EME 460
Geo-Resources Evaluation and Investment Analysis

Inflation and Escalation in Economics

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Inflation

Inflation is an economic term that indicates the increase in price of goods and services over time and can be more precisely defined as “a persistent rise in the prices associated with a basket of goods and services that is not offset by increased productivity.” Inflation causes purchasing power to reduce (more information can be found at Inflation (Investopedia) and at Inflation (Wikipedia). Inflation affects almost everything in the financial market and it is measured and reported by various indexes. The most common index for determining the inflation rate is called the Consumer Price Index or CPI. You can read more about the CPI at the Wikipedia page for Consumer Price Index. Monthly CPI reports are published at the U.S. Bureau of Labor Statistics website.

Escalation

"Escalation refers to a persistent rise in the price of specific commodities, goods, or services due to a combination of inflation, supply/demand, and other effects such as environmental and engineering changes." Factors that affect the escalation include:

  • Inflation
  • Supply/demand
  • Technological Changes
  • Environmental Effects
  • Political Effects
  • Miscellaneous Effects

As defined above, inflation refers to the increased price of a basket of goods and services, while escalation refers to an increase in price of a specified good or service. Inflation is one of the factors that cause escalation. The Alaskan pipeline is a good example that can help with understanding the difference between inflation and escalation. This pipeline was estimated to cost about 900 million dollars in 1969, while the final estimate in 1977 came to about 8 billion dollars for the project, which is around 900% higher than the initial estimation. You should note that just a portion of this increase was due to the inflation rate and that other factors such as supply/demand effects on labor and materials, and environmental and technology changes also contributed to the substantial increase in costs.

There are two techniques used to take into account the effect of inflation and escalation in economic analysis. Both methods should lead into the same results:

1. Escalated dollar analysis

"Escalated dollar values refer to actual dollars of revenue or cost that will be realized or incurred at a specific future point in time."

2. Constant dollar analysis

"Constant dollar values refer to hypothetical constant purchasing power dollars obtained by discounting escalated dollar values at the inflation rate to some arbitrary point in time, which often is the time that corresponds to the beginning of a project. Constant dollars are referred to as real dollars or deflated dollars in many places in the literature."

Escalated dollar analysis considers different purchasing power for different points in time, while constant dollar analysis aims to set a same base and a constant purchasing power for all points in time. Constant dollar analysis requires more calculation and the chance of making mistakes increases, while escalated dollar analysis has more reliable results. Escalated dollar and constant dollar analysis are two different methods and their results shouldn’t be compared. A common mistake in applying the results of constant dollar analysis is to compare the calculated constant dollar ROR with other escalated dollars investment opportunities such as bank interest rate and so on. Therefore, constant dollar ROR for alternative investment opportunities (constant dollar minimum rate of return) should be the base for comparing and evaluating constant dollar analysis for an investment project.

Usually reported cost, revenue, and incomes occurring in different points of time are reported at today’s dollar. Escalated dollar approach applies an assumed escalation rate to predict and increase the sums over time. To do so, similar to compounding technique, a single payment compound amount factor (F/Pi,n) has to be multiplied by the amount, and escalation rate has to be substituted for i.

For example, consider an investment with the following cashflow:

C0=$10,000 C1=$10,000 I2=$15,000 I3=$15,000

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C: Capital Cost, I: Income

Assuming an escalation rate of 12%, escalated dollar cashflow is:

C0=$10,000 C1=$10,000*(F/P12%,1)
=$11,200
I2=$15,000*(F/P12%,2)
=$18,816
I3=$15,000*(F/P12%,3)
=$21,074

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Please watch the following video (6:25) Inflation, escalation, and escalated dollar analysis.

Inflation, escalation, and escalated dollar analysis
Click for the transcript of " Inflation, escalation, and escalated dollar analysis" video.

PRESENTER: In this video, I will explain how to consider inflation and escalation in the economic evaluation of investing project. Inflation is the economic term that indicates the average increase in price over the time. It is usually calculated for a basket of goods or services.

The most common index for determining the inflation rate is called CPI, or Consumer Price Index, and it is published by US Bureau of Labor Statistics. For example, the percentage change in CPI in a year compared to previous year indicates the inflation rate for that year.

Inflation causes purchasing power to reduce. For example, if you had $100 last year and the inflation rate is 5%, it means you won't be able to buy the same thing that you could buy last year. You can buy less.

Escalation is also referred to the price increase, but it is defined for only one good or service. Inflation is reported for basket of goods or service, and it is kind of a general average for the entire economy. But escalation is only for one good or service. So if price of a good or service increases, it can be because of inflation, supply and demand change, technological change, environmental effects, or political effects.

Two techniques are used to take into account the effect of inflation and escalation in economic analysis. Both of them should give you the same result. These two are called escalated dollar and constant dollar.

In escalated dollar analysis, you let your values, payments, income, costs, to be increased according to an escalation rate. In the constant dollar analysis, you will remove the effect of inflation from the increase value, from the escalated cash flow, meaning that you want to consider a hypothetical constant purchasing power.

One thing that you should keep in mind is you can do the constant dollar analysis only when you consider the escalation, only after escalated dollar analysis is done. Escalated and constant dollar analysis are two different methods, and the result shouldn't be compared.

Usually the reported cost, revenue and incomes are happening at different time, and they're reported at today's dollar. Escalated dollar analysis lets you apply the escalation rates to these payments. You assume an escalation rate, and you will predict the increase of each payment over the time.

In order to calculate the escalated dollar cash flow, you will compound each year's payment by the escalation rate, and you will have the escalation cash flow. If you do that for every single year for all the payments, you will have escalated cash flow in the end.

So let's work on this example. Assume this cash flow. We are going to have the investments of $10,000 at the present time and in year 1, and we are going to have the income of $15,000 at year 2 and year 3.

So let's calculate the escalated cash flow, the escalated dollar cash flow, for this investment, considering the escalation rate of 12%. As I explained in previous slides, in order to calculate the escalated dollar cash flow, we need to compound each payment by the escalation rate of 12%. So we need to multiply each year's cash flow by the factor F over P and the escalation rate.

So as you can see here, the present time payment is not going to be affected by the escalation. The first payment, which was at year 1, is going to be multiplied by the factor F over P, 12% of escalation rate, and 1 year of compounding. And the same for the other payments. So the $15,000 of income in the year 2 is going to be compounded for 2 years and 12% of escalation rate, and last year, year 3, it has to be compounded for 3 years by 12% of escalation rate.

And we calculate the result for each year. So the result is going to show us the escalated dollar cash flow considering the escalation rate of 12% for the original cash flow.

In order to calculate escalated dollar cash flow, we need to consider an escalation rate. Many, many investors use the anticipated inflation rate as the escalation rate to calculate the escalated dollar cash flow. But there are commodities, such as construction equipment, steel, concrete, labor, and energy, that may not follow this approximation. We can also have the negative escalation rate in case we are going to anticipate any decrease in costs, revenue, or income.

Credit: Farid Tayari

Escalation rate includes the inflation rate, and constant dollar approach applies a constant purchasing power by removing the effect of inflation rate from escalated dollars. Inflation effect can be removed, similar to discounting technique, by multiplying the single payment present worth factor (P/Fi,n) by escalated dollars and applying inflation rate as i. Many investors choose to utilize the anticipated inflation over future years as an approximation for escalation. Commodity prices, the price for construction equipment, steel, concrete, labor, and energy, may not move in direct correlation with the rate of inflation. Note that negative escalation rate can also be applied, if decrease in costs, revenue, or income is anticipated.

For example, considering inflation rate of 6% for above escalated dollar cashflow, constant dollar cashflow can be calculated as:

C0=$10,000 C1=$11,200*(P/F6%,1)
=$10,566.04
I2=$18,816*(P/F6%,2)
=$16,746.17
I3=$21,074*(P/F6%,3)
=$17,694.07

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Please watch the following video (4:11): Constant dollar analysis.

Constant dollar analysis
Click for the transcript of "Constant dollar analysis" video.

PRESENTER: In this video, I'm going to explain how to apply the constant dollar analysis on an escalated cash flow for a project evaluation. As I explained in previous video, inflation is an indication that shows the increase in the price of a basket of goods or services over the time. But escalation is an indication of a price increase for one good or service.

I explain that we can calculate the escalated cash flow, escalated dollar cash flow, by the compounding payment at each year by the escalation rate. In the constant dollar technique, we will try to remove the effect of inflation in considering constant purchasing power. Because the escalation rate includes inflation, and we want to remove this effect and consider the hypothetical constant purchasing power. We can remove the effect of inflation from the escalated dollar cash flow by discounting payment at each year, considering that the inflation rate.

Let me explain how to calculate the constant dollar cash flow in an example. So in previous example in a previous video, we apply the escalation rate of 12% for the given cash flow that we had. So in order to calculate the escalated dollar cash flow, we compound each year's payment, each payment, by 12% escalation rate, and we calculated the escalated dollar cash flow, which is the escalated dollar cash flow, as you can see here.

So now we want to remove the effect of inflation rates and calculate the constant dollar cash flow. Please note that constant dollar cash flow can be calculated only after you already calculated the escalated dollar cash flow. You already consider it an escalation for your payments. Now, you want to remove the effect of inflation, and you want to consider the constant purchasing power and calculate, which means calculating constant dollar cash flow.

So in order to calculate the constant dollar cash flow, we need to discount each year payment, each year cash flow, by the inflation rate. So present time payment is not going to be affected by any inflation or escalation. Escalated payments at year one, $11,200. So we want to calculate the constant dollar for this payment. We multiply it by-- we discount it by one year, and 6%, and so on for the other payments.

Year three, we discounted for three discounting period and 6% of inflation rate. And the result. So the escalated dollar of $11,200 in the year 1 equals the constant dollar of $10,566. It means considering the inflation rate, the escalated dollar of $11,200 in the year one has the same purchasing power as $10,566 at the present time.

Credit: Farid Tayari

Last but not least, gold has been considered a good hedge against the long-term impact of inflation. Back in 1990, the gold price was $420 per ounce. In the mid 2000s, the price had fallen to $270 per ounce. That means an annual price decline of 4.1% per year over 10 years. During the same period, US inflation (as measured by CPI) averaged approximately 3% per year. If gold price would have increased in value at the rate of inflation, the value in 2000 would have been:

420*( F/ P 3%,10 )=420*1.3439=$564/ounce

Instead, the actual price dropped to $275 per ounce and the corresponding constant dollar equivalent price of gold dropped to

275*( P/ F 3%,10 )=275*0.7441=$205/ounce

In 2008, the gold trading price was $925 per ounce, an investment in an ounce of gold in 1990 would have produced an average annual rate of return of

0=420+925*( P/ F i,18 ) i=ROR=4.48%

After adjusting for an assumed 3% per year inflation, the real return on your investment would be closer to 1.4% per year. The calculations related to this type of constant dollar measure of economic performance will be developed in the Example 5-1 on the next page.

Practice Example:

Currently (May 2020) gold is trading at around $1,700 per ounce. How much would be the average annual rate of return of an investment in one ounce of gold in 1990? How much would be the rate of return, adjusted for inflation, assuming 3% per year of inflation in average?

Click for answer...

Answer: 4.77% and 1.7% (approx.)


Italicized sections are from Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14th edition. Lakewood, Colorado: Investment Evaluations Co.