Energizing Cleaner Production Financial Feasibility Analysis Energizing Cleaner Production Management Course

Profitability Indicators Session Agenda: Introduction Cash Flow Profitability Indicators Simple Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR)

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 analysis Task 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)

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

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

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

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

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 Replacement Replace outdated, worn-out, or damaged equipment or outdated/inefficient management and information systems

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

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

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

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

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

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

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

Simple Payback (in years) 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 =

Simple Payback (in years) 2. Return on Investment Definition: the percentage of initial investment that is recovered each year Initial Investment Year 1 Cash Flow Simple Payback (in years) = 3 years Year 1 Cash Flow Initial Investment ROI (in %) 33% =

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

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 The 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.

Workshop Exercise Question 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.

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...

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 year inflation 5% costs $1 costs $1.05 now next year

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 opportunity Gives you $1.10 a year from now Investing $1 now Investment 10 % interest, or “return on investment”

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

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?

3. 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

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 year It is easiest to convert all project cash flows to their “present value” now, at the very beginning of the project

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

3. 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

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 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? $17,280 1.20 x 1.20 x 1.20 = $10,000 Discount rate is basically the opposite of interest 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

3. Net Present Value Calculating “Present Value” Value of the cash flow in year n Present Value = Future Valuen x (PV Factor) 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

3. Net Present Value The Value of a Future $1 Discount rate (d): 10% 20% 30% 40% Years into future (n) 1 .9091 .8333 .7692 .7142 2 .8264 .6944 .5917 .5102 3 .7513 .5787 .4552 .3644 4 .6830 .4823 .3501 .2603 5 .6209 .4019 .2693 .1859 10 .3855 .1615 .0725 .0346 20 .1486 .0261 .0053 .0012 30 .0573 .0042 .0004 .0000 Present value factors Handout: Table with discount rates

3. 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

3. Net Present Value Workshop Exercise (15 min) Question 3: Calculate the NPV Expected Future Cash Flows Present Value of Cash Flows (at time zero) PV Factor Year X = 1 2 3 - $105,000 + $38,463 - $??? $??? ??? Sum = project’s Net Present Value =

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

3. 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” See the answer sheet of the workshop exercise for more background information

3. Net Present Value Workshop Exercise (answer B) Expected Future Cash Flows Present Value of Cash Flows (at time zero) PV Factor Year X = 1 2 3 - $105,000 + $38,463 + $93,463 .8696 .7561 .6575 - $105,000 33,447 29,082 61.452 -18,981 Sum = project’s Net Present Value =

4. 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

Profitability Indicators Summary Advantages Disadvantages 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

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

Acknowledgements 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). www.energyefficiencyasia.org 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