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Financial Feasibility Analysis 1 Financial Feasibility Analysis Energizing Cleaner Production Management Course

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Financial Feasibility Analysis 2 Session Agenda: Introduction Cash Flow Profitability Indicators 1. Simple Payback 2. Return on Investment (ROI) 3. Net Present Value (NPV) 4. Internal Rate of Return (IRR)

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Financial Feasibility Analysis 3 But first… In what step(s) of the methodology is financial feasibility analysis relevant?

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Financial Feasibility Analysis 4 Introduction Step 4 – Feasibility Analysis Project Selection Technical Environmental Financial Other - Regulatory - Organizational - Health/safety - Community Company’s priority

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Financial Feasibility Analysis 5 Introduction Questions Management Will Ask 1. Is the project profitable? Initial investment costs Annual operating costs and savings –Cost of operating inputs –Cost of waste management –Less tangible costs –Revenues 2. Determine availability of internal investment funds for bigger projects 3. Obtain external financing for remaining projects

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Financial Feasibility Analysis 6 Introduction Capital Budgeting Process Process by which organisation decides: Which investment projects are –Needed –Possible –Special focus on projects that require significant up-front capital investment How to allocate available capital between different projects If additional capital is needed

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Financial Feasibility Analysis 7 Introduction Capital Budgeting Practices Vary widely from company to company –Larger companies tend to have more formal practices than smaller companies –Larger companies tend to make more and larger capital investments than smaller companies –Some industry sectors require more capital investment than others Vary from country to country

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Financial Feasibility Analysis 8 Introduction Typical Project Types and Costs Maintenance –Maintain existing equipment and operations Improvement –Modify existing equipment, processes, and management and information systems to improve efficiency, reduce costs, increase capacity, improve product quality, etc. Replacement –Replace outdated, worn-out, or damaged equipment or outdated/inefficient management and information systems

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Financial Feasibility Analysis 9 Cash Flow Cash Flow Concept Common management planning tool Distinguishes between Costs: cash outflows Revenues/savings: cash inflows

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Financial Feasibility Analysis 10 Cash Flow Types of Cash Flow One-time Annual Other Inflow Equipment salvage value Operating revenues & savings Working capital Outflow Initial investment cost Operating costs & taxes Working capital

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Financial Feasibility Analysis 11 Cash Flow Costs and Savings Initial investment costs –purchase of the camera system, delivery, installation, start-up Annual operating costs (and savings) –Operating input — materials, energy, labour –Incineration — fuel, fuel additive, labour, ash to landfill –Wastewater treatment — chemicals, electricity, labour, sludge to landfill

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Financial Feasibility Analysis 12 Cash Flow Working Capital and Salvage Value Working capital: total value of goods and money needed to maintain project operations –Raw materials inventory –Product inventory –Accounts payable/receivable –Cash-on-hand Salvage Value: resale value of equipment or other materials at the end of the project

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Financial Feasibility Analysis 13 Cash Flow Timing Salvage Value End of project: Time zero: Initial Investment TIME Year 1Year 2Year 3 Annual Revenues/Savings

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Financial Feasibility Analysis 14 Cash Flow Incremental Analysis Needed for many CP or EE projects Compares cash flow of implemented options to the “business as usual” cash flow Covers only the cash flows that change

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Financial Feasibility Analysis 15 Profitability Indicators Definition: “a single number that is calculated for characterisation of project profitability in a concise and understandable form” Common indicators 1.Simple Payback 2.Return on Investment (ROI) 3.Net Present Value (NPV) 4.Internal Rate of Return (IRR)

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Financial Feasibility Analysis Simple Payback Definition: number of years it will take for the project to recover the initial investments Usually a rule of thumb for selecting projects, e.g. payback must be < 3 years Simple Payback (in years) Investment Cash Flow =

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Financial Feasibility Analysis Return on Investment Simple Payback (in years) Initial Investment Year 1 Cash Flow = ROI (in %) Year 1 Cash Flow Initial Investment = 3 years 33% Definition: the percentage of initial investment that is recovered each year

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Financial Feasibility Analysis 18 Workshop Exercise PLS Company: produces rolls of laminated film INVENTORY SLITTING solvent air emissions solvent air emissions printed laminated film plastic film, ink plastic film, aluminium film, adhesive PRINTING LAMINATION Liquid waste ink Solid scrap to waste management to waste management Solid scrap printed film

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Financial Feasibility Analysis 19 Workshop Exercise PLS Company installs QC Camera Printing step Printing errors cause high scrap rate Quality Control (QC) 3-camera system –Detect printing errors –Operators halt the operations before too much solid scrap is generated QC camera system costs US$105,000 to purchase and install 40% reduced scrap and operating costs

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Financial Feasibility Analysis 20 Workshop Exercise Question 1: Calculate annual cash flows using the cash flow worksheet (15 min) Question 2: Calculate simple payback (5 min)

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Financial Feasibility Analysis Net Present Value Money Loses its Value Question: If we were giving away money, would you rather have: (A) $10,000 today, or (B) $10,000 3 years from now Explain your answer...

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Financial Feasibility Analysis Net Present Value Inflation Money loses purchasing power over time as product/service prices rise, so a dollar today can buy more than a dollar next year costs $1 costs $1.05 inflation 5% now next year

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Financial Feasibility Analysis Net Present Value Return on Investment A dollar that you invest today will bring you more than a dollar next year — having the dollar now provides you with an investment opportunity 10 % interest, or “ return on investment ” Investing $1 now Investment Gives you $1.10 a year from now

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Financial Feasibility Analysis Net Present Value PLS Company’s QC Camera Project Initial Investment Cost Annual Operating Costs Business As Usual Annual Savings = US$38,463 Installing quality control camera 0 $ 105,000 $ 2,933,204 $ 2,894,741 (in US$)

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Financial Feasibility Analysis Net Present Value Question Is the annual savings of $38,463 per year for 3 years a sufficient return on the initial investment of $ 105,000?

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Financial Feasibility Analysis Net Present Value Time Value of Money Money is worth more now than in the future because of –Inflation –Investment opportunity “Time value” of money depends on –Rate of inflation –Rate of return on investment

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Financial Feasibility Analysis Net Present Value Cash Flows from Different Years Before you can compare cash flows from different years, you need to convert them all to their equivalent values in a single year It is easiest to convert all project cash flows to their “present value” now, at the very beginning of the project

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Financial Feasibility Analysis Net Present Value Converting Cash Flows to Present Value End of project Time zero: Initial Investment = $105,000 TIME Year 1Year 2Year 3 $38,463 = ?? Annual Savings

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Financial Feasibility Analysis Net Present Value Converting Cash Flows to Present Value Discount rate: Converts future year cash flows to their present value Incorporates: –Desired return on investment –Inflation Reverse of an interest rate calculation

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Financial Feasibility Analysis Net Present Value Discount Rate & Interest Rate Invested at an interest rate of 20%, how much will $10,000 now be worth after 3 years? $10,000 x 1.20 x 1.20 x 1.20 = $17,280 At a discount rate of 20%, how much do I need to invest if I want to have $17,280 in 3 years? $17, x 1.20 x 1.20 = $10,000

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Financial Feasibility Analysis Net Present Value Which Discount Rate? 3. Net Present Value Which Discount Rate? Equal to the required rate of return for the project investment, based on –A basic return - pure compensation for deferring consumption –Any ‘risk premium’ for that project’s risk –Any expected fall in the value of money over time through inflation At least cover the costs of raising the investment financing from investors or lenders (i.e. the company’s “cost of capital”) A single “Weighted Average Cost of Capital” (WACC) characterises the sources and cost of capital to the company as a whole

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Financial Feasibility Analysis Net Present Value Calculating “Present Value” Present Value = Future Value n x (PV Factor) Value of the cash flow in year n Value of cash flow at “Time Zero,” i.e. at project start-up Present Value (PV) Factors or “discount factors” For various values d (discount rate): 10%, 15%, 20% For various years n (number of years) Tables available

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Financial Feasibility Analysis Net Present Value The Value of a Future $1 Discount rate (d): 10% 20% 30% 40% Years into future (n) Handout: Table with discount rates Present value factors

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Financial Feasibility Analysis Net Present Value Net Present Value (NPV) Definition: sum of present values of all project’s cash flows –Negative (cash outflows) –Positive (cash inflows) Characterises the present value of the project to the company – If NPV > 0, the project is profitable – If NPV < 0, the project is not More reliable than Simple Payback or ROI as it considers –Time value of money –All future year cash flows

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Financial Feasibility Analysis Net Present Value Workshop Exercise (15 min) Expected Future Cash Flows - $105,000 + $38,463 PV Factor Present Value of Cash Flows (at time zero) - $??? $??? Year X = ??? Sum = project’s Net Present Value = Question 3: Calculate the NPV

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Financial Feasibility Analysis 36 Question 4: compare the Simple Payback and the NPV 3. Net Present Value Workshop Exercise (5 min)

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Financial Feasibility Analysis Net Present Value Sensitivity Analysis In business as usual scenario PLS Company needs waste water treatment plant in year 3: $150,000 investment –With QC project: $95,000 –Savings: $55,000 Also consider taxes! –Pollution taxes / fees –Tax deductions for equipment depreciation –Tax deduction for “environmental projects”

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Financial Feasibility Analysis Net Present Value Workshop Exercise (answer B) Expected Future Cash Flows - $105,000 + $38,463 + $93,463 PV Factor Present Value of Cash Flows (at time zero) Year X = Sum = project’s Net Present Value = - $105,000 33,447 29, ,981

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Financial Feasibility Analysis Internal Rate of Return (IRR) Definition: discount rate for which NPV = 0, over the project lifetime Tells you exactly what “discount rate” makes the project just barely profitable Similar to NPV, considers –Time value of money –All future year cash flows

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Financial Feasibility Analysis 40 Profitability Indicators Summary AdvantagesDisadvantages Easy to useNeglect TVM Neglect out-year costs Do not indicate project size Considers TVM Needs firm ’ s discount rate Indicates project size Considers TVMRequires iteration Does not indicate project size Simple Payback & ROI NPV IRR

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Financial Feasibility Analysis 41 Financial Feasibility Analysis of Options Thank you for your attention!

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Financial Feasibility Analysis 42 This training session was prepared as part of the development and delivery of the course “Energizing Cleaner Production” funded by InWent, Internationale Weiterbildung und Entwicklung (Capacity Building International, Germany) and carried out by the United Nations Environment Programme (UNEP) The session is based on the presentation “Financing Cleaner Production and Energy Efficiency Projects” from the “Energy Efficiency Guide for Industry in Asia” developed as part of the GERIAP project that was implemented by UNEP and funded by the Swedish International Development Cooperation Agency (Sida). The workshop exercise is taken from “Profiting from Cleaner Production”, in Strategies and Mechanisms For Promoting Cleaner Production Investments In Developing Countries, developed by UNEP Acknowledgements

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