What is the Consumer Price Index (CPI) Whatis the

Define inflation in terms of the purchasing power ofdollars.

Define and describe the relationships between thefollowing: actual and real dollars, inflation, and realand market (combined) interest rates.

How does inflation happen? Describe a fewcircumstances that cause prices in an economy toincrease.

Is it necessary to accountfor inflation in an engineer-ing economy study? What are the two approachesforhandling inflation in such analyses?

In Chapters 5 (Present Worth Analysis) and 6(Annual Cash Flow Analysis) it is assumed thatprices are stable and a machine purchased today for$5000 can be replaced for the same amount many years hence.In fact,priceshave generallybeenrising,so the stable price assumption tends to be incorrect.Under what circumstances is it correct to use thestable price assumption when prices actually arechanging?

An economist has predicted 7% inflation during thenext 10 years. How much will an item that presentlysells for $10 bring a decade hence?

A man bought a 5% tax-free municipalbond. Itcost $1000 and will pay $50 interest each year for20 years. At maturity the bond returns the original$1000. If there is 2% annual inflation, what real rateof return will the investor receive?

A man wishes to set aside some money for his daugh-ters college education. His goal is to have a banksavings account containing an amount equivalent to$20,000 in todays dollars at the girls 18th birthday.The estimated inflation rate is 8%. If the bank pays5% compounded annually, what lump sum should hedeposit on the childs 4thbirthday?

A newspaper reports that in the last 5 years, priceshave increased a total of 50%. This is equivalent towhat annual inflation rate, compounded annually?

An economist has predicted that for the next 5 years,the U.S. will have an 8% annual inflation rate, fol- lowed by 5 years at a 6% inflation rate. This isequivalent to what average price change per year forthe entire 10-year period?

An investor wants a real rate of returniof 10% peryear. If the expected annual inflation rate for the nextseveral years is 6%, what interest rateishould beused in project analysis calculations?

A South American country has had a high rate ofinflation. Recently,its exchangerate was 15 cruzadosper dollar; that is, one dollar will buy 15 cruzados. Itis likely that the country will continue to experiencea 25% inflation rate and that the U.S. will continueat a 7% inflation rate. Assume that the exchangerate will vary the same as the inflation. In this situ-ation, one dollar will buy how many cruzados5 yearsfrom now?

An automaker has a car that gets 10 kilometers perliter of gasoline. Gas prices will increase 12% peryear, compoundedannually, for the next 8 years. Themanufacturer believes that the fuel consumption forits new cars should decline as fuel prices increase tokeep the fuel costs constant. To achieve this, whatmust be the fuel rating, in kilometers per liter, of thecars 8 years hence?

An economist has predicted that during the next6 years, prices in the U.S. will increase 55%. Heexpects a further increase of 25% in the subsequent4years, so that prices at the end of 10 years will haveincreased to 180% of the present level. Compute theinflation rate,f, for the entire 10-year period

Sally Johnson loaned a friend $10,000 at 15%interest, compoundedannually. The loan will be paidin five equal end-of-year payments. Sally expects theinflation rate to be 12%. After taking inflation intoaccount, what rate of return is Sally receiving onthe loan? Compute your answer to the nearest 0.1%.

You may pay $15,000 for an annuity that pays $2500per year for the next 10 years. You want a real rate ofreturn of 5%, and you estimate inflation will average6% per year. Should you buy the annuity?

Inflation has been reality for the general economy ofthe U.S. in many years.Given this assumption,calcu-late the number of years it will take for the purchasingpower of todays dollars to equalone-fifthof theirpresent value. Assume that inflation will average 6%per year.

A homebuilders advertising had the caption, Infla-tion to Continue for Many Years. The ad explainedthat if one buys a home now for $297,000, andinflation continues at 7%, the home will be worth$819,400 in 15 years. Thus, by buying a new homenow, one can realize a profit of $522,400in 15 years.Do you find this logic persuasive? Explain.

You were recently looking at the historical pricespaid for homes in a neighborhood that interests you.Calculate on a year-to-year basis how home prices inthis neighborhood have inflated (aein the table).Average Inflation RateYear Home Price for That Year5 years ago $265,000(a)4 years ago 267,000(b)3 years ago 272,000(c)2 years ago 280,000(d)Last year 283,000(e)This year 290,000 (f,seebelow)(f) What is your estimate of the inflation rate forthis year?

The average cost of a certain model car was $18,000ten yearsago.This yearthe averagecostis $30,000.(a)Calculate the average monthly inflation rate (fm)for this model.(b)Given the monthly ratefm, what is the effectiveannual rate,f, of inflation for this model.(c)Estimate what these will sell for 10 years fromnow, expressed in todays dollars.Contributed by D. P. Loucks, Cornell Universit

Dale saw that the campus bookstore is having aspecialon padsof computation papernormally pricedat $3 a pad, now on sale for $2.50 a pad. This saleis unusual and Dale assumes the paper will not beput on sale again. On the other hand, Dale expects that there will be no increase in the $3 regular price,even though the inflation rate is 2% every 3 months.Dale believes that competition in the paper indus-try will keep wholesale and retail prices constant.He uses a pad of computation paper every 3 months.Dale considers 19.25% a suitable minimum attrac-tive rate of return. Dale will buy one pad of paperfor his immediate needs. How many extra pads ofcomputation paper should he buy?

If inflation averages 2.5% each year from 2000 to2009, what is the purchasing power in 2000 dollarsof $25,000 in 2009?Contributedby PaulR. McCright, Universityof SouthFlorida

If inflation is currently 3.35% and a bank is lendingmoney at 6.65% interest, what is the real interest ratethe bank is earning on its loans?Contributedby PaulR. McCright, Universityof SouthFlorida

Samantha receives a starting salary offer of $60,000for Year 1. If inflation is 4% each year, what must hersalary be to have the same purchasing power in Year10? Year 20? Year 30? Year 40?

Assume that Samantha (Problem 14-24) receives anannual 5% raise. How much more, in Year-1 dollars,is her salary in Year 10? Year 20? Year 30? Year 40?

Inflation is 4%. If $1000 is invested in an accountpaying 6% compounded semiannually, what is theYear-0 dollar value of the account at the end of the5 years?

Assume your salary is $55,000 in 2012 and $160,000in 2042. If inflation has averaged 2% per year, whatis the real or differential inflation rate of salaryincreases?

In the 1920 Sears Roebuck catalog, an oak chest ofdrawers costs $8 plus freight. In 1990 this same chestof drawers, in good condition, is $1200. If the aver-age rate of inflation over that 70-year period was3%, what was the average yearly rate of appreciation,adjusted for inflation?

Assume inflation is 5% per year. What is the price tagin 6 years for an item that has an inflation rate of 4%that costs $400 toda

The expected rise in prices due to inflation over thenext 5 years is expected to be 30%. Determine theaverage annual inflation rate over the 5-year period.

Explain how high inflation in a booming real estatemarket could benefit an engineer who sells a home 5years after she buys it.

Felix Jones, a recent engineering graduate, expectsa starting salary of $65,000 per year. His futureemployer has averaged 5% per year in salaryincreases for the last several years. If inflation is esti-mated to be 4% per year for the next 3 years, howmuch, in Year-1 dollars, will Felix be earning eachyear? What is the inflation rate in Felixs salary?

The price of a HeeHaw Model BR549 computer ispresently $2200. If deflation of 2% per quarter isexpected on this computer, what will its price bein nominal dollars at the end of 1 year? If inflationis 4.5% per year, what will the price be in Year-0dollars?

You place $4000 into an account paying 8% com-pounded annually. Inflation is 5% during each of thenext 3 years. What is the accounts value at the endof the 3 years in Year-0 dollars?

The following series from theHistorical Statistics ofthe United Statescan be combined with data in Table14-2 to construct a long-term measure of inflation.You are asked to develop an average inflation ratefrom 1779 through 2010. Describe and defend yoursolution.1910 = 100 (base)Year1779 1785 1800 1803 1830 1850 1864 1880Index226 92 129 118 91 84 193 1001927 = 100 (base)Year1890 1910 1920 1921 1932 1940 1950 1955Index56 90 154 98 65 79 162 174

If $10,000 is deposited in a 5% savings account andinflation is 3%, what is the value of the accountat theend of Year 20 in Year-0 dollars? If the time value ofmoney is 4%, what is the present worth?

The cost of garbage pickup in Green Gulch is$4,500,000 for Year 1. Estimate the cost in Year 3in Year-1 dollars and in nominal dollars. The popula-tion is increasing at 6%, the nominal cost per ton isincreasing at 5%, and the inflation rate is estimated at 4%.

Your beginning salary is $70,000. You deposit 10%each year in a savings account that earns 6% interest.Your salary increases by 5% per year and inflation is3% per year. What value does your savings accountshow after 40 years? What is the value in Year-1dollars?

The market for widgets is increasing by 15% per yearfrom current profitsof $200,000.Investingin a designchange will allow the profit per widget to stay steady;otherwise the price will drop by 3% per year. If infla-tion in the economy is 2%, what is the present worthin Year-1 dollars of the savings over the next 5 years?10 years? The interest rate is 10%

Enrollment at City University is increasing 3% peryear,its costpercredit houris increasing8% per year,and state funds are decreasing by 4% per year. Statefunds currently pay halfof the costsfor City U., whiletuition pays the rest. What annual increase in tuitionis required?

A homeowneris consideringan upgradeof a fuel-oil-based furnace to a natural gas unit. The investmentin the fixed equipment, such as a new boiler, will be$2500 installed. The cost of the natural gas will aver-age $60 per month over the year, instead of the $145per month that the fuel oil costs. If funds cost 9%per year and cost inflation in fossil fuels will be 3%per year, how long will it take to recover the initialinvestment? Solve on a monthly basis.

Joan earns a salary of $110,000 per year, and sheexpects to receive increases at a rate of 4% per yearfor the next 30 years. She is purchasing a home for$380,000 at 7% for 30 years (under a special vet-erans, preference loan with 0% down). She expectsthe home to appreciate at a rate of 3% per year. Shewill also save 10% of her gross salary in savingscertificates that earn 5% per year. Assume that herpayments and deposits are made annually. If infla-tion is assumed to have a constant 5% rate, what isthe value (in Year-1 dollars) of each of Joans twoinvestments at the end of the 30-year period? Use abefore-tax analysis

Using a market interest rate of 15% and an inflationrate of 8%, calculate the future equivalent in Year 15of:(a)Dollars having todays purchasing power.(b)Then-current purchasing power dollars, of$10,000 today.

The City of Columbia is trying to attract a new manu-facturing business.It hasoffered to install andoperatea water pumping plant to provide service to the pro-posed plant site. This would cost $50,000 now, plus$5000 per year in operating costs for the next 10years, all measured in Year-0 dollars.To reimburse the city, the new businessmust paya fixed uniform annual fee,A, at the end of each year for 10 years. In addition, it is to pay the city $50,000at the end of 10 years. It has been agreed that thecity should receive a 3% rate of return, after takingan inflation rate,f, of 7% into account.Determine the amountof the uniform annual fee.

A firm is having a large piece of equipmentoverhauled. It expects that the machine will beneeded for the next 12 years. The firm has an 8%minimum attractive rate of return. The contractor hassuggested three alternatives:A.A complete overhaul for $6000that should permit12 years of operation.B.A major overhaul for $4500 that can be expectedto provide 8 years of service. At the end of8 years, a minor overhaul would be needed.C.A minor overhaul now. At the end of 4 and8 years, additional minor overhauls would beneeded.If minor overhauls cost $2500, which alternativeshould the firm select? If minor overhauls, whichnow cost $2500, increase in cost at+5% per year,but other costs remain unchanged, which alternativeshould the firm select?

A group of students decided to lease and run agasoline service station. The lease is for 10 years.Almost immediately the students were confrontedwith the need to alter the gasoline pumps to readin liters. The Dayton Company has a conversion kitavailable for $900 that may be expected to last 10years. The firm also sells a $500 conversion kit thathas a 5-year useful life. The students believe that anymoney not invested in the conversion kits may beinvested elsewhere at a 10% interest rate. Income taxconsequences are to be ignored in this problem.(a)Assuming that future replacement kits cost thesame as today, which alternative should beselected?(b)If one assumes a 7% inflation rate, whichalternative should be selected?

Pollution control equipment must be purchased toremove the suspended organic material from liquidbeing discharged from a vegetable packing plant.Two alternative pieces of equipment are availablethat would accomplish the task. A Filterco unit costs$7000 and has a 5-year useful life. A Duro unit, onthe other hand, costs $10,000 but will have a 10-yearuseful life.With inflation, equipment costs are rising at 8%per year, compounded annually, so when the Filterco unit needed to be replaced, the cost would be muchmore than $7000.Based on a 10-yearanalysisperiod,and a 20% minimum attractive rate of return, whichpollution control equipment should be purchased?

Sam bought a house for $150,000 with some creativefinancing. The bank, which agreed to lend Sam$120,000 for 6 years at 15% interest, took a firstmortgage on the house. The Joneses, who sold Samthe house,agreed to lend Sam the remaining $30,000for 6 years at 12% interest. They received a secondmortgage on the house. Thus Sam became the ownerwithout putting up any cash.Sam pays$1500a monthon the first mortgage and $300 a month on the sec-ond mortgage. In both cases these are interest onlyloans, and the principal is due at the end of theloan.Sam rented the house to Justin and Shannon,butafterpayingthetaxes,insurance,andsoon,hehadonly$800 left, so he was forced to put up $1000 a monthto make the monthly mortgage payments. At the endof 3 years, Sam sold the house for $205,000. Afterpaying off the two loans and the real estate broker, hehad $40,365 left.Aftertaking an 8%inflation rate intoaccount,whatwashisbefore-taxrateof return?

Ima Luckygirl recently found out that her grandfa-ther had passed away and left her his Rocky Moun- tain Gold savings account. The only deposit was 50years ago, when Imas grandfather deposited $2500.If the account has earned an average rate of 10% andinflation has been 4%, answer the following:(a)How much money is now in the accountinactualdollars?(b)Express the answer to part(a)in terms of thepurchasing power of dollars from 50 years ago.

Auntie Frannie wants to provide tuition for her twinnephews to attend a private school. She intends tosend a check for $5000 at the end of each of the next8 years.(a)If general price inflation, as well as tuition priceinflation, is expected to average 5% per year forthose 8 years, calculate the present worth of thegifts. Assume that the real interest rate will be 3%per year.(b)If Auntie Frannie wants her gifts to keep pacewith inflation, what would be the present worthof her gifts? Again assume inflation is 5% andthe real interest rate is 3%.

As a recent graduate, you are consideringemployment offers from three different companies.However, in an effort to confuse you and perhaps make their offers seem better, each company hasused a differentpurchasing power basefor express-ing your annual salary over the next 5 years. If youexpectinflation to be 6% for the next 5 years and yourpersonal (real) MARR is 8%, which plan would youchoose?Company A:A constant $50,000 per year interms of todays purchasing power.CompanyB:$45,000the first year,with increasesof $2500 per year thereafter.Company C:A constant $65,000 per year interms of Year-5-based purchasing power

If McDonnell Manufacturing has a MARR of 20%,inflation is 2.75%, and the company uses presentworth analysis with a planning horizon of 15 years inmaking economic decisions, which of the followingalternatives would be preferred?AlternativeAAlternativeBInitial costs$236,000 $345,000Annual operating costs 64,000 38,000Annual maintenance costs 4,000 5,000Salvage value (EOY 20) 23,000 51,000Contributed by PaulR. McCright,UniversityofSouthFlorida

Due to competition from a new polycarbon,revenuesfor the mainstay product of Toys-R-Polycarbon aredeclining at 5% per year. Revenues will be $5M forthis year. The product will be discontinued at the endof Year 6. If the firms interest rate is 10%, calculatethe PW of the revenue stream.

The ABC Block Company anticipates receiving$4000 per year from its investments (inflation rate of0%) over the next 5 years. If ABCs interest rate is8% and the inflation rate is 3%, determine the presentvalue of the cash flows.

The Wildwood Widget Company needs a millingmachine for its new assembly line. The machinepresently costs$85,000,buthas a costinflation rate of2%. Widget will not need to purchasethe machine for2 years. If general inflation is expected to be 4% peryear during those 2 years, determine the price of themachine. What is the present worth of the machineryif the market rate of interest for Widget is 9%?

Bob has lost his job and had to move back in with hismother. She agreed to let Bob have his old room backon the condition that he pay her$1000 rent per year, and an additional $1000 every other year to pay forher biannual jaunt to Florida. Since he is down on hisluck, she will allow him to pay his rent at the end ofthe year. If inflation is 6% and Bobs interest rate is15%, how much is the present cost (in Year-1 dollars)for a 5-year contract? (Note: Moms trips are in Years2 and 4).

A 30-year mortgage for $100,000 has been issued.The interest rate is 10%andpaymentsare made annu-ally. If your time value of money is 12%, what is thePW of the payments in Year-1 dollars if inflation is0%? 3%? 6%? 9%?

What is the Consumer Price Index (CPI)? Whatis the difference between commodity-specific andcomposite price indexes? Can each be used in engi-neering economic analysis?

A composite price index for the cost of vegetar-ian foods calledEggs, Artichokes, and Tofu(EAT)was 330 ten years ago and has averaged an annualincrease of 12% since. Calculate the current value ofthe index

From the data in Table 14-1 in the text, calculate theoverall rate changeof first-class postageas measuredby the LCI for the following decades:(a)The 1970s (19701979)(b)The 1980s (19801989)(c)The 1990s (19901999)(d)The 2000s (20002010)

From the data in Table 14-1 in the text, calcu-late theaverage annual inflation rateof first classpostage as measured by the LCI for the followingyears:(a)End of 1970 to end of 1979(b)End of 1980 to end of 1989(c)End of 1990 to end of 1999(d)End of 1999 to end of 2009

From the data in Table 14-2 in the text, calculate theaverage annualinflation rateas measured by the CPIfor the following years:(a)End of 1973 to end of 1982(b)End of 1980 to end of 1989(c)End of 1985 to end of 2002(d)End of 1994 to end of 2009

(a)Compute the equivalent annual inflation rate,based on the Consumer Price Index, for theperiod from 1990 to 2010. (b)Using the equivalent annual inflation rate com-puted in part (a), estimate the consumer priceindex for 2015.

Redo Problem 14-17, but estimate the annualinflation rate using the period from 1996 to 2006 andthe CPI values in Table 14-2.

Here is some information about a professor salaryindex (PSI).YearPSI Change in PSI2004 823.22%2005 898.502006 100a2007b4.002008 107c2009 116d2010e5.172011 1327.58(a)Calculate the unknown quantitiesa, b, c, d, einthe table. Review Equation 14-3.(b)What is thebase yearof the PSI? How did youdetermine it?(c)Given the data for the PSI, calculate theaverageannual price increasein salaries paid to profes-sors for between 2004 and 2008 and between2006 and 2011.

Homeowner Henry is building a fireplace for hishouse. The fireplace will require 800 bricks.(a)If the costof a Chimney Brick in 1978 was $2.10,calculate the material cost of Henrys project in1998. The Chimney Brick Index (CBI) was 442in 1978 and is expected to be 618 in 1998.(b)Estimate the material cost of a similar fireplaceto be built in the year 2012. What assumption didyou make?

General price inflation is estimated to be 3% for thenext 5 years, 5%the 5 years after that, and 8% the fol-lowing 5 years.If you invest$10,000at 10%for those15 years, what is the future worth of your investmentin actual dollars at that time and in Year-0 dollars atthat time?

Due to cost structures, trade policies, and corporatechanges, three big automakers have different infla-tion rates for the purchase prices of their vehicles.Which car should Mary Clare buy at graduation 3years from now, assuming everything but purchaseprice is equivalent? utomaker CurrentPricex% perYearX$27,500 4 %Y30,000 1.5Z25,000 8

Granny Viola has been saving money in the Bread &Butter mutual fund for 15 years. She has been asteady depositor over those years and has a patternof putting$100 into the account every 3 months. Ifher original investment 15 years ago was $500 andinterest in the account has varied as shown, what isthe current value of her savings?Years Interest Earnedin the Account15 12% compounded quarterly610 16 compounded quarterly1015 8 compounded quarterly

Andrew just bought a new boat for $15,000 to use onthe river near his home. He has taken delivery of theboat and agreed to the terms of the following loan: allprincipal and interest is due in 3 years (balloon loan),first-year annualinterest (on the purchaseprice) is setat 5%, this is to be adjusted up 1.5% per year for eachof the following years of the loan.(a)How much does Andrew owe to pay off the loanin 3 years?(b)If inflation is 4%, what is the payment in Year-0dollars?

Given the following data, calculate the present worthof the investment.First cost=$60,000 Project life=10 yearsSalvage value=$15,000 MARR=25%General price inflation=4% per yearAnnual cost 1=$4500 in Year 1 andinflating at 2.5% per yearAnnual cost 2=$7000 in Year 1 andinflating at 10.0% per yearAnnual cost 3=$10,000 in Year 1 andinflating at 6.5% per yearAnnual cost 4=$8500 in Year 1 andinflating at2.5% per year

As the owner of Beanie Bobs Basement Brewery,you are interested in a construction projectto increaseproductionto offsetcompetition fromyourcrosstownrival, Bad Brads Brewery and Poolhall. Construc-tion cost percentage increases, as well as current costestimates, are given for a 3-year period. Use a marketinterest rate of 25%, and assume that general priceinflation is 5% over the 3- year period. Cost ifIncurredCost PercentageIncreaseItemToday Year 1 Year 2 Year 3Structural$120,000 4.3% 3.2% 6.6%metal/concreteRoofing materials 14,000 2.0 2.5 3.0Heating/plumbing 35,000 1.6 2.1 3.6equipment/fixturesInsulation material 9,000 5.8 6.0 7.5Labor85,000 5.0 4.5 4.5(a)What would the costs be for labor in Years 1, 2,and 3?(b)What is theaverage percentageincreaseof laborcost over the 3-year period?(c)What is the present worth of the insulation costof this project?(d)Calculate the future worth of the labor and insu- lation material cost portion of the project.(e)Calculate the present worth of the totalconstruction project for Beanie Bob.

Philippe Marie wants to race in the Tour de France 10years from now. He wants to know what the cost ofa custom-built racing bicycle will be 10 years fromtoday.Cost Will InflateCurrent Costx%per YearFrame$8002 %Wheels350 10Gearing system 2005Braking system 1503Saddle702.5Finishes1258

Sally Seashell bought a lot at the Salty Sea for$18,000 cash. She does not plan to build on the lot,but instead will hold it as an investment for 10 years.She wants a 10% after-tax rate of return after takingthe 6% annual inflation rate into account. If incometaxes amount to 15% of the capital gain, at whatprice must she sell the lot at the end of the 10 years?

The U.S. tax laws provide for the depreciation ofequipment based on original cost. Yet owing to sub- stantial inflation, the replacement cost of equipmentis often much greater than the original cost. Whateffect, if any, does this have on a firms ability to buynew equipment to replace old equipment?

Tom Ward put $10,000 in a 5-year certificate ofdeposit that pays 12% interest per year. At matu-rity he will receive his $10,000 back. Toms marginalincome tax rate is 42%. If the inflation rate is 7% peryear, find his(a)before-tax rate of return, ignoring inflation(b)after-tax rate of return, ignoring inflation(c)after-tax rate of return, after taking inflation into account.

Dick DeWolf and his wife have a total taxable incomeof $60,000 this year and file a joint federal incometax return. If inflation continues for the next 20 yearsat a 7% annual rate, Dick wonders what their tax-able income must be to provide the same purchas-ing power after taxes. Assuming the federal incometax rate table is unchanged, what must their taxableincome be 20 years from now?

Assume that your private universitys tuition is$28,000.(a)If the inflation rate for tuition is 5% per year,calculate what the tuition will cost 20 years fromnow.(b)If the general inflation rate for the economy is3% per year, express that future tuition in todaysdollars.(c)Calculate the amount you would have to investtoday to pay for tuition costs 20, 21, 22, and 23yearsfrom now.Assumeyou can investat7% peryear,yourincome taxrate is 40%peryear,andthetuition has to be paid atthe beginning ofthe year.Contributed by D. P. Loucks, Cornell University

You must decide when to go on a vacation. Oneoption is right after graduation. The other option isto wait and go after spending 2 years with the PeaceCorps. Assume the vacation costs $2500 now, andyour annual income tax rate is 20% now, and isexpected to continue to be 20% during the next2 years. Also assume the annual inflation rate for aweeks trip to Hawaii (hotel included) is 4%.(a)Calculate the additional money you couldspend on your vacation, after taxes, by puttingyour vacation money ($2500) into a taxableinvestment at 6% per year (before taxes) andwaiting 2 years until after you come out ofthe Peace Corps compared to taking your well-deserved vacation now.(b)If your tax rate drops to 0% while youre in thePeace Corps, how much additional money willyou have for your vacation?Contributed by D. P. Loucks, Cornell University

Sam Johnson inherited $85,000 from his father. Samis considering investing the money in a house, whichhe will then rent to tenants. The $85,000 cost ofthe property consists of $17,500 for the land, and$67,500 for the house. Sam believes he can rent thehouse and have $8000 a year net income left afterpaying the property taxes and other expenses. Thehouse will be depreciated by straight-line deprecia-tion using a 45-year depreciable life.(a)If the property is sold at the end of 5 yearsfor its book value at that time, what after-taxrate of return will Sam receive? Assume that hismarginal personal income tax rate is 34% forfederal and state taxes.(b)Now assume there is 7% per year inflation, com- pounded annually. Sam will increase the rent 7%per year to match the inflation rate, so that afterconsidering increased taxes and other expenses,the annual net income will go up 7% per year.Assume Sams marginal income tax rate remainsat 34% for all ordinary taxable income related tothe property. The value of the property is nowprojected to increase from its present $85,000 ata rate of 10% per year, compounded annually.If the property is sold after 5 years, computethe rate of return on the after-tax cash flow inactual dollars. Also compute the rate of return onthe after-tax cash flow in Year-0 dollars.

A small researchdevicecan bepurchasedfor $10,000and depreciated by MACRS depreciation. The netbenefits from the device, before deducting depre-ciation, are $2000 at the end of the first year andincreasing $1000 per year after that (second yearequals $3000, third year equals $4000, etc.), until thedevice is hauled to the junkyard at the end of 7 years.During the 7-year period there will be an inflation ratefof 7%.This profitable corporation has a 40% combinedfederal and state income tax rate. If it requires a real12% after-tax rate of return on its investment, shouldthe device be purchased?

A couple in Ruston, Louisiana, must decide whetherit is more economical to buy a home or to con- tinue to rent during an inflationary period.The couplerents a one-bedroom duplex for $450 a month plus$139 a month in basic utilities (heating and cooling).These costs have a projected inflation rate of 5%, sothe couples monthly costs per year over a 10-yearplanning horizon are:n=12345678910Rent 450 473 496 521 547 574 603 633 665 698Utilities 139 146 153 161 169 177 186 196 205 216 The couple would like to buy a home thatcosts $75,000. A local mortgage company will pro-vide a loan that requires a down payment of 5%plus estimated closing costs of 1% cash. The cou-ple prefers a 30-year fixed-rate mortgage with an 8%interest rate. The couple falls in the 30% marginalincome tax rate (federal plus state), and as such, buy-ing a home will provide them some tax write-off.It is estimated that the basic utilities for the homeinflating at 5% will cost $160 per month; insuranceand maintenance also inflating at 5% will cost $50per month. The home will appreciate in value about6% per year. Assuming a nominal interest rate of15.5%, which alternative should the couple select?Use a present worth analysis. (Note:Realtors salescommission here is 5%.

When there is little or no inflation, a homeowner canexpect to rent an unfurnished home for 12% of itsmarket value. About1/8of the rental income is paidout for property taxes, insurance, and other operatingexpenses.Thus the net annual income to the owner is10.5% of the market value. Since prices are relativelystable, the future selling price of the property oftenequals the original price paid by the owner.For a $150,000 property (where the land is esti-mated at $46,500 of the $150,000), compute theafter-tax rate of return, assuming the selling price59 months later (in December) equals the originalpurchase price. Use modified accelerated cost rec-overy systemdepreciationbeginning January1.Also,assume a 35% income tax rate.

(This continues Problem 14-83.) As inflation hasincreased throughout the world, the rental income ofhomes has decreased and a net annual rental incomeof 8% of the market value is common. On the otherhand, the market value of homes tends to rise about2% per year more than the inflation rate. As a result,both annual net rental income, and the resale valueof the property rise faster than the inflation rate.Consider the following situation.A $150,000 property (with the house valued at$103,500 and the land at $46,500) is purchased forcash in Year 0. The market value of the propertyincreases at a 12% annual rate. The annual rentalincome is 8% of the beginning-of-year market valueof the property. Thus the rental income also increaseseach year. The general inflation ratefis 10%.The individual who purchased the property hasan average income tax rate of 35% (a)Use MACRS depreciation, beginning January 1,to compute the actual dollar after-tax rate ofreturn for the owner, assuming he sells the prop-erty 59 months later (in December). b)Similarly, compute the after-tax rate of return forthe owner, after taking the general inflation rateinto account, assuming he sells the property 59months later. b)Similarly, compute the after-tax rate of return forthe owner, after taking the general inflation rateinto account, assuming he sells the property 59months later.

Consider two mutually exclusive alternatives statedin Year-0 dollars. Both alternatives have a 3-year lifewith no salvage value. Assume the annual inflationrate is 5%, an income tax rate of 25%, and straight-line depreciation. The minimum attractive rate ofreturn (MARR) is 7%. Use rate of return analysis todetermine which alternative is preferable.YearAB0$420$300200 1502 200 1503 200 150

The purchase of a large-volume copier is being con-sidered. Use MACRS and the current tax law. Thecorporations taxableincomeexceeds$20M.Thefirstcost is $18,000. Maintenance cost per year is $1300in Year-1 dollars. The salvage value after 10 yearsis $2000 in Year-10 dollars. Assume the real MARRis 8%, and the inflation rate is 5%. Find the equiva-lent annualcost after taxes. Does inflation increase ordecrease the annual cost?

Ruralville is suffering a 1% annual loss of popula-tion and property values. Even so, Ruralville mustmaintain its tax collections at a constant value of $3.2million. If the inflation rate is 4.5%, what inflationrate in taxes for the remaining taxpayers is requiredfor Ruralville to attain its goal? (Note: AlthoughRuralville uses a rate of 6% for discountingpurposes,that rate is irrelevant to this problem.)