FINANCIAL EVALUATION PROCEDURES

FINANCIAL EVALUATION PROCEDURES EATON HAUGHTON P.E.CARIBBEAN ESCO LTD.ST. ANN’S BAY, JAMAICATEL/FAX: (876) 974-5064email: eaton@caribbeanesco.comWeb site: www.caribbeanesco.com January 26, 2011

INTRODUCTION Energy conservation opportunities (ECO’s) which generate benefits greater than costs without sacrificing product quality are generally profitable and therefore attractive. Those which require little more than operational changes that can be made at negligible cost clearly fall into this category. Many ECO’s, however, require an initial capital outlay which must be amortized by the energy savings generated over their expected lifetime.

INTRODUCTION Many ECO’s which might have been unprofitable or merely marginal investments before the price of fuels and electricity began their rapid increase are now economically justifiable. The purpose of this session is to review some of the basic tools of financial analysis which may be useful in the economic evaluation of such ECO’s.

INTRODUCTION Sound, consistent economic criteria for evaluating energy conservation opportunities are quite important. Before any investment is undertaken some quantitative measure of profitability is desirable so that the investment’s expected return can be compared with that for alternate investment opportunities. Because true economic cost includes opportunity costs of foregone investments, ECO’s should be considered to be profitable only when their expected rate of return is greater than that which could be realized from alternative investment opportunities, whether in energy conservation or elsewhere.

INTRODUCTION In reality, investment decisions are generally based on more than simple rates of return. Factors such as risk, cash flow, taxation schedules, preference between long- and short-term investments, and others should be considered as well but will not be considered directly here since these factors may vary greatly among companies. The outcome of any economic evaluation may be considerably affected by them, however, so they should not be overlooked in actual applications but used in conjunction with the measurement criteria presented here.

FIRST LEVEL MEASURES OF PERFORMANCE While many energy conservation opportunities may be found during a close examination of plant and operations, some can be quickly rejected because of a low or negative return on investment. First level measures of performance can be useful in screening out such ECO’s without the application of more sensitive second-level measures. In general, however, first-level measurements should not be used for justifying major investments for energy conservation projects since these measures do not reflect the time value of money.* Because first level measurements, such as “payback period” and “return on investment”, are often referenced and useful for screening candidate investments, it is desirable to show how they are computed and why they are not complete.

FIRST LEVEL MEASURES OF PERFORMANCE The information needed to calculate these performance measures is as follows: —First Cost, FC —Annual Operating Cost (if any due to investment), AOC —Annual Fuel Savings, AFS —Projected Fuel Price, PFP —Estimated Lifetime, EL Projected fuel price represents an average fuel price during the estimated lifetime of the investment. The use of current fuel prices will result in lower total savings than can be reasonably expected, inducing a bias against energy conservation investments.

FIRST LEVEL MEASURES OF PERFORMANCE At this point, the net annual saving is defined for application in forthcoming equations and discussion: Net Annual Savings, S = (AFS X PFP)—AOC Defined as the first cost divided by the net annual savings, or PP = .FC or FC (AFS x PFP) — AOC S

Payback Period (PP) The payback period is then compared to the expected lifetime of the investment in order to make some rough judgment as to its potential for re-coupment. A payback period of less than one-half the lifetime of an investment would generally be considered profitable where the lifetime is ten years or less. The payback period as a measure of performance gives rise to problems, however. For instance, dollars saved in future years are credited the same as dollars saved in current years and comparisons between alternative investment opportunities of different lifetimes cannot be made.

Return on Investment (ROl) Is somewhat superior to the above because it takes into account the depletion of the investment over its economic life by providing for renewal through a depreciation charge. Using a straight line depreciation charge (DC) where DC = FC EL the percent return on investment can be calculated using:ROl, %/yr = S – DC x 100% FC

Return on Investment (ROl) ROlhas the advantage of putting investments with different life expectancies on a comparable basis. It is frequently used in the financial analysis of potential investments because of its simplicity of calculation. Where the rate of return appears small, however (say less than 20%), second level measurements are called for.

SECOND LEVEL MEASURES OF PERFORMANCE Second level measures of performance are those which incorporate an allowance for the time value of money, generally in the form of a discount factor. Because of alternative investment opportunities, a dollar held today is worth more than a dollar held in some future time period. The internal rate of return on the best available investment alternative is generally considered to be the appropriate discount rate for evaluating new investment opportunities, unless this rate is below the true borrowing rate when a new investment needs to be financed. In this case, the discount rate must be at least as high as the borrowing rate.

SECOND LEVEL MEASURES OF PERFORMANCE While appropriate discount rates may differ widely in different industries and even among firms within the same industry, corporate discount rates usually run between 10 to 20% or higher. This, again, is equivalent to saying that such a return can be realized elsewhere and thus for a new investment to be justified it must yield a return somewhat greater than this.

SECOND LEVEL MEASURES OF PERFORMANCE It should be noted thatprofits generated by energy savings are generally taxed at the same rate as profits earned elsewhere within or outside of the firm, affirming the need for an equivalent discount rate for energy saving projects. Several second-level measurements for evaluating ECO’s are available. The following three will be presented and discussed: 1) Benefit/cost analysis 2) Time to recoup capital investment 3) Internal rate of return

Benefit/cost analysis Requires the direct comparison of the present value benefits (savings) generated by a given investment with its costs. Generally this is formulated in terms of a benefit/cost ratio (B/C). A ratio greater than unity implies that the expected net benefits (properly discounted and summed over the lifetime of the investment) will exceed the initial costs and therefore such an investment is profitable. Likewise, a benefit/cost ratio less than unity implies that such an investment is not profitable. As an absolute measure of the profitability of an investment this is generally considered superior to all others.

Benefit/cost analysis The stream of benefits, or net savings (S), when constant in each time period, can be expressed in terms of present value (PV) by using a discount rate (D) and summing the benefits over the expected lifetime (EL) of the project. The present value can be easily estimated using the present worth factors (PWF) in Table 1. By finding the appropriate factor (PWF) for the discount rate (D) and expected lifetime (EL) of the investment and multiplying the factor (PWF) by the net annual savings (S), the present value (PV) of the future savings can be determined. If this present value is greater than the first cost of the investment, the project is profitable.

Time to Recoup Capital Investment Time to recoup capital investment, or the “breakeven” period, is similar in concept to the payback period (PP) discussed earlier, except that the breakeven period takes discount rates into consideration. The chief disadvantage of such a measurement is that investments of unequal lifetimes cannot be compared. However, this measurement of performance is often useful to financial planners and budget analysts. The breakeven period (BP) can be quickly approximated using Table 1. Locate in the column for the appropriate discount rate (D) the present worth factor (PWF) on either side of the payback period (PP) calculated as shown previously. The break even period (BP) will be between these two years; interpolation will allow a closer approximation.

The Internal Rate of Return (IRR) Defined as that discount rate, (D), whichreduces the stream of net returns associated with the investment to a present value of zero. While in general the IRR is not always a good measurement of economic performance, IRR will give good results when evaluating a project which has a fixed first cost followed by a stream of positive net benefits. Unfortunately, the calculation of IRR is not a straightforward exercise but requires an iterative approach converging on the solution. Many computerized financial analysis programs can estimate this quite easily.

While the IRR does not require that a discount rate be used in its determination (we are solving for the discount rate), it will be explicitly compared to the appropriate discount rate for the firm in justifying the investment. IRR, like the benefit/cost ratio, is useful when comparing the expected rates of return for alternative investments.

Example of Calculation Management is considering a capital investment in its manufacturing process for energy conservation purposes which will cost $100,000 to design and install but will involve no new recurring costs.

Example of Calculation This project is expected to save an average of 27,500 MBtu of natural gas per year for the next 10 years. The projected average cost of this fuel during the time period is assumed to be $1.00 per MBtu. Assuming that management feels that a 20% discount rate is appropriate, will this be a profitable investment? First Cost (FC) = $100,000 Annual Fuel Savings = 27,500 MBtu/yr Projected Fuel Price = $1.00/Mbtu Net Annual Savings (S) = (AFS X PFP) - AOC = 27,500 MBtu/yr X1.00 $/MBtu - 0 = $27,500 per yr

First Level Measures of Performance A.Payback period (no discounting) PP = FC = $100,000 = 3.6yrS $27,500/yr B. Return on Investment DC = FC = $100,000 = $10,000 per yr EL 10yr ROI, % = S – DC x 100% = yr FC ( $27,500.00 $/yr - $10,000 $/yr ) x 100% = 17.5% per yr

Using return on investment (ROT) as an approximation of the profitability of this project, we see that even after an allowance for depreciation this appears to be an attractive investment. Second level measurements of performance are needed, however, if we wish to incorporate the time value of money into the analysis.

Second Level Measures of Performance A.Benefit/Cost Analysis In order to formulate a benefit/cost ratio we must find the present value of the future savings. Using the present worth factor (PWF) from Table 1 for 20% discount rate (D) and 10 year lifetime (EL) we find that the present value (PV) of the net annual savings (S) is PV = S x PWF = $27.500 x 4.192 = $115,280This will result in a benefit/cost ratio (B/C) equal to :B/C = PV = $ 115,280 or 1.15 FC $100,000 Now it becomes apparent that this is a profitable investment even when the time value of money is considered.

B. Time to Recoup investment can be quickly approximated by using Table 1 and the payback period (PP) estimated earlier as 3.6 years. In the 20% discount rate column one can find that the present worth factor closest to 3.6 is 3.605 which indicates that the investment will be entirely recouped in about 7 years when taking the time value of money into consideration. While this is considerably longer than the payback period without discounting, it provides a much better indication of the profitability of this investment because it includes the cost of foregone investment opportunities. If the proper discount rate has been used any investment which is recouped in a period less than its lifetime should be considered profitable.

I Hope I have Been Able To Shed Some Light on the Subject.

THE BALL IS NOW IN YOUR COURT

FINANCIAL EVALUATION PROCEDURES