Inflation is simply the increase in prices over time. It has a long-term effect on any business and a huge effect on cash flows. But particularly in a project which can typically last for 20 or more years, if increases in costs due to inflation can't be recovered in your revenue, it will destroy the business. So it's important, especially for a long-term model like we're doing for a renewables project, it's very important that inflation gets modeled accurately. The rate of inflation is simply a modeled assumption. So like every other assumption, we put it in the assumptions area of our model in a separate cell in such a way that it can be easily changed. It is just simply an input. We could attach some timings to when it starts to take effect, and we'd need to think about what happens if we have different rates of inflation for different things. The easiest way to model inflation is to think of it as a cumulative compounding thing. So if we have 10% inflation, that doesn't mean prices go from say, a hundred a year to 110, then 120, 130, and 140. No, they compound on each other and grow. So it goes 100, 110, and then 10% more of that, which makes it 121, and then 10% more than 121, which makes it 133 and so on. The easiest way to model this is to use an index, and the formula that you need is brackets 1 plus a rate close backets to the power of which is the little cap type symbol above the 6 on your keyboard to the power of the number of periods that have gone by. The rate comes from the assumptions, and you make that a fixed reference. So you put the dollar signs on it to the power of the number of periods, number of periods usually runs across the top of your model.
It could be that your cost estimates are fixed for a certain period of time, and inflation will then only start after the end of that period of time. In that case, all we need to do is set up a flag, a normal if statement, the sort we've used before. So if the year that you are in is bigger than or equal to the date that inflation starts, that will be an assumption, then give me 1. And if it's not bigger than or equal to that date, give me a 0. So it's a typical 1 0 binary flag.
There's no fundamental reason why everything goes up at exactly the same percentage each year. Revenue might rise at a different rates, costs, or different sorts of costs might be going up at different rates. If those differences are significant, and remember, they are only assumptions, their best guesses. But if you think the differences between the rates are significant enough, all we do is create two different inputs in the assumptions and two different inflation indexes. So maybe we would build one running at 5% a year for revenue and the other running at say, 10% a year for costs. That's a significant difference. It has a big effect on the cash flows. So it's worth modeling two separate numbers. You could have two different costs. One for example, going up 5% a year and the other going up 20% a year. If those costs are significant, and that difference between them is significant enough, build two separate indexes. Ones that you will multiply by the one for 5%. You multiply by the cost base that is going up at 5% a year, and the other you use to multiply the costs that you want to see going up by 20% a year. So it's just two different indexes for two different rates.
