1 EATON HAUGHTON P.E. email: [email protected] Web site: EATON HAUGHTON P.E. CARIBBEAN ESCO...

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1 EATON HAUGHTON P.E. CARIBBEAN ESCO LTD. ST. ANN’S BAY, JAMAICA TEL/FAX: (876) 974-5064 email: [email protected] Web site: www.caribbeanesco.com FINANCIAL EVALUATION PROCEDURES January 26, 2011

Transcript of 1 EATON HAUGHTON P.E. email: [email protected] Web site: EATON HAUGHTON P.E. CARIBBEAN ESCO...

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EATON HAUGHTON P.E.CARIBBEAN ESCO LTD.ST. ANN’S BAY, JAMAICATEL/FAX: (876) 974-5064email: [email protected] site: www.caribbeanesco.com

FINANCIAL EVALUATION PROCEDURES

January 26, 2011

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INTRODUCTION

Energy conservation opportunities (ECO’s) which generate benefits greater

than costs without sacrificing product quality are generally profitable and

therefore attractive.

Those which require little more than operational changes that can be made

at negligible cost clearly fall into this category.

Many ECO’s, however, require an initial capital outlay which must be

amortized by the energy savings generated over their expected lifetime.

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INTRODUCTION

Many ECO’s which might have been unprofitable or merely marginal

investments before the price of fuels and electricity began their rapid increase

are now economically justifiable.

The purpose of this session is to review some of the basic tools of financial

analysis which may be useful in the economic evaluation of such ECO’s.

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INTRODUCTION

Sound, consistent economic criteria for evaluating energy conservation

opportunities are quite important.

Before any investment is undertaken some quantitative measure of

profitability is desirable so that the investment’s expected return can be

compared with that for alternate investment opportunities.

Because true economic cost includes opportunity costs of foregone

investments, ECO’s should be considered to be profitable only when their

expected rate of return is greater than that which could be realized from

alternative investment opportunities, whether in energy conservation or

elsewhere.

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INTRODUCTION

In reality, investment decisions are generally based on more than simple rates

of return.

Factors such as risk, cash flow, taxation schedules, preference between long-

and short-term investments, and others should be considered as well but will

not be considered directly here since these factors may vary greatly among

companies.

The outcome of any economic evaluation may be considerably affected by

them, however, so they should not be overlooked in actual applications but

used in conjunction with the measurement criteria presented here.

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FIRST LEVEL MEASURES OF PERFORMANCE

While many energy conservation opportunities may be found during a close

examination of plant and operations, some can be quickly rejected because

of a low or negative return on investment.

First level measures of performance can be useful in screening out such

ECO’s without the application of more sensitive second-level measures.

In general, however, first-level measurements should not be used for

justifying major investments for energy conservation projects since these

measures do not reflect the time value of money.*

Because first level measurements, such as “payback period” and “return on

investment”, are often referenced and useful for screening candidate

investments, it is desirable to show how they are computed and why they are

not complete.

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FIRST LEVEL MEASURES OF PERFORMANCE

The information needed to calculate these performance measures is as follows:

—First Cost, FC

—Annual Operating Cost (if any due to investment), AOC

—Annual Fuel Savings, AFS

—Projected Fuel Price, PFP

—Estimated Lifetime, EL

Projected fuel price represents an average fuel price during the estimated lifetime

of the investment. The use of current fuel prices will result in lower total savings

than can be reasonably expected, inducing a bias against energy conservation

investments.

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FIRST LEVEL MEASURES OF PERFORMANCE

At this point, the net annual saving is defined for application in

forthcoming equations and discussion:

Net Annual Savings, S = (AFS X PFP)—AOC

Defined as the first cost divided by the net annual savings, or

PP = . FC or FC

(AFS x PFP) — AOC S

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Payback Period (PP)

The payback period is then compared to the expected lifetime of the investment in

order to make some rough judgment as to its potential for re-coupment. A payback

period of less than one-half the lifetime of an investment would generally be

considered profitable where the lifetime is ten years or less.

The payback period as a measure of performance gives rise to problems,

however. For instance, dollars saved in future years are credited the same as

dollars saved in current years and comparisons between alternative

investment opportunities of different lifetimes cannot be made.

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Return on Investment (ROl)

Is somewhat superior to the above because it takes into account the

depletion of the investment over its economic life by providing for

renewal through a depreciation charge.

Using a straight line depreciation charge (DC) where

DC = FC ELthe percent return on investment can be calculated using:

ROl, %/yr = S – DC x 100%

FC

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Return on Investment (ROl)

ROl has the advantage of putting investments with different life expectancies on a comparable basis.

It is frequently used in the financial analysis of potential investments because of its simplicity of

calculation.

Where the rate of return appears small, however (say less than 20%), second level measurements are called for.

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SECOND LEVEL MEASURES OF PERFORMANCE

Second level measures of performance are those which incorporate an

allowance for the time value of money, generally in the form of a discount

factor.

Because of alternative investment opportunities, a dollar held today is worth

more than a dollar held in some future time period.

The internal rate of return on the best available investment alternative is

generally considered to be the appropriate discount rate for evaluating new

investment opportunities, unless this rate is below the true borrowing rate

when a new investment needs to be financed.

In this case, the discount rate must be at least as high as the borrowing rate.

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SECOND LEVEL MEASURES OF PERFORMANCE

While appropriate discount rates may differ widely in different industries

and even among firms within the same industry, corporate discount rates

usually run between 10 to 20% or higher.

This, again, is equivalent to saying that such a return can be realized

elsewhere and thus for a new investment to be justified it must yield a

return somewhat greater than this.

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SECOND LEVEL MEASURES OF PERFORMANCE

It should be noted that profits generated by energy savings are generally

taxed at the same rate as profits earned elsewhere within or outside of

the firm, affirming the need for an equivalent discount rate for energy

saving projects.

Several second-level measurements for evaluating ECO’s are available. The

following three will be presented and discussed:

1) Benefit/cost analysis

2) Time to recoup capital investment

3) Internal rate of return

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Benefit/cost analysis

Requires the direct comparison of the present value benefits (savings)

generated by a given investment with its costs. Generally this is

formulated in terms of a benefit/cost ratio (B/C).

A ratio greater than unity implies that the expected net benefits (properly

discounted and summed over the lifetime of the investment) will exceed

the initial costs and therefore such an investment is profitable.

Likewise, a benefit/cost ratio less than unity implies that such an

investment is not profitable. As an absolute measure of the profitability of

an investment this is generally considered superior to all others.

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Benefit/cost analysis

The stream of benefits, or net savings (S), when constant in each time period,

can be expressed in terms of present value (PV) by using a discount rate (D)

and summing the benefits over the expected lifetime (EL) of the project.

The present value can be easily estimated using the present worth factors

(PWF) in Table 1. By finding the appropriate factor (PWF) for the discount

rate (D) and expected lifetime (EL) of the investment and multiplying the

factor (PWF) by the net annual savings (S), the present value (PV) of the

future savings can be determined.

If this present value is greater than the first cost of the investment, the

project is profitable.

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Time to Recoup Capital Investment

Time to recoup capital investment, or the “breakeven” period, is similar in

concept to the pay- back period (PP) discussed earlier, except that the

breakeven period takes discount rates into consideration.

The chief disadvantage of such a measurement is that investments of

unequal lifetimes cannot be compared. However, this measurement of

performance is often useful to financial planners and budget analysts.

The breakeven period (BP) can be quickly approximated using Table 1.

Locate in the column for the appropriate discount rate (D) the present worth

factor (PWF) on either side of the payback period (PP) calculated as shown

previously.

The break even period (BP) will be between these two years; interpolation

will allow a closer approximation.

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The Internal Rate of Return (IRR)

Defined as that discount rate, (D), which reduces the stream of net returns

associated with the investment to a present value of zero.

While in general the IRR is not always a good measurement of economic

performance,

IRR will give good results when evaluating a project which has a fixed first

cost followed by a stream of positive net benefits.

Unfortunately, the calculation of IRR is not a straightforward exercise but

requires an iterative approach converging on the solution.

Many computerized financial analysis programs can estimate this quite easily.

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While the IRR does not require that a discount rate be used in its determination (we are solving for the discount rate), it will be explicitly compared to the appropriate discount rate for the firm in justifying the investment.

IRR, like the benefit/cost ratio, is useful when comparing the expected rates of return for alternative investments.

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Example of Calculation

Management is considering a capital investment in its manufacturing

process for energy conservation purposes which will cost $100,000 to

design and install but will involve no new recurring costs.

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Example of Calculation

This project is expected to save an average of 27,500 MBtu of natural gas per

year for the next 10 years. The projected average cost of this fuel during the

time period is assumed to be $1.00 per MBtu.Assuming that management feels that a 20% discount rate is appropriate, will this be a profitable investment?

First Cost (FC) = $100,000Annual Fuel Savings = 27,500 MBtu/yrProjected Fuel Price = $1.00/Mbtu

Net Annual Savings (S) = (AFS X PFP) - AOC = 27,500 MBtu/yr X1.00 $/MBtu - 0 = $27,500 per yr

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First Level Measures of Performance

A. Payback period (no discounting) PP = FC = $100,000 = 3.6yr S $27,500/yr

B. Return on Investment DC = FC = $100,000 = $10,000 per yr EL 10yr

ROI, % = S – DC x 100% = yr FC

( $27,500.00 $/yr - $10,000 $/yr ) x 100%

= 17.5% per yr

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Using return on investment (ROT) as an approximation of the profitability of

this project, we see that even after an allowance for depreciation this

appears to be an attractive investment.

Second level measurements of performance are needed, however, if we

wish to incorporate the time value of money into the analysis.

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Second Level Measures of Performance

A. Benefit/Cost Analysis

In order to formulate a benefit/cost ratio we must find the present value of

the future savings.

Using the present worth factor (PWF) from Table 1 for 20% discount rate

(D) and 10 year lifetime (EL) we find that the present value (PV) of the net

annual savings (S) is

PV = S x PWF = $27.500 x 4.192 = $115,280

This will result in a benefit/cost ratio (B/C) equal to :

B/C = PV = $ 115,280 or 1.15 FC $100,000

Now it becomes apparent that this is a profitable investment even when the time value of money is considered.

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B. Time to Recoup investment can be quickly approximated by using Table 1

and the pay- back period (PP) estimated earlier as 3.6 years.

In the 20% discount rate column one can find that the present worth factor

closest to 3.6 is 3.605 which indicates that the investment will be entirely

recouped in about 7 years when taking the time value of money into

consideration.

While this is considerably longer than the payback period without discounting,

it provides a much better indication of the profitability of this investment

because it includes the cost of foregone investment opportunities.

If the proper discount rate has been used any investment which is recouped in

a period less than its lifetime should be considered profitable.

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I Hope I have Been Able To Shed Some Light on the Subject.

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THE BALL IS NOW IN YOUR COURT