Kandahar University
Engineering Faculty
Energy Engineering Department
Chapter 3
Economic Analysis
Lecturer: Senior T. A. Abdul Ghani Noori Date : 2018 / 12 / 19
/ Eng. Ahmad Bilal Muhammadi
Table of Contents
1. Introduction
2. Basic Concepts
3. Inflation Rate
4. Compounding Factors
5. Economic Evaluation Methods among Alternatives
6. Life-Cycle Cost Analysis Method
7. General Procedure for an Economic Evaluation
8. Assignment
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1. Introduction
In most applications, initial investments are required to implement energy
conservation measures.
For an energy retrofit project to be economically worthwhile, the initial
expenses have to be lower than the sum of savings obtained by the reduction
in the operating costs over the lifetime of the project.
Therefore, it is important to compare savings and expenditures of various
amounts of money properly over the lifetime of a project.
In engineering economics, savings and expenditures of amounts of money
during a project are typically called cash flows.
To compare the various cash flows over the lifetime of a project, a life-cycle
cost analysis is typically used.
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2. Basic Concepts
There are several economic parameters that affect a decision between
various investment alternatives.
To perform a sound economic analysis for energy retrofits, it is important
that the auditor be (i) familiar with the most important economic
parameters, and (ii) aware of the basic economics concepts.
The parameters and the concepts that significantly affect the economic
decision making include:
The time value of money and interest rates including simple and
compounded interest
Inflation rate and composite interest rate
Taxes including sales, local, state, and federal tax charges
Depreciation rate and salvage value
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Cont.
When money is borrowed to cover part or all the initial cost of a retrofit
project, a fee is charged for the use of this borrowed money. This fee is
called interest (I), the percentage is called the interest rate (i), and the
amount of money borrowed is called principal (P).
The amount of the fee depends on the value of the principal and the length
of time over which the money is borrowed.
To calculate the total interest charges over the lifetime of a project, two
alternatives are typically considered:
Simple Interest Charges:
The interest fee I to be paid at the end of the life of the loan. The total
amount of payment F, due at the end of the loan period:
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Cont. Compounded Interest Charges
In this case, the lifetime N is divided into smaller periods, typically called
interest periods. The interest fee is charged at the end of each interest
period and is allowed to accumulate from one interest period to the next.
Example 3.1
A building owner has $10,000 available and has the option to invest this
money in bank that has an annual interest rate of 7 percent, how much
will the building owner have after ten years? Compare this amount if
simple interest had been paid.
Solution:
If the interest is compounded, with P = $10,000, N = 10, and i = 0.07, the
investment will accumulate to the total amount F:
F = $10,000 * (1+ 0.07)10 = $19,672
If simple interest had been paid, the total amount that would have
accumulated is slightly less and is determined:
F = $10,000 * (1+ 0.07 *10) = $17,000
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3. Inflation Rate
Inflation occurs when the cost of goods and services increases from one
period to the next.
The interest rate i defines the cost of money, and the inflation rate λ
measures the increase in the cost of goods and services.
Therefore, the future cost of a commodity FC is higher than the present
cost PC of the same commodity. Over a lifetime N the future cost of a
commodity increases exponentially:
If the interest charges are compounded at the same periods during which
inflation occurs, the future worth can be determined from the present value
P as follows:
A composite interest rate θ can be defined to account for the fact that
inflation decreases the buying power of money due to increases in the cost
of commodities:
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Cont. Example 3.2
Determine the actual value of the $10,000 investment for the
building owner of Example 3.1 if the economy experiences an
annual inflation rate of 4 percent.
Solution:
With P = $10,000 and N = 10, the investment will accumulate to the
total amount F:
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Cont. Tax Rate
In most economies, the interest that is received from an investment is
subject to taxation.
If this taxation has a rate t over a period that coincides with the interest
period, then the amount of taxes T to be collected from an investment P
with an interest rate i is determined as follows:
Therefore, the net return from the investment P to the investor after tax
deductions is:
I′ = I −T = (1−t)iP
Therefore, the composite interest rate can be generalized to account for
both inflation and tax rates related to present and future values:
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Cont. Example 3.3
If the building owner is in the 28 percent tax bracket, determine the actual
value of his $10,000 investment considered in Example 3.1 if the economy
experiences an annual inflation rate of 4 percent.
Solution:
The composite interest rate can be determined:
With P = $10,000 and N = 10, the investment will accumulate to the total
amount F:
F = $10,000 * (1+ 0.01)10 = $11,046
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Cont. Cash Flows
In evaluating energy-efficiency projects, it is important to account for the
total cash receipts and disbursements
due to the implementation of an energy conservation measure for each
period during the entire lifetime of the project.
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4. Compounding Factors
Single Payment:
In this case, an initial payment is made to implement a project by
borrowing an amount of money P. The ratio F/P is often called the single
payment compound amount factor (SPCA). The SPCA factor is a
function of i and N and is defined as:
The inverse ratio P/F allows us to determine the value of the cash flow P
needed to attain a given amount of cash flow F after N years. The ratio
P/F is called the single payment present worth (SPPW) factor and is equal
to:
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Cont. Uniform-Series Payment
In the vast majority of energy retrofit projects, the economic benefits are
estimated annually and are obtained after a significant initial investment.
It is hoped that during the lifetime of the project, the sum of all the
annual benefits can surpass the initial investment.
To correlate between P and A, we note that for any year k, the present
worth Pk of the receipt A can be determined by using Eq:
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Cont.
The ratio A/P is called the uniform-series capital recovery factor (USCR).
This USCR factor can be determined as a function of both d and N:
The uniform-series present worth factor (USPW), which allows us to
determine the value of P knowing the amount A, is the ratio P/A and can
be expressed as follows:
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Cont. Example 3.4
Find the various compounding factors for N = 10 years and d = 5 percent.
Solution:
The values of the compounding factors for d = 0.05 and N = 10 years are
summarized below:
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5. Economic Evaluation Methods among Alternatives
To evaluate the cost-effectiveness of energy retrofit projects, several
evaluation tools can be considered.
The basic concept of all these tools is to compare among the alternatives
the net cash flow that results during the entire lifetime of the project.
Net Present Worth:
The basic principle of this method is to evaluate the present worth of the
cash flows that occur during the lifetime of the project.
In the particular but common case of a project with constant annual
revenue, the net present worth is reduced to:
For the project to be economically viable, the net present worth has to be
positive or at worst zero (NPW ≥ 0). Obviously, the higher the NPW is,
the more economically sound the project is.
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Cont. Rate of Return:
In this method, the first step is to determine the specific value of the
discount rate d′, that reduces the net present worth to zero.
This specific discount rate is called the rate of return (ROR). The rate of
return d′ is solution of the following equation:
However, an approximate value of d′ can be obtained by trial and error or
from excel program.
Once the rate of return is obtained for a given alternative of the project,
the actual market discount rate or the minimum acceptable rate of return
is compared to the ROR value. If the value of ROR is larger (d′ > d), the
project is cost-effective.
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Cont. Benefit–Cost Ratio
The benefit–cost ratio (BCR) method is also called the savings-to-
investment ratio (SIR) and provides a measure of the net benefits of the
project relative to its net cost.
The alternative option for the project is considered economically viable
relative to the base case when the benefit–cost ratio is greater than one
(BCR > 1.0).
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Cont. Payback Period
In this evaluation method, the period Y required to recover an initial
investment is determined. The value of Y is the solution of the following
equation:
If the payback period Y is less than the lifetime of the project N (Y < N),
then the project is economically viable.
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Cont. Summary of Economic Analysis Methods
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Cont. Example 3.5
After finding that the old boiler has an efficiency of only 60 percent
whereas a new boiler would have an efficiency of 85 percent, a building
owner of Example 3.1 has decided to invest the $10,000 in getting a new
boiler.
Determine whether this investment is cost effective if the lifetime of the
boiler is ten years and the discount rate is 5 percent. The boiler consumes
5,000 gallons per year at a cost of $1.20 per gallon.
An annual maintenance fee of $150 is required for the boiler.
Use all five methods summarized in Table 3.4 to perform the economic
analysis.
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Cont.
22
Cont.
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6. Life-Cycle Cost Analysis Method
Typically, the method is used to evaluate at least two alternatives of a
given project. Only one alternative will be selected for implementation
based on the economic analysis.
For each alternative including the base case, the total cost is computed
over the project lifetime.
The cost is commonly determined using one of two approaches: the
present worth or the annualized cost estimate.
Then, the alternative with the lowest total cost (or LCC) is typically
selected.
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Cont. Example 3.6
The building owner of Example 3.5 has three options to invest his money
as briefly described below.
A. Replace the entire older boiler (including burner) with more
efficient heating system. The old boiler/burner system has an
efficiency of only 60 percent whereas a new boiler/burner system
has an efficiency of 85 percent. The cost of this replacement is
$10,000.
B. Replace only the burner of the old boiler. This action can increase
the efficiency of the boiler/burner system to 66 percent. The cost
of the burner replacement is $2,000.
C. Do nothing and replace neither the boiler nor the burner.
Determine the best economical option for the building owner. Assume that
the lifetime of the retrofit project is ten years and the discount rate is 5
percent. The boiler consumes 5,000 gallons per year at a cost of $1.20 per
gallon. An annual maintenance fee of $150 is required for the boiler. Use
the life-cycle cost analysis method to determine the best option.
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Cont. Solution:
Therefore, the life-cycle cost for option A is the lowest. Thus, it is
recommended for the building owner to replace the entire boiler/burner
system.
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7. General Procedure for an Economic Evaluation
1. Define the problem that the proposed retrofit project is attempting to
address and state the main objective of the project.
2. Identify the constraints related to the implementation of the project.
3. Identify technically sound strategies and alternatives to meet the
objective of the project.
4. Select a method of economic evaluation.
5. Compile data and establish assumptions.
6. Evaluate the alternatives.
7. Perform sensitivity analysis.
8. Make recommendations.
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8. Assignment
Solve the problems
Any
Question ?
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