Page 374 - Hydrocarbon Exploration and Production Second Edition

Petroleum Economics 361

gather data in
BASE YEAR COST B.Y.C.
today's money

accounts for
X ESCALATOR inflation and
market forces

MONEY used to
OF THE DAY M.O.D calculate
cashflow

correct for loss
÷ MOD DEFLATOR of purchasing
power

REAL TERMS compare
R.T.
MONEY projects

calculate
DISCOUNT profitability
indicators

PRESENT rank projects
VALUE P.V.

Figure 14.14 Handling in£ation ^ types of money.

the MOD back to RT, while the discounting is done to reflect the cost of capital of
the project, correcting future net cashflows to the PV.
The process can be captured in the above diagram (Figure 14.14).
RT refers to the purchasing power of money. Suppose $100 today would buy
100 loaves of bread at $1/loaf. If inflation increased the cost of a loaf to $1.10 in a
year’s time, then the same $100 in a year’s time would only be able to buy 100/1.1
(i.e. 91) loaves of bread. The RT value of the MOD $100 in 1 year’s time is only
$91. Anyone whose income rises slower than inflation will be aware of the loss of
the RT value of their income.
For completeness, when we calculate the project IRR, this is usually performed
by working out what discount rate makes the MOD net cashflow equal to zero, as
discussed in Section 14.3. The real rate of return (RRoR), as used by some
commercial analysts, is the discount rate which sets the RT net cashflow equal to
zero. At low inflation rates, the RRoR is lower than the IRR by approximately the
rate of inflation.