engineering economics notes

8/9/2019 Engineering Economics Notes

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ByProf.AmritNakarmi I/IIMSREE 09July2008

IntroductiontoEconomicsofEnergyProjects(EG854ES)

WhatIsEconomics?

Scarcity

Alleconomicquestionsarisefromasingleandinescapablefact:youcan'talwaysgetwhatyouwant.Welive

inaworldofscarcity.

Scarcitymeansthatwantsalwaysexceedresourcesavailabletosatisfythem.

PeoplegetinvolvedinEconomicActivitytocopewithScarcity.

Economicsisthestudyofhowpeopleusetheirlimitedresourcestotrytosatisfyunlimitedwants.

Facedwithscarcity,wehavetomakechoicesbecausewecan'thaveallwhatwewant.Balancingthe

wantsandtheresourcesavailableiscalledeconomizingoroptimizing.

WhatIsEnergyEconomics?

Whatiscompetition?

Competitionisthecontestforcommandoverscarceresources.

Forhumanlifeandtheproductionprocesses,asufficientlyavailableofenergyisthehighestpriority.

Humanbeings can livewithoutother things,butnotwithoutenergy resources.Energy resourcesarealso

scarceandhence,needsitsoptimizationanditisdealtbyenergyeconomics.

WhatIsEconomicsofEnergyProjects?

EconomicsofEnergyProjectsdealswithhoweconomicallyanenergyprojectcanbeestablishedand

operated.Coststructure,financing,capitalbudgeting(projectevaluation),andfinancialperformanceanalysis

ofthe

energy

projects

orfirms

are

looked

into.

TypesofFirms

Threebasictypesoffirm

Soleproprietorship Partnership Corporationorlimitedcompany

Sole

proprietorship

Itistheoldestformofbusinessorganization.Asinglepersonownsthebusiness,holdstitletoallits

assets,andisresponsibleforallofitsliabilities.

Advantages

Simplicity Quickerdecisionmaking Easytoestablish


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Disadvantages

GoodforsmallfirmsandnotgoodforbigfirmssuchasenergyCos. Responsibleforallliabilities Difficulttoraisecapital Costofcapitalishigh

Partnership

Apartnershipissimilartoaproprietorshipinallaspectsexceptthatthereismorethanoneowner.

Advantages

Decisionmadethroughconsensus/agreement,hencelowrisk Canraisehighercapital Easytoestablishbutmorecomplexthansingleproprietorship

Disadvantages

Responsibleforallliabilities Slowerdecisionmakingprocessthansingleproprietorship Difficulttoraisecapital

CorporationorLimitedCompany

Acompanyisanimpersonalentitycreatedbylaw,whichcanownassetsandliabilities.Themain

featureofthisformisthattheCo.isseparatefromitsowners.Aownersliabilityislimitedtohis/her

shareholdingonly.

Advantages

Limitedliability Canraisehighercapital(akindforenergyCos.) Lowercostofcapital Decisionmakingthroughconsensus

Disadvantages

Slowdecisionmaking Difficulttosetup


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RAISIN

Equity

Equityca

Rightso

R

t

r

R

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FINANCE

apital

pitalreprese

Authorize

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eryresoluti

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The amoun

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ountoffered

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oretheCo.

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he share at

itialpublici

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ge3of55

ompany.

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tovoteon


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PreemptiverightsItenablestheexistingshareholderstomaintaintheirproportionalownershipofthesharesiftheCo.issuedadditionalsharesinthemarket.

SourcesofFinance

Preferential

Capital

(Preferred

shares)

Preferred shares are hybrid forms of capital. They have the characteristics of both the equity (common

shares)andthedebtsuchasdebentures.

Mainfeaturesare:

1. preferredsharedividendispayableafternetincome,2. itiscumulative(dividendifnotpaidinyear,willbeaccumulatednextyear),and3. itistaxableandhasnovotingrights.

Internalaccumulation(retainedearnings)

The internal accruals consist of depreciation and retained earnings. Retained earnings are

muchmoreexpensivethanbankloans,becausetheyareretainedwithoutpayingoutthedividendandcost

ofcapital(interestrate)ofequityishigherthanthatoftheloan.

TermLoans/debentures

Termsaregivenbyfinancialinstitutionssuchasbanksandhavetermoflessthan10years.

Debentures(bonds)areloansraisedfromthepublicandtheinterest(calledhereascoupon)ispaideverysix

months.Itcanbesecuredandunsecured.Debenturescanbeconvertibleintocommonshares.

Workingcapitaladvances(loans)Underacashcreditoroverdraftarrangement,acompanycanborrowrequiredamountifitiswithinitslimit

intheagreementwiththefinancialinstitutionorthebank.

WeightedAverageCostofCapital(WACC)

CostofDebt

A firm with a 40% tax rate issues $1,000 bonds at a face value with coupon rate of 16%. Ignoring

underwritingandissuingexpenses,

Marketyield(marketrateofreturn)=rd=160/1000=16%

Costofdebt(tothecompany)=Rd=160*(10.4)/1000=9.6%

Ifpeopleinvestinbondsforlongterm,then

Pb=Sum(I/(1+rb)t+F/(1+rb)

n


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Costofdebt(totheCo)

NPb=Sum(I*(1Tax)/(1+kb)t+ F/(1+kb)

n

CostofPreferredShare

Acorporationissuesnew$100preferredsharesthatprovide$12inannualdividends.Thefirmhasidentical

preferredsharesoutstandingthatalsotradeat$100/share.Issuingandunderwritingexpensesare5%ofthe

issuepriceandassumedtobetaxdeductible.Thefirmstaxrateis40%.NetProceedsofpreferredshare(totheCo.)=NPp=100(10.4)*5=$97

rp=12/100=12%

kp=12/97=12.37%(costofpreferredsharetotheCo.)

CostofPreferredShare(forlongterminvestment)

Pp=Dp*Sum(1/(1+rp)t)

CostofEquity

Acorporationissuesnew$100commonsharesthatprovide$16inannualdividends.Thefirmhasidentical

commonsharesoutstandingthatalsotradeat$100/share.Issuingandunderwritingexpensesare5%ofthe

issuepriceandassumedtobetaxdeductible.Thefirmstaxrateis40%.

NetProceedsofcommonshare(totheCo.)=NPe=100(10.4)*5=$97

re=16/100=16%

ke=16/97=16.49%(costofequitytotheCo.)

CostofEquity(longterm)

MarketcapitalizationratePe=SUM(Dt/(1+re)

t)

Costofnewshares

NPe=SUM(Dt/(1+ke)t)

CostofEquity

Usuallycostofequityisnotknown,thenwehavetouseCapitalAssetPricingModel(CAPM)tofind

outcostofequity.


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Costof

Costof

Inpractic

e

Weight

IfIisthe

I

where

B

P

Then,

Example

Afirmpl

thatroug

L

P

N

Equity(C

Equity

Coswhe

e,

Shortterm

Historicalris

Betas are e

quityisriskie

edAverag

totalinvest

=B+P+E

isborrowin

ispreferred

ACC=Rb(1T

nWACC

nsonfinan

hlycorrespo

ngtermde

referredshar

ewcommon

PM)

ofEquity

(

re,

Rf=Riskfr

(Rm)=Expe

overnments

kpremiums

timated by

rthanthem

eCostof

ent,then

(loansandb

shares,andE

ax)*B/I+kp*

ingmajorne

dstoitscurr

bt $3

es $1

shares $4

e)=Rf

+Eq

erate

tedReturno

ecurityrates

reusedfort

egressing st

rket)

apital(W

onds),

isequity.

/I+ke*E/I

wexpansion

entcapitals

mil

mil

mil

ityBeta

*(

ntheMarke

areusedasr

heriskprem

ock returns

ACC)

programsb

ructure:

E(Rm)

Rf)

tIndex(Dive

iskfreerate

ium

gainst mark

ydrawingo

sifiedPortfo

et returns (it

funds inth

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lio)

shows how

followingp

ge6of55

much the

roportions


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Issuingandunderwriting expenses canbe ignored.Debt canbe issuedata coupon rateof12%,and the

dividend yield on preferred shareswould be 9%. Common Shares currently trade at $45 per share. The

currentdividendyieldonpreferredshareswouldbe$2.25pershare.Managementfeelsthat,overlongrun,

growthindividendmatch inflationrate,whichisanticipatedtobe10%peryear.Thecorporatetax is40%.

Whatisthefirmsweightedaveragecostofcapital(WACC)?

ExampleonWACC

Thecurrentinterestongovernmentdebtis10%,andthereturnonthemarketisexpectedtoexceedthis

rateby7%.Whatvalueofbetadowehavetoassumeforthefirmifthecostofequityasderivedfromthe

CAPMistomatchtheKe=15%calculatedaccordingtothedividendgrowthmodelunderaboveexample?

kb=(1T)rb=0.6*12%=7.2%

kp=rp=9%

Ke=D1/pe+g=2.25/45+0.1=0.15or15%

Source Proportion Costin% WeightedCost

Debt 30/80=0.375 7.2% 2.7%

Preferred 10/80=0.125 9% 1.13%

Common 40/80=0.50 15% 7.5%

WACC=2.7%+1.13%+7.5%=11.33%

ExampleonWACC

Afirmplansonfinancingmajornewexpansionprogramsbydrawingonfunds inthefollowingproportions

thatroughlycorrespondstoitscurrentcapitalstructure:

Longtermdebt $30mil

Preferredshares $10mil

Newcommonshares $40mil

Issuingandunderwriting expenses canbe ignored.Debt canbe issuedata coupon rateof12%,and the

dividend yield on preferred shareswould be 9%. Common Shares currently trade at $45 per share. The

currentdividendyieldonpreferredshareswouldbe$2.25pershare.Managementfeelsthat,overlongrun,

growthindividendmatch inflationrate,which isanticipatedtobe10%peryear.Thecorporatetax is40%.

Whatisthefirmsweightedaveragecostofcapital(WACC)?

ExampleonWACC

Thecurrentinterestongovernmentdebtis10%,andthereturnonthemarketisexpectedtoexceed

thisrateby7%.Whatvalueofbetadowehavetoassumeforthefirmifthecostofequityasderivedfrom

the

CAPM

is

to

match

the

Ke

=15%

calculated

according

to

the

dividend

growth

model

under

above

example?


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FinancialStatements

Thesearestatementsoffinancialinformationtothemanagersandtheshareholders.

IncomeStatement(ProfitandLossStatement) BalanceSheet Cash flow statement /SourceandUseofFunds Statement (Statementof changes in financial

positions)

IncomeStatement

Itshowstherecordoffinancialeventsbetweentwopointsintime.Ithasrevenuefromsalesandexpenses

incurredduringtheperiod.

NetWorth

Thevalueoftotalassetsminustotalliabilitiesorthevalueoftheowners'claimontheassets.

IncomeStatements(P/Lstatement)

Expendituresareallcashoutflows

ExpensesareonlythoseexpendituresthataffectnetworthoftheshareholdersandappearintheIncome

Statement.

Receiptsareallcashinflows.

Revenuesareonlythosereceiptsthataffectnetworthandthusappearintheincomestatement.

BalanceSheet

Itgivessnapshotsummaryofthefirm'sfinancialpositionatasinglepointintime. The balance sheet shows the net worth of shareholders at a point in time, whereas income

statementmeasureschangesinnetworth.

Liabilitiesindicatewhatmoneyhasbeenmadeavailabletothefirm. Assetsshowhowthefirmhasusedthemoneymadeavailabletoit. CurrentLiabilitiesaretheshort termdebtobligationsofafirm,withmaturitiesof lessthanone

year.

Fixedliabilitiesarefirm'slongtermfinancesuchaslongtermdebtsfrombanksandthepublic. Shareholders'equityisthemoneyinvestedbytheshareholdersandtheretainedearnings.

Fixed

Assetsare

acquired

for

long

term

uses

in

the

firm

such

as

plant,

building,

land,

and

equipment.

CurrentAssetsarecash,accountsreceivables,andinventoriesoffinishedgoodsandrawmaterials. Depreciationistheallocationofcostofanassettodifferenttimeperiods. WorkingCapitaliscomposedoffirm'scurrentassets. NetWorkingCapitalisthedifferencebetweencurrentassetsandcurrentliabilities.


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SomeItemsintheFinancialStatements

Profitistheexcessofrevenuesoverexpensesduringagivenperiodoftime. Cashflowistheactualcashflowinginandoutofafirmoveraparticulartimeperiod. Operatingcash flow is the flowofcasharising from theoperationofa firmandconsistsofnet

profit(profitaftertax)plusnoncashchargessuchasdepreciation.

CashFlowStatement

Source and useoffunds Statement (cash flow statement) is a summary of the flow of the

financialactivityofthefirm.Itshowswherethefirmobtainscashandhowitusesit.

Sourcesoffunds

Increaseinliabilities Increasenetworththroughretainedearningsorcapitalcontributionbytheshareholders Reductioninassetsthroughsalesofassets

Usesoffunds

reductioninliabilities reductioninnetworththroughpaymentofdividendsorlosses increaseinassets

Cashflowfromoperatingactivities

Netprofit Depreciation Decreaseinaccountreceivables Increaseinaccountspayables

Cashflowfrominvestingactivities

Salesoffixedassets Investmentinnewfixedassets

Cashflowfromfinancialactivities

Increaseindebt(cashinflow) Issuanceofnewshares(cashinflow) Dividendpayment(cashoutflow)


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Balan

Income

R

C

G

EN

eSheet

tatement

evenue

ostsofGoo

rossProfit

penses

etIncome

sSold(CO S)

Pa

e10of55


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INTERESTANDINTERESTRATE

Interestisarentalamountchargedbyfinancialinstitutionsfortheuseofmoney.

Interestrate,ortherateofcapitalgrowth,istherateofgainreceivedfromaninvestment.

Usuallythisrateofgainisstatedonaperyearbasis,anditrepresentsthepercentagegainrealizedonthe

moneycommitted to theundertaking.Thus,an11% interest rate indicates that foreverydollarofmoney

used,anadditional$0.11mustbereturnedaspaymentfortheuseofthatmoney.

THETIMEVALUEOFMONEY

Becausemoney can earn at a certain interest rate through its investment for a period of time, a rupee

receivedatsomefuturedateisnotworthasmuchasarupeeinhandatpresent.Thisrelationshipbetween

interestandtimeleadstotheconceptofthetimevalueofmoney.

Arupeeinhandnowisworthmorethanarupeereceivednyearsfromnow.Why?

Becausehavingtherupeenowprovidestheopportunityforinvestingthatrupeefornyearsmorethanthe

rupeetobereceivednyearshence.Sincemoneyhasearningpower,thisopportunitywillearnareturn,so

thatafternyearstheoriginalrupeeplusitsinterestwillbealargeramountthantherupeereceivedatthat

time.Thus,thefactthatmoneyhasatimevaluemeansthatequalrupeeamountsatdifferentpointsintime

havedifferentvalueaslongastheinterestratethatcanbeearnedexceedszero.

It isalsotruethatmoneyhastimevaluebecausethepurchasingpowerofarupeechangesthroughtime.

During periods of inflation the amount of goods that can be bought for a particular amount ofmoney

decreasesasthetimevalueofmoneyitisimportanttorecognizeboththeearningpowerofmoneyandthe

purchasingpowerofmoney.

THEPURCHASINGPOWEROFMONEY

Inflation(pricerises)anddeflation(depreciation,devaluation)aretermsthatdescribechangesinpricelevels

inaneconomy.

SIMPLEANDCOMPUNDINTEREST

SimpleInterest:

Undersimple interest, the interestowed (payable,billed)uponrepaymentofa loan isproportionalto the

lengthof time theprincipal sumhasbeenborrowed.The interest earnedmaybe found in the following


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manner.LetIrepresenttheinterestearned,Ptheprincipalamount,ntheinterestperiod,anditheinterest

rate.Then,

I=P*n*i

SupposethatNRS1,000isborrowedatasimpleinterestrateof12%perannum.Attheendoftheyear,the

interestowedwouldbe,

I=NRS1,000*1*0.12=NRS120

The principal plus interestwould beNRS 1,120 andwould be due at the end of the year. Interest and

principalbecomedue(payable)onlyattheendofthetimeperiod.

CompoundInterest

When loan ismade for several interest periods, interest is calculated and payable at the end of each

interestperiod.Therearenumberofloanrepaymentplans.

Theserangefrompayingtheinterestwhenitisduetoaccumulatingtheinterestuntiltheloanisdue.

Iftheborrowerdoesnotpaytheinterestearnedattheendofeachperiodandischargedinterestonthe

totalamountowed(principalplusinterest),theinterestissaidtobecompounded.

The interestowed inthepreviousyearbecomespartofthetotalamountowedforthisyear.Thisyears

interestchargeincludesinterestthathasbeenearnedonpreviousinterestcharges.

CALCULATIONOFCOMPOUNDINTERESTWHENINTERESTISPAIDANNUALLY

CALCULATIONOFCOMPOUNDINTERESTWHENINTERESTISPERMITTEDTOCOMPOUND


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INTERESTFORMULAS

Let,

I=theannualinterestrate

N=thenumberofannualinterestperiods;

P=apresentprincipalamount;

A=asinglepayment,inaseriesofnequalpayments,madeattheendofeachannualpayments.

F=afutureamountinnannualinterestperiods.

Assumptions:

1. Endofoneyearisthebeginningofthenextyear2. Pisatthebeginningofayearfromatimeregardedasbeingthepresent3. Fisattheendofthenthyearfromatimeregardedasbeingthepresent.4. AnA occurs at the end of each year of the period under consideration.When P andA are

involved,thefirstAoftheseriesoccursoneyearafterP.whenFandAareinvolved,thelastAof

theseriesoccurssimultaneouslywithF.

SinglePaymentCompoundAmountFactor(F/P,i,n)

If an amount P is invested now and earns at the rate i per year, howmuch principal and interest are

accumulatedafter

n

years?

DerivationofSinglepaymentCompoundamountFactor

Theresultingfactor,(1+i)n,isknownasthesinglepaymentcompoundamountfactorandisdenotedby

(F/P,i,n).

Thefutureamount,F,ofapresentprincipalamount,Pisgivenby:F=P(1+i)n


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Example:

If $1,000 is invested at 16% interest compounded annually at the beginning of yearone, the compound

amountattheendofthefourthyearwillbe:F=$1,000(1+0.16)4=$1,000(1.811)=$1,811

SinglePaymentPresentWorthFactor(P/F,i,n)

FindthepresentworthPofafutureamount,Freceivedattheendofnperiodsiftheinterestrateisi.

Thepresentworthinthiscaseisgivenby: P=F[1/(1+i)n]

Theresultingfactor,1/(1+i)n,isknownasthesinglepaymentpresentworthfactorandisdenotedby:

(P/F,i,n).

Example:

Howmuchmustbeinvestednowat16%compoundedannuallysothat$1,811,canbereceived4years?

P=$1,811[1/(1+0.16)4]=$1,811(0.5523)=$1,000

EqualPaymentSeriesCompoundAmountFactor(F/A,i,n)

Tofindthesinglefuturevaluethatwouldaccumulatefromaseriesofequalpaymentsoccurringattheend

ofsucceedinginterestperiods.

IfArepresentsaseriesofnequalpayments

F=A+A(1+i)+..+A(1+i)n2+A(1+i)n1

F=A[(1+i)n1]/i

Theresultingfactor, [(1+ i)n

1]/i, isknownastheequalpayment seriescompoundamountfactorand is

designatedas(F/A,i,n).

Example:

TheCompoundAmountofaSeriesofYearEndPaymentsof$100ofAnnualInterestRateOf12%

EqualPaymentSeriesSinkingFundFactor(A/F,i,n)


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TheequalpaymentseriescompoundamountrelationshipmaybesolvedforAasfollows:

Theresultingfactor,i/[(1+i)n1],isknownastheequalpaymentseriessinkingfundfactor

Example:

It is desired to accumulate $635 by making a series of five equal annual payments at 12% interest

compoundedannually,therequiredamountofeachpaymentwillbe

Equal

Payment

Series

Capital

Recovery

Factor

(A/P,

i,

n)

A deposit of amount P ismade now at an annual interest rate i. The depositorwishes towithdraw the

principal,plusearned interest, inaseriesofequalyearendamountsoverthenextnyears.Whenthe last

withdrawalismade,thereshouldbenofundsleftondeposit.Thevalueofequalyearendamount(annuity)

isgivenby:

Theresultingfactori(1+i)n/[(1+i)n1]isknownastheequalpaymentseriescapitalrecoveryfactorandis

designatedas(A/P,i,n).

Example:

$1,000investedat15%interestcompoundedannuallywillprovideforeightequalyearendpaymentsof

EqualPaymentSeriesPresentWorthFactor,(P/A,i,n)

Tofindwhatsingleamountmustbedepositednowsothatequalendofperiodpaymentscanbemade,P

mustbefoundintermsofA


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Theresultingfactor,[(1+ i)n1]/i(1+i)n,isknownastheequalpaymentseriespresentworthfactorandis

designatedas(P/A,i,n).

Example:

Thepresentworthofaseriesofeightequalannualpaymentsof$223ataninterestrateof15%compounded

annuallywillbe

UniformGradientSeriesFactor,(A/G,i,n)

In some cases, periodic payments do not occur in an equal series.Theymay increase or decrease by a

constantamount.

Let

G=annualchangeorgradient

n=thenumberofyears;

A=theequalannualpayment

Theresultingfactoriscalledtheuniformgradientseriesfactorandisdesignatedas(A/G,i,N)

GeometricGradientSeriesFactor,(A/G,i,n)

In some situations, annualpayments increaseordecrease,not by a constant amount,butby a constant

percentage.Ifgisusedtodesignatethepercentagechangeinthemagnitudeofthetthpaymentisrelatedto

paymentA1as


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TwotypesoflineargradientseriesascompositesofauniformseriesofNpaymentsofA1andthegradient

seriesofincrementsofconstantamountG

ProjectCashFlows

Typicallyacapitalprojectinitiallyrequiresinvestmentoutlayandproducesannualnetcashinflows.

CashOutflows:

Purchaseofnewequipment Workingcapital Manufacturing,operating,andmaintenancecosts Leasingexpenses Interestandrepaymentofborrowedfunds Incometaxesandtaxcredits.

CashInflows:

Borrowedfunds Operatingrevenues Costsavings(orcostreductions) Salvagevalue Workingcapitalrelease(costrecoverybyliquidation)

ElementsofCashOutflows

WorkingCapital:

Itisaninvestmentinnondepreciableassets.


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Someprojectsrequiresuchinvestmentsothatmorefundsareavailableinordertoincreasefirmsrevenues.

Inaccounting,working capital is theamount carried incash,accounts receivable,and inventory (account,

stock)thatisavailabletomeetdaytodayoperatingneeds.

For example, if a company is going to amarket a new product, inventories of the product and larger

inventoriesofrawmaterialswillbeneeded.Accountsreceivablesfromsaleswillincrease,andmanagement

mightalsodecidetocarrymorecashbecauseofhighervolumeofactivities.

Theseareworkingcapitalbutthesehavenotaxeffectandthecashflowsalwayssumtozerooverthelifeof

aprojectbuttheinflowsandoutflowsareshiftedintimeso,theydoaffectthenetpresentworth.

Overhead:

Thecostthatoccursirrespectivetothespecificunitsofoutputofafirmiscalledasoverheadcost.

Inmanufacturing,allcostsotherthandirectmaterialandlaborsaretreatedasoverheadcosts.

Forexample,coststo indirectmaterialand labor,maintenanceandrepairsonproductionequipment;heat

andlight,propertytaxes,royalty,depreciationandinsurance,overtimepremiums.

Depreciationoffactorybuildings isunaffectedbytheamountofproductionduringanyparticularperiod. If

however,anewbuildingisrequiredtomeetanyincreasedproduction,manufacturingoverheadwillcertainly

increase.

Indirectmaterials likesolderused tomakeelectricalconnections inacomputercircuitboardand theglue

usedtobindthebooks,thesearetreatedasapartofmanufacturingoverhead.

Typical examplesof indirect labor include thewagesofjanitors, supervisors,materialhandlers andnight

securityguards.

GainsTax:

Itisataxapplicabletogains(orlosses)occurredontheearningorlossasaresultofdifferenceinthebook

valueandsalvagevalueofanasset.Ifthesalvagevalueishigherthanthebookvaluethenthetaxneedsto

bepaidtoincrementalearning.Similarly,ifthesalvagevalueislessthanthebookvaluethentaxneedstobe

adjustedtotheloss.


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IncomeStatementCashFlowApproach

Oncethecashflowelements(bothinflowsandoutflows)aredetermined,thesemaybegroupedintothree

categories:

Operatingactivities

Cashflowfromoperations(e.g.,currentsalesrevenues,thecostofgoodssold,operatingexpenses (also

includesInterestpayments)andincometaxes)

Cashflowfromoperation=Netincome+Depreciation

Investingactivities

Ingeneral, three investment flowsareassociatedwhilebuyingequipment theyare:original investment,

salvagevalueandworkingcapitalinvestmentorrecovery.

Financingactivities

Itincludes:

Theamountofborrowing, Therepaymentofprincipal.

TheNetCashFlow foragivenyear issimply thesumof thenetcash flows fromoperating, investingand

financingactivities.


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GeneralizedCashFlowApproach

Itisanapproachinwhichnetcashflowisobtainedbyaggregatingindividualitems.

E.g.Acomputerizedmachiningcenterhasbeenproposedforasmalltoolmanufacturingcompany.Ifthenew

system,which costs $125,000 is installed, itwill generate annual revenues of $100,000 andwill require

$20,000 in annual labor, $12,000 in annualmaterial expenses, and another $8,000 in annual overhead

(powerandutility)expenses.Theautomationfacilitywouldbedepreciatedattherateof20%.

The companyexpects tophaseout the facilityat theendof fiveyears,atwhich time itwillbesold for

$10,000.Findtheyearbyyearaftertaxnetcashflowfortheprojectata30%marginaltaxratebasedonthe

netincomeanddeterminetheaftertaxnetpresentworthoftheprojectatthecompanysMARRof15%.

SolveitusingbothIncomeStatementCashFlowandGeneralizedCashFlowApproach.


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ExamplewithFinancing(Borrowing)

In

the

previous

example,

it

is

assumed

that

$62,500

of

the

$125,000

paid

for

the

investment

is

obtained

throughdebtfinancing(debtratio=0.5).Theloanistoberepaidinequalannualinstallmentsat10%interest

overfiveyears.Theremaining$62,500willbeprovidedbyequity(e.g.,fromretainedearnings).Findthenet

aftertaxcashflows.

Solution

Computingtheannualloanrepaymentinstallments:

$62,500(A/P,10%,5)=$16,487.


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Now,computingthecomponentofinterestandloanrepaymentinstallmentsfor5yearsasbelow:

For,n=1,

Theinterestdueatn=1is$6,250(10%of62,500)

Whichleaves16,487 6,250=10,237asleftoverforprincipalpaymentwithloanbalanceas:52,263.

For,n=2is$5,226(10%of52,263)

Whichgives16,4875,226=11,261asleftoverforprincipalpaymentandwithloanbalanceas:41,002


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DepreciationDefinition

Itisalossinvalueoverthetimethepropertyisbeingused.

Depreciable property includes buildings,machinery, equipment and vehicles. Exceptions are land (no

definitelife)andcollectibleitems/inventories(primaryforsale)

EconomicDepreciation(ED)

Example:A cars reliability and appearanceusually declinewith age. The vehicle isworth lesswith each

passingyear.

EDaccumulated=Purchasepricemarketvalue

AccountingDepreciation(AD)

isbasedontheideaofED Thesystematicallocationoftheinitialcostofanassetinpartsoveratime,knownasitsdepreciable

lifeandtheprocessisAD.

Sometimesrefertoitasassetdepreciation ADconceptispopularinengineeringeconomicanalysisbecauseADprovidesabasisfordetermining

theincometaxesassociatedwithanyprojectundertaken.


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Whatconstitutesadepreciableproperty?

Itmustbeusedinbusinessorheldforproductionofincome.

Itmusthavedefiniteservicelifeandthatlifemustbelongerthan1year.

Itmustbesomethingthatwearsout,decays,getsusedup,becomesobsolete,orlosesvaluefrom

naturalcauses.

ClaimingDepreciation

Thetaxpayermustbetheownerofthepropertyfortheclaim

In the case of leased property, lessee is not entitled to depreciate that property (e.g., leased

automobiles)

AccountingfortheDepreciationofCapitalAssets

Therearetwoaspectsofdepreciation:

1. Theactuallesseninginvalueofanassetwithuseandthepassageoftimeand2. Theaccountingforthislesseninginvalue

Depreciationviewsthecostofanassetasaprepaidexpensethatistobechargedagainstprofitsoversome

reasonableperiodoftime.

Rather than charging the entire cost as an expense at the time the asset ispurchased,depreciation is a

systematicway

tospread

the

anticipated

loss

invalue

over

the

life

ofthe

asset.

Thisistheconceptofamortizingthecostofanassetsothattheprofitadlossstatementisamoreaccurate

reflectionofcapitalconsumptionwhichisbasictofinancialreportingandincometaxcalculation.


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ValuetimefunctionandBookvalue

Thevalueofanassetdecreasesyearlyinaccordancewithoneofseveralmathematicalfunctions.

Selectionofparticularfunctioninvolvesdecisionsastothelifeoftheasset,itssalvagevalueandtheform

ofthemathematicalfunction.Ageneralvaluetimefunctionisshownbelow:

Bookvalueistheacquisitioncostofanassetlessitsaccumulateddepreciationcharges.Afunctionsimilar

toabovecanrepresentbookvalue.

BookValueCalculation

Thebookvalueattheendofanyyear(Bt)isequaltothebookvalueatthebeginningoftheyear(initialcost,

P)lessthedepreciationexpenseschargedduringtheyear.

Mathematically,


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BasicDepreciationMethods

Threeimportantmethodswillbediscussed:

1.StraightLineMethods

2.AcceleratedMethods

3.UnitsofProductionMethod

Straight

Line

(SL)

Method

Thismodelassumesthatthevalueofanassetdecreasesattheconstantrate.

Theexpressionfordepreciationchargeinanyyearis:

Andthebookvalueatendofyeartis:

Where,

P=initialcostoftheasset,

F=Salvagevalueand

N=usefullife

Example2:SLDepreciation

Costbasisoftheasset,P=$12,000

UsefulLife,N=5years,

Salvagevalue,F=20%oftheinitialcost=$2400


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AcceleratedDepreciationMethods

Themechanical efficiency of an asset tends to declinewith age, becausemaintenance costs tend to

increase with age, or because of the increasing likelihood that better/efficient equipment will become

availableandmaketheoriginalassetobsolete.

Thisreasoningleadstoamethodnamedaccelerateddepreciationmethodthatchargesalargerfraction

ofthecostasanexpenseoftheearlyyearsthanthatofthelateryears

Thetwomostwidelyusedacceleratedmethodsare:

a. DecliningBalanceb. Sumoftheyeardigits

DecliningBalanceMethod(DB)

CalculationbyDBdepreciationmethodallocatesafixedfractionofthebeginningbookbalanceeachyear.

Thefraction, ,isobtainedasfollows:

=(1/N).(Multiplier)

Themost commonlyusedmultipliersare1.5 ( i.e.,150%DB)and2.0 (called200%ordoubledeclining

balance,DDB)

Whennincreases, decreases.Thisresultsinasituationinwhichdepreciationishighestinthefirstyear

anddecreasesovertheassetsdepreciablelife.

Foradepreciation rate ,thedepreciation charge inanyyear fordecliningbalance canbederivedas

follows:

TotalDB(TDB)depreciationattheendoftyearsiscomputedasfollows:

Thebookvalue,Bt,attheendofyeartisthecostoftheasset,minusthedepreciationattheendoftyears


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Example3:DBMethodforexample2

Here, =(1/N).(multiplier)=(1/5).200%=40%(DoubleDB)

CasesofDBMethods

Whenfinalbookvalue esmatedsalvagevalue,wemustreadjustouranalysisbecauseeithertaxlawdoes

not permit us to depreciate assets below their salvage value or one have not taken full advantage of

depreciationstaxdeferringbenefits.Hence,twocaseswillbediscussed:

Case1:Whenthefinalbookvalueislessthantheestimatedsalvagevalue.

Case2:Whenthefinalbookvalueisgreaterthantheestimatedsalvagevalue.

Case1:WhenBt


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NotethatB4wouldbelessthanF=$2,400,ifthefulldeduction($1,037)hadbeentaken.WeadjustedD4

to$192,makingB4=$2,400.

Case2:WhenBt>F

Example5:Thefinalbookvalue$933isgreaterthantheestimatedsalvagevalueof$0(assume)

To reduce the book value (BV) of an asset to its salvage value as quickly as possible, it can be doneby

switchingfromDBtoSLwheneverSLdepreciationresultsinlargerdepreciationchargesi.e.,switchfromDB

toSLifdepreciationbyDBinanyyearislessthan(orequalto)itwouldbebySL.

Note that ,switching takesplaceatyear4asDBdepreciation is lessthanSLdepreciation .Theresulting

depreciationscheduleis:


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Sumoftheyeardigits(SOYD)MethodofDepreciation

AscomparedtoSLdepreciation,SOYDalsoresultsinlargerdepreciationchargesduringtheearlyyearsof

anassetslifeandsmallerchargesastheassetreachestheendofitsestimatedusefullife.

Here,ifNistheestimatedyearsofusefullife,thenumbers1,2,3,,Naresummed:

SOYD=1+2+3+.+N=N(N+1)/2

Depreciation rate Dn is computed here as a fraction inwhich the denominator is the SOYD and the

numeratoris,forthefirstyear,N;forthesecondyear,N1andsoon.Eachyearthedepreciation

chargeiscomputedbydividingtheremainingusefullifebytheSOYDandbymultiplyingthisratiobythetotal

amounttobedepreciated(PF).Mathematicallyexpressing:


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Example6:SOYDDepreciation

UnitsofProductionMethod

SLmethodcanbeapplicableonlyifthemachine/assetbeusedforexactlythesameamountoftimeeach

year.Whathappenswhenamachineisrun2000hoursoneyearand800hoursthenext?

Theunitsofproductionmethod takes careof such situationwheredepreciation charge for aperiod is

related to the numberof service units consumed in thatperiod i.e., depreciation varieswith production

volume.

Thismethodgivesmoreaccuratepictureofmachineusage.

Bythismethod,thedepreciationinanyyearisgivenby:

Adisadvantageofthismethodisthatthecollectingofdataonmachineuseandtheaccountingmethods

aresomewhattedious.

Example6:UnitsofProductionMethod

Atruckforhaulingcoalhasanestimatedcostof$55,000andisexpectedtogiveservicefor250,000miles,

resulting is a $5,000 salvage value.Compute the alloweddepreciation amount for truckusageof 30,000

miles.

Solution:


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TaxDepreciation

Itisadepreciationmethodbywhichacompanydepreciatesafixedassetfortaxpurposes.Thisisoneof

themanytaxincentiveoptionsthatincreasescashflowsforreinvestment.

ThedepreciationmethodsarecountryspecificandtheseareformulatedbyTaxAuthorityforestimating

depreciationforTaxpurpose.

Usuallyindepreciation,theassetisexpectedtobefullydepreciatedatapproximatelytheendofitsuseful

life.However,fortaxpurpose,itisnotnecessary.

Simplemethodsareestablishedwhichdefinesseveralclassesofassetswithallocatedrateofdepreciation.

BookDepreciationvsTaxDepreciation

SomeoftheTaxDepreciationMethods

ModifiedAcceleratedCostRecoverySystem(MACRS)Method:

MACRSisamethodfortaxdepreciationpracticedindevelopedcountriese.g.US.

MACRSschemeformulatedsimplerguidelineswitheightclassesofassets/properties,eachwithamoreor

lessarbitrarylifecalledarecoveryperiod.Therecoveryperioddonotnecessarilybearanyrelationshipto

expectedusefullives.Thesalvagevalueofpropertyisalwaystreatedaszero.


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MACRSPropertyClassifications

Note:

ADR=AssetDepreciationrange;guidelinespublishedbytheIRS.

Automobileshaveamidpoint lifeof3years intheADRguidelines,butareclassified intoa5yrproperty

class.

MACRSDepreciationSchedules:

MACRSrecoverypercentageasshownisaccordingtoHalfYearConvention(HYC),

DecliningBalanceMethod

HYCassumesthatallassetsareplacedinserviceatmidyearandtheywillhavezerosalvagevalue.

Half of one years depreciation in the first year, full years depreciation in each remaining years and

remaininghalfyearsdepreciationintheyearfollowingtheendofrecoveryperiodistaken.

(Seetable inbook)

MACRSDepreciation:AnExample

#Ataxpayerwantstoplaceinservicea$10,000assetthatisassignedtothe5yrclass.ComputetheMACRS

%andthedepreciationamountsfortheasset.

Solution:

Given:5yrasset,yrconvention

Wecompute, =40%(200%DB),andS=0

Since,

Straightlinerate=1/5=0.20

200%DBrate=2(0.20)=40%

UnderMACRS,salvagevalue(S)=0

Find:MACRSdepreciation%Dnfor$10,000asset.


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Then,beginningwiththefirsttaxableyearandendingwiththesixthyear,MACRSdeduction%iscomputed

asfollows:

DepreciationAmounts

(Dn):

Yr1:20%x$10,000=$2,000;Yr4:11.52%x$10,000=$1,152

Yr2:32%x$10,000=$3,200.Yr5:11.52%x$10,000=$1,152

Yr3:19.20%x$10,000=$1,920;Yr6:5.76%x$10,000=$576

OtherTaxDepreciationMethods

MaximumTaxDepreciationrateclassificationinThailand

Basedonacquisitionprice(SLmethod?)

Thepurchaserwilldepreciatetheassetasifitisacquirednew.

Inthecaseofasecondhandasset,depreciationof theasset,whilewith thepreviousowner,wouldnot

affecttheminimumdepreciationperiodfortheassetto thenewowner. Itwillbetreatedas if it isanew

asset(usingtheassetpricepaidbythenewowner).

CorporateTaxes

CorporaterateisHowarethetaxesreflectedinCashFlow?

Taxappliedtothetaxableincomeofacorporation.


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TaxRatesinThailand

ThemaximumcorporateincometaxrateinThailandis30%onnetprofit.

However,theratesvarydependingontypesoftaxpayers.

CashFlowvsNetIncome

Depreciation=ExpenseorIncome?

AcompanybuysanumericallycontrolledNCmachinefor

Baht3million(year0)andusesitfor5years,afterwhichitisscrapped.


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Thealloweddepreciationrateis20%intheacquisitionprice.Supposethecompanyestimatesthefollowing

revenuesandexpenses,includingdepreciation,forthefirstoperatingyear:

Grossincome=Baht4million

Costofgoodssold=Baht2million

OperatingExpenses=Baht1million

a)IfthecompanypaystaxesattherateofThaiTaxrates,whatisitsnetincomefromtheproject?

b)Assumethat

1)allsalesarecashsalesand

2)operatingexpenseswilldropto80%ofthatinYear1insubsequentyears.Showthenetcashflow.

CostandTimevalueofMoney

ClassificationsofCost

Anumberofcostclassificationshavecomeintousetoserveasabasisforeconomicanalysis.

FirstCost

Firstcostistheinitialcostofcapitalizedproperty,includingtransportation,installation,andotherrelated

initialexpenditures.

Firstcostisusuallymadeupofanumberofcostelementsthatdonotrecurafteranactivityisinitiated.For

purchasedequipment,theseincludeengineeringdesignanddevelopmentcost,testandevaluationcost,and

constructionorproductioncostaswellasshipping,installation,andtrainingcosts.


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Manyactivitiesthatotherwisemaybeprofitablecannotbeundertakenbecausetheirassociatedfirstcost

represents toohigha levelof investment.Many engineeringproposals that areotherwise soundarenot

initiatedbecausethefirstcostinvolvedisbeyondthereachofthecontrollingorganization.

OperationandMaintenanceCost

Whereasfirstcostoccursonlyonceingettinganactivitystarted,

Operationandmaintenancecostisthatgroupofcostsexperiencedcontinuallyovertheusefullifeofthe

activity.

FixedCost

Fixedcostisthatgroupofcostsinvolvedinanongoingactivitywhosetotalwillremainrelativelyconstant

throughouttherangeofoperationalactivity.

Fixedcostsaremadeupofsuchcost itemsasdepreciation,maintenance,taxes, insurance, leaserentals,

interestoninvestedcapital,salesprograms,certainadministrativeexpense,andresearch.

VariableCost

VariableCostisthatgroupofcoststhatvaryinsomerelationshiptothelevelofoperationalactivity.

Ingeneral,allcostssuchasdirect labor,directmaterial,directpower,andthe like,whichcanreadilybe

allocatedtoeachunitproduced,areconsideredtoconstitutevariablecosts,andthebalanceofthecostsof

theenterpriseareregardedasfixed.

IncrementalandMarginalCost

Thetermsincrementalcostandmarginalcostrefertoessentiallythesameconcept.Thewordincrement

meansincrease.

Incrementalcostistheadditionalcostthatwillbeincurredastheresultofincreasingoutputbyonemore

unit.

CostBehaviors

Fixedcostandvariablecostsarethetwomostcommoncostbehaviorpatterns.


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FixedCosts

Thecostsofprovidingacompanysbasicoperatingcapacityareknownasfixedcostorcapacitycost.Fora

costitemtobeclassifiedasfixed,itmusthavearelativelywidespanofoutputwherecostsareexpectedto

remainconstant.Thisspan iscalledtherelevantrange. Inotherwords,fixedcostsdonotchangewithina

given time period although volume may change. For our automobile example, the annual insurance

premium,property taxand license feeare fixed costssince theyare independentof thenumberofmiles

driven per year. Some typical exampleswould be building rents, depreciation buildings,machinery and

equipment,andsalariesofadministrativeandproductionpersonnel.

VariableCosts

Incontrasttofixedoperatingcosts,variableoperatingcostshaveacloserelationshiptothelevelofvolume.

If,forexample,volumeincreases10%,atotalvariablecostwillalsoincreasebyapproximately10%.Gasoline

is a good exampleof a variable automobile cost, as fuel consumption isdirectly related tomiles driven.

Similarly,thetirereplacementcostwillalsoincreaseasavehicleisdrivenmore.Inatypicalmanufacturing

environment,directlaborandmaterialcostsaremajorvariablecosts.

MixedCosts

Somecostsdonotfallpreciselyintoeitherthefixedorthevariablecategory,butcontainelementsofboth.

Werefertotheseasmixedcosts(orsemivariablecosts).Inourautomobileexample,depreciation(lossof

value)isamixedcost.Somedepreciationoccurssimplyfrompassageoftime,regardlessofhowmanymiles

acarisdriven,andthisrepresentsthefixedportionofdepreciation.Ontheotherhand,themoremilesan

automobileisdrivenayear,thefasteritlossesitsmarketvalue,andthisrepresentsthevariableportionof

depreciation. A typical example of amixed cost in manufacturing is the cost of electric power. Some

componentsofpowerconsumption,suchas lightingare independentofoperatingvolume (e.g.numberof

machinehoursoperated).

SunkCost

Asunkcostisapastcostthatcannotbealteredbyfutureactionandisthereforeirrelevant.

LifecycleCost

Lifecyclecostisdefinedasallcosts,bothnonrecurringandrecurring,thatoccuroverthelifecycle.

Manysystemsandproductsareplanned,designed,producedandoperatedwithverylittleconcernoftheir

lifecycle cost. In generation, the elements of lifecycle cost fall into categories that are based on

organizationalactivityoverthelifecycle.Thesearedescribedinthefollowinglist:

oResearch and development cost: initial planning;market analysis; feasibility studies; product research;

requirementsanalysis;engineeringdesign;designdataanddocumentation;software;testandevaluationof

engineeringmodels;andassociatedmanagementfunctions.

oProductionandconstructioncost:manufacturing;facilityconstruction;processdevelopment;production

operations;qualitycontrol


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oOperationandsupportcost:consumeroruseroperationsofthesystemorproduct inthefield;product

distribution;andsustainingmaintenanceandlogisticssupportthroughoutthesystemorproductlifecycle

oRetirementanddisposalcost:disposalofnonrepairableitemsthroughoutthelifecycle;system/product

retirement;materialrecycling;andapplicablelogisticsupportrequirements.

Experiencehas indicated that a largeportionof the total cost formany systems is thedirect resultof

activitiesassociatedwiththeiroperationandsupport.

Throughout the system/product life cycle, there aremany actions required, both technical and non

technical.

Themajorityoftheactions,particularlythoseattheearlierstages,haslifecycleimplicationsanddefinitely

affectslifecyclecost.

FinancialandEconomicEvaluationofProjects

Financialvs.EconomicAnalysis

Bothfinancial

and

economic

analyzes

appraise

the

profit/return

ofan

investment,

but

from

differing

perspectives:

Financialanalysisestimatestheprofit accruingtotheprojectfromthepointsofviewoftheoperatingentity(theutilityandthefirm)

Economic analysismeasures economic benefits and returns from the national economicpointofviewandassessestheeffectoftheprojectontheoveralleconomyofthecountry.

Bothtypesofanalysisareconductedinmonetaryterms,buthavedifferentdefinitionsofcostsandbenefits.

Foraproject tobeeconomicallyviable, itmustbe financially sustainable,aswellaseconomicallyefficient. Ifaproject isnot financiallysustainable,economicbenefitswillnotberealized.Financial

analysisandeconomicanalysisarethereforetwosidesofthesamecoinandcomplementary.

FinancialEvaluationofProjects

Financialevaluationofprojectsisnecessaryto:

evaluatethecommercialviabilityandfinancialsustainabilityofaprojectfromtheviewpointoftheprojectoperatingentity;

assess the degree to which a project will generate sufficient revenues to meet its financialobligations;

assessincentivesforproducers; takeintoaccountallexpendituresandrevenues(costsandbenefits)resultingfromtheproject

Financialevaluationofcostsandbenefitsoflargeprojects

Itiscarriedoutonthreelevels:

Ownersevaluation Bankersevaluation


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EconomicevaluationOwnersEvaluation:

Theowner isconcernedonlywiththereturnto investment(equity)andthuswouldbemore interestedto

knownetbenefitsandtheirnetpresentvalueincomparisonwiththevalueoftheinvestment.

BankersEvaluation:

Thebankerevaluatesthereturnonthetotalinvestment(equity+loans)oftheprojectappliedfortheloan

andconsidersitsprofitabilityi.e.,thebankerwillconsidertheNPVofthewholeinvestmentandnotjustthe

investorsequity.

EconomicEvaluation:

This includesall theeconomiccostsandbenefits i.e.,socialandenvironmental/externalcosts thatcanbe

evaluated.Suchevaluationiscarriedoutspecificallybydevelopmentbanksandsimilarinstitutionsandalso

bytheconcernedplanningdepartmentsinthegovernment.

Project

Financial

Cost

Thethreemaintypesare:

1. Investmentcosts:

Initial Cost (construction and commissioning including land, civilworks, equipment andinstallations)

Replacementcost Residualvalues(valueoftheinvestmentitemsattheendoftheprojectsusefullife)

2. Operatingcosts Fixedcosts: remunerationandbenefits,administrativecosts, insurancepayments,partof

themaintenancecost,etc.

Variablecost(dependsuponthelevelofproduction): fuelandenergy,water,lubricantsandpartofthemaintenancecost,rawmaterials(forindustrialprojects)

3. Workingcapital: Capital required for the stock (spare parts ,fuel, raw materials) to ensure continuous

production

4. FinancialEvaluationofProjects:SomeMethods

5. FinancialEvaluationofProjects:SomeMethods

6. LeastCostSolution PresentValuemethod AnnualCostMethod

7. Measuringworthoftheinvestment InternalRateofReturn NetPresentValue Benefit/CostRatio PaybackPeriod

8. LeastCostSolution:


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The least cost solution aims at evaluating all realistic alternatives (candidates) financially andeconomicallybeforedecidingthealternativethatcanachievetheprojectbenefitsatthe leastcost

i.e., least discounted overall cost over the useful life span of the project or over the specified

planninghorizon.

In thecaseofenergysupply industry,when therearemanyalternativesformeeting theneed forincreased electricity demand, the least cost solution aims at finding out the alternative technical

arrangementthatmeetstherequirementofelectricalenergywiththeleastcosttotheutility,itssite

andtiming.

Inchoosingtheleastcostsolutionwecomparethepresentvalueofthecostofthealternativesandordiscountedenergycost(US/kWh)dependinguponthecostsandtechnicalcharacteristicsofthe

alternatives.

9. Themostpopularmethodsforfinancialevaluationandcomparingalternatives:PresentValuemethod

Hereallcostsandbenefitsoftheprojectornetbenefits(Cashflows)arediscountedtothebaseyear.Thenetpresentvalue(NPV)isnothingbutthedifferencebetweenthediscountedbenefitsandthe

discountedcosts.

Here,benefitsrepresenttheincomeortherevenueproducedbytheproject(financialflowsonly)

Example1:

Acompanyisconsideringbuyinganefficientboilerforitsmanufacturingprocess.Itwouldcost$40,000

immediatelybutwouldsave$7500eachyearforthenext10years.Howeveratthenendofthefifthyeara

onetimemaintenanceexpenseof$5000wouldbeincurred.Iftheownersopportunitycostofcapitalis

8%,shouldthecompanybuytheboiler?Solution:

Themachineisagoodinvestment;itproducesadiscountedsavingsof$6922.2.

Year Benfits,$ Cost,$ Benfits,$ Cost,$0 0 40000 0.0 40000.01 7500 0 6944.4 0.0

2 7500 0 6430.0 0.03 7500 5953.7 0.04 7500 0 5512.7 0.0

5 7500 5,000 5104.4 3402.96 7500 0 4726.3 0.0

7 7500 0 4376.2 0.08 7500 0 4052.0 0.09 7500 0 3751.9 0.0

10 7500 0 3474.0 0.0Total 50325.61 43402.92NPV, $ 6922.7

Discounted Values

0 0(1 ) (1 )

n nt t

t t

t t

C B

r r


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Example3:

Financialevaluationofenergyefficientmotorovera20yearlifetimeandat10%discountfactor

GoodMotor(GM)

Cost:$700

Input

Power

:

7.9

kW

Runninghours:1600h/year

Electricitycost:$0.095/kWh

EnergyEfficientMotor(EEM)

Cost:$846

Input

Power

:

7.5

kW

Runninghours:1600h/year

Electricitycost:$0.095/kWh

Solution:

Theannualelectricitycost(AEC)forthetwomotorsis:

GM:7.9kWx1600h/yrx$0.095/kWh=$1201/yr

EEM:7.5kWx1600h/yrx$0.095/kWh=$1140/yr

NPV=DiscountedbenefitsDiscountedcosts

Here,

discountedbenefits=presentvalueoffuturefuel/energysavings

= AECxPVF(@10%,20yrs)=(12011140)/yrx8.5/yr=$518.5

anddiscountedcost=incrementalcostofbetterproduct(initialcost)

=($846$700)=$146

Therefore,NPVEEM=$518.5 $146=$372.5:>TheEEMisthebetterinvestment!

AnnualCostmethod

Thisisausefulandquickmethodthatgivesrapidresultsandallowstheattentionoftheevaluatortofocus

onafewalternativessupposingthatcertainassumptionsandapproximations arepossible.

Example4:Comparingalternativeprojectsbyevaluatingcostofproductionandprices:

Discountfactor(r)

Cost

Expectedlife(n)

Fixedandrunningcost

Fullloadoperatinghrs

Calculation:

Annuityfactor(r%,n)

Costofproduction=

CombinedCycleSteamTurbine

10%

$1000/kW

30yrs

0.02$/kWh

8000

9.427

($1000/9.427)/8000+ $0.02 = 3.33

/kWh

CombinedCycleGasTurbine

10%

$500/kW

20yrs

0.024$/kWh

7000

8.514

($500/8.514)/7000+$0.024=3.24/kWh


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Example5:

ComparisonofcostofenergyproductionfromWindTurbine, Photovoltaic,andsmallGasTurbinesystem

Photovoltaic WindTurbine GasTurbine

Ownerdiscountrate

Installation

Cost

(P)

Capacity(kW)

Capacityfactor

Heatrate

FuelCost

VariableO&MCost

AnnualO&M

Annualloanpayment@

Annualoperatinghours

Thecostofelectricity

10%

$

10,000

3.0

0.25

(6%interest,20yrloan)

PxCRF=$872/yr

8760x0.25=2190h

=872/(2190x3)

=13.3/kWh

10%

$

2500

0.90

0.385

$100/yr


PxCRF=$275/yr

8760x0.385=3373h

(275+100)/(0.9x3373)

=12.4/kWh

10%

$850/kW

0.70

12500Btu/kWh

$7/106Btu

$0.002/kWh


PxCRF=$99.8/yr

8760x0.7=6132 h

Fuel+O&M+FixedCost

=(12500* 7 /106) +

0.002/kWh+($99.8/6132)

=10.6/kWh

Measuringworthoftheinvestmentforfinancialdecisionmaking:

Theimportantcriterionare: Internalrateofreturn NPVoftheproject Benefit/Costratio Othercriteria(payback,profit/investmentratio,commercialreturnonequitycapital)

Note:

Alltheabovecriteriaexceptforthelast,involvediscounting


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Exa

Whatis this

As a fir

Spreadsvalues)

Since th

Repeat

OCC ofcost of

ple 6 o

ould be theproject desi

The

st estimate, l

heet could be

e sum is positi

ing this iterati

11%, the projborrowing. T

IRR

IRR ,if the orable ?

ondition requi

t IRR = 10%,

sed to comput

ive, let IRR = 1

ve process yi

ect will generis is an attra

pportunity c

red is :

IRR more ea

2%, this woul

elds an IRR o

ate more thative investm

ost of capit

ily using the s

give :

f 17.5%.Sinc

enough incont.

l (OCC) is 1

ntax: IRR(cash

this exceeds

me to cover t

Pa

%t,

-flow

the

he

e45of55


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CapitalCost

O&M

Costa

Volume

of crudeoil

Price ofcrude oil

Cost of

crude oilb

Product

sales /

revenuec

NetBenefits

Year $ million $ million b/d $/bl $ million $ million $ million0 6 0 0 0 0 0 -6.01 45 0 0 0 0 0 -45.0

2 55 0 0 0 0 0 -55.03 52 0 0 0 0 0 -52.0

4 0 18 500 65.0 10.7 27 -1.95 0 35 2500 66.6 55.0 139 49.5

6 0 35 2000 68.3 45.1 116 35.97 0 35 2500 70.0 57.7 151 58.18 0 35 2800 71.7 66.3 141 39.29 0 2800 73.5 68.0 146 78.2

10 0 3000 75.4 74.6 163 88.211 0 3000 77.3 76.5 169 92.9

12 0 3000 79.2 78.4 176 97.713 0 3000 81.2 80.4 183 102.8

14 0 3000 83.2 82.4 191 108.115 0 3000 85.3 84.4 198 113.7

PV@10% $119.48 $88.07 $12,341 $302.02 $704.21 $166.08Notes: IRR 23%

b/d: barrels per daya

O&M include the cost of fuel used by the refineryb

based on 330 days per yearcbased on the yield of various products (gasoline,jet fuel,gasoil,fuel oil and butane)from the refinery and the market prices of theses products

Financial Analysis of a Petroleum Refining Project

Example 7 (IRR)

Benefit-Cost RatioThis method compares the discounted total benefitsof the project to its discounted costs:

0

0

(1 )/

(1 )

nt

t

t

nt

t

t

B

rB C

C

r

Only projects of B/C > 1.0 are adopted. The criteria is useful incapital constraint situation e.g., utility has a lot of feasibleprojects but limited investment budget. In this case, projects areranked in accordance with their B/C ratio and are adoptedaccordingly until their combined costs equal the capitalinvestment budget.

Example 8:

B/C of example-1 = 1.15


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Page47of55

Paybackperiod

Itisthetimerequiredforaproject'stotalbenefitstoexceeditstotalcost.Atthattimeprojectcanbesaidto

havepaidbackitsinitialcost.

Themostcommonapplicationsisintheanalysisofenergyconservationprograms.

Example9:

Energyefficiencyretrofitof largebuildingreducestheannualelectricitydemandforheatingandcooling

from2.3GWhto0.8GWhandthepeakdemandforpowerby150kW.Electricitycosts$0.06/kWhand

demandchargesare$7/kWmonth.Iftheprojectcosts$500,00,whatwouldbethepaybackperiodofthe

investment?

EnergySavings(A)

=(2.30.8)x106kWh/yrx$0.06/kWh=$90,000/yr

DemandSavings(B)

=150kWx$7/kWmonthx12months/yr=$12,600/yr

TotalAnnualSavings: (A)+(B)=$102,600/yr

Simplepaybackperiod =InitialInvestment/AnnualSavings

=$500,000/$102,600/yr

=4.87yr.

AnOverviewofRenewableEnergyProjectFinancingthroughCDM

BriefBackground

FormulationoftheUnitedNationsFrameworkConventiononClimateChange(UNFCCC)in1992. UNFCCsetsanultimateobjectiveofstabilizingatmosphericconcentrationsofgreenhousegasesat

safelevels.

Categorizationofcountriesintotwogroups:AnnexIPartiesi.e.theindustrializedcountrieswhohavehistorically contributed the most to climate change, and nonAnnex I Parties, i.e. developing

countries.

ConferenceofParties(COP) UnitedNationsFrameworkConventiononClimateChange AsthePrecursorofCleanDevelopment

Mechanism

KyotoProtocol

TheProtocolwasadoptedinDecember1997. ItcreateslegallybindingobligationsonAnnexIcountriestoreducetheiremissionsofGHGs.


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A

in

T

Kyoto pr

belowto

C

C

d

Whatar

E

fl

A

d

I

H

d

Whatd

DualObje

lo

sof27Febr

strumentso

heprotocole

tocol requir

thelevelof1

DMisoneof

DM allows

evelopingco

etheaspe

nablesAnne

exibleandco

ssist develo

evelopment

vestorsben

ostCountrie

evelopment.

esCDMai

ctives:

wertheove

hilealso

sup

ary2006,1

ratifications

nteredintof

es develope

990by2012

theKyotom

emission re

ntriestoge

ctsofCDM

1countries

steffective

ing countri

bjectives.

fitbyobtain

sbenefitint

mtoachie

allcostofre

portingsusta

2statesand

,accessions,

orceon16F

countries t

(thefirstco

echanisms t

duction pro

eratecertif

?

(developedc

anner.

s (nonAnn

ingCertificat

heformofi

ve?

ducingGHG

inabledevel

regionalec

approvalsor

bruary2005

o reduce th

mitmentpe

achievethe

ects that a

iedemission

ountries)to

ex I or the

esofEmissio

vestment,a

missions

pmentinitia

nomic integ

acceptances

.

ir GHG emi

iod:20082

objectiveof

ssist in cre

reductions(

meettheire

host count

nsReductio

cesstobett

tiveswithin

ationorgani

.

sions ( CO2

12).

reducingGH

ating sustai

ER)foruse

issionredu

ries) in me

s(CER).

ertechnolog

evelopingc

Pa

zationshave

quivalent) a

emissions.

able develo

bytheinves

tioncommit

ting their s

,andlocals

untries.

e48of55

deposited

t least 5%

pment in

or.

mentsina

ustainable

ustainable


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Page49of55

BenefitsofCDMfordevelopingcountries

AttractforeigninvestmenttocountriesengagedinthetradingofCERs Increasetheprofitabilityofcleanerandmoreefficienttechnologyinenergy,industry,andtransport

sectors.

Helpinwastemanagementoperations. Contributetosustainabledevelopmentofthehostcountry.

ProjectSustainabilityScreening

EstablishmentofSustainableDevelopmentcriteria

Shouldreflecteconomic,social,andenvironmentalsustainabilitydimensions.TheassessmentofSDaspectofaprojectwillinvolveasetofindicators.

A transfer of finances and contribution to sustainable

development in the Host Country

Host Country

Flow of Finances

Flow of Credits

Annex I Country


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Theindicatorsshouldbe:

Complete:adequatetoindicatethedegreetowhichtheoverallobjectiveofsustainabilityhasbeenmet.

Operational:canbeusedinameaningfulwayintheanalysis. Decomposable:thedecisionscanbebrokendownintopartsinvolvingasmallerno.ofindicators. Nonredundant:Theindicatorsshouldbedefinedtoavoiddoublecountingofconsequences. Minimal: It isdesirable to keep the setof indicators as smallaspossible. For instance itmaybe

possibletocombineindicatorstoreducethedimensionalityofthedecisionproblem.

DistributionofRegisteredCDMProjects byHostCountries

DistributionofRegisteredCDMProjectsAccordingtotheSectoralScopes

Others, 16.31%Sri

Lanka, 2.13%Guatemala, 2.13%

Ecuador, 2.13%

Argentina, 2.13%

Republic ofMoldova, 2.1

3%Panama, 2.13%

China, 4.26%

Chile, 4.96%

Honduras, 6.38%

Mexico, 9.22%

India, 19.86%

Brazil, 26.24%

EnergyDemand, (2.96%)Fugitive emissionsfrom fuels (solid, oiland gas), (1.18%)

Fugitive emissionsfrom productionand consumption ofhalocarbons andsulphurhexafluoride, (2.96%)

Waste handling anddisposal, (23.67%)

Chemicalindustries, (1.18%)

Manufacturingindustries, (1.78%)

Agriculture, (10.65%)

Energy industries(renewable - / non-renewablesources), (55.62%)


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AccordingtotheSectoralScopes

CDMProjectRequirements

Baselinestudyforemissions Emissionsadditionality&financialadditionality Hostcountrygovernmentapproval Meetsthesustainabledevelopmentcriteria DemandforCERs priceofCERs

AdditionalityandBaseline

Additionality

GHGreducedbelowwhatwouldhaveoccurredwithouttheprojectactivity

Baselinescenario

RepresentinganthropogenicemissionsbysourcesofGHGsthatwouldoccurwithouttheproposed

projectactivityAdditionalityandBaseline

Energy industries

24%

Energy

9%

Energy distribution

2%

Manufacturing industries

12%

Chemical industries

5%

Fugitive emissions from

fuels

6%

Fugitive emissions from

halocarbons and sulphur

hexafluorid

2%

Waste handling and25%

Afforestation and

reforestatio

3 %

Agriculture8%

Transport

2%

Mining2%


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Identify

Baseline

t0

E

E

C

=tonofe

Examples

Impacto

BaselineE

CERconcep

=startingye

t=Totalemi

DMt=Totale

ER=E0tECD

quivalentC

:

fCERsprice

issionMet

s

arofCDM

sionwithout

issionwith

t

2reduction

ntheproje

odology

CDMprojec

DM

(tradedinth

tsIRR

einternatio almarket:e.g.,5$to25

Pa

/tC)

e52of55


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Page53of55

ThesubstantialimprovementinIRRobservedinBiomassandSolidWastemanagementprojects.

CaseStudyPresentation

FinancialAnalysisofaSmallHydroProjectwithandwithoutCDMBenefits

CharacteristicsoftheproposedCDMProject

Type :Runoftheriverhydroproject InstalledCapacity:3.5MW Category :RenewableEnergyproject(


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IdentificationofAdditionalityoftheProposedCDMProject

GHGemissionsfromthisprojectactivitiesis lowerthanthatinthebaseline ProposedCDMprojectactivitiesisnotabaselinescenarioproject. The project activity is not expected to get implemented in the absence of the CDM due to the

investmentbarrierandfinancialanalysisisusedtodemonstratethis:

24

Detail Cash-flow analysiswithout CDM Credit

Detail Cash-flow analysiswith CDM Credit

ComputeFIRR and FNPV

ComputeFIRR and FNPV

Is financiallyattractive ?

Not a CDM ProjectYES

NO

Is financiallyattractive ?

Consideration forCDM Project

YESNOInfeasible project

Financial Analysis

F u e l

N e t

G e n e r a t i o n

( G W h )

F u e l

C o n s u m e d

( 1 0 3 t o n n e s )

( A )

N e t C a l o r i f ic

V a l u e ( T J / 1 0 3

t o n n e s ) - ( B )

C a r b o n

E m i s s i o n *

F a c t o r

( I P C C ;

t C / T J ) - ( C )

E m i s s i o n

t C O 2 ( D ) =

( A ) x ( B ) x ( C )

x 4 4 / 1 2

C o a l 7 2 5 6 3 5 0 7 7 6 1 6 . 2 2 2 5 . 8 7 7 9 1 1 3 0 1

L i g n it e 1 6 3 6 8 1 1 4 5 4 1 6 .2 2 2 7 . 6 1 8 8 0 1 3 2 8

G a s 1 8 8 2 6 3 7 4 3 4 3 . 3 3 1 5 . 3 9 1 1 6 3 7 3

H y d r o 1 6 5 8 7 0 0

N u c l e a r 4 1 2 2 0 0

T o t a l 1 2 8 4 6 6 1 0 5 8 2 9 0 0 2

( tC O 2 / M W h )

o r tC / M W h

0 . 8 2 4

0 . 2 2 5

B a s e l in e e m i ss io n f a c t o r


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CERvs.FIRR

Example:Breakeven

0

4

8

12

16

20

24

0 (Base

Case)

3 5 10 15 25

CER, $/tC

FIRR,

Break-even CER

MARR

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

0 500 1000 1500 2000 2500

Annual Sales units

PresentWorth

PV Benefits PV Costs

Loss

Profit

Break even- volume

engineering economics notes

Documents