financial feasibility analysis 1 financial feasibility analysis energizing cleaner production...
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Financial Feasibility Financial Feasibility AnalysisAnalysis
Energizing Cleaner ProductionEnergizing Cleaner Production
Management Course Management Course
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Session Agenda:Session Agenda:
Introduction
Cash Flow
Profitability Indicators
1. Simple Payback
2. Return on Investment (ROI)
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
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• task 1a: Meeting with top management• task 1b: Form a Team and inform staff• task 1c: Pre-assessment to collect general information• task 1d: Select focus areas• task 1e: Prepare assessment proposal for top management approval
Step 1: Planning and Organization
• task 2a: Staff meeting and training• task 2b: Prepare focus area flow charts• task 2c: Walkthrough of focus areas• task 2d: Quantify inputs and outputs and costs to establish a baseline• task 2e: Quantify losses through a material and energy balance
Step 2: Assessment
• task 3a: Determine causes of losses• task 3b: Identify possible options• task 3c: Screen options for feasibility analysis
Step 3: Identification of Options
• task 4a: Technical, economic and environmental evaluation of options• task 4b: Rank feasible options for implementation• task 4c: Prepare implementation and monitoring proposal for top
management approval
• task 5a: Implement options and monitor results• task 5b: Evaluation meeting with top management
Step 5: Implementation and Monitoring of Options
• task 6a: Prepare proposal to continue with energy efficiency for top management approval
Step 6: Continuous Improvement
Step 4: Feasibility Analysis of Options
• task 1a: Meeting with top management• task 1b: Form a Team and inform staff• task 1c: Pre-assessment to collect general information• task 1d: Select focus areas• task 1e: Prepare assessment proposal for top management approval
Step 1: Planning and Organization
• task 2a: Staff meeting and training• task 2b: Prepare focus area flow charts• task 2c: Walkthrough of focus areas• task 2d: Quantify inputs and outputs and costs to establish a baseline• task 2e: Quantify losses through a material and energy balance
Step 2: Assessment
• task 3a: Determine causes of losses• task 3b: Identify possible options• task 3c: Screen options for feasibility analysis
Step 3: Identification of Options
• task 4a: Technical, economic and environmental evaluation of options• task 4b: Rank feasible options for implementation• task 4c: Prepare implementation and monitoring proposal for top
management approval
• task 5a: Implement options and monitor results• task 5b: Evaluation meeting with top management
Step 5: Implementation and Monitoring of Options
• task 6a: Prepare proposal to continue with energy efficiency for top management approval
Step 6: Continuous Improvement
Step 4: Feasibility Analysis of Options
But first…But first…In what step(s) In what step(s) of the of the methodology methodology is financial is financial feasibility feasibility analysis analysis relevant?relevant?
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IntroductionIntroduction
Step 4 – Feasibility AnalysisStep 4 – Feasibility Analysis
Project Selection
Technical
Environmental
FinancialOther- Regulatory- Organizational- Health/safety- Community
Company’s priority
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IntroductionIntroduction
Questions Management Will AskQuestions Management Will Ask
1. Is the project profitable?• Initial investment costs
• Annual operating costs and savings
– Cost of operating inputs
– Cost of waste management
– Less tangible costs
– Revenues
2. Determine availability of internal investment funds for bigger projects
3. Obtain external financing for remaining projects
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IntroductionIntroduction
Capital Budgeting ProcessCapital Budgeting Process
Process by which organisation decides:• Which investment projects are
– Needed
– Possible
– Special focus on projects that require significant up-front capital investment
• How to allocate available capital between different projects
• If additional capital is needed
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IntroductionIntroduction
Capital Budgeting PracticesCapital Budgeting Practices
• Vary widely from company to company – Larger companies tend to have more formal
practices than smaller companies
– Larger companies tend to make more and larger capital investments than smaller companies
– Some industry sectors require more capital investment than others
• Vary from country to country
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IntroductionIntroduction
Typical Project Types and CostsTypical Project Types and Costs
• Maintenance– Maintain existing equipment and operations
• Improvement– Modify existing equipment, processes, and
management and information systems to improve efficiency, reduce costs, increase capacity, improve product quality, etc.
• Replacement– Replace outdated, worn-out, or damaged
equipment or outdated/inefficient management and information systems
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Cash FlowCash Flow
Cash Flow ConceptCash Flow Concept
Common management planning tool
Distinguishes between
• Costs: cash outflows
• Revenues/savings: cash inflows
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Cash FlowCash Flow
Types of Cash FlowTypes of Cash Flow
One-time
Annual
Other
Inflow
Equipment salvage value
Operating revenues & savings
Working capital
Outflow
Initial investment
cost
Operating costs & taxes
Working capital
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Cash FlowCash Flow
Costs and SavingsCosts and Savings
• Initial investment costs– purchase of the camera system, delivery,
installation, start-up
• Annual operating costs (and savings)– Operating input — materials, energy, labour
– Incineration — fuel, fuel additive, labour, ash to landfill
– Wastewater treatment — chemicals, electricity, labour, sludge to landfill
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Cash FlowCash Flow
Working Capital and Salvage ValueWorking Capital and Salvage Value
• Working capital: total value of goods and money needed to maintain project operations– Raw materials inventory
– Product inventory
– Accounts payable/receivable
– Cash-on-hand
• Salvage Value: resale value of equipment or other materials at the end of the project
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Cash FlowCash Flow
TimingTiming
Salvage Value
End of project:
Time zero:
Initial Investment
TIMEYear 1 Year 2 Year 3
Annual Revenues/Savings
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Cash FlowCash Flow
Incremental AnalysisIncremental Analysis
• Needed for many CP or EE projects
• Compares cash flow of implemented options to the “business as usual” cash flow
• Covers only the cash flows that change
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Profitability IndicatorsProfitability Indicators
• Definition: “a single number that is calculated for characterisation of project profitability in a concise and understandable form”
• Common indicators1. Simple Payback
2. Return on Investment (ROI)
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
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1. Simple Payback1. Simple Payback
• Definition: number of years it will take for the project to recover the initial investments
• Usually a rule of thumb for selecting projects, e.g. payback must be < 3 years
Simple Payback (in years)
Investment
Cash Flow=
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2. Return on Investment2. Return on Investment
Simple Payback (in years)
Initial Investment
Year 1 Cash Flow=
ROI (in %)Year 1 Cash Flow
Initial Investment=
3 years
33%
• Definition: the percentage of initial investment that is recovered each year
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Workshop ExerciseWorkshop Exercise
PLS Company: produces rolls of PLS Company: produces rolls of laminated filmlaminated film
INVENTORY
SLITTING
solvent airemissions
solvent airemissions
printed laminated
filmplastic film, ink
plastic film, aluminium film, adhesive
PRINTING LAMINATION
Liquid wasteink
Solid scrap
to waste management
to waste management
Solid scrapSolid scrap
printed
film
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Workshop ExerciseWorkshop Exercise
PLS Company installs QC CameraPLS Company installs QC Camera
Printing step
• Printing errors cause high scrap rate
• Quality Control (QC) 3-camera system– Detect printing errors
– Operators halt the operations before too much solid scrap is generated
• QC camera system costs US$105,000 to purchase and install
• 40% reduced scrap and operating costs
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Workshop ExerciseWorkshop Exercise
• Question 1: Calculate annual cash flows using the cash flow worksheet (15 min)
• Question 2: Calculate simple payback (5 min)
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3. Net Present Value3. Net Present Value
Money Loses its ValueMoney Loses its Value
Question:
If we were giving away money, would you rather have:
(A) $10,000 today, or(B) $10,000 3 years from now
Explain your answer...
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3. Net Present Value3. Net Present Value
InflationInflation
Money loses purchasing power over time as product/service prices rise, so a dollar today can buy more than a dollar next year
costs $1 costs $1.05
inflation 5%
nownow next yearnext year
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3. Net Present Value3. Net Present Value
Return on InvestmentReturn on Investment
A dollar that you invest today will bring you more than a dollar next year — having the dollar now provides you with an investment opportunity
10 % interest, or “return on investment”
Investing $1 now
InvestmentGives you
$1.10 a year from now
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3. Net Present Value3. Net Present Value PLS Company’s QC Camera ProjectPLS Company’s QC Camera Project
Initial Investment
Cost
Annual Operating
Costs
BusinessAs
Usual Annual Savings =
US$38,463Installing
quality control camera
00
$ 105,000$ 105,000
$ 2,933,204$ 2,933,204
$ 2,894,741$ 2,894,741
(in US$)
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3. Net Present Value3. Net Present Value QuestionQuestion
Is the annual savings of$38,463 per year for 3 years a sufficient returnon the initial investment of $ 105,000?
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3. Net Present Value3. Net Present Value Time Value of MoneyTime Value of Money
• Money is worth more now than in the future because of– Inflation
– Investment opportunity
• “Time value” of money depends on– Rate of inflation
– Rate of return on investment
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3. Net Present Value3. Net Present Value Cash Flows from Different YearsCash Flows from Different Years
• Before you can compare cash flows from different years, you need to convert them all to their equivalent values in a single year
• It is easiest to convert all project cash flows to their “present value” now, at the very beginning of the project
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3. Net Present Value3. Net Present Value Converting Cash Flows to Present Converting Cash Flows to Present
ValueValue
End of project
Time zero:
Initial Investment = $105,000
TIMEYear 1 Year 2 Year 3
$38,463 $38,463 $38,463
= ??= ??= ??
Annual Savings
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3. Net Present Value3. Net Present Value Converting Cash Flows to Present Converting Cash Flows to Present
ValueValue
Discount rate:
• Converts future year cash flows to their present value
• Incorporates:– Desired return on investment
– Inflation
• Reverse of an interest rate calculation
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3. Net Present Value3. Net Present Value Discount Rate & Interest RateDiscount Rate & Interest Rate
Invested at an interest rate of 20%, how much will $10,000 now be worth after 3 years?
$10,000 x 1.20 x 1.20 x 1.20 = $17,280
At a discount rate of 20%, how much do I need to invest if I want to have $17,280 in 3 years?
$17,280
1.20 x 1.20 x 1.20 = $10,000
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3. Net Present Value3. Net Present Value
Which Discount Rate?Which Discount Rate?
• Equal to the required rate of return for the project investment, based on
– A basic return - pure compensation for deferring consumption
– Any ‘risk premium’ for that project’s risk
– Any expected fall in the value of money over time through inflation
• At least cover the costs of raising the investment financing from investors or lenders (i.e. the company’s “cost of capital”)
• A single “Weighted Average Cost of Capital” (WACC) characterises the sources and cost of capital to the company as a whole
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3. Net Present Value3. Net Present Value
Calculating “Present Value”Calculating “Present Value”
Present Value = Future Valuen x (PV Factor)
Value of the cash flow in year n
Value of cash flow at “Time Zero,” i.e. at project start-up
Present Value (PV) Factors or “discount factors”
• For various values d (discount rate): 10%, 15%, 20%
• For various years n (number of years)
• Tables available
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3. Net Present Value3. Net Present Value The Value of a Future $1The Value of a Future $1
Discount rate (d): 10% 20% 30% 40%
Years into future (n)
1 .9091 .8333 .7692 .7142
2 .8264 .6944 .5917 .5102
3 .7513 .5787 .4552 .3644
4 .6830 .4823 .3501 .2603
5 .6209 .4019 .2693 .1859
10 .3855 .1615 .0725 .0346
20 .1486 .0261 .0053 .0012
30 .0573 .0042 .0004 .0000
Handout: Table with discount rates
Present value factors
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3. Net Present Value3. Net Present Value
Net Present Value (NPV)Net Present Value (NPV)
• Definition: sum of present values of all project’s cash flows – Negative (cash outflows)– Positive (cash inflows)
• Characterises the present value of the project to the company– If NPV > 0, the project is profitable– If NPV < 0, the project is not
• More reliable than Simple Payback or ROI as it considers– Time value of money– All future year cash flows
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3. Net Present Value3. Net Present Value Workshop Exercise (15 min)Workshop Exercise (15 min)
Expected Future Cash
Flows
- $105,000
+ $38,463
+ $38,463
+ $38,463
PVFactor
Present Value of Cash Flows (at time zero)
- $???
$???
$???
$???
$???
Year
0
1
2
3
X =
???
???
???
???
Sum = project’s Net Present Value =
Question 3: Calculate the NPV
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Question 4: compare the Simple Payback and the NPV
3. Net Present Value3. Net Present Value Workshop Exercise (5 min)Workshop Exercise (5 min)
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3. Net Present Value3. Net Present Value Sensitivity AnalysisSensitivity Analysis
• In business as usual scenario PLS Company needs waste water treatment plant in year 3: $150,000 investment– With QC project: $95,000
– Savings: $55,000
• Also consider taxes!– Pollution taxes / fees
– Tax deductions for equipment depreciation
– Tax deduction for “environmental projects”
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3. Net Present Value3. Net Present Value Workshop Exercise (answer B)Workshop Exercise (answer B)
Expected Future Cash
Flows
- $105,000
+ $38,463
+ $38,463
+ $93,463+ $93,463
PVFactor
Present Value of Cash Flows (at time zero)
Year
0
1
2
3
X =
.8696
.7561
.6575
Sum = project’s Net Present Value =
- $105,000
33,447
29,082
61.45261.452
-18,981-18,981
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4. Internal Rate of Return (IRR)4. Internal Rate of Return (IRR)
• Definition: discount rate for which NPV = 0, over the project lifetime
• Tells you exactly what “discount rate” makes the project just barely profitable
• Similar to NPV, considers
– Time value of money
– All future year cash flows
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Profitability Indicators SummaryProfitability Indicators Summary
Advantages Disadvantages
Easy to use Neglect TVM
Neglect out-year costs
Do not indicate project size
Considers TVM Needs firm’s discount rateIndicates project size
Considers TVM Requires iterationDoes not indicate
project size
SimplePayback& ROI
NPV
IRR
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Financial Feasibility Financial Feasibility Analysis of OptionsAnalysis of Options
Thank you for your attention! Thank you for your attention!
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This training session was prepared as part of the development and delivery of the course “Energizing Cleaner Production” funded by InWent, Internationale Weiterbildung und Entwicklung (Capacity Building International, Germany) and carried out by the United Nations Environment Programme (UNEP)
The session is based on the presentation “Financing Cleaner Production and Energy Efficiency Projects” from the “Energy Efficiency Guide for Industry in Asia” developed as part of the GERIAP project that was implemented by UNEP and funded by the Swedish International Development Cooperation Agency (Sida). www.energyefficiencyasia.org
The workshop exercise is taken from “Profiting from Cleaner Production”, in Strategies and Mechanisms For Promoting Cleaner Production Investments In Developing Countries, developed by UNEP
AcknowledgementsAcknowledgements