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Financial Feasibility Analysis Energizing Cleaner Production Management Course

Financial Feasibility Analysis Energizing Cleaner Production Management Course. Session Agenda:. Introduction Cash Flow Profitability Indicators Simple Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR). But first…

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Financial Feasibility Analysis Energizing Cleaner Production Management Course

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  1. Financial Feasibility Analysis Energizing Cleaner Production Management Course

  2. Session Agenda: • Introduction • Cash Flow • Profitability Indicators • Simple Payback • Return on Investment (ROI) • Net Present Value (NPV) • Internal Rate of Return (IRR)

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

  4. IntroductionStep 4 – Feasibility Analysis Company’s priority Technical Project Selection Financial • Other • Regulatory • Organizational • Health/safety • Community Environmental

  5. IntroductionQuestions 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

  6. IntroductionCapital 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

  7. IntroductionCapital 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

  8. IntroductionTypical 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 • Replacement • Replace outdated, worn-out, or damaged equipment or outdated/inefficient management and information systems

  9. Cash FlowCash Flow Concept Common management planning tool Distinguishes between • Costs: cash outflows • Revenues/savings: cash inflows

  10. Cash FlowTypes of Cash Flow Inflow Equipment salvage value Operating revenues & savings Working capital Outflow Initial investment cost Operating costs & taxes Working capital One-time Annual Other

  11. Cash FlowCosts 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

  12. Cash FlowWorking 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

  13. Cash FlowTiming End of project: Salvage Value Annual Revenues/Savings Year 1 Year 2 Year 3 TIME Time zero: Initial Investment

  14. Cash FlowIncremental 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

  15. Profitability Indicators • Definition: “a single number that is calculated for characterisation of project profitability in a concise and understandable form” • Common indicators • Simple Payback • Return on Investment (ROI) • Net Present Value (NPV) • Internal Rate of Return (IRR)

  16. 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 =

  17. 2. Return on Investment • Definition: the percentage of initial investment that is recovered each year Initial Investment Year 1 Cash Flow Simple Payback (in years) = 3 years Year 1 Cash Flow Initial Investment ROI (in %) 33% =

  18. plastic film, aluminium film, adhesive solvent air emissions solvent air emissions INVENTORY printed laminated film printed film SLITTING plastic film, ink PRINTING LAMINATION Solid scrap Solid scrap Solid scrap Liquid waste ink to waste management to waste management Workshop ExercisePLS Company: produces rolls of laminated film

  19. Workshop ExercisePLS 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

  20. Workshop Exercise • Question 1: Calculate annual cash flows using the cash flow worksheet (15 min) • Question 2: Calculate simple payback (5 min)

  21. 3. Net Present ValueMoney 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...

  22. 3. Net Present ValueInflation 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 $1.05 costs $1 next year now

  23. 3. Net Present ValueReturn 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 Gives you $1.10 a year from now Investing $1 now Investment 10 % interest, or “return on investment”

  24. 3. Net Present ValuePLS Company’s QC Camera Project Initial Investment Cost Annual Operating Costs BusinessAs Usual 0 $ 2,933,204 Annual Savings = US$38,463 Installing quality control camera $ 105,000 $ 2,894,741 (in US$)

  25. 3. Net Present ValueQuestion Is the annual savings of$38,463 per year for 3 years a sufficient returnon the initial investment of $ 105,000?

  26. 3. Net Present ValueTime 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

  27. 3. Net Present ValueCash 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

  28. 3. Net Present ValueConverting Cash Flows to Present Value Annual Savings End of project = ?? = ?? = ?? $38,463 $38,463 $38,463 Year 1 Year 2 Year 3 TIME Time zero: Initial Investment = $105,000

  29. 3. Net Present ValueConverting 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

  30. 3. Net Present ValueDiscount 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

  31. 3. Net Present ValueWhich 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

  32. 3. Net Present ValueCalculating “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

  33. 3. Net Present ValueThe Value of a Future $1 Discount rate (d): 10% 20% 30% 40% Years into future (n) 1 .9091 .8333 .7692 .7142 2 .8264 .6944 .5917 .5102 3 .7513 .5787 .4552 .3644 4 .6830 .4823 .3501 .2603 5 .6209 .4019 .2693 .1859 10 .3855 .1615 .0725 .0346 20 .1486 .0261 .0053 .0012 30 .0573 .0042 .0004 .0000 Present value factors Handout: Table with discount rates

  34. 3. Net Present ValueNet 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

  35. 3. Net Present ValueWorkshop Exercise (15 min) Question 3: Calculate the NPV Expected Future Cash Flows Present Value of Cash Flows (at time zero) PV Factor Year = X 0 1 2 3 - $105,000 + $38,463 + $38,463 + $38,463 - $??? $??? $??? $??? $??? ??? ??? ??? ??? Sum = project’s Net Present Value =

  36. 3. Net Present ValueWorkshop Exercise (5 min) Question 4: compare the Simple Payback and the NPV

  37. 3. Net Present ValueSensitivity 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”

  38. 3. Net Present ValueWorkshop Exercise (answer B) Expected Future Cash Flows Present Value of Cash Flows (at time zero) PV Factor Year = X 0 1 2 3 - $105,000 + $38,463 + $38,463 + $93,463 .8696 .7561 .6575 - $105,000 33,447 29,082 61.452 -18,981 Sum = project’s Net Present Value =

  39. 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

  40. Profitability Indicators Summary Advantages Disadvantages Easy to use Neglect TVM Neglect out-year costs Do not indicate project size Considers TVM Needs firm’s discount rate Indicates project size Considers TVM Requires iteration Does not indicate project size Simple Payback & ROI NPV IRR

  41. Financial Feasibility Analysis of Options Thank you for your attention!

  42. 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 projectthat 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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