presentation 14 – guidance on financial analysis of cleaner production options 1 presentation 14...

1Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options

Presentation 14Presentation 14

Guidance on Financial Analysis of Cleaner Production Options


What will we learn here?

Guidance on Financial Analysis of Cleaner Production Options

Introduction: The Need for Financial Analysis

Objectives of this Presentation

Use of Cost Benefit Analysis in Financial Analysis

Introduction to Cost Benefit Analysis

Elements of Cost Benefit Analysis

Case Study #1

Case Study #2

Criteria for Selection of Projects



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Cleaner production options not only avoid and reduce waste generation, but also offer a direct cost advantage to the business.

However, cleaner production options are typically long term, involving medium to high investment, and hence are perceived as a larger business risks than end-of-pipe solutions. The crux of the problem is that this risk is often not clearly quantified and predicted.

Thus, financial analysis of cleaner production options becomes necessary.



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To understand the basics of financial analysis

To implement fundamental principles of financial analysis for cleaner production options

To screen cleaner production options based on financial aspects


Introduction to Cost Benefit Analysis (CBA)

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Introduction to Cost Benefit Analysis (CBA)

• The costs and benefits (environmental, social or economic) must be quantified in monetary terms to the maximum extent possible. Typically, CBA is used as a tool in feasibility studies for selection of an alternative together with for e.g., life cycle assessment, audits, etc.

• Thus, CBA is used in financial analysis to estimate the profitability of a potential investment for a cleaner production option.

• CBA facilitates the comparison of alternatives in terms of the monetary costs involved and the benefits obtained.


Elements of CBA

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Elements of CBA

Cash flow

Present value (PV)

Measures of Profitability

Payback Period

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index

Depreciation


Cash Flow

A Cash Flow is meant to illustrate incomes (“cash inflows”) and expenses (“cash outflows”). They may be conventional and non-conventional. Each arrow represents the time period of a year in this case.

Non-Conventional Cash Flow

-2Cash Inflows

Cash Outflows

$12,000

$7,500. . . . . . . . . . . . . . $7,500

$3,900 $2,600

-1 0

$10,000$8,000

8

Conventional Cash Flow

0 5Cash Inflows

Cash Outflows

$2,000

$600$600$600$600$600


Present Value (PV)

PV is a way of comparing the value of money now with the value of money in the future. A dollar today is worth more than a dollar in the future, because inflation erodes the buying power of the future money, while money available today can be invested to grow.

Calculation of the PV requires the use of “interest rate”. Interest rate is typically a percentage used to calculate the PV. It reflects the time value of money. Generally, this interest rate is taken as equal to the prevailing bank interest rate.

Assuming an interest rate of 10%, the PV of $100 three years from now is approximately $133.


Payback Period

As the name suggests, the Payback Period is the length of time required to recover the cost of an investment.

It is calculated with the formula below:Payback period = $ Invested

$ Return per year

Drawbacks -

The payback period ignores the time value of money

The payback period ignores cash flows after the initial investment has been recouped


Payback Period

If the initial cost of the investment or $ invested = $ 20,000 and the net savings or $ return per year = $ 2,200; then

Payback period = 20,000 / 2,200 = 9.09 years

(say 9.1 years)



NPV may be defined as the difference between the total present value of the cash inflows and the total present value of the cash outflows.

NPV compares the value of the dollar today versus the value of that same dollar in the future, after taking inflation and returns into account.

If the NPV of a prospective project is positive then it should be accepted (i.e. NPV > 0)

However, if the NPV of a prospective project is negative, then the project should be rejected because cash flows are negative (i.e. NPV < 0)

If the NPV of a prospective project is zero then it should probably be rejected as it generates exactly the return that is expected (i.e. NPV = 0)



Let us calculate the NPV from a series of cash flows. The formula is given below.

NPV = -CFo + CF1 + CF2 + CF3 + CFn

(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods (n=3), r = interest rate (say, 10%)

NPV = -500,000 + 100,000 + 150,000 + 200,000 = -$134, 861 (1+0.1)1 (1+0.1)2 (1+0.1)3

0

$500,000

$100,000 $150,000 $200,000

3(positive cash flows)

(negative cash flow)



The IRR method of analyzing a project or option allows one to find the interest rate that is equivalent to the dollar returns expected from the project or option.

Once you know the IRR, you can compare it to the rates you could earn by investing your money in other projects or options.

If the IRR is less than the cost of borrowing used to fund the project, the project will clearly be a money-loser.

However, usually a business owner will insist that in order to be acceptable, a project must be expected to earn an IRR that is at least several percentage points higher than the cost of borrowing, to compensate the company for its risk, time, and trouble associated with the project.



As an example of how IRR works, let us say you are looking at a project costing $7,500 that is expected to return $2,000 per year for five years, or $10,000 in total. The IRR calculated for the project would be 10 percent.

If your cost of borrowing for the project is less than 10 percent, the project may be worthwhile.

If the cost of borrowing is 10 percent or greater, it will not make sense to do the project (at least from a financial perspective) because, at best, you will be breaking even.



The formula used for calculating the IRR is very similar to the formula used for calculating the NPV.

The main difference is that in the IRR formula, you must solve for the interest rate “r”.

0 = -CFo + CF1 + CF2 + CF3 + CFn

(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods, r = interest rate (to be solved for)


Profitability Index (PI)

The PI is the ratio of the PV of future cash inflows by the PV of cash outflows

PI = PV of cash inflows PV of cash outflows

If the 0 < PI < 1, the project or option should be rejected

If the PI > 1, the project or option should be accepted


Depreciation

Depreciation is defined as the decline in the value of an asset with the passage of time, due to general wear and tear or obsolescence

Depreciation is a part and parcel of cash flow calculations

Depreciation may be accounted for in the net annual savings of a cleaner production option


Case study #1

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Case Study #1: Financial Analysis of a Cleaner Production Option in a Bottle Washing Plant

Background

Bottle washing plant BWP utilizes a large quantity of water and caustic soda for bottle washing and rinsing operations

As a cleaner production option, a certain percentage of the caustic soda is to be recovered from the resulting caustic solution, through the use of a membrane filtration (MF) system

The recovered caustic will then be resold at the prevailing market price

Let us examine the financial feasibility of installing the MF system


Case Study #1 - Calculations for the Value of Recoverable Caustic ($ / year)

Data

* The overall caustic recovered from the MF system is 65% by volume

** The number of recovery runs at BWP is 4 times a year and the concentration of caustic by weight is 2.5% or 25 kg/m3

*** The cost of 1 kg of pure caustic solution is $0.5

Volume of caustic

(m3)“A”

Volume of caustic recovered per run*

(m3)“B” = “A” X 0.65

Mass of caustic recovered

per year** (kg/m3)“C” = “B” X 4 X 25

Value of caustic recovered per

year***($ / year) = “C” X

0.5

210 136.5 13,650 6,825

Table 1:


Case Study #1 – Installation Cost for the MF System

System component

Cost ($)

Membrane 7,000

Feed pump 800

High pressure pump

1,600

Cartridge and power

400

Permeate tank 200

Pipes, valves, etc.

8,000

Total investment:

18,000

Table 2

In addition to the initial investment, the manufacturer states that the membrane for the MF system will need to be replaced once in 3 years. The associated cost for this will work out to be $7,500. The total life of the MF system is 12 years.


Case Study #1 - Calculations for the Net Annual Uniform Savings

Net annual uniform savings =

Cost recovered from the sale of caustic annually – annual depreciation cost of the MF system – annual operating costs

Here, depreciation cost of the MF system (assuming nil salvage value at the end of the 12 year period = (18,000 – 0) / 12 = $1,500

Also, annual operating costs = cost for power and the cartridge = $400 (from Table 2)

So, net annual uniform savings = 6,825 – 1,500 – 400 = $4,925 (approx.)


Case Study #1 – Cash Flow Diagram for the Proposed MF System

Cash Inflows (Net annual Uniform Savings)

Cash Outflows (Initial Investment and Replacement Cost)

0

12

$7,500 $7,500 $7,500$18,000

$4,925…………………………………………………………$4,925

Initial one-time investment = $18,000

Membrane replacement cost (once every 3 years) = $7,500

Net annual uniform savings = $4,925 / year


Case Study #1 – Calculation for NPV

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows 12= 4,925 1 = $33,557 t=1 (1 + 0.1)t

PV of cash outflows = 18,000 + 7,500 + 7,500 + 7,500 = $31,049 (1+0.1)3 (1+0.1)6 (1+0.1)9

NPV = PV of cash inflows – PV of cash outflows = $33,557 - $31,049 = $2,508

Since the resultant NPV > 0, the cleaner production option is financially viable.


Case Study #1 – Calculation for IRR

IRR would need to be solved through iteration:

12 0 = 4,925 1 – 18,000 – 7,500 – 7,500 – 7,500 t=1 (1+r)t (1+r)3 (1+r)6 (1+r)9

Taking r = 12% (i.e. 12/100 = 0.12), Left Hand Side (LHS) = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49


Case Study #1 – Solving for the Exact Value of IRR

Taking r = 12% (i.e. 12/100 = 0.12), LHS = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49

Solving for the exact value of IRR through interpolation:

r – 12 = 0 – 664.63 r – 14 -152.49-664.63

IRR = 12.63%

Since the IRR is greater than 10% (i.e. the rate of interest that the money would earn in the bank, investing in this cleaner production option is worthwhile.


Case Study #1 – Calculating the PI

Calculating for the PI:

PI = PV of cash inflows = 33,557 = 1.08 PV of cash outflows 31,049

Since PI > 1, this cleaner production option can be accepted; i.e. it is financially viable


Case study #2

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Case Study #2: A Tweak on Case Study #1 (Pessimistic Scenario)

Background

The background for Case Study #2 stays the same as that for Case Study #1.

However, there will be one change… let us say, that the prevailing market price of the recovered caustic falls to $0.35 per kg (previously, for Case Study #1, the said value was $0.5 per kg).

Let us also say that the manufacturer’s claim for membrane replacement does not hold true, and that the membrane requires replacement once every two years.

Let us examine the financial feasibility of installing the MF system for Case Study #2.


Case Study #2 - Calculations for the Value of Recoverable Caustic (Pessimistic Scenario)

Data

* The overall caustic recovered from the MF system is 65% by volume

** The number of recovery runs at BWP is 4 times a year and the concentration of caustic by weight is 2.5% or 25 kg/m3

*** The cost of 1 kg of pure caustic solution is $0.35

Volume of caustic

(m3)“A”

Volume of caustic recovered per run*

(m3)“B” = “A” X 0.65

Mass of caustic recovered

per year** (kg/m3)“C” = “B” X 4 X 25

Value of caustic recovered per

year***($ / year) = “C” X

0.35

210 136.5 13,650 4,778

Table 3:


Case Study #2 - Calculations for the Net Annual Uniform Savings (Pessimistic Scenario)

Net annual uniform savings =

Cost recovered from the sale of caustic annually – annual depreciation cost of the MF system – annual operating costs

Here, depreciation cost of the MF system (assuming nil salvage value at the end of the 12 year period = (18,000–0)/12 = $1,500 (same as Case Study #1)

Also, annual operating costs = cost for power and the cartridge = $400 (from Table 2, same as Case Study #1)

So, net annual uniform savings = 4,778 – 1,500 – 400 = $2,878 (approx.)


Case Study #2 – Cash Flow Diagram for the Proposed MF System (Pessimistic Scenario)

Cash Inflows (Net annual Uniform Savings)

Cash Outflows (Initial Investment and Replacement Cost)

0

12

$7,500 $7,500 $7,500$18,000

$2,878…………………………………………………………$2,878

Initial one-time investment = $18,000

Membrane replacement cost (once every 2 years) = $7,500

Net annual uniform savings = $2,878/ year

$7,500$7,500


Case Study #2 – Calculation for NPV (Pessimistic Scenario)

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows 12= 2,878 1 = $19,610 t=1 (1 + 0.1)t

PV of cash outflows = 18,000 + 7,500 + 7,500 + 7,500 + 7,500 + 7,500 = $39,945 (1+0.1)2 (1+0.1)4 (1+0.1)6 (1+0.1)8 (1+0.1)10

NPV = PV of cash inflows – PV of cash outflows = $19,610 - $39,945 = - $20,335 (i.e. negative)

Since the resultant NPV < 0, the cleaner production option is not financially viable.


Case Study #2 – Calculating the PI (Pessimistic Scenario)

Calculating for the PI:

PI = PV of cash inflows = 19,610 = 0.49 PV of cash outflows 39,945

Since PI > 1, this cleaner production option cannot be accepted; i.e. it is not financially viable


Other Scenarios

Similarly, it is possible that there may be other pessimistic scenarios

In fact, there could be a permutation-combination of pessimistic scenarios, depending on the market and in-house conditions

The World Wide Web provides certain tools to calculate the NPV and IRR values

Thus the CBA becomes a very important tool is assessing the financial feasibility of the cleaner production project / option

Such analysis will help all concerned (CPC, business / enterprise / industry, financial institution, stakeholders in the option) decide on further steps to be taken for making a bankable project.


Thank you

presentation 14 – guidance on financial analysis of cleaner production options 1 presentation 14...

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