PROJECT CASH FLOW AND EVALUATION

WEEK 2

Baruch College, The City University of New York

WEEK 2: LEARNING OBJECTIVES

1. Identify revenues and expenses and explain their translation to value

2. Apply understanding of line items and their impact on cash flow and value

3. Develop a meaningful understanding of cash flow terminology and notation

4. Recognize Creating Value, Generating Efficiency and Saving Money

5. Identify and describe the six functions of a dollar

WEEK 2 RESOURCES

Websites:

• Department of State Incentives for Renewables & Efficiency (DSIRE)

Textbooks:

• Guide to Energy Management: Chapter 4 – Economic Evaluation

• Energy Star Building Upgrade Manual: Chapter 3 – Investment Analysis

PDFs:

• plaNYC• NYSERDA Lease Based Analysis

WEEK 2: READINGS

Guide to Energy Management: Chapter 4 – Economic Evaluation

ENERGY STAR Building Upgrade Manual: Chapter 3 – Investment Analysis

Lease-based Analysis: NYSERDA Presentation

Database of State Incentives for Renewables & Efficiency (DSIRE)

ENERGY PROJECT FINANCECLASS 2 RESOURCES

Websites:

• DSIRE (Database of State Incentives for Renewables & Effificiency) Website

Textbooks:

• Guide to Energy Management: Chapter 4 – Economic Evaluation• Energy Star Building Upgrade Manual: Chapter 4 – Investment Analysis

PDFs:

• Gross vs. Net Leases: NYSERDA Lease Based Analysis (Page 25)• OpEx – Net Income: NYSERDA Lease Based Analysis (Page 8)• Building Operating Cost Charges : NYSERDA Lease Based Analysis (Page 6)• Base Operating Cost : NYSERDA Lease Based Analysis (Page 9)• Lease Provisions & Capital Costs : NYSERDA Lease Based Analysis (Page

10)• Lease Provisions & Upgrades : NYSERDA Lease Based Analysis (Page 25)• Lease Provisions in Practice : NYSERDA Lease Based Analysis (Page 16)

WHAT IS THE TIME VALUE OF MONEY?

• A dollar today is worth more than a dollar tomorrow

• An investor or a lender who provides a dollar today expects a risk premium return on the dollar

• There are mathematical formulas to determine this or it can be automated with Excel functions

TIME VALUE OF MONEY NOTATION

• Notation:

• n = Number of Periods

• r or i = Interest Rate

• PV = Present Value

• FV = Future Value

• PMT = Payment

• e$ = Energy Dollar

TIME VALUE OF MONEY TERMINOLOGY

Terminology

• Annuity = A Stream of Fixed Payments over a Time Period• Interest – Money that is earned on loaned money• Principal – Money that is owed and upon which interest is earned• Term – Interval extending from beginning of the first compounding period

to the end of the last compounding period.• Compound Interest – Interest earned on previous interest• Nominal Rate of Interest – The stated annual rate of interest not taking

into account compounding• Effective Rate of Interest – The actual annual rate of interest taking into

account the effect of compounding• Annuity – Series of periodic payments• Accumulated Value – Total accumulated values of all payments and

interest as of the end of the annuity term.• Hurdle Rate – The minimum rate of return on a project or investment

required by a manager or investor. In order to compensate for risk, the riskier the project, the higher the hurdle rate.

TIME VALUE OF MONEY ASSUMPTIONS

Assumptions

• Money is always invested and always productive so that returns can be reinvested at a rate equal to r

• The yield curve is flat so that short term interest rates are equivalent to long term interest rates

• Time periods are all of equal length

• Payments are all equal and either all inflows or all outflows

• The interest rate is constant throughout the term

• Annuities are simple, certain, discrete and ordinary

SIX FUNCTIONS OF A DOLLAR

1. What will the value of a dollar grow to in n periods at r interest?

2. What is the value today of a dollar received n periods in the future if one's opportunity cost is r?

3. What will a dollar set aside at the end of each year accumulate to after n periods at r interest?

4. What is the value of the right to receive a dollar each of the next n periods if opportunity cost is r?

5. How much must be set aside in each of n periods at r interest in order to reach a specific sum in the future?

6. What payment is required to amortize a debt of one dollar over n periods at r interest?

1 – FUTURE VALUE OF $1.00

What is the value of a dollar received today, n periods in the future, if the cost is r?

Excel:

Application:

Future value calculations can be used to show the amount of money today’s energy savings will grow to in a specific number of years.

1 – FUTURE VALUEEXCEL DEMONSTRATION

2 – PRESENT VALUE OF $1.00

What is the value today of a dollar received n periods in the future if the cost is r?

Excel:

Application:

Present value calculations can be used to show today’s value of your future energy savings.

2 – PRESENT VALUEEXCEL DEMONSTRATION

3 – FUTURE VALUE OF AN ANNUITY

What will a dollar set aside at the end of each year accumulate to after n periods at r interest?

Excel:

Application:

Future value of an annuity calculations can be used to show the amount of money your energy savings over a specific time frame will be worth at a future date.

3 – FUTURE VALUE OF AN ANNUITYEXCEL DEMONSTRATION

4 – PRESENT VALUE OF AN ANNUITY

What is the value of the right to receive a dollar each of the next n periods if opportunity cost is r?

Excel:

Application:

Present value of an annuity calculations can be used to show the amount of money your energy savings over a specific time frame in the future is worth today.

4 – PRESENT VALUE OF ANNUITYEXCEL DEMONSTRATION

5 – SINKING FUND FACTOR PAYMENT

How much must be set aside in each of n periods at r interest in order to reach a specific sum in the future?

Excel:

Application:

Sinking Fund Factor Payment calculations can be used to show the amount of money you would need to set aside each year in order to achieve a certain target value at a future date.

5 – SINKING FUND FACTOR PAYMENTEXCEL DEMONSTRATION

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6 – DEBT AMORTIZATION PAYMENT

What payment is required to amortize a debt of one dollar over n periods at r interest?

Excel:

Application:

Debt Amortization Payment calculations can be used to show the amount of money you would pay each year in order to completely amortize the amount of debt used to fund energy efficiency upgrades.

6 – DEBT AMORTIZATION PAYMENTEXCEL DEMONSTRATION

HOW DO YOU CALCULATE PROJECT CASH FLOWS?

Use or create an Excel model to calculate cash flows.

Apply the terms and associated costs.

This cash flow does not include the time value of money.

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

Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

WHAT IS NET PRESENT VALUE (NPV)?

• Net Present Value (NPV) – The difference between the present value of cash inflows and the present value of cash outflows.

• NPV is used in capital budgeting to analyze the profitability of an investment or project.

• NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

• The Net Present Value of a project indicates the expected impact of the project on the value of the firm.

• Projects with a positive NPV are expected to increase the value of the firm. Therefore, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted.

• When selecting among mutually exclusive projects, the project with the largest (positive) NPV should be selected.

• In short, accept the project if its NPV is positive, reject the project having a negative NPV. While comparing two or more exclusive projects, all having a positive NPV, accept the one with the highest NPV.

NET PRESENT VALUE (NPV)DECISION RULE

• In Excel: =NPV(r, cashflows)

• In this example the discount rate is 9%

(Approximate to risk cost of capital in 2012)

• By applying a discount rate of 9%, the NPV is positive

• Therefore, you would pursue the project

CALCULATING NET PRESENT VALUE WITH STANDARD DISCOUNT RATE

Year 0 1 2 3 4 5 6 7 8 9 10Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

r 9%NPV 539,618.00

• In Excel: = NPV(r, cash flows)

• In this example the discount rate is 8%

(Approximate to risk cost of capital in 2012)

• By applying the energy savings discount rate of 8%, the NPV is a greater positive value than the 9% standard discount rate

• Therefore, you would pursue this higher NPV project

CALCULATING NET PRESENT VALUE WITH ENERGY SAVINGS DISCOUNT RATE

Year 0 1 2 3 4 5 6 7 8 9 10Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

r(e) 8%NPV $654,807.629% Discount Rate NPV $539,618.00

Change in NPV $115,189.62% Change in NPV 21.35%

NET PRESENT VALUE (NPV) EXAMPLES

Year 0 1 2 3 4 5 6 7 8 9 10Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

r 9%NPV 539,618.00

Year 0 1 2 3 4 5 6 7 8 9 10Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

r 15%NPV 0.00

Year 0 1 2 3 4 5 6 7 8 9 10Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

r 22%NPV (328,050.53)

WHAT IS INTERNAL RATE OF RETURN?

• Commonly-used concept in project and investment analysis.• The IRR of a project or investment is the discount rate that results in an

NPV of zero.• If the company’s actual cost of capital (discount rate) is lower than the

IRR, the project or investment should be undertaken.• Accept the project if the IRR > Hurdle Rate.

• In Excel, IRR function: = IRR(cashflows)

Year 0 1 2 3 4 5 6 7 8 9 10Acquisition Cost (2,000,000)Utilization Cost (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000)Energy Savings 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000Net Annual Savings 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Residual Value 50,000

Cash Flows (2,000,000) 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 450,000

IRR 15.3%

INTRODUCTION OF THE ENERGY DELTA

WEEK 2: IN-CLASS EXERCISES

1. Project Cash Flow / NPV and IRR Calculations

2. Impact of CapEx and OpEx on Cash Flows and NPV

WEEK 2: HOMEWORK

1. Readings for week 3