + rnom

1 + i

3. Nominal versus real growth rates

1 + g real =

1 + gnom

1 + i

Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 5 / 28

Intuition

Assuming that i = 2%

1. if you earn a nominal salary of $160,000 in two years, it is the same in real

terms (i.e., in purchasing power) to what

$160, 000

(1 + 2%)2

= $153, 787can buy today

2. If you can invest a nominal interest rate of 6%, the real interest rate (rate

at which your purchasing power will increase) is

r real =

1 + 6%

1 + 2%

− 1 = 3.9%

3. If nominal GDP increases by 3.5% part of this was simply due to inflation.

The real rate at which the economy grew (how much more stuff we

produced) is only

g real =

1 + 3.5%

1 + 2%

− 1 = 1.47%

Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 6 / 28

Intuition

Assuming that i = 2%

1. if you earn a nominal salary of $160,000 in two years, it is the same in real

terms (i.e., in purchasing power) to w...

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