# Economic Analysis and Economic Decisions for Energy Projects

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1 Economic Analysis and Economic Decisions for Energy Projects

2 Economic Factors As in any investment project, the following factors should be considered while making the investment decisions in energy investment projects

3 Economic Factors Capital cost of the technology Long term debt availability Capacity Risks and uncertainties Time Rate of Inflation Competitors Liquidity Tax and Promotions

4 The Need for Economic Analysis Economics frequently play a dominant role in the decision whether management/owner will invest in an energy savings/investment project or not The communication of energy managers with the decision makers is very important in investment decisions. The energy manager must present projects in economic terms in order to help the decion makers to make their decisions.

5 The Need for Economic Analysis (continued) There are various methods for economic evaluation of energy savings/investment projects. There are many measures of project economic analysis, and many businesses and industries use their own methods or procedures to make their decisions.

6 Profitability Analysis Profitability analysis is concerned with the assesing feasibility of a new project from the point of view of its financial results.

7 Most commonly used profitability methods are: Internal rate of return (IRR) Return on investment (ROI) Net present value (NPV) Simple payback period (SPP) Simple rate of return

8 Simple payback and simple rate of return Simple payback and simple rate of return are usually referred to as simple methods since they do not take into the whole life span of the project

9 Simple payback period SPP does not take into the whole life span of the project. Simple and easy use. SPP is not an acceptable method for longer time periods.

10 Simple Pay Back (SPB) A lighting improvement costs \$1000. The improvement saves \$500 each year. What is the Simple Payback Period? SPP = \$ cost \$ savings / yr = =

11 SPP Example -- Solution A lighting improvement costs \$1000. The improvement saves \$500 each year. What is the Simple Payback Period? \$ cost \$1000 SPP = = = \$ savings/yr \$500/yr 2 yrs

12 Time Value of Money A dollar today worth more than a dollar tomorrow because money has earning power. The dollar today could be invested in a bank and earn interest so that it is worth more than a dollar tomorrow. This relationship between interest and time is called the time value of money.

13 Time Value of Money (cont.) Time value of money should be considered by discounting the future inflows and outflows to their present values. The fundamental approach to correctly account for cash inflows and outflows at different times is called discounted cash flow analysis.

14 Life Cycle Costing LCC is required to see the coupling between the initial cost and the long term economic performance. An energy project life may exceed 20 years. The value of annual operation expenses is related to the time these expenses occur. Because of this, the concept present value (PV) must be utilized.

15 Life Cycle Costing (continued) Present Value or present worth (PW) is the value of sum of money at the present time that, with compound interest, will have a specified value at a certain time in the future. Use Present Value (PV) analysis to find lowest life cycle cost (LCC)

16 Life Cycle Costing (continued) LCC = PV Purchase Cost + + Disposal Cost Operating Cost Need interest tables, a computer, or a calculator to find these PVs

17 Life Cycle Costing (continued) A good project has a Net Present Value (NPV) greater than zero NPV = PV (cash inflows/savings) - PV (cash outflows/costs) The Internal Rate of Return (IRR) is the interest rate (I) at which the PV of the cash inflows/savings equals the PV of the costs (i.e., NPV = 0)

18 Time Value of Money Analysis S = the sum of money at the n th year. i = Annual interest or discount rate n = number of years of life of project The present worth P of S dollars in n th year is

19 The calculation method P = 1 (1 + i n ) S The term P/S=(1+i) -n is frequently referred to as single payment present worth factor (PWF)

20 Ten Steps to Determining Feasibility of Energy Efficiency Projects A Basic Economic Analysis Methodology

21 Approach Life cycle cost (LCC) analysis Separate savings from investments Simplify input Output both absolute (NPV) and relative (SIR) savings Consider cost of capital

22 The Ten Steps 1. Determine old costs (existing baseline conditions). 2. Determine new costs (implementation and beyond). 3. Calculate differences. 4. Choose discount rate. 5. Choose analysis period. 6. Estimate residual value of equipment at end of service life. 7. Calculate present value of annual savings. 8. Calculate present value of investments. 9. Calculate net present value. 10. Calculate savings-to-investment ratio and internal rate of return.

23 Quick Overview Spreadsheet arranges input like this: Spreadsheet calculates two intermediate values: Σ present value of savings Σ present value of investments

24 Calculations The spreadsheet 1. Subtracts total savings from investments to give a net present value (NPV). 2. Divides total savings by investments to give a savings-to-investment ratio (SIR).

25 Outputs LCC indicators of project feasibility Absolute project worth: NPV (net present value) Relative project worth: SIR (savings-to-investment ratio) Specific to user: IRR (internal rate of return) These are economic indicators that investors understand.

26 Step 1 Determine Old Costs (Baseline Conditions) a) Life cycle re-investments b) Annual energy costs c) Annual operations & maintenance (O&M) costs d) Other annual costs

27 Step 1a Life Cycle Re-investments Does existing equipment need an overhaul now (in year zero) to continue in service? If not, when? How often? How much money would have to be re-invested each time? Examples of re-investments Rebuilding a compressor every 5 years Replacing lamps every hours

28 Step 1a Old Re-investment Table Old equipment probably needs periodic re-investment to keep going. Assume: Old re-investment costs = \$ every 4 years (from maintenance records) Assume: Last replacement was two years ago, so next replacement is in year 2. Enter data in "Old" column. Year Old \$ \$ \$ \$ \$

29 Step 1b Annual Energy Costs Old annual energy costs = Old annual energy * cost of energy Example Old annual energy costs = \$ /yr (from energy audit)

30 Step 1c Annual Operations & Maintenance (O&M) Costs Example In this case, assume poor maintenance at low cost. O&M = \$2 500/yr.

31 Step 1d Other Annual Costs List other annual old costs that will be affected by the project, such as - productivity - penalties for pollution

32 Step 2 Determine New Costs (Implementation and Beyond) a) Initial investment b) Life cycle re-investments c) Annual energy costs d) Annual operations & maintenance (O&M) costs e) Other annual costs

33 Step 2a - Initial Investment Initial investment = Basic project cost + engineering + profit + contingency + taxes + other For estimation purposes, add costs as %.

34 Step 2a - Initial Investment (cont.) Basic project cost Initial investment = = \$ (from energy audit) Basic project cost + engineering + profit + contingency + taxes = = = Basic project cost * (1 + 0,2 + 0,1 + 0,1 + 0,2) \$ * 1,6 \$ Enter data in year 0 of "New" column of investment table..

35 Step 2b Life Cycle Re-investments Five year replacement costs = = = 25% of the initial investment (from manufacturer's recommendation) 0,25 * \$ \$ Enter data in years 1 to end of "New" column of the investment table.

36 Steps 2a and 2b New Investment and Re-investment There is no 20 th year for reinvestment, even with 20 year analysis. Investments are considered to be made at the end of each year. At the end of the last year of analysis, the project is over. Further investment requires a new project with new analysis. Year New 0 \$ \$ \$ \$

37 Step 2c - Annual Energy Costs New annual energy costs = New annual energy * cost of energy Example New annual energy costs = \$ /yr (from energy audit)

38 Step 2d Annual Operations & Maintenance (O&M) costs Example New O&M = \$5 000/yr (from manufacturer's recommendations)

39 Step 2e - Other Annual Costs List other annual new costs that will be improved by the project, such as - improved productivity - reduced penalties

40 Step 3 Calculate Differences a) Life cycle investments b) Annual savings

41 Step 3a Life Cycle Investments Investments and re-investments Only non-annual costs Spreadsheet subtracts old costs from new costs. Net = new old Year New Old Net Amount 0 \$ \$ \$ 0 2 \$ \$ \$ 0 4 \$ 0 5 \$ \$ \$ \$ \$ 0 8 \$ 0 9 \$ 0 10 \$ \$ \$ \$ 0 12 \$ 0 13 \$ 0 14 \$ \$ \$ \$ \$ 0 17 \$ 0 18 \$ \$ \$ 0

42 Step 3b Annual Savings Annual cost savings = old energy cost - new energy cost + old O&M - new O&M + old other - new other Example Annual cost savings = \$ \$ \$ \$ \$0 - \$0 = \$ Annual Savings \$ Discount Rate Analysis period (years) Residual value Enter in appropriate input cell.

43 Step 4 - Choose Discount Rate Choose a discount rate r = 12% (from lender interest rate) Enter discount rate in appropriate input cell. Annual Savings Discount Rate 12% Analysis period (years) Residual value

44 Step 5 - Choose Analysis Period Choose analysis period T = 15 years. Enter analysis period in appropriate input cell. Annual Savings Discount Rate Analysis period (years) 15 Residual value

45 Step 6 Estimate Residual Value of Equipment What is equipment worth at end of analysis period? Rule of thumb: Residual value = 10% of purchase price Residual value acts as a credit to the project in the final year. Estimate Annual Savings residual value = \$ Discount Rate Analysis period (years) Enter residual value in appropriate input cell. Residual value \$16 000

46 Step 7 Calculate Present Value of Annual Savings Let: PV AS T AS t = = = Total present value of all annual savings Total number of the years in the analysis Annual savings in the year t For each year: PV of savings = year s savings divided by (1+ discount rate) raised to the power of the year when the savings occur Total PV of savings during analysis period is the sum of all annual PVs. PV AS T = AS 1 = AS 1 + AS t t t= 1 (1+ r) (1+ r) (1+ r) (1+ r) AS 1

47 Step 7 (cont.) Calculate Present Value of Annual Savings For T = 15 years PV AS = \$ Year Annual Savings \$ 0 \$ \$ \$ \$ PV Annual Savings \$ 0 \$ \$ \$ \$ Σ PV Annual Savings \$ \$ \$ \$ \$9 511 \$8 492 \$7 582

48 Step 8 Calculate Present Value of Investments Let:PV I I t = = Present value of investments Investment in the year t For each year: PV of investment = year s investment divided by (1+ discount rate) raised to the power of the year investment occurs Total PV of investments is sum of all annual PVs. Investment in the final year is the decommissioning/clean-up cost (if any), minus the residual value of the equipment. PV I T = I 1 = I 1 + I Res.Val. t t t= 0 (1+ r) (1+ r) (1+ r) (1+ r) (1+ r) I 1 +

49 Step 8 (cont.) Calculate Present Value of Investments For T = 15 PV I = \$ Year Net Life Cyle Investmen \$ \$ 0 -\$ \$ 0 \$ 0 PV Life Cycle Investme \$ \$ 0 -\$ \$ 0 \$ 0 Σ PV Life Cycle Investm \$ Residual \$ 0 -\$ \$ \$ 0 -\$ \$2 923

50 Step 9 - Calculate Net Present Value (NPV) The net present value (NPV) of a project is its life cycle net savings. It is the absolute monetary value of a project. NPV = PV AS -PV I Example NPV = \$ \$ = \$ NPV shows the total potential earnings of a project. NPV considers the effect of interest on future net savings. If NPV > 0, a project is profitable (economically feasible). NPV is a major decision making tool for project owners.

51 Step 10a Calculate Savings-to-Investment Ratio (SIR) Savings-to-investment ratio (SIR) = present value of savings / present value of investments = PV AS / PV I Example SIR = \$ / \$ = 4,9 If SIR > 1,0 a project is profitable (economically feasible). SIR may also be important for project owners.

52 Step 10b Calculate Internal Rate of Return (IRR) IRR is a hypothetical discount rate that causes SIR = 1,0 or NPV = 0. IRR requires an iterative calculation, easy for a computer. If the IRR the discount rate used in the analysis, the investment is worthwhile (economically feasible). A high IRR earns more profit per investment dollar. IRR is a major decision making tool for lenders, usually the first question they ask. Investors may each arbitrarily set their own minimum acceptable IRR, called a "hurdle rate."

53 Outputs A positive NPV (net present value) shows how much money the project will make in its lifetime. A negative NPV shows how much money a project will lose. NPV shows a project's absolute feasibility in terms of money. Example: NPV = \$

54 Outputs (cont.) SIR = 4,9 The SIR (savings-to-investment ratio) is the same as a benefit / cost ratio. With SIR > 1,0 the project makes more money than it costs. With SIR < 1,0 the project costs more than it makes. SIR shows a project's relative feasibility.

55 Outputs (cont.) IRR = 42% IRR (internal rate of return) is the interest in percent that the project's investment will earn. Calculated by finding the theoretical discount rate for which NPV = 0, or SIR = 1,0. Theoretically, any project with an IRR greater than the company's cost of capital is profitable (and will have positive NPV). Companies set "hurdle rates" for IRR. A hurdle rate is an arbitrary minimum IRR that the company will accept for implementing projects. Hurdle rates are normally higher than a company's cost of capital, so only higher profit projects are selected.

56 Outputs (cont.) SPB = 3,0 Simple payback (SPB), expressed in years, does not discount its input or consider future reinvestment costs. SPB is only useful for projects with very quick return. If a project can pay back in a year, for example, there is little need to calculate discounted future values. For longer paybacks, SPB becomes inaccurate.

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