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Use these data to calculate a chain index from 1991 to 2003, setting 1991 = 100.

Discounting and Deflating makes expenditures in different years comparable by correcting for present values the effect of inflation. The future sum is deflated (reduced) because of the increase in the general price level. Discounting is a similar procedure for comparing amounts across different years, correcting for time preference. For example, suppose that by investing £1000 today a firm can receive £1100 in a year's time. To decide if the investment is worthwhile, the two amounts need to be compared.

If the prevailing interest rate is 12%, then the firm could simply place its £1000 in the bank and earn £120 interest, giving it £1120 at the end of the year. Hence the firm should not invest in this particular project; it does better keeping money in the bank. The investment is not undertaken because

where r is the interest rate, 12%. Alternatively, this inequality may be expressed as

The expression on the right-hand side of the inequality sign is the present value (PV) of £1100 received in one year's time. Here, r is the rate of discount

Table 10.20 The cash flows from an investment project

Year

Outlay or income

Discount factor

Discounted income

0 0

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