When using an index to inflate a cash flow, which formula is applied?

When inflating a cash flow using an index, the correct approach is to adjust the cash flow amount based on the change in the index over time, which reflects inflation or changes in purchasing power. The formula applied is to take the cash flow from the earlier period and multiply it by the index in the later period, then divide by the index in the earlier period.

This method ensures that the cash flow is effectively converted to its equivalent value in the later period, taking into account how much the index has changed. The rationale is that the index essentially serves as a measure of inflation; by using it in the formula, you are appropriately escalating the cash flow to maintain its real value against inflation measures.

For instance, if you had a cash flow of £100 in year one and the index was 100, but it rose to 150 by year two, applying the formula would give you a cash flow adjusted for inflation that reflects what that original amount would be worth in the context of the later period’s index. This allows for an accurate comparison of monetary values over time, ensuring financial analyses are relevant and reflective of current economic conditions.