Guidance on Financial Analysis of Cleaner Production Options Presentation 14 Presentation 14: Guidance on Financial Analysis of Cleaner Production Options

What will we learn here? Guidance on Financial Analysis of Cleaner Production Options Introduction: The Need for Financial Analysis Objectives of this Presentation Use of Cost Benefit Analysis in Financial Analysis Introduction to Cost Benefit Analysis Elements of Cost Benefit Analysis Case Study #1 Case Study #2 Criteria for Selection of Projects

Introduction: The Need for Financial Analysis Next Slide

Introduction: The Need for Financial Analysis Cleaner production options not only avoid and reduce waste generation, but also offer a direct cost advantage to the business. However, cleaner production options are typically long term, involving medium to high investment, and hence are perceived as a larger business risks than end-of-pipe solutions. The crux of the problem is that this risk is often not clearly quantified and predicted. Thus, financial analysis of cleaner production options becomes necessary.

Objectives of this Presentation Next Slide

Objectives of this Presentation To understand the basics of financial analysis To implement fundamental principles of financial analysis for cleaner production options To screen cleaner production options based on financial aspects

Introduction to Cost Benefit Analysis (CBA) Next Slide

Introduction to Cost Benefit Analysis (CBA) CBA facilitates the comparison of alternatives in terms of the monetary costs involved and the benefits obtained. The costs and benefits (environmental, social or economic) must be quantified in monetary terms to the maximum extent possible. Typically, CBA is used as a tool in feasibility studies for selection of an alternative together with for e.g., life cycle assessment, audits, etc. Thus, CBA is used in financial analysis to estimate the profitability of a potential investment for a cleaner production option.

Elements of CBA Next Slide

Elements of CBA Cash flow Present value (PV) Measures of Profitability Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index Depreciation

Cash Flow A Cash Flow is meant to illustrate incomes (“cash inflows”) and expenses (“cash outflows”). They may be conventional and non-conventional. Each arrow represents the time period of a year in this case. Conventional Cash Flow 5 Cash Inflows Cash Outflows $2,000 $600 Non-Conventional Cash Flow -2 Cash Inflows Cash Outflows $12,000 $7,500. . . . . . . . . . . . . . $7,500 $3,900 $2,600 -1 $10,000 $8,000 8

Present Value (PV) PV is a way of comparing the value of money now with the value of money in the future. A dollar today is worth more than a dollar in the future, because inflation erodes the buying power of the future money, while money available today can be invested to grow. Calculation of the PV requires the use of “interest rate”. Interest rate is typically a percentage used to calculate the PV. It reflects the time value of money. Generally, this interest rate is taken as equal to the prevailing bank interest rate. Assuming an interest rate of 10%, the PV of $100 three years from now is approximately $133.

Payback Period As the name suggests, the Payback Period is the length of time required to recover the cost of an investment. It is calculated with the formula below: Payback period = $ Invested $ Return per year Drawbacks - The payback period ignores the time value of money The payback period ignores cash flows after the initial investment has been recouped

Payback Period If the initial cost of the investment or $ invested = $ 20,000 and the net savings or $ return per year = $ 2,200; then Payback period = 20,000 / 2,200 = 9.09 years (say 9.1 years)

Net Present Value (NPV) NPV may be defined as the difference between the total present value of the cash inflows and the total present value of the cash outflows. NPV compares the value of the dollar today versus the value of that same dollar in the future, after taking inflation and returns into account. If the NPV of a prospective project is positive then it should be accepted (i.e. NPV > 0) However, if the NPV of a prospective project is negative, then the project should be rejected because cash flows are negative (i.e. NPV < 0) If the NPV of a prospective project is zero then it should probably be rejected as it generates exactly the return that is expected (i.e. NPV = 0)

Net Present Value (NPV) Let us calculate the NPV from a series of cash flows. The formula is given below. $500,000 $100,000 $150,000 $200,000 3 (positive cash flows) (negative cash flow) NPV = -CFo + CF1 + CF2 + CF3 + CFn (1+r)1 (1+r)2 (1+r)3 (1+r)n where CFX = cash flow in year x, n = number of periods (n=3), r = interest rate (say, 10%) NPV = -500,000 + 100,000 + 150,000 + 200,000 = -$134, 861 (1+0.1)1 (1+0.1)2 (1+0.1)3

Internal Rate of Return (IRR) The IRR method of analyzing a project or option allows one to find the interest rate that is equivalent to the dollar returns expected from the project or option. Once you know the IRR, you can compare it to the rates you could earn by investing your money in other projects or options. If the IRR is less than the cost of borrowing used to fund the project, the project will clearly be a money-loser. However, usually a business owner will insist that in order to be acceptable, a project must be expected to earn an IRR that is at least several percentage points higher than the cost of borrowing, to compensate the company for its risk, time, and trouble associated with the project.

Internal Rate of Return (IRR) As an example of how IRR works, let us say you are looking at a project costing $7,500 that is expected to return $2,000 per year for five years, or $10,000 in total. The IRR calculated for the project would be 10 percent. If your cost of borrowing for the project is less than 10 percent, the project may be worthwhile. If the cost of borrowing is 10 percent or greater, it will not make sense to do the project (at least from a financial perspective) because, at best, you will be breaking even.

Internal Rate of Return (IRR) The formula used for calculating the IRR is very similar to the formula used for calculating the NPV. The main difference is that in the IRR formula, you must solve for the interest rate “r”. 0 = -CFo + CF1 + CF2 + CF3 + CFn (1+r)1 (1+r)2 (1+r)3 (1+r)n where CFX = cash flow in year x, n = number of periods, r = interest rate (to be solved for)

Profitability Index (PI) The PI is the ratio of the PV of future cash inflows by the PV of cash outflows PI = PV of cash inflows PV of cash outflows If the 0 < PI < 1, the project or option should be rejected If the PI > 1, the project or option should be accepted

Depreciation Depreciation is defined as the decline in the value of an asset with the passage of time, due to general wear and tear or obsolescence Depreciation is a part and parcel of cash flow calculations Depreciation may be accounted for in the net annual savings of a cleaner production option

Case study #1 Next Slide

Let us examine the financial feasibility of installing the MF system Case Study #1: Financial Analysis of a Cleaner Production Option in a Bottle Washing Plant Background Bottle washing plant BWP utilizes a large quantity of water and caustic soda for bottle washing and rinsing operations As a cleaner production option, a certain percentage of the caustic soda is to be recovered from the resulting caustic solution, through the use of a membrane filtration (MF) system The recovered caustic will then be resold at the prevailing market price Let us examine the financial feasibility of installing the MF system

Case Study #1 - Calculations for the Value of Recoverable Caustic ($ / year) Table 1: Volume of caustic (m3) “A” Volume of caustic recovered per run* (m3) “B” = “A” X 0.65 Mass of caustic recovered per year** (kg/m3) “C” = “B” X 4 X 25 Value of caustic recovered per year*** ($ / year) = “C” X 0.5 210 136.5 13,650 6,825 Data * The overall caustic recovered from the MF system is 65% by volume ** The number of recovery runs at BWP is 4 times a year and the concentration of caustic by weight is 2.5% or 25 kg/m3 *** The cost of 1 kg of pure caustic solution is $0.5

Case Study #1 – Installation Cost for the MF System Table 2 System component Cost ($) Membrane 7,000 Feed pump 800 High pressure pump 1,600 Cartridge and power 400 Permeate tank 200 Pipes, valves, etc. 8,000 Total investment: 18,000 In addition to the initial investment, the manufacturer states that the membrane for the MF system will need to be replaced once in 3 years. The associated cost for this will work out to be $7,500. The total life of the MF system is 12 years.

Case Study #1 - Calculations for the Net Annual Uniform Savings Cost recovered from the sale of caustic annually – annual depreciation cost of the MF system – annual operating costs Here, depreciation cost of the MF system (assuming nil salvage value at the end of the 12 year period = (18,000 – 0) / 12 = $1,500 Also, annual operating costs = cost for power and the cartridge = $400 (from Table 2) So, net annual uniform savings = 6,825 – 1,500 – 400 = $4,925 (approx.)

Case Study #1 – Cash Flow Diagram for the Proposed MF System Cash Inflows (Net annual Uniform Savings) 12 $7,500 $18,000 $4,925…………………………………………………………$4,925 Cash Outflows (Initial Investment and Replacement Cost) Initial one-time investment = $18,000 Membrane replacement cost (once every 3 years) = $7,500 Net annual uniform savings = $4,925 / year

Case Study #1 – Calculation for NPV Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows 12 = 4,925  1 = $33,557 t=1 (1 + 0.1)t PV of cash outflows = 18,000 + 7,500 + 7,500 + 7,500 = $31,049 (1+0.1)3 (1+0.1)6 (1+0.1)9 NPV = PV of cash inflows – PV of cash outflows = $33,557 - $31,049 = $2,508 Since the resultant NPV > 0, the cleaner production option is financially viable.

Case Study #1 – Calculation for IRR IRR would need to be solved through iteration: 12 0 = 4,925  1 – 18,000 – 7,500 – 7,500 – 7,500 t=1 (1+r)t (1+r)3 (1+r)6 (1+r)9 Taking r = 12% (i.e. 12/100 = 0.12), Left Hand Side (LHS) = 664.63 Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49

Case Study #1 – Solving for the Exact Value of IRR Taking r = 12% (i.e. 12/100 = 0.12), LHS = 664.63 Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49 Solving for the exact value of IRR through interpolation: r – 12 = 0 – 664.63 r – 14 -152.49-664.63 IRR = 12.63% Since the IRR is greater than 10% (i.e. the rate of interest that the money would earn in the bank, investing in this cleaner production option is worthwhile.

Case Study #1 – Calculating the PI Calculating for the PI: PI = PV of cash inflows = 33,557 = 1.08 PV of cash outflows 31,049 Since PI > 1, this cleaner production option can be accepted; i.e. it is financially viable

Case study #2 Next Slide

Case Study #2: A Tweak on Case Study #1 (Pessimistic Scenario) Background The background for Case Study #2 stays the same as that for Case Study #1. However, there will be one change… let us say, that the prevailing market price of the recovered caustic falls to $0.35 per kg (previously, for Case Study #1, the said value was $0.5 per kg). Let us also say that the manufacturer’s claim for membrane replacement does not hold true, and that the membrane requires replacement once every two years. Let us examine the financial feasibility of installing the MF system for Case Study #2.

Case Study #2 - Calculations for the Value of Recoverable Caustic (Pessimistic Scenario) Table 3: Volume of caustic (m3) “A” Volume of caustic recovered per run* (m3) “B” = “A” X 0.65 Mass of caustic recovered per year** (kg/m3) “C” = “B” X 4 X 25 Value of caustic recovered per year*** ($ / year) = “C” X 0.35 210 136.5 13,650 4,778 Data * The overall caustic recovered from the MF system is 65% by volume ** The number of recovery runs at BWP is 4 times a year and the concentration of caustic by weight is 2.5% or 25 kg/m3 *** The cost of 1 kg of pure caustic solution is $0.35

Net annual uniform savings = Case Study #2 - Calculations for the Net Annual Uniform Savings (Pessimistic Scenario) Net annual uniform savings = Cost recovered from the sale of caustic annually – annual depreciation cost of the MF system – annual operating costs Here, depreciation cost of the MF system (assuming nil salvage value at the end of the 12 year period = (18,000–0)/12 = $1,500 (same as Case Study #1) Also, annual operating costs = cost for power and the cartridge = $400 (from Table 2, same as Case Study #1) So, net annual uniform savings = 4,778 – 1,500 – 400 = $2,878 (approx.)

Initial one-time investment = $18,000 Case Study #2 – Cash Flow Diagram for the Proposed MF System (Pessimistic Scenario) Cash Inflows (Net annual Uniform Savings) $2,878…………………………………………………………$2,878 12 $18,000 $7,500 $7,500 $7,500 $7,500 $7,500 Cash Outflows (Initial Investment and Replacement Cost) Initial one-time investment = $18,000 Membrane replacement cost (once every 2 years) = $7,500 Net annual uniform savings = $2,878/ year

Case Study #2 – Calculation for NPV (Pessimistic Scenario) Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows 12 = 2,878  1 = $19,610 t=1 (1 + 0.1)t PV of cash outflows = 18,000 + 7,500 + 7,500 + 7,500 + 7,500 + 7,500 = $39,945 (1+0.1)2 (1+0.1)4 (1+0.1)6 (1+0.1)8 (1+0.1)10 NPV = PV of cash inflows – PV of cash outflows = $19,610 - $39,945 = - $20,335 (i.e. negative) Since the resultant NPV < 0, the cleaner production option is not financially viable.

Case Study #2 – Calculation for IRR (Pessimistic Scenario) IRR would need to be solved through iteration. Solving for “r”: 12 0 = 2,878  1 – 18,000 – 7,500 – 7,500 – 7,500 – 7,500 – 7,500 t=1 (1+r)t (1+r)2 (1+r)4 (1+r)6 (1 + r)8 (1 + r)10 Taking r = %, IRR =

Taking r = 13% (i.e. 13/100 = 0.13), IRR = -152.49 Case Study #2 – Solving for the Exact Value of IRR (Pessimistic Scenario) Taking r = 12% (i.e. 12/100 = 0.12), IRR = 664.63 Taking r = 13% (i.e. 13/100 = 0.13), IRR = -152.49 Solving for the exact value of IRR through interpolation: r – 12 = 0 – 664.63 r – 14 -152.49-664.63 IRR = 12.63% Since the IRR is greater than 10% (i.e. the rate of interest that the money would earn in the bank, investing in this cleaner production option is worthwhile.

Case Study #2 – Calculating the PI (Pessimistic Scenario) Calculating for the PI: PI = PV of cash inflows = 19,610 = 0.49 PV of cash outflows 39,945 Since PI > 1, this cleaner production option cannot be accepted; i.e. it is not financially viable

Other Scenarios Similarly, it is possible that there may be other pessimistic scenarios In fact, there could be a permutation-combination of pessimistic scenarios, depending on the market and in-house conditions The World Wide Web provides certain tools to calculate the NPV and IRR values Thus the CBA becomes a very important tool is assessing the financial feasibility of the cleaner production project / option Such analysis will help all concerned (CPC, business / enterprise / industry, financial institution, stakeholders in the option) decide on further steps to be taken for making a bankable project.

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