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Killer Errors – Indexation

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November 2022  |  Model Audit

To help in our mission to save our friends and colleagues from the horrors of modelling errors, we plan to share a series of the most common errors we uncover in our role as model auditors.

We hope this helps you dodge a bullet sometime soon.

No 1. Indexation

Some of the biggest errors we come across, especially in Project Finance and infrastructure deals, are due to the incorrect application of indexation assumptions.

Within Project Finance models, revenues and costs tend to be indexed to take into account the impact of inflation over the life of the project.

The problem with indexation errors is that they compound and get much, much worse over time. Over 30 years (the ball-park in which a typical infrastructure project often sits), indexation at 2.5% (remember those days?) will pretty much double any costs from the beginning of the project. Obviously, missing inflation from a cost can cause you a big problem.

Although it sounds like a schoolboy error, making this kind of mistake is actually easier than it sounds.

Typically not all costs and not all revenues will be subject to indexation over the life of the project, and some may be indexed at different rates to others. Most template models will include arrays of flags and switches to choose between, and it can be all too easy to leave the wrong switch unchecked.

To make matters worse, some investors are interested in real returns (excluding inflation) and others in nominal returns (including inflation). Again, it can be all too easy to confuse the two and wind up with a very big misunderstanding.

When you are reviewing your model (or someone else’s), double- and triple-checking that all indexation assumptions are correctly applied should be one of your top priorities.

If you need an expert error killing machine to audit your models then we should talk.

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Danny Leitch

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