Basics of Financial and Economic Analysis

Farzana Naqvi
Applied Systems Analysis Division Pakistan Atomic Energy Commission 16 April 2013

First Training Course under 4Q HRD Programme of PAEC 15-19 April 2013

BIDNUPP Building, Pakistan Atomic Energy Commission, Islamabad

Need for Economic Analysis (EA)

To indentify Project Portfolio that ensures Best Allocation of Resources

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Why do We Need Such Analyses?

The problem is that: The resources are limited but our desires are unlimited We need to find out the most efficient use of these resources Current developments have resulted in overexploitation of these resources We need to minimize the Burden of Development

Sustainable Development

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Example of Resources for an Energy System

Natural resources (coal, oil, gas, hydro, wind, solar..)

Depletable Renewable

Human resources (Engineering/Procurement/ Construction, Management..)

Man-made Capital stock (Machinery & Equipments..)

Environment (Air, Water, Land,.)

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Economic Analysis of Energy System

Technology Energy resources

Energy demand

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Components of Sustainable Development Plan

Social and Economic Perspective Social and Economic Perspective

Assessment of Assessment of Natural Resources Resources Natural

Assessment of Assessment of Needs and Electricity Water needs

Identification of Identification of Technology Choices Technology Choices

Exogenous Assumptions Assumptions Exogenous

Analysis of Analysis of Supply and Electricity Options Water supply

Regional trade Regional trade of of electricity and fuels

Environmental Environmental Burdens and Burdens and mitigation mitigation

Financial and Financial and other resource other resource requirements requirements

Sustainable supply strategy

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Economic Analysis for Project Portfolio

Comparison of Levelized OR Generation Cost

Optimization model for Least-cost Expansion Plan (MESSAGE, WASP)

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Electricity Installed Capacity in 2011-12

MW Hydel Gas/Oil Coal Nuclear 6,716 15,985 150 787 Shares 28.4% 67.5% 0.6% 3.3%

Wind
Total

50
23,688

0.2%
100.0%

Source: i) State of Industry Report 2012, National Electric Power Regulatory Authority. ii) Power System Statistics 2011-12, 37th Edition, National Transmission and Despatch Company.
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Electricity Generation Mix in Pakistan

Others 0.4% Nuclear 4.9%

Oil 36.2%

Hydro 29.1%

Gas 29.4%

2011-12

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Levelized Electricity Generation Cost

Where I = Investment cost M = Operation and Maintenance cost F= Fuel cost E = Electricity generated r = Discount rate t = Time from year 1 to n n = Economic life of supply project

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MESSAGE
INPUT
Energy system structure (including vintage of plant and equipment)
TWh
600

OUTPUT

500

400

biomass geoth hydro nuclear gas diesel fuel oil

300

Base year energy flows and prices Energy demand projections (MAED) Technology and resource options & their techno-economic performance Technical and policy constraints

MESSAGE

200

coal

100

0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026

Primary and final energy mix Emissions and waste Resource use Build Schedule for infrastructure Import dependence Investment requirements
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Financial analysis To assess Profitability of a business entity e.g., a company, corporation

Comparison with its previous years

Comparison with other entities To select an investment project in: Public sector Private sector

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Need for FA of an Investment Project

To establish profitability of an Identified Investment project under certain terms and conditions for financing it

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Financial Analysis for Appraisal of an Investment Project

Analysis to assess if Income from the project over its operational life, will be sufficient to:

cover all costs and bring back the initial investment with some return

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Financial Analysis for Project Appraisal

The financial analysis is carried out considering:

Conditions in the financial sector Market conditions

Fiscal policy of the government

Risk factors

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Three major components of Financial Analysis (FA)

Financial plan Funds required to build

Cash-flow during operation

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Applied Systems Analysis Division

Some main questions to start FA for Project Appraisal

What will be the capital cost to build the project? Who will provide investment funds during the construction period? What will be the terms and conditions for taking those funds and for repayment of those funds ? What is the expected cash-inflow from the project during its operational life? Will the cash-inflow be sufficient to cover: i) the operating cost and ii) repayment to the project financers? What will be the rate of return to the project owner?
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Capital and other expenditure during construction

Overnight Cost Escalation during construction Interest During Construction (IDC) Other financing costs Contingencies Initial working capital

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Major components of financial sector of a country

Central banking Banking system Commercial banks

Stock market

Capital market

Bonds market

Financial sector

Export-import Banks

Insurance companies

Investment funds

Other financial institutions

World financial sector

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Two basic components of financing

Equity; funds provided by the project owner
Debt; all types of loans/bonds taken by the project owner

Equity

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Major terms and conditions for financing

Interest rate/return on equity Repayment period Repayment method Grace period Capitalization of interest during construction Fees such as management fee Insurance coverage

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Market conditions
Market structure Regulated Open competition Monopoly Cartel Number of clients Quantity to be sold to different clients Price structure Time of receivable ...

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Cash-flow during operation

Cash outflow

Operation cost

Debt service
Taxes, fees... ... Cash inflow

Sales to different clients Other sources of income

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Operation costs and Debt Service

Operation Cost Fuel costs

O&M Costs
Fixed Variable Others Debt Service Repayment of Loan

Interest payment

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Methodology
A set of accounting statements on Cash inflow/outflow statement

Income and expenditure (Profit and loss statement)

Balance Sheet A set of indicators derived from these statements Project risk and sensitivity analysis

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Cost and Benefit Statement

Year (n) Cost ( C ) Million Rs. 40 110 10 10 10 Benefit (B) Million Rs 40 40 40 40 70 Net Benefits Million Rs -40 -70 30 30 30 70 Discount Factor (r) 1.100 1.000 0.909 0.826 0.751 0.683 Net Benefits Discounted at 10% -44.00 -70.00 27.27 24.79 22.54 47.81

-1 0 1 2 3 4

Net Present Value (Million Rs): 8.41

NPV=

(Bn Cn) / (1 + r)n n

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Time Value of Money

Future Value (FV) of a Present Value (PV)

100 0

? 1 2 3 4 5

FV1 1001 0.10 110

Present Value (PV) of a Future Value (FV)

? 0

100 1 2 3 4 5

FV /PV i PV0= 100 / (1+0.01) = N 90.91 PV1 100 1 1 0 .10 PV PV

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90 .91
N

FVN

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100

Time Value of Money

Future Value (FV) of a Present Value (PV)

Present Value (PV) of a Future Value (FV)

FVN PV 1 i PV

1 i
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FVN

What is i ?

FVN PV 1 i FVN
N

PV PV

Applied Systems Analysis Division

100

Economic conditions
Discount rate/factor: Opportunity Cost of Capital Nominal Discount rate: i) ii) iii) Compensation of Inflation Real return Compensation for risk

Inflation: A rise in prices caused by decline in the purchasing power of a currency

Nominal discount rate = [(1+ r)(1+f) ] -1 Where i is real discount rate f is inflation rate
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Set of indicators

NPV: Net Present Value of Benefits

IRR : Discount rate at which NPV of project is zero

Payback Period: Time (Years) required to recover the investment made on the project

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Criteria for Selection of Project

Private Sector: Project with maximum NPV Public Sector:

IRR > prevailing discount rate

On given terms and conditions of financing, NPV is positive.

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Do You Need FA or EA or none?

Thank You
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Major criteria of financial viability

Regulated prices (Cost plus) Public sector projects Net present value of the investment Payback Break even Private sector projects Expected / negotiated / market/regulated prices Rate of return on equity Net present value of the equity ... ...

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B / C = B / ( 1+ r )n / C / ( 1+ r )n ]
n n

Value of discounted benefits = 40 + 36.36 + 33.06 + 30.05 + 47.81 = 187.28 Value of discounted costs = 44 + 110 + 9.09 + 8.26 + 7.51 = 178.86 B / C ratio = 187.28 / 178.86

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Applied Systems Analysis Division

Summary Pro forma financial statement for a power generating company

1998 Income/Expenditure Statement Income of electricity sales Other income Cost of generating (other than fuel) Fuel costs 125.0 2.0 18.0 50.0 128.8 2.7 18.5 52.0 1999

Other expenses
Depreciation Earning before interest and tax (EBIT) Net interest Tax paid Net income Preferred stock dividend (if any) Earning of the common stock

8.0
25.0 26.0 10.0 6.4 9.6 9.6

7.0
25.0 29.0 9.0 8.0 11.7 12.0

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Balance Sheet
Assets Cash and shortterm securities Receivables Inventories Other current assets Total current assets Land, plant and equipment Other longterm assets Total assets 1998 5.5 20.0 15.0 2.5 43.0 554.0 20.0 617.0 1999 5.0 21.0 16.0 2.5 44.5 544.0 40.0 628.5 Equity/Liabilities Debt due Payable Other current liabilities Total current liabilities Long-term debt 1998 10.0 100.0 5.0 115.0 100.0 102.0 300.0 617.0 1999 10.0 95.0 5.0 110.0 90.0 118.9 309.6 628.5

Other long-term liabilities

Preferred stock (if any) Shareholders equity Total liabilities

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Contents Need for Financial Analysis (FA) and Economic Analysis (EA) of Investment Projects

Difference between FA and EA

Terminologies: Inflation Escalation Discount rate Net Present Value (NPV) Rate of Return (RoR) Cost-Benefit Ratio Pay-back period
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Comparison of NPP Cost with the Cost of Alternative Electricity Generation Options
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Hydro: 4.81 to 9.62 Cents/kWh

19.15

15
$ 100/barrel

14.70 11.68 9.96

Upfront Tariff for 1000 MW plant

Cents/kWh

12.04
Upfront Tariff by NEPRA

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8.85

Upfront Tariff for 1000 MW plant

0
Nuclear Oil (Furnace) Coal (Thar)

Coal (Imported)

Gas (Imported)

$ 13/M BTU

Wind

Notes: 1. Interest/discount rate of 10% used for NPP and Oil-based plants. 2. Upfront tariff offered by NEPRA for wind and coal based plants.
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