250 Energy Project Financing: Resources and Strategies for Success
A.9.4 Economic Analysis Under Inflation
Inflation is characterized by a decrease in the purchasing power of
money that is caused by an increase in general price levels of goods and
services without an accompanying increase in value. Inflationary pres-
sure is created when more dollars are put into an economy with no ac-
companying increase in goods and services. In other words, printing
more money without an increase in economic output generates inflation.
A complete treatment of inflation is beyond the scope of this appendix. A
good summary can be found in Sullivan and Bontadelli [1980].
When consideration of inflation is introduced into economic analysis,
future cash flows can be stated in terms of either constant-worth dollars
or then-current dollars. Then-current cash flows are expressed in terms
of the face amount of dollars (actual number of dollars) that will change
hands when the cash flow occurs. Alternatively, constant-worth cash
flows are expressed in terms of the purchasing power of dollars relative
to a fixed point in time known as the base period.Example 27
For the next 4 years, a family anticipates buying $1000 worth of gro-
ceries each year. If inflation is expected to be 3%/yr, what are the then-
current cash flows required to purchase the groceries?To buy the groceries, the family will need to take the following face
amount of dollars to the store. We will somewhat artificially assume
that the family only shops once per year, buys the same set of items
each year, and that the first trip to the store will be one year from
today.Year 1: dollars required $1000.00*(1.03) = $1030.00
Year 2: dollars required $1030.00*(1.03) = $1060.90
Year 3: dollars required $1060.90*(1.03) = $1092.73
Year 4: dollars required $1092.73*(1.03) = $1125.51What are the constant-worth cash flows, if today’s dollars are used as
the base year?The constant worth dollars are inflation free dollars; therefore, the
$1000 of groceries costs $1000 each year.