Financial Feasibility Analysis

Energizing Cleaner Production Management Course

Financial Feasibility Analysis

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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Financial Feasibility Analysis

Step 1 Planning and Organization :

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

task 1 Meeting with top management a: task 1 Form a Team and inform staff b: task 1 Pre-assessment to collect general information c: task 1 Select focus areas d: task 1 Prepare assessment proposal for top management approval e:

Step 1 Assessment :
task 1 Staff meeting and training a: task 1 Prepare focus area flow charts b: task 1 Walkthrough of focus areas c: task 1 Quantify inputs and outputs and costs to establish a ba seline d: task 1 Quantify losses through a material and energy balance e:

Financial Feasibility Analysis

Step 1 Identification of Options :

task 1 Determine causes of losses a: task 1 Identify possible options b: task 1 Screen options for feasibility analysis c:

Step 1 Feasibility Analysis of Options :

task 1 Technical, economic and environmental evaluation of opt ions a: task 1 Rank feasible options for implementation b: task 1 Prepare implementation and monitoring proposal for top c: management approval

Step 1 Implementation and Monitoring of Options :

task 1 Implement options and monitor results a: task 1 Evaluation meeting with top management b:

Step 1 Continuous Improvement :

task 1 Prepare proposal to continue with energy efficiency for top a: management approval

Introduction

Step 4 Feasibility Analysis

Companys priority

Financial Feasibility Analysis

Technical

Other
- Regulatory - Organizational - Health/safety - Community

Project Selection
Environmental

Financial

Introduction

Questions Management Will Ask

1. Is the project profitable?

Financial Feasibility Analysis

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

Financial Feasibility Analysis

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

Financial Feasibility Analysis

Vary from country to country

Introduction

Typical Project Types and Costs

Maintenance
Maintain existing equipment and operations

Financial Feasibility Analysis

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

Financial Feasibility Analysis

Cash Flow

Types of Cash Flow

Outflow One-time
Initial investment cost Operating costs & taxes Working capital Working capital
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Inflow
Equipment salvage value

Financial Feasibility Analysis

Annual Other

Operating revenues & savings

Cash Flow

Costs and Savings

Initial investment costs
purchase of the camera system, delivery, installation, start-up

Financial Feasibility Analysis

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

Financial Feasibility Analysis

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

Financial Feasibility Analysis

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

Financial Feasibility Analysis

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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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Financial Feasibility Analysis

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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Financial Feasibility Analysis

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 Year 1 Cash Flow Initial Investment

Financial Feasibility Analysis

3 years

ROI (in %)

33%

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Workshop Exercise

PLS Company: produces rolls of laminated film

plastic film, aluminium film, adhesive

Financial Feasibility Analysis

INVENTORY

solvent air emissions printed film PRINTING LAMINATION Solid scrap

solvent air emissions printed laminated film SLITTING

plastic film, ink

Solid scrap

Solid scrap

Liquid waste ink

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

Financial Feasibility Analysis

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)

Financial Feasibility Analysis

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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...

Financial Feasibility Analysis

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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

Financial Feasibility Analysis

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

Financial Feasibility Analysis

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

Financial Feasibility Analysis

$ 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?

Financial Feasibility Analysis

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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

Financial Feasibility Analysis

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

Financial Feasibility Analysis

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3. Net Present Value

Converting Cash Flows to Present Value

Annual Savings
= ?? = ?? = ??

End of project

Financial Feasibility Analysis

$38,463

$38,463

$38,463 TIME

Year 1

Year 2

Year 3

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

Financial Feasibility Analysis

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?

Financial Feasibility Analysis

$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

Financial Feasibility Analysis

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3. Net Present Value

Calculating Present Value

Value of the cash flow in year n

Financial Feasibility Analysis

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): 10% .9091 .8264 .7513 .6830 .6209 .3855 .1486 .0573 20% .8333 .6944 .5787 .4823 .4019 .1615 .0261 .0042 30% 40%

Financial Feasibility Analysis

Years into future (n)

1 2 3 4 5 10 20 30

.7692 .7142 .5917 .5102 .4552 .3644 .3501 .2603 .2693 .1859 .0725 .0346 .0053 .0012 .0004 .0000

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)

Financial Feasibility Analysis

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 + $38,463 X PV Factor ??? ??? ??? ??? Present Value of = Cash Flows (at time zero) - $??? $??? $??? $??? $???
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Financial Feasibility Analysis

0 1 2 3

Sum = projects Net Present Value =

3. Net Present Value

Workshop Exercise (5 min)

Question 4: compare the Simple Payback and the NPV

Financial Feasibility Analysis

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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

Financial Feasibility Analysis

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)

Financial Feasibility Analysis
Expected Future Cash Flows - $105,000 + $38,463 + $38,463 + $93,463 .8696 .7561 .6575 Present Value of = Cash Flows (at time zero) - $105,000 33,447 29,082 61.452 -18,981
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Year

PV Factor

0 1 2 3

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

Financial Feasibility Analysis

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Profitability Indicators Summary

Advantages Simple Payback & ROI NPV IRR
Easy to use

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

Financial Feasibility Analysis

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

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Financial Feasibility Analysis of Options

Thank you for your attention!

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Financial Feasibility Analysis

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

Financial Feasibility Analysis

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