Discounted Cash Flow

Related terms:

Exergy, Cash Flow, Internal Rate of Return, net present value, Payback Period,
Incremental, Operating Cost

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Learn more about Discounted Cash Flow

Economic Analysis
Tarek Ahmed, D. Nathan Meehan, in Advanced Reservoir Management and Engi-
neering (Second Edition), 2012

7.4.3 Discounted Cash Flow Return on Investment

Discounted cash flow return on investment (DCFROI) also referred to as discounted
cash flow rate-of-return (DCFROR) or internal rate-of-return (IRR), is defined as the
discount rate at which the NPV is zero. It is very attractive to decision makers because
of its instinctive similarity to the interest rate at a bank. Oil and gas property cash
flows are not the same as putting money in a bank and receiving small interest
payments that are then reinvested over time. DCFROI has several other drawbacks;
however, it is one of the most popular investment evaluation tools, particularly for
investment efficiency. Let us return to Project C in the prior example and continue
to use ANEP discounting but vary the discount rate from 0% to 50% (Figure 7.4).
Figure 7.4. Illustration of calculating DCFROR.

Values above approximately 25% for the discount rate result in negative values for
NPV. Values less than 25% have a positive NPV. Using trial-and-error, the discount
rate that sets the NPV to 0 is 25.35%.

Project D has the identical DCFROI to Project C because all cash flows are just
five times larger. Project A has a DCFROI of 23.38%, and Project B has the lowest
DCFROI at 18.37%. The “best” project will, in fact, depend on the company’s
applicable discount rate, which for this purpose we will take to be the cost of capital.

Now examine the cash flows from Project C. If you were able to invest money in
a bank at 25.35%, would you expect your cash flows to look anything like those
in Project C? The decision maker who uses DCFROR to rank projects will need to
understand its strengths and weaknesses fully.

There are certain types of cash flow schedules in which more than one discount rate
results in a zero value for NPV. Examples of such cases include rate acceleration
incremental evaluations and cases requiring large investments sometime during the
life of the project. A nonunique solution may occur whenever there is more than one
change of sign in the cumulative cash flow. In other words, if the cumulative cash
flow starts out negative, turns positive, and turns negative again (perhaps turning
positive again later), a nonunique solution or a multiple rates-of-return solution
is possible. The incremental cash flow from evaluating an acceleration project is
typical of such a project. Because some companies utilize DCFROI in comparing
alternatives, reporting only one of the values where the discount rate yields a zero
NPV would be misleading.

The SPEE conducted a study based on comparison of various economic evaluation

softwares at the SPEE Petroleum Economics Software Symposium 2000 held on
March 2, 2000 in Houston, TX. Some software products reported only one value;
others printed both. Some issued cautions. The SPEE “Recommended Evaluation
Practice #9 – Reporting Multiple Rates of Return” recommends the following eval-
uation practice:

“In cases where multiple rates of return exist, the reported economic summary
should alert the user of the report that multiple rates of return exist (in lieu of
printing a single rate of return). In these cases the summary output should also
refer the reader to the present value profile data. A suggested presentation for such
an alert on the summary output might be as follows:IRR: Multiple rates of return may
exist, see present value profile plot.”

DCFROI has other problems as a tool for ranking projects. It cannot be calculated in
the following situations:

(a) When cash flows are all negative (dry hole cases, leasing costs, projects that fail
to generate any positive cash flows, etc.).
(b) When cash flows are all positive (farmout of a lease, which becomes a produc-
ing property, situations without investments involved that generate produc-
tion, etc.).
(c) When cash flows are inadequate to achieve simple payout. If the cash flows do
not recover the investment cost, they fail to generate a positive DCFROI (a well
that fails to recover its drilling and completion expenses prior to abandonment,
etc.).

Another complaint that many people express about DCFROI is what is purported to
be the inherent assumption that all cash flows are reinvested at the same discount
rate as the DCFROI rate. This is based on the fact that all cash flows are discounted at
the same rate. In this argument, DCFROI is overly optimistic for high rates-of-return
because when the oil company invests a certain amount of money into a project with
a high DCFROI the cash flows that are returned to the company are reinvested at an
arguably lower rate-of-return. This confusion comes about primarily because many
people view DCFROI as somehow being equivalent to a bank interest rate. If an oil
company does Project C in our prior example, it is not the same thing as investing
$1000 at 25.35% interest. The company in Project C invested $1000 and returned
$1500 in 3 years. Had they invested $1000 in a bank at 25.35% they would have
received $1969 at the end of 3 years. Of course the company did not leave the money
it generated during the first 3 years in a sock in their office desk. But the return they
achieved on reinvested funds is irrelevant unless you are trying to estimate future
wealth of the corporation rather than the marginal contribution of the project.

This argument forms much of the basis for the use of return on discounted cash
outlays (RODCO). On the other side of this argument is the common sense analogy
to interest rates. If the bank loans someone $1000 at 10% interest rate, the return
of interest and principal discounted at 10% will result in a zero NPV as long as the
discounting procedures match. It does not matter what the bank or the borrower
does with other investments; the specific transaction has a 10% DCFROI. The key
issue to remember is that DCFROI is not the equivalent of a bank interest rate and
should generally be used to compare similar projects for investment efficiency.

Very high values of DCFROI can be obtained. When values are calculated above 100%
per year, it is recommended to simply report 100%+ instead of the high values.
DCFROI is a more realistic measure of financial attractiveness than NTIR or payout,
primarily because it incorporates the time value of money. It is an excellent measure
of capital efficiency to compare alternative projects with comparable life spans and
cash flow patterns. It cannot be calculated for certain types of projects and can lead
to multiple solutions in others.

> Read full chapter

Natural Gas Conversion VI

Michael J. Gradassi, in Studies in Surface Science and Catalysis, 2001

4 SUMMARY
A discounted cash flow was used to calculate NPV10 for a representative model of
a GTL Fischer-Tropsch plant. This economic parameter was used to measure value
creation brought about by converting gas to fuel products and to demonstrate value
destruction resulting from GTL project start-up delays. It was further demonstrated
that value so destroyed is unlikely to be recouped, unless significant capital cost
reductions are made and implemented within the span of just a few years. The
Benefit-to-Cost ratio, calculated as the quotient of added NPV10 generated and the
R&D cost to achieve the GTL process improvement, can be used as a tool to pursue
cost effective, value-add research and development. The manufacture of finished
GTL products versus syncrude was used as an example to demonstrate it usefulness.

> Read full chapter

SOCIAL, LEGAL AND ECONOMIC IS-

SUES
J.C. McVEIGH M.A., M.Sc., Ph.D., C. Eng., F.I. Mech.E., F. Inst.E., M.I. Prod.E.,
M.C.I.B.S., in Sun Power (Second Edition), 1983
STANDARD PRESENT VALUE ANALYSIS
Conventional discounted cash flow concepts are used to establish the present value
of future savings and can be used to determine if it is economically justifiable to
invest in a solar heating system, based on the anticipated savings in heating costs
over the lifetime of the system.

The present value of £1 needed in n years’ time, is obtained by assuming today's

money is invested at the ‘market discount rate’ d.

Present value × (1 + r)n = £1 in n years’ time or present value =1/(1 + r)n. An

analysis of appropriate discount rates and the use of payback periods in assessing the
economics of solar heating has been given by Sulock (19). Even with the high interest
rates prevailing in the UK during the late 1970s, inflation rates were consistently
higher than the rates at which money could be borrowed for solar installations, as
these were regarded as an ‘improvement’ and the householder could get tax relief
or an addition to his mortgage.

The equation used to compute the constant annual payment Y necessary to repay a
capital loan C in n years at a fixed annual interest rate r is

(7.1)

This equation is derived by considering the outstanding balance left at the end of
each year when the interest and a proportion of the initial loan have been repaid. At
the end of the first year the outstanding balance is

(7.2)

At the end of the mth year, where m is any number between 1 and n, the outstanding
balance can be expressed as

(7.3)

At the end of the nth year the outstanding balance is zero, and by substituting n for
m in equation (7.3) and equating to zero, the final expression becomes

(7.4)

which is the same as equation (7.1).

> Read full chapter

Prefeasibility Assessment of a Tidal En-
ergy System
Vikas Khare, ... Prashant Baredar, in Tidal Energy Systems, 2019

Advantages
A popular discounted cash flow method, the internal rate of return criterion has
several 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, such as net present value, somewhat difficult
to work with.

Q.8 Calculate the simple payback period for a tidal power plant, that costs $10
million to purchase and install, $0.2 million per year on average to operate
and maintain, and is expected to save $3 million by reducing transmission and
distribution loss of tidal power plants.
Q.9 Calculate the simple payback period for a tidal power plant that costs $20
million to purchase and install, $0.4 million per year on average to operate
and maintain, and is expected to save $6 million by reducing transmission and
distribution loss of tidal power plants.
Q.10Calculate the simple payback period for a tidal power plant that costs $25
million to purchase and install, $0.5 million per year on average to operate
and maintain, and is expected to save $8 million by reducing transmission and
distribution loss of tidal power plants.
Q.11Consider a tidal energy project that has the following cash flow stream:

Investment $1,000,000
Saving in year Cash flow
1 200,000
2 200,000
3 300,000
4 300,000
5 300,000

If the discount rate is 10%, find the net present value at the end of 5 years.

Solution:
NPV = 5273

Q.12Calculate the simple payback period for a tidal power plant that costs $25
million to purchase and install, $0.5 million per year on average to operate
and maintain, and is expected to save $8 million by reducing transmission and
distribution loss of tidal power plants.
Q.13Consider a tidal energy project that has the following cash flow stream:

Investment $2,000,000
Saving in year Cash flow
1 400,000
2 400,000
3 600,000
4 600,000
5 600,000

If the discount rate is 10%, find the net present value at the end of 5 years.

Solution:

NPV = 73,197

Q.14Calculate the simple payback period for a tidal power plant that costs $25
million to purchase and install, $0.5 million per year on average to operate
and maintain, and is expected to save $8 million by reducing transmission and
distribution loss of tidal power plants.
Q.15Consider a tidal energy project that has the following cash flow stream:

Investment $1,000,000
Saving in year Cash flow
1 200,000
2 200,000
3 300,000
4 300,000
5 300,000

If the discount rate is 25%, find the net present value at the end of 5 years.

Solution:

NPV = 337,216

> Read full chapter

Evaluation, risk and feasibility
Eoin H. Macdonald, in Handbook of Gold Exploration and Evaluation, 2007

Discounted cash flow (DCF)

Using the discounted cash flow approach the project can be subjected to various
tests of which the most frequently used are net present value (NPV), internal rate of
return (IRR), and present value ratio (PVR). Equivalent annual value (EAV) is effective
in comparing operational alternatives. These four discounted measures are related
to one another in that a unique stream of cash flows defines each project thus
generating NPV, IRR, PVR, and EAV. The IRR is commonly a single result although in
some cases multiple internal rates of return are possible. The other three measures
are functions of the discount rate chosen as well as the stream of cash flows and
hence a continuous array of results is possible (Malone, 1992).

The above evaluation measures are related products of the same cash flow streams
but it is possible for them to give conflicting indications in relation to choosing
between investment alternatives. The problems, which are usually the result of the
selected discount rate, may in many cases be resolved by adopting the appropriate
discount rate for choosing between these particular alternatives. The cost of capital
may be the appropriate discount rate to evaluate a single investment opportunity
but not when choosing between competing, mutually exclusive investment oppor-
tunities. The reinvestment rate, the rate at which funds generated can be reinvested,
may be significant in choosing the preferred alternative in other cases.

Net present value (NPV)

The NPV of an investment is probably the main evaluation standard in common
use. It is calculated by first discounting the expected investment cash outflow and
the expected cash inflow, year by year, at a predetermined rate of interest. This rate
represents the cost of capital, mine life, growth element and any number of other
investment factors. The NPV is then found by subtracting the present value of the
outflows from the present value of the inflows, having regard to the discounted
salvage value of capital investment items at the end of the project life. A positive
NPV indicates a profitable investment; a negative NPV indicates an unprofitable
investment.

The purpose of NPV in economic valuation is to enable comparison with alternative

investment opportunities. The present value of an investment is a function of the rate
at which cash flows are discounted; different discount rates yield different values.
Nevertheless, the basis of NPV is meaningful only if it is calculated by bringing all
cash flows to a common datum, using an appropriate discount rate. The time datum
is commonly the beginning of the first period of life of the project, after which
expenditure commences. The solution lies in the choice of a minimum or cut-off r
ate, which is equal to or above the earning rate (internal rate of return). Thus, for
NPV = zero, the internal rate of return equals the cut-off rate chosen for the exercise.

Internal rate of return (IRR)

The internal rate of return of a project is the discount rate that would yield a net
present value of zero, i.e., the rate of interest which makes the present value of the
estimated cash inflow equal to the present value of the cash outflow required by
the investment. Zero NPV means that the cash proceeds of the project are exactly
equivalent to the cash proceeds from an alternative investment at the stated rate of
interest. The funds, while invested in the project, are earning at that rate of interest,
i.e., at the project’s internal rate of return.

All things being equal, the higher the IRR, the more attractive the project. In terms
of acquisition or future project development, projects generating IRRs greater than
a company’s target rate of return will be accepted. However, in terms of determining
the valuation of a project no IRR can be calculated where all cash flows are positive, as
in an operating mine situation. Multiple IRRs can arise where there are significant
negative cash flows at other stages of the project as well as at the beginning.

Present value ratio (PVR)

The PVR can be calculated by dividing the NPV of a project by the net present value
of the capital expenditure outflows, discounted at the same rate as used for the
NPV valuation. In effect it measures the net present value of the project per unit of
investment. The alternative method of calculating the PVR is to divide the present
value of all cash flows excluding capital expenditures by the present value of all capital
expenditures, both streams being discounted at the same rate.

The relationship between PVR (1) and PVR (2) is as follows:

9.2

9.3

PCF is the project cash flow excluding capital expenditure; CE is the capital expen-
diture. When the discount rate is the company target rate of return, the rule for
accepting projects is that PVR (1) should be > 0 and PVR (2) should be > 1. The higher
the PVR the better, although it does not help directly in the valuation of projects.
Equivalent average value (EAV)
The equivalent average value of a project can be calculated by multiplying the net
present value of the project by the capital recovery factor for the number of years of
the life of the project, and for the discount rate used in determining the NPV. The
EAV can be used for choosing between different equipment alternatives in which
cases the EAVs are equal annual costs and the lowest cost alternative is selected.

> Read full chapter

Economic evaluation
Hoss Belyadi, ... Fatemeh Belyadi, in Hydraulic Fracturing in Unconventional Reser-
voirs (Second Edition), 2019

Internal rate of return (IRR)

IRR is known as discounted cash-flow rate of return (DCFROR) or simply rate of
return (ROR). IRR is the discount rate when the NPV of particular cash flows is exactly
zero. The higher the IRR, the more growth potential a project has. IRR is an important
decision metric on any project. IRR is frequently used for project evaluation and
profitability of a project. The formula for calculating IRR is basically the same formula
as NPV except that the NPV is replaced by zero and the discount rate is replaced
by IRR as shown in the following equation. As opposed to NPV, IRR assumes that
positive cash flows of a project are reinvested at IRR instead of cost of capital. This is
one of the disadvantages of using the IRR method since it defectively assumes that
positive cash flows are reinvested at the IRR.

When the NPV of a particular project is exactly zero, the IRR will yield cost of capital
of a project. For example, if the cost of capital of a particular publicly traded company
is 9.3% and the NPV of a particular project yields zero, IRR will be 9.3% for that
particular project. This means the present value of all the cash inflows is just enough
to cover the cost of capital. When NPV is zero, no value will be created for the
shareholders. IRR must be higher than the cost of capital of a project to create any
value for the shareholders. When IRR is less than the cost of capital, no value will be
created for the shareholders.

(18.20)

IRR rule of thumb:

The rationale behind IRR in an independent project is:

1. If IRR is greater than WACC (IRR > WACC), the project’s rate of return will
exceed its costs and as a result the project should be accepted.
2. If IRR is less than WACC (IRR < WACC), the project’s rate of return will not
exceed its costs and as a result the project should be rejected.

For example, if a company’s cost of capital (WACC) is 12% and IRR for a particular
project is calculated to be 11%, the project must be declined because it would cost
more to finance the project (through debt and equity) than the actual return of
the project. On the other hand, if a company’s cost of capital is 12% and the IRR
for a specific project is 20%, the project is approved. A lot of companies have a
minimum acceptable IRR before investing in a project. This minimum acceptable
IRR for one particular company could be 15% while for others could be 20% or
25% depending on many factors, especially market conditions. Typically, in the O&G
industry, lower return projects are accepted in a downturn market condition as long
as better investment alternatives are unavailable.

In mutually exclusive projects, the project with higher IRR must be picked. For
example, if IRR on project A is 15% and project B is 20%, project B must be selected.

Example

Calculate the IRR for the cash flows listed in Table 18.9.

Table 18.9. IRR example

Year Profit ($MM)

0 (investment) −$500.00
1 −$100.00
2 $20.00
3 $300.00
4 $400.00
5 $500.00
IRR 19.89%

IRR can be calculated using Eq. (18.20):

As can be determined when manually computing IRR, IRR can be solved either using
trial and error or linear interpolation methods. Financial calculators or Excel are
recommended to perform this calculation. In this example, if various discount rates
are inputted into the above equation when the IRR is 19.89% in the denominator of
each term, the equation is equal to 0. This means the IRR for this particular project
is approximately 20%.

Internal rate of return calculation

As previously discussed, when manually computing IRR, IRR can be calculated
using trial and error, which is tedious and time consuming, or linear interpolation.
Many commercial economic software packages use linear interpolation, in which
the software finds the discount rate when the sign of NPV changes from positive to
negative and linearly interpolates between the two discount rates. One of the flaws
with this type of calculation is that two users who define different series of discount
rates will see different calculated IRR. There are other mathematical methods (not
discussed in this book) such as the root finding method, which can be used to
perform such calculations. In the above example, let us calculate NPV at different
discount rates of 10%, 15%, 18%, and 25%. Afterward, linear interpolation can be
used to calculate the discount rate when NPV is zero.

As can be seen from Table 18.10, NPV goes from 37.08 MM at 18% discount rate
to − 85.92 MM at 25% discount rate. After performing linear interpolation to find
the discount rate when NPV is 0, IRR is found to be 20.11%, which is close 19.89%.
This difference may be expanded at higher IRRs and widely spaced discount rates.
Therefore, users with various series of discount rates will see different calculated
IRRs.

Table 18.10. NPV at various discount rates example

Discount rate 10% 15% 18% 25%

Time 0 − 500.00 − 500.00 − 500.00 − 500.00
Discounted CF, − 90.91 − 86.96 − 84.75 − 80.00
Year 1
Discounted CF, 16.53 15.12 14.36 12.80
Year 2
Discounted CF, 225.39 197.25 182.59 153.60
Year 3
Discounted CF, 273.21 228.70 206.32 163.84
Year 4
Discounted CF, 310.46 248.59 218.55 163.84
Year 5
Summation (NPV) 234.68 102.71 37.08 − 85.92

CF, cash flow; NPV, net present value.

Example

Calculate the IRR using Table 18.11 given the NPV for each discount rate.

Table 18.11. IRR example

Discount 0 5 10 15 20 25 30 35
rate (%)
NPV 200 150 100 20 − 6 − 11 − 16 − 21
($MM)
IRR is the discount rate at which NPV is equal to zero. In this example, NPV at
15% discount rate is $20 MM and NPV at 20% discount rate is −$6 MM. Therefore,
NPV is equal to zero when the discount rate is in between 15% and 20%. Linear
interpolation can be used to find the discount rate when NPV is 0 given the
predefined series of discount rates.

From this example, the discount rate when NPV is 0 is equal to 18.85%.

NPV profile
NPV profile is a graphical representation of project’s NPV against various discount
rates. Discount rates and NPV are subsequently plotted on the x- and y-axis.

Example

Draw the NPV profile for projects A and B and determine which project is better
assuming a cost of capital of 5%.

The first task in this problem is to draw the NPV profile by plotting discount rate
(x-axis) vs NPVs for projects A and B (y-axis). IRR is the point at which NPV curves
cross the x-axis as shown in Fig. 18.2. There is a point referred to as the crossover
point (rate) in Fig. 18.2. Crossover point is the discount rate at which the NPV for
both projects is equal (Table 18.12).

Fig. 18.2. Crossover point illustration.

Table 18.12. Net present value (NPV) profile

Rate (%) NPV (A) NPV (B)

0 $60 $50
5 $43 $39
10 $29 $30
15 $17 $22
20 $5 $15
25 ($4) $6
30 ($15) ($2)

There are three stages in the following NPV profile. The first stage occurs before the
crossover point, and in this phase, the NPV of project A is more than the NPV of
project B. In this stage, there is a conflict between IRR and NPV since the NPV of
project A is more than B, while the IRR of project B is more than A. The company’s
cost of capital in this example is given to be 5%. When cost of capital is less than
crossover point (rate), a conflict exists. When a conflict exists and the cost of capital
is less than the crossover point, the NPV method must be used for decision making.
Therefore, project A is superior to project B in this example since the cost of capital is
given to be 5%. When the cost of capital is low, delaying cash flows is not penalized
as much compared to at a higher cost of capital. When the cost of capital is high
(more than the crossover point) delaying cash flows will be penalized.

At the crossover point (second stage), NPV of both projects is equal. Finally, during
the third stage, NPV for project B is more than NPV for project A. Please note that if
the cost of capital in this problem was given to be 10% instead of 5% (cost of capital
> crossover rate), both NPV and IRR methods would have led to the same project
selection. It is important to note that it is the difference in timing of cash flows that
is causing the crossover between the two projects. The project with faster payback
provides more cash flows in the early years for reinvestment. If the interest rate is
high, it is vital to get the money back faster because it can be reinvested while if the
interest rate is low, there is not such a hurry to get the money back faster.

> Read full chapter

26th European Symposium on Comput-

er Aided Process Engineering
Carina L. Gargalo, ... Gürkan Sin, in Computer Aided Chemical Engineering, 2016

2.2 Techno-economic analysis: methods and assumptions

The economic model used in this study is the discounted cash-flow rate of return
(DCFR). This model is based on the calculation of the net present value (NPV) which
can also be used to calculate the minimum product selling price (MSP) and discount
rate at which the project breaks even. It is assumed that the plant will be 40% equity
financed, where the loan is taken for ten years with 8% interest. The plant is built
within three years (one for engineering planning and two years for construction),
where the principal investment is paid in stages over these three years together with
the respective interest. It is also assumed that 8% of the total capital investment
(TCI) is spent in year -2, 60% is spent before year -1 and 32% before year 0. A 30 year
plant lifetime is also assumed and the Modified Accelerated Cost Recovery System
(MACRS) is used as depreciation method (for a 5 years period). The income tax rate
and discount rate are assumed to be 35% and 10%, respectively. The continuous
processing plant is operated by three shifts of workers, each working 330 days/year
at a rate of 32.7 $/h. The assumptions used are retrieved from Peters et al. (2003)
and Humbird et al. (2011)for the DCFR model. This model can be expressed by Eq.1,
2 and 3, where the input model variables are described in Eq.5.

(1)

(2)

(3)

(4)

(5)

(6)

Where, xp, Pp, xrmi, Prmi, xut, xw, Pw. FCI correspond to sales volume, product price, raw
material(s) inflow, price of raw material(s), utilities needed, price of utilities, waste
outflow(s), waste(s) treatment price(s), and fixed capital investment. Eq. 6 indicates
the subset of inputs identified as uncertain.

> Read full chapter

Unconventional Natural Gas

V. Kuuskraa, in Advances in Energy Systems and Technology, Volume 3, 1982

1 General Structure
The core of the Project Economics Model is a conventional discounted cash flow (net
present value) model. Its unit of analysis is the individual well and its drainage area.
Constant June 1980 costs are assumed throughout.

Individual cash flows are derived as a function of the following factors: production,
as governed by geology and technology; basic costs, as influenced by regional cost
factors and depth of well; stimulation costs, as determined by the size and depth of
the fracture treatment; and special costs, as required, for multiple completions and
for compression.

> Read full chapter

Materials for energy efficiency and

thermal comfort in domestic buildings
A. Peacock, in Materials for Energy Efficiency and Thermal Comfort in Buildings,
2010

22.9.1 Whole life cycle costing

The calculation of whole life costs was based on a discounted cash flow analysis of
the costs and revenues associated with the investment in external wall insulation
over a selected period of time (Masini et al., 2010). External wall insulation leads
to a decrease in energy consumption and therefore expenditure on utility bills. The
only economic benefit that is applied to the deployment of external wall insulation is
the reduction in utility bills. Any other benefits (for instance, enhanced asset value)
are ignored. The costs incurred by the deployment of an external wall system were
assumed to be (a) the initial capital cost, (b) anticipated maintenance costs of the
intervention, and (c) energy costs of the dwelling over a nominal 25-year study
period (2005–30). This seemed a reasonable time frame as defined by the warranty
attracted by the installation of an external wall system. The pre-1900 detached
dwelling described in Table 22.5 was used in this exercise.

The selection of discount rate is a key variable in defining the net present value
(NPV) of an investment and its assignment is a matter of some contention. While
it is reported that studies evaluating energy efficiency technology typically use a
discount rate of 4–8%, the discount rate used here was 3.5%, as this is the discount
rate recommended by the UK Treasury in the appraisal of any investment in the
public sector (Geller and Attali, 2005; HM Treasury, 2003). The whole life cost of the
interventions proposed and the base case scenario for this study is represented by
the generic WLC equation:

22.2

• C is the capital cost which includes the initial investment for the external wall
insulation and the system design (this will be equal to zero for the base case).
• A is the sum of all the yearly anticipated operation and maintenance (O&M)
costs.
•
 M is the sum of non-annually recurring operating, maintenance and repair
costs.
• E is the energy cost, i.e. the sum of the yearly gas and electricity expenditure.

• R is the replacement cost, i.e. the sum of all replacement anticipated over the
life of the intervention.
• The PV subscript indicates the present value of each factor.

The WLC of each intervention set was calculated over a 25-year period and expressed
in NPV terms. The base date chosen was 2005 and hence the values of variables such
as cost of energy consumed, capital and operational costs of the technologies relate
to this base date. The major assumptions made in producing the costing assessment
are given in Table 22.6.

Table 22.6. Major assumptions used in the WLC calculation

Property Condition
Capital cost of system £93/m2 [Peacock et al., 2009]
Total cost of system £12 850
Periodic maintenance assumption 2% of wall area every 8 years
Periodic maintenance cost £250
Initial utility tariff (gas) £0.0208
Energy saving (80% of external wall) 7750 kWh

The discounted cost of the investment was computed using a range of different
annual increases in gas utility tariff. Only when these annual increases became
substantial, i.e. 12% each year of the period studied, did the discounted cost of
the investment in external wall insulation reach zero within the 25-year period
(Fig. 22.11). It would therefore appear that only a limited economic case can be made
for investing in an external wall system of the type described here. A number of
extremely important caveats need to be considered when arriving at this conclusion,
however, some of which are discussed in more detail.
22.11. Effect of annual gas tariff increase on the discounted cost of investing in
external wall insulation for the solid wall detached dwelling.

Caveat 1
The only benefit that is applied to the installation of the external wall system is
the resultant fall in utility bills for the dwelling. The presence of secondary benefits
that are outside the narrow remit of energy consumption have been the subject of
numerous studies dating back more than 15 years. However, their identification has
not led to their inclusion in conventional techno-economic assessment of energy
efficient technologies of the sort being carried out here. Space does not permit
an adequate assessment and subsequent quantification of the specific secondary
benefits that may be accrued by the deployment of external insulation systems. It
does, however, represent a significant research gap. An excellent review of the
literature concerning the quantification of the co-benefits of improved efficiency
in buildings is provided by Ürge-Vorsatz et al. (2009).

Caveat 2
The capital cost figures were sourced from a current market entrant in 2005. The
current total market size for retrofit external insulation wall systems in the UK is
approximately 17 500. As we have seen, if this technology is to contribute to the UK
CO2 emission reduction targets, the number of installations per annum will probably
have to rise to somewhere between 0.5 and 1.0 million per annum. This market
growth will fundamentally alter the supply chain dynamics and knowledge/skill base
of both the system acquisition and the installation of the product on site.

In order that the discounted cost of the system is zero or less over the 25-year period
(assuming that the rise in utility gas tariff is 3% p.a.), the capital cost would have to
fall from £12 800 (£93/m2) to £5 400 (£39/m2). Assuming that the required market
growth indicated above is realised and that the number of installations grew to
approximately 600 000 per annum, this would represent a learning rate (reduction
in capital cost per doubling of market volume) of 19.5%. This is not a fanciful figure
given the range of rates reported in the literature for a range of technologies, some of
which are not subject to the strict rigours imposed by factory production (Table 22.7)
(Tam, 2007).

Table 22.7. Learning rates for a range of different technologies

Technology Country/Region Period Learning rate (%)

Ford Model T USA 1909–23 13
Refrigerators USA 1980–98 12
Clothes washers USA 1980–98 13
Dishwasher USA 1980–98 16
Room air conditioning USA 1980–98 15
Heat pumps Germany 1980–2002 30
Heat pumps Switzerland 1980–2004 24
Façades with insulation Switzerland 1975–2001 17–21
Double glazed coating Switzerland 1985–2001 12–17
windows
CFL Global 1990–2004 10

Clearly, this learning rate would benefit building owners or householders who were
late market entrants. The number of systems that would have to be installed to
achieve this fall in capital cost would be approximately 270 000. If these systems were
to receive a subsidy (a learning investment) to reduce the capital cost to the level
enjoyed by the late entrants, the total cost of subsidy would be approximately £561
million. However, as important as identifying the possible size of subsidy required
is the intention of using it specifically to promote technology diffusion in the
marketplace. The mechanism of distribution, marketing, start-up and exit strategy
of any subsidy scheme is as important as the scale of the subsidy itself (Heimdal and
Bjørnstad, 2009).

Caveat 3
Narrow techno-economic assessments of the sort carried out here assume that
householders are (a) rational economic actors who obey price signals and act ac-
cordingly and (b) have the ability to view investments over a long time frame (in
the case cited here – 25 years). The perception of cost and value is not, however, as
precise an exercise as perhaps the whole life cycle costing exercise suggests. The WLC
approach neglects important cultural signals that may exist to link consumerism
and ownership with, for instance, status, aspirations and societal responsibility. The
extent to which the consumer becomes aspirationally attuned towards ownership of
an energy efficient dwelling may play as important a role in the evolution of a mass
market for energy efficiency products as their capital cost.

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Economic Evaluation
Hoss Belyadi, ... Fatemeh Belyadi, in Hydraulic Fracturing in Unconventional Reser-
voirs, 2017

Internal Rate of Return (IRR)

Internal rate of return (IRR) is known as discounted cash-flow rate of return
(DCFROR) or simply rate of return (ROR). Internal rate of return is the discount
rate when the NPV of particular cash flows is exactly zero. The higher the IRR, the
more growth potential a project has. IRR is an important decision metric on any
project. IRR is frequently used for project evaluation and profitability of a project.
The formula for calculating IRR is basically the same formula as NPV except that the
NPV is replaced by zero and the discount rate is replaced by IRR as shown in Eq.
(18.20). As opposed to NPV, IRR assumes that positive cash flows of a project are
reinvested at IRR instead of cost of capital. This is one of the disadvantages of using
the IRR method since it defectively assumes that positive cash flows are reinvested
at the IRR.

When the NPV of a particular project is exactly zero, the IRR will yield cost of capital
of a project. For example, if the cost of capital of a particular publicly traded company
is 9.3% and the NPV of a particular project yields zero, IRR will be 9.3% for that
particular project. This means the present value of all the cash inflows is just enough
to cover the cost of capital. When NPV is zero, no value will be created for the
shareholders. IRR must be higher than the cost of capital of a project to create any
value for the shareholders. When IRR is less than the cost of capital, no value will be
created for the shareholders.

Equation 18.20. Internal rate of return (IRR).

IRR rule of thumb:

The rationale behind IRR in an independent project is:

1. If IRR is greater than WACC (IRR>WACC), the project’s rate of return will exceed
its costs and as a result the project should be accepted.
2. If IRR is less than WACC (IRR<WACC), the project’s rate of return will not
exceed its costs and as a result the project should be rejected.

For example, if a company’s cost of capital (WACC) is 12% and IRR for a particular
project is calculated to be 11%, the project must be declined because it would cost
more to finance the project (through debt and equity) than the actual return of the
project. On the other hand, if a company’s cost of capital is 12% and the IRR for a
specific project is 20%, the project is approved. A lot of companies have a minimum
acceptable IRR before investing in a project. This minimum acceptable IRR for one
particular company could be 15% while for others could be 20% or 25% depending
on many factors, especially market conditions.

In mutually exclusive projects, the project with higher IRR must be picked. For
example, if IRR on project A is 15% and project B is 20%, project B must be selected.

Example
Calculate the IRR for the cash flows listed in Table 18.9.

Table 18.9. IRR Example

Year Profit ($MM)

0 (investment) −$500.00
1 −$100.00
2 $20.00
3 $300.00
4 $400.00
5 $500.00
IRR 19.89%

IRR can be calculated using Eq. (18.20):

As can be determined when manually computing IRR, IRR can be solved either using
trial and error or linear interpolation methods. Financial calculators or Excel are
recommended to perform this calculation. In this example, if various discount rates
are inputted into the above equation when the IRR is 19.89% in the denominator of
each term, the equation is equal to 0. This means the IRR for this particular project
is approximately 20%.

Internal rate of return calculation:

As previously discussed, when manually computing IRR, IRR can be calculated

using trial and error, which is tedious and time consuming, or linear interpolation.
Many commercial economic software packages use linear interpolation, in which
the software finds the discount rate when the sign of NPV changes from positive to
negative and linearly interpolates between the two discount rates. One of the flaws
with this type of calculation is that two users who define different series of discount
rates will see different calculated IRR. There are other mathematical methods (not
discussed in this book) such as the root finding method, which can be used to
perform such calculations. In the above example, let’s calculate NPV at different
discount rates of 10%, 15%, 18%, and 25%. Afterward, linear interpolation can be
used to calculate the discount rate when NPV is zero.

As can be seen from Table 18.10, NPV goes from 37.08 MM @ 18% discount rate
to -85.92 MM @ 25% discount rate. After performing linear interpolation to find
the discount rate when NPV is 0, IRR is found to be 20.11%, which is close 19.89%.
This difference may be expanded at higher IRRs and widely spaced discount rates.
Therefore, users with various series of discount rates will see different calculated
IRRs.

Table 18.10. NPV at Various Discount Rates Example

Discount Rate 10% 15% 18% 25%

Time 0 −500.00 −500.00 −500.00 −500.00
Discounted CF, −90.91 −86.96 −84.75 −80.00
Year 1
Discounted CF, 16.53 15.12 14.36 12.80
Year 2
Discounted CF, 225.39 197.25 182.59 153.60
Year 3
Discounted CF, 273.21 228.70 206.32 163.84
Year 4
Discounted CF, 310.46 248.59 218.55 163.84
Year 5
Summation 234.68 102.71 37.08 −85.92
(NPV)

CF, cash flow; NPV, net present value.

Example
Calculate the internal rate of return using Table 18.11 given the NPV for each
discount rate.

Table 18.11. IRR Example

Discount 0 5 10 15 20 25 30 35
Rate (%)
NPV 200 150 100 20 −6 −11 −16 −21
($MM)
IRR is the discount rate at which NPV is equal to zero. In this example, NPV
@ 15% discount rate is $20 MM and NPV @ 20% discount rate is $−6 MM.
Therefore, NPV is equal to zero when the discount rate is in between 15% and 20%.
Linear interpolation can be used to find the discount rate when NPV is 0 given the
predefined series of discount rates.

From this example, the discount rate when NPV is 0 is equal to 18.85%.

NPV Profile:

NPV profile is a graphical representation of project’s NPV against various discount

rates. Discount rates and NPV are subsequently plotted on the x- and y-axis.

Example
Draw the NPV profile for projects A and B and determine which project is better
assuming a cost of capital of 5%.

The first task in this problem is to draw the NPV profile by plotting discount rate
(x-axis) versus NPVs for projects A and B (y-axis). IRR is the point at which NPV curves
cross the x-axis as shown in Fig. 18.2. There is a point referred to as the crossover
point (rate) in Fig. 18.2. Crossover point is the discount rate at which the NPV for
both projects is equal (Table 18.12).

Figure 18.2. Crossover point illustration.

Table 18.12. Net Present Value (NPV) Profile

Rate (%) NPV (A) NPV (B)

0 $60 $50
5 $43 $39
10 $29 $30
15 $17 $22
20 $5 $15
25 ($4) $6
30 ($15) ($2)

There are three stages in the following NPV profile. The first stage occurs before the
crossover point, and in this phase, the NPV of project A is more than the NPV of
project B. In this stage, there is a conflict between IRR and NPV since the NPV of
project A is more than B, while the IRR of project B is more than A. The company’s
cost of capital in this example is given to be 5%. When cost of capital is less than
crossover point (rate), a conflict exists. When a conflict exists and the cost of capital
is less than the crossover point, the NPV method must be used for decision making.
Therefore, project A is superior to project B in this example since the cost of capital is
given to be 5%. When the cost of capital is low, delaying cash flows is not penalized
as much compared to at a higher cost of capital. When the cost of capital is high
(more than the crossover point) delaying cash flows will be penalized.

At the crossover point (second stage), NPV of both projects is equal. Finally, during
the third stage, NPV for project B is more than NPV for project A. Please note that
if the cost of capital in this problem was given to be 10% instead of 5% (cost of
capital>crossover rate), both NPV and IRR methods would have led to the same
project selection. It is important to note that it is the difference in timing of cash
flows that is causing the crossover between the two projects. The project with faster
payback provides more cash flows in the early years for reinvestment. If the interest
rate is high, it is vital to get the money back faster because it can be reinvested while
if the interest rate is low, there is not such a hurry to get the money back faster.

Advantages of IRR:

• IRR accounts for time value of money.

• Cash flows over the economic life of the project are taken into account.Disad-
vantage of IRR:
• IRR does not provide a sense of scale about the value created for the share-
holders.
• IRRs cannot be added. If there are four projects with IRRs of 15%, 18%, 22%,
and 12% the total IRR will not be 67%. Instead, cash flows of all the projects
must be combined and IRR can be determined from the combined cash flows.
• IRR assumes that all the future cash flows are reinvested at IRR.

• IRR just like NPV does not give any indication of the size of the original
investment.
• IRR cannot be calculated when:

• cash flows are all negative or positive;

 • total undiscounted revenues are less than the original investment;

• cumulative cash flow stream changes sign more than once by going positive
to negative.

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