Financial Feasibility
Analysis
Energizing Cleaner Production
Management Course
1
Session Agenda:
Introduction
Cash Flow
Profitability Indicators
1.
Simple Payback
2.
Return on Investment (ROI)
3.
Net Present Value (NPV)
4.
Internal Rate of Return (IRR)
2
Step 1: Planning and Organization
But first…
In what step(s)
of the
methodology
is financial
feasibility
analysis
relevant?
•
•
•
•
•
task 1a: Meeting with top management
task 1b: Form a Team and inform staff
task 1c: Pre-assessment to collect general information
task 1d: Select focus areas
task 1e: Prepare assessment proposal for top management approval
Step 2: Assessment
•
•
•
•
•
task 2a: Staff meeting and training
task 2b: Prepare focus area flow charts
task 2c: Walkthrough of focus areas
task 2d: Quantify inputs and outputs and costs to establish a baseline
task 2e: Quantify losses through a material and energy balance
Step 3: Identification of Options
• task 3a: Determine causes of losses
• task 3b: Identify possible options
• task 3c: Screen options for feasibility analysis
Step 4: Feasibility Analysis of Options
• task 4a: Technical, economic and environmental evaluation of options
• task 4b: Rank feasible options for implementation
• task 4c: Prepare implementation and monitoring proposal for top
management approval
Step 5: Implementation and Monitoring of Options
• task 5a: Implement options and monitor results
• task 5b: Evaluation meeting with top management
Step 6: Continuous Improvement
• task 6a: Prepare proposal to continue with energy efficiency for top
management approval
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Introduction
Step 4 – Feasibility Analysis
Technical
Other
- Regulatory
- Organizational
- Health/safety
- Community
Project
Selection
Company’s priority
Financial
Environmental
4
Introduction
Questions Management Will Ask
1. Is the project profitable?
• 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
5
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
• How to allocate available capital
between different projects
• If additional capital is needed
6
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
• Vary from country to country
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Introduction
Typical Project Types and Costs
• Maintenance
– Maintain existing equipment and operations
• 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
8
Cash Flow
Cash Flow Concept
Common management planning tool
Distinguishes between
• Costs: cash outflows
• Revenues/savings: cash inflows
9
Cash Flow
Types of Cash Flow
One-time
Outflow
Inflow
Initial
investment
cost
Equipment
salvage value
Annual
Operating
costs & taxes
Operating
revenues
& savings
Other
Working capital
Working capital
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Cash Flow
Costs and Savings
• Initial investment costs
– purchase of the camera system, delivery,
installation, start-up
•
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
11
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
• Salvage Value: resale value of
equipment or other materials at the
end of the project
12
Cash Flow
Timing
End of project:
Salvage Value
Annual Revenues/Savings
Year 1
Year 2
Year 3
TIME
Time zero:
Initial Investment
13
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
14
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)
15
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
16
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
ROI (in %)
Year 1 Cash Flow
=
3 years
33%
Initial Investment
17
Workshop Exercise
PLS Company: produces rolls of
laminated film
plastic film, aluminium film, adhesive
solvent air
emissions
solvent air
emissions
INVENTORY
plastic film, ink
PRINTING
printed
printed
laminated
film
film
SLITTING
LAMINATION
Solid scrap
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
• QC camera system costs US$105,000
to purchase and install
• 40% reduced scrap and operating
costs
19
Workshop Exercise
• Question 1: Calculate annual cash
flows using the cash flow worksheet
(15 min)
• Question 2: Calculate simple payback
(5 min)
20
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...
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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
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
10 % interest, or
“return on investment”
Gives you
$1.10 a year
from now
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3. Net Present Value
PLS Company’s QC Camera Project
Initial
Investment
Cost
Business
As
Usual
Installing
quality
control
camera
Annual
Operating
Costs
0
$ 2,933,204
$ 105,000
$ 2,894,741
Annual Savings
=
US$38,463
(in US$)
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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?
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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
• “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
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3. Net Present Value
Converting Cash Flows to Present
Value
Annual Savings
= ??
= ??
= ??
$38,463
Year 1
Year 2
End of project
$38,463
Year 3
$38,463
TIME
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
• 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?
$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 project’s 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
company’s “cost of capital”)
• A single “Weighted Average Cost of Capital” (WACC)
characterises the sources and cost of capital to the
company as a whole
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3. Net Present Value
Calculating “Present Value”
Value of the cash flow
in year n
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%
20%
30%
40%
.9091
.8264
.7513
.6830
.6209
.3855
.1486
.0573
.8333
.6944
.5787
.4823
.4019
.1615
.0261
.0042
.7692
.5917
.4552
.3501
.2693
.0725
.0053
.0004
.7142
.5102
.3644
.2603
.1859
.0346
.0012
.0000
Years into future (n)
1
2
3
4
5
10
20
30
Handout: Table with discount rates
Present
value
factors
33
3. Net Present Value
Net Present Value (NPV)
• Definition: sum of present values of all
project’s cash flows
– Negative (cash outflows)
– Positive (cash inflows)
• 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
X
PV
Factor
Present Value
= of Cash Flows
(at time zero)
0
- $105,000
???
- $???
1
+ $38,463
???
$???
2
+ $38,463
???
$???
3
+ $38,463
???
$???
Sum = project’s Net Present Value =
$???
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3. Net Present Value
Workshop Exercise (5 min)
Question 4: compare the Simple Payback
and the NPV
36
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
• 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)
Year
Expected
Future Cash
Flows
X
PV
Factor
Present Value
= of Cash Flows
(at time zero)
0
- $105,000
1
+ $38,463
.8696
33,447
2
+ $38,463
.7561
29,082
3
+ $93,463
.6575
61.452
- $105,000
Sum = project’s Net Present Value =
-18,981
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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
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Profitability Indicators Summary
Advantages
Disadvantages
Simple
Payback
& ROI
Easy to use
Neglect TVM
NPV
Considers TVM
Needs firm’s discount
rate
Indicates project size
IRR
Considers TVM
Neglect out-year costs
Do not indicate project
size
Requires iteration
Does not indicate
project size
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
Financial Feasibility
Analysis of Options
Thank you for your attention!
41
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
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