ByProf.

AmritNakarmi

I/IIMSREE

09July2008

IntroductiontoEconomicsofEnergyProjects(EG854ES)

WhatIsEconomics?
Scarcity
Alleconomicquestionsarisefromasingleandinescapablefact:youcan'talwaysgetwhatyouwant.Welive
inaworldofscarcity.
Scarcitymeansthatwantsalwaysexceedresourcesavailabletosatisfythem.
PeoplegetinvolvedinEconomicActivitytocopewithScarcity.
Economicsisthestudyofhowpeopleusetheirlimitedresourcestotrytosatisfyunlimitedwants.
Facedwithscarcity,wehavetomakechoicesbecausewecan'thaveallwhatwewant.Balancingthe
wantsandtheresourcesavailableiscalledeconomizingoroptimizing.

WhatIsEnergyEconomics?
Whatiscompetition?

Competitionisthecontestforcommandoverscarceresources.
Forhumanlifeandtheproductionprocesses,asufficientlyavailableofenergyisthehighestpriority.
Human beings can live without other things, but not without energy resources. Energy resources are also
scarceandhence,needsitsoptimizationanditisdealtbyenergyeconomics.

WhatIsEconomicsofEnergyProjects?
EconomicsofEnergyProjectsdealswithhoweconomicallyanenergyprojectcanbeestablishedand
operated.Coststructure,financing,capitalbudgeting(projectevaluation),andfinancialperformanceanalysis
oftheenergyprojectsorfirmsarelookedinto.

TypesofFirms
Threebasictypesoffirm

Soleproprietorship
Partnership

Corporationorlimitedcompany

Soleproprietorship

Itistheoldestformofbusinessorganization.Asinglepersonownsthebusiness,holdstitletoallits
assets,andisresponsibleforallofitsliabilities.
Advantages

Simplicity
Quickerdecisionmaking

Easytoestablish
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Disadvantages

GoodforsmallfirmsandnotgoodforbigfirmssuchasenergyCos.
Responsibleforallliabilities
Difficulttoraisecapital
Costofcapitalishigh

Partnership
Apartnershipissimilartoaproprietorshipinallaspectsexceptthatthereismorethanoneowner.
Advantages

Decisionmadethroughconsensus/agreement,hencelowrisk
Canraisehighercapital
Easytoestablishbutmorecomplexthansingleproprietorship

Responsibleforallliabilities
Slowerdecisionmakingprocessthansingleproprietorship
Difficulttoraisecapital

Disadvantages

CorporationorLimitedCompany

Acompanyisanimpersonalentitycreatedbylaw,whichcanownassetsandliabilities.Themain
featureofthisformisthattheCo.isseparatefromitsowners.Aownersliabilityislimitedtohis/her
shareholdingonly.
Advantages

Limitedliability
Canraisehighercapital(akindforenergyCos.)
Lowercostofcapital
Decisionmakingthroughconsensus

Slowdecisionmaking
Difficulttosetup

Disadvantages

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RAISING
GFINANCES
S

EquityC
Capital
Equitycap
pitalrepresen
ntsownershipcapitalasequity(common)sharehold
derscollectivelyowntheccompany.

Authorized
d capital The amount of capital that a Co. can potentially issue, as
a per its
memorand
dumofassociation.
Issuedcap
pitaltheam
mountofferedbytheCo.to
otheshareho
olders.
Subscribed
dcapitalTh
hepartoftheissuedcapitaalwhichhasb
beensubscrib
bedtotheinvvestors.
PaidupcaapitalTheactualamounttpaidupbyttheinvestors.
Parvalue
Itisthevalu
uestatedinthememorandumandthesharecertificcate.
BookvalueItisthesumofthepaaidupcapital andretained
dearningsdivvidedbythe numberof
ngshares.
outstandin
Market Vaalue It is th
he value of the
t share at which it is trraded in the stock exchan
nge or the
market.
blicOffering((IPO)Thein
nitialpublicisssueofthesh
harestothem
membersoftthepublic.
InitialPub
Subsequen
ntofferingiscalledSecond
darypublicofffering(SPO).
Rights Issu
ue It is thee selling of th
he security in the primarry market byy issuing shares to the
existingsh
hareholders.

Rightsoffequitysharreholders

Righttoincom
meTheequiityshareholdershaveresidualclaimto
otheincomeofthefirmaffterpaying
hedebtobligaationandpreeferredsharedividends.Th
heresidualin
ncomecanbeewithheldbytheCo.as
th
reetainedearningsorpaidoutasdividend.
RighttocontrolEquitysh
hareholdersaaretheactuallownersofth
heCo.andhaavetheright tovoteon
onplacedbefforetheCo.
evveryresolutio

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PreemptiverightsItenablestheexistingshareholderstomaintaintheirproportionalownershipof
thesharesiftheCo.issuedadditionalsharesinthemarket.

SourcesofFinance
PreferentialCapital(Preferredshares)
Preferred shares are hybrid forms of capital. They have the characteristics of both the equity (common
shares)andthedebtsuchasdebentures.

Mainfeaturesare:
1. preferredsharedividendispayableafternetincome,
2. itiscumulative(dividendifnotpaidinyear,willbeaccumulatednextyear),and
3. itistaxableandhasnovotingrights.

Internalaccumulation(retainedearnings)

The internal accruals consist of depreciation and retained earnings. Retained earnings are
muchmoreexpensivethanbankloans,becausetheyareretainedwithoutpayingoutthedividendandcost
ofcapital(interestrate)ofequityishigherthanthatoftheloan.

TermLoans/debentures
Termsaregivenbyfinancialinstitutionssuchasbanksandhavetermoflessthan10years.
Debentures(bonds)areloansraisedfromthepublicandtheinterest(calledhereascoupon)ispaideverysix
months.Itcanbesecuredandunsecured.Debenturescanbeconvertibleintocommonshares.

Workingcapitaladvances(loans)
Underacashcreditoroverdraftarrangement,acompanycanborrowrequiredamountifitiswithinitslimit
intheagreementwiththefinancialinstitutionorthebank.

WeightedAverageCostofCapital(WACC)
CostofDebt
A firm with a 40% tax rate issues $1,000 bonds at a face value with coupon rate of 16%. Ignoring
underwritingandissuingexpenses,

Marketyield(marketrateofreturn)=rd=160/1000=16%
Costofdebt(tothecompany)=Rd=160*(10.4)/1000=9.6%

Ifpeopleinvestinbondsforlongterm,then
Pb=Sum(I/(1+rb)t+F/(1+rb)n

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Costofdebt(totheCo)

NPb=Sum(I*(1Tax)/(1+kb)t+F/(1+kb)n

CostofPreferredShare
Acorporationissuesnew$100preferredsharesthatprovide$12inannualdividends.Thefirmhasidentical
preferredsharesoutstandingthatalsotradeat$100/share.Issuingandunderwritingexpensesare5%ofthe
issuepriceandassumedtobetaxdeductible.Thefirmstaxrateis40%.

NetProceedsofpreferredshare(totheCo.)=NPp=100(10.4)*5=$97
rp=12/100=12%
kp=12/97=12.37%(costofpreferredsharetotheCo.)

CostofPreferredShare(forlongterminvestment)
Pp=Dp*Sum(1/(1+rp)t)

CostofEquity
Acorporationissuesnew$100commonsharesthatprovide$16inannualdividends.Thefirmhasidentical
commonsharesoutstandingthatalsotradeat$100/share.Issuingandunderwritingexpensesare5%ofthe
issuepriceandassumedtobetaxdeductible.Thefirmstaxrateis40%.

NetProceedsofcommonshare(totheCo.)=NPe=100(10.4)*5=$97
re=16/100=16%
ke=16/97=16.49%(costofequitytotheCo.)

CostofEquity(longterm)
Marketcapitalizationrate

Pe=SUM(Dt/(1+re)t)

Costofnewshares

NPe=SUM(Dt/(1+ke)t)

CostofEquity
Usuallycostofequityisnotknown,thenwehavetouseCapitalAssetPricingModel(CAPM)tofind
outcostofequity.

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CostofEquity(CA
APM)

CostofEquity

CosttofEquity(kke)=Rf+Equ
uityBeta*((E(Rm)Rf)

wherre,

Rf=Riskfreeerate
ontheMarkettIndex(DiverrsifiedPortfolio)
EE(Rm)=ExpecctedReturno

Inpracticee,
Shorttermggovernmentsecurityratesareusedasrriskfreeratess
Historicalriskpremiumsaareusedforttheriskpremiium
Betas are esstimated by regressing
r
sto
ock returns against
a
market returns (itt shows how much the
eq
quityisriskierthanthemaarket)

WeightedAveraggeCostofC
Capital(W
WACC)
IfIistheetotalinvestm
ment,then
I==B+P+E
where
Bisborrowingg(loansandbonds),
Pispreferredsshares,andEEisequity.
Then,
W
WACC=R
Tax)*B/I+kp*P
P/I+ke*E/I
b(1T

Exampleo
onWACC
Afirmplaansonfinanccingmajorneewexpansion
nprogramsbyydrawingon
nfundsintheefollowingproportions
thatrough
hlycorrespon
ndstoitscurrrentcapitalsttructure:
Lo
ongtermde
ebt
$30
0mil
Preferredsharres
$10
0mil
Newcommonshares $40
0mil
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Issuing and underwriting expenses can be ignored. Debt can be issued at a coupon rate of 12%, and the
dividend yield on preferred shares would be 9%. Common Shares currently trade at $45 per share. The
currentdividendyieldonpreferredshareswouldbe$2.25pershare.Managementfeelsthat,overlongrun,
growthindividendmatchinflationrate,whichisanticipatedtobe10%peryear.Thecorporatetaxis40%.
Whatisthefirmsweightedaveragecostofcapital(WACC)?

ExampleonWACC
Thecurrentinterestongovernmentdebtis10%,andthereturnonthemarketisexpectedtoexceedthis
rateby7%.Whatvalueofbetadowehavetoassumeforthefirmifthecostofequityasderivedfromthe
CAPMistomatchtheKe=15%calculatedaccordingtothedividendgrowthmodelunderaboveexample?

kb=(1T)rb=0.6*12%=7.2%
kp=rp=9%
Ke=D1/pe+g=2.25/45+0.1=0.15or15%
Proportion Costin%
Source
Debt
30/80=0.375 7.2%
Preferred
10/80=0.125 9%

Common
40/80=0.50 15%

WeightedCost

2.7%

1.13%

7.5%

WACC=2.7%+1.13%+7.5%=11.33%

ExampleonWACC
Afirmplansonfinancingmajornewexpansionprogramsbydrawingonfundsinthefollowingproportions
thatroughlycorrespondstoitscurrentcapitalstructure:
Longtermdebt
$30mil
Preferredshares
$10mil
Newcommonshares $40mil
Issuing and underwriting expenses can be ignored. Debt can be issued at a coupon rate of 12%, and the
dividend yield on preferred shares would be 9%. Common Shares currently trade at $45 per share. The
currentdividendyieldonpreferredshareswouldbe$2.25pershare.Managementfeelsthat,overlongrun,
growthindividendmatchinflationrate,whichisanticipatedtobe10%peryear.Thecorporatetaxis40%.
Whatisthefirmsweightedaveragecostofcapital(WACC)?

ExampleonWACC
Thecurrentinterestongovernmentdebtis10%,andthereturnonthemarketisexpectedtoexceed
thisrateby7%.Whatvalueofbetadowehavetoassumeforthefirmifthecostofequityasderivedfrom
theCAPMistomatchtheKe=15%calculatedaccordingtothedividendgrowthmodelunderaboveexample?

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FinancialStatements
Thesearestatementsoffinancialinformationtothemanagersandtheshareholders.

IncomeStatement(ProfitandLossStatement)
BalanceSheet
Cash flow statement / Source and Use of Funds Statement (Statement of changes in financial
positions)

IncomeStatement
Itshowstherecordoffinancialeventsbetweentwopointsintime.Ithasrevenuefromsalesandexpenses
incurredduringtheperiod.

NetWorth
Thevalueoftotalassetsminustotalliabilitiesorthevalueoftheowners'claimontheassets.

IncomeStatements(P/Lstatement)
Expendituresareallcashoutflows
Expenses areonlythoseexpendituresthataffectnetworthoftheshareholdersandappearintheIncome
Statement.
Receiptsareallcashinflows.
Revenuesareonlythosereceiptsthataffectnetworthandthusappearintheincomestatement.

BalanceSheet

Itgivessnapshotsummaryofthefirm'sfinancialpositionatasinglepointintime.
The balance sheet shows the net worth of shareholders at a point in time, whereas income
statementmeasureschangesinnetworth.

Liabilitiesindicatewhatmoneyhasbeenmadeavailabletothefirm.
Assetsshowhowthefirmhasusedthemoneymadeavailabletoit.
CurrentLiabilities aretheshorttermdebtobligationsofafirm,withmaturitiesoflessthanone

year.

Fixedliabilitiesarefirm'slongtermfinancesuchaslongtermdebtsfrombanksandthepublic.
Shareholders'equityisthemoneyinvestedbytheshareholdersandtheretainedearnings.
Fixed Assets are acquired for longterm uses in the firm such as plant, building, land, and
equipment.

CurrentAssetsarecash,accountsreceivables,andinventoriesoffinishedgoodsandrawmaterials.
Depreciationistheallocationofcostofanassettodifferenttimeperiods.
WorkingCapitaliscomposedoffirm'scurrentassets.
NetWorkingCapitalisthedifferencebetweencurrentassetsandcurrentliabilities.

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SomeItemsintheFinancialStatements

Profitistheexcessofrevenuesoverexpensesduringagivenperiodoftime.
Cashflowistheactualcashflowinginandoutofafirmoveraparticulartimeperiod.
Operating cash flow is the flow of cash arising from the operation of a firm and consists of net
profit(profitaftertax)plusnoncashchargessuchasdepreciation.

CashFlowStatement

Source and useoffunds Statement (cash flow statement) is a summary of the flow of the
financialactivityofthefirm.Itshowswherethefirmobtainscashandhowitusesit.

Sourcesoffunds

Increaseinliabilities
Increasenetworththroughretainedearningsorcapitalcontributionbytheshareholders
Reductioninassetsthroughsalesofassets

Usesoffunds

reductioninliabilities
reductioninnetworththroughpaymentofdividendsorlosses
increaseinassets

Cashflowfromoperatingactivities

Netprofit
Depreciation
Decreaseinaccountreceivables
Increaseinaccountspayables

Cashflowfrominvestingactivities

Salesoffixedassets
Investmentinnewfixedassets

Cashflowfromfinancialactivities

Increaseindebt(cashinflow)
Issuanceofnewshares(cashinflow)

Dividendpayment(cashoutflow)

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BalancceSheet

IncomeSStatement
Revenue
CostsofGood
dsSold(COG
GS)
G
GrossProfit
Exxpenses
N
NetIncome

Pagge10of55


INTERESTANDINTERESTRATE
Interestisarentalamountchargedbyfinancialinstitutionsfortheuseofmoney.
Interestrate,ortherateofcapitalgrowth,istherateofgainreceivedfromaninvestment.
Usuallythisrateofgainisstatedonaperyearbasis,anditrepresentsthepercentagegainrealizedonthe
money committed to the undertaking. Thus, an 11% interest rate indicates that for every dollar of money
used,anadditional$0.11mustbereturnedaspaymentfortheuseofthatmoney.

THETIMEVALUEOFMONEY
Because money can earn at a certain interest rate through its investment for a period of time, a rupee
receivedatsomefuturedateisnotworthasmuchasarupeeinhandatpresent.Thisrelationshipbetween
interestandtimeleadstotheconceptofthetimevalueofmoney.

Arupeeinhandnowisworthmorethanarupeereceivednyearsfromnow.Why?
Becausehavingtherupeenowprovidestheopportunityforinvestingthatrupeefornyearsmorethanthe
rupeetobereceivednyearshence.Sincemoneyhasearningpower,thisopportunitywillearnareturn,so
thatafternyearstheoriginalrupeeplusitsinterestwillbealargeramountthantherupeereceivedatthat
time.Thus,thefactthatmoneyhasatimevaluemeansthatequalrupeeamountsatdifferentpointsintime
havedifferentvalueaslongastheinterestratethatcanbeearnedexceedszero.

Itisalsotruethatmoneyhastimevaluebecausethepurchasingpowerofarupeechangesthroughtime.
During periods of inflation the amount of goods that can be bought for a particular amount of money
decreasesasthetimevalueofmoneyitisimportanttorecognizeboththeearningpowerofmoneyandthe
purchasingpowerofmoney.

THEPURCHASINGPOWEROFMONEY
Inflation(pricerises)anddeflation(depreciation,devaluation)aretermsthatdescribechangesinpricelevels
inaneconomy.

SIMPLEANDCOMPUNDINTEREST

SimpleInterest:
Under simple interest, the interest owed (payable, billed) upon repayment of a loan is proportional to the
length of time the principal sum has been borrowed. The interest earned may be found in the following

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manner.LetIrepresenttheinterestearned,Ptheprincipalamount,ntheinterestperiod,anditheinterest
rate.Then,

I=P*n*i
SupposethatNRS1,000isborrowedatasimpleinterestrateof12%perannum.Attheendoftheyear,the
interestowedwouldbe,
I=NRS1,000*1*0.12=NRS120
The principal plus interest would be NRS 1,120 and would be due at the end of the year. Interest and
principalbecomedue(payable)onlyattheendofthetimeperiod.

CompoundInterest
When loan is made for several interest periods, interest is calculated and payable at the end of each
interestperiod.Therearenumberofloanrepaymentplans.
Theserangefrompayingtheinterestwhenitisduetoaccumulatingtheinterestuntiltheloanisdue.
Iftheborrowerdoesnotpaytheinterestearnedattheendofeachperiodandischargedinterestonthe
totalamountowed(principalplusinterest),theinterestissaidtobecompounded.
Theinterestowedinthepreviousyearbecomespartofthetotalamountowedforthisyear.Thisyears
interestchargeincludesinterestthathasbeenearnedonpreviousinterestcharges.

CALCULATIONOFCOMPOUNDINTERESTWHENINTERESTISPAIDANNUALLY

CALCULATIONOFCOMPOUNDINTERESTWHENINTERESTISPERMITTEDTOCOMPOUND

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INTERESTFORMULAS
Let,
I=theannualinterestrate
N=thenumberofannualinterestperiods;
P=apresentprincipalamount;
A=asinglepayment,inaseriesofnequalpayments,madeattheendofeachannualpayments.
F=afutureamountinnannualinterestperiods.

Assumptions:
1. Endofoneyearisthebeginningofthenextyear
2. Pisatthebeginningofayearfromatimeregardedasbeingthepresent
3. Fisattheendofthenthyearfromatimeregardedasbeingthepresent.
4. An A occurs at the end of each year of the period under consideration. When P and A are
involved,thefirstAoftheseriesoccursoneyearafterP.whenFandAareinvolved,thelastAof
theseriesoccurssimultaneouslywithF.

SinglePaymentCompoundAmountFactor(F/P,i,n)
If an amount P is invested now and earns at the rate i per year, how much principal and interest are
accumulatedafternyears?

DerivationofSinglepaymentCompoundamountFactor

Theresultingfactor,(1+i)n,isknownasthesinglepaymentcompoundamountfactorandisdenotedby
(F/P,i,n).
Thefutureamount,F,ofapresentprincipalamount,Pisgivenby:F=P(1+i)n

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Example:
If $1,000 is invested at 16% interest compounded annually at the beginning of year one, the compound
amountattheendofthefourthyearwillbe:F=$1,000(1+0.16)4=$1,000(1.811)=$1,811

SinglePaymentPresentWorthFactor(P/F,i,n)
FindthepresentworthPofafutureamount,Freceivedattheendofnperiodsiftheinterestrateisi.
Thepresentworthinthiscaseisgivenby:P=F[1/(1+i)n]
Theresultingfactor,1/(1+i)n,isknownasthesinglepaymentpresentworthfactorandisdenotedby:
(P/F,i,n).

Example:
Howmuchmustbeinvestednowat16%compoundedannuallysothat$1,811,canbereceived4years?
P=$1,811[1/(1+0.16)4]=$1,811(0.5523)=$1,000

EqualPaymentSeriesCompoundAmountFactor(F/A,i,n)
Tofindthesinglefuturevaluethatwouldaccumulatefromaseriesofequalpaymentsoccurringattheend
ofsucceedinginterestperiods.
IfArepresentsaseriesofnequalpayments
F=A+A(1+i)+..+A(1+i)n2+A(1+i)n1
F=A[(1+i)n1]/i
Theresultingfactor,[(1+i)n 1]/i,isknownastheequalpaymentseriescompoundamountfactorandis
designatedas(F/A,i,n).

Example:
TheCompoundAmountofaSeriesofYearEndPaymentsof$100ofAnnualInterestRateOf12%

EqualPaymentSeriesSinkingFundFactor(A/F,i,n)
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TheequalpaymentseriescompoundamountrelationshipmaybesolvedforAasfollows:

Theresultingfactor,i/[(1+i)n1],isknownastheequalpaymentseriessinkingfundfactor

Example:
It is desired to accumulate $635 by making a series of five equal annual payments at 12% interest
compoundedannually,therequiredamountofeachpaymentwillbe

EqualPaymentSeriesCapitalRecoveryFactor(A/P,i,n)
A deposit of amount P is made now at an annual interest rate i. The depositor wishes to withdraw the
principal,plusearnedinterest,inaseriesofequalyearendamountsoverthenextnyears.Whenthelast
withdrawalismade,thereshouldbenofundsleftondeposit.Thevalueofequalyearendamount(annuity)
isgivenby:

Theresultingfactori(1+i)n/[(1+i)n1]isknownastheequalpaymentseriescapitalrecoveryfactorandis
designatedas(A/P,i,n).

Example:
$1,000investedat15%interestcompoundedannuallywillprovideforeightequalyearendpaymentsof

EqualPaymentSeriesPresentWorthFactor,(P/A,i,n)
Tofindwhatsingleamountmustbedepositednowsothatequalendofperiodpaymentscanbemade,P
mustbefoundintermsofA

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Theresultingfactor,[(1+i)n1]/i(1+i)n,isknownastheequalpaymentseriespresentworthfactorandis
designatedas(P/A,i,n).

Example:
Thepresentworthofaseriesofeightequalannualpaymentsof$223ataninterestrateof15%compounded
annuallywillbe

UniformGradientSeriesFactor,(A/G,i,n)
In some cases, periodic payments do not occur in an equal series.They may increase or decrease by a
constantamount.
Let
G=annualchangeorgradient
n=thenumberofyears;
A=theequalannualpayment

Theresultingfactoriscalledtheuniformgradientseriesfactorandisdesignatedas(A/G,i,N)

GeometricGradientSeriesFactor,(A/G,i,n)
In some situations, annual payments increase or decrease, not by a constant amount, but by a constant
percentage.Ifgisusedtodesignatethepercentagechangeinthemagnitudeofthetthpaymentisrelatedto
paymentA1as

Page16of55

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TwotypesoflineargradientseriesascompositesofauniformseriesofNpaymentsofA1andthegradient
seriesofincrementsofconstantamountG

ProjectCashFlows
Typicallyacapitalprojectinitiallyrequiresinvestmentoutlayandproducesannualnetcashinflows.

CashOutflows:
Purchaseofnewequipment
Workingcapital
Manufacturing,operating,andmaintenancecosts
Leasingexpenses
Interestandrepaymentofborrowedfunds
Incometaxesandtaxcredits.

CashInflows:
Borrowedfunds
Operatingrevenues
Costsavings(orcostreductions)
Salvagevalue
Workingcapitalrelease(costrecoverybyliquidation)

ElementsofCashOutflows

WorkingCapital:
Itisaninvestmentinnondepreciableassets.

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Someprojectsrequiresuchinvestmentsothatmorefundsareavailableinordertoincreasefirmsrevenues.
In accounting, working capital is the amount carried in cash, accounts receivable, and inventory (account,
stock)thatisavailabletomeetdaytodayoperatingneeds.
For example, if a company is going to a market a new product, inventories of the product and larger
inventoriesofrawmaterialswillbeneeded.Accountsreceivablesfromsaleswillincrease,andmanagement
mightalsodecidetocarrymorecashbecauseofhighervolumeofactivities.
Theseareworkingcapitalbutthesehavenotaxeffectandthecashflowsalwayssumtozerooverthelifeof
aprojectbuttheinflowsandoutflowsareshiftedintimeso,theydoaffectthenetpresentworth.

Overhead:
Thecostthatoccursirrespectivetothespecificunitsofoutputofafirmiscalledasoverheadcost.
Inmanufacturing,allcostsotherthandirectmaterialandlaborsaretreatedasoverheadcosts.
Forexample,coststoindirectmaterialandlabor,maintenanceandrepairsonproductionequipment;heat
andlight,propertytaxes,royalty,depreciationandinsurance,overtimepremiums.
Depreciationoffactorybuildingsisunaffectedbytheamountofproductionduringanyparticularperiod.If
however,anewbuildingisrequiredtomeetanyincreasedproduction,manufacturingoverheadwillcertainly
increase.
Indirect materials like solder used to make electrical connections in a computer circuit board and the glue
usedtobindthebooks,thesearetreatedasapartofmanufacturingoverhead.
Typical examples of indirect labor include the wages of janitors, supervisors, material handlers and night
securityguards.

GainsTax:
Itisataxapplicabletogains(orlosses)occurredontheearningorlossasaresultofdifferenceinthebook
valueandsalvagevalueofanasset.Ifthesalvagevalueishigherthanthebookvaluethenthetaxneedsto
bepaidtoincrementalearning.Similarly,ifthesalvagevalueislessthanthebookvaluethentaxneedstobe
adjustedtotheloss.

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IncomeStatementCashFlowApproach
Oncethecashflowelements(bothinflowsandoutflows)aredetermined,thesemaybegroupedintothree
categories:

Operatingactivities
Cashflowfromoperations(e.g.,currentsalesrevenues,thecostofgoodssold,operatingexpenses(also
includesInterestpayments)andincometaxes)

Cashflowfromoperation=Netincome+Depreciation

Investingactivities
In general, three investment flows are associated while buying equipment they are: original investment,
salvagevalueandworkingcapitalinvestmentorrecovery.

Financingactivities
Itincludes:
Theamountofborrowing,
Therepaymentofprincipal.

The Net Cash Flow for a given year is simply the sum of the net cash flows from operating, investing and
financingactivities.

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GeneralizedCashFlowApproach
Itisanapproachinwhichnetcashflowisobtainedbyaggregatingindividualitems.
E.g.Acomputerizedmachiningcenterhasbeenproposedforasmalltoolmanufacturingcompany.Ifthenew
system, which costs $125,000 is installed, it will generate annual revenues of $100,000 and will require
$20,000 in annual labor, $12,000 in annual material expenses, and another $8,000 in annual overhead
(powerandutility)expenses.Theautomationfacilitywouldbedepreciatedattherateof20%.

The company expects to phase out the facility at the end of five years, at which time it will be sold for
$10,000.Findtheyearbyyearaftertaxnetcashflowfortheprojectata30%marginaltaxratebasedonthe
netincomeanddeterminetheaftertaxnetpresentworthoftheprojectatthecompanysMARRof15%.

SolveitusingbothIncomeStatementCashFlowandGeneralizedCashFlowApproach.

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ExamplewithFinancing(Borrowing)
In the previous example, it is assumed that $62,500 of the $125,000 paid for the investment is obtained
throughdebtfinancing(debtratio=0.5).Theloanistoberepaidinequalannualinstallmentsat10%interest
overfiveyears.Theremaining$62,500willbeprovidedbyequity(e.g.,fromretainedearnings).Findthenet
aftertaxcashflows.
Solution
Computingtheannualloanrepaymentinstallments:
$62,500(A/P,10%,5)=$16,487.
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Now,computingthecomponentofinterestandloanrepaymentinstallmentsfor5yearsasbelow:

For,n=1,
Theinterestdueatn=1is$6,250(10%of62,500)

Whichleaves16,4876,250=10,237asleftoverforprincipalpaymentwithloanbalanceas:52,263.

For,n=2is$5,226(10%of52,263)
Whichgives16,4875,226=11,261asleftoverforprincipalpaymentandwithloanbalanceas:41,002

Page23of55

Depreciation
Definition
Itisalossinvalueoverthetimethepropertyisbeingused.

Depreciable property includes buildings, machinery, equipment and vehicles. Exceptions are land (no
definitelife)andcollectibleitems/inventories(primaryforsale)

EconomicDepreciation(ED)
Example: A cars reliability and appearance usually decline with age. The vehicle is worth less with each
passingyear.

EDaccumulated=Purchasepricemarketvalue

AccountingDepreciation(AD)
isbasedontheideaofED
Thesystematicallocationoftheinitialcostofanassetinpartsoveratime,knownasitsdepreciable
lifeandtheprocessisAD.
Sometimesrefertoitasassetdepreciation
ADconceptispopularinengineeringeconomicanalysisbecauseADprovidesabasisfordetermining
theincometaxesassociatedwithanyprojectundertaken.

Page24of55

Whatconstitutesadepreciableproperty?
Itmustbeusedinbusinessorheldforproductionofincome.
Itmusthavedefiniteservicelifeandthatlifemustbelongerthan1year.
Itmustbesomethingthatwearsout,decays,getsusedup,becomesobsolete,orlosesvaluefrom
naturalcauses.

ClaimingDepreciation
Thetaxpayermustbetheownerofthepropertyfortheclaim

In the case of leased property, lessee is not entitled to depreciate that property (e.g., leased
automobiles)

AccountingfortheDepreciationofCapitalAssets

Therearetwoaspectsofdepreciation:
1. Theactuallesseninginvalueofanassetwithuseandthepassageoftimeand
2. Theaccountingforthislesseninginvalue

Depreciationviewsthecostofanassetasaprepaidexpensethatistobechargedagainstprofitsoversome
reasonableperiodoftime.

Rather than charging the entire cost as an expense at the time the asset is purchased, depreciation is a
systematicwaytospreadtheanticipatedlossinvalueoverthelifeoftheasset.

Thisistheconceptofamortizingthecostofanassetsothattheprofitadlossstatementisamoreaccurate
reflectionofcapitalconsumptionwhichisbasictofinancialreportingandincometaxcalculation.

Page25of55


ValuetimefunctionandBookvalue
Thevalueofanassetdecreasesyearlyinaccordancewithoneofseveralmathematicalfunctions.

Selectionofparticularfunctioninvolvesdecisionsastothelifeoftheasset,itssalvagevalueandtheform
ofthemathematicalfunction.Ageneralvaluetimefunctionisshownbelow:

Bookvalueistheacquisitioncostofanassetlessitsaccumulateddepreciationcharges.Afunctionsimilar
toabovecanrepresentbookvalue.

BookValueCalculation
Thebookvalueattheendofanyyear(Bt)isequaltothebookvalueatthebeginningoftheyear(initialcost,
P)lessthedepreciationexpenseschargedduringtheyear.

Mathematically,

Page26of55

BasicDepreciationMethods
Threeimportantmethodswillbediscussed:
1.StraightLineMethods
2.AcceleratedMethods
3.UnitsofProductionMethod

StraightLine(SL)Method
Thismodelassumesthatthevalueofanassetdecreasesattheconstantrate.

Theexpressionfordepreciationchargeinanyyearis:

Andthebookvalueatendofyeartis:

Where,
P=initialcostoftheasset,
F=Salvagevalueand
N=usefullife

Example2:SLDepreciation
Costbasisoftheasset,P=$12,000
UsefulLife,N=5years,
Salvagevalue,F=20%oftheinitialcost=$2400

Page27of55

AcceleratedDepreciationMethods
The mechanical efficiency of an asset tends to decline with age, because maintenance costs tend to
increase with age, or because of the increasing likelihood that better/efficient equipment will become
availableandmaketheoriginalassetobsolete.

Thisreasoningleadstoamethodnamedaccelerateddepreciationmethodthatchargesalargerfraction
ofthecostasanexpenseoftheearlyyearsthanthatofthelateryears

Thetwomostwidelyusedacceleratedmethodsare:
a. DecliningBalance
b. Sumoftheyeardigits

DecliningBalanceMethod(DB)
CalculationbyDBdepreciationmethodallocatesafixedfractionofthebeginningbookbalanceeachyear.
Thefraction,,isobtainedasfollows:
=(1/N).(Multiplier)

The most commonly used multipliers are 1.5 ( i.e., 150% DB) and 2.0 (called 200% or double declining
balance,DDB)

Whennincreases,decreases.Thisresultsinasituationinwhichdepreciationishighestinthefirstyear
anddecreasesovertheassetsdepreciablelife.

For a depreciation rate ,the depreciation charge in any year for declining balance can be derived as
follows:

TotalDB(TDB)depreciationattheendoftyearsiscomputedasfollows:

Thebookvalue,Bt,attheendofyeartisthecostoftheasset,minusthedepreciationattheendoftyears

Page28of55


Example3:DBMethodforexample2

Here,=(1/N).(multiplier)=(1/5).200%=40%(DoubleDB)

CasesofDBMethods
Whenfinalbookvaluees matedsalvagevalue,wemustreadjustouranalysisbecauseeithertaxlawdoes
not permit us to depreciate assets below their salvage value or one have not taken full advantage of
depreciationstaxdeferringbenefits.Hence,twocaseswillbediscussed:
Case1:Whenthefinalbookvalueislessthantheestimatedsalvagevalue.
Case2:Whenthefinalbookvalueisgreaterthantheestimatedsalvagevalue.

Case1:WhenBt<F
Example4:Thefinalbookvalue$933islessthantheestimatedsalvagevalueof$2,400.

To avoid deducting depreciation charges that would drop the book value (BV) below the salvage value F,
adjustdepreciationamountssuchthatBt=FintheperiodwhentheimpliedBVislowerthanF.
Page29of55

NotethatB4wouldbelessthanF=$2,400,ifthefulldeduction($1,037)hadbeentaken.WeadjustedD4
to$192,makingB4=$2,400.

Case2:WhenBt>F
Example5:Thefinalbookvalue$933isgreaterthantheestimatedsalvagevalueof$0(assume)

To reduce the book value (BV) of an asset to its salvage value as quickly as possible, it can be done by
switchingfromDBtoSLwheneverSLdepreciationresultsinlargerdepreciationchargesi.e.,switchfromDB
toSLifdepreciationbyDBinanyyearislessthan(orequalto)itwouldbebySL.

Note that , switching takes place at year 4 as DB depreciation is less than SL depreciation .The resulting
depreciationscheduleis:

Page30of55

Sumoftheyeardigits(SOYD)MethodofDepreciation
AscomparedtoSLdepreciation,SOYDalsoresultsinlargerdepreciationchargesduringtheearlyyearsof
anassetslifeandsmallerchargesastheassetreachestheendofitsestimatedusefullife.

Here,ifNistheestimatedyearsofusefullife,thenumbers1,2,3,,Naresummed:
SOYD=1+2+3+.+N=N(N+1)/2

Depreciation rate Dn is computed here as a fraction in which the denominator is the SOYD and the
numeratoris,forthefirstyear,N;forthesecondyear,N1andsoon.Eachyearthedepreciation
chargeiscomputedbydividingtheremainingusefullifebytheSOYDandbymultiplyingthisratiobythetotal
amounttobedepreciated(PF).Mathematicallyexpressing:

Page31of55

Example6:SOYDDepreciation

UnitsofProductionMethod
SLmethodcanbeapplicableonlyifthemachine/assetbeusedforexactlythesameamountoftimeeach
year.Whathappenswhenamachineisrun2000hoursoneyearand800hoursthenext?

The unitsofproduction method takes care of such situation where depreciation charge for a period is
related to the number of service units consumed in that period i.e., depreciation varies with production
volume.

Thismethodgivesmoreaccuratepictureofmachineusage.

Bythismethod,thedepreciationinanyyearisgivenby:

Adisadvantageofthismethodisthatthecollectingofdataonmachineuseandtheaccountingmethods
aresomewhattedious.

Example6:UnitsofProductionMethod
Atruckforhaulingcoalhasanestimatedcostof$55,000andisexpectedtogiveservicefor250,000miles,
resulting is a $5,000 salvage value. Compute the allowed depreciation amount for truck usage of 30,000
miles.
Solution:

Page32of55

TaxDepreciation
Itisadepreciationmethodbywhichacompanydepreciatesafixedassetfortaxpurposes.Thisisoneof
themanytaxincentiveoptionsthatincreasescashflowsforreinvestment.

ThedepreciationmethodsarecountryspecificandtheseareformulatedbyTaxAuthorityforestimating
depreciationforTaxpurpose.

Usuallyindepreciation,theassetisexpectedtobefullydepreciatedatapproximatelytheendofitsuseful
life.However,fortaxpurpose,itisnotnecessary.

Simplemethodsareestablishedwhichdefinesseveralclassesofassetswithallocatedrateofdepreciation.

BookDepreciationvsTaxDepreciation

SomeoftheTaxDepreciationMethods

ModifiedAcceleratedCostRecoverySystem(MACRS)Method:
MACRSisamethodfortaxdepreciationpracticedindevelopedcountriese.g.US.

MACRSschemeformulatedsimplerguidelineswitheightclassesofassets/properties,eachwithamoreor
lessarbitrarylifecalledarecoveryperiod.Therecoveryperioddonotnecessarilybearanyrelationshipto
expectedusefullives.Thesalvagevalueofpropertyisalwaystreatedaszero.

Page33of55

MACRSPropertyClassifications

Note:
ADR=AssetDepreciationrange;guidelinespublishedbytheIRS.
Automobileshaveamidpointlifeof3yearsintheADRguidelines,butareclassifiedintoa5yrproperty
class.

MACRSDepreciationSchedules:
MACRSrecoverypercentageasshownisaccordingtoHalfYearConvention(HYC),

DecliningBalanceMethod
HYCassumesthatallassetsareplacedinserviceatmidyearandtheywillhavezerosalvagevalue.

Half of one years depreciation in the first year, full years depreciation in each remaining years and
remaininghalfyearsdepreciationintheyearfollowingtheendofrecoveryperiodistaken.
(Seetableinbook)

MACRSDepreciation:AnExample
#Ataxpayerwantstoplaceinservicea$10,000assetthatisassignedtothe5yrclass.ComputetheMACRS
%andthedepreciationamountsfortheasset.
Solution:

Given:5yrasset,yrconvention
Wecompute,=40%(200%DB),andS=0
Since,
Straightlinerate=1/5=0.20
200%DBrate=2(0.20)=40%
UnderMACRS,salvagevalue(S)=0
Find:MACRSdepreciation%Dnfor$10,000asset.
Page34of55

Then,beginningwiththefirsttaxableyearandendingwiththesixthyear,MACRSdeduction%iscomputed
asfollows:

DepreciationAmounts(Dn):
Yr1:20%x$10,000=$2,000;Yr4:11.52%x$10,000=$1,152
Yr2:32%x$10,000=$3,200.Yr5:11.52%x$10,000=$1,152
Yr3:19.20%x$10,000=$1,920;Yr6:5.76%x$10,000=$576

OtherTaxDepreciationMethods
MaximumTaxDepreciationrateclassificationinThailand
Basedonacquisitionprice(SLmethod?)
Thepurchaserwilldepreciatetheassetasifitisacquirednew.

In the case of a second hand asset, depreciation of the asset,while with the previous owner, would not
affect theminimumdepreciationperiodfortheassetto thenewowner. It willbetreatedasifitisa new
asset(usingtheassetpricepaidbythenewowner).

CorporateTaxes
CorporaterateisHowarethetaxesreflectedinCashFlow?
Taxappliedtothetaxableincomeofacorporation.
Page35of55


TaxRatesinThailand
ThemaximumcorporateincometaxrateinThailandis30%onnetprofit.

However,theratesvarydependingontypesoftaxpayers.

CashFlowvsNetIncome
Depreciation=ExpenseorIncome?
AcompanybuysanumericallycontrolledNCmachinefor
Baht3million(year0)andusesitfor5years,afterwhichitisscrapped.

Page36of55

Thealloweddepreciationrateis20%intheacquisitionprice.Supposethecompanyestimatesthefollowing
revenuesandexpenses,includingdepreciation,forthefirstoperatingyear:
Grossincome=Baht4million
Costofgoodssold=Baht2million
OperatingExpenses=Baht1million
a)IfthecompanypaystaxesattherateofThaiTaxrates,whatisitsnetincomefromtheproject?
b)Assumethat
1)allsalesarecashsalesand
2)operatingexpenseswilldropto80%ofthatinYear1insubsequentyears.Showthenetcashflow.

CostandTimevalueofMoney
ClassificationsofCost
Anumberofcostclassificationshavecomeintousetoserveasabasisforeconomicanalysis.
FirstCost
Firstcostistheinitialcostofcapitalizedproperty,includingtransportation,installation,andotherrelated
initialexpenditures.

Firstcostisusuallymadeupofanumberofcostelementsthatdonotrecurafteranactivityisinitiated.For
purchasedequipment,theseincludeengineeringdesignanddevelopmentcost,testandevaluationcost,and
constructionorproductioncostaswellasshipping,installation,andtrainingcosts.

Page37of55

Manyactivitiesthatotherwisemaybeprofitablecannotbeundertakenbecausetheirassociatedfirstcost
represents too high a level of investment. Many engineering proposals that are otherwise sound are not
initiatedbecausethefirstcostinvolvedisbeyondthereachofthecontrollingorganization.

OperationandMaintenanceCost
Whereasfirstcostoccursonlyonceingettinganactivitystarted,
Operationandmaintenancecostisthatgroupofcostsexperiencedcontinuallyovertheusefullifeofthe
activity.

FixedCost
Fixedcostisthatgroupofcostsinvolvedinanongoingactivitywhosetotalwillremainrelativelyconstant
throughouttherangeofoperationalactivity.
Fixedcostsaremadeupofsuchcostitemsasdepreciation,maintenance,taxes,insurance,leaserentals,
interestoninvestedcapital,salesprograms,certainadministrativeexpense,andresearch.

VariableCost
VariableCostisthatgroupofcoststhatvaryinsomerelationshiptothelevelofoperationalactivity.
Ingeneral,allcostssuchasdirectlabor,directmaterial,direct power,andthelike,whichcanreadilybe
allocatedtoeachunitproduced,areconsideredtoconstitutevariablecosts,andthebalanceofthecostsof
theenterpriseareregardedasfixed.

IncrementalandMarginalCost
Thetermsincrementalcostandmarginalcostrefertoessentiallythesameconcept.Thewordincrement
meansincrease.
Incrementalcostistheadditionalcostthatwillbeincurredastheresultofincreasingoutputbyonemore
unit.

CostBehaviors
Fixedcostandvariablecostsarethetwomostcommoncostbehaviorpatterns.

Page38of55

FixedCosts
Thecostsofprovidingacompanysbasicoperatingcapacityareknownasfixedcostorcapacitycost.Fora
costitemtobeclassifiedasfixed,itmusthavearelativelywidespanofoutputwherecostsareexpectedto
remainconstant.Thisspaniscalledtherelevantrange.Inotherwords,fixedcostsdonotchangewithina
given time period although volume may change. For our automobile example, the annual insurance
premium, property tax and license fee are fixed costs since they are independent of the number of miles
driven per year. Some typical examples would be building rents, depreciation buildings, machinery and
equipment,andsalariesofadministrativeandproductionpersonnel.

VariableCosts
Incontrasttofixedoperatingcosts,variableoperatingcostshaveacloserelationshiptothelevelofvolume.
If,forexample,volumeincreases10%,atotalvariablecostwillalsoincreasebyapproximately10%.Gasoline
is a good example of a variable automobile cost, as fuel consumption is directly related to miles driven.
Similarly,thetirereplacementcostwillalsoincreaseasavehicleisdrivenmore.Inatypicalmanufacturing
environment,directlaborandmaterialcostsaremajorvariablecosts.

MixedCosts
Somecostsdonotfallpreciselyintoeitherthefixedorthevariablecategory,butcontainelementsofboth.
Werefertotheseasmixedcosts(orsemivariablecosts).Inourautomobileexample,depreciation(lossof
value)isamixedcost.Somedepreciationoccurssimplyfrompassageoftime,regardlessofhowmanymiles
acarisdriven,andthisrepresentsthefixedportionofdepreciation.Ontheotherhand,themoremilesan
automobileisdrivenayear,thefasteritlossesitsmarketvalue,andthisrepresentsthevariableportionof
depreciation. A typical example of a mixed cost in manufacturing is the cost of electric power. Some
componentsofpowerconsumption,suchaslightingareindependentofoperatingvolume(e.g.numberof
machinehoursoperated).

SunkCost
Asunkcostisapastcostthatcannotbealteredbyfutureactionandisthereforeirrelevant.

LifecycleCost
Lifecyclecostisdefinedasallcosts,bothnonrecurringandrecurring,thatoccuroverthelifecycle.

Manysystemsandproductsareplanned,designed,producedandoperatedwithverylittleconcernoftheir
lifecycle cost. In generation, the elements of lifecycle cost fall into categories that are based on
organizationalactivityoverthelifecycle.Thesearedescribedinthefollowinglist:

o Research and development cost: initial planning; market analysis; feasibility studies; product research;
requirementsanalysis;engineeringdesign;designdataanddocumentation;software;testandevaluationof
engineeringmodels;andassociatedmanagementfunctions.

oProductionandconstructioncost:manufacturing;facilityconstruction;processdevelopment;production
operations;qualitycontrol
Page39of55

oOperationandsupportcost:consumeroruseroperationsofthesystemorproductinthefield;product
distribution;andsustainingmaintenanceandlogisticssupportthroughoutthesystemorproductlifecycle

oRetirementanddisposalcost:disposalofnonrepairableitemsthroughoutthelifecycle;system/product
retirement;materialrecycling;andapplicablelogisticsupportrequirements.
Experience has indicated that a large portion of the total cost for many systems is the direct result of
activitiesassociatedwiththeiroperationandsupport.
Throughout the system/product life cycle, there are many actions required, both technical and non
technical.
Themajorityoftheactions,particularlythoseattheearlierstages,haslifecycleimplicationsanddefinitely
affectslifecyclecost.

FinancialandEconomicEvaluationofProjects
Financialvs.EconomicAnalysis
Bothfinancialandeconomicanalyzesappraisetheprofit/returnofaninvestment,butfromdiffering
perspectives:
Financialanalysisestimatestheprofitaccruingtotheprojectfromthepointsofviewofthe
operatingentity(theutilityandthefirm)
Economic analysis measures economic benefits and returns from the national economic
pointofviewandassessestheeffectoftheprojectontheoveralleconomyofthecountry.

Bothtypesofanalysisareconductedinmonetaryterms,buthavedifferentdefinitionsofcostsand
benefits.

For a project to be economically viable, it must be financially sustainable, as well as economically

efficient. If a project is not financially sustainable, economic benefits will not be realized. Financial
analysisandeconomicanalysisarethereforetwosidesofthesamecoinandcomplementary.

FinancialEvaluationofProjects
Financialevaluationofprojectsisnecessaryto:
evaluatethecommercialviabilityandfinancialsustainabilityofaprojectfromtheviewpointofthe
projectoperatingentity;
assess the degree to which a project will generate sufficient revenues to meet its financial
obligations;
assessincentivesforproducers;
takeintoaccountallexpendituresandrevenues(costsandbenefits)resultingfromtheproject

Financialevaluationofcostsandbenefitsoflargeprojects
Itiscarriedoutonthreelevels:
Ownersevaluation
Bankersevaluation
Page40of55

 Economicevaluation
OwnersEvaluation:
Theownerisconcernedonlywiththereturntoinvestment(equity)andthuswouldbemoreinterestedto
knownetbenefitsandtheirnetpresentvalueincomparisonwiththevalueoftheinvestment.

BankersEvaluation:
Thebankerevaluatesthereturnonthetotalinvestment(equity+loans)oftheprojectappliedfortheloan
andconsidersitsprofitabilityi.e.,thebankerwillconsidertheNPVofthewholeinvestmentandnotjustthe
investorsequity.

EconomicEvaluation:
This includes all the economic costs and benefits i.e., social and environmental/external costs that can be
evaluated.Suchevaluationiscarriedoutspecificallybydevelopmentbanksandsimilarinstitutionsandalso
bytheconcernedplanningdepartmentsinthegovernment.

ProjectFinancialCost
Thethreemaintypesare:
1.
Investmentcosts:
Initial Cost (construction and commissioning including land, civil works, equipment and
installations)
Replacementcost
Residualvalues(valueoftheinvestmentitemsattheendoftheprojectsusefullife)
2. Operatingcosts
Fixedcosts:remunerationand benefits,administrativecosts,insurance payments, part of
themaintenancecost,etc.
Variablecost(dependsuponthelevelofproduction):fuelandenergy,water,lubricantsand
partofthemaintenancecost,rawmaterials(forindustrialprojects)
3. Workingcapital:
Capital required for the stock (spare parts ,fuel, raw materials) to ensure continuous
production
4. FinancialEvaluationofProjects:
SomeMethods
5. FinancialEvaluationofProjects:
SomeMethods
6. LeastCostSolution
PresentValuemethod
AnnualCostMethod
7. Measuringworthoftheinvestment
InternalRateofReturn
NetPresentValue
Benefit/CostRatio
PaybackPeriod
8. LeastCostSolution:
Page41of55

The least cost solution aims at evaluating all realistic alternatives (candidates) financially and
economicallybeforedecidingthealternativethatcanachievetheprojectbenefitsattheleastcost
i.e., least discounted overall cost over the useful life span of the project or over the specified
planninghorizon.

In the case of energy supply industry, when there are many alternatives for meeting the need for
increased electricity demand, the least cost solution aims at finding out the alternative technical
arrangementthatmeetstherequirementofelectricalenergywiththeleastcosttotheutility,itssite
andtiming.

Inchoosingtheleastcostsolutionwecomparethepresentvalueofthecostofthealternativesand
ordiscountedenergycost(US/kWh)dependinguponthecostsandtechnicalcharacteristicsofthe
alternatives.
9. Themostpopularmethodsforfinancialevaluationandcomparingalternatives:
PresentValuemethod
Hereallcostsandbenefitsoftheprojectornetbenefits(Cashflows)arediscountedtothebaseyear.
Thenetpresentvalue(NPV)isnothingbutthedifferencebetweenthediscountedbenefitsandthe
discountedcosts.

n
n
Ct
Bt

t
t
t 0 (1 r )
t 0 (1 r )

Here,benefitsrepresenttheincomeortherevenueproducedbytheproject(financialflowsonly)

Example1:
Acompanyisconsideringbuyinganefficientboilerforitsmanufacturingprocess.Itwouldcost$40,000
immediatelybutwouldsave$7500eachyearforthenext10years.Howeveratthenendofthefifthyeara
onetimemaintenanceexpenseof$5000wouldbeincurred.Iftheownersopportunitycostofcapitalis
8%,shouldthecompanybuytheboiler?
Solution:

Year
0
1
2
3
4
5
6
7
8
9
10

Benfits,$
0
7500
7500
7500
7500
7500
7500
7500
7500
7500
7500

Cost,$
40000
0
0
0
5,000
0
0
0
0
0
Total
NPV, $

Discounted Values
Benfits,$
Cost,$
0.0
40000.0
6944.4
0.0
6430.0
0.0
5953.7
0.0
5512.7
0.0
5104.4
3402.9
4726.3
0.0
4376.2
0.0
4052.0
0.0
3751.9
0.0
3474.0
0.0
50325.61 43402.92
6922.7

Themachineisagoodinvestment;itproducesadiscountedsavingsof$6922.2.

Page42of55

Example3:
Financialevaluationofenergyefficientmotorovera20yearlifetimeandat10%discountfactor
GoodMotor(GM)

EnergyEfficientMotor(EEM)

Cost:$700

Cost:$846

InputPower:7.9kW

InputPower:7.5kW

Runninghours:1600h/year

Runninghours:1600h/year

Electricitycost:$0.095/kWh

Electricitycost:$0.095/kWh

Solution:
Theannualelectricitycost(AEC)forthetwomotorsis:
GM:7.9kWx1600h/yrx$0.095/kWh=$1201/yr
EEM:7.5kWx1600h/yrx$0.095/kWh=$1140/yr
NPV=DiscountedbenefitsDiscountedcosts

Here,
discountedbenefits=presentvalueoffuturefuel/energysavings
=AECxPVF(@10%,20yrs)=(12011140)/yrx8.5/yr=$518.5
anddiscountedcost=incrementalcostofbetterproduct(initialcost)
=($846$700)=$146
Therefore,NPVEEM=$518.5$146=$372.5:>TheEEMisthebetterinvestment!

AnnualCostmethod
Thisisausefulandquickmethodthatgivesrapidresultsandallowstheattentionoftheevaluatortofocus
onafewalternativessupposingthatcertainassumptionsandapproximationsarepossible.
Example4:Comparingalternativeprojectsbyevaluatingcostofproductionandprices:
Discountfactor(r)

CombinedCycleSteamTurbine

CombinedCycleGasTurbine

Cost

10%

10%

Expectedlife(n)

$1000/kW

$500/kW

Fixedandrunningcost

30yrs

20yrs

Fullloadoperatinghrs

0.02$/kWh

0.024$/kWh

Calculation:

8000

7000

Annuityfactor(r%,n)

9.427

8.514

Costofproduction=

($1000/9.427)/8000+ $0.02 = 3.33

/kWh

($500/8.514)/7000+$0.024=3.24/kWh

Page43of55

Example5:
ComparisonofcostofenergyproductionfromWindTurbine,Photovoltaic,andsmallGasTurbinesystem

Photovoltaic

WindTurbine

GasTurbine

Ownerdiscountrate

10%

10%

10%

InstallationCost(P)

$10,000

$2500

$850/kW

Capacity(kW)

3.0

0.90

0.70

Capacityfactor

0.25

0.385

12500Btu/kWh

Heatrate

$7/106Btu

FuelCost

$0.002/kWh

VariableO&MCost

AnnualO&M

$100/yr

(10%interest,20yrloan)

Annualloanpayment@

(6%interest,20yrloan)

(7%interest,15yrloan)

PxCRF=$99.8/yr

Annualoperatinghours

PxCRF=$872/yr

PxCRF=$275/yr

8760x0.7=6132h

Thecostofelectricity

8760x0.25=2190h

8760x0.385=3373h

Fuel+O&M+FixedCost

=872/(2190x3)

(275+100)/(0.9x3373)

=(12500*
7
/106)
0.002/kWh+($99.8/6132)

=13.3/kWh

=12.4/kWh

=10.6/kWh

Measuringworthoftheinvestmentforfinancialdecisionmaking:

Theimportantcriterionare:
Internalrateofreturn
NPVoftheproject
Benefit/Costratio
Othercriteria(payback,profit/investmentratio,commercialreturnonequitycapital)

Note:
Alltheabovecriteriaexceptforthelast,involvediscounting

Page44of55

Exam
mple 6 on
n IRR
What would
w
be the IRR ,if the opportunity
o
c
cost of capita
al (OCC) is 11
1%t,
is this project desirable ?

The condition
c
required is :
As a firs
st estimate, le
et IRR = 10%,

Since th
he sum is positiive, let IRR = 12%, this would
d give :
Repeatiing this iteratiive process yields an IRR of 17.5%.Since
e this exceeds the
OCC off 11%, the projject will generrate more than
n enough inco
ome to cover the
cost of borrowing. Th
his is an attrac
ctive investme
ent.
Spreadsh
heet could be used
u
to compute
e IRR more eas
sily using the sy
yntax: IRR(cash
h-flow
values)

Pagge45of55

Example 7 (IRR)
Financial Analysis of a Petroleum Refining Project

Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
PV@10%

Product
Volume
O&M of crude Price of Cost of
sales /
Capital
a
b
c
oil
crude oil crude oil revenue
Cost
Cost
$ million $ million
b/d
$/bl
$ million $ million
6
0
0
0
0
0
45
0
0
0
0
0
55
0
0
0
0
0
52
0
0
0
0
0
0
18
500
65.0
10.7
27
0
35
2500
66.6
55.0
139
0
35
2000
68.3
45.1
116
0
35
2500
70.0
57.7
151
0
35
2800
71.7
66.3
141
0
2800
73.5
68.0
146
0
3000
75.4
74.6
163
0
3000
77.3
76.5
169
0
3000
79.2
78.4
176
0
3000
81.2
80.4
183
0
3000
83.2
82.4
191
0
3000
85.3
84.4
198
$119.48 $88.07 $12,341
$302.02 $704.21

Net
Benefits
$ million
-6.0
-45.0
-55.0
-52.0
-1.9
49.5
35.9
58.1
39.2
78.2
88.2
92.9
97.7
102.8
108.1
113.7
$166.08

IRR
23%
Notes:
b/d: barrels per day
a
O&M include the cost of fuel used by the refinery
b
based on 330 days per year
c
based on the yield of various products (gasoline,jet fuel,gasoil,fuel oil and butane)
from the refinery and the market prices of theses products

Benefit-Cost Ratio
This method compares the discounted total benefits
of the project to its discounted costs:
n

B/C

Bt

(1 r )
t 0
n

Ct

(1 r )
t 0

Only projects of B/C > 1.0 are adopted. The criteria is useful in
capital constraint situation e.g., utility has a lot of feasible
projects but limited investment budget. In this case, projects are
ranked in accordance with their B/C ratio and are adopted
accordingly until their combined costs equal the capital
investment budget.
Example 8:
B/C of example-1 = 1.15

Page46of55

Paybackperiod
Itisthetimerequiredforaproject'stotalbenefitstoexceeditstotalcost.Atthattimeprojectcanbesaidto
havepaidbackitsinitialcost.

Themostcommonapplicationsisintheanalysisofenergyconservationprograms.

Example9:
Energyefficiencyretrofit oflarge buildingreducestheannual electricitydemandforheating andcooling
from2.3GWhto0.8GWhandthepeakdemandforpowerby150kW.Electricitycosts$0.06/kWhand
demandchargesare$7/kWmonth.Iftheprojectcosts$500,00,whatwouldbethepaybackperiodofthe
investment?
EnergySavings(A)
=(2.30.8)x106kWh/yrx$0.06/kWh=$90,000/yr
DemandSavings(B)
=150kWx$7/kWmonthx12months/yr=$12,600/yr
TotalAnnualSavings:(A)+(B)=$102,600/yr
Simplepaybackperiod=InitialInvestment/AnnualSavings

=$500,000/$102,600/yr

=4.87yr.

AnOverviewofRenewableEnergyProjectFinancingthroughCDM
BriefBackground

FormulationoftheUnitedNationsFrameworkConventiononClimateChange(UNFCCC)in1992.

UNFCCsetsanultimateobjectiveofstabilizingatmosphericconcentrationsofgreenhousegasesat
safelevels.

Categorizationofcountriesintotwogroups:AnnexIPartiesi.e.theindustrializedcountrieswhohave
historically contributed the most to climate change, and nonAnnex I Parties, i.e. developing
countries.

ConferenceofParties(COP)

UnitedNationsFrameworkConventiononClimateChangeAsthePrecursorofCleanDevelopment
Mechanism

KyotoProtocol

TheProtocolwasadoptedinDecember1997.

ItcreateslegallybindingobligationsonAnnexIcountriestoreducetheiremissionsofGHGs.
Page47of55

Asof27Febru
uary2006,16
62statesand
dregionaleco
onomicintegrrationorganizationshave deposited
nstrumentsoffratificationss,accessions,approvalsoracceptances.
in

Th
heprotocole
enteredintofforceon16Feebruary2005
5.

Kyoto pro
otocol requires developed
d countries to reduce theeir GHG emisssions ( CO2 equivalent)
e
at least 5%
belowtotthelevelof1990by2012(thefirstcom
mmitmentperriod:200820
012).

oachievetheobjectiveofreducingGHG
Gemissions.
CDMisoneoftheKyotomeechanismsto
nable develo
opment in
CDM allows emission reduction projjects that assist in creaating sustain
untriestogen
neratecertiffiedemissionreductions(C
CER)forusebytheinvesttor.
deevelopingcou

WhatarretheaspectsofCDM
M?

En
nablesAnnexx1countries(developedccountries)tomeettheirem
missionreducctioncommitmentsina
flexibleandco
osteffectivem
manner.

Assist develop
ping countriees (nonAnnex I or the host countries) in meeeting their sustainable
s
deevelopmento
objectives.

In
nvestorsbene
efitbyobtainiingCertificatesofEmissio
onsReduction
ns(CER).

HostCountriessbenefitintheformofin
nvestment,acccesstobetteertechnologyy,andlocalssustainable
deevelopment.

Whatdo
oesCDMaiimtoachieve?
DualObjeectives:
lo
owertheoverrallcostofred
ducingGHGeemissions
whilealsosup
w
portingsustainabledevelo
opmentinitiativeswithind
developingco
ountries.

Pagge48of55

A transfer of finances and contribution to sustainable

development in the Host Country

Flow of Finances

Annex I Country

Host Country

Flow of Credits

BenefitsofCDMfordevelopingcountries
AttractforeigninvestmenttocountriesengagedinthetradingofCERs

Increasetheprofitabilityofcleanerandmoreefficienttechnologyinenergy,industry,andtransport
sectors.

Helpinwastemanagementoperations.

Contributetosustainabledevelopmentofthehostcountry.

ProjectSustainabilityScreening

EstablishmentofSustainableDevelopmentcriteria
Shouldreflecteconomic,social,andenvironmentalsustainabilitydimensions.
TheassessmentofSDaspectofaprojectwillinvolveasetofindicators.
Page49of55

Theindicatorsshouldbe:
Complete:adequatetoindicatethedegreetowhichtheoverallobjectiveofsustainabilityhasbeen
met.
Operational:canbeusedinameaningfulwayintheanalysis.
Decomposable:thedecisionscanbebrokendownintopartsinvolvingasmallerno.ofindicators.
Nonredundant:Theindicatorsshouldbedefinedtoavoiddoublecountingofconsequences.
Minimal: It is desirable to keep the set of indicators as small as possible. For instance it may be
possibletocombineindicatorstoreducethedimensionalityofthedecisionproblem.

DistributionofRegisteredCDMProjectsbyHostCountries

Others,
Sri 16.3
Lanka,
1%2.13
%
Guatemala,
2
.13%
Ecuador, 2.1
3%
Argentina, 2.
13%
Republic of
Moldova, 2.1
3%
Panama, 2.1
3%

Brazil, 26.24
%

China, 4.26%
India, 19.86
%

Chile, 4.96%
Honduras, 6.
38%
Mexico, 9.22
%

DistributionofRegisteredCDMProjectsAccordingtotheSectoralScopes
Energy
Demand, (2.96%)
Fugitive emissions
from fuels (solid, oil
and gas), (1.18%)

Energy industries
(renewable - / nonrenewable
sources), (55.62%)

Fugitive emissions
from production
and consumption of
halocarbons and
sulphur
hexafluoride, (2.96
%)
Waste handling and
disposal, (23.67%)

Chemical
industries, (1.18%)

Manufacturing
industries, (1.78%)

Agriculture, (10.65%
)

Page50of55


AccordingtotheSectoralScopes

Fugitive emissions from

fuels
6%

Chemical industries
5%

Manufacturing industries
12%

Fugitive emiss ions from

halocarbons and sulphur
hexafluorid
2%
Waste handling an d
25%

Energy distribution
2%
Afforestation and
reforestatio
3%

Energy
d
d
9%

Energy in du stries

24%

CDMProjectRequirements
Baselinestudyforemissions
Emissionsadditionality&financialadditionality
Hostcountrygovernmentapproval
Meetsthesustainabledevelopmentcriteria
DemandforCERspriceofCERs

Agriculture
8%
Trans port
2%
Mining
2%

AdditionalityandBaseline

Additionality

GHGreducedbelowwhatwouldhaveoccurredwithouttheprojectactivity

Baselinescenario

RepresentinganthropogenicemissionsbysourcesofGHGsthat wouldoccur without the proposed

projectactivityAdditionalityandBaseline

Page51of55

IdentifyB
BaselineEm
missionMeth
hodology

Baseline//CERconceptts
t0=startingye
earofCDM
E0t
ssionwithoutCDMprojectt
0 =Totalemis
ECDMt
=Totalem
missionwithC
CDM
C
CER=E0tECDM
Mt
=tonofe
equivalentCO
O2reduction(tradedintheinternation
nalmarket:e.g.,5$to25$
$/tC)

Exampless:
ImpactofCERspriceo
ontheprojecctsIRR

Pagge52of55

Country
Costa Rica
Jamaica
Chile
Costa Rice
Gyana
Brazil
India

Project
Wind power
Wind power
Hydro
Hydro
Bagasse
Biomass
Solid Waste

IRR with
IRR without
Carbon finance Carbon finance
(%)
(%)
9.7
10.6
17
18
9.2
10.4
7.1
9.7
7.2
7.7
8.3
13.5
13.8
18.7

Change
in IRR
(%)
0.9
1.0
1.2
2.6
0.5
5.2
4.9

ThesubstantialimprovementinIRRobservedinBiomassandSolidWastemanagementprojects.

CaseStudyPresentation
FinancialAnalysisofaSmallHydroProjectwithandwithoutCDMBenefits
CharacteristicsoftheproposedCDMProject
Type
:Runoftheriverhydroproject
InstalledCapacity:3.5MW
Category

:RenewableEnergyproject(<15MW)
Loadtype

:Nationalgrid
Developer

:Private
CountrysPowerDevelopmentScenario
Theprojectissituatedinacountrywheredieselandfueloilbasedgenerationsystemsupply70%of
electricityandtheremainingissuppliedbyhydrosources.
Inthelast5years,allthenewcapacityaddedisbasedondieselandfueloil.
LCGEPshowsthatfutureadditionstopowergenerationcapacitywillbebasedonfueloilordiesel
thoughsomeexploitablehydrocapacityisavailable.
The baseline emission factor is the emission factor of the diesel based generation system of
appropriatecapacityandloadfactor.(MethodI)
EstimationofBaselineCERMethodI
CDM Paramters
Hydo Power
Capacity
10 MW
Output
67 GWh/a
Emissions
0 t CO2/a

Thermal power plant (Diesel)

Input
(1)
181,081
Emission factor (2)
0.202
Emissions
(3)=(1)*(2)
36,506
Efficiency
0.37
Output
67
CER price
(4)
10
CERs
(3)*(4)
365,059

MWh/a
tC/MWh
tC/a
GWh/a
US$/tC
US$/a

EstimationofBaselineCERMethodII
Theemissionfactoristheweightedaverageemissions(inkgCO2e/kWh)ofallthegenerationunitsinthe
system.Theemissioncoefficientiscalculatedassumoftotalemissionfromeachofthegenerationunits
dividedbythesumoftheirgenerationinthatyear.

Page53of55

N et
G e n e ra tio n
(G W h )
Fuel
C oal
72563
L ig n ite
16368
G as
18826
H yd ro
16587
N u c le a r
4122
T o ta l
128466
B a s e lin e e m is s io n fa c to r
(tC O 2 /M W h )
o r tC /M W h

Fuel
C o nsum ed
(1 0 3 to n n e s )
(A )
50776
11454
3743

N e t C a lo rific
V a lu e (T J /1 0 3
to n n e s ) - (B )
1 6 .2 2
1 6 .2 2
4 3 .3 3

C arb o n
E m is s io n *
F a c to r
(IP C C ;
tC /T J )- (C )
2 5 .8
2 7 .6
1 5 .3
0
0

E m issio n
tC O 2 (D ) =
(A )x (B )x (C )
x 4 4 /1 2
77911301
18801328
9116373
0
0
105829002

0 .8 2 4
0 .2 2 5

IdentificationofAdditionalityoftheProposedCDMProject
GHGemissionsfromthisprojectactivitiesislowerthanthatinthebaseline
ProposedCDMprojectactivitiesisnotabaselinescenarioproject.
The project activity is not expected to get implemented in the absence of the CDM due to the
investmentbarrierandfinancialanalysisisusedtodemonstratethis:

Financial Analysis
Detail Cash-flow analysis
without CDM Credit
Compute
FIRR and FNPV
Is financially
attractive ?

YES

Not a CDM Project

NO
Detail Cash-flow analysis
with CDM Credit
Compute
FIRR and FNPV
Infeasible project

NO

Is financially
attractive ?

YES

Consideration for
CDM Project
24

Page54of55

CERvs.FIRR
24
20
MARR
FIRR, %

16
12
8
4
Break-even CER
0
0 (Base
Case)

10

15

25
CER, $/tC

Example:Breakeven

$350,000
$300,000

Present Worth

Break even- volume

$250,000

Profit

$200,000
$150,000

Loss

$100,000
$50,000
$0
0

500

1000

1500

2000

2500

Annual Sales units

PV Benefits

PV Costs

Page55of55