Undiscounted Appraisal Methods

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					         Appendix 2


Investing in Energy Efficiency
                        Investing in Energy Efficiency


Introduction

Section 2.6 of this manual has some introductory material on investment in energy
efficiency including the purpose of financial appraisal and key steps in appraisal. This
Appendix provides information on key appraisal methods and a tool to evaluate an
organisation‟s current practice in investment - the Financial Energy Management Matrix.
For further information on this subject see SEI‟s manual “Investing in Energy: A Practical
Guide to Preparing and Presenting Energy Investment Proposals”. It was published in
2004 by SEI and is available free of charge and can be downloaded from SEI‟s website
www.sei.ie.
Undiscounted Appraisal Methods

Before any method of appraisal can be applied, it is necessary to identify the energy
saving opportunities and gather all the appropriate information. All the costs and benefits
must be established and the time period over which this will occur. This will yield the
cash flow for the project and help to build the case.

Simple Payback is the simplest method of evaluation but also the crudest and it can be
misleading.

If we take the following project (Project X) where a €10,000 investment is made today
(Year 0) with savings of €5,000 per year achieved over 3 years.

             Year            Capital Cost (€)                Savings (€)

               0                  (€10,000)                        -
               1                                                €5,000
               2                                                €5,000
               3                                                €5,000

Payback is defined as the capital cost divided by the annual savings.

       Payback (Years)        =        Capital Cost
                                      Annual Savings

       Payback                =       €10,000 = 2.0 years
                                       €5,000


Advantages of Payback: Payback is simple to calculate, easy to understand, is
expressed in tangible terms (years). Also, it does not require any assumptions about the
project lifetime or interest rates.

Disadvantages of Payback: Payback has the disadvantage of not taking into account
savings achieved after the payback period. Also the time value of money is ignored (e.g.
€5,000 saved in 3 years time is worth less than €5,000 saved today). Finally, at the end
of the project life no account is taken of any residual capital asset value.

Payback simply indicates the time when the cashflow becomes positive.
However, in many organisations payback is used as a method of filtering out „good‟ from
„poor‟ projects. This can lead to serious errors. For example if faced with following
choice between Project X and Project Y.

                                      Project X                     Project Y

       Capital                        €10,000                       €10,000
       Annual savings                  €5,000                        €4,500
       Payback                        2 years                       2.2 years

       Project Life                    3 years                      10 years

If the investment sum available is limited to €10,000, a choice must be made. On a simple
payback basis the choice is Project X. However, if the life of both projects is taken into
account: then Project Y will clearly be more attractive than Project X over a 10 year
period, because a considerable amount of savings are made after the payback period.

Discounted Appraisal Methods

Discounted evaluation methods take into account the time value of money, life of the
project, interest rates and other factors. A key purpose of discounting is to take into
account that the value of a sum to be received next year is less than the value of the
same sum received today.

For example, if €935 were deposited in a bank at an interest rate of 7%, one year from
now the value would be €1000. This is calculated from a compound interest formula:

S      =      A (1+r)ⁿ
A      =      initial sum
S      =      sum accumulated after „n‟ years
r      =      interest rate

So   S = 935 (1+0.07)1 = €1000

If we have an energy saving project which delivers savings of €1000 one year from now it
is helpful to know what they would be worth in today‟s money. This can be done by
rearranging the above formula to:

A      =        S
              (1+r)ⁿ

A      =      today‟s (present) value of € received in „n‟ years time

r      =      discount rate

S      =      forecast savings in year „n‟

So if a project delivers €1000 saving a year from now, then at a discount rate of 7% then
it is worth in today‟s money:
A       =       1000          =      €935
               (1+0.07)1


                      Compounding
                         7%



            Present                     Future
€935                                                 €1000


                      Discounting
                          7%

The purpose of discounting future savings in each year in the project life is to get all the
savings assembled in a common time currency of today‟s value or “present value”. When
added together they represent the gross present value. If the capital cost is deducted
we have the net present value or NPV.

If we return to Projects X and Y and using a nominal discount rate of 13% we can
calculate the NPV of each project:

Project X
        Year        Capital         Savings        Discount Factor      Present Value
                  Expenditure                      at 13% Discount
                                                         Rate
    0            (€10,000)              -                 1.0                (€10,000)
    1                                €5000               0.885                   €4425
    2                                €5000               0.783                   €3915
    3                                €5000               0.693                   €3465
                                                  Net Present Value              €1805
Project Y
      Year          Capital          Savings       Discount Factor      Present Value
                  Expenditure                      at 13% Discount
                                                         Rate
        0           (€10,000)            -                 1.0                (€10,000)
        1                             €4500              0.885                   €3982
        2                             €4500              0.783                   €3523
        3                             €4500              0.693                   €3118
        4                             €4500              0.613                   €2758
        5                             €4500              0.543                   €2443
        6                             €4500              0.480                   €2160
        7                             €4500              0.425                   €1912
        8                             €4500              0.376                   €1692
        9                             €4500              0.333                   €1498
       10                             €4500              0.295                   €1327
                                                   Net Present Value           €14,413


The Net Present Value is a financial measure of particular interest to financial managers.
It tells them what the project will earn over its costs in today‟s money over its expected
lifetime. The NPV of a project should be positive to be a viable option. In comparing
Project X with Project Y, then Project Y gives a much greater NPV and therefore is more
attractive. A key issue to consider is the risk that the life of Project Y is significantly
longer (i.e. 10 years) and the building may be refurbished, sold or demolished during this
10 year period.
Selecting Discount Rates: The appropriate discount rate can be shown, from the
application of more advanced financial theory, to be the cost of capital, i.e. interest which
has to be paid on acquiring the capital to invest in the project. This idea is comparatively
new and over some years use of the phrase “cost of capital” has been displacing the
term “discount rate”. Public sector bodies often use a fixed discount rate. In the private
sector it is worth asking the finance/accounting department what discount rates they use
for NPV calculations.
Internal Rate of Return: If we take Project X and keep repeating the calculation using
higher discount rates the Net Present Value decreases and passes zero to become a
negative number. This occurs between 23% and 24% discount rate.
The discount rate which yields an NPV = 0 is significant. It defines the Internal Rate of
Return.
              + €25
                                                                                           DR     NPV
              + €20                                                                        22%    +€ 21.50
                                                                                           23%    +€ 5.50
                                                                                           24%    - € 10.00
              + €15                                                                        25%    - € 24.00

              + €10

              + €5                                                 IRR = 23.3%
Net Present




                         21%             22%        23%            24%            25%
Value




                         Discount Rate


              - €5


              - €10


              - €15


              - €20


              - €25




              Internal Rate of Return (IRR) is defined as the discount rate at which the Net Present
              Value reduces to zero.
              It is often used as a financial yardstick in organisations with no particular policy on
              discount rates, in which case it is not possible to calculate NPVs.
              The Internal Rate of Return is significant in that it roughly represents the rate of return
              money would have to earn in the organisation or externally to be a better investment.
              The higher the IRR the better. IRRs allow projects or investments to be compared.
              The IRR can be compared with the current interest rate for borrowing the capital required.
              If the IRR is lower than this interest rate, the project would loose money if it was financed
              by borrowing. If the IRR is greater than the cost of borrowing the capital, the project will
              generate enough income to repay the loan and still provide profit.
Sensitivity Analysis


In evaluating a project, some of the quantitative aspects of the project may not be known
initially and therefore are assumed or estimated. Sensitivity analysis is the process by
which these estimates are tested to determine what impact they may have on the value of
a project.
For example for Project Y if the project life and discount rate remain fixed but the capital
costs and the annual savings varied it is possible to see the impact of the changes in the
NPV.
Project Y
Capital €      Annual          Project Life      Discount Rate            NPV
               Savings
                                  (years)
 €10000          €4500               10                13%              €14413
 €15000          €4500               10                13%              € 9410
 €10000          €4000               10                13%              €11700
 €15000          €4000               10                13%              € 6700


By varying key parameters it is possible to test the sensitivity of the project. It is likely that
decision makers will ask questions about sensitivity, e.g.
“What happens to the NPV if the price of gas increases by 15%?”
It is well worth anticipating questions and possibly pre-empting them during a written or
verbal presentation to show to the decision-makers that you are aware of the impact on
the project by variations in key parameters.




       Selecting Discount Rates

       In the private sector it is important to ask the finance department or
       accounts what discount rate should be used for NPV calculations. The
       rate will vary from company to company depending on their financial
       situation, how cash rich the company is, the cost of borrowing and assets
       and liabilities. Typically discount rates are between 6 and 12%. In the
       public sector a test discount is usually used and this tends to be fixed for
       long periods typically at 6%