Part 2 Financial Metrics and Rates of Return

Part 2Financial Metrics and Rates of Return

Christopher RussellEnergy PathFINDERwww.energypathfinder.com(443) [email protected]

(c)2009 Energy Pathfinder Mangement Consulting, LLC www.energypathfinder.com 2

Samuel Goldwyn (1879-1974)

“Spare no expense to save money on this one.”

2

Outline for Part 2

3©2011 Energy PathFINDER.com

1. EXAMPLE PROJECT

2. RETHINKING “SIMPLE PAYBACK”

3. “RATE OF RETURN” EXPLAINED

4. “CASH FLOW” EXPLAINED & UTILIZED

5. INVESTMENT PERFORMANCE METRICS

$1,500,000 cost $150,000 rebate (YR1) $200,000 downpayment

Cap. recovery:25 YRS/8%

$1,300,000 borrowed20YRS/4%

25 YR economic life 1.5% energy price escal. Declining balance CCA (4%) $0.17/CM natural gas $0.05/kWh electricity $30,000 O&M saving/yr

BOILER / STEAM UPGRADE


BEFORE AFTERELEC kWh 5 260 000 543 600 000GAS Cu M 4 734 000 542 100 000

ANNUAL O&M $72,000 $42,000

About Financial Metrics Simple Payback Return on Investment Life Cycle Cost Net Present Value Internal Rate of Return Rates of Return, Discount, etc. Save or buy? Cost of doing nothing Break-even analysis Budget for additional analysis


$1,500,000 cost $251,300 1st-year savings

SPB = COST/ ANNUAL SAVINGS

SPB = 6 YEARS

HURDLE = 2 YRS OR LESS.

OUTCOME: REJECT.

Simple Payback?


Simple Payback!

Keep pushing the same buttons,Keep getting the same results


Outline for Part 2


1. EXAMPLE PROJECT





Make the case:What do business leaders want to know?

What’s the benefit? How many dollars? How quickly do the dollars accrue? What’s the risk of investing? What’s the risk of NOT investing?

What’s the most that I should pay for it?…per current investment criteria

How does this compare to other ways to use money?


Capital investment goals. Assumption: investors want to grow their

business

The business already produces returns at some “velocity”

Additional capital investments should improve the business’ overall rate of capital recovery

Principles for any CAPEX project


Simple payback…

Ignores value accruing after the investment pays for itself

Payback ≠ cost of capital≠ rate of return over time≠ investment comparison metric

Says nothing about value lost when refusing to invest


Do you….use simple paybackto measuremutual fundperformance?

©2011 Energy PathFINDER.com 12

Outline for Part 2


1. EXAMPLE PROJECT





Investment returns are a ratio measure.

“Value” = ratio of benefits to investment For lenders, value = interest received from a

loan For investors, value = new cash flow generated Real returns are after-tax cash flow (ATCF)

ATCF INVESTMENT

= RATE OF RETURN (VALUE!)


CAPEX Investment Questions

OPERATING PERFORMANCEImprove production costs?

ECONOMIC PERFORMANCEImprove the firm’s capital recovery rate?

FINANCIAL PERFORMANCEBeneficial terms of finance?


ProductionFacility

POWERHOUSE

$0.925926INPUTS

$1.00REVENUE

A MONEY-MAKING MACHINE

Example: 8% Rate of Return16©2011 Energy PathFINDER.com

RELATIVE RATES OF RETURN

YOUR COMPANY

8%BEST

COMPETITOR10%

COST TO BORROW

4%

MUTUAL FUNDS

3%


ProductionFacility

POWERHOUSE

$0.925926INPUTS

$1.00REVENUE


“YES” to any Investment that Increases the VELOCITY of

Total Invested Capital.

Outline for Part 2


1. EXAMPLE PROJECT





Annual Cash Flow Elements

OPERATING PERFORMANCE

ENERGY SAVINGS(+/-) NET CHANGE, O&MOPERATING INCOME

ECONOMIC PERFORMANCE

DEPRECIATION CHARGESINCOME TAXINTERNAL CAPITAL RECOVERYNET INCOME

FINANCIAL PERFORMANCE

DEBT SERVICEFREE CASH FLOW


Cash Flow Elements - Purpose


IMPACT ON BUDGET?


IMPACT ON FIRM’S CAPITAL PRODUCTIVITY?


IMPACT ON CASH FLOW?


Cash Flow Elements - Answers


PRE-TAX RESULTS

COMPARE TO INTERNAL PROJECTS


POST-TAX RESULTS

CAPITAL PERFORMANCE

PRIOR TO DISTORTION BY

LENDER’S TERMS


RETURNS AFTER ACCOMMODATING LENDERS


Cash Flow Elements - IMPACTS

METRICS IMPACTOPERATING PERFORMANCE

• SIMPLE PAYBACK• ACCOUNTING ROI

PRODUCTION COST, BUDGET

ECONOMIC PERFORMANCE DISCOUNTED

CASH FLOW ANALYSIS

INTERNAL CAPITAL INVESTED


BORROWED CAPITAL


CAPEX Investment Strategy OPERATING PERFORMANCE

Escalate energy prices?Account for non-energy benefits?

ECONOMIC PERFORMANCEExpense from revenue budget?Invest internal capital? Amortize? At what rate? All up front?

FINANCIAL PERFORMANCEBorrow at what terms (APR, years)?

CAPITAL SOURCES?REVENUE/EXPENSEINTERNAL CAPITAL

BORROWED CAPITALTOTAL PROJECT COST

REBATESTOTAL BASIS FOR

DEPRECIATION


Cash Flow Elements - ExampleFIRST YEAR RESULTS

ABC = A+B

ENERGY SAVINGS………………O&M COST SAVINGS…………..OPERATING INCOME ………….

$281,300$30,000

$311,300DEFGH

= C-D= E x Tax

= D+E-F-G

DEPRECIATION………………….TAXABLE INCOME………………INCOME TAX (35%)……………..CAPITAL RECOVERY (8%/25)…NET INCOME…………………….

$27,000$284,300$99,505$18,524

$193,271IJKL = H-I+J+K

DEBT SERVICE…………………..TAX SAVINGS ON INTEREST….REBATE……………………………FREE CASH FLOW………………

$94,533$17,924

$150,000$266,663


Project Cash Flow

YRNOMINAL

INVESTMENTOPERATING

INCOME

AFTER TAX NET

INCOMEDEBT

SERVICE

OUTLAY AFTER

FINANCEFREE CASH

FLOW0 -$1,000,000 -$200,0001 $150,000 $311,300 $193,271 -$94,533 -$76,609 $266,6632 $0 $315,520 $205,086 -$94,533 -$77,227 $127,8593 $0 $319,802 $207,129 -$94,533 -$77,870 $129,2594 $0 $324,149 $209,243 -$94,533 -$78,539 $130,7055 $0 $328,562 $211,429 -$94,533 -$79,235 $132,193

… … … … … … …25 $0 $432,119 $443,432 $0 $0 $443,432



‐$300,000

‐$200,000

‐$100,000

$0

$100,000

$200,000

$300,000

$400,000

$500,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

INCREMENTAL ANNUAL CASH FLOWUndiscounted Cash Flow Resulting from Project Finance & Implementation

TAX‐ADJUSTED_DEBT_SERVICE FREE_CASH_FLOW

‐$500,000$0

$500,000$1,000,000$1,500,000$2,000,000$2,500,000$3,000,000$3,500,000$4,000,000$4,500,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

CUMULATIVE FREE CASH FLOWUndiscounted Free Cash Flow After Project Finance

CUMULATIVE_CASH_FLOW

About Cash Flow Elements

CHANGE ANNUALLY CONSTANT

ENERGY PRICES ●ENERGY SAVINGS VOLUME ●

DEPRECIATION CHARGE ●CAPITAL RECOVERY ●

TAX RATE ●FREE CASH FLOW ●


Outline for Part 2


1. EXAMPLE PROJECT





Return onInvestment

CONS Results vary with cash flow elements over successive years ROI is confined to the project only; contribution to overall profitability

or wealth is not measured Analysis does not clearly isolate the impact of individual variables Fails to measure the cost of NOT doing the project

1st Year Operating Income

Total Nominal Investment

ROI =

PROS• Easy to understand• Good for comparing the attractiveness of two or more projects


$311,300

$1,350,000= 23%

Life Cycle Cost

LCC = total cost of ownership Acquisition Energy inputs Maintenance Insurance, licenses, disposal….


Capital (2%)

Energy (97%)

Maintenance (1%)

Life-Cycle Cost

CONS Difficult to implement as a practical management metric; no single

person of department clearly “owns” responsibility for life-cycle costs No indication of wealth created by the project or variability in

profitability Not useful for comparing dissimilar projects Fails to measure the cost of NOT doing the project

Total cost of ownership, including capital, operating costs and

energy consumption.

PROS• Good for comparing the total ownership for two or more similar

purpose projects.


Life-Cycle Costs (Example)

THIRD PARTY CAPITAL………. $1,300,000 0%INTERNAL CAPITAL…………… $200,000 0%CURRENT EXPENSE…………. $0 0%INTEREST COSTS……………...

$1,022,152 0%

25-YR SUM, O&M COSTS…….. $1,050,000 0%25-YR SUM, ENERGY…………. $2,777,633,984 100%TOTAL LIFE-CYCLE COST…… $2,781,037,733 100%


Net Present Value(NPV)

CONS Entire calculation relies on a series of guesses about future returns Analysis fails isolate variables that can be linked to specific

responsibilities Fails to measure the cost of NOT doing the project

Annual Cash Flowt

PROS• Captures full measure of value added by the project’s returns• Reflects risk by incorporating the time-value of money• Excellent tool for ranking two or more options by the value they

generate

(1+r)t∑T

t-1-Cash Flow

In Year0


Internal Rate of Return

CONS Fails to measure the absolute value of wealth created Entire calculation relies on a series of guesses about future returns Analysis fails isolate variables that can be linked to specific

responsibilities Fails to measure the cost of NOT doing the project

Cash Flowt

PROS• Captures full measure of value added by the project’s returns• Reflects risk by incorporating the time-value of money• Excellent tool for ranking two or more options by the value they

generate

(1+r)t∑T

t-1+Cash Flow

In Year0= 0

IRR = r so that:

Where “T” = economic life of the project in years“t” represents each individual year in the project’s economic life∑ indicates summation across all “t” years


©2011 Energy PathFINDER.com

HORSEPOWERPAYLOAD

IRRNPVHow much volume?

How much muscle?

36

Profitability index (PI)

PI =

DISCOUNTED VALUE OF AFTER-TAX BENEFITS

DISCOUNTED VALUE OF ALL PROJECT INVESTMENTS



YR

ANNUAL INVESTMENT

AND REBATES NET INCOMECUMULATIVE

PI0 $1,500,0001 -$150,000 $193,271 0.12 $0 $205,086 0.33 $0 $207,129 0.44 $0 $209,243 0.55 $0 $211,429 0.6… … … …25 $0 $443,432 1.8



PI = $2,396,038$1,361,111

Future values discounted at 8%

$1,044,927 in additional capital created by end of year 25

= 1.8 THRU 25 YRS


Capital Goes SOMEWHERE…Every choice offers a rate of return

Energy project: After-tax rate of return Core business: cost of internal capital Stocks/mutual funds

compare to Cost to borrow


?25% -

0% -

50% -

75% -

100% -

Investor’s Rates of Return (Thru 25 Yrs)PROJECT COST:ECONOMIC LIFE:

$1,500,00025 YRS

25% -

0% -

50% -

75% -

100% -


EXAMPLE: 6-YR PaybackOperating Results

IRR = 96% AFTER TAXES AND FINANCE

IRR = 23.8% BEFORE TAXES

MUTUAL FUNDS = 4%COST TO BORROW = 3%

COST OF INTERNAL CAPITAL = 8%

Energy Investment Outcomes

Say “No” to Energy Efficiency Live with inefficiencies. Live with cash drain. Compensate for cash flow losses – HOW?

Say “Yes” to Energy Efficiency Create supplemental cash flow Subsidize other investment opportunities Expand the range of potential investment opportunities


BC Hydro Investment Calculator

Simple Payback Accounting Return on Investment Life-Cycle Cost Profitability Index Internal Rate of Return


Pre- and Post-Tax Results

QUESTIONS?HASTINGS STREET, VANCOUVER 1967

Documents

Part 2 Financial Metrics and Rates of Return