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Financial Feasibility Analysis

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Financial Feasibility Analysis Energizing Cleaner Production Management Course Introduction Step 4 Feasibility Analysis Introduction Questions Management Will Ask 1. – PowerPoint PPT presentation

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Title: Financial Feasibility Analysis


1
Financial Feasibility Analysis Energizing
Cleaner Production Management Course
2
Session Agenda
  • Introduction
  • Cash Flow
  • Profitability Indicators
  • Simple Payback
  • Return on Investment (ROI)
  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)

3
But first In what step(s) of the methodology is
financial feasibility analysis relevant?
4
IntroductionStep 4 Feasibility Analysis
Companys priority
Technical
Project Selection
Financial
  • Other
  • Regulatory
  • Organizational
  • Health/safety
  • Community

Environmental
5
IntroductionQuestions Management Will Ask
  • 1. Is the project profitable?
  • Initial investment costs
  • Annual operating costs and savings
  • Cost of operating inputs
  • Cost of waste management
  • Less tangible costs
  • Revenues
  • 2. Determine availability of internal investment
    funds for bigger projects
  • 3. Obtain external financing for remaining
    projects

6
IntroductionCapital Budgeting Process
  • Process by which organisation decides
  • Which investment projects are
  • Needed
  • Possible
  • Special focus on projects that require
    significant up-front capital investment
  • How to allocate available capital between
    different projects
  • If additional capital is needed

7
IntroductionCapital Budgeting Practices
  • Vary widely from company to company
  • Larger companies tend to have more formal
    practices than smaller companies
  • Larger companies tend to make more and larger
    capital investments than smaller companies
  • Some industry sectors require more capital
    investment than others
  • Vary from country to country

8
IntroductionTypical Project Types and Costs
  • Maintenance
  • Maintain existing equipment and operations
  • Improvement
  • Modify existing equipment, processes, and
    management and information systems to improve
    efficiency, reduce costs, increase capacity,
    improve product quality, etc.
  • Replacement
  • Replace outdated, worn-out, or damaged equipment
    or outdated/inefficient management and
    information systems

9
Cash FlowCash Flow Concept
  • Common management planning tool
  • Distinguishes between
  • Costs cash outflows
  • Revenues/savings cash inflows

10
Cash FlowTypes of Cash Flow
Inflow Equipment salvage value Operating
revenues savings Working capital
Outflow Initial investment cost Operating
costs taxes Working capital
One-time Annual Other
11
Cash FlowCosts and Savings
  • Initial investment costs
  • purchase of the camera system, delivery,
    installation, start-up
  • Annual operating costs (and savings)
  • Operating input materials, energy, labour
  • Incineration fuel, fuel additive, labour, ash
    to landfill
  • Wastewater treatment chemicals, electricity,
    labour, sludge to landfill

12
Cash FlowWorking Capital and Salvage Value
  • Working capital total value of goods and money
    needed to maintain project operations
  • Raw materials inventory
  • Product inventory
  • Accounts payable/receivable
  • Cash-on-hand
  • Salvage Value resale value of equipment or other
    materials at the end of the project

13
Cash FlowTiming
End of project
Salvage Value
Annual Revenues/Savings
TIME
Year 1
Year 2
Year 3
Time zero
Initial Investment
14
Cash FlowIncremental Analysis
  • Needed for many CP or EE projects
  • Compares cash flow of implemented options to the
    business as usual cash flow
  • Covers only the cash flows that change

15
Profitability Indicators
  • Definition a single number that is calculated
    for characterisation of project profitability in
    a concise and understandable form
  • Common indicators
  • Simple Payback
  • Return on Investment (ROI)
  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)

16
1. Simple Payback
  • Definition number of years it will take for the
    project to recover the initial investments
  • Usually a rule of thumb for selecting projects,
    e.g. payback must be lt 3 years

Simple Payback (in years)
Investment Cash Flow

17
2. Return on Investment
  • Definition the percentage of initial investment
    that is recovered each year

Initial Investment Year 1 Cash Flow
Simple Payback (in years)

3 years
Year 1 Cash Flow Initial Investment
ROI (in )
33

18
Workshop ExercisePLS Company produces rolls of
laminated film
19
Workshop ExercisePLS Company installs QC Camera
  • Printing step
  • Printing errors cause high scrap rate
  • Quality Control (QC) 3-camera system
  • Detect printing errors
  • Operators halt the operations before too much
    solid scrap is generated
  • QC camera system costs US105,000 to purchase and
    install
  • 40 reduced scrap and operating costs

20
Workshop Exercise
  • Question 1 Calculate annual cash flows using the
    cash flow worksheet (15 min)
  • Question 2 Calculate simple payback (5 min)

21
3. Net Present ValueMoney Loses its Value
  • Question
  • If we were giving away money, would you rather
    have (A) 10,000 today, or (B) 10,000 3 years
    from now Explain your answer...

22
3. Net Present ValueInflation
  • Money loses purchasing power over time as
    product/service prices rise, so a dollar today
    can buy more than a dollar next year

inflation 5
costs 1.05
costs 1
now
next year
23
3. Net Present ValueReturn on Investment
  • A dollar that you invest today will bring you
    more than a dollar next year having the dollar
    now provides you with an investment opportunity

Gives you 1.10 a year from now
Investing 1 now
Investment
10 interest, or return on investment
24
3. Net Present Value PLS Companys QC Camera
Project
Initial Investment Cost
Annual Operating Costs
BusinessAs Usual
0
2,933,204
Annual Savings US38,463
Installing quality control camera
105,000
2,894,741
(in US)
25
3. Net Present Value Question
  • Is the annual savings of38,463 per year for 3
    years a sufficient returnon the initial
    investment of 105,000?

26
3. Net Present Value Time Value of Money
  • Money is worth more now than in the future
    because of
  • Inflation
  • Investment opportunity
  • Time value of money depends on
  • Rate of inflation
  • Rate of return on investment

27
3. Net Present Value Cash Flows from Different
Years
  • Before you can compare cash flows from different
    years, you need to convert them all to their
    equivalent values in a single year
  • It is easiest to convert all project cash flows
    to their present value now, at the very
    beginning of the project

28
3. Net Present Value Converting Cash Flows to
Present Value
Annual Savings
End of project
?? ?? ??
38,463
38,463
38,463
TIME
Year 1
Year 2
Year 3
Time zero
Initial Investment 105,000
29
3. Net Present Value Converting Cash Flows to
Present Value
  • Discount rate
  • Converts future year cash flows to their present
    value
  • Incorporates
  • Desired return on investment
  • Inflation
  • Reverse of an interest rate calculation

30
3. Net Present Value Discount Rate Interest
Rate
Invested at an interest rate of 20, how much
will 10,000 now be worth after 3 years?
10,000 x 1.20 x 1.20 x 1.20 17,280
At a discount rate of 20, how much do I need to
invest if I want to have 17,280 in 3 years?
17,280
1.20 x 1.20 x 1.20 10,000
31
3. Net Present ValueWhich Discount Rate?
  • Equal to the required rate of return for the
    project investment, based on
  • A basic return - pure compensation for deferring
    consumption
  • Any risk premium for that projects risk
  • Any expected fall in the value of money over time
    through inflation
  • At least cover the costs of raising the
    investment financing from investors or lenders
    (i.e. the companys cost of capital)
  • A single Weighted Average Cost of Capital
    (WACC) characterises the sources and cost of
    capital to the company as a whole

32
3. Net Present ValueCalculating Present Value
Value of the cash flow in year n
Present Value Future Valuen x (PV Factor)
Value of cash flow at Time Zero, i.e. at
project start-up
  • Present Value (PV) Factors or discount factors
  • For various values d (discount rate) 10, 15,
    20
  • For various years n (number of years)
  • Tables available

33
3. Net Present Value The Value of a Future 1
Discount rate (d) 10 20 30 40
Years into future (n) 1 .9091 .8333
.7692 .7142 2 .8264 .6944 .5917
.5102 3 .7513 .5787 .4552 .3644
4 .6830 .4823 .3501 .2603 5 .6209
.4019 .2693 .1859 10 .3855 .1615 .0725
.0346 20 .1486 .0261 .0053 .0012
30 .0573 .0042 .0004 .0000
Present value factors
Handout Table with discount rates
34
3. Net Present ValueNet Present Value (NPV)
  • Definition sum of present values of all
    projects cash flows
  • Negative (cash outflows)
  • Positive (cash inflows)
  • Characterises the present value of the project to
    the company
  • If NPV gt 0, the project is profitable
  • If NPV lt 0, the project is not
  • More reliable than Simple Payback or ROI as it
    considers
  • Time value of money
  • All future year cash flows

35
3. Net Present Value Workshop Exercise (15 min)
Question 3 Calculate the NPV
Expected Future Cash Flows
Present Value of Cash Flows (at time zero)
PV Factor
Year

X
- 105,000 38,463 38,463 38,463

- ??? ??? ??? ??? ???
0 1 2 3
??? ??? ??? ???
Sum projects Net Present Value
36
3. Net Present Value Workshop Exercise (5 min)
  • Question 4 compare the Simple Payback and the NPV

37
3. Net Present Value Sensitivity Analysis
  • In business as usual scenario PLS Company needs
    waste water treatment plant in year 3 150,000
    investment
  • With QC project 95,000
  • Savings 55,000
  • Also consider taxes!
  • Pollution taxes / fees
  • Tax deductions for equipment depreciation
  • Tax deduction for environmental projects

38
3. Net Present Value Workshop Exercise (answer B)
Expected Future Cash Flows
Present Value of Cash Flows (at time zero)
PV Factor
Year

X
- 105,000 38,463 38,463 93,463

0 1 2 3
.8696 .7561 .6575
- 105,000 33,447 29,082 61.452 -18,981
Sum projects Net Present Value
39
4. Internal Rate of Return (IRR)
  • Definition discount rate for which NPV 0, over
    the project lifetime
  • Tells you exactly what discount rate makes the
    project just barely profitable
  • Similar to NPV, considers
  • Time value of money
  • All future year cash flows

40
Profitability Indicators Summary
Advantages Disadvantages Easy to use Neglect
TVM Neglect out-year costs Do not indicate
project size Considers TVM Needs firms
discount rate Indicates project size Considers
TVM Requires iteration Does not indicate
project size
Simple Payback ROI NPV IRR
41

Financial Feasibility Analysis of Options Thank
you for your attention!
42
Acknowledgements
This training session was prepared as part of the
development and delivery of the course
Energizing Cleaner Production funded by InWent,
Internationale Weiterbildung und Entwicklung
(Capacity Building International, Germany) and
carried out by the United Nations Environment
Programme (UNEP) The session is based on the
presentation Financing Cleaner Production and
Energy Efficiency Projects from the Energy
Efficiency Guide for Industry in Asia developed
as part of the GERIAP project that was
implemented by UNEP and funded by the Swedish
International Development Cooperation Agency
(Sida). www.energyefficiencyasia.org The
workshop exercise is taken from Profiting from
Cleaner Production, in Strategies and Mechanisms
For Promoting Cleaner Production Investments In
Developing Countries, developed by UNEP
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