The Role of Interest and Inflation Rates in Present-Worth Analysis in the United States

Document Type

Article

Department

Engineering (HMC)

Publication Date

1983

Abstract

Estimating the present worth of cash flows is a difficult task. First, in order to estimate future costs, the engineering economist must forecast the rate of inflation to be used to escalate today's prices into the future when the costs will be incurred. Second, in order to discount future costs to account for the "time value of money", he must select an appropriate rate of interest. What constitutes an appropriate rate of interest, whether for public or private purposes, has been an area of much disagreement [3, 17] and therefore all interest rates used in this paper will be only for illustrative purposes. But, one area of some agreement among economists is that interest rates have a built-in premium for inflation [5, 12, 13, IS, 16, 19, 22, 23] and therefore, in general, inflation and interest rates fluctuate in the same direction. For example, in Figure 1 we show an important interest rate, the yield of new issues of AAA corporate bonds [4], and an important inflation rate, the annual rate of increase in the Consumer Price Index [4]. Forecasting these rates can be very difficult, for they often rise and fall unpredictably [7, 9]. However, in present worth analysis, as we shall see, the engineering economist can make use of the fact that, to a large extent, interest and inflation rates tend to cancel each other [8, 14]. We will develop a method that combines inflation and interest rates into one parameter V that, as our analysis of historical data shows, is significantly less variable than either of these rates. This eliminates the difficult task of having to estimate future inflation and interest rates when calculating the present value of cash flows.

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© 1983 Taylor and Francis

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