Project Profitability Assessment

Project Profitability Assessment
Now we move on to the final major section of the course, profitability assessment. This section will draw upon the material discussed previously in the course.

Contents Capital budgeting (of “environmental” projects)
Project cash flows and simple payback The Time Value of Money (TVM) and Net Present Value (NPV) Two small group exercises Capital budgeting with inflation and tax Sensitivity analysis Key profitability indicators After identifying and estimating relevant costs for a proposed Cleaner Production project, the next component of the capital budgeting process is to evaluate the profitability of the project. Several indicators will be discussed. Some indicators, such as “Simple Payback” are easy to calculate, but have drawbacks. The calculation of other indicators, such as Net Present Value, are more involved but have the advantage of taking into account the concept of “time value of money” (discussed in more detail later). In small groups, participants will have an opportunity to practice calculating the profitability of a Cleaner Production project using a real case study, as well as discuss sensitivity analysis.

Capital Budgeting (of “Environmental” Projects)
[15 min] First, a presentation on the capital budgeting process will be given with a focus on environmental projects.

Capital budgeting The process by which an organization:
Decides which investment projects are needed & possible, with a special focus on projects that require significant up-front investment (i.e., capital) Decides how to allocate available capital between different projects Decides if additional capital is needed Capital budgeting is a process which involves collecting and analysing the costs and benefits of project in order to make the best possible investment decisions possible for the company. The word “capital” implies “funds to invest” — but don’t forget that some Cleaner Production projects are so easy to implement that they do not require any up-front investment at all. However, most of the same cost identification and estimation principles apply whether you need an up-front investment or not.

Capital budgeting practices
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 Capital budgeting practices may also vary from country to country Capital budgeting is typically not regulated, unlike external accounting and reporting standards for publicly held firms. However, accounting associations do usually give guidance— next slide.

Typical project types & goals (1)
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 Examples of project types with a Cleaner Production focus: Maintenance— e.g., proper maintenance of a piece of machinery can allow it to operate more efficiently and save money in energy costs and “down time” costs. Improvement— e.g., installing a solvent recovery system means less solvent purchases and less waste Replacement— e.g., replacing an old spray booth with a mode efficient model means purchasing less paint, reducing emissions, and improving worker safety because of improved air quality. (CONTINUED ON NEXT SLIDE)

Typical project types & goals (2)
Expansion e.g., obtain and install new process lines, initiate new product lines Safety make worker safety improvements Environmental e.g., reduce use of toxic materials, increase recycling, reduce waste generation, install waste treatment Others... CONTINUED Examples of project types: Expansion— e.g., creation of an environmentally friendly product line such as recycled plastic bags; double capacity of the facility by adding a new process line Safety— e.g., installing a ventilation system in a spray booth to reduce worker exposure to paint vapours; automate the movement of solvents via piping to reduce worker exposure Environmental— install on-site wastewater treatment, install stack scrubber to reduce air emissions, implement better materials handling methods to reduce scrap and waste Others? — Ask participants for other ideas. When reviewing these with the class, try to use examples given by the participants themselves in the last exercise.

The poor reputation of “environmental” investment projects
Many people in industry view “environmental” projects as increasingly necessary to stay in business, but as automatic financial losers because: they associate “environmental projects” with pollution control systems such as wastewater treatment plants, which can be quite costly (end-of-pipe) they are unaware of the potential financial benefits of preventive environmental management practices Ask the students if “environmental” projects at their facilities are generally viewed as financial losers or financial winners. “Environmental” projects are typically viewed as financial losers, partly because of the historical reliance of environmental regulation on expensive pollution control and treatment options.

We know better! We have learned that some environmental projects, i.e., Cleaner Production (CP) projects, can go hand in hand with: Production efficiency improvements Product quality improvements Production expansion So, do not place your project idea into a single narrow category — think broadly about all the possible benefits Cleaner Production investments can be profitable! Not only do the participants have to think differently, but their colleagues and the financial institutions as well.

Decision-making factors
Today’s focus Technical Project selection Regulatory Financial The financial aspect (the monetary value of the project) is only one component that is figured into the decision making process. Other aspects are important as well: Technical— Whether the project is technically feasible given the level of technology in the country, or whether the necessary replacement parts or service technicians are available. Regulatory— An upcoming regulation may completely change how valuable an investment project is. For example, if more stringent wastewater treatment standards are planned, an upgrade to a facility’s on-site wastewater treatment system will allow the company to avoid potentially large fines (and potential shut-down). Organisational— A company may be trying to pursue particular business strategies which will effect the types of projects that seem most attractive to implement. For example, if the company is trying to expand production in its current process line, then an upgrade may be a good investment. If a company is trying to get into new markets and phasing out of old ones, then upgrades may not make sense, and equipment for new product lines does make sense. Organizational

Project Cash Flows and Simple Payback
[15 min] Now we begin actual profitability assessment. First we need to understand the concept of project cash flows, and then we can use the indicator “Simple Payback” to conduct a project evaluation.

The Cash Flow Concept The Cash Flow Concept is a common management planning tool. It distinguishes between: (a) costs -> cash outflows (b) revenues/savings -> cash inflows “Cash out” are costs, “cash in” are revenues or savings. 12

Cash Flow Analysis Measures the difference between
Relies on every day life principles Measures the difference between What we received, and What we paid out Only cash receipts and cash payments are included in the analysis Applicable also to forecast cash available

Types of Cash Flows One-time Annual Other Outflow
Initial investment cost Operating costs & taxes Working capital Inflow Equipment salvage value Operating revenues & savings Working capital Some flows occur only once during a project— such as initial investment costs for a Cleaner Production investment project. Another example is a one-time savings resulting from an avoided cost, such as a costly waste-water treatment upgrade (the PLS example). Some flows occur every year— such as annual savings resulting from reduced material inputs and waste disposal costs after implementing a Cleaner Production project. Working capital is discussed in the next slide. 14

Cash Outflow Analysis (1)
INITIAL INVESTMENT Planning/ Engineering Permitting Site Preparation Purchased Equipment Working Capital Utility Systems & Connections Start-up/Training Contingency (Salvage Value)

Working Capital Working Capital is: “the total value of goods and money necessary to maintain project operations” It includes items such as: Raw materials inventory Product inventory Accounts payable/receivable Cash-on-hand Working capital examples are shown. 16

Salvage Value Salvage Value is the resale value of equipment or other materials at the end of the project Salvage usually happens at the end of a project. For example, if a Cleaner Production investment involves the purchase of a piece of equipment that will only last for five years, the sale of the equipment at the end of the project is considered the salvage value. 17

Cash Outflow Analysis (2)
Direct costs Input costs Other costs Loan repayments Interest on loan application

Cash Inflow Analysis Sales Savings Salvage value
Cash shortfall / surplus

Cash Flow Forecast/Projection (1)
We are looking at the likely future cash position. We examine the possible effects of changes in the cash flow components .

Cash Flow Forecast/Projection (2)
Make assumptions about likely outcomes regarding: Inflation Market size Demand for goods and services Interest Rates

Cashflow Projection Worksheet

Annual Operating Costs & Savings (see also Cleaner Production Investment Decision: Costs and Savings checklist) Operating Inputs Materials Energy Labour Floor Space Taxes Depreciation Cost of capital Waste Management includes waste handling, recycling, treatment, disposal, and regulatory compliance Materials Energy Labour Floor space Fees Taxes & Depreciation Cost of Capital Less Tangibles Productivity Future regulation Potential liability Insurance Company image Revenues Product sales By-product sales Pollution credits

Annual Operating Costs Annual Financing Payments
Timing of Cash Flows End of project: Salvage Value Annual Revenues/Savings Working capital Year 1 Year 2 Year 3 TIME This diagram depicts the cash flows for a project. It includes the initial investment at the beginning (left), annual costs and revenues (end of each year), and finally salvage value at the end of the project (right). Annual Operating Costs Annual Tax Payments Annual Financing Payments Time zero: Working Capital Initial Investment 24

Cash Flow Analysis structure
There are two basic ways to structure a project financial analysis: 1) Stand-alone analysis Considers only the cash flows of the proposed project 2) Incremental analysis Compares the cash flows of the proposed project to the “business as usual” cash flows A new Cleaner Production project is usually implemented in the context of already existing operations. This new project can be evaluated in two ways. The first considers only cash flows of the project itself. More often, though, an incremental analysis is conducted which takes into account a base case (business as usual) and a case after implementation of the Cleaner Production project. 25

Incremental analysis for CP
For many CP projects, you will need to do an incremental analysis — compare the CP cash flows to the “business as usual” cash flows You only need to estimate the cash flows that change when you improve the “business as usual” operations For the incremental analysis, though, you don’t need to evaluate costs for the entire facility, just relevant costs to the project. For example, the evaluation of the Quality Control camera project for PLS, the cost estimation was limited to the printing step. The profitability assessment of that project will also be limited to the printing step. 26

Profitability indicators
A profitability indicator, or “financial indicator”, is: “a single number that is calculated for characterisation of project profitability in a concise, understandable form.” Common examples are: Simple Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR) Now for the profitability calculations. This is a list of four that will be covered today. We will get started with Simple Payback before lunch. 27

Simple Payback (in years)
This indicator incorporates: the initial investment cost the first year cash flow from the project Simple Payback (in years) Initial Investment Year 1 Cash Flow Two pieces of information are needed to calculate Simple Payback for a Cleaner Production investment project: Initial investment First year total cash flow For Cleaner Production projects, the total cash flows for each year is expected to be POSITIVE, meaning that there are net savings each year (otherwise we would know right away that the project is not profitable). The cash flows for each year may or not be the same. For this calculation, only the cash flow for year 1 is used. The result of the calculation can be thought of as “the number of years it takes to pay back the investment.” = 28 24

How to interpret simple payback
The simple payback calculated for a project is usually compared to a company rule of thumb called a “hurdle” rate: e.g., if the payback period is less than 3 years, then the project is viewed as profitable Different companies expect (and require) projects to pay themselves back within a certain number of years— called the “hurdle rate”. Projects must pay themselves back in LESS time than the hurdle rate. For example, if a company has a hurdle rate of 3 years, the payback on the project must be less than three years for this company to consider it profitable enough to implement it. 29

Small Group Exercise: Profitability Assessment at the PLS Company— Part I “Cash Flows & Simple Payback” Ask the participants to pull the entire exercise out of the notebooks so that it will be easier to work on. [30 min]

The PLS company’s QC camera project
PLS decided to purchase and install a camera system to monitor quality control (QC) of the print jobs as they actually occur Allows the operators to detect print errors earlier and halt the operations before too much solid scrap is generated Has reduced generation of full-run solid scrap by about 40% This is the second Cleaner Production project at PLS — a little more complex than the scrap recycling project. This QC camera project focused on reducing scrap from full production runs in the Printing step. It has significant waste reductions! 143

Costs and savings included in the QC camera analysis
Initial investment costs purchase of the camera system, delivery, installation, start-up Annual operating costs (and savings) Operating input — materials (plastic film, ink), energy, labour Incineration — fuel, fuel additive, labour, ash to landfill Wastewater treatment — chemicals, electricity, labour, sludge to landfill In order to conduct a profitability assessment, we will need to determine the initial investment costs and the annual operating savings (we assume this project will result in savings!) from these three categories. 32

QC camera project Cash flows
Annual savings = ??? Year 1 Year 2 Year 3 TIME Annual Tax Payments = 0 (PLS has tax holiday) Financing Payments = 0 (PLS paid cash) Here is a cash flow diagram for this project. We are told that the initial investment for this project is US$105,000. But we now need to know the annual savings. Time zero: Working Capital = 0 (not important for this project) Initial Investment = $105,000 33

Initial Investment Cost Annual Operating Costs Business As Usual ??? Annual Savings = ??? The QC Camera Project The annual savings can be considered by looking at the incremental cost change resulting from the project. We can calculate the annual savings by taking the annual operating costs “before” implementation and subtract from it the annual operating costs “after” implementation. This difference is the annual savings. US $ 105,000 ??? 34

Exercise instructions Part I
Introduction (5 min.), detailed in your handout Question 1 (15 min.) Question 2 (5 min.) Discuss your answers with the other small groups and the instructor (5 min.) Review the exercise goals and instructions with the class. See the Instructor Notes for this exercise for more details.

The Time Value of Money and Net Present Value (NPV)
[30 min] In order to understand the financial indicator called Net Present Value (NPV), participants will have to understand the concept of time-value-of-money. Main learning points in the session: Technique of evaluation by companies of potential projects, by present value Concept of time value of money The 3 elements of the time value of money The basic question — is the money which is expected to come in, in future, sufficient to justify paying out money on the initial investment which is required now?

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... First, invite answers — people should agree on (A). Then, ask them to define WHY they would prefer money now. The point is that there is more than one reason, and the aim is to get participants to identify the THREE distinct reasons of: Inflation A basic rate of return (to persuade people to defer their consumption), and Risk Emphasise that the reason is not only inflation (though this may be the most obvious one to many). Ask them to imagine a situation (if they can!) where: There is no inflation ($1 will buy exactly the same in 3 years as it does today), or their loan is ‘inflation-proofed’ (guaranteed against inflation) There is no risk - they are putting their money with an entirely safe institution, e.g. a major international bank. Even in this situation, most people would still require some positive real return on their money to be persuaded to tie it up for some time rather than to enjoy it immediately.

Inflation costs $1.05 costs $1 inflation 5%
Money loses purchasing power over time as product/service prices rise, so a dollar today can buy more than a dollar next year. inflation 5% Inflation rates can be widely different in different countries and at different times. As we know from experiencing inflation, the same item will go up in price as time passes— things cost more in the future. As a result of inflation, money is more valuable now than later. We can say that money loses purchasing power over time. (Unless it is invested into something where it can make some money back— like Cleaner Production). costs $1.05 costs $1 next year now 38

Investment opportunity
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 Gives you $1.10 a year from now Investing $1 now Investment Point out that from the viewpoint of the company which is borrowing money (or raising it through equity), the lenders’ perceptions of risk may be open to influence by the company. If it can persuade lenders that the project is a low-risk one, it may be able to borrow money more cheaply. Inflation, though, is outside the influence of any single company. Interest, or “return on investment” 39

Time Value of Money (TVM)
Money now is worth more than money in the future because of: a) inflation b) investment opportunity The exact “time value” of your money depends on the magnitude of the: a) rate of inflation and b) rate of return on investment Summary of points made so far.

TVM and project profitability
When you invest in a capital project, you have: (1) An initial investment happening NOW (2) A series of future cash inflows, over time, that pay back the initial investment So, it is important to take the Time Value of Money (TVM) into account when you are estimating project profitability How does the concept of Time Value of Money apply to project profitability? Because you want to make a comparison between the total value of these two things: (1) Total value of initial investment (2) Total value of all annual future cash flows (savings) together In order to to that, and knowing that money changes value over time, we want to know the total value of all the annual future cash flows (2) in TODAYS DOLLARS. That way we can compare apples and apples. Both (1) and (2) need to be in today’s dollars to be able to make a comparison. Net Present Value allows you to do this.

Initial Investment Cost Annual Operating Costs Business As Usual $ 2,933,204 Annual Savings = US$38,463 The QC Camera Project Let’s look again at the Cleaner Production project at PLS. This slide shows the incremental costs/savings. For an initial investment cost of US $105,000, the cost savings of $38,463 per year was experienced. $ 105,000 $ 2,894,741 (in US$) 42

Question: Is the annual savings of $38,463 per year for 3 years a sufficient return on the initial investment of $ 105,000? This is the question the company has to address in its analysis. Invite participants to suggest answers — then say “let’s see” and move on to the next slide!

Answer? You might think about adding up the annual savings over the 3 years: Savings per year $38,463 x 3 years Total savings $115,389 But: this ignores the Time Value of Money (the fact that $38,463 in year 1 is not the same as $38,463 in year 2 or year 3) A ‘straw man’ answer - it has been stated only so that it can be easily knocked down again. Refer back to the opening question ‘would you prefer $10,000 now or in 3 years?’. Since any given amount is more attractive sooner rather than later, this shows that the value of money depends not only on the amount but also on when you receive it; the time value of money (repeat and emphasise this term)

Comparing 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 Here we talk again about the need to compare the investment cost with all future cost savings. To do this, it is easiest to convert all future annual cost savings to their PRESENT VALUE, which is the value of all these cash flows if they were to occur NOW (at the beginning of the project when the investment is made). 45

Converting the PLS cash flows to their “present value”
Annual Savings End of project = ?? $38,463 $38,463 $38,463 Year 1 Year 2 Year 3 TIME Here is a diagram to illustrate the cash flows. Even though the annual savings occur at different years, we can convert their values to be as if they occurred at the beginning of the project. Time zero: Initial Investment = $105,000 46

Converting cash flows to their present value
You can convert future year cash flows to their present value using a “discount rate” that incorporates: Desired return on investment Inflation The discount rate calculation is simple — mathematically, it is the reverse of an interest rate calculation How do these values get converted? How does money change value over time? The answer is that we need to use a “discount rate” (expressed as a percentage) which incorporates two concepts: The desired return on investment: if a company invests money somewhere, it expects to get a return on that investment. Why would a company invest in a project in their own company and get a return of 1% when they could invest it in a bank for 5% (for example). Inflation: the company expects that its investment will keep up with inflation. 47

Interest rate calculation
Invested at an interest rate of 20%, how much will $10,000 now be worth after 3 years? After year $10,000 x = $12,000 $10,000 x 1.20 x = $14,400 $10,000 x 1.20 x 1.20 x = $17,280 Note: these calculations are on a compound basis Note: the 20% is on a compound basis, i.e. it assumes that the interest is paid at the end of every year and can be re-invested at the start of the next year, so that the annual interest increases from year-to-year. The interest rate calculation is done in order to demonstrate the concept of time value of money. This will be the same with projects done by companies - the income earned from the project in Year 1 is available to be re-invested at the start of Year 2.

Discounting calculation
The discounting calculation is essentially the opposite of the interest rate calculation. If you want to have $17,280 in 3 years, how much would you have to invest now? $17, = $10,000 1.20 x 1.20 x needed now In other words, $17,280 in year 3 has a present value of $10,000 Calculation of compound interest is going forward in time. As we can see here, discounting is this process in reverse.

Which discount rate? (1) The discount rate a company chooses should be equal to the required rate of return for the project investment The required rate of return will usually incorporate three distinct elements: 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 This slide provides more information on how a company determines what rate of return is expected.

Which discount rate? (2) At a minimum, the chosen discount rate should cover the costs of raising the investment financing from investors or lenders (i.e. the company’s “cost of capital”) Often, rather than trying to identify the exact source of capital (and its associated cost) for each individual project, a firm will develop a single “Weighted Average Cost of Capital” (WACC) that characterises the sources and cost of capital to the company as a whole. More information on how a company chooses a discount rate. Participants do not need to have a full understanding of where discount rates come from, but do need to understand what a discount rate is and how it is used in NPV calculations.

Discounting (1) Present Value = Future Valuen (1 + d)n
The value of the cash flow in year n Present Value = Future Valuen (1 + d)n The value of the cash flow at “Time Zero,” i.e., at project start-up n = the number of years after project start-up d = the discount rate Here is the mathematical formula for discounting.To discount a future cash flow to a present value, this formula is used. Tables also can be used to make this calculation. 52

Discounting (2) Present Value = Future Valuen x (PV Factor)
The value of the cash flow in year n Present Value = Future Valuen x (PV Factor) Present Value (PV) Factors have been calculated for various values of d (discount rate) and n (number of years) and have been tabulated for easy use. (Also called discount factors) The value of the cash flow at “Time Zero,” i.e., at project start-up If you want to use tables, you will look up a Present Value factor based on the two important variables: number of years, discount rate. You then multiply this factor by the future value— this will result in the present value. (Participants will have a chance to practice these calculations in a few minutes). 53

PresentValue factors Value of $1 in the future, NOW
Discount rate (d): 10% 20% 30% 40% Years into future (n) A sample of possible combinations of rates of different rates of return and time-horizons. A handout of a fuller table is provided with the next group exercise. Computer spreadsheets can also be used to calculation present values of cash flows. Point out that this table shows that future money becomes increasingly less attractive, relative to its present value: The higher is the rate of return The further you go into the future

Net Present Value (NPV) If NPV > 0, the project is profitable
Net Present Value (NPV) = the sum of the present values of all of a project’s cash flows, both negative (cash outflows) and positive (cash inflows) NPV characterises the present value of the project to the company If NPV > 0, the project is profitable If NPV < 0, the project is not After converting all future cash flows to present values, you can add them all up together (including the initial investment) to get one total present value (or “Net” present value). If this value is greater than zero, it means that the future values MORE THAN OFFSET the initial investment. Profitable! If this value is less than zero, it means that the future values DO NOT OFFSET the initial investment. Not profitable.

Estimating Net Present Value
Expected Future Cash Flows Present Value of Cash Flows (at time zero) Year PV Factor = * 1 2 3 - $105,000 + $38,463 - $??? $??? ??? This table sets up a calculation of Net Present Value for the PLS QC Camera Cleaner Production project. The question marks in the “PV factor” column can be determined either with the mathematical formula, or with the tables. You will make these calculations now in a group exercise. Sum = the project’s Net Present Value = 56

Time for lunch! [60 min] You should remind participants where lunch is, and what time to return After lunch we will engage in a group exercise to practice Simple Payback calculations, and then move on to Net Present Value, a more complex (but more valuable) indicator.

Small Group Exercise: Profitability Assessment at the PLS Company— Part II “Net Present Value”
Ask the students to pull the entire exercise out of the notebooks so that it will be easier to work on. They should be be sure they take out the PV factor tables. [45 min]

Located in your handout
Also — you will need the handout: “Performing Net Present Value (NPV) Calculations” This handout will provide guidance in making these calculations. Located in your handout 3

Converting the PLS cash flows to their “present value”
End of project = ?? $38,463 $38,463 $38,463 Year 1 Year 2 Year 3 TIME Once again, here is the cash flow diagram. The annual savings need to be converted into present values. Time zero: Initial Investment = $105,000 60

Exercise instructions Part II
Introduction (5 min.), detailed in your handout Question 3 (15 min.) Question 4 (5 min.) Discuss your answers with the other small groups and the instructor (15 min.) Lessons learned (5 min.) Review the exercise instructions with the class. See the Instructor Notes for this exercise for more details.

Capital Budgeting: inflation & tax [30 min]
The exercise in the first part of this session ignored the potential effects of inflation and tax on project analysis. This introduces these additional factors, by examining how they would affect the analysis of the project that participants have just been working on. Some participants may find this content difficult, so take it steadily.

Discounting and inflation (1)
even without inflation, money has a time value due to supply/demand for money inflation increases both: future cash flows interest rates (and  discount rates) these offset each other Bullet 1 repeats the point made earlier in this session, that even in an economy where money maintained the same purchasing power over time (theoretically possible even if it may be difficult to imagine!), there would still usually be a demand for finance over time which would mean that there would be some positive interest rate due to people’s natural ‘impatience to consume’. Inflation does not alter this, though it makes the business environment more uncertain and difficult to deal with. If there is inflation, it will affect BOTH elements in a NPV analysis:- - future cash flows will increase, by the rate of inflation (this is assumes, for the moment, that this can be predicted - unlikely often to be valid, but a working assumption for the time being to get the main messages across) - correspondingly, investors/lenders will require a higher rate of return on their investments because they expect that because of inflation the $’s they will receive in future years will be worth less, in purchasing power, than the $’s they will have to invest today. To put it another way - in order to maintain the same real rate of return on their investments, they will require an increased nominal rate.

With 10% inflation (say), future cash flows will  by 10% each year Investors & lenders will also require a higher rate to compensate for their loss in purchasing power If 15% was acceptable with no inflation, with 10% inflation they will now require 115% x 110% = 126.5% Ask participants: suppose you would be prepared to lend your money only if you get a rate of return of 10%, in real terms? - i.e. to give up consuming 10 units of a product today only if you will instead receive 11 units in 1 year. If there is inflation in the economy, i.e. the value of money is falling over time, of (say) 20% this will mean that the price of this product will increase from (say) $10 today to $12 in 1 year. To be able to purchase 11 units in 1 year’s time would therefore require a money sum at that time of (11 $12) = $132. Therefore, if an investor who requires a real return on their money of 10% expects inflation in the next year of 20%, they will require a nominal rate of return of (110% x 120%) - 100% = 132% - 100% = 32% This simple arithmetic calculation of course ignores several practical problems in dealing with inflation in practice (as many participants may be able to testify!), in particular predicting in advance with any confidence what level inflation is likely to be at in future years. However the main point is that inflation and increased discount rates tend to offset each other. Support this by pointing out that economies with higher-than-average rates of inflation usually also tend to have similarly higher-than-average interest rates.

PLS Company, now assuming 10% inflation and 26.5% discount rate: Year Cash flow PV factor PV ($) @ 26.5% ($) 1 42, ,466 2 46, ,088 3 51, ,289 87,843 less: initial investment 105,000 Net Present Value ,157 i.e. same NPV* as with zero inflation, 15% discount rate * ignoring minor rounding difference

What is the current rate of inflation in the economy?
What return on their capital will the lender really earn on their money, after allowing for the erosion of their capital over time through inflation? This slide provides an opportunity for participants to talk about their own national circumstances, and to relate the general principles to this, and for some interactive discussion.. Check before the course the current level of inflation in the economy and prevailing levels of interest rates (but also ask participants to volunteer the amount, so they can show their awareness). From these, calculate (on flipchart) what the effective real rate of return is that investors/lenders are receiving. Point out that part of the interest rate on the lender’s money is merely compensation for the loss of part of their capital through inflation. If they are to maintain the value of their capital over time in terms of its purchasing power, they would have to re-invest this, merely not to be worse off in real terms. If they were to consume this, they would effectively be living off their capital. It is only any interest received in excess of inflation that is their real return, which they can safely consume without being worse off. It is possible that at a particular point in time, the inflation in a country may exceed its current interest rates. If so, explain that this is usually only a short-term phenomenon. Strictly, the relevant inflation rate here is what lenders expect it to be in the future, which may not be the same as what it has been in the recent past (which is what official inflation rates tell you). If real interest rates were permanently negative this would imply that savers were actually prepared to pay borrowers for the privilege of having their money looked after for them. This is theoretically possible but not normal.

Tax payments Taxes can be an important project cash flow
Depending on a facility’s location, a firm may have to pay national and/or local income taxes on the revenues or savings generated by a project Other types of taxes may also be relevant - sales taxes, pollution taxes, etc. Taxes may be an important component of the annual cash flows. New environmental taxes (or expected ones) are important considerations in your assessment. Introduce country- or region-specific tax information if it is applicable. 67

Tax deductions or credits
Tax deductions or credits can also be important One example is the income tax deduction often given for equipment depreciation, which is the loss in value of a physical asset (e.g., a piece of equipment) as the asset ages Some “environmental” investments can receive special tax credits Firms should take advantage of tax deductions when possible. Also, it is possible to receive special tax credits for environmental investments. This addition to the cash flow is important. Add country- or region- specific information on credits for environmental projects if available. 68

Tax and project appraisal
assume 30% rate of taxes of firms’ profits tax is based on accounting profits, not on cashflows accounting profits are after deducting depreciation tax is payable 1 year after the profits have been realised The treatment of tax here is a generic example, and there will undoubtedly be national differences. These could include:- - a rate different to 30% (some countries have different rates for different types of firms, e.g. depending on size) - the period allowed to pay the tax more be more or less than 1 year - there may be different possible methods of calculating depreciation - there may be special incentives allowed by government through the tax system to certain industry sectors or for particular types of project - other differences, depending on national tax laws. Emphasise here that tax is invariably calculated on accounting profits, not on cashflows. However, the NPV calculation is still based on cashflows.

Depreciation A project needs $12,000 for a new machine which will last 3 years assume the machine has no residual value after 3 years depreciation per year: initial cost = $12,000 = $4,000 per year asset life 3 years For simplicity, this assumes the simplest possible method of depreciation: straight line, with no residual value of the asset at the end of its life. Explain that there may be other methods which apply in the particular country, in particular ‘reducing balance’ methods. However the basic method of calculating the tax payable, and the NPV of a project taking this into account, are not affected by this.

Profit earned by project
Profit earned by project in each year: cash inflow per year $6,000 less: depreciation $4,000 contribution to profit $2,000 30% $600 This calculates the tax payable on each year’s profits.

NPV of project, with tax time cash tax net PV PV factor
now -12, , ,000 1 +6, , ,000 2 +6, , ,750 3 +6, , ,125 Net Present Value $414 If tax is brought in, the effects of the project on the firm will now stretch into Year 4, since the tax is paid a year after the profits have been realised. The tax of $600 on Year 3’s profits is paid in Year 4, after the project itself has ended. This calculation indicates that if tax is brought in, then the project becomes unattractive. Note however that if the analysis is done on after-tax cash flows then the discount rate should be less than if it were done on pre-tax cash flows. This would mean a lower discount rate, which might compensate for the cash which is going out to pay the tax.

Project appraisal with inflation and tax
depreciation (and accounting profits) are based on the asset’s original cost the asset’s original cost does not increase with inflation over the life of the project project analysis is then easier using nominal (not real) cashflows and discount rates It is not essential that all participants fully understand the reasoning behind this at this stage, but they should be aware of the complicating effects of evaluating projects with tax brought into the analysis, particularly in high-inflation countries. ‘Nominal’ here means:- - future cashflows include an allowance for expected inflation - the discount rate is based on the full amounts expected to be paid - i.e. including all 3 elements of time-value of money, compensation for inflation, and risk. You can mention that the effect of this is that projects (and firms’ activities generally) tend to become less profitable, since they are paying tax on the inflated amounts of the inflows, but getting relief on the cost of the original assets at only a low, outdated amount. The effect of this is greater, the higher the level of inflation (and the higher the tax rate) in the particular country.

Some good reasons to use a longer analysis time horizon
Some out-year costs may be missed if the time horizon is too short, e.g., a required wastewater treatment plant upgrade in the future Some annual operating costs may change significantly over time, e.g., disposal fees at landfills Short time horizons neglect the impact of the time value of money, especially in times of significant inflation, deflation, changing cost of capital, etc. We recommend using a longer analysis time horizon! This allows more future years of cost savings to be included in your analysis. 143

Profitability assessment tips
Be sure to: Include all relevant and significant costs/savings in the profitability analysis Think long-term (or at least medium-term!) Incorporate the time value of money Use multiple profitability indicators Perform sensitivity analyses for data estimates that are uncertain This list highlights the important things to consider when doing profitability assessments.

Time for a break! [15 min] Be sure to tell participants exactly what time to return and that they should be timely.

Sensitivity Analysis [15 min]
This short section mentions some elements that should help interpret profitability indicators, such as sensitivity analysis.

Sensitivity Analysis Introduction
An important management tool questioning potential project benefit risks. Assumptions surrounding a project are computed to produce a base NPV and IRR. From the base case, changes in the original assumptions are made to gauge their effect on the NPV and IRR. Input variables varied adversely by 10%

Sensitivity Analysis Example Input Variables Varied by 10%

Sensitivity Analysis Summary
Sensitivity Analysis permits project proposals to be evaluated simply. The model can evaluate sensitive variables without having to input any additional data.

Sensitivity Analysis Conclusion
By amending the original data, a variable whose change generates a negative NPV and /or an IRR lower than the firm’s cost of capital, is deemed to be sensitive. An investigation would need to be undertaken for a contingent plan. If results of the investigation are unfavourable, the project is unacceptable on economic grounds. However, development projects with social aspects may be treated differently.

Key Profitability Indicators
[15 min] This section summarises profitability indicators. Two new ones are introduced.

Profitability indicators
We have seen so far: Simple Payback Net Present Value (NPV) But there are others, common examples are: Return on Investment (ROI) Internal Rate of Return (IRR) ROI and IRR are just being introduced for the first time. Some participants may not have seen these before. They are discussed in more detail in the next few slides. 83

Simple Payback and Return on Investment (ROI)
These indicators incorporate: the initial investment cost the first year cash flow Initial Investment Year 1 Cash Flow Simple Payback (in years) = ROI is similar to Simple Payback— it is the inverse. It indicates the return on the investment in percent that the project will yield. Year 1 Cash Flow Initial Investment ROI (in %) = 84 24

How to interpret Simple Payback and ROI
The simple payback or ROI calculated for a project are usually compared to a company rule of thumb called a “hurdle” rate: e.g., if the project payback period is less than 3 years, then the project is viewed as profitable e.g., if the ROI is 33%, then the project is viewed as profitable Point out that the calculation on the last slide did not involve any discounting, so is usually called “simple payback”. The use of the payback method is sometimes criticised for encouraging companies to think only of-short-term benefits. 85

Net Present Value (NPV)
NPV is a more reliable profitability indicator than Simple Payback or ROI as it considers both the time value of money and all future year cash flows NPV = the sum of the discounted cash flows over the lifetime of the project, using the company’s cost of capital as the discount rate The reason so much time was dedicated to the concept of time value of money and NPV is because it is a very valuable tool which has advantages over Simple Payback. 86

Internal Rate of Return (IRR)
IRR is similar to NPV in that it considers both the time value of money and all future year cash flows IRR = the discount rate for which NPV = 0, over the project lifetime (calculated in an iterative fashion) It tells you exactly what “discount rate” makes the project just barely profitable IRR is closely related to NPV: They both involve discounting IRR is in fact defined in terms of NPV (“the rate of return at which NPV is zero”). IRR does not directly measure the actual amount that the project will add to total company value, so it is inferior to the NPV method.In other words, a very small project with a better IRR will not yield as much cash return as a large project with a smaller IRR. However some people find it more helpful to think in terms of a % rate of return on a project, than in terms of a monetary value. It also can be useful in determining what discount rate would be needed to make the project just barely over the edge of profitability. This ‘break-even’ rate of return is called the Internal Rate of Return (IRR) — “internal” since it has been calculated from just the data on this project, without reference to the rates currently ruling in external markets. It therefore does not in itself reflect anything about the rates of return which are currently being required by those external markets. Instead, the IRR can be used as a benchmark to compare against external market rates, to assess whether the project is likely to be profitable for the company. 87

Profitability indicator summary (1)
Advantage Disadvantage Easy to use Neglect TVM Neglect out-year costs Do not indicate project size Considers TVM Needs firm’s discount rate Indicates project size Considers TVM Requires iteration Does not indicate project size Simple Payback & ROI NPV IRR This table lists some advantages and disadvantages of the different profitability indicators. All points have already been mentioned, but allows participants to see it summarised in one place. 145

Profitability indicator summary (2)
NPV is generally the most valuable, problem-free indicator Other indicators that consider the time value of money (e.g., IRR) are also useful Payback and ROI are easy to understand and use, but of limited accuracy However, Simple Payback is particularly useful with uncertain or risky investment climates Two profitability indicators — IRR and payback— can be used as alternative methods to NPV for assessing the overall attractiveness of a project. However these are only second-best alternatives to NP. NPV is still the most appropriate measure because it directly reflects the value which is created by the project for the company (and therefore for its investors/lenders). The other two methods are sometimes used as an alternative to NPV (or as well as NPV) since they can be simpler to calculate and/or to understand. 89 26

Interpret profitability indicators with caution...
We have seen that Simple Payback has some limitations as a project profitability indicator Be aware of the advantages and limitations of the indicators you use The best approach is to use several indicators to give a balanced view of project profitability This slide is to alert participants that these profitability indicators cannot be used blindly. They are tools that provide information, and need to be used and interpreted properly to get meaningful results. Also indicate that a few other indicators will also be discussed a little later. 143

Other Profitability Assessment Issues
[15 min] This section briefly mentions some additional issues associated with conducting profitability assessments.

Other issues There are other issues that impact a project’s profitability, which we do not have time to address today Source and cost of project financing Can you think of others? The first two items will be discussed in the next several slides.

Project financing Different sources of project financing may have differing impacts on project profitability Be sure to take financing payments such as lease payments or payments on loan principal and interest into account appropriately when estimating profitability Of course, financing is necessary to obtain the capital for a Cleaner Production investment. 93

Project Profitability Assessment Summary and Q&A
[15 min] This section summarises and allows participants to ask questions, ask for clarifications, make comments.

Project profitability assessment
Capital budgeting (of “environmental” projects) Project cash flows and simple payback The Time Value of Money and Net Present Value (NPV) Two small group exercises Capital budgeting : inflation and tax Sensitivity analysis Key profitability indicators Ask participants if they have any questions regarding material covered in any of these sections.

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