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Unit 2

Financial Management
g

Asst.Prof. Swati Prajapati


Mechanical engineering
g g department
p
Parul institute of engineering and technology

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CONTENT
‰ Introduction
‰Investment Need, Appraisal
pp and Criteria
‰Investment Selection Procedure
‰Introduction About Finance Analysis
‰ Finance
Fi A
Analysis
l i TTechniques
h i
1.Simple Pay Back Period
2.Return On Investment
3.Net Preset Value
4.Internal Rate Of Return

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Introduction
y In the process of energy management, at some stage,
investment would be required for reducing the
energy consumption of a process or utility. Investment
wouldld be
b required
i d for
f modifications/
difi i / retrofitting
fi i and
d
for incorporating new technology.
y IIt is
i essential
i l to identify
id if the h benefits
b fi off the
h proposed d
measure with reference to not only energy savings but also
other associated benefits such as increased productivity,
productivity
improved product quality etc.
y The cost involved in the proposed measure should be
captured following:
• Direct project cost
• Additional operations and maintenance cost
• Training of personnel on new technology
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etc. 3
Introduction
y Financial management is very broad term and it
is highly focused by all company.
y In case of energy management, investment is
required
i d tot beb done
d f
for reducing
d i th
the
energy consumption of process or utility.
y Also investment is required for modification
of existing systems.
y Any financial investment is done after
considering various benefit related to
investment.

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Investment Need
To convince any organization to commit itself to a
program of investment in energy efficiency, they
need to demonstrate:
™ The size of the energy problem it currently faces.
™ The technical and good maintenance measure available to
reduce waste
™ The predicted return achieved on particular measures
over time.

The need for investments in energy conservation can


arise under following circumstances,
circumstances

™ For new equipment,


q p , pprocess improvements
p etc.
™ To implement or upgrade the energy information system
™ To provide staff training 2/1/2019 5
Criteria
B f
Before k any investments,
you make i i is
it i important
i h
to ensure that

™You are getting the best performance from existing plant and
equipment
™Your energy charges are set at the lowest possible tariffs
™You are consuming the best energy forms –fuels or electricity as
efficiently as possible
™Good cleaning practices are being regularly accomplished.

When listing
g investment opportunities
pp , the followingg criteria need
to be considered:

™The energy consumption per unit of production of a plant


™The current state of repair and energy efficiency of the building
design , plant and services ,including controls.
™The quality of the indoor environment not just room temperature
b t indoor
but i d air
i quality
lit and
d air
i change
h rates,
t draft,
d ft under
d and d overheating,
h ti
etc.
™The effect of any proposed measure2/1/2019
on staff attitudes and behavior. 6
Investment Appraisal (Evaluation)

Energy manager has to identify the cost saving


arisingg from energy
gy management
g could be redeployed
p y within
his organization to the maximum effect.
To do this, he has to work out how benefits of
increased energy efficiency can be best sold to top
management as,

d
™Reducing
™R operating
i production
d i cost
™Increasing employee comfort and well-being
p
™Improvingg cost-effectiveness and p
profits
™Protecting under funded core activities
™the quality of service or customer care delivered
™Protecting the environment.
environment

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Investment Selection Procedure
1. Identification of potential investment opportunities

2. Assembling of proposed investments

3 Comparative
3. C i (rate of return, breakeven times) analysis
l i off

investments opportunities.
pp

4. Decision making & implementation(wrong decision can

lead to failure of project)

5 Performance review of implemented investment


5.

opportunity 2/1/2019 8
TIME VALUE OF MONEY
y Time value of money indicates that time has an impact on the
value of cash flows.

y Cash flows of nominal equal value over a time series result in


different effective value cash flows that makes future cash flows
less valuable over time.

y Thus, a cash flow today is more valuable than an identical cash


flow in the future
y Eg.
y Sale of stock (positive cash flow)
y Repurchase of company stock (negative cash flow)
y Issuance of debt, such as bonds (positive cash flow)
y Repayment
py of debt (negative
( g cash flow))
y Payment of dividends (negative cash flow)
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TIME VALUE OF MONEY
y This decrease occurs because the discount
factor represents the expected rate of return of each cash
fl
flow i a different
in diff i
investment with
i h identical
id i l risk.
ik

y With each additional period,


period the present value of a
subsequent future cash flow decreases
y Rs.100 received one year from now is only worth Rs.90.91
in today's money (i.e. Rs.90.91 plus 10% interest equals
Rs.100). Thus Rs.90.91 represents the present value of
Rs.100 cash flow occurring one year in the future. If the
interest rate were something different than 10%, then the
equivalent present value would also change.

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2/1/2019 11
Introduction To Financial Analysis
•When we decide to invest in increasing its energy
efficiency it should apply exactly the same criteria to
reducing its consumption as it applies to all its other
investments.
•The
Th basic
b i criteria
i i for
f financial
fi i l iinvestment appraisal
i l
are as follow:
9Simple payback
9Return on investment (ROI)
9Net preset value(NPV) and Cash flow
9Internal rate of return(IRR)

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y Decision of selecting / rejecting the investment
proposal
p p is depending
p g upon
p 2 things:
g
1.Amount require for investment
2. Return from investment
y There are many projects which can give faster return
but the amount of return is small and in other hand,
the p
project
j mayy be which can ggive higher
g return in
longer run.
y Various Tools
1. Payback period
2. Ratio of investment
3
3. N t presentt value
Net l
4. Internal rate of return
5
5. Cash flow
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y The basic criteria for financial investment
appraisal
pp include:

y Simple Payback - a measure of how long it will be


before the investment makes money, and how long the
financing term needs to be.
y Return on Investment (ROI) and Internal Rate of
Return (IRR) - measure that allow comparison with
other investment options.
y Net Present Value (NPV) and Cash Flow - measures
that allow financial planning of the project and provide the
company with all the information needed to incorporate
energy efficiency projects into the corporate financial
system.

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1.SIMPLE PAYBACK PERIOD:
y It is number of the years required to recover the initial
i t t considering
investment, id i only
l the
th nett annuall savings.
i

‰ Payback period is the length of time required to recover


the
h investment
i on theh project.
j
‰ Simple payback period also counts the operating &
maintenance cost
‰ Simple Payback Period (SPP) represents, as a first
approximation; the time (number of years) required to
recover the initial investment (First Cost), considering only
th Net
the N t Annual
A l Saving:
S i

CALCULATION:
Simple payback period= First cost /
(Yearly benefits-Yearly cost)

¾ The shorter the payback period, the more desirable the


project. 2/1/2019 15
Example
A co-generation plant installation is expected to
reduce a company’s annual energy bill by Rs.24 lakhs.
If the capital cost of the new cogeneration installation
i Rs.90
is R 90 lakhs
l kh and d the
th annuall maintenance
i t andd
operating costs are Rs. 6 lakhs, What will be the
expected pay back period for the project?

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Example
A co-generation plant installation is expected to
reduce a company’s annual energy bill by Rs.24 lakhs.
If the capital cost of the new cogeneration installation
i Rs.90
is R 90 lakhs
l kh and d the
th annuall maintenance
i t andd
operating costs are Rs. 6 lakhs, What will be the
expected pay back period for the project?

First Cost
Simple pay back Period =
Yearlybenifits - Yearly costs
90
Simple pay back Period =
24 - 6
Simple pay back Period = 5 year

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Example
Cost of an heat exchanger is Rs.1.00 lakhs .Calculate
simple pay back period considering annual saving
potential of Rs.60,000/- and annual operating cost of
Rs.15,000/-

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Example
Cost of an heat exchanger is Rs.1.00 lakhs .Calculate
simple pay back period considering annual saving
potential of Rs.60,000/- and annual operating cost of
Rs.15,000/-

First Cost
Simple pay back Period =
Y l b ifit - Yearly
Yearlybenifits Y l costs
t
100000
Simple pay back Period =
60000 - 15000
Simple pay back Period = 2 year 2 month 9days

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Example
Calculate simple pay back period for a boiler that cost
Rs.75.00 lakhs to purchase and Rs.5 lakhs per year
on an average to operate and maintain and is
expected to annually save Rs.30 lakhs.

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Example
Calculate simple pay back period for a boiler that cost
Rs 75 00 lakhs to purchase and Rs.5
Rs.75.00 Rs 5 lakhs per year
on an average to operate and maintain and is
expected
p to annually
y save Rs.30 lakhs.

First Cost
Simple pay back Period =
Yearlybenifits - Yearly costs
75
Simple
p ppayy back Period =
30- 5
Simple pay back Period = 3 year

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ADVANTAGES:
d l used
•A widely d investment criterion, the
h payback
b k period d seems
to offer the following advantages:
•It is simple, both in concept and application. Obviously a
shorter payback generally indicates a more attractive
investment. It does not use tedious calculations.
• It favours projects, which generate substantial cash inflows in
earlier years, and discriminates against projects, which bring
substantial cash inflows in later yyears but not in earlier yyears.
DISADVANTAGES:
•It fails to consider the time value of money
•It ignores cash flows beyond the payback period, leads to
demonstration against the project generated substantial cash
flow last year.
year
• measure of project capital recovery, not profitability
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Example Of Uneven Cash Flow:
Company C is planning to undertake another project requiring
i iti l investment
initial i t t off $50 million
illi and d iis expected
t d tto generate
t
$10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the
payback value of the project.

Solution
YEAR CASHFLOW CUMMULATIV
(in millions) E CASHFLOW
0 (50) (50)
1 10 (40)
2 13 ( )
(27)
3 16 (11)
4 19 8
5 22 30

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Payback Period = 3 + ( |-$11M| / $19M )

Payback Period = 3 + ( $11M / $19M )

Payback Period = 3 + 0.58

Payback Period = 3.58 years

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Examples:
Example of Even Cash Flows
Company C is planning to undertake a project requiring initial
investment of $100 million. The project is expected to generate
$25 million per year for 10 years. Calculate the payback period
of the project.
p j

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Examples:
Example of Even Cash Flows
Company C is planning to undertake a project requiring initial
investment of $100 million. The project is expected to generate
$25 million per year for 10 years. Calculate the payback period
of the project.
p j

Solution

Payback Period
= Initial Investment / Annual Cash Flow
= $100M / $25M = 4 years

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2. RETURN ON INVESTMENT
¾ROI h “annual
express the “ l return”” from
f h project
the j as a
percentage of capital cost.
¾Annual return includes cash flow over the project life &
discount rate by converting the total present value of ongoing
cash flow to an equivalent annual amount over the life of the
project which can be compared to capital cost.
project, cost
¾It is broad indicator of the annual return expected from
initial capital
p investment, expressed
p as a ppercentage
g :

Annual net cash flow


ROI = ×100
Capital
i l Cost

¾ROI
O must always be higher than cost off money ; greater the
return on investment better is the investment.
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•A small business may be able to save $5,000 in operating
expenses (and thus raise profit by the same amount) by
spending $25,000 on a piece of new equipment.

Thi yields
•This i ld an ROI off $5
$5,000
000 / $25,000
$25 000 or 20 percent.
t

•If this figure is higher than the company's cost of capital (the
interest paid on debt and the dividends paid to investors) prior
to the investment, and no better investment opportunities exist
for those funds, it may make sense to purchase the equipment.

LIMITATION:

•Does not take into account time value of money


•Doest not account for the variable nature of the annual net
cash inflows.
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3.NET PRESENT VALUE
y The difference between the present value of cash inflows and
the present value of cash outflows. NPV is used in capital
budgeting to analyze the profitability of an investment or
project.

NPV analysis is sensitive to the reliability of future cash


inflows that an investment or project will yield.
n
CF0 CF1 CFn CFt
NPV =
(1 + K )0
+
(1 + K )1
+ − − − − − − − − + = ∑
(1 + K ) n i =0 (1 + K )t
Where NPV= Net Present Value
CFt= Cash Flow occurring at the end of year ‘t’ ( t=0,1,2,……,n)
n= Life of the Project
K= Discount rate
ADVANTAGES
• It takes into account the time value of money.
money
• It considers the cash flow stream in its project life.
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3.NET PRESENT VALUE
y In finance, the net present value (NPV) or net
present worth (NPW) is defined as the sum of
th presentt values
the l (PV ) off incoming
(PVs) i i and
d outgoing
t i
cash flows over a period of time.

y Incoming and outgoing cash flows can also be


described as benefit and cost cash flows,
respectively.
l

y It is one of the most reliable measures used in


capital budgeting because it accounts for time
value of money by using discounted cash inflows.

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3.NET PRESENT VALUE

y If, for example, the capital required for Project A


can earn 5% elsewhere,, use this discount rate in
the NPV calculation to allow a direct comparison
to be made between Project A and the
alternative.

y The NPV of an investment is determined by


calculating the present value (PV) of the total
benefits and costs which is achieved by
discounting the future value of each cash flow.

y NPV is a useful tool to determine whether a


pproject
j or investment will result in a net pprofit or
a loss because of its simplicity
2/1/2019 31
3.NET PRESENT VALUE
y Thus we have the following two formulas for
the calculation of NPV:
y When cash inflows are even:
y NPV = R ×1 − ((1 + i))n− Initial Investment
y In the above formula,
p
R is the net cash inflow expected to be
received each period;
i is the required rate of return per period;
n are the number of periods during which
the project is expected to operate and
generatet cashh inflows.
i fl
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3.NET PRESENT VALUE
When cashflow are uneven
n
CF0 CF1 CFn CFt
NPV =
(1 + K )0
+
(1 + K )1
+ − − − − − − − − + = ∑
(1 + K ) n i =0 (1 + K )t

Where NPV= Net Present Value


CFt= Cash Flow occurring at the end
of year ‘t’ ( t=0,1,2,……,n)
n= Life of the Project
K= Discount rate

ADVANTAGES
• It takes into account the time value of money.
• I considers
It id h cashh flflow stream iin its
the i project
j lif
life.

2/1/2019 33
NET PRESENT VALUE
y EXAMPLE
y A corporation must decide whether to introduce
a new product line. The company will have
immediate costs of 100,000 at t = 0. Recall, a cost
is a negative or outgoing cash flow
flow, thus this cash
flow is represented as -100,000. The company
assumes the pproduct will pprovide equal
q benefits
of 10,000 for each of 12 years beginning at t = 1.

y For simplicity, assume the company will have no


outgoing cash flows after the initial 100,000 cost.

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NET PRESENT VALUE
y This also makes the simplifying assumption that
the net cash received or ppaid is lumped
p into a
single transaction occurring on the last day of
each year.

y At the end of the 12 years the product no longer


provides
d any cashh flow
fl and
d is discontinued
d d
without any additional costs.

y Assume that the effective annual discount rate is


10%.
10%
2/1/2019 35
Year Cash flow Present value

T=0 −100,000

T=1 9,090.91

T=2 8,264.46

T=3 7,513.15

T=4 6,830.13

T=5 6,209.21

T=6 5,644.74

T=7 5,131.58

T=8 4,665.07

T=9 4,240.98

T = 10 3,855.43

T = 11 3 504 94
3,504.94

T = 12 3,186.31
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NET PRESENT VALUE
y Th totall present value
The l off the
h incoming
i i cashh
flows is 68,136.92. The total present value of the
outgoing
g g cash flows is simply p y the 100,000 at
time t = 0.Thus:
y

Rearranging the formula:

y In the above example:

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NET PRESENT VALUE
y Observe that as t increases the present value of
each cash flow at t decreases.
y For example, the final incoming cash flow has a
future value of 10,000 at t = 12 but has a
present value (at t = 0) of 3,186.31. The opposite
of discounting is compounding.
y Taking the example in reverse, it is the equivalent
of investing 3,186.31 at t = 0 (the present value)
att an interest
i t t rate
t off 10% compounded d d for
f 12
years, which results in a cash flow of 10,000 at t =
12 (the future value).
value)

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NET PRESENT VALUE
y The importance of NPV becomes clear in this
instance.

y Although the incoming cash flows (10,000 x 12 =


120,000) appear to exceed the outgoing cash flow
(100,000), the future cash flows are not adjusted
using the discount rate.
rate

y Thus, the project appears misleadingly profitable.


Thus profitable
When the cash flows are discounted however, it
indicates the pproject
j would result in a net loss of
31,863.08.
2/1/2019 39
NET PRESENT VALUE

y The concept of time value of money indicates


that cash flows in different periods of time cannot
be accurately compared unless they have been
adjusted to reflect their value at the same period
of time (in this instance, t = 0).

y It is the present value of each future cash flow


that must be determined in order to pprovide anyy
meaningful comparison between cash flows at
different periods of time.

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NET PRESENT VALUE
¾ Advantage and Disadvantage of NPV
y Advantage: Net present value accounts for time
value of money. Thus it is more reliable than other
investment appraisal techniques which do not
discount future cash flows such payback period and
accountingg rate of return.

y Disadvantage:
g It is based on estimated future cash
flows of the project and estimates may be far from
actual results.

41
4.INTERNAL RATE OF RETURN:
IRR of an investment is the discount rate at which the
net present value of costs (negative cash flows) of the
investment equals
q the net present
p value of the benefits
(positive cash flows) of the investment.

It is also calculated from the formula of NPV.

n
CFt
NPV = ∑ − CF0
(1 + K )
t =0 (
t

Where r= internal rate of return.


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INTERNAL RATE OF RETURN
y Internal rate of return (IRR) method also
takes into account the time value of money.

y It analyzes an investment project by comparing


the internal rate of return to the minimum
required
i d rate
t off return
t off the
h company.

y The internal
Th i l rate off return is the h rate at
which an investment project promises to
generate a return during its useful life.
life

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INTERNAL RATE OF RETURN
y In more specific terms, the IRR of an investment
is the interest rate at which the net present
p
value of costs (negative cash flows) of the
investment equals the net present value of the
b fi (positive
benefits ( i i cashh flows)
fl ) off the
h investment.
i

y Internal rates of return are commonly used to


evaluate the desirability of investments or
projects.
projects
y The higher a project's internal rate of return, the
more desirable it is to undertake the project

2/1/2019 44
ADVANTAGES:
•It takes into account the time value of money.
•It considers the cash flow stream in its entirety.
•It makes sense to businessmen who prefer to
think in terms of rate of return and find an
absolute quantity , like NPV.
DISADVANTAGES
•The internal rate of return figure can not
distinguish between leading and borrowing and
hence a high internal rate of return need not
necessarily be a desirable features.

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INTERNAL RATE OF RETURN
y Example-2
y The management of VGA Textile Company is
considering to replace an old machine with a new
one. The new machine will be capable of
performing
f some tasks
k muchh faster
f than
h theh oldld
one. The installation of machine will cost $8,475
and will reduce the annual labour cost by $1,500.
The useful life of the machine will be 10 years
with no salvage value. The minimum required rate
off return is
i 15%.
15%
y Required: Should VGA Textile Company purchase
the machine? Use internal rate of return (IRR)
method for your conclusion.
2/1/2019 46
INTERNAL RATE OF RETURN
¾ Solution:
y To conclude whether the proposal should be
accepted or not, the internal rate of return
promised by machine would be found out first
and then compared to the company
company’ss minimum
required rate of return.

y The first step in finding out the internal rate of


return is to compute a discount factor
called internal rate of return factor. It is
computed by dividing the investment required for
the project by net annual cash inflow to be
ggenerated byy the pproject.
j The formula is ggiven
below:
2/1/2019 47
INTERNAL RATE OF RETURN

y ,The required investment is $8,475 and the net


annual cost saving is $1,500. The cost saving is
equivalent to revenue and would, therefore, be
treated as net cash inflow.
y Using this information,
information the internal rate of
return factor can be computed as follows:
y Internal rate of return factor =
$8,475 /$1,500
=5.650

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INTERNAL RATE OF RETURN
y After computing the internal rate of return
factor, the next step is to locate this discount
factor in “present value of an annuity of $1 in
arrears table”.
y Since the useful life of the machine is 10 years,
the factor would be found in 10-period line or
row.
y It is 12%. It means the internal rate of return
promised
i d by
b the
h project
j iis 12%
12%. Th
The final
fi l step is
i
to compare it with the minimum required rate of
return of the VGA Textile Company
Company. That is 15%
15%.

2/1/2019 49
INTERNAL RATE OF RETURN
y Example-2
y If an investment may be given by the
sequence of cash flows

yYear (n ) Cash flow (Cn )


y0 -123400
y1 36200
y2 54800
y3 8100
2/1/2019 50
INTERNAL RATE OF RETURN
y then the IRR is given by

In this case, the answer is 5.96% (in the calculation,


that is, r = .0596).

2/1/2019 51
Example
A company invests Rs.10 lakhs and completes an energy efficiency
j t att the
project th beginning
b i i off year 1.
1 The
Th firm
fi i investing
is i ti it own
its
money and expects an internal rate of return, IRR, of at least 26%
on constant positive annual net cash flow of Rs.2 lakhs, over a
period of 10 y
p years,, starting
g with yyear 1.
•Will the project meet the firm’s expectations?
•What is the IRR of this measure?

2/1/2019 52
Example
A company invests Rs.10 lakhs and completes an energy efficiency
j
project h beginning
at the b i i off year 1. The
h firm
fi iis iinvesting
i iits own
money and expects an internal rate of return, IRR, of at least 26%
on constant positive annual net cash flow of Rs.2 lakhs, over a
period of 10 years, starting with year 1.
•Will the project meet the firm’s expectations?
•What is the IRR of this measure?

Here d = 0.26 and check to what extent NPV > 0 at n = 10 years.

NPV = -1,000,000
, , + 200,000
, + 200,000
, + ……200,000
, =
1.261 (1.26)2 (1.26)10
= - 1,000,000 + 158,730 + 125,976 + 99,981 + 79,350
+ 62,976 + 49,981 + 39,668 + 31,482 + 24,986 +
19 830
19,830
= - 307,040
Since NPV is negative at 26%, project will not meet the firm’s
expectations, because this means that the factor of 1.26 must be
selected smaller in order to have NPV = 0

(ii) The IRR is 15.1%. Any result2/1/2019


between 14.5 and 15.5 is valid53
Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.

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Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.

NPV=-50,000+(15000/1.16)+18000/(1.16x1.16)+
(20000/(1.16x1.16x1.16))

= -50,000
50 000 + 12931 + 13377 + 12813
= (- 10879)

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Example
A investment
An i t t off Rs.
R 1.10
1 10 Lakh
L kh is
i made
d forf i bl speed
a variable d
drive at the beginning of the year, which is also the date of first
operation. Savings expected over 4 years are Rs. 28,000, Rs.
35,000, Rs. 40,000 and Rs. 40,000 respectively. Find out the
IRR of the project.

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Example
A investment
An i t t off Rs.
R 1.10
1 10 Lakh
L kh is
i made
d forf i bl speed
a variable d
drive at the beginning of the year, which is also the date of first
operation. Savings expected over 4 years are Rs. 28,000, Rs.
35,000, Rs. 40,000 and Rs. 40,000 respectively. Find out the
IRR of the project.

1,10,000 = 28,000/(1+r/100)+35,000/(1+r/100)2
+40,000/(1+r/100)3 + 40,000/(1+r/100)4

IRR = 11 % (app)

2/1/2019 57
Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.

2/1/2019 58
Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.

NPV=-50,000+(15000/1.16)+18000/(1.16x1.16)+
(20000/(1.16x1.16x1.16))

= -50,000
50 000 + 12931 + 13377 + 12813
= (- 10879)

2/1/2019 59
Example
A ppressure reducing
g valve is p
proposed
p to be replaced
p by
y a
steam turbine. The investment required is Rs.40 lakhs.
Additional maintenance and operating costs for the turbine is
expected to be Rs. 1 lakh per annum. If the annual savings
is Rs.9
Rs 9 lakhs,
lakhs calculate the payback period and Return on
Investment.

2/1/2019 60
Example
A ppressure reducing
g valve is p
proposed
p to be replaced
p by
y a
steam turbine. The investment required is Rs.40 lakhs.
Additional maintenance and operating costs for the turbine is
expected to be Rs. 1 lakh per annum. If the annual savings
is Rs.9
Rs 9 lakhs,
lakhs calculate the payback period and Return on
Investment.
First Cost
Simple pay back Period =
Y l b ifit - Yearly
Yearlybenifits Y l costs
t

Payback period = 40/(9 –1)


1)

= 5 years
A n n u a l n e t c a sh flo w
ROI = × 100
C a p ita l C o s t

Return on Investment = (9
(9-1)/40
1)/40
= 1/5
= 20 %
2/1/2019 61
Example
The following are the cash flows for a simple insulation up
gradation project.
a) Calculate the NPV if the cost of capital or discount rate is
8%
b) Calculate
C l l t the
th IRR
YEAR 0 1 2 3 4
Cash flow -18,000 -5,000 10,000 10,000 10,000

2/1/2019 62
Example
The following are the cash flows for a simple insulation up
gradation project.
a) Calculate the NPV if the cost of capital or discount rate is
8%
b) Calculate
C l l t the
th IRR
YEAR 0 1 2 3 4
Cash flow -18,000 -5,000 10,000 10,000 10,000

NPV = -18,000
18,000 - 5,000 + 10,000 + 10,000 + 10,000
(1.08)1 1.082 1.083 1.084
= 1,232

0 = -18,000 - 5,000 + 10,000 + 10,000 + 10,000


(1+k)1 (1+k)2 (1+k)3 (1+k)4

IRR = 10. %

2/1/2019 63
Example
Rs 25
An energy saving proposal involves an investment of Rs.
lakhs in an industry and is expected to yield an average
annual net saving of Rs. 5 lakhs/annum. The cost of
borrowing of the investment is 14%. Compute the return on
investment for this proposal and state with reason whether
the investment is justified

2/1/2019 64
Example
Rs 25
An energy saving proposal involves an investment of Rs.
lakhs in an industry and is expected to yield an average
annual net saving of Rs. 5 lakhs/annum. The cost of
borrowing of the investment is 14%. Compute the return on
investment for this proposal and state with reason whether
the investment is justified

A n n u a l n e t c a shh flo
fl w
ROI = × 100
C a p ita l C o s t

The Return On Investment (ROI) = 5/25 *100 = 20%

The cost of borrowing = 14%

Since ROI is higher than interest rate, the proposal is justified

2/1/2019 65
Example
A paper mill has two investment options for energy saving
projects:
Option : A Investment envisaged Rs.40 lakhs , annual return is
Rs.8 lakhs, life of the project is 10 years, discount rate 10% .

Option : B Investment envisaged Rs.24 Rs 24 lakhs,


lakhs annual return
Rs.5 lakhs, life of the project is 8 years, discount rate is 10%.

Calculate IRR of both the options and suggest which option the
paper mill should select considering the risk is same for
both the options.

2/1/2019 66
Example
A paper mill has two investment options for energy saving
projects:
Option : A Investment envisaged Rs.40 lakhs , annual return is
Rs.8 lakhs, life of the project is 10 years, discount rate 10% .

Option : B Investment envisaged Rs.24 Rs 24 lakhs,


lakhs annual return
Rs.5 lakhs, life of the project is 8 years, discount rate is 10%.

Calculate IRR of both the options and suggest which option the
paper mill should select considering the risk is same for both the
options.
Option A
8 x 105 8 x 105
40 x 105 = -------------- + - - - + -------------
( 1 + X )1 ( 1 + X )10
IRR = 15.10 %
Option B
5 x 105 5 x 105
24 x 105 = -------------- + - - - + -------------
( 1 + X )1 ( 1 + X )8
IRR = 13 %
Based on IRR, Option A has higher IRR and the mill may opt for
2/1/2019 67
option A
Example

A Project which has the following cash flow stream


Calculate NPV
The cost of capital, K for the firm is 10%

INVESTMENT Rs(10,00,000)

YEAR CASHFLOW
1 2,00,000
2 2,00,000
3 3,00,000
4 3,00,000
5 3,50,000
, ,

2/1/2019 68
INVESTMENT Rs(10,00,000)

YEAR CASHFLOW
1 2,00,000
2 2,00,000
3 3,00,000
4 , ,
3,00,000
5 3,50,000

n
CF0 CF1 CFn CFt
NPV =
(1 + K )0
+
(1 + K )1
+ − − − − − − − − + = ∑
(1 + K ) n i =0 (1 + K )t
−1, 000, 000 200, 000 200, 00 300, 00
V=
NPV + + +
(1 + 0.10) 0
(1 + 0.10) (1 + 0.10) (1 + 0.10)3
1 2

300, 00 350, 00
+ +
(1 + 0.10) 4 (1 + 0.10)5
= -5,273
2/1/2019 69
Project1 Project2
Capital cost 30000 30000
Example
Using the net present Year Net annual Net annual
value method, evaluate Saving(Rs) Saving(Rs)
the
h financial
fi i l merits
i off two 1 +6600 +6000
proposed projects shown
in table. The annual rate is 2 +6600 +6000
8 % for each project. 3 +6300 +6000
4 +6300 +6000
5 +6000 +6000
6 +6000 +6000
7 +5700 +6000
8 +5700 +6000
9 +5400 +6000
10 +5400 +6000
Total net saving +60000 +60000
at end of tenth
2/1/2019year 70
CASH FLOW

Cash flow is the net amount of cash and cash-


equivalents moving into and out of a business.
business

Cash flow is used to assess the quality of a company's


income, that is, how liquid it is, which can indicate
whether the company is positioned to remain solvent.

The level of cash flow is not necessarily a good measure


of pe
o performance,
o a ce, aand vvice ce ve
versa:
sa: high
g levels
eve s o
of cas
cash flow
ow
do not necessarily mean high or even any profit; and
high levels of profit do not automatically translate
into high or even positive cash flow
flow.

2/1/2019 71
RISK ANALYSIS
• Risk is degree of measuring the loss or damage to the
project.

• for project Many assumption are taken for the prediction of


f
future off project.

•Based on assumption the outcome are being assumed, some of


the assumption are significant effect on output.

•The present day cash flows, such as capital cost, energy cost
savings, maintenance costs, etc can usually be estimated
f i l accurately.
fairly t l

•Even though these costs can be predicted with some certainty, it


should always
y be remembered that theyy are only
y estimates.

•Cash flows in future years normally contain inflation (when the


price level of goods and services rises, the value of currency reduces)
components which are often "guess"
guess at best.
best The project life itself
is an estimate that can vary significantly.
72
SENSITIVITY ANALYSIS
Sensitivityy analysis
y is an assessment of risk. Because of the
uncertainty in assigning values to the analysis, it is
recommended that a sensitivity analysis be carried out -
particularly on projects where the feasibility is marginal.
marginal

•Suppose, for example, that a feasible project is based on an


energy cost saving i that
h escalates
l at 10% per year, but
b a
sensitivity analysis shows the break-even is at 9% (i.e. the
pproject
j becomes unviable if the inflation of energy
gy cost falls
below 9%). There is a high degree of risk associated with this
project - much greater than if the break-even value was at
2%.
2%

•Sensitivity analysis is undertaken to identify those


parameters thath are both
b h uncertain
i and
d for
f which
hi h the
h
project decision, taken through the NPV or IRR, is
sensitive.
y Many of the computer spreadsheet programs have
built-in "what if" functions that make sensitivity
easy If carried out manually,
analysis easy. manually the sensitivity
analysis can become laborious - reworking the
analysis many times with various changes in the
parameters.
• Sensitivity and risk analysis should lead to
improved
p project
p j design,
g , with actions jjustifying
y g
against major sources of uncertainty being
outlined.
y The various micro and macro factors that are
considered for the sensitivity analysis are listed
below.
y Mi
Micro factors
f
y • Operating expenses (various expenses items)
y • Capital structure
y • Costs of debt, equity
y • Changing of the forms of finance e.g. rental
y • Changing the project duration/life 74
Macro/ MAJOR FACTORS
• Macro economic variables are the variable that affects the
operation of the industry of which the firm operates.
They cannot be changed by the firm's management.
Macro economic variables, which affect projects, include
among others:
Changes in interest rates
• Changes in the tax rates
• Changes in the accounting standards e.g. methods of calculating
d
depreciation
i i
• Changes in depreciation rates
• Extension of various g
government subsidized p
projects
j e.g.
g rural
electrification
• General employment trends e.g. if the government changes the salary scales
• Energy Price change
• Technology changes
Financing Options
There are various options for financing in-house
energy management
1. From a central budget
2. From a specific departmental or section budget such as
engineering
3. By obtaining a bank loan
4 By raising money from stock market
4.
5. By awarding the project to Energy Service Company
(ESCO)
6. By retaining a proportion of the savings achieved.

76
Self-Financing Energy Management
One way to make energy management self-financing is to split
savings to provide identifiable returns to each interested
party. This has the following benefits:

• Assigning a proportion of energy savings to your energy


management budget means you have a direct financial
incentive to identify and quantify savings arising from
your own activities.

• Separately identified returns will help the constituent parts of


your organization understanding whether they are each
getting good value for money through their support for
energy management.

• If operated successfully, splitting the savings will improve


motivation
ti ti andd commitmentit t to
t energy managementt
throughout the organization since staff at all levels will see a
financial return for their effort or support.

• But the main benefit is on the independence and longevity


of the energy management function.
2/1/2019 77
Energy Service Companies (ESCO)

•If the project is to be financed externally, one of the


attractive options
p for manyy organizations
g is the use of
energy performance contracts delivered by energy
service companies, or ESCOs.

•ESCOs are usually companies that provide a complete


energy project service, from assessment to design to
construction
i or installation,
i ll i along
l with
i h engineering
i i
and project management services, and financing.

•In one way or another, the contract involves the


capitalization of all of the services and goods
purchased and repayment out of the energy savings
purchased,
that result from the project.
2/1/2019 78
•In performance contracting, an end-user (such as an
industry, institution, or utility), seeking to improve its
efficiency contracts with ESCO for energy
energy efficiency,
efficiency services and financing.
•In some contracts, the ESCOs provide a guarantee for the
savings that will be realized, and absorbs the cost iff real
savings fall short of this level.
yp y there will be a risk management
•Typically, g cost involved in
the contract in these situations. Insurance is sometimes
attached, at a cost, to protect the ESCO in the event of a
savings shortfall.
shortfall
•Energy efficiency projects generate incremental cost
savings as opposed to incremental revenues from the
sale
l off outputs.
•The energy cost savings can be turned into incremental cash
flows to the lender or ESCO based on the commitment
of the energy user (and in some cases, a utility) to pay for
the savings. 79
Role of Energy Service Companies (ESCO)

2/1/2019 80
Energy Performance Contracting
Performance contracting represents one of the ways
to address several of the most frequently
mentioned
ti d barriers
b i t investment.
to i t t Performance
P f
contracting through an ESCO transfers the
technology and management risks away from the
end-user to the ESCO.
For energygy users hesitant to invest in energy gy
efficiency, a performance contract can be a
powerful incentive to implement a project.
Performance contracting also minimizes or
eliminates the up-front cash outlay required by the
end user Payments are made over time as the energy
end-user.
savings are realized.
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