Interest Rates, Inflation and Pricing

5. Inflation
1.0 INTRODUCTION
5.1 Price Inflation
1.1 Definitions
2.0 CALCULATION OF INTEREST 5.2 Using index to measure Price
level change
2.1 Simple interest, Effective and
nominal interest rate 5.3 Measures of Inflation
2.2 Calculation Simple interest, 5.4 Causes of Inflation
Effective and nominal interest 5.5 Measures to control inflation
rate
5.6 Effects of inflation
3. 0 INTEREST FORMULAS AND
TABLES IN RELATION TO 5.6.2Advantage of inflation
ENGINEERING ECONOMY 5.6.3Disadvantages of inflation
3.1 Cash Flow Diagram. 5.7 Inflation and investment
3.2 Interest Calculation 5.8 Inflation calculation
4.0 Pricing
6.0 CONCLUSION

1
This part of the course deals with mathematical
method of calculating interest rate (simple and
compound) and equivalence as basis for making
engineering economy studies.
It is important that engineers should be able to
appreciate the value of money and interpret its
use in a way similar to that in which they
interpret all the other materials and resources in
which they endeavor to design economically.

2
Interest may be defined as money paid for the use of
borrowed money.
The rate of interest is ratio between the chargeable or
payable at the end of time, usually a year or less, and the
money owed at the beginning of the period.
When interest is paid on not only the principal amount
invested, but also on any previous interest earned, this is
called compound interest
Nominal interest rate is annual rate of interest without
considering the effect of any compounding during the
year.
Effective annual interest rate is annual interest rate taking
into account the effect of any compounding during the
year.
Inflation is the situation where price of goods and services
are increasing time to time while deflation is the reverse.

3
Interest = Principle X Interest rate X Time
I= P. i. n
Effective annual interest rate eIff = ( 1 + r/m)m -1
Where r = nominal annual interest rate in decimal
m = number of compound period per year

1) If bank pay 1.5 interest in saving account every three months. What is
Nominal and effective interest rate.
a) Nominal interest rate is = (12/3)*1.5= 6%
b) Effective interest rateeffI = ( 1 + i /m)m -1
4
= ( 1 + 6/4)-1 = ( 1 + 1.5)4 -1
= 0.06136 =6.136%

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Calculation of interest payments
Evaluation of investment options
Bond pricing
Determination of Inflation adjusted interest
rates
Net present value method
Annual cost method
Internal rate of return
Benefit cost analysis
 2 )If loan of Tsh 1000, nominal interest of 10% compounded quarterly.
What is effective interest rate?
Solution
Ieff = ( 1 + r/m)m-1 = ( 1 + 0.1/4)4 -1 = 0.1038
The annual interest would be 1000(0.1038) = 103.8

3 ) How much will accumulate in individual retirement account in 15 years if

TSHS 500 is deposited in the account at the end of each quarter during that time?
The account earn 12% per annum interest compounded quarterly. What is
effective interest rate?
Solution
F=?, N= 15 years, A =500, n= 4*15=60, r = 12, i= 12/4= 3%
F = A(F/A, i%, n) compound amount
F = 500(F/A, 3%, 60) = 500(163.053) =81,526.5
b) Effective interest rate Ieff = ( 1 + r/m)m-1 = ( 1 + 0.12/4)4 -1 = 0.1255 =
7
12.55%.
In solving any interest problem, it is necessary to note
which of the various elements of such problems (i, n, P,
F, and A) are known and which are wanted.
F = future value, a value at some future point in time
P = present value, a value today which is usually
designated as time 0
i = rate of interest per compounding period
n = number of compounding periods
A = Uniform series
S= Salvage or resale value

8
The solution of engineering economics problems that
involve evaluation and or comparison of cash flow is
facilitated by preparing diagrams representing the
movement of cash over time.
Arrows pointing downward indicate negative cash flow
and upward indicating positive cash flow or cash receipts.

F
P

1 2 3
1 2 3
P
(a) (a) i=10%
i=10%

9
 3.2.1 Single Payments
F = P (1+ i)n where (1+ i)n
Known as single payment compound amount factor.

Notation (F/P,i%,n) That is F = P (1+ i)n is P(F/P,i%,n)

3.2.2 Uniform series Payment

F = A(F/A, i%, n) compound amount
A= F(A/F, i%, n) Uniform series sinking fund
P = A(P/A, i%, n) Present worth
A = P(F/P, i%, n) Capital recovery

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(1) How much a family can invest from now to provide a
lump sum of TZS 10,000,000 for school fees at the end of
six years from now if interest rate is 5%.
Solution
I= 0.05, n= 6, F= 10,000,000, P=?
P = F (1+ i)n is P = F(P/F, i%, n)

F (1000)

(a) 6
P i=5%
?

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(2) If £1000 invested at 6% compound interest on 1981
how much will be accumulated on 1991?
Soln
I= 0.06, n=10 P=£1000, F=?
By table isF= P(F/P,i%,n)
= 1000(1.791)= £1791

(a) i=6% 10
P (1000)

12
 (3) If £840 was invested at 6% in 1978, what
equal year end withdrawals can be made
each year for ten years, leaving nothing in
the fund after the tenth withdrawals?
Soln
i= 0.06, n=10, P=£840, A=?
By table is A = P(A/P, i%, n)
= 840(0.13587)
= £114.1

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(4) How much must be deposited at 6%
interest each year for 7 years beginning on
1982 in order to accumulate £ 1504 on the
date of last deposit, 1988.
Soln
i= 0.06, n=7, F=£1504, A=?
By table is A= F(A/F, i%, n)
= 1504(0.11914)
= £179.2

14
 (5) How much would you need to deposit at
6%, on January 1981, in order to draw out
179.2 at the end of each years, for 7 years
leaving nothing in fund at the end?
Soln
i= 0.06, n=7, A=£179.2, P=?
By table is P= A(P/A, i%, n)
= 179.2(5.582)
= £1000

15
•A bond is simply a long term debt.
•When you own a bond, you receive a
fixed interest payment each year until
the bond matures.
•This payment is known as the
coupon.
At maturity the the debt is repaid.

The amount that is repaid is known as the

bond’s face value,
value par value, or maturity
value.
Suppose you bought the 9% coupon bond in
1993, each bond having the face value of
1000Tsh. and maturing in 1998. You could
then look forward to the following cash
payments.
1993 1994 1995 1996 1997 1998
90 90 90 90 90 1090
What is the market value of this stream of
cash flows?

To answer, we need to look at the return

provided by similar securities.
In 1993 Tanzania Government Treasury
bonds with similar maturities offered a
return of about 5.3%.
Therefore, to value these bonds, we need to
discount the prospective stream of cash
flows at 5.3%

PV = {90/(1+r)} + {90/(1+r)2} + {90/(1+r)3}

+ {90/(1+r)4} + {90/(1+r)5}
PV = {90/(1.053)} + {90/(1.053)2} +
{90/(1.053)3} + {90/(1.053)4} +
{90/(1.053)5}

PV = 1158.87Tsh
Example No.1

Investors will pay 1158.87Tsh. for a 9%, 5

year Treasury bond, when the interest rate is
5.3%. Suppose that the interest rate is much
higher, 15%, say . Now what is the value of
the bond? Face value of each bond is
Tsh.1000
PV = {90/(1+r)} + {90/(1+r)2} + {90/(1+r)3}
+ {90/(1+r)4} + {90/(1+r)5}

PV = {90/(1.15)} + {90/(1.15)2} +
{90/(1.15)3} + {90/(1.15)4} + {90/(1.15)5}

PV = 798.87Tsh.
Suppose you are considering purchase of a
bond. Your investment adviser quotes a
current price. How do you calculate the rate
of return the bond offers.

For bonds purchased at face value the

answer is easy. The rate of return is the
coupon rate
A measure of rate of return that takes
account of both current yield and
appreciation or depreciation of a bond’s
value over its life is called yield to maturity
or internal rate of return. This is the discount
rate that makes the present value of bonds
payments equal to its price.
Example No.2

If the price of the bond is 1158.87, what

return do investors expect? Face value is
1000 and coupon rate is 9%.
PV = {90/(1+r) } + {90/(1+r)2} + {90/(1+r)3}
+ {90/(1+r)4} + {1090/(1+r)5}
PV = 1158.87
r = 5.3% (This is the Yield to Maturity)
PV = {90/(1+r) } + {90/(1+r)2} + {90/(1+r)3}
+ {90/(1+r)4} + {1090/(1+r)5}

PV = 1158.87

r = 5.3% (This is the Yield to Maturity)

Inflation is the situation where price of goods
and services are increasing time to time while
deflation is reverse.
Causes of inflation are (1) Demand pull
inflation (2)Cost push Inflation.
Demand-pull Inflation caused by excessive
demand, demand is greater than supply price
increase.
Cost –push Inflation are the inflation which
occur when firm’s go up, to maintain their
profit margin they put their price up.

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The number of goods that
are representative of
economy are put together
into Market basket. CPI this year-CPI previous year
Inflation rate = X 100
Cost of this basket result CPI previous year

the price index, ie

Customer Price index (CPI)
and Producer Price index
(PPI).
CPI Measure the cost of
living
PPI measure the price PPI this year-PPI previous year
change form the seller Inflation rate =
PPI previous year
X 100

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 Demand-pull inflation
(I) Increase income tax to reduce consumer
spending
(ii)Control supply of money
(iii)Reducing government spending.
Cost-push inflation
Reduce indirect taxation.
Wage and price controls may be instituted to
check inflation

31
 Advantage of inflation
1)Firm increasing prices and profit before they
pay out higher wage
2)Deptor(borrowers) gain they use money now
so get interest free loan
Disadvantages of inflation
1)Creditor lose when loan paid
2)Fixed income people suffer
3)Domestic product be less competitive to
foreign product

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Table 1: Tanzania Consumer Price Index And Inflation Rates 1995-2005

Period/year CPI inflation rate

1995 115.8 28.4

1996 140.1 21.0
1997 162.6 16.1
1998 183.5 12.8
1999 197.9 7.9
2000 209.7 5.9
2001 220.4 1
2002 230.5 4.6
2003 240.7 4.4
2004 250.8 4.2

2005 261.8 4.4

Source BOT

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Inflation reducing the rate of return of
investor to even negative
When price level rise (Inflation), The
purchasing power of money goes down.
This implies that prospective inflation can
be an additional source of lack of
commensurability of cash flows at different
date.

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 If an index represent the price of cement
increase $231 to $287 over period of 3
years. What is inflation rate?
Solution:
F=P(1+f)n
287=231(1+f)3
1+f=(1.2424)1/3
1.075=1+f
f=0.075= 7.5%

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 A project has be analyzed assuming 6%
inflation and found to have monetary
internal rate of return of (IRR) of 22% What
is the real IRR of project.
Solution:
1+i
Real IRR = − 1
1+f
=((1+.22)/(1+.06))-1 =0.1509 =15.09%
15.09%

36
 Mr Maeda borrowed Tsh 700,000 from Phoya in Jan
2009. He was required to pay after one year with
interest of 10% annualy. Phoya did not consider
inflation then. But in Jan 2010 when Maeda paid the
inflation was 10.30 % refer to BOT.
Soln
norminal interest rate 10%
Inflation rate=10.3
Real interest rate= 10-10.3=-0.3%
Income Phoya he wished to receive
=700,000+10%x700,000=770,000
But due to inflation Actual money maeda pay to Phoya
was=700,000-0.3% *700,000= 697,900.

37
 Table 2: Problem 14.1
A B C D E F

CPI After Tax

Year Cash flow before Cash flow for Cash flow From table Cash flow
Tax Tax After tax 14-1 Converted to
Page 314 1960

1960 $ (9,600) 0 -9600 88.7 -9600

1961 $ 400 0 400 89.6 396
1962 $ 400 0 400 90.6 392
1963 $ 400 0 400 91.7 387
1964 $ 400 0 400 92.9 382
1965 $ 400 0 400 94.5 375
1966 $ 400 0 400 97.2 365
1967 $ 400 0 400 100 355
1968 $ 400 0 400 104.2 340
1969 $ 400 0 400 109.8 323
1970 $ 10,400 -100 10300 116.3 7856
$ 4,400 4300 1571 38
 Rate of
return P P
before P− A ,i,n − F ,i,n = 0
tax and A F
inflation
Pw=9600, i= 4 .5
A=400, P P
F=10,000, 9600 − 400 ,i, 10 − 10 , 000 ,i, 10 = − 4 . 2
n=10years
A F
i= 5 , 372 .2
interpolate i = 4 .5055 thats i = 4 .5

39
 W hen inflation is considered rate of return is
P
-P + F ,i,n = 0
F
P P P P
396 ,i, 1 392 ,i, 2 387 ,i, 3 375 ,i, 4
F F F F
P P P P
365 ,i, 5 355 ,i, 6 340 ,i, 7 340 ,i, 8
F F F F
P P
323 ,i, 9 7856 ,i, 10
F F

righ

= 0

− 9600

40
 Table 3: Problem 14.3
A B C D= B-C E= (P/F),4% F

Estimate price After Tax

Year Cash flow before Cash flow for Cash flow index Cash flow
Tax Tax 30% After tax assuming 100 Converted
at date to 0 date

0 $ (10,000) 0 -10,000 100 -10000

1 $ 1,200 $ (360) $ 840 104 808
2 $ 1,200 $ (360) $ 840 108.16 777
3 $ 1,200 $ (360) $ 840 112.49 747
4 $ 1,200 $ (360) $ 840 116.99 718
5 $ 1,200 $ (360) $ 840 121.67 690
6 $ 1,200 $ (360) $ 840 126.53 664
7 $ 1,200 $ (360) $ 840 131.59 638
8 $ 1,200 $ (360) $ 840 136.86 614
9 $ 1,200 $ (360) $ 840 142.33 590
10 $ 11,200 $ (360) $ 10,840 148.02 7323
$ 12,000 -3600 8400 3569

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Rate of return now w ithout inflation
P P
P− A ,i,n − F ,i,n = 0
A F
i= 9
P P
10 , 000− 840 ,i, 10 − 10 , 000 ,i, 10 = − 384 .88
A F
i= 8 , 268 . 4
interpolate , 0 ⇒ i = 8 . 4% thats i = 8 .4%

42
 W hen inflation is considered rate of return is
P P P P
808 ,i, 1 777 ,i, 2 747 ,i, 3 718 ,i, 4
F F F F
P P P P
690 ,i, 5 664 ,i, 6 638 ,i, 7 614 ,i, 8
F F F F
P P
599 ,i, 9 7323 ,i, 10
F F

righ

= 0

− 10 , 000

43
It is important that engineers should be able to
appreciate the value of money and interpret its use in a
way similar to that in which they interpret all the other
materials and resources in which they endeavor to
design economically.
Interest rate table giving three significant figures are
adequate for purpose of most economy studies.
The impact of inflation on economy study is that it
reduces the rate of return of investments in various
ways and also it affects individual taxpayers.

44