UNIT-2

ENERGY ECONOMIC ANALYSIS

**Sharen Ranjit
 Introduction:
• Energy projects important economy and environment
• More energy conservation projects better is for environment
• Biggest constraint (lack of finance)

• Variety of financial arrangements to overcome initial cost.

• The energy managers and auditors use simple payback analysis to evaluate projects.
• Financial issues associated with capital investment in E saving projects are discussed.
 When planning an energy efficiency or energy
management project:
• How much will the proposal cost?
• How much money will be saved by the proposal?
• Funding?
• Invest in greater return projects
• Capital value of plant decrease with time
• More maintenance for older plants
 FIXED & VARIABLE COST:
VARIABLE COST:
• cost vary directly with output of a plant or production process (fuel cost)
FIXED COST:
• Cost which are not dependent on plant or process output (site rent, insurance)
Total cost = Fixed cost + Variable cost
 INTEREST CHARGES
• To finance projects, organizations often borrow money banks or other leading organizations
• cost more than similar projects Financed from organization‘s own funds
interest charges must be paid on the
loan.
• how interest charge calculated?
SIMPLE INTEREST: (fixed % of capital borrowed for each year)

COMPOUND INTEREST: (calculated annually)

 INVESTMENT NEED, APPRAISAL & CRITERIA:
NEED
• Installing new equipment
• Improving process
• Providing staff training
• Upgrading/implementing energy information system
 Queries by management to E auditor
 The basic criteria for financial investment appraisal include:
 Payback period: how long is the financing term
 Defined as time (no: of years)
 One payback period ends capital cost recovered
 Any additional cost profit
 Shorter payback period more attractive project

 Net present value (NPV) & Cash Flow: incorporate E efficient projects into corporate financial system
 Return on Investment (ROI) & Internal Rate of Return (IRR): Comparison with other investment options
 annual return expected from a project as percentage of capital cost
ROI = annual net cash flow/capital cost x 100
 ROI must be higher than cost of money
 Greater ROI better is investment
 TIME VALUE OF MONEY
• A project usually entails
 an investment for the initial cost of installation capital cost
 a series of annual costs and/or cost savings (Operating, energy,
maintenance)

throughout the life of the project

• To assess project feasibility all these present and future cash flows
must be analyzed.
• Cash flow equated to a common basis.
• The problem with equating cash flows value of money changes
with time.
• The method by which these various cash flows are related is called
Discounting, or the present value concept.
• The relationship between present and future value is determined as follows:
 NET PRESENT VALUE METHOD

• The net present value method considers the time value of money.
• Future cash flow to its current value today

• the present value determined from future plans

• by using an assumed interest rate, usually referred to as a discount rate.

discounting compounding.

• COMPOUNDING DETERMINES THE FUTURE VALUE OF PRESENT CASH FLOWS

• DISCOUNTING DETERMINES THE PRESENT VALUE OF FUTURE CASH FLOWS.
 Time Value of Money Definitions:
o Present Value (P)—the current value or principal amount.
o Future Value (F or S)—the future value of a current investment.
o Interest/Discount Rate (i)—the “carrying” charge for the use or investment of funds.
o Term of Investment (N)—the number of years the investment is held.
o Period (M)—the time schedule at which the interest/discount rate is applied.
o Annuity (A or R)—a series of equal payments made over the term of an investment.

o Gradient (G)—an escalating annuity (i.e., one that rises at a uniform rate throughout the term of the
investment).
DEVELOPING CASH FLOW MODEL:

o cash flow model assumes that cash flow occur at discrete points in time.
o So interest is computed & payable at discrete points in time
o Cash flow diagrams are often used to help visualize the flow of capital throughout
the term of an investment.
When drawing a cash flow diagram, the following rules are applied:
o Arrows Always Point Away from the Time Axis
o Arrows Pointing Up Are Income
o Arrows Pointing Down Are Expenses
o Arrows Can Be Summed in the Same Year.
 CASH FLOW MODEL IS DEVELOPED AS FOLLOWS:

(1 + i)" is referred to as the "Single Payment Compound Amount"

• The cash flow model can also be used to find the present value of a future sum.

To develop the cash flow model for the "Uniform Series Compound cash Amount" factor, the following cash
flow diagram is drawn

Where A is a uniform series of year-end payments

F is the future sum of A payments for n interest periods

The A dollars deposited at the end of the nth period earn no interest contribute A dollars to the fund.
The A dollars deposited at the end of the (n - 1) period earn interest for 1 contribute A (1 + i) dollars to the fund.
The A dollars deposited at the end of the (n - 2) period earn interest for 2 years contribute A(1+ i)^2
• These years of earned interest in the contributions will continue to increase in this manner.
• The total in the fund F is, thus, equal to A + A(1 +i)+A(1 +i)2 + A(1 +i)3 + A(1 +i)4 +...+
A(1+i)n-2 + A(1 +i)n-1.
LIFE-CYCLE COSTING

• The three most commonly used methods in life-cycle costing are

• the annual cost
• present worth
• rate-of-return analysis
 PAYBACK ANALYSIS
• The simple payback = initial investment /annual savings after taxes.
• method does not take into account the effect of interest or escalation rate.
• method is frequently used
• It should be used in conjunction with other decision-making tools
• Once the payback period has ended, all the project capital costs will have been recovered and
any additional cost savings achieved can be seen as clear 'profit'.
• The shorter the payback period, the more attractive the project becomes