Effect of Inflation on Present Value Analysis
If rate of
inflation is expected to be greater (or smaller) for some particular benefits and/or costs
than for costs in general, then the discount rate for these items should be appropriately
adjusted downward (upward).
Example: Suppose in the previous example that
equipment costs are expected to increase at a
rate that is 3 percent higher than the general inflation rate, which governs maintenance
costs. The discount rate
applicable to alternative C should be lowered by 3 percentage
points while neither A or B need any adjustment.
Therefore, alt. C costs are
i = 0.08 - 0.03 = 0.05, n = 10, SPPW=
0.614
P
= $140,000 + $140,000 (0.614)
= $140,000 + $85,960
= $225,960, now alternative C is no longer preferable, and alternative A
again is the
preferred (lowest cost) alternative.