In this chapter, investment analysis tools relevant to energy management projects will be discussed.
Simple Pay Back Period:
Simple Payback Period (SPP) represents, as a first approximation; the time (number of years) required to recover the initial investment (First Cost), considering only the Net Annual Saving:
The simple payback period is usually calculated as follows:
Simple Payback Period = First cost/Yearly Benefits – Yearly Costs
Examples
Simple payback period for a continuous Deodorizer that costs Rs.60 lakhs to purchase and install, Rs.1.5 lakhs per year on an average to operate and maintain and is expected to save Rs. 20 lakhs by reducing steam consumption (as compared to batch deodorizers), may be calculated as follows:
Simple Payback Period = 60/20-1.5= 3years 3 months
According to the payback criterion, the shorter the payback period, the more desirable the project.
Advantages
A widely used investment criterion, the payback period seems to offer the following advantages:
• It is simple, both in concept and application. Obviously a shorter payback generally indicates a more attractive investment. It does not use tedious calculations.
• It favours projects, which generate substantial cash inflows in earlier years, and discriminates against projects, which bring substantial cash inflows in later years but not in earlier years.
Limitations
• It fails to consider the time value of money. Cash inflows, in the payback calculation, are simply added without suitable discounting. This violates the most basic principle of financial analysis, which stipulates that cash flows occurring at different points of time can be added or subtracted only after suitable compounding/discounting.
• It ignores cash flows beyond the payback period. This leads to discrimination against projects that generate substantial cash inflows in later years.
To illustrate, consider the cash flows of two projects, A and B:
The payback criterion prefers A, which has a payback period of 3 years, in comparison to B, which has a payback period of 4 years, even though B has very substantial cash inflows in years 5 and 6.
• It is a measure of a project’s capital recovery, not profitability.
• Despite its limitations, the simple payback period has advantages in that it may be useful for evaluating an investment.
Time Value of Money
A project usually entails an investment for the initial cost of installation, called the capital cost, and a series of annual costs and/or cost savings (i.e. operating, energy, maintenance, etc.) throughout the life of the project. To assess project feasibility, all these present and future cash flows must be equated to a common basis. The problem with equating cash flows which occur at different times is that the value of money changes with time. The method by which these various cash flows are related is called discounting, or the present value concept.
For example, if money can be deposited in the bank at 10% interest, then a Rs.100 deposit will be worth Rs.110 in one year’s time. Thus the Rs.110 in one year is a future value equivalent to the Rs.100 present value. In the same manner, Rs.100 received one year from now is only worth Rs.90.91 in today’s money (i.e. Rs.90.91 plus 10% interest equals Rs.100). Thus Rs.90.91 represents the present value of Rs.100 cash flow occurring one year in the future. If the interest rate were something different than 10%, then the equivalent present value would also change. The relationship between present and future value is determined as follows:
Future Value (FV) = NPV (1 + i)n or NPV = FV / (1+i)n
Where
FV = Future value of the cash flow
NPV= Net Present Value of the cash flow
i = Interest or discount rate
n = Number of years in the future
Return on Investment (ROI)
ROI expresses the “annual return” from the project as a percentage of capital cost. The annual return takes into account the cash flows over the project life and the discount rate by converting the total present value of ongoing cash flows to an equivalent annual amount over the life of the project, which can then be compared to the capital cost. ROI does not require similar project life or capital cost for comparison.
This is a broad indicator of the annual return expected from initial capital investment, expressed as a percentage:
ROI= Annual Net Cash Flow/Capital Cost X 100
ROI must always be higher than cost of money (interest rate); the greater the return on investment better is the investment.
Limitations
- It does not take into account the time value of money.
- It does not account for the variable nature of annual net cash inflows.
Net Present Value
The net present value (NPV) of a project is equal to the sum of the present values of all the cash flows associated with it. Symbolically,
Where NPV = Net Present Value
CFt = Cash flow occurring at the end of year ‘t’ (t=0,1,….n)
n = life of the project
κ = Discount rate
The discount rate (κ) employed for evaluating the present value of the expected future cash flows should reflect the risk of the project.
Example
To illustrate the calculation of net present value, consider a project, which has the following cash flow stream:
The net present value represents the net benefit over and above the compensation for time and risk.
Hence the decision rule associated with the net present value criterion is: “Accept the project if the net present value is positive and reject the project if the net present value is negative”.
Advantages
The net present value criterion has considerable merits.
• It takes into account the time value of money.
• It considers the cash flow stream in its project life.
Internal Rate of Return
This method calculates the rate of return that the investment is expected to yield. The internal rate of return (IRR) method expresses each investment alternative in terms of a rate of return (a compound interest rate). The expected rate of return is the interest rate for which total discounted benefits become just equal to total discounted costs (i.e net present benefits or net annual benefits are equal to zero, or for which the benefit / cost ratio equals one). The criterion for selection among alternatives is to choose the investment with the highest rate of return.
The rate of return is usually calculated by a process of trial and error, whereby the net cash flow is computed for various discount rates until its value is reduced to zero.
The internal rate of return (IRR) of a project is the discount rate, which makes its net present value (NPV) equal to zero. It is the discount rate in the equation:
where
CFt = cash flow at the end of year “t”
κ = discount rate
n = life of the project.
CFt value will be negative if it is expenditure and positive if it is savings.
In the net present value calculation we assume that the discount rate (cost of capital) is known and determine the net present value of the project. In the internal rate of return calculation, we set the net present value equal to zero and determine the discount rate (internal rate of return), which satisfies this condition.
To illustrate the calculation of internal rate of return, consider the cash flows of a project:
Since this value is now less than 100,000, we conclude that the value of k lies between 15 per cent and 16 per cent. For most of the purposes this indication suffices.
Advantages
A popular discounted cash flow method, the internal rate of return criterion has several advantages:
• It takes into account the time value of money.
• It considers the cash flow stream in its entirety.
• It makes sense to businessmen who prefer to think in terms of rate of return and find an absolute quantity, like net present value, somewhat difficult to work with.
Limitations
• The internal rate of return figure cannot distinguish between lending and borrowing and hence a high internal rate of return need not necessarily be a desirable feature.