Financial Feasibility Analysis

Energizing Cleaner Production

Management Course

Session Agenda:

Introduction Cash Flow Profitability Indicators

1. 2. 3. 4. Simple Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR)
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Step 1: Planning and Organization

But first
In what step(s) of the methodology is financial feasibility analysis relevant?

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 2: Assessment
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 3: Identification of Options

task 3a: Determine causes of losses task 3b: Identify possible options task 3c: Screen options for feasibility analysis

Step 4: Feasibility Analysis 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

Step 5: Implementation and Monitoring of Options

task 5a: Implement options and monitor results task 5b: Evaluation meeting with top management

Step 6: Continuous Improvement

task 6a: Prepare proposal to continue with energy efficiency for top management approval

Introduction

Step 4 Feasibility Analysis

Companys priority

Technical

Other
- Regulatory - Organizational - Health/safety - Community

Project Selection
Environmental

Financial

Introduction

Questions 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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Introduction

Capital 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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Introduction

Capital 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

Introduction

Typical 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 Flow

Cash Flow Concept

Common management planning tool
Distinguishes between

Costs: cash outflows

Revenues/savings: cash inflows

Cash Flow

Types of Cash Flow

Outflow
One-time
Initial investment cost Operating costs & taxes Working capital

Inflow
Equipment salvage value

Annual

Operating revenues & savings Working capital

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Other

Cash Flow

Costs 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 Flow

Working 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 Flow

Timing
End of project:

Salvage Value Annual Revenues/Savings

Year 1

Year 2

Year 3

TIME

Time zero:

Initial Investment

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Cash Flow

Incremental 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 Indicators
Definition: a single number that is calculated for characterisation of project profitability in a concise and understandable form
Common indicators
1. 2. 3. 4. Simple Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR)
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1. 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 Investment
Definition: the percentage of initial investment that is recovered each year
Initial Investment Simple Payback = (in years) Year 1 Cash Flow

3 years

ROI (in %)

Year 1 Cash Flow

= Initial Investment

33%

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Workshop Exercise

PLS Company: produces rolls of laminated film

plastic film, aluminium film, adhesive solvent air emissions printed plastic film, ink PRINTING solvent air emissions printed laminated

INVENTORY

film
LAMINATION Solid scrap Liquid waste ink

film

SLITTING

Solid scrap

Solid scrap

to waste management

to waste management

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Workshop Exercise

PLS 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 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 Value

Money 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 Value

Inflation
Money loses purchasing power over time as product/service prices rise, so a dollar today can buy more than a dollar next year

inflation 5%

costs $1
now

costs $1.05
next year
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3. Net Present Value

Return 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
Investing $1 now Investment Gives you $1.10 a year from now

10 % interest, or return on investment

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3. Net Present Value

PLS Companys QC Camera Project

Initial Investment Cost Business As Usual Annual Operating Costs

$ 2,933,204

Installing quality control camera

Annual Savings = US$38,463

$ 105,000

$ 2,894,741

(in US$)
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3. Net Present Value

Question

Is the annual savings of $38,463 per year for 3 years a sufficient return on the initial investment of $ 105,000?

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3. Net Present Value

Time 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 Value

Cash 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 Value

Converting Cash Flows to Present Value

Annual Savings
= ?? = ?? = ??

End of project

$38,463

$38,463

$38,463

Year 1

Year 2

Year 3

TIME

Time zero:

Initial Investment = $105,000

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3. Net Present Value

Converting Cash Flows to Present Value

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 Value

Discount 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 Value

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 projects 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 companys cost of capital)
A single Weighted Average Cost of Capital (WACC) characterises the sources and cost of capital to the company as a whole 31

3. Net Present Value

Calculating Present Value

Value of the cash flow in year n

Present Value = Future Valuen x (PV Factor)

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 Value

The Value of a Future $1

Discount rate (d):
Years into future (n)

10% .9091 .8264 .7513 .6830 .6209 .3855 .1486 .0573

20% .8333 .6944 .5787 .4823 .4019 .1615 .0261 .0042

30% .7692 .5917 .4552 .3501 .2693 .0725 .0053 .0004

40% .7142 .5102 .3644 .2603 .1859 .0346 .0012 .0000

1 2 3 4 5 10 20 30

Present value factors

Handout: Table with discount rates

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3. Net Present Value

Net Present Value (NPV)

Definition: sum of present values of all projects 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 Value

Workshop Exercise (15 min)

Question 3: Calculate the NPV
Year

Expected Future Cash Flows - $105,000

+ $38,463 + $38,463

PV Factor

Present Value = of Cash Flows (at time zero) - $???

$??? $???

0
1 2

???
??? ??? ???

+ $38,463

$???
$???
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Sum = projects Net Present Value =

3. Net Present Value

Workshop Exercise (5 min)

Question 4: compare the Simple Payback and the NPV

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3. Net Present Value

Sensitivity 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 Value

Workshop Exercise (answer B)

Expected Future Cash Flows - $105,000 + $38,463 + $38,463 + $93,463 .8696 .7561 .6575

Year

PV Factor

Present Value = of Cash Flows (at time zero)

0 1 2 3

- $105,000
33,447 29,082

61.452
-18,981
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Sum = projects Net Present Value =

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 Summary

Advantages

Disadvantages
Neglect TVM Neglect out-year costs Do not indicate project size

Simple Payback & ROI

NPV

Easy to use

Considers TVM Needs firms discount rate Indicates project size Considers TVM Requires iteration Does not indicate project size

IRR

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Financial Feasibility Analysis of Options

Thank you for your attention!

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Acknowledgements
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
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