ECE 333

Green Electric Energy

Lecture 14
Engineering Economics

Professor Tom Overbye

Department of Electrical and
Computer Engineering
 Announcements

Be reading Chapter 5
•
Homework 6 is due Oct 22. It is 4.9, 5.2, 5.4, 5.6, 5.11
•
Wind Farm field trip will be on Nov 5 from about 8am to 4pm – turn in forms to sign up.
•
Campus Wind Turbine Project: Let your voice be heard! If you would like to email your student senators
• with your wind turbine views some folks to talk with are Bradley Tran (president-iss@illinois.edu), Bobby
Gregg (bobby.gregg@gmail.com), Melanie Cornell (cornell4@illinois.edu)
 Energy Economic Concepts
(From Prof. Gross)
• The economic evaluation of a renewable energy resource
requires a meaningful quantification of cost elements
– fixed costs
– variable costs
• We use engineering economics notions for this purpose
since they provide the means to compare on a consistent
basis
– two different projects; or,
– the costs with and without a given project
 Time Value of Money

• Basic notion: a dollar today is not the same as a

dollar in a year
• We represent the time value of money by the
standard approach of discounted cash flows
• The notation is
P = principal
i = interest value
• The convention we use is that payments occur at the
end of each period (e.o.p.)
Simple Example

loan P for 1 year

repay P + iP = P ( 1 + i ) at the end of 1 year
year 0 P
year 1 P (1 + i)

loan P for n years

year 0 P
year 1 (1 + i) P repay/reborrow
year 2 ( 1 + i )2 P repay/reborrow
M 3
year ( 1M+ i )3 P M
repay/reborrow
.
year n ( 1 + i )n P repay
 Compound Interest
e.o.p. amount owed interest for amount owed for next period
next period
0 P Pi P + Pi = P(1+i )

1 P(1+i ) P(1+i ) i P(1+i ) + P(1+i ) i = P(1+i ) 2

2 P(1+i ) 2 P(1+i ) 2 i P(1+i ) 2 + P(1+i ) 2 i = P(1+i ) 3

3 P(1+i ) 3 P(1+i ) 3 i P(1+i ) 3 + P(1+i ) 3 i = P(1+i ) 4

M M
n-1 P(1+i ) n-1 P(1+i ) n-1 i P(1+i ) n-1 + P(1+i ) n-1 i = P(1+i ) n

n P(1+i ) n

The value in the last column for the e.o.p. (k-1) provides the value in
the first column for the e.o.p. k (e.o.p. is end of period)
 Terminology/Overview

• Cash flow diagrams

Incoming cash flow

0 1 2 3 4
Outward cash flows
Present

• Common conversion factors

– Present Value- (P|A,i%,n) and (P|F,i%,n)
– Future Value- (F|A,i%,n) and (F|P,i%,n)
– Capital Recovery Factor- (A|P,i%,n)
 Cash Flows

• A cash flow is a transfer of an amount A t from one

entity to another at e.o.p. time t
• A cash-flow set { A0 , A1 , A2 ,..., An} corresponds to the set
of times { 0 ,1, 2,..., n}
• The convention for Ex.
cash flows is
+ inflow I take out a loan
− outflow 0 1 2 3 4
I make equal repayments

• Each cash flow has (1) amount, (2) time, and (3) sign
 Cash Flows

• Given a cash-flow set { A , A , A ,..., A }

0 1 2 n we
define the future worth F n of the cash flow set at e.o.y.
n as n

∑ A ( 1 + i)
n− t
Fn = t
t =0

A0 A1 A2 At A n-2 A n-1 An

... ...
0 1 2 t n–2 n–2 n
 Cash Flows

• Note that each cash flow A t in the set contributes

differently to F n
A0 ( 1 + i )
n
A0 →
A1 ( 1 + i )
n−1
A1 →
A2 ( 1 + i )
n− 2
A2 →
M M
At ( 1 + i )
n− t
At →
M M
An → An
 Discount Rate

• The interest rate i is typically referred to as the

discount rate and is denoted by d
• In converting a future amount F to a present worth
P we can view the discount rate as the interest rate
that can be earned from the best investment
alternative
• A postulated savings of $ 10,000 in a project in 5
years is worth at present

= 10,000 ( 1 + d )
−5
P = F5 β 5
 Discount Rate

• For d = 0.1, P = $ 6,201,

while for d = 0.2, P = $ 4,019
• In general, the lower the discount factor, the
higher the present worth
• The present worth of a set of costs under a given
discount rate is called the life-cycle costs
 Cash Flow Example

• Find the future worth of cash flows at the end of year 5

d = %12 $ 3,000

F5=?
0 1 2 3 4 5
year

$ 2,000 $ 2,000

Answer: outflow of $2571

 Cash Flows

• Single-payment compound amount factor-

( 1+ i)
n

• Single-payment present worth factor-

β @( 1 + i ) = ( 1+ i)
−1 −n
β n

• n is typically in years and need not be an integer value

 Cash Flows

• We define the present worth P of the cash flow set as

n n

∑A β ∑ A ( 1 + i)
−t
P = t
t
= t
t =0 t =0
• Note that n

∑ A ( 1 + i)
−t
P = t
t =0

∑ A ( 1 + i ) (11 4+ i4) 2( 14+4i) 3

−t n −n
= t
t =0
1
 Cash Flows
cont’d n
P = ( 1 + i ) ∑ At ( 1 + i )
−n n −t

142 4 3 t =0
1 4 42 4 43
β n
F n

= β n Fn
or equivalently

Fn = ( 1 + i ) P
n

This is the lump equivalent sum at the end of n periods.

F is the future worth, and P is the present worth
 Example 1

• Consider a loan of $4,000 at 8% interest to be repaid in

two installments
– $ 1,000 and interest at the e.o.y. (end of year) 1
– $ 3,000 and interest at the e.o.y. 4
• The cash flows are
– e.o.y. 1: 1000 + 4000 (.08) = $ 1,320
– e.o.y. 4: 3000 (1 + .08 ) 3 = $ 3,779.14
• Note that the loan is made in year 0 present dollars,
but the repayments are in year 1 and
year 4 future dollars
 Example 2

• Given that
P = $1,000 and i = .12

• Then we say that for the cost of money of 12%, P

and F are equivalent in the sense that $1,000 today
has the same worth as $1,762.34 in 5 years

P ( 1 + i) = $1,000( 1 + .12)
5 5
= $1,762.34 = F
 Example 3

• Consider an investment that returns

$1,000 at the e.o.y. 1
rate at which
$2,000 at the e.o.y. 2 money can be
freely lent or
i = 10%
borrowed
• We evaluate P
P = $ 1,000 ( 1 + .1) + $ 2,000( 1 + .1)
−1 −2

142 43 142 43
β β 2

= $ 909.9 + $ 1,652.09 = $ 2,561.98

Net Present Value (NPV) for Example 3

• Next, suppose that this investment requires $ 2,400

now. At 10%, the investment has a net present value
(NPV ) of
NPV = $ 2,561.98 – $ 2,400 = $ 161.98
$ 1,000 $ 2,000
$ 2,561.98
0 1 2
$ 2,400 year

NPV=$ 161.98 { 0 1 2
 Uniform Cash Flow Set

• Consider the cash-flow set { A0 , A1 , A2 ,..., An} with

At = A t = 1, 2,..., n
• Such a set is called an equal payment cash flow set
• Each payment can be thought of as a future value and
the results will be the same
• We compute the present worth
n n
P = ∑ At β
t =1
t
= A ∑ β t = Aβ 1 + β + β 2 + ... + β n− 1 
t =1
 Uniform Cash Flow Set, cont.

• Now, for 0 < β < 1 , we have the identity

∞
1
∑β j
=
1−β
∞
∑β
j
j =0
• It follows that j=0
∞
1 + β + ... + β n−1 = ∑ β
j =0
j
− β n

 1 + β + β 2
+... + β n −1
+...
∞
= ( 1−β n ) ∑ β j

j =0
1− β n
=
1− β
 Uniform Cash Flow Set, cont.

• Therefore  1 − β n
P = A β 
 1− β 
β = (1 + d)
−1
• But and so
1 d
1−β = 1− = = βd
1+ d 1+d
• We write P = A 1 − β n

d
1− βn
• We call the equal payment series present
d value function
Uniform Cash Flows, PVF

1−β n
1 − (1 + d ) −n
(1 + d ) − 1
n
= =
d d d (1 + d )n
this is also written as (P|A,d%,n)
 In the News: States Not Meeting
Renewable Energy Goals
• USA Today had an article last week that discussed progress states
were making on meeting their renewable portfolio standards; 35
states have such goals
• There is no central clearing house on compliance, so the article
just discussed several examples
– NJ would like to have 1000MW of offshore wind by 2012, but will miss
that by about a year
– CA has a 20% goal by 2010, but won’t achieve that until 2013 or 2014
– AZ planned to get 0.3% from solar by 2009, but probably won’t achieve
that until 2011

www.usatoday.com/money/industries/energy/2009-10-08-altenergy_N.htm
 California and Solar

• In California Gov Schwarzenegger signed two solar energy

bills this week that will help make solar energy more cost
effective for consumers (with solar).
– AB 920 requires utility companies to pay customers for any surplus
electricity they produce from solar or wind (previously they had to
give it back any surplus for free)
– AB 32 creates an above-market tariff, called a “feed-in-tariff” that
requires the state’s utilities to buy solar electricity from 1.5 to 3.0
MW units at rates above what they would pay for conventional
sources
 Equivalence

• We consider two cash-flow sets

{ A : t = 0,1, 2,..., n}
a
t and { A : t = 0,1, 2,..., n}
b
t

under a given discount rate d

• We say are equivalent cash-flow sets if
{A }a
t and { A } b
t
their future worths (or their net worths at any point in
time) are identical.
 Equivalence, Example

• Consider the two cash-flow sets 8,200.40

under d = 7%

2000 2000 2000 2000 2000

0 1 2 3 4 5 6 7 0 1 2
a b
 Equivalence, cont.
7
• We compute P a = 2000 ⋅ ∑ β t
= 7162.33
t =3

and P b = 8200.40 ⋅ β 2 = 7162.33

• Therefore, { A a } and { A b} are equivalent cash flow sets

t t
under d = 7%
 Example

• Consider the set of cash flows illustrated below

$ 400
$ 300
$ 200 $ 200

3
0 1 2 4 5 6 7 8

d = 6%
$ 300
 Example, cont.

• We compute F 8 at t = 8 for d = 6%
F8 = 300 ( 1 + .06) − 300( 1 + .06)
7 5
+
200 ( 1 + .06) + 400( 1 + .06)
4 2
+ 200
= $ 951.56

• We next compute P
P = 300 ( 1 + .06) − 300( 1 + .06)
−1 −3

+ 200 ( 1 + .06 ) + 400( 1 + .06) + 200( 1 + .06)

−4 −6 −8

= $ 597.04
• We check that for d = 6%
F8 = 597.04 ( 1 + .06) = $ 951.56
8
 Motor Purchase Example

• We consider the purchase of two 100-hp motors – a

and b – to be used over a 20-year period; the discount
rate is 10%
• The relative merits of a and b are
motor costs ( $ ) load ( kW )

a 2,400 79.0

b 2,900 77.5

• The motor is used 1,600 hours per year and electricity

costs are constant at 0.08 $/kWh
 Motor Purchase Example, motor a

• We evaluate yearly energy costs over 20 years for motor a

A a = ( 79.0 kW ) ( 1600 h / yr) ( .08 $ / kWh) = $ 10,112/ yr

0 1 2 t 19 20
... ... ...
Aa Aa Aa Aa Aa

$2400

20

∑ ( 1.1of) motor
−t
• We a
= 2, 400
P evaluate the+present
10,112worth = $a88, 489
t =1
 Motor Purchase Example, motor b

• We evaluate yearly energy costs over 20 years for motor b

A b = ( 77.5 kW ) ( 1600 h / yr) ( .08 $ / kWh) = $ 9, 920 / yr
0 1 2 t 19 20
... ... ...
Ab Ab Ab Ab Ab

$2900

20
• ∑ ( 1.1) of
−t
WePnext
b
= evaluate
2, 900 + the present
9, 920 worth = motor b
$ 87, 354
t =1
 Motor Purchase Example, cont.

• Comparing the present worths of motors a and b gives the

following:

P a − P b = 88, 489 − 87, 354 = $ 1,135

• Therefore, the purchase of motor b results in a savings of $

1,135 compared to motor a due to the use of the smaller
load motor under the specified 10% discount rate

• What if it were a generator instead of a motor?

 Infinite Horizon Cash-Flow Sets

• Consider a uniform cash-flow set with n → ∞

{ At = A : t = 0, 1, 2, ... }
• Then,
P = A
( 1 − β n
) A
1
d n →∞ d
For an infinite horizon uniform cash-flow set

A
= d
P
 Infinite Horizon Cash-Flow Sets, cont.

• We may view d as the capital recovery factor with the

following interpretation:

For an initial investment of P,

dP = A
is the annual amount recovered in terms of
returns on investment
 Internal Rate of Return

• We consider a cash-flow set

{A t = A : t = 0, 1, 2, ... }
• The value of d for which
n
P = ∑ t =0
A β
t =0
t

is called the internal rate of return (IRR)

• The IRR is a measure of how fast we recover an
investment or stated differently, the speed with which
the returns recover an investment
 Internal Rate of Return Example

• Consider the following cash-flow set

$6,000 $6,000 $6,000 $6,000 $6,000
0

1 2 3 4 8

$30,000
 Internal Rate of Return

• The present value

1− β 8
P = − 30,000 + 6,000 =0
d
has the (non-obvious) solution of d equal to about 12%.
• The interpretation is that under a 12% discount rate, the present
value of the cash flow set is 0 and so 12% is the IRR for the given
cash- flow set
– The investment makes sense as long as other investments yield less than
12%.
 Internal Rate of Return

• Consider an infinite horizon simple investment

A A A
...
0 1 2 n
I
A ratio of annual return to
• Therefore d = I initial investment
• For I = $ 1,000 and A = $ 200, d = 20% and we
interpret that the returns capture 20% of the investment
each year or equivalently that we have a simple
payback period of 5 years
 Efficient Refrigerator Example

• A more efficient refrigerator incurs an investment of

additional $ 1,000 but provides $ 200 of energy savings
annually
• For a lifetime of 10 years, the IRR is computed from the
solution of
1− β 10
0 = − 1,000 + 200
d
or The solution of this equation
1− β 10
= 5 requires either an iterative
d approach or a value looked
up from a table
 Efficient Refrigerator Example, cont.

•IRR tables show that 1 − β 10

= 5.02
d d = 15%
and so the IRR is approximately 15%
If the refrigerator has an expected lifetime of 15 years this
value becomes

1 − β 15
= 5.00
d d = 18.4%

As was mentioned earlier, the value is 20% if it lasts forever

Impacts of Inflation

• Inflation is a general increase in the level of prices in an

economy; equivalently, we may view inflation as a general
decline in the value of the purchasing power of money
• Inflation is measured using prices: different products may
have distinct escalation rates
• Typically, indices such as the CPI – the consumer price index
– use a market basket of goods and services as a proxy for the
entire U.S. economy
– reference basis is the year 1967 with the price of $ 100 for the basket
(L 0); in the year 1990, the same basket cost $ 374 (L 23 )
 Figuring Average Rate of Inflation

• Calculate average inflation rate e from 1967 to 1990

374
( 1 + e) =
23
= 3.74
100 Current
ln ( 3.74 )
ln ( 1 + e ) = → e = 0.059% (1/2009)
23 basket
value is
about 632.

Source: http://en.wikipedia.org/wiki/File:US_Historical_Inflation.svg