In my experience the larger resource companies have no problems in modelling real inputs, using nominal outputs as appropriate in these models (tax calcs, depreciation, working capital etc), converting the final cashflow stream to a real basis to compute a real NPV.

The main problem area is the understanding and use of the term “escalation”. If people are using “escalation” and “inflation” interchangeably then hopefully they aren’t either driving, or providing, information for the financial model. As long as the base estimate is built up clearly, showing the step wise application of any real escalation, cpi or other macroeconomic indices, contractural agreed indices etc then there should be no issue.

MY definition of the distinctions are:

Constant Money Terms- Models where no escalation has been applied; with the resultant inaccuracies in Tax and Working Capital calculations.

Nominal Terms (Escalated Terms/Money of the Day Terms/Inflated Money Terms)- Appropriate escalation factors for revenue and cost streams have been applied from appropriate base estimation dates.

Real Money Terms- De-escalated Nominal cashflows.

In addition, further confusion/errors arise when the timing of discounting for NPV purposes is included; the Real cash flow is often de-escalated to a different base time period than the base discount period. (Note the different and often confused terms de-escalation and discounting). So one could have cash-flows de-escalated to mid-year, and discounted at year end. This is inevitably not explicitly stated.

When I was in my financial modeling school of hard knocks (Gold Fields Mining and Development in the mid 90’s), we had to report NPV’s in the long winded-

“NPV at a discount rate of X%, as at DateY, in Real DateZ money terms”.

For marginal projects (which most mining projects end up being!!) getting this right (and understood by decision makers) can be life or death for multi billion dollar investments.

One pretty neat approach to monitoring the effective escalation of key cashflow lines is to include a Compound Average Growth Rate (“CAGR”). Even though CAGR doesn’t guarantee that escalation has been implemented correctly, at least it could be used to indicate divergence from expected outcomes.

This is particularly efficient if the CAGR for the main cashflow lines are included in a key output Data Table generated with a Scenario Manager so that an independent reviewer can analyse the correlation to CPI.

Here is a video of CAGR: http://www.auditexcel.co.za/CAGR%20Project.html Not sure how useful it it but I hope it explains financial modelling of CAGR or at least give a good introduction.

“The concepts of ‘real’ and ‘nominal’ is often not fully understood – I have actually come across people reversing the definitions of the two.”

This is a good point, to be clear for other readers, “Nominal” means it has been escalated using some kind of macroeconomic index, real means it hasn’t – in a nutshell.

I think my suggestion of building in escalation mechanics but having assumptions as zero is less complex than building in a Real versus Nominal switch but I can see problems with this too, especially for interest rates.

One way of reducing the overall risk associated with this concept is to insist that on each line item, as well as a title and a unit (GBP M, say) that there is also a field for “Real” or “Nominal”, this at least makes the builder, reader, think about it more often.

Although we (Navigator) operate all over the world, I would say the two most public errors I have heard about / witnessed have both in the Asia Pacific region and relate to a double or no escalation of a contract price. Ouch.

So what’s our conclusion? I think it is understand the terms ‘real’ and ‘nominal’, make sure each line item is clearly labelled all the way through to a metric that uses it. So for an NPV (for example) one should state clearly.

1. Units
2. Pre / Post Tax
3. Geared / ungeared
4. Discount rate
5. Reference date
5. Were real or nominal cashflows used to derive it.

That’s a lot of things to go wrong along the way!

Would you be able to flesh out my simplistic Real / Nominal definition?

The words also don’t translate well into other languages potentially causing confusion with people who do not speak English as their first language.

Perhaps to mitigate the issues mentioned in the article, Authorities in the UK (and probably other countries too) who are at the receiving end of bids from potential contractors, often require financial models to produce certain results in both real and nominal terms or to have a switch to easily show the model results in one or the other.

In the case of PFI/PPP-type contracts, the transfer (or not) of risk to the private contractor is a fundamental concept and one of the risk areas is inflation. It is therefore very important that financial models properly model inflation so that the risks and financial implications of changes to inflation assumptions can be understood and taken into account in the bid pricing.

This certainly adds more complexity to a financial model and therefore increases the risk of errors. In fact, in the only case I have heard of where a model auditor was successfully sued for not spotting an error in a model, the error had to do with the inflation calculations.