# Chapter 1.6 Financial Management

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1 Chaper 1.6 Financial Managemen Par I: Objecive ype quesions and answers 1. Simple pay back period is equal o: a) Raio of Firs cos/ne yearly savings b) Raio of Annual gross cash flow/capial cos n c) = (1 k 0 ) d) All he above 2. Simple payback period for an energy efficien moor ha coss Rs. 1.5 lakh o purchase and insall and is expeced o save Rs lakh per annum is: a) 1.1 years b) 2 years c) 0.75 years d) 2.25 years 3. Which of he following equaion used o calculae he fuure value of he cash flow? a) NPV (1 i) n b) NPV (1 i) n c) NPV (1 i) n b) NPV/ (1 i) n 4. The NPV of equipmen is Rs and ineres on discoun rae is 10%. The fuure value of he cash flow a he end of 2 years is: a) Rs b) Rs. 12,100 c) Rs d) Rs The cos of replacemen of inefficien compressor wih an energy efficien compressor in a plan was Rs 5 lakh. The ne annual cash flow is Rs 1.25 lakh. The reurn on invesmen is: a) 15% b) 20% c) 25% d) 19.35% 6. The raio of annual ne cash flow o capial cos is a) Ne presen value b) Inernal rae of reurn c) Reurn on invesmen d) Discoun facor 7. The broad indicaor of he annual reurn expeced from iniial capial invesmen is a) NPV b) IRR c) ROI d) Discoun facor 8. The sum of presen values of all he cash flows associaed wih i is called a) Reurn on Invesmen b) Inernal Rae of Reurn c) Ne Presen Value d) None of he above 9. The facor ha reflecs he risk of he projec while evaluaing he presen value of he expeced fuure cash flow is a) Life of he projec b) Discoun rae c) Capial cos d) All he above 10. IRR sands for a) Inegraion rae of reurn b) Ineres reurn rae c) Inernal rae of reurn d) Invesmen reurn rae 1.6 Financial managemen - revised (able forma) 42

2 11. For all he expendiures in he plan, he value of cash flow a he end of he year will be a) Posiive b) Negaive c) Nil d) None of he above 12. The se ne presen value o deermine inernal rae of reurn is a) 1 b) 0 c) 10 d) The inernal rae of reurn canno disinguish beween a) Lending b) Borrowing c) Boh a & b d) None 14. Sensiiviy analysis is an assessmen of a) Profis b) Losses c) Risk d) all 15. The presen value of a Rs cos in year 0 projeced o 10 years a an escalaion rae of 5% and a 10% ineres rae is: a) Rs b) Rs. 628 c) Rs. 1 d) Rs The presen value of Rs in 10 years ime a an ineres rae of 10% is: a) Rs b) Rs. 386 c) Rs. 349 d) Rs Wha is ESCO? a) Energy saving company b) Energy sourcing company c) Energy service company d) Energy secion of company 18. ROI mus always be han ineres rae a) Lower b) Higher c) Equal d) No relaion 19. The key o he successful involvemen of an ESCO in performance conracing is: a) Monioring b) Verificaion c) Boh a & b d) None 20. Coss associaed wih he design, planing, insallaion and commissioning of a projec are: a) Variable coss b) Capial coss c) Salvage value d)none Par II: Shor ype quesions and answers 1. Lis ou differen coss involved in he process of implemening energy managemen? Differen coss involved in he process of implemening energy managemen are: i) Direc projec cos ii) Addiional operaions and mainenance cos iii) Training of personnel 2. Wha circumsances need invesmens for energy conservaion in any plan? The need for invesmens in energy conservaion can arise under following circumsances: i. For new equipmen, process improvemens ec. ii. To provide saff raining iii. To implemen or upgrade he energy informaion sysem 1.6 Financial managemen - revised (able forma) 43

3 iv. And oher prioriies 3. Wha crieria need o be considered while lising down he invesmen opporuniies for any energy conservaion projec? When lising invesmen opporuniies he following crieria need o be considered: i) Energy consumpion per uni of producion of a plan or process ii) Curren sae of repair and energy efficiency iii) Qualiy of he indoor environmen iv) Effec of any proposed measure on saff aiudes and behaviour 4. Why organizaions hesian o inves money on energy conservaion projecs? i. Organizaion ypically gives prioriy o invesing in wha hey see as heir core or profimaking aciviies in preference o energy efficiency ii. Even when hey do inves in saving energy, hey end o demand faser raes of reurn han hey require from oher kinds of invesmen. 5. Wha are he basic crieria for financial invesmen appraisal? The basic crieria for financial invesmen appraisal include Simple payback period, Reurn on invesmen and inernal rae of reurn Ne presen value and cash flow 6. Why shor erm payback is an inadequae yardsick for assessing longer erm benefis? The benefis arising from some energy saving measures may coninue long afer heir payback periods. Such measures do no need o be wrien off using fas discouning raes bu can be regarded as adding o he long erm value of he asses. For his reason, shor erm payback is an inadequae yardsick for assessing longer erm benefis 7. How do you relae plan mainenance o achieve energy efficiency in a plan? There is a clear dependence relaionship beween energy efficiency and mainenance. This operaes a wo levels: Iniially, improving energy efficiency is mos cos-effecively done in exising faciliies hrough normal mainenance procedures Subsequenly, unless mainenance is regularly underaken, savings from insalled echnical measure, wheher in new-build or exising faciliies, may no be realized. 8. Lis down he advanages wih Simple Payback period echnique A widely used invesmen crierion, he simple payback period offers he following advanages: I is simple, boh in concep and applicaion. Obviously a shorer payback generally indicaes a more aracive invesmen. I does no use edious calculaions. I favours projecs, which generae subsanial cash inflows in earlier years, and discriminaes agains projecs, which bring subsanial cash inflows in laer years bu no in earlier years. 9. Wha are he limiaions wih Reurn on Invesmen echnique? The limiaions wih ROI echnique are: I does no ake ino accoun he ime value of money. I does no accoun for he variable naure of annual ne cash inflows. 1.6 Financial managemen - revised (able forma) 44

4 10. Calculae ne presen value for an invesmen owards a Compac Fluorescen Lamp (L). The following able gives invesmen and cash flow. (Assume discoun rae is 10% and life of he L is 2 years). Invesmen Rs.400/- Savings in year Cash flow, Rs Year # Year # Invesmen : Rs 400/- Discoun rae (k) : 10% (i.e. 0.1) Life of he L () : 2 years n NPV : = (1 k 0 ) NPV = 0 0 ( 1 k) 1 1 ( 1 k) 2 2 ( 1 k) = 400 (1 0.1) (1 0.1) (1 0.1) 2 = = Rs 1335/- 11. Wha are he main advanages wih Ne Presen Value crierion? The ne presen value crierion has considerable meris. i. i akes in o accoun he ime value of money ii. i considers he cash flow sream in is projec life 12. Wha is he limiaion wih inernal rae of reurn figure? The inernal rae of reurn figure canno disinguish beween lending and borrowing and hence a high inernal rae of rerun need no necessarily be a desirable feaure. 13. Wha are differen kinds of cash flows in any energy managemen projec? Generally here are wo kinds of cash flow; he iniial invesmen as one or more insalmens, and he savings arising from he invesmen. 14. Lis down he facors need o be considered in calculaing annual cash flows. Taxes, Asse depreciaion and inermien cash flows 15. Under which circumsances sensiiviy analysis is required? Sensiiviy analysis is an assessmen of risk. Sensiiviy analysis is carried ou paricularly on projecs where he feasibiliy is marginal. 1.6 Financial managemen - revised (able forma) 45

5 16. Calculae he presen value of ax cash flow from a Rs. 10,000 invesmen owards 5 hp energy efficien moor wih 30% declining balance depreciaion rae, 50% ax rae and 10% ineres rae. Presen Value = P x d x / (i d)= (10000 x 0.3 x 0.5)/ ( ) = Rs Lis down any hree opions available for financing in-house energy managemen? i. From a capial budge ii. From a specific deparmen or secion budge iii. By obaining bank loan iv. By raising money from sock marke 18. How o make energy managemen self financing? One way o make energy managemen self financing is o spli savings o provide idenifiable reurns o each ineresed pary. 19. How an energy manager uilises if he has access o a proporion of he revenue savings arising from saff aciviies? if, an energy manager has access o a proporion of he revenue savings arising from saff s aciviies, hen hese can be reinvesed in: Furher energy efficiency measures Aciviies necessary o creae he righ climae for successful energy managemen which do no, of hemselves, direcly generae savings Mainaining or up-grading he managemen informaion sysem. 20. Wha do you undersand abou ESCOs? ESCOs are usually companies ha provide a complee energy projec service, from assessmen o design o consrucion or insallaion, along wih engineering and projec managemen services, land financing. Par III: Long ype quesions and answers 1. An energy audior recommended o replace an old air fan and incompeenly designed air delivery duc sysem causing Rs 23 lakh a year in elecriciy cos by changing he sysem wih a modern backward curved fan wih adequaely designed duc sysem for oal invesmen coss of Rs 2.2 lakh. Expeced elecriciy cos reducion is 5%. Considering over 15 years susained savings, calculae IRR Life of he modified sysem : 15 years Expeced annual savings : 5% : 0.05 x Rs. 1,15,000 / year Invesmen : Rs 2,20,000/- 1.6 Financial managemen - revised (able forma) 46

6 S = (1 i) (1 i) n n xi xi 1 S = annual energy savings I = Invesmen N = years I = Inernal rae of reurn (1 i) = (1 i) xi 1 By rial and error mehod, I = 52% 2. Annual savings afer replacemen of boiler for hree years is Rs. 5, 00,000, Rs. 5, 50,000, Rs. 6, 50,000. Toal projec cos is Rs 13.5 lakh. Considering cos of capial as 12%, wha is he ne presen value of he proposal? Cash flow sream of projec Invesmen Rs 13,50,000 Annual savings Cashflow 1 5,00, ,50, ,50,000 Cos of capial o he plan is 12%. The ne presen value of he proposal is: NPV = (1.12) (1.12) (1.12) = = 13,47,541 NPV = 13,50,000-13,47,541 = Wha is performance conracing? The core of performance conracing is an agreemen involving a comprehensive package of services provided by an ESCO, including: An energy efficiency opporuniy analysis Projec developmen Engineering Financing Consrucion/Implemenaion Training 1.6 Financial managemen - revised (able forma) 47

7 Monioring and verificaion Monioring and verificaion, is key o he successful involvemen of an ESCO in performance conracing where energy cos savings are being guaraneed. ESCOs are no bankers in he narrow sense. Their srengh is in puing ogeher a package of services ha can provide guaraneed and measurable energy savings ha serve as he basis for guaraneed cos savings. Bu, he energy savings mus be measurable. The Figure 6.1 shows ESCO Role. Refer figure No. 6.1 page No. 127 of book I need o form par of answer 4. Explain he limiaions wih Simple Payback Period echnique wih an example. The limiaions are: I fails o consider he ime value of money. Cash inflows, in he payback calculaion, are simply added wihou suiable discouning. This violaes he mos basic principle of financial analysis, which sipulaes ha cash flows occurring a differen poins of ime can be added or subraced only afer suiable compounding/discouning. I ignores cash flows beyond he payback period. This leads o discriminaion agains projecs ha generae subsanial cash inflows in laer years. To illusrae, consider he cash flows of wo projecs, A and B: Invesmen Rs. (100,000) Rs.(100,000) Savings in Year Cash Flow of A Cash flow of B 1 50,000 20, ,000 20, ,000 20, ,000 40, ,000 50, ,000 The payback crierion prefers A, which has a payback period of 3 years, in comparison o B, which has a payback period of 4 years, even hough B has very subsanial cash inflows in years 5 and 6. I is a measure of a projec s capial recovery, no profiabiliy. Despie is limiaions, he simple payback period has advanages in ha i may be useful for evaluaing an invesmen. 1.6 Financial managemen - revised (able forma) 48

8 5. Calculae he inernal rae of reurn for he following cash flow of a projec. Year Cash flow (100,000) 30,000 30,000 40,000 45,000 The inernal rae of reurn is he value of r which saisfies he following equaion: 30,000 30,000 40,000 45, ,000 = (1 κ) 1 ( 1 κ) 2 ( 1 κ ) 3 ( 1 κ ) 4 The calculaion of κ involves a process of rial and error. Try wih differen values of κ ill he righ-hand side of he above equaion is equal o 100,000. To begin wih, ry κ = 15 per cen. This makes he righ-hand side equal o: 30,000 30,000 40,000 45, = 100, 802 (1.15) (1.15) 2 (1.15) 3 (1.15) 4 This value is slighly higher han our arge value, 100,000. So increase he value of κ from 15 per cen o 16 per cen. (In general, a higher κ lowers and a smaller r increases he righ-hand side value). The righ-hand side becomes: 30,000 30,000 40,000 45, = 98, 641 (1.16) (1.16) 2 (1.16) 3 (1.16) 4 Since his value is now less han 100,000, i can be concluded ha he value of r lies beween 15 per cen and 16 per cen. For mos of he purposes his indicaion suffices. 1.6 Financial managemen - revised (able forma) 49

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