bio-energy 7th shrestha 1st revised

8/8/2019 Bio-Energy 7th Shrestha 1st Revised

1/45

JFITASIAN INSTITUTE OF TECHNOLOGY

1

e-learn

ing

co

urs

e

e-learning course onBio-energy for achieving MDGs

Prof. Ram M. ShresthaSchool of Environment, Resources and Development

Asian Institute of TechnologyThailand

E-mail: [email protected]

21 June 2007

Lecture 7:Financial Analysis of Renewable Energy Projects


2/45


2

e-learn

ing

co

urs

e

Contents Characteristics of RE Projects

Financial analysis vs. Economic Analysis

Components of project costs and benefits

Time Value of Money

Criteria for Financial Viability of Project

Financial Analysis under Uncertainty

- Sensitivity Analysis

- Break-even analysis

- Scenario Analysis


3/45


3

e-learn

ing

co

urs

e

Characteristics of RE Projects

Most RE projects normally involve:

- High initial costs (capital intensive)- Low operating cost

- Environmental/climate benefits, cleaner than fossil

fuel technologies, e.g. biomass energy- Local level employment generation (especially, from biomass

projects)

- Resource availability site specific and subject to fluctuations(especially in the case of solar, wind and hydro)

- Sustainable resource use

RE projects also help to reduce national energy import dependency.


4/45


4

e-learn

ing

co

urs

e

Current Status of Renewable EnergyTechnologiesTechnology Capacity factor (%) Turnkey investment

costs (U.S.$/Kw)Current energy costof new systems

Potential futureenergy cost

Biomass Energy

Electricity

Heat

Ethanol

25 - 80

25 - 80

900 - 3,000

250 - 750

5 15 /kWh

1 5 /kWh

8 25 $/GJ

4 10 /kWh

1 5 /kWh

6 10 $/GJ

Wind Electricity 20 - 30 1,100 1,700 5 13 /kWh 3 10 /kWh

Solar PhotovoltaicElectricity

8 - 20 5,000 10,000 25 125 /kWh 5 or 6 25 /kWh

Solar ThermalElectricity

20 - 35 3,000 4,000 12 18 /kWh 4 10 /kWh

Low-temperature

Solar Heat

8 - 20 500 1,700 3 20 /kWh 2 or 3 10 /kWh

Hydroelectricity

Large

Small

35 - 60

20 - 70

1,000 3,500

1,200 3,000

2 8 /kWh

4 10 /kWh

2 8 /kWh

3 10 /kWh

Geothermal Energy

Electricity

Heat

45 - 90

20 - 70

800 3,000

200 2,000

2 10 /kWh

0.5 5 /kWh

1 or 2 8 /kWh

0.5 5 /kWh


5/45


5

e-learn

ing

co

urs

e

What is Financial Analysis?

Financial evaluation mainly focuses into

- Money aspects of the project, and

- Rewards and financial profitability to the investors.

The main objective of the financial analysis is to look intothe financial benefits, costs and profitability of the projectfrom the investors perspective.

Financial analysis (FA) includes direct transfer paymentssuch as taxes, duties, subsidies in the evaluation.

FA does not account for the externalities such asenvironmental impacts and their costs.

FA normally uses market prices of inputs and outputs


6/45


6

e-learn

ing

co

urs

e

Financial Vs. Economical AnalysisOn the other hand, economic evaluation

- estimates project benefits and returns from theperspective of national economy and assesses theeffects that the project will have on the overall

economy of the country.

- takes into account the social and environmental

costs and benefits of the project.- excludes transfer payments and

- uses border prices for traded goodsand shadow

prices for non-traded goods and services.

As the main focus of our discussion is on financial analysis, we willtry to put more concentration in this area rather than the economicalanalysis in the later part of our presentation.


7/45


7

e-learn

ing

co

urs

e

Financial Analysis in the Project Cycle

The Project Cycle is the framework to design, prepare,

implement and supervise projects. The project cycle includes six stages such as,

Identification

Preparation

AppraisalNegotiation/Approval

Implementation, and

Evaluation.

The Appraisal phase includes evaluation of financial,economic, technical, institutional, environmental andsocial aspects of the project.


8/45


8

e-learn

ing

co

urs

e

Components of Project Costs Project Costs:

Investment costs Operating costs

Investment Costs: Include initial costs and replacement costs

Initial Costs, referred to as the first cost, which is usually made up of anumber of cost elements that do not recur after an activity is initiated. For

example, construction and commissioning, including land, civil works,transportation, equipment & installations and other related initial expenditures

Initial cost is the major component of an RE project. Such cost is normallyhigher in RE projects than in non-RE projects. As such, high initial cost

presents the major barrier to the adoption of RETs.

Replacement Costs, refers to the cost of equipment and installationsprocured during the operating phase of the project, to maintain its originalproductive capacity.


9/45


9

e-learn

ing

co

urs

e

Project Costs (Contd.)

Operating Costs: Costs experienced continually over theuseful life of the project activity. They are of two broadcategories:

- Fixed Costs (FC)- variable costs (VC)

Fixed Cost (FC): Group of costs whose value will remain relatively

constant throughout the range of operational activity or output levelof the project. FC includes the following cost items:

- maintenance- insurance- lease rentals

- interest payment on invested capital- certain administrative expense, and- research.


10/45


10

e-learn

ing

co

urs

e

Project costs (contd.)

Variable Costs (VC): Group of costs that vary withthe level of operational activity or output. In general,VC includes costs of:

- labor,

- materials,- fuel cost*

- tax

*Biomass cost in the case of biomass energy

projects; none in solar, wind and hydro.


11/45


11

e-learn

ing

co

urs

e

Project Benefits

RE Project Financial Benefits include:

- Revenue earned from the output of the project

- Tax credits (if applicable)

- Subsidy (if applicable)

- Carbon credits

(if the project is eligible for such benefits, e.g., under the cleandevelopment mechanism (CDM); in the case of a biomass project, suchcredits can be available only if biomass is produced on a sustainable basis)

A RE investment tax credit is an immediate reduction in income tax equalto a percentage of the installed cost of a new RE investment. Tax creditsfor renewable energy technologies (RETs) can enhance after-tax cash flowand promote RE investment.

Often, governments may also provide subsidy on the cost of RETsequipments to promote RE.


12/45


12

e-learn

ing

co

urs

e

Flow Chart of Financial Analysis Under CertaintyDefine the parameters of the project

e.g. Service life, Discount Rate, Size of the Project,

Dem and, etc.

For a given size of the RE project,

determine the cash inflows and cashoutflows for each Year

Calculate the total NPW oralternative financial indicator of

the project

Use of decision rule forproject investment

Investment

Decision


13/45


13

e-learn

ing

co

urs

e

Time Value of Money

Interest rate, or the rate of capital growth, is the rate of gain

received from an investment. For example, a 11% interestrate indicates that for every dollar of money used, anadditional $0.11 must be returned as payment for the use ofthat money.

The relationship between interest and time leads to theconcept of the time value of money.

Money has an earning power. A dollar in hand now is worthmore than a dollar received n years from now. This isbecause having the dollar now provides the opportunity forinvesting that dollar for n years more than the dollar to bereceived n years hence, i.e. this investment will earn a return.


14/45


14

e-learn

ing

co

urs

e

Time Value of Money (Contd.)

This can be illustrated as:

The purchasing power of a dollar changes through time. This is because

the future values are eroded by inflation.

An entrepreneur expects to gain a premium on his investment, to allow forthe following three factors: inflation, risk taking and the expectation of a realreturn.


15/45


15

e-learn

ing

co

urs

e

Present Worth Calculation Present valuing (discounting) is central to the financial and

economical evaluation process. Since most of the project costs, aswell as benefits, occur in the future, it is essential that these shouldbe discounted to their present value (worth) to enable properevaluation.

Hence, the present worth (P) of a future amount (say, Fn) in year n

will be calculated as:

P = Fnx [1/(1+i)n]

That is,

Present Value (P) = Fnx Discount Factor

where, discount factor = 1/(1+i)n

For example, if Fn= $1,000, i = 12% per year and n = 5 Years, then,

P = $1,000 x [1/(1 + 0.12)5] = $567.40


16/45


16

e-learn

ing

co

urs

e

Future Worth Calculation

Future worth analysis calculates the future worth of an

investment undertaken. Future value is simply the sumto which a dollar amount invested today will grow givensome appreciation rate.

The future amount (Fn) in year n of a present principalamount, P, is given by:

Fn= P(1 + i)n ..(1)

For example, if P= $567.40, i = 12% per year and n = 5 Years,

then, Fn= $567.40 x (1 + 0.12)5= $1,000


17/45


17

e-learn

ing

co

urs

e

Equivalence relationship between F and P


18/45


18

e-learn

ing

co

urs

e

Capital Recovery Factor (CRF)

A Capital Recovery Factor (CRF) converts a present

value into a stream of equal annual payments over aspecified time, at a specified discount rate (interest).

The value of an equal payment (A) to be made in each ofn periods here is given by:

A = P [i(1+i)n

]/[(1+i)n-1

]That is, A = P x CRF

Where, CRF= capital recovery factor = [i(1+i)n]/[(1+i)n-1]

The capital recovery factor can be interpreted as theamount of equal (or uniform) payments to be received forn years such that the total present value of all theseequal payments is equivalent to a payment of one dollarat present, if interest rate is i.


19/45


19

e-le

arn

ing

co

urs

e

Annuity factor

Given uniform cash flow series (A), Find P.

Present value of the series in this case is givenby:

P = A x Annuity factor

where, Annuity factor = 1/CRF


20/45


20

e-le

arn

ing

co

urs

e

Example

Given, P = $250,000, i = 8% per year, N = 6 years, find A.

$ 250,000

0

1 2 3 4 5 6

A A A A A A

Years

Figure: A loan cash flow diagram

Here, CRF = 0.2163

A = $250,000x CRF = $54,075


21/45


21

e-le

arn

ing

co

urs

e

Criteria for Financial Viability of a Project

There are several alternative criteria for financialevaluation. They are:

Net Present Worth (NPW) (or Net Presentvalue)

Annual Equivalent Worth (AE) Financial Internal Rate of Return (FIRR)

Benefit-Cost Ratio (B/C ratio) Payback Period (a simple but not sound

basis)

Net Present Worth (NPW): It is the difference

between the present value of cash inflows (revenues) andthe present value of cash outflows (costs) at the minimumattractive rate of return of the project owner.


22/45


22

e-le

arn

ing

co

urs

e

Basic procedure for net present worth calculation

1. Determine the interest rate that the firm wishes to earn on its

investments. This interest rate is often referred to as either arequired rate of return or a minimum attractive rate of return(MARR).

2. Estimate the service life of the project.3. Estimate the cash inflow for each period over the projects

service life.4. Estimate the cash outflow over each service period.5. Determine the net cash flows:

net cash flow = cash inflow cash outflow

6. Find the present worth of each years net cash flow at theMARR.

7. Add up all the present worth figures during the service life of theproject. The sum so obtained is the projects NPW.


23/45


23

e-le

arn

ing

co

urs

e

Net Present Worth Criterion (Contd.)

A positive NPW means that the equivalent worth of the inflows isgreater than the equivalent worth of outflows, so the project makes aprofit.

Therefore, the decision rule will be as follows:

If NPW(i) > 0, accept the project for investment.

If NPW(i) = 0, remain indifferent.

If NPW(i) < 0, reject the investment.

where, i = MARR.


24/45


24

e-le

arn

ing

co

urs

e

Annual Equivalent Worth

The annual equivalent worth (AE) criterion provides an alternative

basis for measuring the worth of an investment by determining equalpayments on an annual basis.

To compute AE, first of all we have to find the net present worth(NPW) of the original series and then multiply this amount by the

capital recovery factor. The decision rule is as follows:

If AE(i) > 0, accept the project for investment.

If AE(i) = 0, remain indifferent to the investment.

If AE(i) < 0, reject the project for investment. Note that, accepting a project that has a positive AE(i) is equivalent to

accepting a project that has a positive PW(i).


25/45


25

e-le

arn

ing

co

urs

e

Financial Internal Rate of Return (FIRR) The FIRR is an indicator to measure the financial return on

investment of an income generation project and is used to make theinvestment decision.

The FIRR is obtained by equating the present value of investmentcosts (as cash out-flows) and the present value of net incomes (ascash in-flows) and thus finds out the break-even interest rate, i*.

In general, the decision rule is as follows: If FIRR > MARR, then, accept the project. If FIRR = MARR, then, remain indifferent. If FIRR < MARR, then, reject the project.


26/45


26

e-le

arn

ing

co

urs

e

Benefit-Cost Ratio (B/C ratio)

B/C ratio is the ratio of the total present value ofbenefits during the service life of the project to thetotal present value of the costs at the MARR.

A project is accepted for investment if B/C ratio isgreater than or equal to unity and rejected otherwise.


27/45


27

e-le

arn

ing

co

urs

e

B/C Ratio (Contd.)

A

Initial cost $ 2Annual benefit and

costs:$ 1Power Sales

-

Let us consider an example of a hydropowerproject as follows:

Interest rate=12%, Life=50 yearsAnnual Benefit = 1000000 + 250000

+ 350000 + 100000

= $ 1700000

Present value of benefit

= 1700000 *(annuity factor)

= 1700000*18.2559

= $ 31035030Then,Present value of operating and maintenance cost = 200000 * 18.2559

= $ 3651180Total cost (C) = 25000000+ 3651180B/C ratio = 31035030 / (3651180 + 25000000) = 1.08Since the B/C ratio is greater then unity, the project is accepted!


28/45


28

e-le

arn

ing

co

urs

e

Payback Period The payback period is the time that a project is expected to take in

order to earn net revenue equal to the capital cost of the project.

It is utilized for small investments, like improvements and energyefficiency measures, since it is easy to understand by business

managers.

Drawbacks

- It tells the analyst nothing about the project earning rate after thepayback period and does not consider the total profitability or size ofthe project.

- If a company makes investment decisions solely on the basis of thepayback period, it considers only those projects with a paybackperiod shorter than the maximum acceptable payback period.


29/45


29

e-le

arn

ing

co

urs

e

Payback Period (Contd.)

The payback period method ignores inflation and discriminatesagainst large capital-intensive infrastructure projects with longgestation times. Therefore, it is a poor criterion in itself and it mustbe used in conjunction with other criteria.

The Pay- Back Period can be calculated as

Pay-back period = Total Investment Cost Subsidy amountAnnual Revenue Annual Expenditure

If the subsidy amount is not given then we can exclude the subsidy

amount in the above example.

Fl Ch f Fi i l A l i d U i


30/45


30

e-le

arn

ing

co

urs

e

Flow Chart of Financial Analysis under UncertaintyDefine the parameters of the project

e.g. Service life , Discount Rate , Size ofthe Project , Demand , etc .

For a given size of the RE project ,

determine the cash inflows and cash

outflows for each Year

Calculate the total NPW or

alternative financialindicator of the project

Use of decision rule

for project investment

Investment

Decision

Sensitivity Analysis

Break -even Analysis

Scenario Analysis


31/45


31

e-le

arn

ing

co

urs

e

Financial Analysis under Uncertainty In the foregoing discussion, we assumed that all the parameters of the

project for financial evaluation are known for certainty. However, this isnot usually the case. From a practical point of view the project

parameters may face uncertainty and the actual value could vary.

Projects that involve new technologies (renewable and clean-coaltechnologies), or projects with lengthy lead times (nuclear and hydro-power) involve a lot of investment and have more than the average levelof risk.

For example, the demand may not turn out to be as estimated, the tariffis lower than expected, project execution may take more time andinvolve more cost than planned.

In RE projects, RE resource availability itself is subject to some

uncertainty and hence the uncertainty in RE output.

Cost overruns, which are caused by project delays, or inaccuracies inestimation do not only significantly change project costs but alsosubstantially reduce net benefits.


32/45


32

e-le

arn

ing

co

urs

e

Financial Analysis under Uncertainty(contd.)

Generally, there are several procedures toanalyze the project under uncertainty,such as:

Sensitivity Analysis

Break-Even Analysis

Scenario Analysis


33/45


33

e-le

arn

ing

co

urs

e

Sensitivity Analysis A sensitivity analysis reveals how much the NPW will

change in response to a given change in an input variable.

This kind of analysis determines the effect on the NPWwith variations in the input variables such as revenues,operating cost, and salvage value etc.

Sensitivity analysis sometimes also called as what-ifanalysis.

Sensitivity analysis begins with a base case situation,which is developed by using the most likely values foreach input. Then the value of the specific variable ofinterest is changed above or below its most likely value,while holding all other variables constant.

S (C )


34/45


34

e-le

arn

ing

co

urs

e

Sensitivity Analysis (Contd.)Next, a new NPW for each of the values are obtained.

A convenient and useful way to present the results of asensitivity analysis is to plot sensitivity graphs.

The slopes of the lines show how sensitive the NPW is to

changes in each of the inputs.

The steeper the slope, the more sensitive the NPW is toa change in a particular variable. Sensitivity graphsidentify the crucial variables that affect the final outcomemost.

Let us construct a sensitivity graph for five of the transmissionprojects key input variables such as unit price, product demand,variable cost, fixed cost and salvage value.


35/45


35

e-le

arn

ing

co

urse

Sensitivity Analysis (Contd.)

The base case NPW is $40,169. We plot the base case NPW on the

ordinate of the graph with 0% deviation and then reduce the value ofthe input variables by 5% of its base case value and recompute theNPW with all other variables held at their base case value. Werepeat the process by either decreasing or increasing therelative deviation from the base case.

FromFigure 1, we can see that the projects NPW is

- Very sensitive to the changes in product demand and

unit price,

- Fairly sensitive to changes in variable costs, and

- Relatively insensitive to changes in the fixed cost and the salvage

value.


36/45


36

e-le

arn

ing

co

urse

Sensitivity Analysis (Contd.)

Sensitivity Analysi

0

10000

20000

30000

4000050000

60000

70000

80000

90000

-20% -15% -10% -5% 0% 5% 10% 15% 20%

Deviation

NPW(1

5%) Unit Price

Demand

Variable Cost

Fixed Cost

Salvage Value

Figure 1: Sensitivity Graph


37/45


37

e-le

arn

ing

co

urse

Break-Even Analysis

When we perform a sensitivity analysis of a project, we are asking

how serious the effect of lower revenues or higher costs will be onthe projects profitability. Sometimes the question may be insteadhow much sales or revenue can decrease below forecasts beforethe project begins to lose money. This type of analysis is known asbreak-even analysis.

Break-even analysis is a technique for studying the effect ofvariations in output on a firms NPW.

Figure 2 shows the plot of the PWs of cash inflows and outflowsunder various assumptions about annual sales. The two lines

crosses when sales are X1 units, the point at which the project hasa zero NPW. It is seen that as long as the sales are greater orequal to X1 units the project has a positive NPW.

Break even Analysis


38/45


38

e-le

arn

ing

co

urse

Break-even Analysis

0

0

Y1

Y2

Y

NPW(MARR %)

Annual Sales Units (X)

X1 units

Loss

ProfitBreak - even point

Outflow

Inflow

Break Even Analysis basedon net cash flow

Figure 2:

X1


39/45


39

e-le

arn

ing

co

urse

Scenario Analysis

A more comprehensive approach to deal with uncertainty than

sensitivity and break-even analysis is Scenario Analysis. Both Sensitivity and Break-even analysis are useful but they have

certain limitations. Often it is quite difficult to specify precisely therelationship between a particular variable and the NPW. Therelationship is further complicated by interdependencies among the

variables. It may also complicate the analysis too much to permitmovement in more than one variable at a time.

Scenario Analysis is a technique that considers the sensitivity ofNPW both to changes in key variables and to the range of likely

values of those variables. For example, in its simplest form it involves selecting scenarios such

as, a best-case scenario, a worst-case scenario and the most-likely-case scenario.

S (C )


40/45


40

e-le

arn

ing

co

urse

Scenario Analysis (Contd.)

The best-case scenario will incorporate future parameters that are morefavorable to the project success than they appear at the time of evaluation.

The worst-case scenario is the analysis with less favorable values such aslow unit sales, low unit price, high variable cost per unit, high fixed cost etc.

The most-likely-case scenario (base case) is the analysis with the mostlikely inputs and outputs from the point of view of the project evaluator.

The NPW under the worst and the best conditions are then calculated andcompared with the expected, or the base case, NPW.

Generally, we find that the worst case produces a negative NPW, the bestcase produces a large positive NPW and the most likely case produces apositive NPW.

But still by only observing all these results, it is not possible and easy tointerpret the scenario analysis or make a decision based on it.

Clearly, we need estimates of the probabilities of occurrence of the worstcase, the best case and the most likely or base case and all the otherpossibilities.


41/45


41

e-le

arn

ing

co

urse

Concept of MARR

The minimum attractive rate of return (MARR) is the

interest rate at which a firm can always earn orborrow money under a normal operatingenvironment. It is generally dictated by managementand is the rate at which NPW analysis should be

conducted.

Usually the selection of the MARR is a policydecision made by top management and it is possible

for the MARR to change over the life of the project.


42/45


42

e-le

arn

ing

co

urse

Basis for Selecting the MARR:

The Cost of Capital of a firm is the required rate of

return that makes an investment project worthwhile.

The cost of capital of a firm investing in the projectcan be expressed as the weighted average cost of

capital if the firm mobilizes its fund through differentsources of financing, e.g., debt and equity.

The cost of capitalis normally considered as the rate

of return that a firm would receive if it invested itsmoney somewhere else with a similar risk.


43/45


43

e-le

arn

ing

co

urse

Basis for Selecting the MARR (contd.)

Any additional risk associated with the project also has tobe considered.

If the project belongs to the normal risk category, thecost of capital may already reflect the risk premium.

However, if we are dealing with a project with higher risk,the additional risk premium may be added onto the costof capital.

In total, the discount rate (or, MARR) to use for financialevaluation would be equivalent to the firms cost ofcapital for a project of normal risk, but could be muchhigher if we are dealing with a risky project.


44/45


44

e-le

arn

ing

co

urse

References

Park, Chan S., Contemporary Engineering Economics, 4th edition,

Prentice-Hall, N.J., 2007.

Hisham Khatib, Economic Evaluation of Projects in the ElectricitySupply Industry, IEE Power and Energy Series 44, London.

United Nations Development Programme, United NationsDepartment of Economic and Social Affairs, World Energy Council,2000, World Energy Assessment, Energy and the Challenge ofSustainability.

Intermediate Technology Development Group, 1997, FinancialGuidelines for Micro Hydro Projects, Nepal.


45/45

45

e-le

arn

ing

co

urse

Thank you!

bio-energy 7th shrestha 1st revised

Documents