Larry Guentert
Purdue University
Admin Computing
October 4, 2012
Agenda
 Capital Budgeting Terminology
 Traditional Project Calculations
 Comparisons of Methods
 Eco Building Considerations
 A Proposed Approach
 Conclusion
 Questions
Capital Budgeting
• Large investment in plant or equipment
with returns over a period of time.
•
Investment may take place over a period of time
•
A Strategic Investment Decision
May include: Expansion, Improvement,
Replacement, R & D
Present Value
 The current worth of a future sum of money or stream of cash flows
given a specified rate of return. Future cash flows are discounted at the
discount rate, and the higher the discount rate, the lower the present
value of the future cash flows.
 Explanation: The basis is that receiving $1,000 now is worth more than
$1,000 five years from now, because if you got the money now, you
could invest it and receive an additional return over the five years
PV = C1 / ( 1 + r) where c1 = is the cash flow of at
date 1 and r is the rate of return.
Cost of Capital
 The cost of capital determines how a company can raise
money (through a stock issue, borrowing, or a mix of the
two). This is the rate of return that a firm would receive if it
invested in a different vehicle with similar risk. It may
reflect risk in the investment.
Cash Flows
£000's
2000
2001
2002
2003
2004
2005
SALES
14000
16000
18000
20000
22000
90000
VARIABLE COSTS
-9800
-11200
-12600
-14000
-15400
-63000
-200
-200
-200
-200
-200
-1000
OPERATING EXPENSES
EQUIPMENT COSTS
-15000
CASHFLOWS
-15000
4000
4600
5200
5800
6400
1.00
0.893
0.797
0.712
0.636
0.567
-15000
3571
3667
3701
3686
3632
DF @ 12%
NPV
-15000
11000
3257
1.00
0.84
0.58
0.49
Cash flows =19.75
Sales + Variable
Costs +0.70
Operating
Expenses
+ 0.41
Equipment Costs
IRR = 19.75%
-15000
3340
3208
3028
2820
2599
-4
Main Investment Rules Used
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback
• Return on Assets or Investment (RoA or RoI)
• Profitability Index
Net Present Value
 The current worth of a future sum of money or stream
of cash flows given a specified rate of return. Future
cash flows are discounted at the discount rate, and the
higher the discount rate, the lower the present value of
the future cash
NPV Equation
(where Co is initial cost of project, r = rate, t = time periods)
 NPV compares the value of a dollar today to the value of that
same dollar in the future, taking inflation and returns into
account. If the NPV of a prospective project is positive, it should
be accepted. However, if NPV is negative, the project should
probably be rejected because cash flows will also be negative.
NPV Equation
Treatment of depreciation in NPV analysis.
-We only use cash flows in investment appraisal.
-Depreciation is not a cash flow.
-However, depreciation (capital allowances) is allowable
against tax (see income statement), which affects cash
flow.
For cash flow, add depreciation back
Internal Rate of Return
You can think of IRR as the rate of growth a project is expected to
generate. While the actual rate of return that a given project ends up
generating will often differ from its estimated IRR rate, a project with a
substantially higher IRR value than other available options would still
provide a much better chance of strong growth
Equation:
IRR Rule
 Accept the project if the IRR is greater than the
discount rate (cost of capital). Reject the project if the
IRR is less than the discount rate.
IRR Issues
 IRR cannot not be use to rate mutually exclusive
projects
 The IRR also cannot be use in the usual manner for
projects that start with an initial positive cash inflow,
 Intermediate cash flows are never reinvested
Payback Method
 The length of time required to recover the cost of an
investment. The payback period of a given investment
or project is an important determinant of whether to
undertake the position or project, as longer payback
periods are typically not desirable for investment
positions.
Payback Method Issues
 Ignores overall return (time value of money)
 Ignores impact of large flows
 Ignores timing of flows
 desirable for investment positions.
 It is not for very long financing. Many times companies
have to pay more than they actually acquire
Profitability Index
A regulation for evaluating whether to proceed with a
project or investment. The profitability index rule
states: If the profitability index or ratio is greater than
1, the project is profitable and may receive the green
signal to proceed. Conversely, if the profitability ratio
or index is below, the optimum course of action may
be to reject or abandon the project
PI = Cash flows / Initial Investment
Return on Assets
 A measure of profit per dollar of assets.
 Return on Assets = Net Income / Total Assets
 Example: RoA = $363 / $3588 = 10.12%
RoA, PI Issues:
 Do not consider the time value of money
Example
Cash Flows
£000's
2000
2001
2002
2003
2004
2005
SALES
14000
16000
18000
20000
22000
90000
VARIABLE COSTS
-9800
-11200
-12600
-14000
-15400
-63000
-200
-200
-200
-200
-200
-1000
OPERATING EXPENSES
EQUIPMENT COSTS
-15000
CASHFLOWS
-15000
4000
4600
5200
5800
6400
1.00
0.893
0.797
0.712
0.636
0.567
-15000
3571
3667
3701
3686
3632
1.00
0.84
0.70
0.58
0.49
0.41
-15000
3340
3208
3028
2820
2599
DF @ 12%
NPV
19.75
IRR = 19.75%
-15000
Source: Ross, Westerfield , Jaffe (2010)
11000
3257
-4
20
Accounting Method Usage in Industry
Source: http://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf (2002)
Green Building
IRR for LEED Building
 U.S. Green Building Council (USGBC) reports that,
projects that achieved LEED and Energy Star status
normally achieve an Internal Rate of Return (IRR) of
20% or more. This is primarily from increased annual
energy savings
 Source: http://greeneconomypost.com/return-on-
investment-for-green-leed-projects-10962.htm
23
Eco Cost Facts
 PV panels decreasing in costs
 Negligible degradation: actual modules appear to be
degrading at 0.2–0.5% per year (Chianese et al., 2003).
 Inverter reliability increasing and inverter reliability
and cost are both improving rapidly (Navigant, 2006;
Mitchell, 2010; Heacox, 2010).
Eco Cost Facts
 Wind, other systems, high maintenance
 Lifespan of mechanical systems < PV
(CSP, Wind farms)
Eco – Economic Considerations:
 PV is often considered too costly
 But PV systems have long lifespan and negligible operating
costs
 PV’s not considered by business because future cash flows
do not add to asset value
 What about depreciation?
 Definition of 'Modified Accelerated Cost Recovery
System - MACRS'
 The new accelerated cost recovery system, created after the
release of the Tax Reform Act of 1986, which allows for
greater accelerated depreciation over longer time periods.
PhotoVoltaic Panel Costs
Source for below: http://solarcellcentral.com/cost_page.html
Proposed Better Methods
 LCOE for electricity
 Use modified LCOE for just certain components of a
facility
 WLC for the complete project
Proposed New Method For Energy:
Levelized Cost of Electricity (LCOE)
A levelized cost of electricity(LCOE) is defined in any operating
year as the sum of all costs prior to and including that year
divided by the sum of all outputs. This is a levelized cost of
electricity with a zero discount rate which is not the traditional
metric.
By Ken Zwiebel GWU
Proposed New Method: Levelized
Cost of Electricity (LCOE)
Source: Ken Zwiebel, GWU
http://solar.gwu.edu/Presentations/KZSolarContract.pdf
Best Solution Found:
 Whole Life Costing and Performance
 Whole Life Costing (WLC) is a powerful tool for
calculating the lowest cost options for the entire
commercial life of a building. It encourages the use
of best value building designs and reduces the costs
and disruption of unplanned repairs and maintenance
(Proposed by the Building Research Establishment (BRE)
U.K.)
WLC
 Whole Life Cost is the analysis of all relevant and
identifiable financial cash flows regarding the
acquisition and use of an asset. Uses NPV.
Activities in Sustainability
WLC Is
 A finance method to guide decision making
 Includes Capital costs
 Includes Revenue costs
 Does it include end of life cost for any project
exceeding 10 years?
 Demolition is first cost of next project
 How do I cost what I don’t know
 Expressed as an annual cash flow for the life of the
asset
An Asset is
 Anything that we buy or construct
 Can be a facility (building)
 Can be a component
 Any number of assets can be combined
 The asset can be income generating or not.
Life Time Total Cost of Ownership
How Do We Measure WLC?
 Total whole life cost ~ TWLC
 Annualized whole life cost ~ AWLC
 Discounted cashflow ~ DCF
 $’s x % = a number
 Net present value ~ NPV
 Discount rate
 What % should we use?
 Can be used for non financial e.g. kWh
Recommendation for WLC
 Introduce and develop WLC in your organization and





your supply chain
Take Small Steps - Progress Slowly
Understand What You Have Achieved
Step back - see the ‘Big Picture’
Benchmark - process not answers
Appropriateness & Fitness - Every Project is Different
WLC
 Rules of thumb
 Spreadsheet
 Simple, easy to use, easy to manipulate
 Proprietary
 Restrictive
 WLCF
 Uses WLCF view and is supplier based
 Can be used for Buildings
Questions?