FINANCIAL

ANALYSIS
Alka
Assistant Director
Power System Training Institute
Bangalore
 Need for investments
 For new equipment, process improvements
etc.
 To implement or upgrade the energy
information system
 To provide staff training
 And other priorities
 Criteria for investments
 Before you make any investments, it is
important to ensure that
1. Your energy charges are set at the lowest
possible tariffs
2. You are consuming the best energy forms –
fuels or electricity - as efficiently as possible
3. You are getting the best performance from
existing plant and equipment
4. Good housekeeping practices are being
regularly employed, at least by key personnel.
 Fixed and Variable Costs

 Variable costs are those which vary

directly with the output of a particular plant
or production process, such as fuel costs.
 Fixed costs are those costs,which are not
dependent on plant or process output,
such as site-rent and insurance.
 The total cost of any project is therefore
the sum of the fixed and variable costs.
 Break-even point
 The concept of fixed and variable costs
can be used to determine the break-even
point for a proposed project. The break-
even point can be determined by using the
following equation.
 Example
The capital cost of the DG set is Rs.9,00,000, the
annual output is 219 MWh, and the maintenance
cost is Rs.30,000 per annum. The cost of producing
each unit of electricity is 3.50 Rs./kWh. Find
1. The total cost of a diesel generator operating over
a 5-year period ?
2. The breakeven point for the generator If the
electricity bought from a utility company costs an
average of Rs.4.5/kWh, and the average output is
50 kW ? Also find the breakeven point for the
generator if the the average output is 70 kW
Solution 1
 Solution 2
4.5 x 50 x n = (9,00,000 + 150000) + (3.5 x 50 x n)
n = 21000 hours

If the average output is 70 kW, the break-even point is

given by:
4.5 x 70 x n = (9,00,000 + 150000) + (3.50 x 70 x n)
n = 15000 hours

Thus, increasing the average output of the generator

significantly reduces the break-even time for the project.
This is because the capital investment (generator) is
being better utilised.
 Cash Flows
 Costs are cash outflows & benefits are cash
inflows.
 Cash flows related to a project are
1. Capital costs

2. Annual cash flows

 Capital costs
 These are the costs associated with the
design, planning, installation & commissioning
of the project.
 These are usually one-time costs unaffected
by inflation or discount rate factors.
 Although installments paid over a period of
time will have time costs associated with
them.
 Annual cash flows
 Annual cash flows occur each year over
the life of the project.
 These include annual savings ,taxes,
insurance, equipment leases, energy
costs, maintenance, operating labour etc.
 Increases in any of these costs represent
negative cash flows, whereas decreases
in the cost represent positive cash flows.
 Time Value of Money
 Money has time value. A rupee today is more
valuable than a year hence due to following
reasons :
1. Individuals prefer current consumption to
future consumption
2. In an inflationary period a rupee today
represents a greater real purchasing power
than a rupee a year hence
3. Capital can be employed productively to
generate positive returns.
 Discounting
 To assess project feasibility, all present and future
cash flows must be equated to a common basis.
 The problem with equating cash flows which occur at
different times is that the value of money changes with
time.
 The method by which these various cash flows are
related is called discounting , or the present value
concept.
 The relationship between present and future value is
n
FV = NPV (1 + i)
FV = future value of the cash ,flow
NPV = Net Present Value of the cash flow
i = Interest or discount rate
n = Number of years in the future
 Financial Analysis Techniques
 Non discounted cash flow methods
1. Simple Pay Back Period

 Discounted cash flow methods

1. Net Present Value Method
2. Internal Rate of Return Method
Simple Pay Back Period (SPP)
• Simple Pay Back Period (SPP) : represents
the time (number of years) required to recover
the initial investment considering only the Net
Annual Saving. A shorter payback generally
indicates a more attractive investment.

SPP = . First Cost .

Yearly Benefits - Yearly Costs
 Advantages of SPP

1. It is simple, both in concept and application.

2. In general risk increases with futurity. This
method helps in weeding out risky projects as
it favours projects which generate substantial
cash inflows in earlier years, & discriminates
against projects, which bring substantial cash
inflows in later years but not in earlier years.
 Limitations of SPP
1.It fails to consider the time value of money.
2.It ignores cash flows beyond the payback
period & hence it favours projects, which
generate substantial cash inflows in earlier
years, and discriminates against projects,
which bring substantial cash inflows in later
years but not in earlier years.
3.It is a measure of a project's capital
recovery, not profitability.
 Example
A new small cogeneration plant installation is
expected to reduce a company's annual energy
bill by Rs.4,86,000. If the capital cost of the new
boiler installation is Rs.22,20,000 and the
annual maintenance and operating costs are Rs.
42,000, the expected payback period for the
project can be worked out as.
Solution
PB = 22,20,000 / (4,86,000 – 42,000) = 5.0 years
 Net Present Value Method
• NPV of a project is equal to the sum of the present
values of all the cash flows associated with it. NPV
represents the net benefit over and above the
compensation for time and risk. Hence we should
accept the project if the NPV is positive and reject
the project if the NPV is negative. The discount rate
(k) should reflect the risk of the project.
NPV = ∑ CFt / (1+ k) t
Where CFt is Cash flow occurring at the end of year
't' (t=0 ,l,... .n) .
CFt value will be negative if it is expenditure and
positive if it is savings.
n = life of the project ; k = Discount rate .
 Advantages of NPVMethod
• It takes into account the time value of money.
• It considers cash flows over full project life
time.
 Limitations of NPV Method
• Difficult to understand & calculate
• Calculation of the required rate of return is a serious
problem.
• May not give satisfactory results in the case of two
projects having different lives. In general , the project
with shorter economic life would be preferable, other
things being equal . It may be that a project which has
a higher NPV value may also have a larger economic
life so that funds will remain invested for longer
period , while the alternative proposal may have
shorter life but smaller present NPV value . In such
situation NPV method may not reflect the true worth of
the alternative proposal.
Profitability index
 Internal Rate of Return
• IRR calculates the rate of return that an
investment is expected to yield. The expected
rate of return is the compound interest rate for
which NPV =0.
• The project is to be selected if the IRR is more
than the required rate of return. The criterion for
selection among alternatives is to choose the
investment with the highest rate of return.
• In the NPV calculation we assume that the
discount rate is known and determine the NPV
of the project. In the IRR calculation, we set the
NPV equal to zero and determine the discount
rate ( IRR ) by a process of trial and error ,which
satisfies this condition.
 Advantages of IRR
1. It takes into account the time value of money.
2. It considers the cash flows over the complete
project life time.
3. Businessmen understand the concept of IRR
much more readily than the concept of NPV.
As businessmen prefer to think in terms of
rate of return and find an absolute quantity, like
NPV difficult to understand.
 Limitations of IRR
1. It involves tedious calculation. It generally
involves trial & error method.
2. The IRR figure cannot distinguish
between lending and borrowing and hence
a high IRR need not necessarily be a
desirable feature. Hence this method is
not suitable for evaluating mutually
exclusive proposals .
A proposed project requires an initial capital investment of
Rs.20 000. Find out the internal rate of return for the project
if the cash flows generated by the project are shown in the
table below ?
For12% discount rate, NPV is positive; for 16% discount
rate, NPV is negative. Thus for some discount rate
between 12 and 16 percent, NPV is 0. To find the value
exactly, one can interpolate between the two rates as
follows:
 Factors Affecting Analysis

• The capital value of plant and equipment

generally depreciates over time. General
inflation reduces the value of savings as
time progresses.
• The capital depreciation of an item of
equipment can be considered in terms of
its salvage value at the end of the analysis
period.
It is proposed to install a heat recovery equipment in a
factory. The capital cost of installing the equipment is
Rs.20,000 and after 5 years its salvage value is
Rs.1500. If the savings accrued by the heat recovery
device are as shown below, Find the NPV after 5 years.
Assuming discount rate is 8%. Also calculate the NPV of
the scheme assuming the discount rate remains at 8%
and that the rate of inflation is 5%.
It is evident that over a 5-year life span the net present
value of the project is Rs.4489.50. Had the salvage
value of the equipment not been considered, the NPV of
the project would have been only Rs.3468.00.
Real interest rate = Discount rate – Rate of inflation
Real interest rate = 8 – 5 = 3%
 PROBLEM
Two energy conservation projects have been
proposed. For the first project, a capital
investment of Rs.15,000/- is required and the net
annual saving is Rs. 5000/- for 5 years. For the
second project, a capital investment of Rs.
15000/- produces a savings of Rs. 5000/- for first
2 years and Rs. 6000/- for next 3 years. Salvage
value at the end of 5 years for the second
project is Rs. 1000/-. Determine:
(i) Net present value for both the projects with a
discount factor of 9%.
(ii) Profitability index for both the projects with a
discount factor of 9%.
(iii) Internal rate of return for both the projects.
 ANSWER
(i) NPV for project 1 = – 15000 + 5000/1.09 + 5000/(1.09)2 +
5000/(1.09)3 + 5000/(1.09)4 + 5000/(1.09)5 = + 4448.3
NPV for project 2 = – 15000 + 5000/1.09 + 5000/(1.09)2 +
6000/(1.09)3 + 6000/(1.09)4 + 6000/(1.09)5 + 1000/(1.09)5 = +
7228.7

(ii) Profitability index for project 1 = 4448.3 / 15000 = 0.297

Profitability index for project 2 = 7228.7 / 15000 = 0.481

(iii) NPV for project 1 with 19% discount rate = +288

NPV for project 1 with 20% discount rate = - 46.9
IRR for project 1 = 19.96 %
NPV for project 2 with 25 % discount rate = +23.36
NPV for project 2 with 26 % discount rate = - 298
IRR for project 2 = 25.07 %
 PROBLEM
It is proposed to install at the beginning of the year a heat
recovery equipment in a food processing industry. The
capital cost of the equipment is Rs 20,000/. The savings
accrued by the unit are constant and Rs 5,000/- annually.
The discount rate is 8%.
Calculate the Net Present Value (NPV) for 5 years.
Is the investment recovered after 5 years? Explain!
Is the investment recovered after 7 years? Explain!
Estimate the IRR for this investment after 7 years if the
salvage value of the equipment is Rs 2,000 at the end of
7th year.
 ANSWER
(I) NPV over 5 years at 8% = -20,000 + 5,000/ 1.08 + 5,000/ 1.082 +
5,000/ 1.083 + 5,000/ 1.084 + 5,000/ 1.085 = MINUS Rs. 36

(II) The investment is not recovered after 5 years because the

NPV is negative.

(III)NPV = Result of (i) + 5,000/ 1.086 + 5,000/ 1.087 = Rs 6032.

The investment is recovered after 7 years because NPV is
positive.

(IV) Use discount rate of 17.4% which results in NPV ~ 0 over 7

years. Therefore IRR is estimated to be 17.4% .