Sulaimani Polytechnic University

Technical College of Engineering

Petroleum and Energy Engineering Department

Energy Management

Lecture 4: Economic Analysis

 OBJECTIVE
• Understanding the importance of life cycle cost concepts in the
economic analysis of projects
• Introduce the general characteristics of capital investments and
sources of funds for capital investment
• Understanding how measures the worth are applied to the process of
making decisions when a set of potential projects are to be evaluated.
 1. Life Cycle Cost
• The basic criterion for evaluating any investment decision is that the
savings generated by the investment must be greater than the costs
incurred.
• The number of years over which the incomes accumulate and the
relative importance of future dollars (revenues or costs) relative to
present dollars are important factors in making sound investment
decisions.
• The life cycle cost approach provides a significantly better
evaluation of long term implications of an investment than methods
which focus on first cost or near term results.
 1. Life Cycle Cost
An example of the importance of life cycle costs is shown in Figure 1
which shows the estimated costs of owning and operating an oil-fired
furnace to heat a 2,000-squarefoot house in the northeast United States.
Of particular note is that the initial costs represent only 23% of the total
costs incurred over the life of the furnace.

Figure 1: 15-Year life cycle costs of a heating system

2. GENERAL CHARACTERISTICS
OF CAPITAL INVESTMENTS
 2.1 Capital Investment Characteristics
When companies spend money, the outlay of cash can be broadly
categorized into one of two classifications; expenses or capital
investments.
Expenses are generally those cash expenditures that are routine,
ongoing, and necessary for the ordinary operation of the business.
Capital investments, are generally more strategic and have long term
effects.
• Decisions made regarding capital investments are usually made at
higher levels within the organizational hierarchy.
 2.1 Capital Investment Characteristics
Three characteristics of capital investments are of concern when
performing life cycle cost analysis;

• Capital investments usually require a relatively large initial cost

• Benefits (revenues or savings) resulting from the initial cost occur
in the future, normally over a period of years
• Relatively irreversible
 2.2 Capital Investment Cost Types
In almost every case, the costs which occur over the life of a capital
investment can be classified into one of the following categories:
• Initial Cost: Initial costs include all costs associated with preparing the
investment for service. This includes purchase cost as well as installation
and preparation costs. This is usually not repeated during the life of an
investment
• Annual Expenses and Revenues: are the periodic costs and benefits
generated throughout the life of the investment.
• Periodic Replacement and Maintenance: are similar to annual expenses
and revenues except that they do not (or are not expected to) occur
annually.
• Salvage Value: is the revenue (or expense) attributed to disposing of the
investment at the end of its useful life.
 2.3 Cash Flow Diagram
A suitable way to display the revenues (savings) and costs related with an
investment is a cash flow diagram.

By using a cash flow diagram, the timing of the cash flows are more apparent and
the chances of properly applying time value of money concepts are increased.

Upward directed lines indicate cash inflow (revenues or savings) while downward
directed lines indicate cash outflow (costs).
 What are the cash inflows and outflows?

Cash Inflows Cash Outflows

• Cash sales • Payments to suppliers
• Receipts from trade debtors • Wages and salaries
• Sale of fixed assets • Payments for fixed assets
• Interest on bank balances • Tax on profits
• Grants • Interest on loans & overdrafts
• Loans from bank • Dividends paid to shareholders
• Share capital invested • Repayment of loans
 Sample of Cash flow diagram
• The heat pump costs (cash outflow) $1500 more than the baseboard system,
• The heat pump saves (cash inflow) $380 annually in electricity costs,
• The heat pump has a $50 higher annual maintenance costs (cash outflow),
• It has a $150 higher salvage value (cash inflow) at the end of 15 years,
• It requires $200 more in replacement maintenance (cash outflow) at the end of
year 8.

Figure 2: Heat pump and baseboard system differential life cycle costs
 3. Source of Funds
The process of obtaining funds for capital investment is called financing. There are
two broad sources of financial funding; debt financing and equity financing.

Debt financing: involves borrowing and utilizing money which is to be repaid at a

later point in time. Debt financing does not create an ownership position for the
lender within the borrowing organization.

Equity financing: under equity financing the lender acquires an ownership (or
equity) position within the borrower’s organization. As a result of this ownership
position, the lender has the right to participate in the financial success of the
organization as a whole.
 4. Time Value of Money Concepts
Most people have an natural sense of the time value of money. Given a choice
between $100 today and $100 one year from today, almost everyone would prefer
the $100 today. Why is this the case?
Two primary factors lead to this time preference associated with money; interest
and inflation.
Interest: is the ability to earn a return on money which is loaned rather than
consumed.
Inflation: measures how fast the prices of goods and services increase over a given
period of time. An increase in inflation means that prices are quickly rising. If the
inflation rate decreases, the prices of goods and services are still increasing, but at a
slower pace.
 4.1 The Mathematics of Interest
The basic formula for studying and understanding interest calculations is:
Fn = P + In
where:
Fn = a future amount of money at the end of the nth year;
P = a present amount of money at the beginning of the year which is n years prior to
Fn;
In = the amount of accumulated interest over n years; and
n = the number of years between P and F.

There are two major approaches for determining the value of In; simple interest
and compound interest.
 Example 1
Determine the balance which will accumulate at the end of year 4 in an account
which pays 10%/yr simple interest if a deposit of $500 is made today. Repeat it for
compound interest.
Simple interest Compound interest

Notice that the balance available for withdrawal is higher under compound interest
($732.05 > $700.00). This is due to earning interest on principal plus interest rather
than earning interest on just original principal. Since compound interest is by far
more common in practice than simple interest.
 4.2 Single Sum Cash Flows
The factor 1 + 𝑖 𝑛 is known as the single sum, future worth factor or the single
payment, compound amount factor.

• This factor is denoted (F|P,i,n) where F denotes a future amount, P denotes a

present amount, i is an interest rate (expressed as a percentage amount), and n
denotes a number of years.

• The factor (F|P,i,n) is read “to find F given P at i% for n years.”

 4.3 Uniform Series Cash Flows
A uniform series of cash flows exists when the cash flows in a series occur every
year and are all equal in value.
• Figure 2 shows the cash flow diagram of a uniform series of withdrawals. The
uniform series has length 4 and amount 2000.

• The factor (P|A,i,n) is known as the uniform series, present worth factor and is
read “to find P given A at i% for n years”.

Figure 2
 Example 2

• The interpretation of the result is as follows: if we deposit $6479.40 in an

account paying 9%/yr interest, we could make withdrawals of $2000 per year
for four years starting one year after the initial deposit to deplete the account at
the end of 4 years.
Summary of discrete compounding time value of money factors
 5. PROJECT MEASURES OF WORTH
The measures are used to evaluate the attractiveness of a single investment
opportunity.

The measures to be presented are:

(1) present worth,
(2) annual worth,
(3) internal rate of return,
(4) payback period.
 5.1 Present Worth
The concept of present worth as a measure of investment worth can be generalized
as follows:
Measure of Worth: Present Worth

Description: All cash flows are converted to a single sum equivalent at time zero
using i=MARR.

𝑛
Calculation Approach: 𝑃𝑊 = 𝑡=0 𝐴𝑡 (𝑃|𝐹, 𝑖, 𝑡)

Decision Rule: If PW≥0, then the investment is attractive.

 5.2 Annual Worth
An alternative to present worth is annual worth (AW). The annual worth measure
converts all cash flows to an equivalent uniform annual series of cash flows over the
investment life using i=MARR. The annual worth measure is generally calculated
by first calculating the present worth measure and then multiplying this by the
appropriate (A|P,i,n) factor.
• The concept of annual worth as a measure of investment worth can be
generalized as follows:
Measure of Worth: Annual Worth
Description: All cash flows are converted to an equivalent uniform annual series of
cash flows over the planning horizon using i=MARR.
Calculation Approach: AW = PW (A|P,i,n)
Decision Rule: If AW≥0, then the investment is attractive.
 5.3 Internal Rate of Return
One of the problems associated with using the present worth or the annual worth
measures of worth is that they depend upon knowing a value for MARR.
• If the value of MARR changes, the value of PW or AW must be recalculated to
determine whether the attractiveness/unattractiveness of an investment has
changed.
• The internal rate of return (IRR) approach is designed to calculate a rate of return
that is “internal” to the project.
if IRR > MARR, the project is attractive,
if IRR < MARR, the project is unattractive,
if IRR = MARR, indifferent.
• Thus, if MARR changes, no new calculations are required. We simply compare
the calculated IRR for the project to the new value of MARR and we have our
decision.
 5.4 Payback Period
The payback period of an investment is generally taken to mean the number of years
required to recover the initial investment through net project returns.

Measure of Worth: Payback Period

Description: The number of years required to recover the initial investment by
accumulating net project returns is determined.

𝑚
Calculation Approach: PBP = the smallest m such that 𝑡=1 At ≥ C0

Decision Rule: If PBP is less than or equal to a predetermined limit (often called a
hurdle rate), then the investment is attractive.
 Example 3
Using the cash flow diagrams of below figure to find payback period
(a) PBP=2 (1200>1000 @ t=2)
(b) PBP=4 (1000300>1000) @ t=4).
• If the decision hurdle rate is 3 years (a very common rate), then investment is
attractive but investment (b) is not.
 Example 4
If MARR is 12%/yr which projects should be accepted?
 Solution
Using present worth as the measure of worth:

PW(A) = -1000+600*(P|A,12%,4) = -1000+600(3.0373) = $822.38 ⇒ Accept A

PW(B) = -1300+800*(P|A,12%,4) = -1300+800(3.0373) = $1129.88 ⇒ Accept B
PW(C) = -400+120*(P|A,12%,4) = -400+120(3.0373) = -$35.52 ⇒ Reject C
PW(D) = -500+290*(P|A,12%,4) = -500+290(3.0373) = $380.83 ⇒ Accept D

Therefore, Accept Projects A, B, and D and Reject Project C

 Example 5
A homeowner needs to decide whether to install R-11 or R-19 insulation in the attic
of her home. The R-19 insulation costs $150 more to install and will save
approximately 400 kWh per year. If the planning horizon is 20 years and electricity
costs $0.08/kWh is the additional investment attractive at MARR of 10%?
Solution:
At $0.08/kWh, the annual savings are: 400 kWh * $0.08/kWh = $32.00
Using present worth as the measure of worth:
PW = -150 + 32*(P|A,10%,20)
PW = -150 + 32*(8.5136) = -150 + 272.44 = $122.44

Decision: PW≥0 ($122.44>0.0), therefore the R-19 insulation is attractive.

 Example 6
An economizer costs $20,000 and will last 10 years. It will generate savings of
$3,500 per year with maintenance costs of $500 per year. If MARR is 10%, is the
economizer an attractive investment?
Solution:
Using present worth as the measure of worth:
PW = -20000 + 3500*(P|A,10%,10) - 500*(P|A,10%,10)
PW = -20000 + 3500*(6.1446) - 500*(6.1446)
PW = -20000.00 + 21506.10 - 3072.30 = -$1566.20

Decision: PW<0 (-$1566.20<0.0), therefore the economizer is not attractive.

 Example 7
If the economizer from previous Example has a salvage value of $5000 at the end of
10 years is the investment attractive?
Solution:
Using present worth as the measure of worth:

PW = -20000 + 3500*(P|A,10%,10) - 500*(P|A,10%,10) + 5000*(P|F,10%,10)

PW = -20000 + 3500*(6.1446) - 500*(6.1446) + 5000*(0.3855)
PW = -20000.00 + 21506.10 - 3072.30 + 1927.50 = $361.30

Decision: PW≥0 ($361.30≥0.0), therefore the economizer is now attractive.

 Reference
Doty, Steve, and Wayne C. Turner. Energy management handbook. Crc Press, 2006.