Financial Analysis of Projects I PDF

Financial Analysis of Projects I
Slide 1: Financial Analysis of Projects I

Welcome to Financial Analysis of Projects I
Slide 2: Welcome
For best viewing results, we recommend that you maximize your browser window now. The screen controls allow you
to navigate through the eLearning experience. Using your browser controls may disrupt the normal play of the
course. Click the attachments link to download supplemental information for this course. Click the Notes tab to read a
transcript of the narration.
This course explores various calculations involved in a financial analysis. Practice equations are included in this
course and we provide examples in Excel. A basic understanding of creating tables in Excel is required. You may
also find it useful to have a calculator, paper and pencil accessible.
Slide 3: Objectives
At the completion of this course you should be able to:
Use simple financial terminology when presenting projects for approval
Determine simple return on investment and payback period of a project
Construct a cash flow table and obtain the discounted payback, net present value and internal rate of return of a
project
Explain the importance of lifecycle costing
Slide 4: Introduction
Rising energy prices, dwindling resources and environmental impacts are headline news for todays business
owners. Energy efficiency projects have been shown to be low risk, high return investments.
Financial analysis is key to getting your project approved by decision makers. If your project is presented using the
language and terms they recognize, you will be off to a good start.
Therefore energy managers require a thorough grasp of how economic analysis is used to evaluate return on
investment. This enables you to compare and prioritize projects, and gain management approval.
Slide 5: How Does a CFO Make Decisions?
Very often you will need to obtain project approval from a chief financial officer, or CFO.
How does a CFO make a decision?
CFOs fiscal accountability is very high so they need to be approached from the financial angle.
They want to see a true value proposition that is quantifiable
They want to see critical financial metrics when evaluating investment. So we need to know these metrics well.
They often like to have those metrics presented in spreadsheet form, showing assumptions, so that they can test
additional scenarios as required.
They prefer professional-looking presentations to gain their attention, and that they can use to communicate
internally
2011 Schneider Electric. All rights reserved. All trademarks provided are the property of their respective owners.

They like to have practical information to be able to validate value claims
CFOs look for unbiased, independent perspectives before putting full trust in the analysis. Providing a few wellchosen case studies or references helps to build their confidence that the project value can be derived in the real
world.
CFOs will invest in what they determine to be sound investments. We must help them make the right decisions.
Slide 6: Financial Analysis
Financial analysis is not comprised of just a single component. Instead, it is a collection of methods, skills, tools,
activities, and ideas. They can be combined and used in many different ways to assess the relative value of an
investment over time. Applying this collection in a particular situation requires making choices among the ideas and
methods available and conducting an analysis appropriate to the decision at hand.
In most cases we want to compare the benefits realized to the investment made. The investment, or costs, can be
items like new controls, new equipment, or new lighting. The return, or benefits, can be described as energy savings,
increased occupancy, increased revenue, or increased efficiency. Lets talk a bit more about the benefits realized
from energy efficiency.
Slide 7: Benefits
The primary benefit that is evaluated in a financial analysis is savings resulting from the project, especially the energy
savings. But, in fact, a wide range of benefits can be realized from energy efficiency projects.
The benefits can include:
Energy savings
Savings in raw materials
Reduction in labor effort
Time savings
Improvement in occupant comfort and satisfaction
Reduction in occupant complaints
Increased property value
Increased equipment life
Avoiding lost business, and
Avoiding increases in utility rates
Increased productivity, and
Goodwill
Although you may not be able to put a financial value on all these benefits, it can be useful to include them in your
project presentation.
Slide 8: Process for Financial Analysis
As we will see, there are a number of different ways of evaluating the financial worth of a project. During the process
of financial analysis we have to:
Determine which financial metric is used to analyze investments
Determine the acceptable threshold for that metric
Obtain all the costs of the project
List all the benefits, and

Determine the total impact, not just of the energy savings, but of all the benefits we just discussed
Slide 9: Financial Terms
It is important to have a solid understanding of the most common financial terms used during financial analysis in
order to be able to use them and explain all of them clearly when presenting the case for your project.
The financial terms well define in this section include:
CAPEX and OPEX
Return on investment
Cash Flow
Payback Period
Cost of Capital
Present Value
Discounted Payback
Net Present Value
Internal Rate of Return
Hurdle Rate
Life Cycle Costing
Salvage Value
Please click these terms in order, starting with CAPEX and OPEX. When youve learned about each of them, feel
free to review any of them before clicking the continue arrow to move on.
Slide 12: CAPEX and OPEX
What is CAPEX and OPEX?
CAPEX is an abbreviation for capital expenditure. This is money that a company spends to buy or upgrade physical
assets such as property, buildings or equipment.
OPEX is an abbreviation for operating expenditure. These are the ongoing costs of running the business, such as
energy bills, salaries, and raw materials.
Slide 13: Return on Investment (ROI)
Return on investment, or ROI, is a measure of the return, or benefit, realized on the project compared to the
investment made. It is usually expressed as a percentage. There is an easy formula to calculate simple ROI.
Simple ROI = Gains Costs / Costs
Lets see an example. Anand is evaluating the addition of a cooling tower. The investment is 50,000 over 5 years.
He expects the project will save 70,000 during that 5 year period.
ROI = 70,000 50,000 / 50,000
This gives us an ROI of 40%

An ROI above 0 indicates that the investment returns more than it costs. Higher percentages indicate higher returns.
The simple ROI method is simple to calculate and understand and it is commonly-used.
However:
It does not indicate how long it may take to obtain the return on investment. Its important to clearly state the period
used for the ROI calculation
It also ignores issues such as the value of money over time. As we will see, other financial measures take time
value of money into account and provide a more sophisticated view of the investment
Slide 14: Cash Flow
What do we mean by cash flow?
For projects, cash flow is defined as the net cash coming in or going out each year. Cash received represents
positive cash flow, and cash paid out is negative cash flow. Cash flow is not the same as profitability. It measures the
cash (i.e. money) being received or paid out by the company at different times.
A Cash In example would be revenue, or savings that we expect to receive.
Examples of Cash Out include:
Up-front cost or investment in other words capital expenditure or CAPEX
Additional investments required in the future also CAPEX
Operating expenditures or OPEX
The difference is net cash.
In a typical investment, the initial cash flow is negative (representing the cash out figure), with an expectation of a
future positive cash flow (or cash in) due to the benefits of doing the project.
Slide 15: Janets Project
Lets see an example. You can download Janets project from the Attachments link at the top of your page.
Janet plans to invest 15,000 on variable speed drive controls for fans in her facility. She has calculated the
expected savings from the project, and they are 7,000 in year 1, 6,000 in year 2. However, in year 3 a different
manufacturing process will be launched and those fans will not be used as much, so she has calculated the savings
will be 3,000 in years 3 and 4. In year 5, the product will be obsolete and the production line will close down, so she
has decided there will be no more savings after that.
We can make a Cash Flow table for Janets project. You can see it in the Excel file that we provided, and you can
also see it here. At the outset we expect a negative cash flow of 15,000. We will put that in year zero. Then, the
savings that we expect to receive are listed for each year.
The cash flow for the year is the total of column B and A.

The last column in this table is a running total for the project which shows the sum of previous years.
Slide 16: Payback Period

The payback period answers the question:
When exactly do we get our money back?
In other words, when does our project break even?
If you look at our cash flow table, our running total becomes positive in the third year. But how far into the year?
Figuring this is easy. Using your calculator simply divide the last negative balance in the running total by the cash
flow from the break even year.
This is when we will break even in the final year.
What does this mean? We broke even 2/3 of the way through the 3rd year. The total time required to pay back the
money we borrowed was 2.67 years.
We did the calculation in this example using the cash flow table because the savings are estimated to be different
each year. If you estimate that the project will have the same savings every year, there is a simple formula:
Payback period = Initial cost / Annual savings
This is sometimes called simple payback.
What are the advantages of the payback period method?
It is simple to calculate and understand. It is therefore convenient for simple internal rules of thumb for making quick
decisions to either reject a proposal or take the analysis further.
It is also commonly-used
Often, company guidelines are that simple payback must be less than a certain number of years for a project to be
considered.
What are the disadvantages of the payback period method?

It ignores benefits after the end of the payback period. The payback period only considers the time it takes to
recover the initial investment. It doesnt measure the total benefit of the investment at all. It could lead to rejecting
projects with high total savings and accepting ones that pay for themselves faster but deliver less total benefit.
It may be complicated to calculate for recurring investments. The calculation can be more complicated if there are
other investments in later years and/or year-by-year variations in the project returns or savings.
It does not take into account the time value of money, and this is the biggest disadvantage of the payback period as
a decision tool.
To address these limitations, discounted payback can be used, which has cost of capital and time value of money
built in.
Slide 17: Cost of Capital
The Cost of Capital is the required return necessary to make a capital investment project worthwhile. It is the rate of
return that the firm would get if it invested the same amount of money elsewhere with similar risk. If the project return
is less than the cost of capital, it is not worth doing the company would get a better return by investing somewhere
else. Typically, companies compare investments using a normal market interest rate of 8%.
There are two parts to Cost of Capital:
The Cost of Debt is the interest rate that the customer is being charged if they fund the project with a loan or bond.
This is the effective rate a company pays on its current debt.
The Cost of Equity represents the compensation that the market demands in exchange for bearing the risk of
ownership. It is the return stockholders require for a company.
Slide 18: Present Value
The time value of money is related to the notion that money now is more valuable than money in the future.
For example, would you prefer to have $100 now, or $100 in a years time?
Its better to have $100 now, because in a years time $100 will not be worth as much.
If you assumed that your money could earn 10% interest in a year, $100 paid now would have the same value as
$110 paid a year from now. Your $100 has a future value of $110. Conversely, $110 in a year has a present value
of $100.
You can calculate the present value of a future amount using this formula:
PV = FV/(1 + i)n
PV is the present value of the cash flow
FV is the future value of the cash flow
i is the interest rate. This can also be called the discount rate, rate of return (ROR) or minimum attractive rate of
return (MARR). Cost of capital may be used as the interest rate, or a higher value may be used to take account of
risks.
n is the time in years when the future cash flow occurs

Over a period of years, you would receive compound interest interest earned on the interest from previous years.
This is covered by the power of n in the equation.
Present value may also be called discounted present value.
Try calculating the discounted cash flow in our example for the flow of 6000 that comes in year 2.
Let's say the interest rate is 10%. Click here when you are ready to check your calculation.
Slide 19: Discounted Present Value
The future value is 6,000. The interest rate I is 0.1. And n is 2 years. So our calculation looks like this:
PV = 6000/(1 + 0.1)2 = 6000/(1.1)2 = 6000/1.21 = 4958.68
At this rate of interest, 6,000 in year 2 is worth a bit less than 5,000 today.
Slide 20: Discounted Present Value
For each year the calculation will be different, because the number of years is different, and the future value is
different. The interest rate each year can be different too then the formula looks like this.
PV = FV/(1 + i1) (1 + i2) (1 + i3)(1 + in)
Each value of i is the interest rate for a different year.
Slide 21: Discounted Payback
Discounted payback is similar to the payback calculation we performed earlier, except you first discount your future
cash flows to obtain their present value. Why? Because it is money you will get in the future, and will be less valuable
than money today. In doing this, we are now accounting for the time value of money.
Lets see how this impacts on Janets project. We have added a column for the discounted cash flows. You can
explore this in the Excel file on the discounted payback tab, and you can also see it here. Each row was calculated
using the present value formula that we just learned about, and an interest rate of 10%. If you like, calculate them
yourself to check that you understand where the numbers came from.
When we take the cost of capital into account, we can see that our project does not pay for itself as quickly as we first
thought.
We actually break even sometime in the 4th year But when in the 4th year?
Lets look at our equation: Negative balance / Cash flow from the break even year = When we will break even in the
final year
So, break even during final year = Last negative balance / Cash flow from break even year
1,423.74 / 2,049.04 = 0.69
Using the discounted payback method, we break even after 3.69 years.

Slide 22: Net Present Value (NPV)
Once you understand discounted payback, Net Present Value (NPV) is easy! The NPV is the sum of the present
value of all the cash flows. It is the final running total number. In the example we see here, the NPV is 625.30. This
means that taking the whole project into consideration, including its costs and returns, it is worth 625 in todays
money.
The NPV is affected by how many years are included in the analysis. Remember Janet? She has just been told that
the production line will be needed for another 2 years. So she has added two more rows to her table.
Now that she can include two more years of savings in the calculation, the NPV of her project just went up to
4,181.48. Note that there is no change to the discounted payback period. The project still breaks even in 3.69 years.
This is why using payback period can fail to take into account the full value of a project.
Slide 23: Net Present Value (NPV)

Basically, the NPV and discounted payback apply the same idea, with slightly different answers. The discounted
payback is a period of time, and the NPV is the total value of the project attained by adding all the discounted cash
flows together.
If the NPV is positive, then the project should be approved. It shows that more money is being made on the
investment, than is being spent on the Cost of Capital. If the NPV is negative, then the project should not be
approved because more is being paid in interest on the borrowed money, than is being made from the project.
Generally speaking, the better the project, the higher the NPV. But high NPV projects may rely on a long period of
future cash flows and a high initial investment. This may make project decision makers choose projects with lower
NPVs and shorter paybacks.
What are the advantages of using the NPV method?
It takes into account the time value of money
It is easy to compute even when cash flows vary from year to year
You can use a simple table in Excel
Please note: To calculate the NPV, you need to find out from the project decision maker what is the internal cost of
capital that they use. This is the value that you will use as the interest rate, i, that is used in the calculation. The
actual value used is an internal decision and convention chosen by the financial department. Note that it is generally

not the interest rate that is currently prevailing in the external credit market. It is usually higher.
Slide 24: Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) method is another way that project decision makers can decide whether to approve
a project. It is another method that allows you to consider the time value of money. It represents the return a
company would get if it invested in itself, rather than elsewhere. Essentially, it allows you to find the interest rate that
is equivalent to the monetary returns you expect from your project. Once you know the rate, you can compare it to
the rates you could earn by investing your money in other projects or investments. The IRR is the interest rate that
makes NPV equal zero.
There are two ways that you can find the IRR for our example project.
The first way is trial and error. Change the value of the interest rate used in the calculation until the final value in the
running total is zero. If you had to calculate all the cash flows by hand, that would be time consuming. But in Excel
you can just change the interest rate value until the NPV is close to zero. Note that when you do this you are not
changing the real interest rate or the real NPV of your project. Youre just finding the interest rate which is equivalent
to the project returns.
You can look on the Internal Rate of Return tab in the Excel file and experiment with changing the interest rate to try
to find the IRR. When the NPV after 6 years is close to zero, that interest rate is equal to the internal rate of return.
Well visit this again in part II of this class, where we will build up an Excel analysis together.
Excel includes a function to calculate IRR using an iterative technique.
Taking 6 years of savings into account, Janets project has an IRR of 21%. Thats significantly higher than the cost of
capital at 10%.
If the original projections of 4 years were in effect, the IRR would be 12%. 12% is still better than 10%, so the project
might still be attractive, but its not quite as likely to get approved.
Slide 25: Internal Rate of Return
If the internal rate of return is less than the cost of borrowing used to fund your project, the project will clearly be a
money-loser. However, usually a business owner will insist that in order to be acceptable, a project must be expected
to earn an IRR that is at least several percentage points higher than the cost of borrowing, to compensate the
company for its risk, time, and trouble associated with the project.
The advantage of IRR is that it accounts for the time value of money.
What are the disadvantages of IRR?
It doesnt take into account the size of the initial investment
In some cases it could bias decisions towards smaller projects with high IRRs, rather than larger projects with lower
IRR percentages but higher NPVs
The calculation can sometimes give a wrong result in some cases of large investments later in the project (such that
the net cash flow changes sign). This is a technical issue with the way the IRR is calculated
Slide 26: Hurdle Rate

The hurdle rate is the minimum rate of return that must be met for a company to undertake a particular project. The
hurdle rate is usually determined by evaluating existing opportunities in operations expansion, rate of return for
investments, and other factors deemed relevant by management. A risk premium can also be attached to the hurdle
rate if management feels that specific opportunities inherently contain more risk than others that could be pursued
with the same resources. A large problem with using a hurdle rate is that profitable projects will be turned down. In
addition, a hurdle rate that is too large will create a bias in favor of short-term projects over long-term projects. Thus,
a common method for evaluating a hurdle rate is to apply the discounted cash flow method to the project and then
compare that figure against returns that would be available if the same resources were invested in securities.
Slide 27: Life Cycle Costing
Life cycle costing is a method of analysis that ensures all the costs of owning an asset are included. Sometimes this
is called TCO, or Total Cost of Ownership.
Lets look at another example project. Pascal is planning to replace an air compressor in the plant. He has narrowed
down the choice to two quotations.
The first unit costs $25,000. The second costs $30,000. Which will Pascal choose?
If Pascal focuses only on initial cost, he will choose the first unit. But the life cycle cost approach would require
Pascal to think about other costs such as:
Cost to install the unit
Energy consumed by the unit
Spare parts
Labor required to operate the unit, including training
Labor required to maintain the unit, including training
Lifetime of the unit how long before it has to be replaced
Cost to dispose of the unit at end of life. This is especially significant for equipment that includes hazardous
materials, such as mercury
Many types of equipment, from lamps to motors, consume several times their initial cost in energy during their
lifetime. Spending a little more on a high efficiency unit at the outset can yield a rapid payback when the energy costs
are taken into account over the life of the unit.
When Pascal takes into account the energy efficiency of the two compressors, and the impact on labor, he realizes
that the first one has a life cycle cost of $250,000 over 10 years. The second one is more energy efficient and easier
to operate. Its life cycle cost is just $200,000.
Life cycle cost analysis can incorporate the time value of money. In effect it is the net present value analysis,
ensuring that all the relevant factors are taken into account.
Slide 28: Salvage Value
Salvage value is the value of the equipment at the end of the project. Sometimes the salvage value is positive, for
example, if the equipment can be sold, reused, or has scrap value. Sometimes it is negative, for example, if there is a
cost for decommissioning or disposal.
Salvage value can be an additional positive or negative cash flow that comes at the end of a project. Lets look at

Janets project one more time. She has determined that at the end of year 6, it will cost 2,000 to decommission the
equipment. When she adds this negative flow to her table, the IRR drops from 21% to 19% and the NPV falls from
4,181 to 1,189.
Slide 29: Using Interest Tables

Most financial evaluations incorporate 4 items
The initial investment, sometimes denoted by P
The annual return denoted by A
The interest rate (i)
The lifetime of the project (n)
If you know any three of these values, you can obtain the fourth one.
Calculating discounted cash flows by hand for a project with a long lifetime is an arduous process. The discounted
cash flow for each year has to be calculated separately, and then added up. We have been doing the calculations in
Excel tables, so Excel has been doing the hard work for us.
Historically, financial analysts used interest tables to save time when solving financial analysis questions. These are
tables with pre-calculated factors relating P to A for a given value of i and n. Some people still use this method.
If you see financial notes that include terms like P/A, or present value factor, that indicates the use of an interest
table.
Lets imagine a boiler economizer where the initial investment is $26,000.
The minimum attractive rate of return is 15%.
The lifetime of the project is 5 years.
How much does the annual return from the project have to be to make it worthwhile?
If you were using an interest table, you would first find the table for interest rates of 15%.
You are looking for A, the annual return, so you would look for the column that says To find A given P or (P|A, i%,
n), and the row for 5 years.
The number at the intersection is 0.2983. This number is a conversion factor that allows calculation of present value.

A = P * conversion factor.
So in this case, A = 26,000 * 0.2983 = 7755.80
The savings for each year must be at least $7755.80 to achieve a rate of return of 15% on the initial investment.
Now that we have spreadsheet programs such as Excel, it is easy to construct tables of discounted cash flow and it
is not necessary to use interest tables. But they are still commonly used by many people.
Slide 30: Obtain Approval

The purpose of all this analysis is to equip you to present energy efficiency projects to financial decision makers and
obtain approval.
Sometimes the project will be approved as long as it passes certain criteria. Those criteria could be simple payback,
net present value, or internal rate of return.
Often, the project will be compared to other projects and the ones with the most attractive financial profile will be
approved. If available capital is limited, as is often the case, even projects that pass the minimum standard may not
gain approval if there are other, stronger projects. These other possibilities may have nothing to do with energy
management. The company may be deciding whether to complete an energy efficiency project or something entirely
different such as renovating the company cafeteria.
Slide 31: Obtain Approval
To increase the likelihood that your project will be approved:
Make sure you understand the capital budgeting process at your company. When is the capital budget created? If
you submit your project when the capital budgeting process has just been closed, you may need to wait for several
months or even a year before another opportunity arises.

Find out from the financial controller the key numbers that you should use such as what the company uses as its
cost of capital.
Also, find out what decision criteria and thresholds are used for project approval by decision makers do they want
to see simple payback, NPV or IRR, and what are the minimum required values?
Ensure that you include the life cycle costs.
Include a summary of non-financial benefits.
Investigate if there are any utility rebates or other incentives available that can improve the financial analysis. Utility
rebates can be substantial, in the area of 30% or more of project costs. In Part II of this course, we will look at tax
credits.
Even if your project cant be approved now, keep a copy of the financial analysis handy. If other projects are
cancelled or delayed, capital budget may become available. Towards the end of the year a use it or lose it situation
may prevail. You may be able to quickly secure approval if you are ready to make use of the investment
immediately.
You may download this list by clicking the attachments link at the top of your screen.
Slide 32: Summary
Now, lets summarize what we have learned today.
Financial analysis is key to getting your project approved by decision makers. If your project is presented using the
language and terms they recognize, you will be off to a good start.
The return on investment or ROI is the ratio of the return, or benefit, realized, to the investment made
Common steps in a financial analysis include
Creating a cash flow table which allows for the calculation of the payback period
Calculating the discounted cash flows (or present value of each cash flow) allows for the calculation of net present
value (NPV) and calculating the Internal Rate of Return (IRR)
The final step is to make a decision based on the analysis
The final decision can depend on many other elements besides those listed here. Depending on the company, not all
these steps may be required to gain approval.
Simple payback is easy to calculate and widely used but it does not take into account the total savings from the
project.
The advantage of NPV and IRR is that they take into account the time value of money
Lifecycle costing includes all the costs of ownership, including the initial purchase price, the cost of energy,
maintenance and operations.

Slide 33: Financial Analysis of Projects II
In the next class in this series we will look at some common pitfalls when estimating project savings. Well also see
how to construct formulas in Excel for NPV, IRR and other financial values, plus how to include depreciation and tax
credits to obtain the after tax cash flows that can make your project more attractive.
Slide 34: Thank You!
Thank you for participating in this course.

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Financial Analysis of Projects I

Slide 1: Financial Analysis of Projects I

Slide 16: Payback Period

Slide 23: Net Present Value (NPV)

Slide 29: Using Interest Tables

Slide 30: Obtain Approval

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