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INDICATORS OF FINANCIAL PERFORMANCE
Meenu Mishra
UNIVERSITY OF PETROLEUM AND ENERGY STUDIES
Financing Businesses and
Projects
To determine the feasibility of businesses/projects:
A. Technical aspects  Technology, design, operations and
maintenance (O&M) aspects;
B. Financial aspects  Cost, finance, uncertainty analysis;
C. Managerial aspects  Developer, energy performance contractor
(EPC), O&M contractor;
D. Market aspects  Who buys power, how much, at what rate, how is
payment secured;
E. Regulatory aspects  Licenses, permits, approvals needed;
F. Economic aspects  External benefits, environment, etc.; and
G. Contractual and legal matters  How risks are allocated.
•
Chandra, P. “Projects: Planning, Analysis,
Selection, implementation and Review”, Tata
McGrawHill, (1995).
•
Degarmo, E. P., J. R. Canada and W. G.
Sullivan, “Engineering Economy”, Collier
MacMillan, (1990).
•
Kandpal, T. C. and H. P. Garg, “Financial
Evaluation of Renewable Energy
Technologies”, Macmillan India Ltd. (2003).
. What Skills Will Your Business
Require
Before you can start a business, certain skill sets must be acquired.
All successful businesses have included people with the necessary
skills. Even if the skill sets do not exist at this stage, it is important to
know what skills the team will need to establish your business
successfully.
a. Marketing and Sales: Identify customers for the product or services
of the business and develop a pricing, advertising and promotion
strategy to attract them. A person needs to determine and make use
of the business's competitive advantage.
b. Operation: Operate and maintain the business in a costeffective
manner.
c.Distribution: Select the most efficient and effective method of
delivering your product or service to customers.
d.Financial Planning: Estimate the financial requirements of a business
analyses such as Cash Flows, Income Statements and Balance
Sheets
•
e. Management: Oversee and coordinate all of the
participants in the business, with respect to the
company’s mission, performance, schedule and budget.
•
f.Permitting, Legal and Regulatory Matters: Understand
and comply with the relevant rules and regulations
governing your business.
•
g.Negotiations: Reach agreements with all of the parties
with whom the business interacts—contractors,
customers, government authorities, employees.
•
h.Bank and Investor Relationships: Raise debt and
equity and build business relationships that result in cost
effective capital sources for the project
BASICS OF BUSINESS FINANCE
•
What is a Budget .
•
Budget is the ultimate tool for any type of venture. It is a
forecast of all the cash income sources and to that end
cash expenditures, normally worked upon a yearly basis.
Budget provides the tools to monitor and control the
income and relevant expenditures through out the
business. Budget helps to find out how much money is
available and how far the targets being met in the
financial terms and what direction needs to take in any
unfavourable circumstances.
•
Budget consist of three basic elements : a) Sales
Revenue
•
b) Costs
•
c) Profit
Sales Revenue:
•
Revenue from sales is the chief source of
income and determines the sales
operations. It is an estimation that will
accrue to the business as accurately as
possible. The past experience of sales
record and the industry average would
help in arriving the figure. Once the sales
target is arrived at, then the necessary
costs can be worked upon.
Costs:
•
Estimation of costs is a complicated procedure. Small
changes in the assumptions on which the costs are
estimated can render the whole budgeting exercise
futile. There are two types of costs – one that changes
with the volumes of sales called variable costs and the
other one that does not change called as fixed costs.
•
Variable Costs:
•
Variable costs are those that changes directly with the
extent of sales/services produced
•
Larger sales means procuring more raw material,
distribution cost,etc is variable cost. The more cable
connections means more material,
accessories,supervision,equipments etc.
•
Fixed Costs:
•
Fixed costs are those which remain unchanged
by the volumes of sales.This means such
expenditure continue to incur and have no
relationship to the volume of services and sales.
•
Semi variable costs:
•
There are some costs in most of the
businesses such as salaries and service
engineer, more conncetion may require
additional service of a engineer., telephone call
bills etc.
Working capital is the difference between a
business’ current assets and its liabilities . The
working capital is the amount of money required
by a business to cover its short term liabilities.
And includes the following:
•
Cash
•
Marketable securities
•
Accounts receivables
•
Inventories
•
Accounts payable
•
Wages /salaries and taxes
•
How to prepare a Budget?
•
In order to prepare a good budget ,
following three questions must addressed:
•
How much net profit the business must
make?
•
How much will it cost to reach that level of
profit?
•
How much sales revenue is necessary?
•
Breakeven Analysis
This simply means that the sales /services
revenue must be so much to cover all costs
incurred in the venture and are fully recovered.
The recovery of fixed costs and deduction of the
variable costs will help determine the volume of
the sales to reach the breakeven point and that
any excess difference with the sales volume as
compared with the costs results in profit.
Pattern of investment / capital
•
There are four different ways to raise the capital
required.
Personal Financing:
•
This is dealer’s personal money and since it is personal
no interest is payable and readily accessible.This is the
easiest way to finance the venture.
Credit Capital:
•
Credit can be obtained from credit companies or the
suppliers who supply the goods and services and give
grace period to clear the dues or interest is charged.
Such arrangement helps the retail dealers to expand
the customer nbase.However such facility is not
available for the new business/venture
Equity Capital:
• Equity financing does not require the business to directly repay the
money lent or invested by the financier. Under such arrangement
the financiaer becomes a partner in the business and gets the
share in all business profits. They would also have some control
over the running of the business.
Debt Financing:
• This is the most preferred pattern of financing a new venture. Here
it is the diredt obligation to pay the interest on the amount lent out by
the financier. The biggest advantage is that the financier has no
control over the business as against the equity financing. It is not
the worry of the financier if the business is making profit or not and
that the repayment must be regular with the interest
What is interest
•
Interest is the charge on money lent. In
debt financing there are tow parties
borrower and lender. A borrower is the
one who receives the money from the
lender. An interest amount is the charge
fixed on the money lent and usually it is
stated in a percentage as demanded by
the lender
Methods of calculating interest
•
Interest only – meaning only interest during the
loan duration and the last instalment is paid
along with the principal amount
•
Equal payments—here the interest and the
principal to be repaid are spread over evenly for
the entire period
•
Equal principal payment – in this case, the
principal amount is paid in equal instalments,
while the interest
decreases ( based on the balance of principal
amount)
What is Net Present Value (NPV)?
•
Present Value or PV is a method to
calculate what would be the value of a
future cash flow if it were to happen today.
Here a discount rate (similar to interest
rate) is used to calculate the PV. Interest
represents what one would earn whereas
the discount works backward to give the
value for today.
Basic Formulae of Financial Mathematics
To find Given Factor Name Formula
F P (F/P,i,n) Single payment
compound amount
factor
F = P(1+i)
n
P F (P/F,i,n) Single amount
present worth factor
P =
) i + (1
F
= P
n
F A (F/A,i,n) Uniform series
compound amount
factor
F = A
]
]
]
i
1  ) i + (1
n
A F (A/F,i,n) Uniform series
sinking fund factor
A = F
]
]
]
1  ) i + (1
i
n
P A (P/A,i,n) Uniform series
present worth factor
P = A
]
]
]
) i + i(1
1  ) i + (1
n
n
A P (A/P,i,n) Uniform series
capital recovery
factor
A = P
]
]
]
1  ) i + i(1
) i + i(1
n
n
WHY STUDY ECONOMICS
OF ENERGY SYSTEMS?
Alternative options of
energy resource technology combinations,
and
investment opportunities
are available to the end user(s).
Hence,
Financial viability to the individuals, and
Economic viability to the society/country
of different energy resourcetechnology
combinations must be evaluated and ensured
prior to their large scale dissemination.
Manual Pump
Human
Muscle
Draught
Animal
Oil
Coal
Gas
Hydro
Fuelwood
Animal Dung
Solar
Radiation
Wind
Agriresidue
Animal Driven Pump
Engine Pump
Motor Pump
Hydram Pump
Dual Fuel Engine Pump
Dual Fuel Engine Pump
Solar Thermal Pump
Motor Pump
Windmill Pump
Diesel
Electricity
Producer Gas
Biogas
PV Electricity
Mechanical
Power
for
Water
Pumping
Some Resource  Technology Combinations for Irrigation Water Pumping
Financial Analysis
Financial Evaluation Essentially Includes a Comparison of
Costs Benefits
Existing (today) and in near future (tomorrow)
•
The money has time value due to
– Investment option
–
Change in purchasing power of money
Need to take into account the time value of money
Measures of Economic Performance
Unit Cost
of Useful
Energy
Internal Rate
of Return
Payback
Period(s)
Net
Present
Value
Benefit
to Cost
Ratio
x
Cost and performance related
parameters of the resource
technology combinations
x
Discount rate
x
Monetary worth of fuel saved
needs to be quantified
Simple Payback Period
•
Definition: An investment's payback period in years is
equal to the net investment amount divided by the average
annual cash flow from the investment.
•
What it means: How long will it take to get my money
back?
•
In the case of simple payback period the interest rate is
assumed to be equal to zero and the payback period is
computed as the smallest value of n that satisfies the
equation.
B
n
: cash receipts (benefits)
C
n
: cash expenses (costs)
n=0
n
n n
sp
(
B

C
) 0
∑
≥
Simple Payback Period
i i
o
C B
C
SPP
C
o
: Capital cost
B
i
: Annual benefits
C
i
: Annual O&M cost
A proposed replacement of the insulation in an industrial
solar water heating system will cost Rs. 600,000/, will last 15
years and will save Rs. 85,000/ per year over the existing
system. What is the simple payback period of the proposal?
•
Simple payback period
= (Initial investment / Net annual savings)
It may be noted that the simple payback period is much
less than the expected useful life of the insulation. Hence
the proposal may be accepted if simple payback period is
used as the criteria for appraisal of the investment.
600000
7.06 years
85000
· ≅
The cash flows of two projects A and B are
given in Table. Determine the simple payback
period for both the projects.
Cash Flow (Rs.) Cumulative Cash flow (Rs.) Year
Project A Project B Project A Project B
0 1000 1000 1000 1000
1 500 100 500 900
2 400 300 100 600
3 300 400 200 200
4 100 600 300 400
•
The cumulative cash flow at the end of each year for
both the projects are also shown in Table.
•
For project A, by the year 3 the cumulative inflows have
more than recovered the initial investment. Obviously,
the simple payback for project A would occur in third
year.
•
If it is assumed that the cash flow of Rs. 300/ is
uniformly distributed over the third year, the exact value
of simple payback period can be determined as
•
Simple pay back period of project A
•
Similarly, simple payback period for project B
years 33 . 2
300
100
2 ≅ + ·
years 33 . 3
600
200
3 ≅ + ·
SIMPLE PAYBACK PERIOD (CONTD…)
•
STRENGTHS:
It's easy to compute, easy to understand and
provides some indication of risk by separating
longterm projects from shortterm projects.
•
WEAKNESSES:
It doesn't measure profitability, doesn't
account for the time value of money and
ignores financial performance after the break
even period.
Discounted Payback Period
•
Definition:
The discounted payback period calculates the number of
years it takes one to recoup one’s initial investment,
valuing all cash flows in present value terms.
Strengths:
It accounts for the time value of money and provides some
indication of risk by separating longterm projects from
shortterm projects.
Weaknesses:
It doesn't measure profitability, and ignores financial
performance after the breakeven period.
Discounted Payback Period (Contd…)
• The discounted payback period n
dp
is the smallest n that
satisfies the expression.
(1)
where i is the interest rate (or the minimum acceptable
rate of return).
•
An analytical expression for the discounted payback
period can be derived for the case of uniform net annual
cash flows for all years of the useful life T of the project.
•
i.e. when
n=0
n
n n
n
dp
(
B

C
)
1
(1+i )
0
∑
≥
( ) ..T 2,........ 1, n all for C B C B
n n
· − · −
Discounted Payback Period (Contd…)
•
In such a case, equation (1) can be written as
(2)
• where it is assumed that B
o
 C
o
= C
o
, the
initial investment. Equation (2) can be
rewritten as
or
( )
( )
( )
( )
( )
( )
o
n
C
i 1
C  B
  
i 1
C B
d 1
C B
dp
·
+
+
+
−
+
+
−
( )
( )
( )
o
n
n
C
i 1 i
1 i 1
C B
dp
dp
·
]
]
]
+
− +
−
( )
( ) C B
iC
i 1 1
o
n
dp
−
· + −
−
Discounted Payback Period (Contd…)
or
or
or
(3)
Equation (3) can be used to determine the
discounted payback period for projects with an
initial investment followed by uniform periodic net
cash flows.
( )
( )
( )
o
n
iC C B
C  B
i 1
dp
− −
· +
−
( ) ( ) ( ) { ¦
o dp
iC C B ln C B ln i 1 ln n − − − − · +
( ) ( ) { ¦
( ) i 1 ln
iC C B ln C B ln
n
o
dp
+
− − − −
·
Discounted Payback Period
d 1 ln
dC C B ln C B ln
DPP
o i i i i
+
− − − −
·
C
o
: Capital cost
B
i
: Annual benefits
C
i
: Annual O&M cost
d : Discount rate
A 100 litre per day capacity domestic solar water heating system costs
Rs. 20,000/ to purchase and install. Annual maintenance costs of the
system are expected to be Rs. 500/ The solar water heating system saves
consumption of electricity in an electric geyser on 100 days of the year by
heating 100 litres of water from 15ºC to 60ºC. Determine the discounted
payback period if the overall efficiency of the electric geyser is 90% and
the marginal cost of electricity to the user is Rs. 3.00/kwh. Use an interest
rate of 5%.
Electricity saved by the solar water heating system in one day
= 5.83 kWh/day
Monetary worth of electricity saved by the solar water heating system
during the year is
= (5.83 kWh/day) (100 days/year) (Rs. 3.00/kWh)
= Rs. 1750 per year
Net annual saving = 1750  500 = Rs. 1250/.
( )
100kg 4.2kJ / kgºC 60 15 ºC
1 kWh
0.9 3600 kJ
× × −
 `
·
. ,
•
The discounted payback period can be estimated as
or
Once again, n
dp
may be compared with the maximum
acceptable payback period, n
max
, to decide upon the
acceptability of the project.
Obviously, if the cumulative discounted value of net
annual benefits do not exceed the initial capital investment
within a certain maximum acceptable time horizon the
project is rejected.
( ) ( ) ( ) ( ) { ¦
( )
dp
ln 1250 ln 1250 0.05 20000
n
ln 1 0.05
− −
·
+
( ) ( )
( ) 05 . 1 ln
250 ln 1250 ln −
·
years 33 n
dp
≅
PAYBACK PERIOD (S): LIMITATIONS
•
The payback period is a simple but crude measure
which indicates the time of recovery of the
investment. It suffers from the following deficiencies.
The simple payback period fails to consider the time
value money.
All cash flows that would commonly occur after the
computed payback time (n
sp
or n
dp
) are neglected.
Thus the payback period method makes no allowance
for projects with long gestation periods (the selection
of maximum acceptable payback period, n
max
, usually
being arbitrary).
PAYBACK PERIOD (S): ADVANTAGES
(i) It is very easy to understand.
(ii) It can function like many other rules of thumb to shortcut the process
of generating information and then evaluating it. The method reduces
the information search by focusing on the time when the investor
expects to recoup the initial investment. Thus, the payback period
allows the decision maker to judge whether the life of the project past
the payback period is sufficient to make the investment financially
attractive.
(iii) It emphasizes a rapid recovery of initial investment which may be a
very important objective in a variety of situations. These include
speculative investors desirous of rapid recovery of the initial
investment (as they may have very limited time horizon)
situations where there is a high degree of uncertainty concerning
the future; and
situations when the investors have access to financial resources
for only a short period of time.
NET PRESENT VALUE
•
The difference between the present value of the benefits and the costs
resulting from an investment is the net present value (NPV) of the
investment.
A positive NPV means a positive surplus indicating that the financial
position of the investor will be improved by undertaking the project.
A negative NPV would indicate a financial loss.
An NPV of zero would mean that the present value of all benefits over
the useful lifetime are equal to the present value of all the costs.
•
In mathematical terms,
(1)
B
j
= benefits at the end of period j
C
j
= costs at the end of period j
n = useful life of the project
i = interest rate
NPV =
B

C
(1+i )
j=0
n
j j
j
∑
NET PRESENT VALUE
•
Equation (1) involves subtracting of the costs from the benefits at any
period and then multiplying the result by the single payment present
worth factor for that period.
•
Finally, the NPV is determined by algebraically adding the results for all
the periods under consideration.
• It often happens that (B
j
 C
j
) is constant for all j's except for j = 0. In such
a case, equation (1) can be modified as
• since B
o
the benefits in the 0
th
year are invariably zero and (B
j
 C
j
) is
constant (=BC) for j = 1 to n,
(2)
•
with Co representing the initial capital investment in the project.
( )
( )
( )
n
j j
o o j
j 1
B C
NPV B C
1 i
·
−
· − +
+
∑
( )
( )
n
0 j
j 1
1
NPV  C B C
1 i ·
· + −
+
∑
( )
( )
( )
n
0 n
1 i 1
or NPV  C B C
i 1 i
]
+ −
· + −
]
+
]
]
NET PRESENT VALUE (Contd…)
•
The present value of an investment's future net cash flows
minus the initial investment. If positive, the investment
should be made (unless an even better investment exists),
otherwise it should not.
C
o
: Capital cost
B
i
: Annual benefits
C
i
: Annual O&M cost
d : Discount rate
t : Useful lifetime
S : Salvage value
( )
( )
( ) ( )
t
o
t
t
i i
d 1
S
C
d 1 d
1 d 1
C B NPV
+
+ −
¹
'
¹
¹
'
¹
+
− +
− ·
A small wind mill for water pumping costs Rs. 10,000/ to
purchase and install on the field of a farmer. It is expected to save
Rs. 800/ worth of diesel annually to the farmer and its annual
maintenance cost is estimated at Rs. 200/. Calculate the NPV of
the investment on the windmill if the useful life of the windmill is
10 years and the interest rate is 12%.
Net annual benefits of using a windmill = 800  200 = Rs. 600/
Since the amount of net annual benefits is constant over the
useful life of the windmill, the NPV can be estimated as
=  10,000 + 3390
=  6630/
Therefore, the investment in the windmill is not a financially viable
investment for the farmer.
( )
( )
( )
]
]
]
+
− +
− + ·
n
n
0
i 1 i
1 i 1
C B C  NPV
( )
( )
( )( )
]
]
]
+
− +
+ ·
10
10
12 . 0 1 12 . 0
1 12 . 0 1
600 10,000 
NET PRESENT VALUE (Contd…)
•
Equations (1) and (2) are based on the assumption
that the interest rate i, remains constant over time.
The NPV could also be calculated with different rates
of interest over time. If i
j
represents the interest rate
over jth period, equation (1) for NPV can be modified
as
( )
( )
( )
( )
( ) ( )
( )
( ) ( )
( )
( )
( ) ( ) ( )
1 1 2 2
0 0
1 1 2
j j
n n
1 2 n 1 2 j
B C B C
NPV B C
1 i 1 i 1 i
B C
B C
 
1 i 1 i 1 i 1 i 1 i 1 i
− −
· − + + + − −
+ + +
−
−
+ +
+ + − − + + + − − +
NET PRESENT VALUE (Contd…)
•
The acceptance criteria of an investment
project, as evaluated from the NPV method are
(a) NPV > 0 , accept the project
(b) NPV = 0, remain indifferent
(c) NPV < 0, reject the project
NPV Method (Advantages)
•
The NPV method has a number of features that make it
suitable as a basis of comparing alternative investment
possibilities. These include
•
It considers the time value of money in its computation
through the interest rate i.
•
It concentrates the equivalent value of any cash flow in a
single index at a particular point in time (the present).
•
The value of NPV is always unique irrespective of the
investment's cash flow pattern. In other words, any sequence
of receipts and disbursements will give a unique NPV amount
for a selected value of interest rate i.
•
The NPV amount is the equivalent amount by which the
equivalent receipts of a cash flow exceed (or fail to equal) the
equivalent disbursements of that cash flow.
Features of NPV Method (Contd…)
•
The NPV method focuses attention on quantity of money which
is what the evaluation is ultimately concerned with. Other
criteria of evaluating and comparing alternative investment
opportunities rank different options by ratios and thus do not
directly address the question of maximizing profit.
•
In the NPV method the future receipts or expenditures are
transformed into equivalent present worth. In this form, it is
very easy, even for a person not conversant with the intricacies
of financial analysis, to see the financial advantage of one
alternative over one or more alternatives.
•
Its computation is straight forward.
•
Since, for all values of interest rate greater than zero the
numerical magnitude of the present worth of a future receipt or
disbursement will always be less than its value in future, the
present worth amounts are offer called the discounted cash
flows. Similarly, the interest rate used in the calculation of NPV
is referred to as the discount rate.
COMPARISON OF NPV FOR ALTERNATIVES
WITH DIFFERENT LIVES
•
Often it is necessary to compare alternatives investment
options with different economic lives. In using the NPV
method to compare alternative investments, it is important to
evaluate the costs and benefits of each alternative over an
equal number of years. This may be done in any one of the
following ways depending upon the nature of the investment:
•
The costs and benefits can be measured over a time period
that is a common multiple of the economic lives of different
alternatives. Benefits and costs are, however, assumed to be
the same during the successive lives.
For example, if it desired to compare alternatives which
have lives of 3 years and 5 years, respectively, the alternatives
must be compared over a period of 15 years, with
reinvestment assumed at the end of each life cycle. The
terminal salvage value of the investments, must also be
included as an income in the corresponding year(s).
COMPARISON OF NPV FOR ALTERNATIVES
WITH DIFFERENT LIVES
In an alternative approach, benefits and costs of each
alternative investment option can be calculated in annual cost
terms based on its own economic life. These annual benefits
and costs can then be used to calculate the present value of
benefits and costs for the desired number of years of service.
This avoids the need to find a common multiple of the lives of
the alternatives.
Alternatively, if either alternative is to be used for only a
limited period of time which is less than a common multiple of
the economic lives of the alternatives, the estimated cash flows
associated with each system over the period of analysis can be
discounted to present value. The expected remaining value of
each system at the time of termination should, however, be
taken into account in determining the present value.
Two or more alternatives may also be compared on the basis
of their capitalized NPV which represents the NPV of a given
alternative in perpetuity.
LIMITATIONS OF NPV METHOD
•
As regards the limitations of the NPV method, the
following points are worth mentioning.
The NPV method focuses only on net benefits and
does not distinguish between an investment involving
relatively large costs and benefits and one involving
much smaller costs and benefits as long as the two
projects result in equal NPV.
Thus, it does not give any indication of the scale of
effort required to achieve the result.
LIMITATIONS OF NPV METHOD (Contd…)
The results of NPV method are quite sensitive to
the interest/discount rate chosen.
Thus failure to select an appropriate value of the
interest rate used in computation of NPV may
alter or even reverse the relative ranking of
different alternatives being compared using this
method.
For example, with very low values of interest rate an
alternative with benefits spread far into the future
may unjustifiably appear more profitable than an
alternative whose benefits are more quickly realized
but of lower amount in undiscounted terms.
•
We have
•
It may be noted that as the interest rate i is increased every
cash flow in the future is discounted to the present by a
factor of the general form 1/(1+i)
j
.
•
As i approaches infinity, 1/(1+i)
j
approaches zero for all
point in time except.
•
Mathematically, for two extreme values of the interest rate,
the above equation gives
for i = 0, and
NPV =  Co for i = ∞
NPV =
B

C
(1+i )
j=0
n
j j
j
∑
( )
·
· −
∑
n
j j
j 0
NPV B C
Equivalent Uniform Annual Worth
•
Equivalent uniform annual worth is a measure
used for comparing alternative projects.
•
In this case all disbursements (irregular and
uniform) are converted to an equivalent annual
amount, that is a year end amount, which is the
same each year.
•
It may be noted that any cash flow can be
converted into a series of equal annual payments by
first calculating the present worths for the original
cash flow and then multiplying the present worth
amount by the capital recovery factor.
Equivalent Uniform Annual Worth (Contd…)
• If B
j
and C
j
respectively represent the benefits and costs
in j
th
year, then the present worth of net benefits in the j
th
year shall be equal to with i representing
the prevailing interest rate.
•
Thus the cumulative present worth of all cash flows of
investment can be determined as
•
where n is the useful life of the investment/project.
( ) ( ) , i 1 / C B
j
j j
+ −
( )
∑
·
+
−
n
0 j
j
j j
) i 1 (
C B
Equivalent Uniform Annual Worth (Contd…)
•
The equivalent uniform annual worth (EUAW) of the
investment can be determined by multiplying the
cumulative present worth of all cash flow by the
capital recovery factor. Therefore
(1)
•
For specified finite values of i and n, Eqn. (1) can be
expressed as a product of the net present value (NPV)
of the investment and a constant term.
( )
( )
( )
( )
¹
'
¹
¹
'
¹
− +
+
¹
'
¹
¹
'
¹
+
−
·
∑
·
1 i 1
i 1 i
i 1
C B
EUAW
n
n
n
0 j
j
j j
¹
'
¹
¹
'
¹
¹
'
¹
¹
'
¹
∑
1  ) i + (1
) i + i(1
) i + (1
1
)
C

B
( = EUAW
n
n
j
j j
n
0 = j
Cost of a 2m3 floating drum type biogas plant is Rs. 10,000/.
During its useful life of 20 years, besides other routine
maintenance costs of Rs. 300/ each year, replacement of the
steel gasholder in the 10th year is expected to cost Rs. 4000.
Determine the equivalent annual cost of the biogas plant for
an interest rate of 10%.
•
Present values of all the costs associated with the biogas
plant
= Rs. 14096. 24
( )
( ) ( ) ( )
10 20 2
0.1 1
4000
1 . 0 1
1
....
1 . 0 1
1
0.1 1
1
300 10000
+
+
]
]
]
+
+
+
+
+
+ ·
( )
( ) ( ) ( )
10 20
20
1.1
4000
1.1 1 . 0
1 1.1
300 10000 +
]
]
]
−
+ ·
( ) ( ) 1542.17 8.513564 300 10000 + + ·
1542.17 2554.07 10000 + + ·
Example (Contd…)
•
Hence the equivalent annual cost of the biogas
plant
= Rs. 1655.74
( ) ( )
( )
]
]
]
− +
+
·
1 1 . 0 1
0.1 0.1 1
14096.24
20
20
( ) ( ) 0.1174596 14096.24 ·
THE BENEFITCOST RATIO METHOD
•
The BenefitCost (BC) ratio method of analysis is based
on the ratio of the benefits to costs associated with a
particular project.
•
The ratio of benefits to costs as a measure of financial or
economic efficiency is conceptually simple and quite
versatile and it measures cost efficiency.
•
The first step in a BC ratio analysis is to identify the
costs and benefits separately.
•
In general, the benefits are advantages (fuel savings in
the case of energy projects) expressed in monetary terms
and the disadvantages are the associated disbenefits.
•
The costs are the anticipated expenditures for
construction, installation, operation, maintenance etc.
THE BENEFITCOST RATIO METHOD (Contd…)
•
Let B and C be the present values of the cash inflows
(benefits) and outflows (costs) defined as
(1)
(2)
where B
j
and C
j
respectively represent the benefits
and costs at the end of j
th
period and n the useful life
of the project.
) i + (1
B
= B
j
j
n
0 = j
∑
) i + (1
C
= C
j
j
n
0 = j
∑
THE BENEFITCOST RATIO METHOD (Contd…)
•
The equivalent present value cost C (Eq. 2) may be splitted
into two components
(i) the initial capital expenditure, and
(ii) the annual costs accrued in each successive period.
•
If it is assumed that the initial investment is required in the
first m periods and that the annual costs accrue in each
following period till the end of the useful life of n periods,
the above two components of the equivalent present value
cost C may be expressed as
and
with
) i + (1
C
= C
j
j
m
0 = j
o ∑
) i + (1
C
= C
j
j
n
1 m+ = j
∑
′
C + C = C
o
′
Aggregate BC Ratio
•
It is the ratio of the present value of total benefits to total
costs.
or
Obviously, to accept a project, the ratio (B/C)aggregate
must be greater than 1.
0) > C + C (or 0 > C ,
C + C
B
=
C
B
=
C
B
o
o aggregate
′
′
,
`
.

) j + /(1
C
+ ) j + /(1
C
) j + /(1
B
=
C
B
n
j
n
1 m j
n
j
m
0 = j
n
j
n
0 = j
aggregate
∑ ∑
∑
+ ·
,
`
.

Net BC Ratio
•
In another definition of BC ratio, only the initial
capital expenditure is considered as a cash outlay,
and equivalent benefits become net benefits (i.e.
annual revenues minus annual outlays).
•
This net benefitcost ratio is expressed as
Once again, for a project to be viable, the ratio
(B/C)
net
must be greater than 1.
•
The benefitcost ratio defined in this manner
essentially provides an index which indicates the net
benefit expected per unit of capital investment and
can hence be used as a profitability index.
0 > C ,
C
C B
=
C
B
o
o net
′
,
`
.

SAVINGS TO INVESTMENT RATIO
•
The savings to investment ratio is defined as
•
It may be noted that the savings to investment ratio as
defined above makes a comparison between the
surplus at time zero and the capital investment itself.
The above Eq. can be modified as
or
o savings
C
C B
=
C
B
,
`
.

o
o
o savings
C
) C + C ( B
=
C
C B
=
C
B
′
,
`
.

1
C
B
1 
C
C B
=
C
B
net o savings
−
,
`
.

·
′
,
`
.

SAVINGS TO INVESTMENT RATIO
• It may be noted (B/C)
net
and (B/C)
savings
will
always yield the same decision for an
investment as both the ratios differ by 1
only.
•
For an investment to be acceptable, the
value of (B/C)
savings
must be positive (or
equal to zero in the limiting case).
Advantages of B  C ratio
•
The benefitcost ratio method offers the following
advantages over other measures of evaluating different
alternatives.
It compares alternatives on a common scale and
permits evaluation of different sized alternatives.
It can be used to rank alternative projects to determine
the most profitable alternative for an investor with a
limited budget.
It directly provides an indication of whether a project is
worthwhile.
It can also be used to determine the optimal size of a
project if it is computed for increments in the
investment size.
Limitations of B  C ratio
•
The benefitcost ratio is influenced by the decision as to
whether an item is classified as a cost or as a disbenefit
i.e. whether it appears in the denominator or
numerator of the ratio. Often it may be an arbitrary
decision but can lead to inefficient ranking of
investment alternatives.
•
For example, for ratios greater than one, adding costs to
the denominator will reduce the ratio more than
subtracting the same costs from the numerator.
•
The simple benefitcost ratio can not be used for
determining efficient scale of a given project.
Incremental analysis is required to be undertaken for
this purpose.
Benefit to Cost Ratio
]
]
]
]
]
]
]
¹
'
¹
¹
'
¹
+
− +
+
¹
'
¹
¹
'
¹
+
− +
·
t
t
i o
t
t
i
d 1 d
1 d 1
C C
d 1 d
1 d 1
B
C
B
C
o
: Capital cost
B
i
: Annual benefits
C
i
: Annual O&M cost
d : Discount rate
t : Useful lifetime
Benefittocost ratio (B/C) is the numerical ratio
whose size indicates the economic performance of
an investment.
PROBLEM FOR PRACTICE
•
The latest building regulations in a city stipulate that all new student
hostels must use solar energy for water heating. The manager of a hostel
under construction is considering two solar water heating systems for
supplementing a natural gas fired water heating system. One of the
systems (alternative X) is based on double glazed flat plate collectors and
the other (alternative Y) uses evacuated tubular collectors. Both the
options have a useful life of 20 years and the associated costs and benefits
are tabulated below:
•
Which option should be preferred on the basis of incremental net benefits 
cost ratio? Use an interest rate of 10% and also assume that the salvage
value is negligible for both alternatives. What if the benefit  cost ratio for
each alternative is computed and the alternative with higher benefit  cost
ratio is selected?
Amount (Rs.)
Alternative X Alternative Y
Capital cost 32,00,000 27,00,000
Annual maintenancecost 50,000 80,000
Annual benefits due to fuel saving 6,00,000 5,60,000
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