09 July 2008
Introduction to Economics of Energy Projects (EG854ES)
What Is Economics?
All economic questions arise from a single and inescapable fact: you can't always get what you want. We live in a world of scarcity. Scarcity means that wants always exceed resources available to satisfy them. People get involved in Economic Activity to cope with Scarcity. Economics is the study of how people use their limited resources to try to satisfy unlimited wants. Faced with scarcity, we have to make choices because we can't have all what we want. Balancing the wants and the resources available is called economizing or optimizing.
What Is Energy Economics?
What is competition?
Competition is the contest for command over scarce resources. For human life and the production processes, a sufficiently available of energy is the highest priority. Human beings can live without other things, but not without energy resources. Energy resources are also scarce and hence, needs its optimization and it is dealt by energy economics.
What Is Economics of Energy Projects?
Economics of Energy Projects deals with how economically an energy project can be established and operated. Cost structure, financing, capital budgeting (project evaluation), and financial performance analysis of the energy projects or firms are looked into.
Types of Firms
Three basic types of firm
Sole proprietorship Partnership Corporation or limited company
Sole proprietorship It is the oldest form of business organization. A single person owns the business, holds title to all its assets, and is responsible for all of its liabilities. Advantages Simplicity Quicker decision‐making Easy to establish Page 1 of 55
Good for small firms and not good for big firms such as energy Cos. Responsible for all liabilities Difficult to raise capital Cost of capital is high
Partnership A partnership is similar to a proprietorship in all aspects except that there is more than one owner. Advantages Disadvantages Responsible for all liabilities Slower decision‐making process than single proprietorship Difficult to raise capital Decision made through consensus/agreement , hence low risk Can raise higher capital Easy to establish but more complex than single proprietorship
Corporation or Limited Company A company is an impersonal entity created by law, which can own assets and liabilities. The main feature of this form is that the Co. is separate from its owners. A owner’s liability is limited to his/her shareholding only. Advantages Disadvantages Slow decision‐making Difficult to set up Limited liability Can raise higher capital (a kind for energy Cos.) Lower cost of capital Decision‐making through consensus
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RAISING G FINANCES S
Equity C Capital
Equity cap pital represen nts ownership capital as equity (common) sharehold ders collectively own the c company. Authorized capital – The amount of capital that a Co. can potentially issue, a per its d as memorand dum of association. Issued cap pital – the am mount offered by the Co. to o the shareho olders. Subscribed d capital – Th he part of the issued capita al which has b been subscrib bed to the inv vestors. Paid‐up ca apital – The actual amount t paid up by t the investors. Par value – – It is the valu ue stated in the memorandum and the share certific cate. Book value – It is the sum of the pa aid‐up capital and retained d earnings div vided by the number of ng shares. outstandin Market Va alue – It is th value of t share at which it is tr he the raded in the stock exchan or the nge market. blic Offering ( (IPO) – The in nitial public is ssue of the sh hares to the m members of t the public. Initial Pub Subsequen nt offering is called Second dary public of ffering (SPO). Rights Issu –It is the selling of th security in the primar market by issuing shares to the ue e he ry y existing sh hareholders.
Rights of f equity shar reholders
Right to incom me – The equi ity shareholders have residual claim to o the income of the firm af fter paying he debt obliga ation and pre eferred share dividends. Th he residual in ncome can be e withheld by the Co. as th re etained earnings or paid out as dividend. Right to control – Equity sh hareholders a are the actual l owners of th he Co. and ha ave the right to vote on very resolutio on placed bef fore the Co. ev
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Pre‐emptive rights – It enables the existing shareholders to maintain their proportional ownership of the shares if the Co. issued additional shares in the market.
Sources of Finance
Preferential Capital (Preferred shares)
Preferred shares are hybrid forms of capital. They have the characteristics of both the equity (common shares) and the debt such as debentures.
Main features are :
1. preferred share dividend is payable after net income, 2. it is cumulative (dividend if not paid in year, will be accumulated next year), and 3. it is taxable and has no voting rights.
Internal accumulation (retained earnings) The internal accruals consist of depreciation and retained earnings. Retained earnings are
much more expensive than bank loans, because they are retained without paying out the dividend and cost of capital (interest rate) of equity is higher than that of the loan.
Terms are given by financial institutions such as banks and have term of less than 10 years. Debentures (bonds) are loans raised from the public and the interest (called here as coupon) is paid every six months. It can be secured and unsecured. Debentures can be convertible into common shares.
Working capital advances (loans)
Under a cash credit or overdraft arrangement, a company can borrow required amount if it is within its limit in the agreement with the financial institution or the bank.
Weighted Average Cost of Capital (WACC)
Cost of Debt
A firm with a 40% tax rate issues $1,000 bonds at a face value with coupon rate of 16%. Ignoring underwriting and issuing expenses,
Market yield (market rate of return) = rd =160/1000 = 16% Cost of debt (to the company)=Rd=160*(1‐0.4)/1000 =9.6%
If people invest in bonds for long‐term, then Pb =Sum(I/(1+rb)t + F/(1+rb)n
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Cost of debt (to the Co) NPb =Sum(I*(1‐Tax)/(1+kb)t + F/(1+kb)n
Cost of Preferred Share
A corporation issues new $100 preferred shares that provide $12 in annual dividends. The firm has identical preferred shares outstanding that also trade at $100/share. Issuing and underwriting expenses are 5% of the issue price and assumed to be tax deductible. The firm’s tax rate is 40%.
Net Proceeds of preferred share (to the Co.) =NPp=100‐(1‐0.4)*5 =$97 rp= 12/100 = 12% kp=12/97 = 12.37% (cost of preferred share to the Co.)
Cost of Preferred Share (for long‐term investment) Pp=Dp*Sum(1/(1+ rp)t)
Cost of Equity
A corporation issues new $100 common shares that provide $16 in annual dividends. The firm has identical common shares outstanding that also trade at $100/share. Issuing and underwriting expenses are 5% of the issue price and assumed to be tax deductible. The firm’s tax rate is 40%.
Net Proceeds of common share (to the Co.) = NPe= 100‐(1‐0.4)*5 = $97 re= 16/100 = 16% ke = 16/97 = 16.49% (cost of equity to the Co.) Cost of Equity (long‐term) Market capitalization rate Pe= SUM(Dt/(1+ re)t) Cost of new shares NPe = SUM(Dt/(1+ ke)t)
Cost of Equity
Usually cost of equity is not known, then we have to use Capital Asset Pricing Model (CAPM) to find out cost of equity.
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Cost of Equity (CA APM)
Cost of Equity
Cost t of Equity (ke) = Rf + Equ k uity Beta * ( m ) ‐ Rf) (E(R
wher re, ee rate Rf = Risk fre E(R cted Return o on the Market t Index (Diver rsified Portfolio) E m) = Expec e, In practice • Short term g government security rates are used as r risk free rates s • Historical risk premiums a are used for t the risk premi ium • Betas are es stimated by r regressing sto returns a ock against market returns (it shows how much the t eq quity is riskier than the ma arket)
Weighted Averag ge Cost of C Capital (W WACC)
If ‘I’ is the e total investm ment, then I = =B+P+E where B is borrowing g (loans and bonds), P is preferred s shares, and E E is equity. Then, WACC =Rb(1‐T W Tax)*B/I +kp*P P/I + ke*E/I
Example o on WACC A firm pla ans on financ cing major ne ew expansion n programs by y drawing on n funds in the e following proportions that rough hly correspon nds to its curr rent capital st tructure: Lo ong –term de ebt $30 0 mil Preferred shar res $10 0 mil New common shares $40 0 mil Pa age 6 of 55
Issuing and underwriting expenses can be ignored. Debt can be issued at a coupon rate of 12%, and the dividend yield on preferred shares would be 9%. Common Shares currently trade at $45 per share. The current dividend yield on preferred shares would be $2.25 per share. Management feels that, over long run, growth in dividend match inflation rate, which is anticipated to be 10% per year. The corporate tax is 40%. What is the firm’s weighted average cost of capital (WACC) ?
Example on WACC
The current interest on government debt is 10%, and the return on the market is expected to exceed this rate by 7%. What value of beta do we have to assume for the firm if the cost of equity as derived from the CAPM is to match the Ke =15% calculated according to the dividend growth model under above example?
kb = (1‐T) rb =0.6*12% =7.2% kp = rp =9% Ke =D1 / pe+g =2.25/45+0.1 = 0.15 or 15% Proportion Cost in % Source Debt 30/80 =0.375 7.2% Preferred 10/80 =0.125 9% Common 40/80 =0.50 15%
WACC = 2.7% +1.13% +7.5% =11.33%
Weighted Cost 2.7% 1.13% 7.5%
Example on WACC A firm plans on financing major new expansion programs by drawing on funds in the following proportions that roughly corresponds to its current capital structure: Long –term debt $30 mil Preferred shares $10 mil New common shares $40 mil Issuing and underwriting expenses can be ignored. Debt can be issued at a coupon rate of 12%, and the dividend yield on preferred shares would be 9%. Common Shares currently trade at $45 per share. The current dividend yield on preferred shares would be $2.25 per share. Management feels that, over long run, growth in dividend match inflation rate, which is anticipated to be 10% per year. The corporate tax is 40%. What is the firm’s weighted average cost of capital (WACC) ?
Example on WACC The current interest on government debt is 10%, and the return on the market is expected to exceed this rate by 7%. What value of beta do we have to assume for the firm if the cost of equity as derived from the CAPM is to match the Ke =15% calculated according to the dividend growth model under above example?
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These are statements of financial information to the managers and the shareholders. Income Statement (Profit and Loss Statement) Balance Sheet Cash flow statement / Source and Use of Funds Statement (Statement of changes in financial positions)
It shows the record of financial events between two points in time. It has revenue from sales and expenses incurred during the period.
The value of total assets minus total liabilities or the value of the owners' claim on the assets.
Income Statements (P/L statement)
Expenditures are all cash outflows Expenses are only those expenditures that affect net worth of the shareholders and appear in the Income Statement. Receipts are all cash inflows. Revenues are only those receipts that affect net worth and thus appear in the income statement.
It gives snapshot summary of the firm's financial position at a single point in time. The balance sheet shows the net worth of shareholders at a point in time, whereas income statement measures changes in net worth.
Liabilities indicate what money has been made available to the firm. Assets show how the firm has used the money made available to it. Current Liabilities are the short ‐term debt obligations of a firm, with maturities of less than one
Fixed liabilities are firm's long‐term finance such as long‐term debts from banks and the public. Shareholders' equity is the money invested by the shareholders and the retained earnings. Fixed Assets are acquired for long‐term uses in the firm such as plant, building, land, and
Current Assets are cash, accounts receivables, and inventories of finished goods and raw materials. Depreciation is the allocation of cost of an asset to different time periods. Working Capital is composed of firm's current assets. Net Working Capital is the difference between current assets and current liabilities.
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Some Items in the Financial Statements
Profit is the excess of revenues over expenses during a given period of time. Cash flow is the actual cash flowing in and out of a firm over a particular time period. Operating cash flow is the flow of cash arising from the operation of a firm and consists of net
profit (profit after tax) plus non‐cash charges such as depreciation.
Cash Flow Statement
Source‐ and ‐use‐of‐funds Statement (cash flow statement) is a summary of the flow of the financial activity of the firm. It shows where the firm obtains cash and how it uses it.
Sources of funds
Increase in liabilities Increase net worth through retained earnings or capital contribution by the shareholders Reduction in assets through sales of assets
Uses of funds
reduction in liabilities reduction in net worth through payment of dividends or losses increase in assets
Cash flow from operating activities
Net profit Depreciation Decrease in account receivables Increase in accounts payables
Cash flow from investing activities
Sales of fixed assets Investment in new fixed assets
Cash flow from financial activities
Increase in debt (cash inflow) Issuance of new shares (cash inflow) Dividend payment (cash outflow)
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Balanc ce Sheet
Statement Income S Revenue Costs of Good ds Sold (COGS) G Gross Profit G Ex xpenses Net Income N
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INTEREST AND INTEREST RATE
• Interest is a rental amount charged by financial institutions for the use of money. • Interest rate, or the rate of capital growth, is the rate of gain received from an investment. • Usually this rate of gain is stated on a per‐year basis, and it represents the percentage gain realized on the money committed to the undertaking. Thus, an 11% interest rate indicates that for every dollar of money used, an additional $0.11 must be returned as payment for the use of that money.
THE TIME VALUE OF MONEY
Because money can earn at a certain interest rate through its investment for a period of time, a rupee received at some future date is not worth as much as a rupee in hand at present. This relationship between interest and time leads to the concept of the time value of money. • A rupee in hand now is worth more than a rupee received n years from now. Why? Because having the rupee now provides the opportunity for investing that rupee for n years more than the rupee to be received n years hence. Since money has earning power, this opportunity will earn a return, so that after n years the original rupee plus its interest will be a larger amount than the rupee received at that time. Thus, the fact that money has a time value means that equal rupee amounts at different points in time have different value as long as the interest rate that can be earned exceeds zero. It is also true that money has time value because the purchasing power of a rupee changes through time. During periods of inflation the amount of goods that can be bought for a particular amount of money decreases as the time value of money it is important to recognize both the earning power of money and the purchasing power of money.
THE PURCHASING POWER OF MONEY
Inflation (price rises) and deflation (depreciation, devaluation) are terms that describe changes in price levels in an economy. SIMPLE AND COMPUND INTEREST
Under simple interest, the interest owed (payable, billed) upon repayment of a loan is proportional to the length of time the principal sum has been borrowed. The interest earned may be found in the following
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manner. Let I represent the interest earned, P the principal amount, n the interest period, and i the interest rate. Then,
I = P* n* i
Suppose that NRS1, 000 is borrowed at a simple interest rate of 12% per annum. At the end of the year, the interest owed would be, I = NRS 1,000 *1*0.12 = NRS 120 The principal plus interest would be NRS 1,120 and would be due at the end of the year. Interest and principal become due (payable) only at the end of the time period.
• When loan is made for several interest periods, interest is calculated and payable at the end of each interest period. There are number of loan repayment plans. • These range from paying the interest when it is due to accumulating the interest until the loan is due. • If the borrower does not pay the interest earned at the end of each period and is charged interest on the total amount owed (principal plus interest), the interest is said to be compounded. • The interest owed in the previous year becomes part of the total amount owed for this year. This year’s interest charge includes interest that has been earned on previous interest charges. CALCULATION OF COMPOUND INTEREST WHEN INTEREST IS PAID ANNUALLY
CALCULATION OF COMPOUND INTEREST WHEN INTEREST IS PERMITTED TO COMPOUND
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INTEREST FORMULAS Let, I = the annual interest rate N = the number of annual interest periods; P = a present principal amount; A = a single payment, in a series of n equal payments, made at the end of each annual payments. F = a future amount in n annual interest periods. Assumptions: 1. End of one year is the beginning of the next year 2. P is at the beginning of a year from a time regarded as being the present 3. F is at the end of the nth year from a time regarded as being the present. 4. An A occurs at the end of each year of the period under consideration. When P and A are involved, the first A of the series occurs one year after P. when F and A are involved, the last A of the series occurs simultaneously with F. Single‐Payment Compound‐Amount Factor (F/P, i, n) If an amount P is invested now and earns at the rate i per year, how much principal and interest are accumulated after n years? Derivation of Single‐payment Compound‐amount Factor
• The resulting factor, (1 + i)n, is known as the single payment compound‐amount factor and is denoted by (F/P, i, n). • The future amount, F, of a present principal amount, P is given by: F = P(1 + i)n Page 13 of 55
Example: If $1,000 is invested at 16% interest compounded annually at the beginning of year one, the compound amount at the end of the fourth year will be: F = $1,000(1 + 0.16)4 = $1,000(1.811) = $1,811 Single‐Payment Present‐Worth Factor (P/F, i, n) Find the present worth P of a future amount, F received at the end of n periods if the interest rate is i. •The present worth in this case is given by: P = F [1/ (1 + i)n] •The resulting factor, 1/ (1 + i) n, is known as the single payment present‐worth factor and is denoted by: (P/F, i, n). Example: How much must be invested now at 16% compounded annually so that $1,811, can be received 4 years? P= $1,811 [1/(1 + 0.16)4] = $1,811(0.5523) = $1,000
Equal‐Payment‐Series Compound‐Amount Factor (F/A, i, n)
To find the single future value that would accumulate from a series of equal payments occurring at the end of succeeding interest periods. If A represents a series of n equal payments F = A + A (1 +i) + ….. + A (1 + i)n‐2 + A(1 + i)n‐1 F = A [(1+i)n – 1]/i The resulting factor, [(1 + i)n ‐1] /i, is known as the equal payment‐ series compound‐amount factor and is designated as (F/A,i,n). Example: The Compound Amount of a Series of Year‐End Payments of $100 of Annual Interest Rate Of 12%
Equal‐Payment‐Series Sinking Fund Factor (A/F, i, n) Page 14 of 55
The equal‐payment‐series compound‐amount relationship may be solved for A as follows:
The resulting factor, i/ [(1 +i)n – 1], is known as the equal‐payment series sinking‐fund factor Example: It is desired to accumulate $635 by making a series of five equal annual payments at 12% interest compounded annually, the required amount of each payment will be
Equal‐Payment‐Series Capital Recovery Factor (A/P, i, n) A deposit of amount P is made now at an annual interest rate i. The depositor wishes to withdraw the principal, plus earned interest, in a series of equal year‐end amounts over the next n years. When the last withdrawal is made, there should be no funds left on deposit. The value of equal year‐end amount (annuity) is given by:
The resulting factor i(1+i)n / [(1 + i) n 1] is known as the equal payment series capital‐recovery factor and is designated as (A/P, i, n). Example: $1,000 invested at 15% interest compounded annually will provide for eight equal year‐end payments of
Equal‐Payment‐Series Present‐Worth Factor, (P/A, i, n)
• To find what single amount must be deposited now so that equal end‐of‐period payments can be made, P must be found in terms of A
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The resulting factor, [(1 + i)n‐1]/i (1 +i)n, is known as the equal‐payment series present‐worth factor and is designated as (P/A, i, n). Example: The present worth of a series of eight equal annual payments of $223 at an interest rate of 15% compounded annually will be
Uniform‐Gradient‐Series Factor, (A/G, i, n)
In some cases, periodic payments do not occur in an equal series.They may increase or decrease by a constant amount. Let G = annual change or gradient n = the number of years; A = the equal annual payment
The resulting factor is called the uniform gradient series factor and is designated as (A/G, i, N) Geometric Gradient‐Series Factor, (A/G, i, n) In some situations, annual payments increase or decrease, not by a constant amount, but by a constant percentage. If g is used to designate the percentage change in the magnitude of the tth payment is related to payment A1 as
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Two types of linear gradient series as composites of a uniform series of N payments of A1 and the gradient series of increments of constant amount G
Project Cash Flows Typically a capital project initially requires investment outlay and produces annual net cash inflows. Cash Outflows: Purchase of new equipment Working capital Manufacturing, operating, and maintenance costs Leasing expenses Interest and repayment of borrowed funds Income taxes and tax credits. Cash Inflows: • Borrowed funds • Operating revenues • Cost savings (or cost reductions) • Salvage value • Working capital release (cost recovery by liquidation)
Elements of Cash Outflows
It is an investment in non‐depreciable assets.
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Some projects require such investment so that more funds are available in order to increase firm’s revenues. In accounting, working capital is the amount carried in cash, accounts receivable, and inventory (account, stock) that is available to meet day‐to‐day operating needs. For example, if a company is going to a market a new product, inventories of the product and larger inventories of raw materials will be needed. Accounts receivables from sales will increase, and management might also decide to carry more cash because of higher volume of activities. These are working capital but these have no tax effect and the cash flows always sum to zero over the life of a project but the inflows and outflows are shifted in time so, they do affect the net present worth.
The cost that occurs irrespective to the specific units of output of a firm is called as overhead cost. In manufacturing, all costs other than direct material and labors are treated as overhead costs. For example, costs to indirect material and labor, maintenance and repairs on production equipment; heat and light, property taxes, royalty, depreciation and insurance, overtime premiums. Depreciation of factory buildings is unaffected by the amount of production during any particular period. If however, a new building is required to meet any increased production, manufacturing overhead will certainly increase. Indirect materials like solder used to make electrical connections in a computer circuit board and the glue used to bind the books, these are treated as a part of manufacturing overhead. Typical examples of indirect labor include the wages of janitors, supervisors, material handlers and night security guards.
It is a tax applicable to gains (or losses) occurred on the earning or loss as a result of difference in the book value and salvage value of an asset. If the salvage value is higher than the book value then the tax needs to be paid to incremental earning. Similarly, if the salvage value is less than the book value then tax needs to be adjusted to the loss.
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Income Statement Cash Flow Approach
Once the cash flow elements (both inflows and outflows) are determined, these may be grouped into three categories: Operating activities • Cash flow from operations (e.g., current sales revenues, the cost of goods sold, operating expenses (also includes Interest payments) and income taxes) Cash flow from operation = Net income + Depreciation Investing activities In general, three investment flows are associated while buying equipment they are: original investment, salvage value and working capital investment or recovery. Financing activities • It includes: • The amount of borrowing, • The repayment of principal. The Net Cash Flow for a given year is simply the sum of the net cash flows from operating, investing and financing activities. Page 20 of 55
Generalized Cash Flow Approach
• It is an approach in which net cash flow is obtained by aggregating individual items. E.g. A computerized machining center has been proposed for a small tool manufacturing company. If the new system, which costs $125,000 is installed, it will generate annual revenues of $100,000 and will require $20,000 in annual labor, $12,000 in annual material expenses, and another $8,000 in annual overhead (power and utility) expenses. The automation facility would be depreciated at the rate of 20%. • The company expects to phase out the facility at the end of five years, at which time it will be sold for $10,000. Find the year‐by‐year after‐tax net cash flow for the project at a 30% marginal tax rate based on the net income and determine the after‐tax net present worth of the project at the company’s MARR of 15%. • Solve it using both Income Statement Cash Flow and Generalized Cash Flow Approach.
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Example with Financing (Borrowing) In the previous example, it is assumed that $62,500 of the $125,000 paid for the investment is obtained through debt financing (debt ratio =0.5). The loan is to be repaid in equal annual installments at 10% interest over five years. The remaining $62,500 will be provided by equity (e.g., from retained earnings). Find the net after‐tax cash flows. Solution Computing the annual loan repayment installments: $62,500 (A/P, 10%,5) = $16,487. Page 22 of 55
Now, computing the component of interest and loan repayment installments for 5 years as below:
For, n = 1, The interest due at n = 1 is $6,250 (10% of 62,500) Which leaves 16,487 ‐ 6,250 = 10,237 as left over for principal payment with loan balance as: 52,263. For, n = 2 is $5,226 (10% of 52,263) Which gives 16,487 – 5,226 = 11,261 as left over for principal payment and with loan balance as: 41,002 …
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Definition • It is a loss in value over the time the property is being used. • Depreciable property includes buildings, machinery, equipment and vehicles. Exceptions are land (no definite life) and collectible items/inventories (primary for sale) Economic Depreciation (ED) Example: A car’s reliability and appearance usually decline with age. The vehicle is worth less with each passing year. ED accumulated = Purchase price – market value Accounting Depreciation (AD) is based on the idea of ED The systematic allocation of the initial cost of an asset in parts over a time, known as its depreciable life and the process is AD. Sometimes refer to it as “asset depreciation” AD concept is popular in engineering economic analysis because AD provides a basis for determining the income taxes associated with any project undertaken. Page 24 of 55
What constitutes a depreciable property? • It must be used in business or held for production of income. • It must have definite service life and that life must be longer than 1 year. • It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.
Claiming Depreciation • The tax payer must be the owner of the property for the claim • In the case of leased property, lessee is not entitled to depreciate that property (e.g., leased automobiles)
Accounting for the Depreciation of Capital Assets
There are two aspects of depreciation: 1. The actual lessening in value of an asset with use and the passage of time and 2. The accounting for this lessening in value Depreciation views the cost of an asset as a prepaid expense that is to be charged against profits over some reasonable period of time. Rather than charging the entire cost as an expense at the time the asset is purchased, depreciation is a systematic way to spread the anticipated loss in value over the life of the asset. This is the concept of amortizing the cost of an asset so that the profit ad loss statement is a more accurate reflection of capital consumption which is basic to financial reporting and income tax calculation. Page 25 of 55
Value time function and Book value • The value of an asset decreases yearly in accordance with one of several mathematical functions. • Selection of particular function involves decisions as to the life of the asset, its salvage value and the form of the mathematical function. A general value‐time function is shown below:
Book value is the acquisition cost of an asset less its accumulated depreciation charges. A function similar to above can represent book value. Book Value Calculation The book value at the end of any year (Bt) is equal to the book value at the beginning of the year (initial cost, P) less the depreciation expenses charged during the year. Mathematically,
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Basic Depreciation Methods
Three important methods will be discussed: 1. Straight‐Line Methods 2. Accelerated Methods 3. Units‐of Production Method
Straight‐Line (SL) Method
This model assumes that the value of an asset decreases at the constant rate. The expression for depreciation charge in any year is:
And the book value at end of year t is:
Where, P = initial cost of the asset, F = Salvage value and N = useful life
Example 2: SL Depreciation
Cost basis of the asset, P = $ 12,000 Useful Life, N = 5 years, Salvage value, F =20% of the initial cost = $2400
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Accelerated Depreciation Methods
• The mechanical efficiency of an asset tends to decline with age, because maintenance costs tend to increase with age, or because of the increasing likelihood that better/efficient equipment will become available and make the original asset obsolete. • This reasoning leads to a method named “accelerated depreciation method “ that charges a larger fraction of the cost as an expense of the early years than that of the later years • The two most widely used accelerated methods are : a. Declining Balance b. Sum‐of‐the‐year‐digits
Declining Balance Method (DB)
• Calculation by DB depreciation method allocates a fixed fraction of the beginning book balance each year. The fraction, α, is obtained as follows: α = (1/N) . (Multiplier) • The most commonly used multipliers are 1.5 ( i.e., 150% DB) and 2.0 (called 200% or double declining balance , DDB) • When “n” increases , α decreases. This results in a situation in which depreciation is highest in the first year and decreases over the asset’s depreciable life. • For a depreciation rate α ,the depreciation charge in any year for declining –balance can be derived as follows:
• Total DB (TDB) depreciation at the end of t years is computed as follows:
• The book value, Bt, at the end of year t is the cost of the asset, minus the depreciation at the end of t years
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Example 3 : DB Method for example 2 Here, α = (1/N) . (multiplier) = (1/5) . 200% = 40% (Double DB)
Cases of DB Methods When final book value ≠ es mated salvage value, we must re‐adjust our analysis because either tax law does not permit us to depreciate assets below their salvage value or one have not taken full advantage of depreciation’s tax‐deferring benefits. Hence, two cases will be discussed: Case 1 : When the final book value is less than the estimated salvage value. Case 2: When the final book value is greater than the estimated salvage value. Case 1: When Bt < F Example 4: The final book value $ 933 is less than the estimated salvage value of $2,400.
To avoid deducting depreciation charges that would drop the book value (BV) below the salvage value F, adjust depreciation amounts such that Bt = F in the period when the implied BV is lower than F. Page 29 of 55
Note that B4 would be less than F = $ 2,400, if the full deduction ( $1,037) had been taken. We adjusted D4 to $ 192 , making B4 = $ 2,400. Case 2: When Bt > F Example 5: The final book value $ 933 is greater than the estimated salvage value of $ 0 (assume)
To reduce the book value (BV) of an asset to its salvage value as quickly as possible, it can be done by switching from DB to SL whenever SL depreciation results in larger depreciation charges i.e., switch from DB to SL if depreciation by DB in any year is less than ( or equal to ) it would be by SL.
Note that , switching takes place at year 4 as DB depreciation is less than SL depreciation .The resulting depreciation schedule is :
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Sum‐of‐the‐year‐digits (SOYD) Method of Depreciation
• As compared to SL‐depreciation, SOYD also results in larger depreciation charges during the early years of an asset’s life and smaller charges as the asset reaches the end of its estimated useful life. • Here, if N is the estimated years of useful life, the numbers 1, 2, 3,…,N are summed: SOYD = 1 + 2 + 3 +…….+ N = N (N+1) / 2 • Depreciation rate Dn is computed here as a fraction in which the denominator is the SOYD and the numerator is, for the first year, N; for the second year, N‐1 and so on. Each year the depreciation charge is computed by dividing the remaining useful life by the SOYD and by multiplying this ratio by the total amount to be depreciated (P‐F). Mathematically expressing:
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Example 6 : SOYD Depreciation
Units‐of‐Production Method • SL method can be applicable only if the machine/asset be used for exactly the same amount of time each year. What happens when a machine is run 2000 hours one year and 800 hours the next? • The units‐of‐production method takes care of such situation where depreciation charge for a period is related to the number of service units consumed in that period i.e., depreciation varies with production volume. • This method gives more accurate picture of machine usage. • By this method, the depreciation in any year is given by:
• A disadvantage of this method is that the collecting of data on machine use and the accounting methods are somewhat tedious. Example 6: Units‐of‐Production Method A truck for hauling coal has an estimated cost of $55,000 and is expected to give service for 250,000 miles, resulting is a $5,000 salvage value. Compute the allowed depreciation amount for truck usage of 30,000 miles. Solution : Page 32 of 55
• It is a depreciation method by which a company depreciates a fixed asset for tax purposes. This is one of the many tax incentive options that increases cash flows for reinvestment. • The depreciation methods are country specific and these are formulated by Tax Authority for estimating depreciation for Tax purpose. • Usually in depreciation, the asset is expected to be fully depreciated at approximately the end of its useful life. However, for tax purpose, it is not necessary. • Simple methods are established which defines several classes of assets with allocated rate of depreciation. Book Depreciation vs Tax Depreciation
Some of the Tax Depreciation Methods
Modified Accelerated Cost Recovery System (MACRS) Method: • MACRS is a method for tax depreciation practiced in developed countries e.g. US. • MACRS scheme formulated simpler guidelines with eight classes of assets/properties, each with a more or less arbitrary life called a recovery period. The recovery period do not necessarily bear any relationship to expected useful lives. The salvage value of property is always treated as zero. Page 33 of 55
MACRS Property Classifications
Note: • ADR = Asset Depreciation range; guidelines published by the IRS. • Automobiles have a midpoint life of 3 years in the ADR guidelines, but are classified into a 5 yr property class. MACRS Depreciation Schedules : MACRS recovery percentage as shown is according to Half Year‐Convention (HYC), Declining Balance Method • HYC assumes that all assets are placed in service at midyear and they will have zero salvage value. • Half of one year’s depreciation in the first year, full year’s depreciation in each remaining years and remaining half‐year’s depreciation in the year following the end of recovery period is taken. (See table in book) MACRS Depreciation: An Example # A taxpayer wants to place in service a $10,000 asset that is assigned to the 5‐yr class. Compute the MACRS % and the depreciation amounts for the asset. Solution: Given: 5‐yr asset, ½ yr convention We compute, α = 40% (200%DB), and S = 0 Since, Straight‐line rate = 1/5 = 0.20 200% DB rate = 2(0.20) = 40% Under MACRS, salvage value (S) = 0 Find: MACRS depreciation % Dn for $10,000 asset. Page 34 of 55
Then, beginning with the first taxable year and ending with the sixth year, MACRS deduction % is computed as follows:
Depreciation Amounts (Dn): Yr 1: 20% x $10,000 = $ 2,000; Yr 4: 11.52% x $10,000 = $ 1,152 Yr 2: 32% x $10,000 = $ 3,200. Yr 5: 11.52% x $10,000 = $ 1,152 Yr 3: 19.20% x $10,000 = $ 1,920; Yr 6: 5.76% x $10,000 = $ 576 Other Tax Depreciation Methods Maximum Tax Depreciation rate classification in Thailand • Based on acquisition price (SL method?) – The purchaser will depreciate the asset as if it is acquired new. – In the case of a second hand asset, depreciation of the asset, while with the previous owner, would not affect the minimum depreciation period for the asset to the new owner. It will be treated as if it is a new asset (using the asset price paid by the new owner).
Corporate Taxes Corporate rate is How are the taxes reflected in Cash Flow? Tax applied to the taxable income of a corporation. Page 35 of 55
Tax Rates in Thailand The maximum corporate income tax rate in Thailand is 30% on net profit.
However, the rates vary depending on types of tax payers. Cash Flow vs Net Income Depreciation = Expense or Income ? A company buys a numerically controlled NC machine for Baht 3 million (year 0) and uses it for 5 years, after which it is scrapped.
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The allowed depreciation rate is 20% in the acquisition price. Suppose the company estimates the following revenues and expenses, including depreciation, for the first operating year: Gross income = Baht 4 million Cost of goods sold = Baht 2 million Operating Expenses = Baht 1 million a) If the company pays taxes at the rate of Thai Tax rates, what is its net income from the project? b) Assume that 1) all sales are cash sales and 2) operating expenses will drop to 80% of that in Year 1 in subsequent years. Show the net cash flow.
Cost and Time value of Money
Classifications of Cost A number of cost classifications have come into use to serve as a basis for economic analysis. First Cost • First cost is the initial cost of capitalized property, including transportation, installation, and other related initial expenditures. • First cost is usually made up of a number of cost elements that do not recur after an activity is initiated. For purchased equipment, these include engineering design and development cost, test and evaluation cost, and construction or production cost as well as shipping, installation, and training costs.
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• Many activities that otherwise may be profitable cannot be undertaken because their associated first cost represents too high a level of investment. Many engineering proposals that are otherwise sound are not initiated because the first cost involved is beyond the reach of the controlling organization. Operation and Maintenance Cost • Whereas first cost occurs only once in getting an activity started, • Operation and maintenance cost is that group of costs experienced continually over the useful life of the activity. Fixed Cost • Fixed cost is that group of costs involved in an on going activity whose total will remain relatively constant throughout the range of operational activity. • Fixed costs are made up of such cost items as depreciation, maintenance, taxes, insurance, lease rentals, interest on invested capital, sales programs, certain administrative expense, and research. Variable Cost • Variable Cost is that group of costs that vary in some relationship to the level of operational activity. • In general, all costs such as direct labor, direct material, direct power, and the like, which can readily be allocated to each unit produced, are considered to constitute variable costs, and the balance of the costs of the enterprise are regarded as fixed. Incremental and Marginal Cost • The terms incremental cost and marginal cost refer to essentially the same concept. The word increment means increase. • Incremental cost is the additional cost that will be incurred as the result of increasing output by one more unit.
Cost Behaviors Fixed cost and variable costs are the two most common cost behavior patterns. Page 38 of 55
Fixed Costs The costs of providing a company’s basic operating capacity are known as fixed cost or capacity cost. For a cost item to be classified as fixed, it must have a relatively wide span of output where costs are expected to remain constant. This span is called the relevant range. In other words, fixed costs do not change within a given time period although volume may change. For our automobile example, the annual insurance premium, property tax and license fee are fixed costs since they are independent of the number of miles driven per year. Some typical examples would be building rents, depreciation buildings, machinery and equipment, and salaries of administrative and production personnel. Variable Costs In contrast to fixed operating costs, variable operating costs have a close relationship to the level of volume. If, for example, volume increases 10%, a total variable cost will also increase by approximately 10%. Gasoline is a good example of a variable automobile cost, as fuel consumption is directly related to miles driven. Similarly, the tire replacement cost will also increase as a vehicle is driven more. In a typical manufacturing environment, direct labor and material costs are major variable costs. Mixed Costs Some costs do not fall precisely into either the fixed or the variable category, but contain elements of both. We refer to these as mixed costs (or semi‐variable costs). In our automobile example, depreciation (loss of value) is a mixed cost. Some depreciation occurs simply from passage of time, regardless of how many miles a car is driven, and this represents the fixed portion of depreciation. On the other hand, the more miles an automobile is driven a year, the faster it losses its market value, and this represents the variable portion of depreciation. A typical example of a mixed cost in manufacturing is the cost of electric power. Some components of power consumption, such as lighting are independent of operating volume (e.g. number of machine‐hours operated). Sunk Cost A sunk cost is a past cost that cannot be altered by future action and is therefore irrelevant. Life‐cycle Cost Life‐cycle cost is defined as all costs, both nonrecurring and recurring, that occur over the life cycle. Many systems and products are planned, designed, produced and operated with very little concern of their life‐cycle cost. In generation, the elements of life‐cycle cost fall into categories that are based on organizational activity over the life cycle. These are described in the following list: o Research and development cost: initial planning; market analysis; feasibility studies; product research; requirements analysis; engineering design; design data and documentation; software; test and evaluation of engineering models; and associated management functions. o Production and construction cost: manufacturing; facility construction; process development; production operations; quality control Page 39 of 55
o Operation and support cost: consumer or user operations of the system or product in the field; product distribution; and sustaining maintenance and logistics support throughout the system or product life cycle o Retirement and disposal cost: disposal of non repairable items throughout the life cycle; system/product retirement; material recycling; and applicable logistic support requirements. • Experience has indicated that a large portion of the total cost for many systems is the direct result of activities associated with their operation and support. • Throughout the system/product life cycle, there are many actions required, both technical and non‐ technical. • The majority of the actions, particularly those at the earlier stages, has life‐cycle implications and definitely affects life‐cycle cost.
Financial and Economic Evaluation of Projects
Financial vs. Economic Analysis • Both financial and economic analyzes appraise the profit/return of an investment, but from differing perspectives: – Financial analysis estimates the profit accruing to the project from the points of view of the operating entity (the utility and the firm) – Economic analysis measures economic benefits and returns from the national economic point of view and assesses the effect of the project on the overall economy of the country. • Both types of analysis are conducted in monetary terms, but have different definitions of costs and benefits. • For a project to be economically viable, it must be financially sustainable, as well as economically efficient. If a project is not financially sustainable, economic benefits will not be realized. Financial analysis and economic analysis are therefore two sides of the same coin and complementary.
Financial Evaluation of Projects
Financial evaluation of projects is necessary to: • evaluate the commercial viability and financial sustainability of a project from the viewpoint of the project operating entity; • assess the degree to which a project will generate sufficient revenues to meet its financial obligations; • assess incentives for producers; • take into account all expenditures and revenues (costs and benefits) resulting from the project Financial evaluation of costs and benefits of large projects It is carried out on three levels: • Owner’s evaluation • Banker’s evaluation Page 40 of 55
• Economic evaluation Owner’s Evaluation: The owner is concerned only with the return to investment (equity) and thus would be more interested to know net benefits and their net present value in comparison with the value of the investment. Banker’s Evaluation: The banker evaluates the return on the total investment (equity + loans) of the project applied for the loan and considers its profitability i.e., the banker will consider the NPV of the whole investment and not just the investors’ equity. Economic Evaluation: This includes all the economic costs and benefits i.e., social and environmental/external costs that can be evaluated .Such evaluation is carried out specifically by development banks and similar institutions and also by the concerned planning departments in the government.
Project Financial Cost
The three main types are: 1. Investment costs: – Initial Cost (construction and commissioning including land, civil works, equipment and installations) – Replacement cost – Residual values (value of the investment items at the end of the project’s useful life) 2. Operating costs – Fixed costs: ‐ remuneration and benefits, administrative costs, insurance payments, part of the maintenance cost, etc. – Variable cost (depends upon the level of production):‐ fuel and energy, water, lubricants and part of the maintenance cost, raw materials (for industrial projects) 3. Working capital: – Capital required for the stock (spare parts ,fuel, raw materials) to ensure continuous production 4. Financial Evaluation of Projects: Some Methods 5. Financial Evaluation of Projects: Some Methods 6. Least Cost Solution – Present Value method – Annual Cost Method 7. Measuring worth of the investment – Internal Rate of Return – Net Present Value – Benefit/Cost Ratio – Payback Period 8. Least Cost Solution: Page 41 of 55
The least cost solution aims at evaluating all realistic alternatives (candidates) financially and economically before deciding the alternative that can achieve the project benefits at the least cost i.e., least discounted overall cost over the useful life span of the project or over the specified planning horizon. – In the case of energy supply industry, when there are many alternatives for meeting the need for increased electricity demand, the least cost solution aims at finding out the alternative technical arrangement that meets the requirement of electrical energy with the least cost to the utility, its site and timing. – In choosing the least cost solution we compare the present value of the cost of the alternatives and or discounted energy cost (US¢ /kWh) depending upon the costs and technical characteristics of the alternatives. 9. The most popular methods for financial evaluation and comparing alternatives: Present Value method – Here all costs and benefits of the project or net benefits (Cash flows) are discounted to the base year. The net present value (NPV) is nothing but the difference between the discounted benefits and the discounted costs.
n n Ct Bt t t t 0 (1 r ) t 0 (1 r ) Here, benefits represent the income or the revenue produced by the project (financial flows only)
Example 1: A company is considering buying an efficient boiler for its manufacturing process. It would cost $ 40,000 immediately but would save $7500 each year for the next 10 years. However at then end of the fifth year a one time maintenance expense of $ 5000 would be incurred .If the owner’s opportunity cost of capital is 8%, should the company buy the boiler? Solution:
Discounted Values Benfits,$ Cost,$ 0.0 40000.0 6944.4 0.0 6430.0 0.0 5953.7 0.0 5512.7 0.0 5104.4 3402.9 4726.3 0.0 4376.2 0.0 4052.0 0.0 3751.9 0.0 3474.0 0.0 50325.61 43402.92 6922.7
Year 0 1 2 3 4 5 6 7 8 9 10
Benfits,$ 0 7500 7500 7500 7500 7500 7500 7500 7500 7500 7500
Cost,$ 40000 0 0 0 5,000 0 0 0 0 0 Total NPV, $
The machine is a good investment; it produces a discounted savings of $ 6922.2 .
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Example 3: Financial evaluation of energy efficient motor over a 20 year life time and at 10% discount factor Good Motor (GM) Cost: $700 Input Power : 7.9 kW Running hours: 1600 h/year Electricity cost : $ 0.095 / kWh Energy Efficient Motor (EEM) Cost: $846 Input Power : 7.5 kW Running hours: 1600 h/year Electricity cost : $ 0.095 / kWh
Solution : The annual electricity cost (AEC) for the two motors is: GM : 7.9kW x 1600h/yr x $ 0.095/kWh = $1201/yr EEM: 7.5kW x 1600h/yr x $ 0.095/kWh = $1140/yr NPV = Discounted benefits – Discounted costs Here, discounted benefits = present value of future fuel/energy savings = ΔAEC x PVF(@10%,20yrs) = (1201‐1140)/yr x 8.5/yr = $518.5 and discounted cost = incremental cost of better product (initial cost) = ($846‐$700)= $146 Therefore, NPVEEM = $518.5 ‐ $ 146 = $372.5 :> The EEM is the better investment ! Annual Cost method This is a useful and quick method that gives rapid results and allows the attention of the evaluator to focus on a few alternatives supposing that certain assumptions and approximations are possible. Example 4: Comparing alternative projects by evaluating cost of production and prices:
Discount factor ( r ) Cost Expected life ( n ) Fixed and running cost Full load operating hrs Calculation: Annuity factor (r%, n) Cost of production = Combined Cycle Steam Turbine 10% $ 1000/kW 30 yrs 0.02 $/kWh 8000 9.427 ($1000/9.427)/8000+ $0.02 = 3.33 ¢/kWh Combined Cycle Gas Turbine 10% $ 500/ kW 20 yrs 0.024 $/kWh 7000 8.514 ($500/8.514)/7000+ $0.024 = 3.24 ¢/kWh
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Example 5: Comparison of cost of energy production from Wind Turbine, Photovoltaic ,and small Gas Turbine system
Owner discount rate Installation Cost (P) Capacity (kW) Capacity factor Heat rate Fuel Cost Variable O&M Cost Annual O&M Annual loan payment @ Annual operating hours The cost of electricity Photovoltaic 10% $ 10,000 3.0 0.25 ‐ ‐ ‐ ‐ (6% interest, 20 yr loan) P x CRF = $ 872/yr 8760 x 0.25 =2190 h =872/(2190 x 3) = 13.3 ¢/kWh Wind Turbine 10% $ 2500 0.90 0.385 ‐ ‐ ‐ $100/yr (7% interest,15 yr loan) P x CRF = $ 275/yr 8760 x 0.385 = 3373h (275+100) / (0.9 x 3373) =12.4 ¢/kWh =10.6 ¢/kWh Gas Turbine 10% $850/kW 0.70 12500 Btu/kWh $ 7 /106 Btu $ 0.002/kWh ‐ (10% interest, 20 yr loan) P x CRF =$99.8/yr 8760 x 0.7 = 6132 h Fuel + O&M + Fixed Cost =(12500* 7 /106) 0.002/kWh+($99.8/6132) +
Measuring worth of the investment for financial decision making : • The important criterion are : – Internal rate of return – NPV of the project – Benefit/Cost ratio – Other criteria (pay back, profit/investment ratio ,commercial return on equity capital)
Note: All the above criteria except for the last, involve discounting
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Exam mple 6 on IRR n
What would be the IRR ,if the o w opportunity c cost of capita (OCC) is 11 al 1%t, is this project desirable ?
The c condition required is : As a firs estimate, le IRR = 10%, st et
Since th sum is positi he ive, let IRR = 12%, this would give : d Repeati this iterati process yields an IRR of 17.5%.Since this exceeds the ing ive e OCC of 11%, the proj f ject will gener rate more than enough inco n ome to cover the cost of borrowing. Th is an attrac his ctive investme ent.
Spreadsh heet could be u used to compute IRR more eas using the sy e sily yntax: IRR(cash h-flow values)
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Example 7 (IRR)
Financial Analysis of a Petroleum Refining Project
Product Volume O&M of crude Price of Cost of sales / Capital a b c oil crude oil crude oil revenue Cost Cost $ million $ million b/d $/bl $ million $ million 6 0 0 0 0 0 45 0 0 0 0 0 55 0 0 0 0 0 52 0 0 0 0 0 0 18 500 65.0 10.7 27 0 35 2500 66.6 55.0 139 0 35 2000 68.3 45.1 116 0 35 2500 70.0 57.7 151 0 35 2800 71.7 66.3 141 0 2800 73.5 68.0 146 0 3000 75.4 74.6 163 0 3000 77.3 76.5 169 0 3000 79.2 78.4 176 0 3000 81.2 80.4 183 0 3000 83.2 82.4 191 0 3000 85.3 84.4 198 $119.48 $88.07 $12,341 $302.02 $704.21 Net Benefits $ million -6.0 -45.0 -55.0 -52.0 -1.9 49.5 35.9 58.1 39.2 78.2 88.2 92.9 97.7 102.8 108.1 113.7 $166.08
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 PV@10%
IRR 23% Notes: b/d: barrels per day a O&M include the cost of fuel used by the refinery b based on 330 days per year c based on the yield of various products (gasoline,jet fuel,gasoil,fuel oil and butane) from the refinery and the market prices of theses products
This method compares the discounted total benefits of the project to its discounted costs:
(1 r ) (1 r )
t 0 t 0 n
Only projects of B/C > 1.0 are adopted. The criteria is useful in capital constraint situation e.g., utility has a lot of feasible projects but limited investment budget. In this case, projects are ranked in accordance with their B/C ratio and are adopted accordingly until their combined costs equal the capital investment budget. Example 8: B/C of example-1 = 1.15
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It is the time required for a project's total benefits to exceed its total cost. At that time project can be said to have “paid back” its initial cost. The most common applications is in the analysis of energy conservation programs. Example 9: Energy efficiency retrofit of large building reduces the annual electricity demand for heating and cooling from 2.3 GWh to 0.8 GWh and the peak demand for power by 150 kW. Electricity costs $ 0.06/kWh and demand charges are $7/kW‐month.If the project costs $ 500,00,what would be the payback period of the investment ? Energy Savings (A) = (2.3‐0.8) x 106 kWh/yr x $ 0.06/kWh = $ 90,000/yr Demand Savings (B) = 150 kW x $ 7/kW‐month x 12 months/yr = $ 12,600/yr Total Annual Savings: (A ) + (B) = $ 102,600/yr Simple payback period = Initial Investment / Annual Savings = $500,000/$102,600/yr = 4.87 yr.
An Overview of Renewable Energy Project Financing through CDM
Formulation of the United Nations Framework Convention on Climate Change (UNFCCC) in 1992. UNFCC sets an “ultimate objective” of stabilizing atmospheric concentrations of greenhouse gases at safe levels. Categorization of countries into two groups: Annex I Parties i.e. the industrialized countries who have historically contributed the most to climate change, and non‐Annex I Parties, i.e. developing countries. Conference of Parties (COP) United Nations Framework Convention on Climate Change‐ As the Precursor of Clean Development Mechanism
The Protocol was adopted in December 1997. It creates legally binding obligations on Annex I countries to reduce their emissions of GHGs. Page 47 of 55
As of 27 Febru uary 2006, 16 62 states and d regional eco onomic integr ration organizations have deposited nstruments of f ratifications s, accessions, approvals or acceptances. in
Th he protocol e entered into f force on 16 Fe ebruary 2005 5.
Kyoto pro otocol requires developed countries to reduce the GHG emis d eir ssions ( CO2 e equivalent) at least 5% below to t the level of 1990 by 2012 (the first com mmitment per riod :2008‐20 012).
echanisms to o achieve the objective of reducing GHG G emissions. CDM is one of the Kyoto me jects that assist in crea ating sustain nable develo opment in CDM allows emission reduction proj eveloping cou untries to gen nerate “certif fied emission reductions (C CER)” for use by the invest tor. de
What ar re the aspects of CDM M ?
En nables Annex x‐1 countries (developed c countries) to meet their em mission reduc ction commitments in a flexible and co ost‐effective m manner. Assist develop ping countrie (non‐Annex I or the host countries) in mee es eting their s sustainable de evelopment o objectives. In nvestors bene efit by obtaini ing Certificates of Emissio ons Reduction ns (CER). Host Countries s benefit in the form of in nvestment, ac ccess to bette er technology y, and local s sustainable de evelopment.
What do oes CDM ai im to achieve?
Dual Obje ectives: • lo ower the over rall cost of red ducing GHG e emissions • w while also supporting sustainable develo opment initiatives within d developing co ountries. Pag ge 48 of 55
Flow of Finances A transfer of finances and contribution to sustainable development in the Host Country
Annex I Country Host Country
Flow of Credits Benefits of CDM for developing countries • Attract foreign investment to countries engaged in the trading of CERs • Increase the profitability of cleaner and more efficient technology in energy, industry, and transport sectors. • • Help in waste management operations. Contribute to sustainable development of the host country.
Project Sustainability Screening
Establishment of Sustainable Development criteria Should reflect economic, social, and environmental sustainability dimensions. The assessment of SD aspect of a project will involve a set of indicators. Page 49 of 55
The indicators should be : Complete: adequate to indicate the degree to which the overall objective of sustainability has been met. Operational: can be used in a meaningful way in the analysis. Decomposable: the decisions can be broken down into parts involving a smaller no. of indicators. Non‐redundant: The indicators should be defined to avoid double counting of consequences. Minimal: It is desirable to keep the set of indicators as small as possible. For instance it may be possible to combine indicators to reduce the dimensionality of the decision problem. Distribution of Registered CDM Projects by Host Countries Distribution of Registered CDM Projects According to the Sectoral Scopes Page 50 of 55
Energy industries (renewable - / nonrenewable sources), (55.62%) Fugitive emissions from production and consumption of halocarbons and sulphur hexafluoride, (2.96 %) Waste handling and disposal, (23.67%) Chemical industries, (1.18%) Manufacturing industries, (1.78%) Agriculture, (10.65% ) Energy Demand, (2.96%) Fugitive emissions from fuels (solid, oil and gas), (1.18%) India, 19.86 % Brazil, 26.24 % Others, 16.3 Sri Lanka, 2.13 1% % Guatemala, 2 .13% Ecuador, 2.1 3% Argentina, 2. 13% Republic of Moldova, 2.1 3% Panama, 2.1 3% China, 4.26% Chile, 4.96% Honduras, 6. 38% Mexico, 9.22 %
According to the Sectoral Scopes
Fugitive emissions from fuels 6% Chemical industries 5% Manufacturing industries 12% Fugitive emiss ions from halocarbons and sulphur hexafluorid 2% Waste handling an d 25%
Energy distribution 2% Energy d d 9% Afforestation and reforestatio 3% Agriculture 8% Trans port 2% Mining 2%
Energy in du stries 24% CDM Project Requirements Baseline study for emissions Emissions additionality & financial additionality Host country government approval Meets the sustainable development criteria Demand for CERs ‐ price of CERs
Additionality and Baseline
Additionality GHG reduced below what would have occurred without the project activity Baseline scenario Representing anthropogenic emissions by sources of GHGs that would occur without the proposed project activity Additionality and Baseline Page 51 of 55
Identify B Baseline Em mission Meth hodology
Base line/ /CER concept ts t0 = starting ye ear of CDM E0 =Total emis ssion without CDM project t 0t EC =Total em mission with C CDM CDMt CER = E0t – ECDM Mt = ton of e equivalent CO O2 reduction (traded in the international market: e.g., 5 $ to 25$ n $/tC )
s: Examples Impact of CERs price o on the projec cts’ IRR
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Country Costa Rica Jamaica Chile Costa Rice Gyana Brazil India
Project Wind power Wind power Hydro Hydro Bagasse Biomass Solid Waste
IRR with IRR without Carbon finance Carbon finance (%) (%) 9.7 10.6 17 18 9.2 10.4 7.1 9.7 7.2 7.7 8.3 13.5 13.8 18.7
Change in IRR (%) 0.9 1.0 1.2 2.6 0.5 5.2 4.9
The substantial improvement in IRR observed in Biomass and Solid Waste management projects.
Case Study Presentation
Financial Analysis of a Small Hydro Project with and without CDM Benefits Characteristics of the proposed CDM Project Type : Run‐of‐the river hydro project Installed Capacity: 3.5 MW Category : Renewable Energy project (<15 MW) Load type : National grid Developer : Private Country’s Power Development Scenario • The project is situated in a country where diesel and fuel oil based generation system supply 70% of electricity and the remaining is supplied by hydro sources. • In the last 5 years, all the new capacity added is based on diesel and fuel oil. • LCGEP shows that future additions to power generation capacity will be based on fuel oil or diesel though some exploitable hydro capacity is available. • The baseline emission factor is the emission factor of the diesel based generation system of appropriate capacity and load factor. (Method I) Estimation of Base‐line CER‐Method I
CDM Paramters Hydo Power Capacity 10 MW Output 67 GWh/a Emissions 0 t CO2/a Thermal power plant (Diesel) Input (1) 181,081 Emission factor (2) 0.202 Emissions (3)=(1)*(2) 36,506 Efficiency 0.37 Output 67 CER price (4) 10 CERs (3)*(4) 365,059
MWh/a tC/MWh tC/a GWh/a US$/tC US$/a
Estimation of Base‐line CER‐Method II The emission factor is the weighted average emissions (in kg CO2e/kWh) of all the generation units in the system. The emission coefficient is calculated as sum of total emission from each of the generation units divided by the sum of their generation in that year.
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N et G e n e ra tio n (G W h ) Fuel C oal 72563 L ig n ite 16368 G as 18826 H yd ro 16587 N u c le a r 4122 T o ta l 128466 B a s e lin e e m is s io n fa c to r (tC O 2 /M W h ) o r tC /M W h
Fuel C o nsum ed (1 0 3 to n n e s ) (A ) 50776 11454 3743
N e t C a lo rific V a lu e (T J /1 0 3 to n n e s ) - (B ) 1 6 .2 2 1 6 .2 2 4 3 .3 3
C arb o n E m is s io n * F a c to r (IP C C ; tC /T J )- (C ) 2 5 .8 2 7 .6 1 5 .3 0 0
E m issio n tC O 2 (D ) = (A )x (B )x (C ) x 4 4 /1 2 77911301 18801328 9116373 0 0 105829002
0 .8 2 4 0 .2 2 5
Identification of Additionality of the Proposed CDM Project • GHG emissions from this project activities is lower than that in the baseline • Proposed CDM project activities is not a baseline scenario project. • The project activity is not expected to get implemented in the absence of the CDM due to the investment barrier and financial analysis is used to demonstrate this:
Detail Cash-flow analysis without CDM Credit Compute FIRR and FNPV
Is financially attractive ?
Not a CDM Project
NO Detail Cash-flow analysis with CDM Credit Compute FIRR and FNPV Infeasible project NO
Is financially attractive ?
Consideration for CDM Project
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CER vs. FIRR
24 20 MARR 16 FIRR, % 12 8 4 Break-even CER 0 0 (Base Case) 3 5 10 15 25 CER, $/tC
Example : Break‐even
Present Worth $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $0 0 500 1000 1500 2000 2500 Break even- volume Profit
Annual Sales units PV Benefits PV Costs
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