Economic Analysis

Unit 6
 Introduction

• The financial viability of installing renewable energy systems primarily

depends on (1) the initial installation cost and (2) net annual energy
production. For grid-connected systems, the value of generated
electricity is also crucial, either as the price paid by utilities for large-scale
systems or the retail value of displaced electricity for on-site use.

• Renewable energy must compete with fossil fuels, whose prices are
unpredictable, especially when considering carbon emissions and geopolitical
costs. To expand market adoption, the energy return must outweigh costs
within a reasonable period. In remote areas without electricity access,
renewable energy may be cost-competitive, though its value depends on
resource availability.
 Economic Considerations

Capital Investments:
When companies spend money, the outlay of cash can be broadly categorized
into one of two classifications
• Expenses are generally those cash expenditures that are routine, on-going,
and necessary for the ordinary operation of the business.
• Capital investments, on the other hand, are generally more strategic and
have long term effects.
 Economic Considerations

Capital Investments:
Three characteristics of capital investments are of concern when performing
life cycle cost analysis.
• First, capital investments usually require a relatively large initial cost.
 “Relatively large” may mean several hundred dollars to a small company
or many millions of dollars to a large company.
• Second characteristic of a capital investment is that the benefits (revenues
or savings) resulting from the initial cost occur in the future, normally over
a period of years.
 The period between the initial cost and the last future cash flow is the
life cycle or life of the investment.
 Economic Considerations
Capital Investments:
Three characteristics of capital investments are of concern when performing
life cycle cost analysis.
• Third characteristic of capital investments is that they are relatively
irreversible.
 Frequently, after the initial investment has been made, terminating or
significantly altering the nature of a capital investment has substantial
(usually negative) cost consequences.
Capital Investment Cost Categories:
The costs which occur over the life of a capital investment can be classified
into one of the following categories:
• Initial Cost
• Annual Expenses and Revenues
• Periodic Replacement and Maintenance
• Salvage Value (the estimated value of an asset at the end of its useful life.)
 Initial Cost
• Initial cost refers to the total expenses incurred at the beginning of a project or investment. It includes all the

expenses related to planning, designing, and implementing a project or investment. Some common components

of initial costs may include:

• Capital expenses: These are costs associated with acquiring the necessary equipment, machinery, and other

assets required to launch the project.

• Labor expenses: These are the costs associated with hiring and training staff for the project.

• Legal and administrative expenses: These include expenses for obtaining permits, licenses, and other legal and

administrative requirements necessary to start the project.

• Marketing and advertising expenses: These are costs associated with promoting the project and creating

awareness about it among potential customers.

• Research and development expenses: These are costs associated with conducting

research and development activities to determine the feasibility and potential success of

the project.
• Overhead expenses: These are indirect expenses that are not directly related to the

project, but are necessary to keep the project running, such as rent, utilities, and

insurance.
• The total initial cost of a project is an important consideration when determining whether

the project is financially viable and can generate sufficient returns to justify the

investment.
 Annual costs
• Annual costs refer to the ongoing expenses associated with running a business or maintaining an
investment over the course of a year. These costs may include:
• Operating expenses: These are expenses related to day-to-day operations, such as salaries, rent, utilities,
supplies, and maintenance.
• Marketing and advertising expenses: These include ongoing expenses related to advertising, promotions,
and other marketing activities.
• Insurance expenses: These are expenses related to insurance policies, such as liability, property, and health
insurance.
• Depreciation expenses: These are expenses related to the reduction in value of assets over time, such as
equipment and buildings.
• Interest expenses: These are expenses related to interest payments on loans, lines of credit, or other forms
of debt.
• Taxes: These are expenses related to income tax, property tax, and other taxes.
• Research and development expenses: These are ongoing expenses related to ongoing research and
development activities to improve products, services, or processes.
 Cash Flow Diagram
• 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 are more apparent and the chances of
properly applying time value of money concepts
are increased.
• It is usually advantageous to determine 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.
• Receipts and disbursements are then located on the time scale in
accordance with the problem specifications.
• Individual outlays or receipts are indicated by drawing vertical lines
appropriately placed along the time scale.
• The relative magnitudes can be suggested by the heights, but exact
scaling generally does not enhance the meaningfulness of the diagram.
• Upward directed lines indicate cash inflow (revenues or savings) while
 Financial Analysis Techniques

• The basic criteria for financial investment appraisal include:

• Payback period — is a measure of how long it will be before the
investment recovers itself. This can determine how long the financing
term needs to be there.
• Net Present Value (NPV) and Cash Flow — are measures that allow
financial planning of the project taking into account streams of money
inflow and outflow over a period of time. These measures 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) —
are measures that allow comparison with other investment options
 Payback Period
• 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 Savings (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’.
 Return on Investment (ROI)

• ROI expresses the “annual return” expected from a project as a percentage of capital
cost or initial investment. ROI is an inverse of payback period.
• This is a broad indicator of the annual return expected from initial capital investment,
expressed as a percentage:

• ROI must always be higher than cost of money (interest rate); the greater the return
on investment better is the investment.
Advantages

• Simple method and easy to calculate

• Returns expressed as percentage makes it easier to evaluate against the
borrowing interest

Limitations of ROI

• It does not take into account the time value of money.

• It also does not account for the variable nature of annual net cash inflows.
The 25 percent return indicated in the Example would be economically valid
only if the investment yields Rs. 25,000 per year in perpetuity -not a very
realistic condition!
 Net Present Value

• The net present value method considers the time value of money. This is done by
equating future cash flow to its current value today, or in other words by 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.
• 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.
• As a matter of convention, costs are represented as negative values and savings as positive
values.
• The sum of all the present values is known as the net present value (NPV).
• The higher the net present value, the more attractive is the proposed project.
Using the net present value analysis technique, evaluate the financial merits of the two proposed projects
shown in the table. The annual discount rate is 12% for each project.

Project 1 Project 2
Capital cost (Rs.) 50,000 50,000
Year Net annual saving (Rs.) Net annual saving (Rs.)
1 +8,000 +8,600
2 +8,000 +8,600
3 +8,000 +8,300
4 +8,000 +8,300
5 +8,000 +8,000
6 +8,000 +8,000
7 +8,000 +7,700
8 +8,000 +7,700
9 +8,000 +7,400
10 +8,000 +7,400
Total net savings at end of 10th year 80,000 80,000