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Financial Management

g

Mechanical engineering

g g department

p

Parul institute of engineering and technology

2/1/2019 1

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

2/1/2019 2

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

2/1/2019

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.

2/1/2019 4

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.

arise under following circumstances,

circumstances

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 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)

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

2/1/2019 7

Investment Selection Procedure

1. Identification of potential investment opportunities

3 Comparative

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

l i off

investments opportunities.

pp

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.

different effective value cash flows that makes future cash flows

less valuable over time.

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)

2/1/2019 9

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

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.

2/1/2019 10

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)

2/1/2019 12

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

2/1/2019 13

y The basic criteria for financial investment

appraisal

pp include:

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.

2/1/2019 14

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

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)

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?

2/1/2019 16

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

2/1/2019 17

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/-

2/1/2019 18

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

2/1/2019 19

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.

2/1/2019 20

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

2/1/2019 21

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

2/1/2019 22

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

2/1/2019 23

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

2/1/2019 24

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

2/1/2019 25

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

2/1/2019 26

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 :

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.

2/1/2019 27

•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:

•Doest not account for the variable nature of the annual net

cash inflows.

2/1/2019 28

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.

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.

2/1/2019 29

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.

described as benefit and cost cash flows,

respectively.

l

capital budgeting because it accounts for time

value of money by using discounted cash inflows.

2/1/2019 30

3.NET PRESENT VALUE

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.

calculating the present value (PV) of the total

benefits and costs which is achieved by

discounting the future value of each cash flow.

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

2/1/2019 32

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

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.

outgoing cash flows after the initial 100,000 cost.

2/1/2019 34

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.

provides

d any cashh flow

fl and

d is discontinued

d d

without any additional costs.

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

2/1/2019 36

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

2/1/2019 37

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)

2/1/2019 38

NET PRESENT VALUE

y The importance of NPV becomes clear in this

instance.

120,000) appear to exceed the outgoing cash flow

(100,000), the future cash flows are not adjusted

using the discount rate.

rate

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

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).

that must be determined in order to pprovide anyy

meaningful comparison between cash flows at

different periods of time.

2/1/2019 40

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.

n

CFt

NPV = ∑ − CF0

(1 + K )

t =0 (

t

2/1/2019 42

INTERNAL RATE OF RETURN

y Internal rate of return (IRR) method also

takes into account the time value of money.

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

2/1/2019 43

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

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.

2/1/2019 45

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.

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

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

2/1/2019 48

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

y0 -123400

y1 36200

y2 54800

y3 8100

2/1/2019 50

INTERNAL RATE OF RETURN

y then the IRR is given by

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?

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

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.

2/1/2019 54

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 55

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.

2/1/2019 56

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

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

(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

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% .

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% .

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

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

equivalents moving into and out of a business.

business

income, that is, how liquid it is, which can indicate

whether the company is positioned to remain solvent.

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.

f

future off project.

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

should always

y be remembered that theyy are only

y estimates.

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

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%

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:

management budget means you have a direct financial

incentive to identify and quantify savings arising from

your own activities.

your organization understanding whether they are each

getting good value for money through their support for

energy management.

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.

of the energy management function.

2/1/2019 77

Energy Service Companies (ESCO)

attractive options

p for manyy organizations

g is the use of

energy performance contracts delivered by energy

service companies, or ESCOs.

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.

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.

2/1/2019 82

2/1/2019 83

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