Larry Guentert Purdue University Admin Computing October 4, 2012

Agenda Capital Budgeting Terminology Traditional Project Calculations Comparisons of Methods Eco Building Considerations A Proposed Approach Conclusion Questions

Capital Budgeting Large investment in plant or equipment with returns over a period of time. Investment may take place over a period of time A Strategic Investment Decision May include: Expansion, Improvement, Replacement, R & D

Present Value The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Explanation: The basis is that receiving $1,000 now is worth more than $1,000 five years from now, because if you got the money now, you could invest it and receive an additional return over the five years PV = C1 / ( 1 + r) where c1 = is the cash flow of at date 1 and r is the rate of return.

Cost of Capital The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk. It may reflect risk in the investment.

Cash Flows Cash flows = Sales + Variable Costs + Operating Expenses + Equipment Costs

Main Investment Rules Used Net Present Value (NPV) Internal Rate of Return (IRR) Payback Return on Assets or Investment (RoA or RoI) Profitability Index

Net Present Value The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash

NPV Equation NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. (where Co is initial cost of project, r = rate, t = time periods)

NPV Equation Treatment of depreciation in NPV analysis. -We only use cash flows in investment appraisal. -Depreciation is not a cash flow. -However, depreciation (capital allowances) is allowable against tax (see income statement), which affects cash flow. For cash flow, add depreciation back

Internal Rate of Return You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth Equation:

IRR Rule Accept the project if the IRR is greater than the discount rate (cost of capital). Reject the project if the IRR is less than the discount rate.

IRR Issues IRR cannot not be use to rate mutually exclusive projects The IRR also cannot be use in the usual manner for projects that start with an initial positive cash inflow, Intermediate cash flows are never reinvested

Payback Method The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.

Payback Method Issues Ignores overall return (time value of money) Ignores impact of large flows Ignores timing of flows desirable for investment positions. It is not for very long financing. Many times companies have to pay more than they actually acquire

A regulation for evaluating whether to proceed with a project or investment. The profitability index rule states: If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project PI = Cash flows / Initial Investment Profitability Index

Return on Assets A measure of profit per dollar of assets. Return on Assets = Net Income / Total Assets Example: RoA = $363 / $3588 = 10.12%

RoA, PI Issues: Do not consider the time value of money

Example

20 Cash Flows Source: Ross, Westerfield, Jaffe (2010)

Accounting Method Usage in Industry Source: (2002)

Green Building

23 IRR for LEED Building U.S. Green Building Council (USGBC) reports that, projects that achieved LEED and Energy Star status normally achieve an Internal Rate of Return (IRR) of 20% or more. This is primarily from increased annual energy savings Source: investment-for-green-leed-projects htm

Eco Cost Facts PV panels decreasing in costs Negligible degradation: actual modules appear to be degrading at 0.2–0.5% per year (Chianese et al., 2003). Inverter reliability increasing and inverter reliability and cost are both improving rapidly (Navigant, 2006; Mitchell, 2010; Heacox, 2010).

Eco Cost Facts Wind, other systems, high maintenance Lifespan of mechanical systems < PV (CSP, Wind farms)

Eco – Economic Considerations: PV is often considered too costly But PV systems have long lifespan and negligible operating costs PV’s not considered by business because future cash flows do not add to asset value What about depreciation? Definition of 'Modified Accelerated Cost Recovery System - MACRS' The new accelerated cost recovery system, created after the release of the Tax Reform Act of 1986, which allows for greater accelerated depreciation over longer time periods.

PhotoVoltaic Panel Costs Source for below:

Proposed Better Methods LCOE for electricity Use modified LCOE for just certain components of a facility WLC for the complete project

Proposed New Method For Energy: Levelized Cost of Electricity (LCOE) A levelized cost of electricity(LCOE) is defined in any operating year as the sum of all costs prior to and including that year divided by the sum of all outputs. This is a levelized cost of electricity with a zero discount rate which is not the traditional metric. By Ken Zwiebel GWU

Proposed New Method: Levelized Cost of Electricity (LCOE)

Source: Ken Zwiebel, GWU

Best Solution Found: Whole Life Costing and Performance Whole Life Costing (WLC) is a powerful tool for calculating the lowest cost options for the entire commercial life of a building. It encourages the use of best value building designs and reduces the costs and disruption of unplanned repairs and maintenance (Proposed by the Building Research Establishment (BRE) U.K.)

WLC Whole Life Cost is the analysis of all relevant and identifiable financial cash flows regarding the acquisition and use of an asset. Uses NPV.

Activities in Sustainability

WLC Is A finance method to guide decision making Includes Capital costs Includes Revenue costs Does it include end of life cost for any project exceeding 10 years? Demolition is first cost of next project How do I cost what I don’t know Expressed as an annual cash flow for the life of the asset

An Asset is Anything that we buy or construct Can be a facility (building) Can be a component Any number of assets can be combined The asset can be income generating or not.

Life Time Total Cost of Ownership

How Do We Measure WLC? Total whole life cost ~ TWLC Annualized whole life cost ~ AWLC Discounted cashflow ~ DCF $’s x % = a number Net present value ~ NPV Discount rate What % should we use? Can be used for non financial e.g. kWh

Recommendation for WLC Introduce and develop WLC in your organization and your supply chain Take Small Steps - Progress Slowly Understand What You Have Achieved Step back - see the ‘Big Picture’ Benchmark - process not answers Appropriateness & Fitness - Every Project is Different

WLC Rules of thumb Spreadsheet Simple, easy to use, easy to manipulate Proprietary Restrictive WLCF Uses WLCF view and is supplier based Can be used for Buildings

Questions?