CHAPTER 8: ENERGY ECONOMICS

An energy project can be considered economically viable if all the following

conditions are satisfied1. Benefits of the project exceed the costs
2. The proposed project is more profitable than alternative methods of
achieving the same objectives
3. The project is on the proper scale to achieve the same objectives
4. Capital is available to complete the project.
8.1 Pay Back Period
A quantative yardstick to measure the effectiveness of conservation projects is
the pay back period. Pay back period is based on determining the number of
years required for the invested capital to be recovered from net cash flows.
Pay back period ( N * ) = Net investment or capital cost/Net annual savings or
cash flows
or,
N*
t =0

cFt cost t > 0

(8.1)

or,
cash flows in time t -investment cost>0
Disadvantages:
1. The time value of money is not considered.
2. The effect of cash flows (savings) after the payback period is not
considered
Advantage
1. A rapid pay back may be prime criterion for judging an investment when
financial resources are available to the investor only for a short period of
time.
2. The speculative investor desires for rapid recovery of the initial
investment.
3. The determination of breakeven life ( N * ) is helpful in accessing the
availability of achieving a successful investment.

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8.2 Return of Investment (ROI) Method

The return of investment method estimates the net annual return as percentage
of the capital investment.
ROI = Net annual return/ Capital investment x 100%
(8.2)
It is reciprocal of pay back period. There is a cut off value of ROI, below which
the investment will not be worth while.
Let, A = Capital cost of energy conservation equipment
B = Annual operating cost
C = Annual fuel savings in million kJ
D = Project fuel price in Rs/million kJ
N = Equipment life time in years
Net annual savings,

S =CDB

(8.3)

Pay back period,

N* =

A
A
=
S CD B

(8.4)

Example 8.1:
A company is considering installation of a new energy efficient equipment in its
manufacturing process. The installation cost of the equipment is estimated to be
Rs 20.0 Lakhs and equipment required Rs 60,000/year for annual operating cost.
The equipment is expected to save an average Rs 31,000 million kilo Joule per
year over next 10 years. Fuel cost is Rs 30/ million kJ. Calculate the pay back
period.
The management of the company has taken a decision to implement the scheme
so that there will be at least 50% ROI. Should the project be implemented or not.
Solution:
Capital= A = Rs 20, 00, 000.00
Running cost= B = Rs 60, 000.00
Annual fuel saving= C = Rs 31,500 106 kJ/kg

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Fuel price= D = Rs 30/million kJ

Life of equipment = N = 10 years
Now,
Net annual saving= S = C D B = 885000
Pay back period N ' =
ROI =

A
= 2.26 years
S

S
= 44.25%
A

Hence project can not be implemented.

If we use straight line depreciation:
If, G = 0 A' = A
f =

A
= 200000
N

ROI =

S f
= 34.25%
A'

8.3 Straight Line Depreciation

The useful life of any plant may be fixed by the time till it becomes either unfit for
further use or obsolete due to new technical improvement.
Therefore, money may be set aside every year so that at the end of the useful life
of the plant, there will be sufficient sum available to purchase a new plant to carry
on the business.
Let,
G = Salvage value, value of the plant after expiry of its useful life
A = Capital invested
N = Equipment life in year

Hence, total depreciation,

Depriciation charge, f is

A' = A G
f =

A'
per year
N

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(8.5)
(8.6)

8.4 Reducing Balance Depreciation

Depriciation in any year is a fixed proportion of the value at the beginning of the
year.
Let, f = yearly depreciation
At the end of first year, the value of the equipment is= A fA = A (1 f )
At the end of second year, value of the equipment is=
2
A (1 f ) fA (1 f ) = A (1 f )
At the end of Nth year, value of the equipment =salvage value, G = A (1 f )
Now,
or,

G = A (1 f )

log G = log A + N log (1 f )

or,
log (1 f ) =

1
G
log
N
A

(8.7)
(8.8)
(8.9)

or,
1 f = exp

1
G
log
N
A

(8.10)

1
G
log
N
A

(8.11)

or,
f = 1 exp

8.5 Sinking Fund Depreciation

A loan may be taken from a bank to purchase a new equipment. The loan must
be repaid over a life time of the equipment. The annual installments are paid into
a deposit is called the sinking fund .
Let, A' = Sum to be paid at the end of N years= A G
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1. At the end of 1st year, Rs. P is deposited to bank. After ( N 1) years this will
be worth P (1 + i )

N 1

2. At the end of 2nd year, Rs P is deposited to bank, after ( N 2 ) years, this will
be worth P (1 + i )

N 2

3. At the end of ( N 1) th year Rs P is deposited. After 1 year this will be P (1 + i )

At the end of N years, the value of all sums deposited will be
S = P (1 + i )

N 1

+ P (1 + i )

N 2

+ P (1 + i )

N 3

+ ........ + P (1 + i ) + P

or,
P (1 + i ) 1

(8.13)

S=

(8.12)

=A

'

Example 8.2:
A plant having a first cost of Rs 20,000.00 has an estimated salvage value of Rs
2000.00 at the end. Its useful life is 20 years. What will be the value of the plant
halfway its life:
(a) On the basis of straight line depreciation
(b) On a reducing balance basis
On a sinking fund basis as 6% interest compounded annually
Solution:
(a) Straight Line depreciation method
G = Rs 2000.00 after 20 years
Total depreciation, A' = A G = Rs 20,000.00 Rs 2000.00 = Rs18,000.00
A' Rs18000.00
=
= Rs900.00 per year
N
20
At the end of 10 years, the value will be= Rs 20,000.00- Rs 900.00x10=Rs
11,000.00
f =

(b) Reducing balance depreciation method

log (1 f ) =

1
G
log
N
A

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Hence, f = 0.108
Value of the plant after 10 years=
10
10
A (1 f ) = Rs 20,000.00 (1 0.108 ) = Rs 6306.00
(c ) Sinking fund method
p=

Ai'

(1 + i )

N 1

0.06 Rs18,000.00

(1 + 0.06 )

20

= Rs 489.00

At the end of 10 years, the depreciation sum is

(1 + 0.06 )
= Rs 489.00

10

= Rs 6400.00
0.06
Value of the plant after 10 years is
= Rs 20,000.00 Rs 6400.00 = Rs13,600.00
A

'

8.6 Net Present Value Method (NPV)

Cash flows (savings) streams at different time periods differe in value and can be
compared only when they are expressed in terms of a common denominator, i.e.,
present value.
Some discount rate is to be selected. All cash flows are connected to the present
value based on the discount rate.
CF3
CFN
CF1
CF2
salvage value
+
+
+ ........ +
+
(8.14)
2
3
N
N
(1 + i ) (1 + i ) (1 + i )
(1 + i )
(1 + i )
Net present value (NPV) =Present value of cash in flow-Present value of cash
out flow

Present value=

If, NPV > 0, then accept the period.

Example 8.3: A chemical company is considering investment to an energy project
costing Rs 4,00,000.00. The estimated salvage value is zero. The tax rate is also
zero. The company uses straight line depreciation and the proposed project has
cash flows as follows
Year
1
2
3
4
5

Cash flows (Rs)

1,00,000.00
1,00,000.00
1,50,000.00
1,50,000.00
2,50,000.00

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Determine (a) Pay back period

(b) NPV at 15% interest
Solution:
(a)
Year
1
2
3

CF
1,00,000.00
1,00,000.00
1,50,000.00

Cumulative CF
1,00,000.00
2,00,000.00
3,50,000.00

N= Rs 50,000.00/Rs 150000.00=0.33 years

Pay back period= 3.33 years
(b)
Year
1
2
3
4
5

CF
1,00,000
1,00,000
1,50,000
1,50,000
2,50,000

1
(1 + i )
1

(1 + i )

75,600.00

0.658

98,700.00

0.572

85,800.00

0.497

1,24,250.00

(1 + i )

0.756

(1 + i )

Total Present
value
87,000.00

(1 + i )

Present value at
15 %
0.87

Total Rs 4,71,350.00

NPV=Rs 4,71,350.00 -Rs 4,00,000.00=Rs 71,350.00

Hence the project is acceptable.

196