Professional Documents
Culture Documents
Financial Management
g
2/1/2019 1
CONTENT
Introduction
Investment Need, Appraisal
pp and Criteria
Investment Selection Procedure
Introduction About Finance Analysis
Finance
Fi A
Analysis
l i TTechniques
h i
1.Simple Pay Back Period
2.Return On Investment
3.Net Preset Value
4.Internal Rate Of Return
2/1/2019 2
Introduction
y In the process of energy management, at some stage,
investment would be required for reducing the
energy consumption of a process or utility. Investment
wouldld be
b required
i d for
f modifications/
difi i / retrofitting
fi i and
d
for incorporating new technology.
y IIt is
i essential
i l to identify
id if the h benefits
b fi off the
h proposed d
measure with reference to not only energy savings but also
other associated benefits such as increased productivity,
productivity
improved product quality etc.
y The cost involved in the proposed measure should be
captured following:
• Direct project cost
• Additional operations and maintenance cost
• Training of personnel on new technology
2/1/2019
etc. 3
Introduction
y Financial management is very broad term and it
is highly focused by all company.
y In case of energy management, investment is
required
i d tot beb done
d f
for reducing
d i th
the
energy consumption of process or utility.
y Also investment is required for modification
of existing systems.
y Any financial investment is done after
considering various benefit related to
investment.
2/1/2019 4
Investment Need
To convince any organization to commit itself to a
program of investment in energy efficiency, they
need to demonstrate:
The size of the energy problem it currently faces.
The technical and good maintenance measure available to
reduce waste
The predicted return achieved on particular measures
over time.
You are getting the best performance from existing plant and
equipment
Your energy charges are set at the lowest possible tariffs
You are consuming the best energy forms –fuels or electricity as
efficiently as possible
Good cleaning practices are being regularly accomplished.
When listing
g investment opportunities
pp , the followingg criteria need
to be considered:
d
Reducing
R operating
i production
d i cost
Increasing employee comfort and well-being
p
Improvingg cost-effectiveness and p
profits
Protecting under funded core activities
the quality of service or customer care delivered
Protecting the environment.
environment
2/1/2019 7
Investment Selection Procedure
1. Identification of potential investment opportunities
3 Comparative
3. C i (rate of return, breakeven times) analysis
l i off
investments opportunities.
pp
opportunity 2/1/2019 8
TIME VALUE OF MONEY
y Time value of money indicates that time has an impact on the
value of cash flows.
2/1/2019 10
2/1/2019 11
Introduction To Financial Analysis
•When we decide to invest in increasing its energy
efficiency it should apply exactly the same criteria to
reducing its consumption as it applies to all its other
investments.
•The
Th basic
b i criteria
i i for
f financial
fi i l iinvestment appraisal
i l
are as follow:
9Simple payback
9Return on investment (ROI)
9Net preset value(NPV) and Cash flow
9Internal rate of return(IRR)
2/1/2019 12
y Decision of selecting / rejecting the investment
proposal
p p is depending
p g upon
p 2 things:
g
1.Amount require for investment
2. Return from investment
y There are many projects which can give faster return
but the amount of return is small and in other hand,
the p
project
j mayy be which can ggive higher
g return in
longer run.
y Various Tools
1. Payback period
2. Ratio of investment
3
3. N t presentt value
Net l
4. Internal rate of return
5
5. Cash flow
2/1/2019 13
y The basic criteria for financial investment
appraisal
pp include:
2/1/2019 14
1.SIMPLE PAYBACK PERIOD:
y It is number of the years required to recover the initial
i t t considering
investment, id i only
l the
th nett annuall savings.
i
CALCULATION:
Simple payback period= First cost /
(Yearly benefits-Yearly cost)
2/1/2019 16
Example
A co-generation plant installation is expected to
reduce a company’s annual energy bill by Rs.24 lakhs.
If the capital cost of the new cogeneration installation
i Rs.90
is R 90 lakhs
l kh and d the
th annuall maintenance
i t andd
operating costs are Rs. 6 lakhs, What will be the
expected pay back period for the project?
First Cost
Simple pay back Period =
Yearlybenifits - Yearly costs
90
Simple pay back Period =
24 - 6
Simple pay back Period = 5 year
2/1/2019 17
Example
Cost of an heat exchanger is Rs.1.00 lakhs .Calculate
simple pay back period considering annual saving
potential of Rs.60,000/- and annual operating cost of
Rs.15,000/-
2/1/2019 18
Example
Cost of an heat exchanger is Rs.1.00 lakhs .Calculate
simple pay back period considering annual saving
potential of Rs.60,000/- and annual operating cost of
Rs.15,000/-
First Cost
Simple pay back Period =
Y l b ifit - Yearly
Yearlybenifits Y l costs
t
100000
Simple pay back Period =
60000 - 15000
Simple pay back Period = 2 year 2 month 9days
2/1/2019 19
Example
Calculate simple pay back period for a boiler that cost
Rs.75.00 lakhs to purchase and Rs.5 lakhs per year
on an average to operate and maintain and is
expected to annually save Rs.30 lakhs.
2/1/2019 20
Example
Calculate simple pay back period for a boiler that cost
Rs 75 00 lakhs to purchase and Rs.5
Rs.75.00 Rs 5 lakhs per year
on an average to operate and maintain and is
expected
p to annually
y save Rs.30 lakhs.
First Cost
Simple pay back Period =
Yearlybenifits - Yearly costs
75
Simple
p ppayy back Period =
30- 5
Simple pay back Period = 3 year
2/1/2019 21
ADVANTAGES:
d l used
•A widely d investment criterion, the
h payback
b k period d seems
to offer the following advantages:
•It is simple, both in concept and application. Obviously a
shorter payback generally indicates a more attractive
investment. It does not use tedious calculations.
• It favours projects, which generate substantial cash inflows in
earlier years, and discriminates against projects, which bring
substantial cash inflows in later yyears but not in earlier yyears.
DISADVANTAGES:
•It fails to consider the time value of money
•It ignores cash flows beyond the payback period, leads to
demonstration against the project generated substantial cash
flow last year.
year
• measure of project capital recovery, not profitability
2/1/2019 22
Example Of Uneven Cash Flow:
Company C is planning to undertake another project requiring
i iti l investment
initial i t t off $50 million
illi and d iis expected
t d tto generate
t
$10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the
payback value of the project.
Solution
YEAR CASHFLOW CUMMULATIV
(in millions) E CASHFLOW
0 (50) (50)
1 10 (40)
2 13 ( )
(27)
3 16 (11)
4 19 8
5 22 30
2/1/2019 23
Payback Period = 3 + ( |-$11M| / $19M )
2/1/2019 24
Examples:
Example of Even Cash Flows
Company C is planning to undertake a project requiring initial
investment of $100 million. The project is expected to generate
$25 million per year for 10 years. Calculate the payback period
of the project.
p j
2/1/2019 25
Examples:
Example of Even Cash Flows
Company C is planning to undertake a project requiring initial
investment of $100 million. The project is expected to generate
$25 million per year for 10 years. Calculate the payback period
of the project.
p j
Solution
Payback Period
= Initial Investment / Annual Cash Flow
= $100M / $25M = 4 years
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2. RETURN ON INVESTMENT
¾ROI h “annual
express the “ l return”” from
f h project
the j as a
percentage of capital cost.
¾Annual return includes cash flow over the project life &
discount rate by converting the total present value of ongoing
cash flow to an equivalent annual amount over the life of the
project which can be compared to capital cost.
project, cost
¾It is broad indicator of the annual return expected from
initial capital
p investment, expressed
p as a ppercentage
g :
¾ROI
O must always be higher than cost off money ; greater the
return on investment better is the investment.
2/1/2019 27
•A small business may be able to save $5,000 in operating
expenses (and thus raise profit by the same amount) by
spending $25,000 on a piece of new equipment.
Thi yields
•This i ld an ROI off $5
$5,000
000 / $25,000
$25 000 or 20 percent.
t
•If this figure is higher than the company's cost of capital (the
interest paid on debt and the dividends paid to investors) prior
to the investment, and no better investment opportunities exist
for those funds, it may make sense to purchase the equipment.
LIMITATION:
2/1/2019 30
3.NET PRESENT VALUE
ADVANTAGES
• It takes into account the time value of money.
• I considers
It id h cashh flflow stream iin its
the i project
j lif
life.
2/1/2019 33
NET PRESENT VALUE
y EXAMPLE
y A corporation must decide whether to introduce
a new product line. The company will have
immediate costs of 100,000 at t = 0. Recall, a cost
is a negative or outgoing cash flow
flow, thus this cash
flow is represented as -100,000. The company
assumes the pproduct will pprovide equal
q benefits
of 10,000 for each of 12 years beginning at t = 1.
2/1/2019 34
NET PRESENT VALUE
y This also makes the simplifying assumption that
the net cash received or ppaid is lumped
p into a
single transaction occurring on the last day of
each year.
T=0 −100,000
T=1 9,090.91
T=2 8,264.46
T=3 7,513.15
T=4 6,830.13
T=5 6,209.21
T=6 5,644.74
T=7 5,131.58
T=8 4,665.07
T=9 4,240.98
T = 10 3,855.43
T = 11 3 504 94
3,504.94
T = 12 3,186.31
2/1/2019 36
NET PRESENT VALUE
y Th totall present value
The l off the
h incoming
i i cashh
flows is 68,136.92. The total present value of the
outgoing
g g cash flows is simply p y the 100,000 at
time t = 0.Thus:
y
2/1/2019 37
NET PRESENT VALUE
y Observe that as t increases the present value of
each cash flow at t decreases.
y For example, the final incoming cash flow has a
future value of 10,000 at t = 12 but has a
present value (at t = 0) of 3,186.31. The opposite
of discounting is compounding.
y Taking the example in reverse, it is the equivalent
of investing 3,186.31 at t = 0 (the present value)
att an interest
i t t rate
t off 10% compounded d d for
f 12
years, which results in a cash flow of 10,000 at t =
12 (the future value).
value)
2/1/2019 38
NET PRESENT VALUE
y The importance of NPV becomes clear in this
instance.
2/1/2019 40
NET PRESENT VALUE
¾ Advantage and Disadvantage of NPV
y Advantage: Net present value accounts for time
value of money. Thus it is more reliable than other
investment appraisal techniques which do not
discount future cash flows such payback period and
accountingg rate of return.
y Disadvantage:
g It is based on estimated future cash
flows of the project and estimates may be far from
actual results.
41
4.INTERNAL RATE OF RETURN:
IRR of an investment is the discount rate at which the
net present value of costs (negative cash flows) of the
investment equals
q the net present
p value of the benefits
(positive cash flows) of the investment.
n
CFt
NPV = ∑ − CF0
(1 + K )
t =0 (
t
y The internal
Th i l rate off return is the h rate at
which an investment project promises to
generate a return during its useful life.
life
2/1/2019 43
INTERNAL RATE OF RETURN
y In more specific terms, the IRR of an investment
is the interest rate at which the net present
p
value of costs (negative cash flows) of the
investment equals the net present value of the
b fi (positive
benefits ( i i cashh flows)
fl ) off the
h investment.
i
2/1/2019 44
ADVANTAGES:
•It takes into account the time value of money.
•It considers the cash flow stream in its entirety.
•It makes sense to businessmen who prefer to
think in terms of rate of return and find an
absolute quantity , like NPV.
DISADVANTAGES
•The internal rate of return figure can not
distinguish between leading and borrowing and
hence a high internal rate of return need not
necessarily be a desirable features.
2/1/2019 45
INTERNAL RATE OF RETURN
y Example-2
y The management of VGA Textile Company is
considering to replace an old machine with a new
one. The new machine will be capable of
performing
f some tasks
k muchh faster
f than
h theh oldld
one. The installation of machine will cost $8,475
and will reduce the annual labour cost by $1,500.
The useful life of the machine will be 10 years
with no salvage value. The minimum required rate
off return is
i 15%.
15%
y Required: Should VGA Textile Company purchase
the machine? Use internal rate of return (IRR)
method for your conclusion.
2/1/2019 46
INTERNAL RATE OF RETURN
¾ Solution:
y To conclude whether the proposal should be
accepted or not, the internal rate of return
promised by machine would be found out first
and then compared to the company
company’ss minimum
required rate of return.
2/1/2019 48
INTERNAL RATE OF RETURN
y After computing the internal rate of return
factor, the next step is to locate this discount
factor in “present value of an annuity of $1 in
arrears table”.
y Since the useful life of the machine is 10 years,
the factor would be found in 10-period line or
row.
y It is 12%. It means the internal rate of return
promised
i d by
b the
h project
j iis 12%
12%. Th
The final
fi l step is
i
to compare it with the minimum required rate of
return of the VGA Textile Company
Company. That is 15%
15%.
2/1/2019 49
INTERNAL RATE OF RETURN
y Example-2
y If an investment may be given by the
sequence of cash flows
2/1/2019 51
Example
A company invests Rs.10 lakhs and completes an energy efficiency
j t att the
project th beginning
b i i off year 1.
1 The
Th firm
fi i investing
is i ti it own
its
money and expects an internal rate of return, IRR, of at least 26%
on constant positive annual net cash flow of Rs.2 lakhs, over a
period of 10 y
p years,, starting
g with yyear 1.
•Will the project meet the firm’s expectations?
•What is the IRR of this measure?
2/1/2019 52
Example
A company invests Rs.10 lakhs and completes an energy efficiency
j
project h beginning
at the b i i off year 1. The
h firm
fi iis iinvesting
i iits own
money and expects an internal rate of return, IRR, of at least 26%
on constant positive annual net cash flow of Rs.2 lakhs, over a
period of 10 years, starting with year 1.
•Will the project meet the firm’s expectations?
•What is the IRR of this measure?
NPV = -1,000,000
, , + 200,000
, + 200,000
, + ……200,000
, =
1.261 (1.26)2 (1.26)10
= - 1,000,000 + 158,730 + 125,976 + 99,981 + 79,350
+ 62,976 + 49,981 + 39,668 + 31,482 + 24,986 +
19 830
19,830
= - 307,040
Since NPV is negative at 26%, project will not meet the firm’s
expectations, because this means that the factor of 1.26 must be
selected smaller in order to have NPV = 0
2/1/2019 54
Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.
NPV=-50,000+(15000/1.16)+18000/(1.16x1.16)+
(20000/(1.16x1.16x1.16))
= -50,000
50 000 + 12931 + 13377 + 12813
= (- 10879)
2/1/2019 55
Example
A investment
An i t t off Rs.
R 1.10
1 10 Lakh
L kh is
i made
d forf i bl speed
a variable d
drive at the beginning of the year, which is also the date of first
operation. Savings expected over 4 years are Rs. 28,000, Rs.
35,000, Rs. 40,000 and Rs. 40,000 respectively. Find out the
IRR of the project.
2/1/2019 56
Example
A investment
An i t t off Rs.
R 1.10
1 10 Lakh
L kh is
i made
d forf i bl speed
a variable d
drive at the beginning of the year, which is also the date of first
operation. Savings expected over 4 years are Rs. 28,000, Rs.
35,000, Rs. 40,000 and Rs. 40,000 respectively. Find out the
IRR of the project.
1,10,000 = 28,000/(1+r/100)+35,000/(1+r/100)2
+40,000/(1+r/100)3 + 40,000/(1+r/100)4
IRR = 11 % (app)
2/1/2019 57
Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.
2/1/2019 58
Example
p
Calculate the Net Present Value of a project at a discount
rate of 16% with an investment of Rs 50,000 at the
beginning of the first year, and savings of Rs 15,000, Rs.
18,000
18 000 and Rs.
Rs 20,000
20 000 respectively at the end of the first,
first
second and third year.
NPV=-50,000+(15000/1.16)+18000/(1.16x1.16)+
(20000/(1.16x1.16x1.16))
= -50,000
50 000 + 12931 + 13377 + 12813
= (- 10879)
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Example
A ppressure reducing
g valve is p
proposed
p to be replaced
p by
y a
steam turbine. The investment required is Rs.40 lakhs.
Additional maintenance and operating costs for the turbine is
expected to be Rs. 1 lakh per annum. If the annual savings
is Rs.9
Rs 9 lakhs,
lakhs calculate the payback period and Return on
Investment.
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Example
A ppressure reducing
g valve is p
proposed
p to be replaced
p by
y a
steam turbine. The investment required is Rs.40 lakhs.
Additional maintenance and operating costs for the turbine is
expected to be Rs. 1 lakh per annum. If the annual savings
is Rs.9
Rs 9 lakhs,
lakhs calculate the payback period and Return on
Investment.
First Cost
Simple pay back Period =
Y l b ifit - Yearly
Yearlybenifits Y l costs
t
= 5 years
A n n u a l n e t c a sh flo w
ROI = × 100
C a p ita l C o s t
Return on Investment = (9
(9-1)/40
1)/40
= 1/5
= 20 %
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Example
The following are the cash flows for a simple insulation up
gradation project.
a) Calculate the NPV if the cost of capital or discount rate is
8%
b) Calculate
C l l t the
th IRR
YEAR 0 1 2 3 4
Cash flow -18,000 -5,000 10,000 10,000 10,000
2/1/2019 62
Example
The following are the cash flows for a simple insulation up
gradation project.
a) Calculate the NPV if the cost of capital or discount rate is
8%
b) Calculate
C l l t the
th IRR
YEAR 0 1 2 3 4
Cash flow -18,000 -5,000 10,000 10,000 10,000
NPV = -18,000
18,000 - 5,000 + 10,000 + 10,000 + 10,000
(1.08)1 1.082 1.083 1.084
= 1,232
IRR = 10. %
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Example
Rs 25
An energy saving proposal involves an investment of Rs.
lakhs in an industry and is expected to yield an average
annual net saving of Rs. 5 lakhs/annum. The cost of
borrowing of the investment is 14%. Compute the return on
investment for this proposal and state with reason whether
the investment is justified
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Example
Rs 25
An energy saving proposal involves an investment of Rs.
lakhs in an industry and is expected to yield an average
annual net saving of Rs. 5 lakhs/annum. The cost of
borrowing of the investment is 14%. Compute the return on
investment for this proposal and state with reason whether
the investment is justified
A n n u a l n e t c a shh flo
fl w
ROI = × 100
C a p ita l C o s t
2/1/2019 65
Example
A paper mill has two investment options for energy saving
projects:
Option : A Investment envisaged Rs.40 lakhs , annual return is
Rs.8 lakhs, life of the project is 10 years, discount rate 10% .
Calculate IRR of both the options and suggest which option the
paper mill should select considering the risk is same for
both the options.
2/1/2019 66
Example
A paper mill has two investment options for energy saving
projects:
Option : A Investment envisaged Rs.40 lakhs , annual return is
Rs.8 lakhs, life of the project is 10 years, discount rate 10% .
Calculate IRR of both the options and suggest which option the
paper mill should select considering the risk is same for both the
options.
Option A
8 x 105 8 x 105
40 x 105 = -------------- + - - - + -------------
( 1 + X )1 ( 1 + X )10
IRR = 15.10 %
Option B
5 x 105 5 x 105
24 x 105 = -------------- + - - - + -------------
( 1 + X )1 ( 1 + X )8
IRR = 13 %
Based on IRR, Option A has higher IRR and the mill may opt for
2/1/2019 67
option A
Example
INVESTMENT Rs(10,00,000)
YEAR CASHFLOW
1 2,00,000
2 2,00,000
3 3,00,000
4 3,00,000
5 3,50,000
, ,
2/1/2019 68
INVESTMENT Rs(10,00,000)
YEAR CASHFLOW
1 2,00,000
2 2,00,000
3 3,00,000
4 , ,
3,00,000
5 3,50,000
n
CF0 CF1 CFn CFt
NPV =
(1 + K )0
+
(1 + K )1
+ − − − − − − − − + = ∑
(1 + K ) n i =0 (1 + K )t
−1, 000, 000 200, 000 200, 00 300, 00
V=
NPV + + +
(1 + 0.10) 0
(1 + 0.10) (1 + 0.10) (1 + 0.10)3
1 2
300, 00 350, 00
+ +
(1 + 0.10) 4 (1 + 0.10)5
= -5,273
2/1/2019 69
Project1 Project2
Capital cost 30000 30000
Example
Using the net present Year Net annual Net annual
value method, evaluate Saving(Rs) Saving(Rs)
the
h financial
fi i l merits
i off two 1 +6600 +6000
proposed projects shown
in table. The annual rate is 2 +6600 +6000
8 % for each project. 3 +6300 +6000
4 +6300 +6000
5 +6000 +6000
6 +6000 +6000
7 +5700 +6000
8 +5700 +6000
9 +5400 +6000
10 +5400 +6000
Total net saving +60000 +60000
at end of tenth
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CASH FLOW
2/1/2019 71
RISK ANALYSIS
• Risk is degree of measuring the loss or damage to the
project.
•The present day cash flows, such as capital cost, energy cost
savings, maintenance costs, etc can usually be estimated
f i l accurately.
fairly t l
76
Self-Financing Energy Management
One way to make energy management self-financing is to split
savings to provide identifiable returns to each interested
party. This has the following benefits:
2/1/2019 80
Energy Performance Contracting
Performance contracting represents one of the ways
to address several of the most frequently
mentioned
ti d barriers
b i t investment.
to i t t Performance
P f
contracting through an ESCO transfers the
technology and management risks away from the
end-user to the ESCO.
For energygy users hesitant to invest in energy gy
efficiency, a performance contract can be a
powerful incentive to implement a project.
Performance contracting also minimizes or
eliminates the up-front cash outlay required by the
end user Payments are made over time as the energy
end-user.
savings are realized.
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