Year 1 2 3 Total

PVF 0.9091 0.8264 0.7513

Net Cash Flow $100,000 $100,000

PV of Net Cash Flow

PV =

FV (1 + i) n PVF = 1 (1 + i) n

$90,910 CHAPT E R F O RT Y -T W O $100,000 $82,640 $75,130

E VALUATING P$248,680 ROJECT F INANCIAL P OTENTIAL

FV = P(1 + i) n

n order to receive funding, be it equity, debt, or a combination of both, energy resource optimization projects must be evaluated with respect to other project opportunities and uses of available funding. Prospective investors go to great lengths to properly evaluate capital investments. Often times, they will use a mixture of simple analytical tools, such as payback or substitute comparisons, and more complex tools, such as internal rate of return and other cash analysis tools, as well as price earnings (PE) and other net income oriented ratio analysis tools. All have their place and all have their weaknesses. A good investor will use many or even all of these analytical tools, while relying heavily on previous experience in investing to make a decision. It is important to remember that the results of any analysis are only as valid as the assumptions on which they are based. Sophisticated analysis performed with gross estimates of costs and savings, or of risk or escalation rates, will likely not yield useful results. In making capital budgeting presentations, it is strongly recommended to properly categorize the low- and high-risk projects and assign higher return requirements to the riskier commitments. To do otherwise might allow the analysis results to direct all funds to the high return, high risk ventures. This chapter focuses on the analytical tools used to evaluate capital commitments. It begins with definitions of the most commonly used tools in formal capital budget analysis and then proceeds with a detailed discussion of the most commonly used financial analysis techniques.

COMMONLY USED TOOLS

The tools most commonly used in formal capital budget analysis and presentation include: Simple payback analysis, which determines how many years of earnings (or savings) it will take to payback the investment. Simple rate of return (ROR) analysis, which determines the percentage or rate at which an investment will return. Discounted payback period analysis, which considers the time in which the present value of benefits equals the initial investment. Net present value (NPV) analysis, or sum of the

discounted net cash flows (DCFs) over the life of the project, which measures the amount by which a projects stream of benefits exceed all costs, including the cost (or opportunity cost) of capital. Generally, the discount rate applied to the stream of benefits is equal to the cost (or opportunity cost) of capital. Internal rate of return (IRR) analysis, which determines the discount rate for which NPV is equal to 0. Savings investment ratio (SIR) analysis, which compares benefits and costs by dividing the present value of returns by the present value of the investment. Each of these methodologies is presented with the assumption that an initial investment is made in Year 0. This is the full investment minus any offset costs. In retrofit applications, if the replaced equipment can be sold, it may have a salvage value. This value, minus any depreciation impact or other selling costs, can be subtracted from the initial investment to arrive at a net investment. Similarly, assets at the end of a contract term may have value and could possibly be sold. Costs that are avoided as a result of the investment should also be considered. For example, if equipment overhaul is required to allow a facility to continue to use existing equipment, that cost may be subtracted from the initial investment in the new equipment for analysis purposes. If the investment allows a facility to avoid installing new equipment, such as a new electric service substation to support growth requirements elsewhere in the facility, that too may be subtracted from the initial investment. Difficulties arise when replaced equipment remains in place and adds backup in the form of system redundancy. In some cases, this can be quantified based on the cost of an avoided outage, while in other cases it is relegated to qualitative benefit status. One should conduct a similar analysis for ongoing operations, maintenance, and repair (OM&R) expenses. If costs are avoided as a result of the installation of new equipment, the investment analysis should consider only incremental operations costs. Generally, a savings of $1 per year of OM&R expenses equates to about $5 to $8 in capital savings. Thus, emphasis should be placed on operating cost savings. Payback and simple ROR methods are generally

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Combined Heating, Cooling & Power Handbook: Technologies & Applications

reserved for preliminary screening analyses. They are too crude for proper evaluation of capital commitments because they do not adequately consider the time value of money. They are important, however, as practical tools used to limit a wide range of options and determine, on a preliminary basis, project potential. Consider, for example, life-cycle feasibility analyses, as discussed in the previous chapter, and the level of detail required for more intensive capital budget analyses. The most efficient approach to project financial analysis may be to eliminate many or even most of the potential options through simple payback or ROR analyses, and then to apply the more rigorous IRR or NPV analysis to the remaining few options. It is important to remember that the more high-powered analyses may be equally as misleading as the simple analyses if the input assumptions are not reasonably accurate. The annual positive net cash flow from a project is generally considered to be after-tax distributable cash. While most taxes are not paid at a project level (but at a corporate level), taxes are a cost of entering into the project and must be considered. Generally, the project is considered a full taxpayer by most corporations and tax benefits are assumed to be used in the year they are made available. The most commonly used tools in formal capital budget cash analysis and presentation include IRR, NPV, and its derivative, SIR, analyses. IRR is also a good tool for evaluating opportunities of different risk and for lease vs. buy (or various combinations of debt and equity) analysis. Other net income-oriented analyses are also used by some organizations, mostly publicly traded companies.

as an economic screening indicator. The two critical disadvantages are that it does not consider the time value of money or the effect of cash flow occurring after the payback period is considered (i.e., where cash flow is heavily weighted toward the out years). Because project service life is not considered, there is no way to differentiate between two investments that have the same payback but different useful service lives. Simple ROR calculates the percentage or rate at which an investment is going to return. This is calculated in percent as: x 100% (42-2) The simple ROR is the reciprocal of payback (and as such offers the same advantages and disadvantages), expressed as a percentage. Using the previous example, the simple ROR, in percent, based on Equation 42-2, is: $25,000 $100,000 Life-cycle analyses evaluate the sum total of project incremental costs and benefits over the life of the project. To accomplish this, a cash flow analysis must be performed for every year of the projects life. In each year, different things will happen. For example, a significant expenditure for overhaul may be expected in certain years. Also, energy and other resource costs are projected to change over time. Therefore, each year will have a different net benefit and the net benefits (or net revenues) of each year must be related to each other. Present value (PV) or present worth analysis is a means of equating an amount received or paid in the future in today's dollars. Virtually all sophisticated economic analyses use the basic concepts of PV to account for the time value of money over the life of a project. Energy saving projects produce cost savings over varying number of years. The value of a dollar saved in Year 5 must be differentiated from a dollar saved in Year 1 based on the time value of money. So must the investment made at the beginning of the project in Year 0. Thus, all cash flow in every year of a project, whether costs, savings, or net cash flow, must be related to each other in a way that accounts for when they occur. This can be accomplished through PV analysis. In some cases, there is a uniform flow of savings in each year. In other cases, there are unequal amounts of savings produced in each year. Given some anticipated future value (FV) or future worth of savings over a x 100% = 25% Simple rate = Annual net positive cash flow of return Project investment cost

FINANCIAL ANALYSIS TECHNIQUES

Simple payback is a commonly employed method that calculates the time required to recover an original investment through the net savings realized or net income derived from the investment. Simple payback is calculated as follows: Simple payback = Project investment cost Annual net positive cash flow (42-1)

If the project investment cost is $100,000 and the annual net positive cash flow is $25,000, the simple payback, based on Equation 42-1, is: $100,000 = 4 years $25,000 The advantages of simple payback analysis are that it requires simple computation and is easily conceptualized

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number of years, PV calculations are used to determine the dollar amount today (PV) that is equivalent to some anticipated FV amount. The equivalence depends on the rate of interest that can be earned on investments during the time period under consideration, or the discount rate. The PV of a future sum of money over a number of periods at a given interest rate per period is calculated as: PV = FV (1 + i) n (42-3)

Where: i = Threshold interest rate or discount rate per period n = Number of periods over which the value is calculated PV may be considered the determination of the sum of money that would have to be invested at a given interest rate per year to yield a specified amount at a specified future date. For example, if the annual interest rate were 10%, the PV of $1,000 to be received at the end of a period of 10 years would be calculated as: PV = $1,000 = $386 (1 + 0.1) 10

Where: i = Threshold interest or discount rate per period n = Period in which the future amount is earned For any given discount rate, the PVF can be identified from a standard compound interest table or calculated. For example, given a discount rate of 10%, annual PVFs or discount factors over a three year period would be calculated, based on Equation 42-5, as: 1 1 = Year 1 = = 0.9091 1 (1.10) 1 (1 + 0.10) 1 1 = Year 2 = = 0.8264 (1.10) 2 (1 + 0.10) 2 1 1 = Year 3 = = 0.7513 (1.10) 3 (1 + 0.10) 3 Using these annual PVFs and an annual end-of-theyear positive net cash flow of $100,000, the PV of each of the cash flows over the three year period would be calculated as:
Year 1 2 3 Total PVF 0.9091 0.8264 0.7513 Net Cash Flow $100,000 $100,000 $100,000 PV of Net Cash Flow $90,910 $82,640 $75,130 $248,680

Thus, given an interest or discount rate of 10%, were one to consider $1,000 of savings in Year 10 as equivalent to $1,000 in the present, conclusions drawn from the analysis would be erroneous. Conversely, the FV of a present sum of money (PV) over n periods at an interest rate i per period would be calculated as: FV = P(1 + i) n (42-4)

FV may be considered the determination of what a sum of money in the present would be worth if invested at a given interest rate per year at a specified future date. For example, if the annual interest rate is 10%, the future value at the end of Year 10 of $1,000 invested today would be calculated as: FV = $1,000 (1 + 0.1)10 = $2,594

Discounting
The process of calculating PV is called discounting. To determine the PV of future sums, a stream of annual net cash flows must be adjusted (or discounted) by multiplying each years total by a PV factor (PVF). PVF is expressed as: 1 PVF = (42-5) (1 + i) n

If, in Year 0, the project required an investment of $200,000, the simple payback would be 2 years. Yet, when the cash flows are time-valued, the investment would not be recovered until sometime in Year 3. Where as a nondiscounted method such as simple payback or ROR would assume the cumulative net cash flow to be $300,000 at the end of Year 3, the discounted analysis reveals a smaller PV sum of $248,680. As indicated by the continually diminishing PVF, when applied over a longer term, for example 10 or 20 years, this gap between discounted and non-discounted cumulative net cash flow widens, showing non-discounted analysis methods to be crude and potentially misleading. Extending this analysis out to 15 years, for example, shows the PV of the cumulative net cash flow to be about $760,000, or just about half of the non-discounted amount of $1,500,000. If the initial investment were $800,000 instead of $200,000, the simple payback would be 8 years. However, if the useful life of the project were only 15 years, the discounted analysis would show the net annual cash flow to never fully pay back the investment. The critical value of PV-type analysis is that by the

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process of discounting, a series of cash flows can be adjusted to determine their actual value in the present. Thus, an investor can view two opportunities, each perhaps with a different life cycle and cash flow shape, and conduct a more objective analysis as to which one, on the basis of the assumptions used, is better. If cash flows are a fixed uniformed series of equal amounts in each year, the PV is the product of the cumulative PVF for the series and the payment amount. PVFs can be found in standard tables or determined using computer spreadsheet functions. PVF for a series of years can be calculated as: (1 + i) n 1 (42-6) i(1 + i) n Using the previous example, the 3-year cumulative PVF is calculated as: PVF(i,n)ser = PVF(i, n)ser = and the PV is: 0.331 (1 + 1 = = 2.4868 3 0.1331 0.1(1 + 0.1) 0.1) 3

Consideration of Inflation
In addition to the time value of money, another factor to consider with respect to the return on a multi-year investment is inflation. Inflation reflects the rise in the actual cost of commodities over time. Different economic goods inflate at different rates. In an energy savings project, fuel, electricity, and maintenance, for example, may all inflate at different rates. In a multi-year cash flow analysis, each cost or savings line item can be inflated at a different rate. In many cases, net annual savings are simply inflated at an average rate. In order to perform a PV calculation for a uniform series of annual cash flows, an effective interest rate may be applied that reflects the combination of inflation and interest rate. The effective interest rate can be calculated as: ieff = i inf 1+i 1= 1 + inf 1 + inf (42-8)

Where: i = Interest rate inf = Inflation rate If, for example, the interest rate were 10% and the inflation rate 4%, the effective interest rate would be: ieff = 0.10 0.04 1 + 0.10 = 0.058 1= 1 + 0.04 1 + 0.04

Capital recovery factor (CRF) is the reciprocal of the PVF. It is used to calculate future equal payments required to repay a PV of money over a specified number of periods at a given interest rate. This is used to determine mortgage payment and can be found in a table of annual capital recovery factors or determined using computer spreadsheet functions. CRF can be expressed as: CRF(i,n) = i(1 + i) n i = n (1 + i) 1 1 (1 + i) -n (42-7)

Given these rates, the PVF for the example shown above would be:
3 PVF (ieff ,n)ser = (1 + 0.058) 1 = 0.1843 = 2.6865 0.058 (1 + 0.058) 3 0.0686

and the PV would be:

If the $200,000 investment required to generate the $100,000 of annual savings, shown above, were to be financed over three years at a 10% interest rate, the CRF would be: 0.1331 = 0.4021 0.331 and the annual payment would be: CRF(i,n) = ($200,000)CRF (i,n) = ($200,000)(0.4021) = $80,402 Since debt is a factor in most investments, discounting and PV analysis is a critical element of the evaluation process. Financing options are addressed further in the next chapter.

Given the fact that interest rates, energy costs, and other project cost factors are subject to unpredictable volatility, the concept of accounting for the effects of inflation should be viewed cautiously. An alternative approach is the use of sensitivity analyses for major cost factors. Sensitivity analyses may be designed, for example, to evaluate the impact on the investment if power or fuel costs double, or drop in half. The investor can attempt to assess the risk of such an occurrence and adjust the investment hurdle rate accordingly.

Time Value of System Replacement Costs

In most retrofit applications, the new equipment being installed replaces existing equipment that is in

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Evaluating Project Financial Potential

working order. If the replaced equipment can be sold, it has salvage value, which is deducted from the initial investment. Similarly, if the new equipment will have a value after the term of the contract (or finance period), it also has salvage value. However, it is important to consider the consequences of maintaining that equipment in place and not making the investment in the new system. To do this in a life-cycle analysis, one must consider as the base case (or baseline) keeping the unit in place over its useful life. If the existing equipment requires an overall, the overhaul is considered the initial Year 0 investment in the base case. In the life-cycle analysis, one must consider the year in which the existing equipment would have to be replaced. If, for example, the unit had a potential useful life of five years, the base case option would be to keep the unit in place and replace it in five years. The life-cycle analysis would compare the annual cash flows of the base case and the alternative case installing the new equipment in Year 0. This life-cycle cost can then be compared with investing in the more efficient replacement equipment in Year 0 and operating that unit in each of the proceeding years. This type of analysis is only possible when one considers annual cash flows over the life cycle of an investment, put into financial perspective based on the time value of money.

TYPES OF TIME VALUE FINANCIAL ANALYSIS TECHNIQUES

In performing time-valued project economic analyses, numerous factors must be considered on an annual basis. These factors include capital and interest expense, energy operating cost savings, OM&R costs, salvage value, replacement costs, disposal costs, property tax, insurance, deprecation, and other tax deductions. Following are descriptions of several types of time-valued financial analysis techniques. Discounted cash flows (DCFs) are a series of annual net cash flows, including all of the incremental economic factors of a project, translated into PV dollars in
Year 0 1 2 3 Net CF ($200,000) $105,000 $108,000 $110,000 PVF (@25%) 1.0000 0.8000 0.6400 0.5120 DCF (@25%) ($200,000) $84,000 $69,120 $56,320

each year. The PVs listed previously in the three year series represent the annual DCFs. When considering various project options, applied discount rates may be varied based on an estimate of risk. The period in which the cumulative DCF equals zero, or the time-valued positive cash flow equals the initial investment in Year 0, is referred to as the discounted payback period. Uniform annualized costs for a project are the uniform periodic, or average annual, cost over the project life or analysis period. To determine uniform annualized costs, one must first calculate the PV of all cost factors (i.e., net OM&R costs and depreciation) and then apply a capital recovery factor to the investment (minus salvage value) to determine equal payments over the analysis period. The NPV measures all of the economic consequences of the project by determining the net gain or loss from a project at a given discount rate. NPV is the sum of the DCFs over the life of the project, or the cumulative DCF. This measures the amount by which a projects benefits exceed all costs, including the cost (or opportunity cost) of capital. If a project is financed, there is no discounted payback period because there is no initial cash outlay in Year 0. However, the NPV can always be calculated, because it simply looks at net cash flow in each year. The payment made for debt and amortization are accounted for in each year they are made and calculated into the cash flow of each year. The totals (net cash flow) for each year are then discounted to establish their PV and summed to determine the NPV. IRR measures all economic consequences of a project by determining the discount rate as applied to the projects cash flow, which produces an NPV equal to 0. IRR can be hand-calculated using trial and error discounting calculation or performed easily using a programmed computer function. Consider a project requiring a $200,000 investment that produces net annual cash flow over three years of $105,000, $108,000, and $110,000. Using the trial and error approach, IRR may be determined as shown in Figure 42-1: The IRR can be found by interpolating the NPVs
Cum. DCF (@25%) ($200,000) ($116,000) ($46,880) $9,440 PVF (@30%) 1.0000 0.7692 0.5912 0.4552 DCF (@30%) Cum. DCF (@30%)

($200,000) ($200,000) $80,766 ($119,234) $63,850 ($55,384) $50,072 ($5,312)

Figure 42-1 IRR Determination Using Trial and Error Approach.

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between 25% and 30%: IRR = 25% + 9,440 (30% 25%) = 28.2% (9,440 + 5,312)

NPV and IRR are generally calculated using spreadsheets with net DCFs over the life of the project. When considering multiple options, spreadsheets are generated for each option based on the complete operation or on the incremental changes vs. a base case. The development of such spreadsheets allows for a complete life-cycle analysis of the investment. They contain a translation of what is expected to occur in each year of the project into a PV dollar figure. If, for example, over the course of a 30 year project life, system overhaul is required every 10 years, that cost is plugged into Years 10 and 20. Often, replacement costs, overhaul costs, and other periodic costs are included on an annualized basis or on a per unit output basis (i.e., $/hp-h or $/kWh). This allows for more streamlined life-cycle analyses in which annual costs can be uniformly inflated over the life of the project. Typically uniform inflation rates are established for each major cost factor, such as electricity, fuel, and maintenance. A more basic method simply applies one inflation rate to first year net savings in order to generate a stream of annual cash flows. Consider, for example, a $1,000,000 project that produces net annual savings, inclusive of all operating costs, of $125,000. Fifteen year cash flows are shown in Figure 42-2 using a uniform 2% inflation rate. The pre-tax IRR for this investment works out to 11%, which assumes that the $1 million investment is made at the end of Year 0 and each annual cash flow is received in one payment at the end of Years 1 through 15. At a cost of capital, or discount rate, of 10%, the NPV over the 15 year project life works out to a modest $53,707. If, instead of 2%, a 4% inflation rate is used, the IRR and NPV work out to 12.8% and $168,311, respectively. If this cash flow stream were considered at a discount rate of 12%, the NPV would be reduced to $43,212, showing the powerful impact of discount rate consideration. Another use of IRR analysis is to evaluate buy vs. lease (or finance) options. In such cases, the buy scenario, as shown in Figure 42-2, includes negative cash flow in Year
YEAR Annual cash flow 0 $(1,000,000) 1 $125,000 2 $127,500

0, followed by positive cash flows over each year, ending perhaps with a salvage value at the end. The lease scenario will show annual cash flows, net of the lease (or finance) payments. By comparing the DCF or IRR of each scenario, the higher annual cash flows of the buy option, excluding Year 0, may be accurately matched against the lower annual cash flows of the lease option, which does not require a capital expenditure. Commonly, a project will be funded with a combination of equity and debt. If, in the above example, the investor funded the project through a combination of 40% equity and 60% debt, at a rate of 9%, the pre-tax IRR would be increased from 11% to 13.5% and the NPV increased to $84,470. While this approach does produce a higher return on equity, it also comes with an incremental increase in the risk profile for the equity holder, as equity will be subordinate to debt service. This is a very simplified overview of a complex issue. In most cases, an investor that performs a buy vs. lease (or finance) analysis must consider multiple issues in making such a decision. These include balance sheet, credit effects, top line and bottom line growth aspects, and benefits relating to book income (as IRR and NPV are strictly cash analyses tools). Such considerations are often specific to individual companies and are not discussed herein.

Limitations of NPV and IRR

When considering an investment, a positive NPV indicates that the investment is expected to produce a PV of all of the benefits, which outweighs the PV of all of the costs, given the cost of capital or the hurdle rate. However, difficulties may arise when comparing several investment options, each with a positive NPV. Also, because access to capital always has limitations, a consumer must often choose between several sound investment opportunities. While NPV does consider all parts of the investment over its economic life, including the time value of money, it depends on selection of an appropriate discount rate (the impact of which can be significant, as shown in the above example), which involves subjective judgment. When considering two options with the same useful project lives and the same initial investment requirement, the one with the greater NPV would be the logical choice,
3 4 $132,651 5 $135,304 10 15

$130,050

$149,387 $164,935

Fig. 42-2 15 Year Cash Flow on $1 Million Investment with $125,000 First Year Net Annual Savings and 2% Inflation Rate.

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assuming equal risk. However, when considering two projects that require different investment levels and/or have different useful project lives, additional information, such as what will be done after the life of the shorter project, would be required to make the best selection. Consider two project options in which Option 1 had an NPV that was twice that of Option 2, but also required an investment that was three times greater. If the IRR of Option 2 was considerably greater than that of Option 1, Option 2 might be chosen despite having a lower NPV. It would tie up less capital (or available debt) and provide greater return per dollar invested. The evaluation of these investment options might also include an analysis of what else could be done with available capital if the lower cost investment is chosen. In this case, the combined NPV and IRR of Option 2 and another investment opportunity would be compared to Option 1. In some cases, the threshold discount rate might be greater for the larger investment. Additionally, the larger capital requirement may preclude another project and the profits or savings lost from that opportunity must be considered in the threshold discount rate. Another factor that must be applied in capital budgeting analysis is risk rate. Simply put, if two options show the same NPV or IRR, and one is considered to have more risk, the other would be the logical choice. Consider an economical performance evaluation of a cogeneration system option with risk rate impact factors mitigated through manufacturers warrantees and guaranteed OM&R contracts. Compare this option to capital allocations to a new product line. The new product option would have to display a significantly higher IRR to compensate for the greater risk of under-performance or failure. SIR is another investment analysis tool used for evaluating energy operating cost savings projects. It is a variation of the NPV method, computed by dividing the PV of returns by the PV of the investment. Whereas NPV combines all benefits and costs, SIR compares benefits and costs. If the resulting ratio is greater than 1, it implies that returns exceed the investment. The greater the SIR, the more desirable the project. SIR is computed as: SIR = PV of returns PV of investment (42-9)

are being considered with either limited access to capital (and/or debt) or limited applications, the projects with the highest SIR would be the ones that will maximize the NPV for each dollar invested.

Depreciation
Depreciation of assets is a principal tax consideration in most projects. Depreciation may be considered from different perspectives. The perspectives used in capital budgeting are physical depreciation and tax depreciation as it affects cash flows. Physical depreciation is a loss of ability to produce future cash flows because of obsolescence or deterioration resulting from wear. As a result of time and use, the value of the asset erodes. Installed energy systems have varying useful lives. While performance may be maintained, the value of the system is decreasing because its useful service life is being used up. At the end of its useful life, the system may have no real value or may have some salvage value. Accounting depreciation is an internal method of tracking the life of an investment and recovering an initial investment in an asset so that funds will be available to replace it. In an accounting sense, the initial investment in the asset may be considered as a prepaid expense and the accounting depreciation is a method of charging against it over time. It is meant to reflect, in an accounting and fiscal sense, the effect of physical depreciation of the asset. Tax depreciation is a method of claiming non-cash flow expenses over the useful life of an asset to allow for the recovery of the initial investment so that it can be replaced when it is retired. This allows a portion of the returned earnings to be set aside, free of tax, to serve as a replacement fund. For tax depreciation, the value of the asset is considered to be used up over a specific time frame in specific, not necessarily uniform, increments. There are several acceptable methods of depreciating assets. These include a straight line method, in which the loss of value is constant and directly proportional to the age of the asset, and various accelerated depreciation methods which allow for greater depreciation during the early years of the assets useful life. The IRS sets guidelines for the useful life of most equipment. It is usually advantageous to accelerate tax depreciation as much as possible due to the time value of money. After an asset has been fully depreciated from a tax

Whereas IRR does not indicate the amount of profit to be earned from a project, and NPV does not indicate the amount of investment required for a project, SIR considers both. A greater SIR indicates a greater value of NPV for each dollar invested. Therefore, when several projects

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perspective, it is considered to have no value. Often, however, a system will remain in operation long after it has been fully depreciated, meaning the physical depreciation period extends beyond the tax depreciation period. Any continued earnings are fully taxable since the full value of the asset has already been recovered. Capital gains and losses occur when assets are sold for more or less than their cost. If equipment is sold after it has been fully depreciated, its salvage value is fully taxable. As with all other project factors, tax rates and depreciation schedules will vary widely among different facilities.

taxes are equal to the product of the applicable federal, state, and local income tax rates and taxable income. Deferred taxes are equal to the difference between taxes and current taxes. Current taxes are owed in the year the income is recognized, while deferred taxes accrue as a liability on the projects balance sheet and are paid during years in which taxable depreciation is less than book depreciation. After-tax cash flow is EBITDA minus any interest and principal on any project debt, as well as current taxes. After-tax earnings, or net income, is EBT minus taxes.

DETERMINING AFTER-TAX EARNINGS

While some simplified project analyses may deal with gross operating profit or pre-tax revenues, the ultimate value of an investment is based on its anticipated net, or after-tax, financial impact on a cash, and sometimes, book basis. The following definitions are useful when considering net financial impact: Gross operating profit is the difference between total revenue and the sum of all operating costs. This is referred to in accounting terms as earnings before interest, taxes, and depreciation and amortization (EBITDA). Earnings before interest and taxes (EBIT) is EBITDA minus book depreciation and amortization on the asset. Pre-tax book income is EBIT minus any interest on any project debt. This is also called earnings before taxes (EBT). Taxable income is EBITDA minus interest, as well as tax depreciation and amortization on the asset. Often, taxable income will be less than EBT because tax depreciation is commonly accelerated in the early years, as compared to straight-line book depreciation. Taxes are equal to the product of the applicable federal, state, and local income tax rates and EBT. Current

SUMMARY
The financial analysis tools presented in this chapter provide a broad, but simplistic, introduction to the types of analyses required to make informed investment decisions. Greater detail is available in a wide number of standard accounting and financial analysis texts. Updated information is essential, since tax laws are continually changing. Beyond this basic understanding, no major investment should be made without the review and approval of knowledgeable financial experts. The financial analyst must be familiar with the specific financial situation of the host facility/investor and must understand all of the key financial implications of the project under consideration, inclusive of all obligations and risks. The type of contract to be used for the execution of the work is a key consideration factor, as is the financial condition of the contractors and any potential partners. Finally, it is important to note that most projects are partially, or even fully, funded with debt. Hence, the type of financing instrument contemplated for the project is of principal importance to the financial analyst. The following chapter presents information on the various types of contracts and financing arrangements most commonly used for the implementation of energy resource optimization projects.

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