UNIT – 2

ENERGY ECONOMIC ANALYSIS

 The time value money concept

 developing cash flow of models
 Payback analysis depreciation
 taxes and tax credit – numerical problems

Introduction

Energy projects are very important to the economy and environment. In case of energy
conservation projects—the more the number, the better it is for the environment. It is important
to justify any capital investment project by carrying out a financial appraisal. However, the
biggest constraint in increasing the number of energy projects is the lack of finance. Alternative
finance arrangements can overcome the "initial cost" obstacle, allowing flu-ms to implement
more energy management proposals. However, many energy managers are either unaware or
have difficulty in understanding the variety of financial arrangements available to them. Most of
the energy managers and auditors use simple payback analysis to evaluate projects, which do not
reveal the added value of after-tax benefits. Sometimes energy managers do not implement
Energy Management Proposals because financial terminology and contractual details intimidate
them. The financial issues associated with the capital investment in energy saving projects are
investigated in this chapter.

When planning an energy efficiency or energy management project, the costs involved should
always be considered. Therefore, as with any other type of investment, energy management
proposals should show the likely return on any capital that is invested. Consider the case of an
energy auditor who advises the senior management of an organization that capital should be
invested in new boiler plant. Inevitably, the management of the organization would ask:

• How much will the proposal cost?

• How much money will be saved by the proposal? These are, of course, not unreasonable
questions, since within any organization there are many worthy causes, each of which requires
funding and it is the job of senior management to invest in capital where it is going to obtain the
greatest return. In order to make a decision about any course of action, management needs to be
able to appraise all the costs involved in a project and determine the potential returns. This
however, is not quite as simple as it might first appear. The capital value of plant or equipment
usually decreases with time and it often requires more maintenance as it gets older. If money is
borrowed from a bank to finance a project, then interest will have to be paid on the loan.
Inflation too will influence the value of any future energy savings that might be achieved. It is
therefore important that the cost appraisal process allows for all these factors, with the aim of
determining which investments should be undertaken, and of optimizing the benefits achieved.
To this end a number of accounting and financial appraisal techniques have been developed
which help energy managers and auditors make correct and objective decisions. The financial
issues associated with capital investment in energy saving projects are investigated in this
chapter. In particular, the discounted cash flow techniques of net present value and internal rate
of return are discussed in detail.

Fixed and Variable Costs When appraising the potential costs involved in a project it is
important to understand the difference between fixed and variable costs. Variable costs are those
which vary directly with the output of a particular plant or production process, such as fuel costs.
Fixed costs are those costs, which are not dependent on plant or process output, such as site-rent
and insurance. The total cost of any project is therefore the sum of the fixed and variable costs.
Example 1 illustrates how both fixed and variable costs combine to make the total operating cost.
Interest Charges
In order to finance projects, organizations often borrow money from banks or other leading
organizations. Projects financed in this way cost more than similar projects financed from
organization‘s own funds, because interest charges must be paid on the loan. It is therefore
important to understand how interest charges are calculated. Interest charges can be calculated by
lending organization in two different ways: simple interest and compound interest.
(i) Simple interest: If simple interest is applied, then charges are calculated as a fixed percentage
of the capital that is borrowed. A fixed interest percentage is applied to each year of the loan and
repayments are calculated using the equation.

(ii) Compound interest: Compound interest is usually calculated annually (although this is not
necessarily the case). The interest charged is calculated as a percentage of the outstanding loan at
the end of each time period. It is termed 'compound' because the outstanding loan is the sum of
the unpaid capital and the interest charges up to that point. The value of the total repayment can
be calculated using the equation.

Investment Need, Appraisal and Criteria

When planning an energy efficiency or energy management project, the investment involved
should be considered. The need for investments in energy conservation can arise for installing
new equipment, improving process, providing staff training, and implementing or upgrading
energy information system. Therefore, as with any type of investment, energy management
proposals should show the likely return on any capital that is invested. Consider a case of an
energy auditor or consultant who advises the senior management of an organization that capital
should be invested in new boiler plant. Inevitably, the management of the organization would
enquire.

Financial Analysis Techniques

In most respects, investment in energy efficiency is not different from any other area of financial
management. So when the organization first decides to invest in increasing its energy efficiency,
it should apply exactly the same criteria to reduce its energy consumption as it applies to all its
other investments. A faster or more attractive rate of return on investment in energy efficiency
should not be demanded.

The basic criteria for financial investment appraisal include:

• Payback period - a measure of how long it will be before the investment makes money, and
how long the financing term needs to be

• Net Present Value (NPV) and Cash Flow - measures that allow fmancial planning of the
project and provide the company with all the information needed to incorporate energy
efficiency projects into the corporate financial system

• Return on Investment (ROI) and Internal Rate of Return (IRR) - measure that allow
comparison with other investment options

Payback Period

The simplest technique which can be used to appraise a proposal is payback analysis. The
payback period can be defined as the time (number of years) required to recover the initial
investment (capital cost), considering only the Annual Net Saving (Yearly benefits-Yearly
costs). Once the payback period has ended, all the project capital costs will have been recovered
and any additional cost savings achieved can be seen as clear 'profit'.

The shorter the payback period, the more attractive the project becomes. The length of the
maximum permissible payback period generally varies with the company concerned.
Time Value of Money

A project usually entails an investment for the initial cost of installation, called the capital cost,
and a series of annual costs and/or cost savings (i.e. operating, energy, maintenance, etc.)
throughout the life of the project. To assess project feasibility, all these present and future cash
flows must be equated to a common basis. The problem with equating cash flows which occur at
different times is that the value of money changes with time. The method by which these various
cash flows are related is called discounting, or the present value concept.

For example, if money can be deposited in the bank at 10% interest, then a Rs. 100 deposit will
be worth Rs.110 in one year's time. Thus the Rs.110 in one year is a future value equivalent to
the Rs. 100 present value.

In the same manner, Rs.100 received one year from now is only worth Rs.90.91 in today's
money (i.e. Rs.90.91 plus 10% interest equals Rs.100). Thus Rs.90.91 represents the present
value of Rs.100 cash flow occurring one year in the future. If the interest rate were something
different than 10%, then the equivalent present value would also change. The relationship
between present and future value is determined as follows:
Net Present Value Method

The net present value method considers the time value of money. This is done by equating future
cash flow to its current value today, in other words determining the present value of any future
cash flow. The present value is determined by using an assumed interest rate, usually referred to
as a discount rate. Discounting is the opposite process to compounding. Compounding
determines the future value of present cash flows, whereas discounting determines the present
value of future cash flows.

The net present value method calculates the present value of all the yearly cash flows (i.e. capital
costs and net savings) incurred or accrued throughout the life of a project and summates them.
Costs are represented as negative value and savings as a positive value. The sum of all the
present value is known as the net present value (NPV). The higher the net present value, the
more attractive the proposed project.

The net present value (NPV) of a project is equal to the sum of the present values of all the cash
flows associated with it. Symbolically,

Cash Flow

Capital Investment Considerations

To judge the attractiveness of any investment, we must consider the following four elements
involved in the decision: 1 Initial capital cost or net investment V Net operating cash inflows (the
potential benefits) 1 Economic life (time span of benefits) 1 Salvage value (any final recovery of
capital)
Initial capital cost or net investment

When companies spend money, the outlay of cash can be broadly categorized into one of two
classifications; expenses or capital investments. Expenses are generally those cash expenditures
that are routine, ongoing, and necessary for the ordinary operation of the business. Capital
investments, on the other hand, are generally more strategic and have long term effects.
Decisions made regarding capital investments are usually made by senior management and carry
with them additional tax consequences as compared to expenses.

The capital investments usually require a relatively large initial cost. The initial cost may occur
as a single expenditure or occur over a period of several years. Generally, the funds available for
capital investments projects are limited.

Initial capital costs include all costs associated with preparing the investment for service. This
includes purchase cost as well as installation and preparation costs. Initial costs are usually
nonrecurring during the life of an investment.

Net operating cash inflows

The benefits (revenues or savings) resulting from the initial cost for a capital investment occur in
the future, normally over a period of years. As a rule, the cash flows which occur during a year
are generally summed and regarded as a single end-of-year cash flow. Annual expenses and
revenues are the recurring costs and benefits generated throughout the life of the investment after
adjusting for applicable taxes and effects of depreciation. Periodic replacement and maintenance
costs are similar to annual expenses and revenues except that they do not occur annually.

Economic life

The period between the initial cost and the last future cash flow is the life cycle or life of the
investment.
Salvage value

The salvage (or terminal) value of an investment is the revenue (or expense) attributed to
disposing of the investment at the end of its useful life. If substantial recovery of capital from
eventual disposal of assets at the end of the economic life, these estimated amounts have to be
made part of the analysis. Such recoveries can be proceeds from the sale of facilities and
equipment (beyond the minor scrap value), as well as the release of any working capital
associated with the investment.

Cash Flow Diagrams

A convenient way to display the revenues (savings) and costs associated with an investment is a
cash flow diagram. By using a cash flow diagram, the timing of the cash flows is clear and the
chances of properly applying time value of money concepts are increased.

The economic life establishes the time frame over which the cash flows occur first. This
establishes the horizontal scale of the cash flow diagram. This scale is divided into time periods
which are frequently, but not always, years. Individual outlays or receipts are indicated by
drawing vertical lines appropriately placed along the time scale.

Upward directed lines indicate cash inflow (revenues or savings) while downward directed

lines Indicate cash outflows

Depreciation

Depreciation refers to two aspects of the same concept:

1. the decrease in value of assets (fair value depreciation), and

2. The allocation of the cost of assets to periods in which the assets are used
(depreciation with the matching principle).

The former affects the balance sheet of a business or entity, and the latter affects the net income
that they report. Generally the cost is allocated, as depreciation expense, among the periods in
which the asset is expected to be used. This expense is recognized by businesses for financial
reporting and tax purposes. Methods of computing depreciation, and the periods over which
assets are depreciated, may vary between asset types within the same business and may vary for
tax purposes. These may be specified by law or accounting standards, which may vary by
country. There are several standard methods of computing depreciation expense, including fixed
percentage, straight line, and declining balance methods. Depreciation expense generally begins
when the asset is placed in service. For example, a depreciation expense of 100 per year for 5
years may be recognized for an asset costing 500
Methods of depreciation

Here are several methods for calculating depreciation, generally based on either the passage of
time or the level of activity (or use) of the asset. Straight-line depreciation

Straight-line depreciation is the simplest and most often used method. In this method, the
company estimates the salvage value (scrap value) of the asset at the end of the period during
which it will be used to generate revenues (useful life). (The salvage value is an estimate of the
value of the asset at the time it will be sold or disposed of; it may be zero or even negative.
Salvage value is also known as scrap value or residual value.) The company will then charge the
same amount to depreciation each year over that period, until the value shown for the asset has
reduced from the original cost to the salvage value.

Straight-line method:

For example, a vehicle that depreciates over 5 years is purchased at a cost of $17,000, and
will have a salvage value of $2000. Then this vehicle will depreciate at $3,000 per year, i.e.
(17-2)/5 = 3. This table illustrates the straight-line method of depreciation. Book value at the
beginning of the first year of depreciation is the original cost of the asset. At any time book
value equals original cost minus accumulated depreciation.

book value = original cost − accumulated depreciation Book value at the end of year
becomes book value at the beginning of next year. The asset is depreciated until the book
value equals scrap value.
 Depreciation Accumulated depreciation Book value
expense at year-end at year-end

(original cost) 17,000

$3,000 $3,000 $14,000

3,000 6,000 11,000

3,000 9,000 8,000

3,000 12,000 5,000

3,000 15,000 (scrap value) 2,000

If the vehicle was to be sold and the sales price exceeded the depreciated value (net book
value) then the excess would be considered a gain and subject to depreciation recapture. In
addition, this gain above the depreciated value would be recognized as ordinary income by
the tax office. If the sales price is ever less than the book value, the resulting capital loss is
tax deductible. If the sale price were ever more than the original book value, then the gain
above the original book value is recognized as a capital gain.

If a company chooses to depreciate an asset at a different rate from that used by the tax office
then this generates a timing difference in the income statement due to the difference (at a
point in time) between the taxation department's and company's view of the profit.

Declining Balance Method

Suppose a business has an asset with $1,000 original cost, $100 salvage value, and 5 years of
useful life. First, the straight-line depreciation rate would be 1/5, i.e. 20% per year. Under the
double-declining-balance method, double that rate, i.e. 40% depreciation rate would be used.
The table below illustrates this:
 Depreciation Depreciation Accumulated Book value at
rate expense depreciation end of year

original cost 1,000.00

40% 400.00 400.00 600.00

40% 240.00 640.00 360.00

40% 144.00 784.00 216.00

40% 86.40 870.40 129.60

129.60 - 100.00 29.60 900.00 scrap value 100.00

When using the double-declining-balance method, the salvage value is not considered in
determining the annual depreciation, but the book value of the asset being depreciated is
never brought below its salvage value, regardless of the method used. Depreciation ceases
when either the salvage value or the end of the asset's useful life is reached.

Since double-declining-balance depreciation does not always depreciate an asset fully by its
end of life, some methods also compute a straight-line depreciation each year, and apply the
greater of the two. This has the effect of converting from declining-balance depreciation to
straight-line depreciation at a midpoint in the asset's life.

With the declining balance method, one can find the depreciation rate that would allow
exactly for full depreciation by the end of the period, using the formula:

, where N is the estimated life of

the asset (for example, in years).
Annuity depreciation

Annuity depreciation methods are not based on time, but on a level of Annuity. This could be
miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life
is estimated in terms of this level of activity. Assume the vehicle above is estimated to go
50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost -
$2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then
calculated by multiplying the number of miles driven by the per-mile depreciation rate.

Sum-of-years-digits method

Sum-of-years-digits is a depreciation method that results in a more accelerated write-off than

the straight line method, and typically also more accelerated than the declining balance
method. Under this method the annual depreciation is determined by multiplying the
depreciable cost by a schedule of fractions.

depreciable cost = original cost − salvage value

book value = original cost − accumulated depreciation

Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage value of
$100, compute its depreciation schedule.

First, determine years' digits. Since the asset has useful life of 5 years, the years' digits are: 5,
4, 3, 2, and 1.

Next, calculate the sum of the digits: 5+4+3+2+1=15

The sum of the digits can also be determined by using the formula (n 2+n)/2 where n is equal
to the useful life of the asset in years. The example would be shown as (52+5)/2=15

Depreciation rates are as follows:

5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and
1/15 for the 5th year.
 Total
Depreciation Depreciation Accumulated Book value at
depreciable
rate expense depreciation end of year
cost

1,000 (original cost)

900 5/15 300 =(900 x 5/15) 300 700

900 4/15 240 =(900 x 4/15) 540 460

900 3/15 180 =(900 x 3/15) 720 280

900 2/15 120 =(900 x 2/15) 840 160

900 1/15 60 =(900 x 1/15) 900 100 (scrap value)

Units-of-production depreciation method

Under the units-of-production method, useful life of the asset is expressed in terms of the
total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected to
produce 6,000 units.

Depreciation per unit = ($70,000−10,000) / 6,000 = $10

10 × actual production will give the depreciation cost of the current year.

The table below illustrates the units-of-production depreciation schedule of the asset.
 Units of Depreciation Depreciation Accumulated Book value at
production cost per unit expense depreciation end of year

70,000 (original cost)

1,000 10 10,000 10,000 60,000

1,100 10 11,000 21,000 49,000

1,200 10 12,000 33,000 37,000

1,300 10 13,000 46,000 24,000

1,400 10 14,000 60,000 10,000 (scrap value)

Depreciation stops when book value is equal to the scrap value of the asset. In the end,
the sum of accumulated depreciation and scrap value equals the original cost.

Units of time depreciation

Units of time depreciation is similar to units of production, and is used for depreciation
equipment used in mine or natural resource exploration, or cases where the amount the
asset is used is not linear year to year.

A simple example can be given for construction companies, where some equipment is
used only for some specific purpose. Depending on the number of projects, the
equipment will be used and depreciation charged accordingly.

Group depreciation method

Group depreciation method is used for depreciating multiple-asset accounts using

straight-line-depreciation method. Assets must be similar in nature and have
approximately the same useful lives.
Composite depreciation method

The composite method is applied to a collection of assets that are not similar, and have
different service lives. For example, computers and printers are not similar, but both are
part of the office equipment. Depreciation on all assets is determined by using the
straight-line-depreciation method.

Historical Salvage Depreciable Depreciation

Asset Life
cost value cost per year

Computers $5,500 $500 $5,000 5 $1,000

Printers $1,000 $100 $ 900 3 $ 300

Total $ 6,500 $600 $5,900 4.5 $1,300