Presentation on theme: "Energizing Cleaner Production"— Presentation transcript:
1 Energizing Cleaner Production Financial Feasibility AnalysisEnergizing Cleaner ProductionManagement Course
2 Profitability Indicators Session Agenda:IntroductionCash FlowProfitability IndicatorsSimple PaybackReturn on Investment (ROI)Net Present Value (NPV)Internal Rate of Return (IRR)
3 But first…In what step(s) of the methodology is financial feasibility analysis relevant?Ask participants to indicate in what steps of the methodology is financial feasibility relevant?(Click once) Arrows appear:Task 4a – technical, economic and environmental feasibility analysisTask 5a – implement options and monitor results (here the financial costs and savings of implemented options are measured and compared to the calculated values in task 4a)
5 Introduction Questions Management Will Ask 1. Is the project profitable?Initial investment costsAnnual operating costs and savingsCost of operating inputsCost of waste managementLess tangible costsRevenues2. Determine availability of internal investment funds for bigger projects3. Obtain external financing for remaining projects
6 Introduction Capital Budgeting Process Process by which organisation decides:Which investment projects areNeededPossibleSpecial focus on projects that require significant up-front capital investmentHow to allocate available capital between different projectsIf additional capital is needed
7 Introduction Capital Budgeting Practices Vary widely from company to companyLarger companies tend to have more formal practices than smaller companiesLarger companies tend to make more and larger capital investments than smaller companiesSome industry sectors require more capital investment than othersVary from country to country
8 Introduction Typical Project Types and Costs MaintenanceMaintain existing equipment and operationsImprovementModify existing equipment, processes, and management and information systems to improve efficiency, reduce costs, increase capacity, improve product quality, etc.ReplacementReplace outdated, worn-out, or damaged equipment or outdated/inefficient management and information systems
11 Cash Flow Costs and Savings Initial investment costspurchase of the camera system, delivery, installation, start-upAnnual operating costs (and savings)Operating input — materials, energy, labourIncineration — fuel, fuel additive, labour, ash to landfillWastewater treatment — chemicals, electricity, labour, sludge to landfill
12 Cash Flow Working Capital and Salvage Value Working capital: total value of goods and money needed to maintain project operationsRaw materials inventoryProduct inventoryAccounts payable/receivableCash-on-handSalvage Value: resale value of equipment or other materials at the end of the project
13 Cash Flow Timing Year 1 Year 2 Year 3 Salvage Value End of project:Salvage ValueAnnual Revenues/SavingsYear 1Year 2Year 3TIMETime zero:Initial Investment
14 Cash Flow Incremental Analysis Needed for many CP or EE projectsCompares cash flow of implemented options to the “business as usual” cash flowCovers only the cash flows that change
15 Profitability Indicators Definition: “a single number that is calculated for characterisation of project profitability in a concise and understandable form”Common indicatorsSimple PaybackReturn on Investment (ROI)Net Present Value (NPV)Internal Rate of Return (IRR)
16 Simple Payback (in years) Definition: number of years it will take for the project to recover the initial investmentsUsually a rule of thumb for selecting projects, e.g. payback must be < 3 yearsSimple Payback (in years)InvestmentCash Flow=
17 Simple Payback (in years) 2. Return on InvestmentDefinition: the percentage of initial investment that is recovered each yearInitial InvestmentYear 1 Cash FlowSimple Payback (in years)=3 yearsYear 1 Cash FlowInitial InvestmentROI (in %)33%=
18 Workshop Exercise PLS Company: produces rolls of laminated film INVENTORYSLITTINGsolvent airemissionsprintedlaminatedfilmplastic film, inkplastic film, aluminium film, adhesivePRINTINGLAMINATIONLiquid wasteinkSolid scrapto wastemanagementThe PLS Company is a medium-sized firm that produces rolls of printed, laminated film. The film is sold to food processing companies, who use it to manufacture food packages such as flexible pouches for fruit juices. The acronym PLS reflects the three main manufacturing steps at the facility: Printing, Laminating, and Slitting.
19 Workshop Exercise PLS Company installs QC Camera Printing stepPrinting errors cause high scrap rateQuality Control (QC) 3-camera systemDetect printing errorsOperators halt the operations before too much solid scrap is generatedQC camera system costs US$105,000 to purchase and install40% reduced scrap and operating costsThe PLS Company bought a quality control (QC) camera system and installed it on the print line. Full production run printing errors could then be detected earlier than was possible without the cameras. The project reduced the scrap rate from full production runs by about 40% and reduced annual operating costs accordingly.
20 Workshop ExerciseQuestion 1: Calculate annual cash flows using the cash flow worksheet (15 min)Question 2: Calculate simple payback (5 min)Note to the trainer: the 1.5 hour session does not include question 1, so only do this question if you have sufficient time.
21 3. 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...
22 3. 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 yearinflation 5%costs $1costs $1.05nownext year
23 3. 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 opportunityGives you $1.10 a year from nowInvesting $1 nowInvestment10 % interest, or “return on investment”
24 3. Net Present Value PLS Company’s QC Camera Project Initial InvestmentCostAnnual OperatingCostsBusiness As Usual$ 2,933,204Annual Savings =US$38,463Installing quality control camera$ 105,000$ 2,894,741(in US$)
25 3. 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?
26 3. Net Present Value Time Value of Money Money is worth more now than in the future because ofInflationInvestment opportunity“Time value” of money depends onRate of inflationRate of return on investment
27 3. 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 yearIt is easiest to convert all project cash flows to their “present value” now, at the very beginning of the project
28 3. Net Present Value Converting Cash Flows to Present Value Annual SavingsEnd of project= ??$38,463$38,463$38,463Year 1Year 2Year 3TIMETime zero:Initial Investment = $105,000
29 3. Net Present Value Converting Cash Flows to Present Value Discount rate:Converts future year cash flows to their present valueIncorporates:Desired return on investmentInflationReverse of an interest rate calculation
30 3. 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 = $17,280At a discount rate of 20%, how much do I need to invest if I want to have $17,280 in 3 years?$17,2801.20 x 1.20 x = $10,000Discount rate is basically the opposite of interest rate
31 3. Net Present Value Which Discount Rate? Equal to the required rate of return for the project investment, based onA basic return - pure compensation for deferring consumptionAny ‘risk premium’ for that project’s riskAny expected fall in the value of money over time through inflationAt 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
32 3. Net Present Value Calculating “Present Value” Value of the cash flow in year nPresent Value = Future Valuen x (PV Factor)Value of cash flow at “Time Zero,” i.e. at project start-upPresent Value (PV) Factors or “discount factors”For various values d (discount rate): 10%, 15%, 20%For various years n (number of years)Tables available
33 3. Net Present Value The Value of a Future $1 Discount rate (d): 10% 20% 30% 40%Years into future (n)Present value factorsHandout: Table with discount rates
34 3. Net Present Value Net Present Value (NPV) Definition: sum of present values of all project’s cash flowsNegative (cash outflows)Positive (cash inflows)Characterises the present value of the project to the companyIf NPV > 0, the project is profitableIf NPV < 0, the project is notMore reliable than Simple Payback or ROI as it considersTime value of moneyAll future year cash flows
35 3. Net Present Value Workshop Exercise (15 min) Question 3: Calculate the NPVExpected Future Cash FlowsPresent Value of Cash Flows (at time zero)PVFactorYearX=123- $105,000+ $38,463- $???$??????Sum = project’s Net Present Value =
36 3. Net Present Value Workshop Exercise (5 min) Question 4: compare the Simple Payback and the NPV
37 3. Net Present Value Sensitivity Analysis In business as usual scenario PLS Company needs waste water treatment plant in year 3: $150,000 investmentWith QC project: $95,000Savings: $55,000Also consider taxes!Pollution taxes / feesTax deductions for equipment depreciationTax deduction for “environmental projects”See the answer sheet of the workshop exercise for more background information
38 3. Net Present Value Workshop Exercise (answer B) Expected Future Cash FlowsPresent Value of Cash Flows (at time zero)PVFactorYearX=123- $105,000+ $38,463+ $93,463.8696.7561.6575- $105,00033,44729,08261.452-18,981Sum = project’s Net Present Value =
39 4. Internal Rate of Return (IRR) Definition: discount rate for which NPV = 0, over the project lifetimeTells you exactly what “discount rate” makes the project just barely profitableSimilar to NPV, considersTime value of moneyAll future year cash flows
40 Profitability Indicators Summary Advantages DisadvantagesEasy to use Neglect TVMNeglect out-year costsDo not indicate project sizeConsiders TVM Needs firm’s discount rateIndicates project sizeConsiders TVM Requires iterationDoes not indicate project sizeSimplePayback& ROINPVIRR
41 Thank you for your attention! Financial Feasibility Analysis of OptionsThank you for your attention!
42 AcknowledgementsThis 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