11 PERFORMING FINANCIAL ANALYSIS

11.1 Introduction

When planning an energy efficiency or energy management project, the costs

involved should always be considered. Therefore, as with any other type of
investment, energy management proposals should show the likely return on any
capital that is invested. Consider the case of an energy auditor who advises the senior
management of an organisation that capital should be invested in new boiler plant.
Inevitably, the management of the organisation would ask:
How much will the proposal cost?
How much money will be saved by the proposal?
These are, of course, not unreasonable questions, since within any organisation there
are many worthy causes, each of which requires funding and it is the job of senior
management to invest in capital where it is going to obtain the greatest return. In
order to make a decision about any course of action, management needs to be able to
appraise all the costs involved in a project and determine the potential returns.
This however, is not quite as simple as it might first appear. The capital value of
plant or equipment usually decreases with time and it often requires more
maintenance as it gets older. If money is borrowed from a bank to finance a project,
then interest will have to be paid on the loan. Inflation too will influence the value of
any future energy savings that might be achieved. It is therefore important that the
cost appraisal process allows for all these factors, with the aim of determining which
investments should be undertaken, and of optimising the benefits achieved. To this
end a number of accounting and financial appraisal techniques have been developed
which help energy managers and auditors make correct and objective decisions.

The financial issues associated with capital investment in energy saving projects are
investigated in this chapter. In particular, the discounted cash flow techniques of net
present value and internal rate of return are discussed in detail.

11.2 Fixed and Variable Costs

When appraising the potential costs involved in a project it is important to understand
the difference between fixed and variable costs. Variable costs are those which vary
directly with the output of a particular plant or production process, such as fuel costs.
Fixed costs are those costs, which are not dependent on plant or process output, such
as site-rent and insurance. The total cost of any project is therefore the sum of the
fixed and variable costs. Example 1 illustrates how both fixed and variable costs
combine to make the total operating cost.
Example 1

The capital cost of the DG set is Rs.9,00,000, the annual output is 219 MWh, and the
maintenance cost is Rs.30,000 per annum. The cost of producing each unit of
electricity is 3.50 Rs./kWh. The total cost of a diesel generator operating over a 5-year
period, taking into consideration both fixed and variable cost is:

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Item Type of cost Calculation Cost

Capital cost of generator Fixed - 9,00,000
Annual maintenance Fixed 30,000 x 5 (years) 1,50,000
Fuel cost Variable 219,000 x 3.50 x 5 38,32,500
Total cost 48,82,500
From Example 1, it can be seen that the fixed costs represent almost 21.5% of the
total cost. In fact, the annual electricity output of 219 MWh assumes that the plant is
operating with an average output of 50 kW. If this output were increased to an
average of 70 kW, then the fuel cost would become Rs. 53,65,500 with the result that
the fixed costs would drop to 16.37% of the total. Thus the average unit cost of
production decreases as output increases.

The concept of fixed and variable costs can be used to determine the break-even
point for a proposed project. The break-even point can be determined by using the
following equation.

UC util x Wav , x n = FC + (UC prod x Wav x n)

Where,
UCutil is the unit cost per kWh of energy bought from utility (Rs./kWh)
UCprod is the unit cost per kWh of produced energy (Rs./kWh)
FC is the fixed costs (Rs.)
Wav is the average power output (or consumption) (kW)
n is the number of hours of operation (hours).

Example 2

If the electricity bought from a utility company costs an average of Rs.4.5/kWh, the
break-even point for the generator described in Example 1, when the average output is
50 kW is given by:
4.5 x 50 x n = (9,00,000 + 150000) + (3.5 x 50 x n)

n = 21000 hours

If the average output is 70 kW, the break-even point is given by:

4.5 x 70 x n = (9,00.000 + 150000) + (3.50 x 70 x n)

n = 15000 hours
Thus, increasing the average output of the generator significantly reduces the break-
even time for the project. This is because the capital investment (i.e. the generator) is
being better utilised.

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11.3 Interest Charges

In order to finance projects, organizations often borrow money from banks or other
leading organizations. Projects financed in this way cost more than similar projects
financed from organisation’s own funds, because interest charges must be paid on the
loan. It is therefore important to understand how interest charges are calculated.
Interest charges can be calculated by lending organization in two different ways:
simple interest and compound interest.

(i) Simple interest: If simple interest is applied, then charges are calculated as a fixed
percentage of the capital that is borrowed. A fixed interest percentage is applied to
each year of the loan and repayments are calculated using the equation.

Total Repayment Value (TRV) = LV + (IR/100 + LV x P)

Where TRV is the total repayment value (Rs.), LV is the value of initial loan (Rs.), IR
is the interest rate (%), and P is the repayment period (years).

(ii) Compound interest: Compound interest is usually calculated annually (although

this is not necessarily the case). The interest charged is calculated as a percentage
of the outstanding loan at the end of each time period. It is termed 'compound'
because the outstanding loan is the sum of the unpaid capital and the interest
charges up to that point. The value of the total repayment can be calculated using
the equation.

TRV = LV x (1 + IR/100) p

The techniques involved in calculating simple and compound interest are illustrated
in Example 3 given below:

Example 3
A company borrows Rs.3,00,00,00 to finance a new boiler installation. If the interest
rate is 10% per annum and the repayment period is 5 years, let us calculate the value
of the total repayment and the monthly repayment value, assuming (i) simple interest
and (ii) compound interest.

(i) Assuming simple interest:

Total repayment = 30,00,000 + (10/100 x 30,00,000 x 5) = Rs.45,00,0 00
Monthly repayment = 45,00,000/ (5 x 12) = Rs.75,000

(ii) Assuming compound interest

Repayment at end of year 1 = 30,00,000 + (10/100 x 30,00,000) = Rs. 33,00,000
Repayment at end of year 2 = 33,00,000 + (10/100 x 33,00,000) = Rs. 36,30,000

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Similarly, the repayments at the end of years 3, 4 and 5 can be calculated:

Repayment at end of year 3 = Rs. 39,93,000
Repayment at end of year 4 = Rs. 43,92,300
Repayment at end of year 5 = Rs. 48,31530

Alternatively, the following equation can be used to determine the compound

interest repayment value.

Total repayment value = 30,00,000 x (1 + 10/100) 5 = Rs. 48,31,530

4831530
Monthly repayment = = Rs.80,525
5 x 12
It can be seen that by using compound interest, the lender recoups an additional
Rs.33,1530. It is not surprisingly lenders usually charge compound interest on loans.

11.4 Simple Payback Period

This is the simplest technique that can be used to appraise a proposal. The simple
payback period can be defined as 'the length of time required for the running total of
net savings before depreciation to equal the capital cost of the project’. In theory,
once the payback period has ended, all the project capital costs will have been
recouped and any additional cost savings achieved can be seen as clear 'profit'.
Obviously, the shorter the payback period, the more attractive the project becomes.
The length of the maximum permissible payback period generally varies with the
business culture concerned. In some companies, payback periods in excess of 3 years
are considered acceptable.

The payback period can be calculated using the equation

Capital cost of the project (in Rs.)

Simple payback period (years) =
Net Annual savings (in Rs.)

CC
PB =
AS

Where PB is the payback period (years), CC is the capital cost of the project (Rs.),
and AS is the annual net cost saving achieved (Rs.).

The annual net cost saving (AS) is the least savings achieved after all the operational
costs have been met. Simple payback period is illustrated in Example 4.

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Example 4
A new small cogeneration plant installation is expected to reduce a company's annual
energy bill by Rs.4,86,000. If the capital cost of the new boiler installation is
Rs.22,20,000 and the annual maintenance and operating costs are Rs. 42,000, the
expected payback period for the project can be worked out as.

Solution
PB = 22,20,000/ (4,86,000 - 42,000) = 5.0 years

11. 5 Discounted Cash Flow Methods

The payback method is a simple technique, which can easily be used to provide a
quick evaluation of a proposal. However, it has a number of major weaknesses:
The payback method does not consider savings that are accrued after the
payback period has finished.

The payback method does not consider the fact that money, which is
invested, should accrue interest as time passes. In simple terms there is a
'time value' component to cash flows. Thus Rs.1000 today is more valuable
than Rs.1000 in 10 years' time.
In order to overcome these weaknesses a number of discounted cash flow techniques
have been developed, which are based on the fact that money invested in a bank will
accrue annual interest. The two most commonly used techniques are the 'net present
value' and the 'internal rate of return' methods.

Net Present Value Method

The net present value method considers the fact that a cash saving (often referred to
as a 'cash flow') of Rs.1000 in year 10 of a project will be worth less than a cash flow
of Rs.1000 in year 2. The net present value method achieves this by quantifying the
impact of time on any particular future cash flow. This is done by equating each
future cash flow to its current value today, in other words determining the present
value of any future cash flow. The present value (PV) is determined by using an
assumed interest rate, usually referred to as a discount rate. Discounting is the
opposite process to compounding. Compounding determines the future value of
present cash flows, where" discounting determines the present value of future cash
flows.
In order to understand the concept of present vale, consider the case described in
Example 3.
If instead of installing a new cogeneration system, the company invested
Rs.22,20,000 in a bank at an annual interest rate of 8%, then:
The value of the sum at the end of year 1 = 22,20,000 + (0.08 x 22,20,000) = Rs.23,97,6 00

The value of the sum at the end of year 2 = 23,97,600 + (0.08 x 23,97,600) = Rs.25,89,4 08

The value of the investment would grow as compound interest is added, until after n
years the value of the sum would be:

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FV = D x (1 + IR/100) n

Where FV is the future value of investment in Rs., and D is the value of initial deposit
(or investment) in Rs., IR is Interest Rate and n is number of years.

Example :
The future value of the investment made at present, after 5 years will be:

FV = 22,20,000 x (1 + 8/100)5 = Rs. 32,61,908.4

So in 5 years the initial investment of 22,20,000 will accrue Rs.10,41,908.4 in

interest and will be worth Rs.32,61,908.4. Alternatively, it could equally be said that
Rs.32,61908.4 in 5 years time is worth Rs.22,20,000 now (assuming an annual
interest rate of 8%). In other words the present value of Rs.32,61,908.40 in 5 years
time is Rs.22,00,000 now.

The present value of an amount of money at any specified time in the future can be
determined by the following equation.

PV = S x (1 + IR/100) -n
Where PV is the present value of S in n years time (Rs.), and S is the value of cash
flow in n years time (Rs.).

The net present value method calculates the present value of all the yearly cash flows
(i.e. capital costs and net savings) incurred or accrued throughout the life of a project,
and summates them. Costs are represented as a negative value and savings as a
positive value. The sum of all the present values is known as the net present value
(NPV). The higher the net present value, the more attractive the proposed project.

The present value of a future cash flow can be determined using the equation above.
However, it is common practice to use a discount factor (DF) when calculating
present value. The discount factor is based on an assumed discount rate (i.e. interest
rate) and can be determined by using equation.

DF = ( 1 + IR/100) -n

The product of a particular cash flow and the discount factor is the present value.

PV = S x DF

The values of various discount factors computed for a range of discount rates (i.e.
interest rates) are shown in Table 11.1. The Example 5 illustrates the process involved
in a net present value analysis.

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Table 11.1 Computed Discount Factors

Discount rate % (or interest rate %)
Year 2 4 6 8 10 12 14 16
0 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
1 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.862
2 0.961 0.825 0.890 0.857 0.826 0.797 0.769 0.743
3 0.942 0.889 0.840 0.794 0.751 0.712 0.675 0.641
4 0.924 0.855 0.792 0.735 0.683 0.636 0.592 0.552
5 0.906 0.822 0.747 0.681 0.621 0.567 0.519 0.476
6 0.888 0.790 0.705 0.630 0.564 0.507 0.456 0.410
7 0.871 0.760 0.665 0.583 0.513 0.452 0.400 0.354
8 0.853 0.731 0.627 0.540 0.467 0.404 0.351 0.305
9 0.837 0.703 0.592 0.500 0.424 0.361 0.308 0.263
10 0.820 0.676 0.558 0.463 0.386 0.322 0.270 0.227
11 0.804 0.650 0.527 0.429 0.350 0.287 0.237 0.195
12 0.788 0.625 0.497 0.397 0.319 0.257 0.208 0.168
13 0.773 0.601 0.469 0.368 0.290 0.229 0.182 0.145
14 0.758 0.577 0.442 0.340 0.263 0.205 0.160 0.125
15 0.743 0.555 0.417 0.315 0.239 0.183 0.140 0.108
16 0.728 0.534 0.394 0.292 0.218 0.163 0.123 0.093
17 0.714 0.513 0.371 0.270 0.198 0.146 0.108 0.080
18 0.700 0.494 0.350 0.250 0.180 0.130 0.095 0.069
19 0.686 0.475 0.331 0.232 0.164 0.116 0.083 0.060
20 0.673 0.456 0.312 0.215 0.149 0.104 0.073 0.051

Example 5
Using the net present value analysis technique, let us evaluate the financial merits of
the proposed projects shown in the Table below. Assume an annual discount rate of
8% for each project.
.
Project – 1 Project - 2
Capital cost (Rs.) 30 000.00 30 000.00

Year Net annual saving (Rs.) Net annual saving (Rs.)

1 +6 000.00 +6 600.00
2 +6 000.00 +6 600.00
3 +6 000.00 +6 300.00
4 +6 000.00 +6 300.00
5 +6 000.00 +6 000.00
6 +6 000.00 +6 000.00
7 +6 000.00 +5 700.00
8 +6 000.00 +5 700.00
9 +6 000.00 +5 400.00
10 +6 000.00 +5 400.00
Total net saving at + 60 000.00 + 60 000.00
end of year 10

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Solution

The annual cash flows should be multiplied by the annual discount factors for a rate
of 8% to determine the annual present values, as shown in the Table below:

Year Discount Project 1 Project 2

Factor for Net Present Net Present
8% savings value (Rs.) savings value (Rs.)
(a) (Rs.) (a x b) (Rs.) (a x c)
(b) (c)
0 1.000 -30 000.00 -30 000.00 -30 000.00 -30 000.00
1 0.926 +6 000.00 +5 556.00 +6 600.00 +6 111.60
2 0.857 +6 000.00 +5 142.00 +6 600.00 +5 656.20
3 0.794 +6 000.00 +4 764.00 +6 300.00 +5 002.20
4 0.735 +6 000.00 +4 410.00 +6 300.00 +4 630.50
5 0.681 +6 000.00 +4 086.00 +6 000.00 +4 086.00
6 0.630 +6 000.00 +3 780.00 +6 000.00 +3 780.00
7 0.583 +6 000.00 +3 498.00 +5 700.00 +3323.10
8 0.540 +6 000.00 +3 240.00 +5 700.00 +3 078.00
9 0.500 +6 000.00 +3 000.00 +5 400.00 +2 700.00
10 0.463 +6 000.00 +2 778.00 +5 400.00 +2 500.20
NPV = +10 254.00 NPV = +10 867.80

It can be seen that over a 10 year life-span the net present value for Project 1 is
Rs.10,254.00, while for Project 2 it is Rs.10,867.80. Therefore Project 2 is the
preferential proposal.

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The whole credibility of the net present value method depends on a realistic
prediction of future interest rates, which can often be unpredictable. It is prudent
therefore to set the discount rate slightly above the interest rate at which the capital
for the project is borrowed. This will ensure that the overall analysis is slightly
pessimistic, thus acting against the inherent uncertain ties in predicting future savings.
Internal rate of return method

It can be seen from Example 5 that both projects returned a positive net present value
over 10 years, at a discount rate of 8%. However, if the discount rate were reduced
there would come a point when the net present value would become zero. It is clear
that the discount rate which must be applied, in order to achieve a net present value
of zero, will be higher for Project 2 than for Project 1. This means that the average
rate of return for Project 2 is higher than for Project 1, with the result that Project 2 is
the better proposition.

The discount rate which achieves a net present value of zero is known as the internal
rate of return (IRR). The higher the internal rate of return, the more attractive the
project.

Example 6 illustrates how an internal rate of return analysis is performed.

Example 6
A proposed project requires an initial capital investment of Rs.20 000. The cash flows
generated by the project are shown in the table below:

Year Cash flow (Rs.)

0 -20,000.00
1 +6000.00
2 +5500.00
3 +5000.00
4 +4500.00
5 +4000.00
6 +4000.00
Given the above cash flow data, let us find out the internal rate of return for the
project.

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Solution

Cash 8% discount rate 12% discount rate 16% discount rate

flow Discount Present Discount Present Discount Present
(Rs.) factor value factor value factor value
(Rs.) (Rs.) (Rs.)
0 -20000 1.000 -20000 1.000 -20000 1.000 -20000
1 6000 0.926 5556 0.893 5358 0.862 5172
2 5500 0.857 4713.5 0.797 4383.5 0.743 4086.5
3 5000 0.794 3970 0.712 3560 0.641 3205
4 4500 0.735 3307.5 0.636 3862 0.552 2484
5 4000 0.681 2724 0.567 2268 0.476 1904
6 4000 0.630 2520 0.507 2028 0.410 1640
NPV = 2791 NPV = 459.5 NPV = -1508.5

It can clearly be seen that the discount rate which results in the net present value
being zero lies somewhere between 12% and 16%.
For12% discount rate, NPV is positive; for 16% discount rate, NPV is negative. Thus
for some discount rate between 12 and 16 percent, present value benefits are equated
to present value costs. To find the value exactly, one can interpolate between the two
rates as follows:

459.5
Internal rate of return = 0.12 + (0.16 - 0.12) x
(459.5 - (-1508.5))

459.5
Internal rate of return = 0.12 + (0.16 - 0.12) x = 12.93%
(459.5 + 1508.5)

Thus the internal rate of return for the project is 12.93 %. At first sight both the net
present value and internal rate of return methods look very similar, and in some
respects are. Yet there is an important difference between the two. The net present
value method is essentially a comparison tool, which enables a number of projects to
be compared, while the internal rate of return method is designed to assess whether
or not a single project will achieve a target rate of return.
Profitability index
Another technique, which can be used to evaluate the financial viability of projects,
is the profitability index. The profitability index can be defined as:

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Sum of the discounted net savings

Profitability index =
Capital costs

The higher the profitability index, the more attractive the project.

The application of profitability index is illustrated in Example 7.

Example 7
Determine the profitability index for the projects outlined in Example 5

10254
For Project 1 : Profitability index = = 0.342
30000

10 867
For Project 2 : Profitability index = = 0.362
30000

Project 2 is therefore a better proposal than Project 1.

11.6 Factors Affecting Analysis

Although the Examples 5 and 6 illustrate the basic principles associated with the
financial analysis of projects, they do not allow for the following important
considerations:

• The capital value of plant and equipment generally depreciates over time
• General inflation reduces the value of savings as time progresses. For
example, Rs.1000 saved in 1 year’s time will be worth more than Rs.1000
saved in 10 years time.

The capital depreciation of an item of equipment can be considered in terms of its

salvage value at the end of the analysis period. The Example 8 illustrates the point.

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Example 8

It is proposed to install a heat recovery equipment in a factory. The capital cost of

installing the equipment is Rs.20,000 and after 5 years its salvage value is Rs.1500. If
the savings accrued by the heat recovery device are as shown below, we have to find
out the net present value after 5 years. Discount rate is assumed to be 8%.

Data
Year 1 2 3 4 5
7000 6000 6000 5000 5000

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Solution
Discount Capital Net Present
Factor for Investment Savings Value
8% (Rs.) (Rs.) (Rs.)
Year (a) (b) (c) (a) x (b + c)

0 1,000 -20,000.00 -20,000.00

1 0.926 +7000.00 +6482.00
2 0.857 +6000.00 +5142.00
3 0.794 +6000.00 +4764.00
4 0.735 +5000.00 +3675.00
5 0.681 +1,500.00 +5000.00 +4426.50

NPV = +4489.50

It is evident that over a 5-year life span the net present value of the project is
Rs.4489.50. Had the salvage value of the equipment not been considered, the net
present value of the project would have been only Rs.3468.00.

Real value
Inflation can be defined as the rate of increase in the average price of goods and
services. In some countries, inflation is expressed in terms of the retail price index
(RPI), which is determined centrally and reflects average inflation over a range of
commodities. Because of inflation, the real value of cash flow decreases with time.
The real value of sum of money (S) realised in n years time can be determined using
the equation.

RV = S x ( 1 + R/100) -n

Where RV is the real value of S realized in n years time. S is the value of cash flow in
n years time and R is the inflation rate (%).

As with the discount factor it is common practice to use an inflation factor when
assessing the impact of inflation on a project. The inflation factor can be determined
using the equation.
IF = (1 + R/100) -n
The product of a particular cash flow and inflation factor is the real value of the cash
flow.
RV = S x IF

The application of inflation factors is considered in Example 9.

Example 9

Recalculate the net present value of the energy recovery scheme in Example 8,
assuming the discount rate remains at 8% and that the rate of inflation is 5%.

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Solution

Because of inflation; Real interest rate = Discount rate – Rate of inflation

Therefore Real interest rate = 8-5 = 3%

Year Capital Net real Inflation Net real Real Present

Investment Savings Factor Savings Discou Value
(Rs.) (Rs.) For 5% (Rs.) nt (Rs.)
Factor
For 3%

0 -20,000.00 1.000 -20,000.00 1.000 -20,000.00

1 +7000.00 0.952 +6664.00 0.971 +6470.74
2 +6000.00 0.907 +5442.00 0.943 +5131.81
3 +6000.00 0.864 +5184.00 0.915 +4743.36
4 +5000.00 0.823 +4145.00 0.888 +3654.12
5 +1500.00 +5000.00 0.784 +5096.00 0.863 +4397.85

NPV = +4397.88

The Example 9 shows that when inflation is assumed to be 5%, the net present value
of the project reduces from Rs.4489.50 to Rs.4397.88. This is to be expected, because
general inflation will always erode the value of future ‘profits’ accrued by a project.

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