Energy Management and Planning MSJ 0210 Measures for

Energy Management and Planning MSJ 0210 Measures for evaluating investment Eduard Latõšov

Measures for evaluating investment Commonly used stages for evaluating investment 1). Calculate simple payback time Acceptable – resume (stage 2). Not acceptable – reject. 2). Calculate: - Discounted payback time - Net present value - Internal rate of return Evaluate Project feasibility

Simple Payback Time (Payback Period)

Simple Payback Time Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. When cash inflows are uneven, cannot use this formula.

Simple Payback Time Example 1: Even Cash Flows Company C is planning to undertake a project requiring initial investment of 100 000 €. The project is expected to generate 25 000 € for 10 years. Calculate the payback period of the project.

Simple Payback Time When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period: In the above formula, A is the last period with a negative cumulative cash flow; B is the absolute value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A

Simple Payback Time Example 2: Uneven Cash Flows Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate: $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.

Simple Payback Time Example 2: Uneven Cash Flows

Discounted Payback Time One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value of money by discounting the cash inflows of the project.

Discount rate The discount rate is an interest rate used to adjust a future cash flow to its present value: its value to the organization today, which normally corresponds to Year 0. The discount rate is expressed either as a percentage or as its decimal equivalent— for example, 10 percent or 0. 1. Mathematically, if r is the discount rate, then the present value (PV) of a single cash flow (CF) received one year from now—that is, in Year 1—is defined by this equation: PV = CF x 1/(1 + r)

Discount rate For example, if the discount rate is 10 percent, then the present value of a $4, 000 cash flow expected one year from now is: PV = $4, 000 x 1/(1 + 0. 1) = $3, 636 More generally, for any cash flow received in Year t (where t represents the elapsed time in years), the present value is the product of the future cash flow and the present value factor, 1/(1 + r)t: PV = CF x 1/(1 + r)t For example, if the discount rate is 10 percent, the present value of $4, 000 received five years from now is: PV = $4, 000 x 1/(1 + 0. 1)5 = $4, 000 x 0. 621 = $2, 484

Discount rate You might find it useful to think of discounting as the inverse of earning interest. In fact, if you invested $2, 484 today in a certificate of deposit (CD) that paid 10 percent interest annually, then in five years the CD would be worth $4, 000.

Discounted Payback Time Calculation of Discounted Payback Time is generally the same as for Simple Payback Time. Difference: Cash flows must be discounted (recalculated to present value, or Discounted Cash Flow)

Net Present Value Net present value (NPV) is a measure of investment worth that explicitly accounts for the time value of money. Like payback period, NPV is computed from the stream of cash flows resulting from the investment. Unlike payback period, those cash flows are adjusted (or “discounted”) so as to place relatively greater value on nearterm cash flows and relatively lesser value on cash flows that are more distant in the future.

Net Present Value The NPV of an investment is the sum of the present values of all the cash flows, including the initial outlay (expressed as a negative number).

Net Present Value Interpreting and applying net present value. NPV is a measure of the investment’s financial worth to the organization, taking into account the preference for receiving cash flows sooner rather than later. An investment is financially worthwhile if its NPV is greater than zero, because the present value of future cash flows is greater than the outlay. In the rare case of an opportunity with a zero NPV, the organization should theoretically be indifferent between making or not making the investment. A positive NPV is the net gain to the organization from making the investment—assuming that the discount rate properly adjusts for the timing of the cash flows. Besides helping to decide whether an investment is worthwhile, the NPV can be used to choose among alternative investments. If an organization has two or more investment opportunities but can only pick one, the financially sound decision is to pick the one with the greatest NPV.

Net Present Value, Internal Rate of Return Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Calculation For NPV we need: 1). Cash flows 2). Discount rate

Calculation For IRR we need: 1). Cash flows

Exercise 1 After investments (30 000 €) to energy efficiency improvement solution annual savings are assumed to be 150 MWh. The lifetime of this solution is 15 years. Energy costs before implementation of this solution are 12 000 € and after 7500 €. Company’s required rate of return is 7%. Calculate IRR and NPV. Give advise to investor. (IRR = 12, 4%, NPV = 10 267 €)

Exercise 2 After investments (40 000 €) to energy efficiency improvement solution annual savings are assumed to be 150 MWh. Energy price is 35 EUR/MWh. Company’s required rate of return is 7%. Project expected lifetime is 15 years. Calculate IRR and NPV. Give advise to investor. (IRR = 10%, NPV = 7 305 €)

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