Module 5

Economic analysis methods-cash flow model, time value of money,

evaluation of proposals, pay-back method, average rate of return method,
internal rate of return method, present value method, life cycle costing
approach. Computer aided Energy Management Systems (EMS)
 In the process of energy management, at some stage, investment would be
required for reducing the energy consumption of a process or utility.
Investment would be required for modifications/retrofitting and for
incorporating new technology.
It would be judious to adopt a systematic approach for merit rating of the
different investment options with regard to the anticipated savings.

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It is essential to identify the benefits of the proposed measure with
reference to not only energy savings but also other associated benefits
such as increased productivity, improved product quality etc.
The cost involved in the proposed measure should be captured in totality
by.
● Direct project cost
● Additional operations and maintenance cost
● Training of personnel on new technology etc.
 Based on the above, the energy economics can be carried out by the
energy management team.
Energy manager has to identify how cost savings arising from energy
management could be redeployed within his organization to the
maximum effect.
To do this, he has to work out how benefits of increased energy
efficiency can be best sold to top management as,
●

●
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Reducing operating /production costs
Increasing employee comfort and well-being
● Improving cost-effectiveness and/or profits
● Protecting under-funded core activities
● Enhancing the quality of service or customer care delivered
● Protecting the environment
Cash Flow Model
Cash Flow (CF) is the increase or decrease in the amount of money a
business, institution, or individual has.
In finance, the term is used to describe the amount of cash
(currency) that is generated or consumed in a given time period.
Cash flow calculations provide information on profitability, quality
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of earnings, liquidity, risks, capital requirements, future growth,
dividends, etc.
They are some of the most important tools for value investment
analysis of investment opportunities.
Cash flows are classified as operating, investing, or financing
activities on the statement of cash flows, depending on the nature of
the transaction.
● Each of these three classifications is defined as follows.
● Operating activities include cash activities related to net income. For
example, cash generated from the sale of goods (revenue) and cash
paid for merchandise (expense) are operating activities because
revenues and expenses are included in net income.
Investing activities include cash activities related to noncurrent assets.
Noncurrent assets include
1) long-term investments
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2) property, plant, and equipment
3) the principal amount of loans made to other entities.
For example, cash generated from the sale of land and cash paid for an
investment in another company are included in this category. (Note
that interest received from loans is included in operating activities.)
 Financing activities include cash activities related to noncurrent
liabilities and owners’ equity.
Noncurrent liabilities and owners’ equity items include
1) The principal amount of long-term debt,
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2) Stock sales and repurchases, and
3) Dividend payments. (Note that interest paid on long-term debt is
included in operating activities.)
Time Value of Money
A project usually entails an investment for the initial cost of installation,
called the capital cost, and a series of annual costs and/or cost savings (i.
e. operating, energy, maintenance, etc.) throughout the life of the
project.
To assess project feasibility, all these present and future cash flows

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must be equated to a common basis.
The problem with equating cash flows which occur at different times is
that the value of money changes with time.
The method by which these various cash flows are related is called
discounting, or the present value concept.
For example, if money can be deposited in the bank at 10% interest,
then a Rs.100 deposit will be worth Rs.110 in one year's time. Thus the
Rs.110 in one year is a future value equivalent to the Rs.100 present
value.
In the same manner, Rs.100 received one year from now is only worth
Rs.90.91 in today's money (i.e. Rs.90.91 plus 10% interest equals Rs.100).
Thus Rs.90.91 represents the present value of Rs.100 cash flow
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occurring one year in the future.
The relationship between present and future value is determined as
follows:
Future Value (FV) = NPV (1 + i)n or
NPV = FV / (1+i)n
Where FV = Future value of the cash flow
Evaluation of Proposals
Following four methods are usually used for the evaluation of capital
investment proposals:
● The average rate of return method.
● The payback period method (also known as cash payback period
method).
● The net present value method.
●
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The internal rate of return method.
Method 1 and 2 are the methods that do not use the present values.
Method 3 and 4 use the present [Link] this can be grouped into two
categories.
Methods That Ignore Present Value:
Methods that do not use the present value (average rate of return
method and payback method) are easy to use. Management uses these
methods initially to screen proposals. If a proposal meets the minimum
standards set by management, it is subject to further analysis
otherwise it is dropped from further consideration.
Methods That Use Present Value:
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Methods that use present values (net present value method and
internal rate of return method) in the capital investment analysis take
into account the time value of money. The concept is that the money
has value over time because it can be invested to earn interest income.
A dollar in hand today is more valuable than a dollar to be received a
year from today.
Example 1
If we invest Rs 5,000 today to earn a 10% interest per year, we will
have Rs 5,500 after one year. Thus Rs 5,000 is the present value of Rs
5,500 to be received a year from today if the rate of interest is 10%.
Example 2
A new small cogeneration plant installation is expected to reduce a

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company's annual energy bill by Rs.4,86,000. If the capital cost of the
new boiler installation is Rs.22,20,000 and the annual maintenance
and operating costs are Rs. 42,000, the expected payback period for
the project can be worked out as.
Solution
PB = 22,20,000 / (4,86,000 – 42,000) = 5.0 years
Simple Pay-Back Period
Simple Payback Period (SPP) is defined as the time (number of years)
required to recovering the initial investment (First Cost), considering
only the Net Annual Saving.
The payback period of a given investment or project is an important
determinant of whether to undertake the position or project, as
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longer payback periods are typically not desirable for investment
positions.
The payback period ignores the time value of money (TVM), unlike
other methods of capital budgeting such as net present value (NPV),
internal rate of return (IRR), and discounted cash flow.
Example : Uneven Cash Flows
Project Y has an initial investment of $21 000 and will offer the
following net cash inflows over the next 5 years.

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● The formula to calculate payback period of a project depends on
whether the cash flow per period from the project is even or uneven.
In case they are even, the formula to calculate payback period is:
●

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Even Cash Flows
Example 1: Company C is planning to undertake a project requiring initial
investment of $105 million. The project is expected to generate $25 million
per year for 7 years. Calculate the payback period of the project.

Solution
Payback period=initial investment / Annual Cash flow = $105 M / $25 M = 4.2
Years
Example 2 : Even Cash Flows
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Project X costs $21 000 and will return a net cash inflow of $5 000 per period.
What will the payback period be for this project?
Payback period=initial investment / Annual Cash flow = $21000/ $5000 = 4.2
Years
When cash inflows are uneven, we need to calculate the cumulative net
cash flow for each period and then find payback period.
Example : Uneven Cash Flows
Company A have decided that they need to replace some of the
machinery in their workshop. The new assets will cost $80,[Link]
estimated cash inflows over the next few years is listed here:find
payback period?

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Payback + Cost Savings
There are times when a business will look at implementing some new
machinery in order to save costs and they have to decide whether it’s
worthwhile investing in it. There normally is a time period associated with
these types of investment.
Example: Raju is looking to get a new piece of machinery that will replace
5 workers who currently do the packing manually on the conveyer belt.

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The workers are each paid $40,000 a year and the new machinery costs
$850,000. Raju has a rule that says the payback period must be 5 years of
less.
Solution
Payback Period = Initial Investment / Annual Net Cost Saving
Payback Period = $850,000 / $200,000
The payback period will be 4.25 years and thus would be accepted as it fits
within the 5 year pattern.
Payback + Cost Savings+ Different Inflows
There are times when a business will look at implementing some new
machinery in order to save costs but will also have an impact on their
overall cash flows as well. There is normally a time period associated with
these types of investment.
Example: Raju is looking to get a new piece of machinery that will
replace 5 workers who currently do the packing manually on the

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conveyer belt. The workers are each paid $40,000 a year and the new
machinery costs $850,000. The business will have to pay additional
insurance costs of $20,000 per year and repair and maintenance costs
of $30,000. Raju has a rule that says the payback period must be 5 years
of less.
Solution
Payback Period = Initial Investment / Annual Net Cost Saving
Payback Period = $850,000 / $150,000
Savings = 200,000 - 30,000 - 20,000 = $150,000
A widely used investment criterion, the payback period seems to offer
the following advantages:
It is simple, both in concept and application.
Obviously a shorter payback generally indicates a more attractive
investment. It does not use tedious calculations.
It favours projects, which generate substantial cash inflows in earlier

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years, and discriminates against projects, which bring substantial
cash inflows in later years but not in earlier years.
Limitations
It fails to consider the time value of money
It ignores cash flows beyond the payback period.
Does not consider profitability of economic life of project,
Does not reflect all the relevant dimensions of profitability.
Average Rate of Return / Accounting Rate of Return (ARR)
The ARR is the percentage rate of return expected on an investment or
asset as compared to the initial investment cost.
ARR divides the average revenue from the asset by the initial
investment to derive the ratio or return that can be expected over the
lifetime of the project.
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ARR does not consider the time value of money or cash flows, which
can be an integral part of maintaining a business.
This method is based on conventional accounting concepts.
This method has been introduced to overcome the disadvantage of
pay back period.
The profits under this method is calculated as profit after depreciation
and tax of the entire life of the project.
For example, if the ARR for Project A was 15% and for Project B was 20%,
then Project B would be chosen because the ARR percentage is higher
than Project A.
The project with the higher rate of return than the minimum rate
specified by the firm also known as cut off rate, is accepted and the

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other which gives a lower expected rate of return than the minimum
rate is rejected.
Accept or Reject Criterion: Under the method, all project, having
Accounting Rate of return higher than the minimum rate established
by management will be considered and those having ARR less than the
pre-determined rate will be rejected. This method ranks a Project as
number one, if it has highest ARR, and lowest rank is assigned to the
project with the lowest ARR.
The technique used for calculating ARR is as follows:
Divide the net profit generated by an investment by the number of
years the project is expected to last (this is the average annual
return)
Divide the average annual return by the initial outlay / cost of
investment
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Multiply your answer by 100 to give the ARR as a percentage.
Merits
It is very simple to understand and use.
It can readily be calculated by using the accounting data.
This method takes into account saving over the entire economic life
of the project. Therefore, it provides a better means of comparison
of project than the pay back period.
This method through the concept of "net earnings" ensures a

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compensation of expected profitability of the projects.

It ignores time value of money.

It does not consider the length of life of the projects.
It is not consistent with the firm's objective of maximizing the
market value of shares.
It ignores the fact that the profits earned can be reinvested.
Example: Suzy owns a business manufacturing fragranced candles.
Suzy is looking to expand her business and to do this she will need to
buy some new machinery to help produce more fragranced candles.
Suzy has searched online and found two machines that are suitable
to help her achieve increased output. The cost of buying each
machine and the annual estimated net profits are provided in the
table below: find average rate of return of both the machines.

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Discounted cash flow methods
The payback method is a simple technique, which can easily be used to
provide a quick evaluation of a proposal. However, it has a number of
major weaknesses:
● The payback method does not consider savings that are accrued after
the payback period has finished.
●

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The payback method does not consider the fact that money, which is
invested, should accrue interest as time passes. In simple terms there is
a 'time value' component to cash flows. Thus Rs.1000 today is more
valuable than Rs.1000 in 10 years' time.

In order to overcome these weaknesses a number of discounted cash flow

techniques have been developed, which are based on the fact that money
invested in a bank will accrue annual interest. The two most commonly
used techniques are the 'net present value' and the 'internal rate of return'
Net Present Value Method
The net present value method considers the fact that a cash saving
(often referred to 'cash flow') of Rs.1000 in year 1 of a project will be
worth less than a cash flow of Rs.1000 in year 2.
The net present value method achieves this by quantifying the impact
of time on any particular future cash flow.
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This is done by equating each future cash flow to its current value
today, in other words determining the present value of any future
cash flow.
The present value (PV) is determined by using an assumed interest
rate, usually referred to as a discount rate.
Discounting is the opposite process to compounding.
Compounding determines the future value of present cash flows, where" discounting
determines the present value of future cash flows.
If a company invested Rs.22, 20,000 in a bank with interest rate 8% annually, then the
future value of this money after 5 years can be found out as following.

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Where, FV- future value
PV-Value of initial investment
R- Interest rate
n- number of years
The future value of the investment made at present, after 5 years will be:

FV = 22,20,000 x (1 + 8/100)5 = Rs.32,61,908.4

So in 5 years the initial investment of 22,20,000 will accrue
Rs.10,41,908.4 in interest and will be worth Rs.32,61,908.4.
Alternatively, it could equally be said that Rs.32,61908.4 in 5 years
time is worth Rs.22,20,000 now (assuming an annual interest rate of
8%).
In other words the future value of Rs.32,61,908.40 in 5 years time is
Rs.22,00,000 now.
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The present value of an amount of money at any specified time in
the future can be determined by the following equation.

Where, PV- Present value

S-Value of cash flow in ‘n’ year times IR- Interest rate
n- number of years
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.
Costs are represented as a negative value and savings as a positive
value. The sum of all the present values is known as the net present
value (NPV).
The higher the net present value, the more attractive the proposed

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project. The discount factor is based on an assumed discount rate (i.e.
interest rate) and can be determined by using equation.

The product of a particular cash flow and the discount factor is the
present value.
Using the net present value analysis technique, let us evaluate the
financial merits of the proposed projects shown in the Table below.
Assume an annual discount rate of 8% for each project.

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It can be seen that over a 10 year life-span the net present value for
Project 1 is Rs.10,254.00, while for Project 2 it is Rs.10,867.80. Therefore
Project 2 is the preferential proposal
Advantages of net present value (NPV)
It is considered to be conceptually superior to other methods.
It does not ignore any period in the project life or any cash flows.
It is mindful of the time value of money.
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It is easier to apply NPV than IRR(Internal rate of return).
It prefers early cash flows compared to other methods
Disadvantages of net present value (NPV)
The NPV calculations unlike IRR method, expects the
management to know the true cost of capital.
NPV gives distorted comparisons between projects of unequal
size or unequal economic life. In order to overcome this
limitation, NPV is used with the profitability index.
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Problem
It is proposed to install a heat recovery equipment in a factory. The
capital cost of installing the equipment is Rs.20,000 and after 5 years
its salvage value is Rs.1500. If the savings accrued by the heat

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recovery device are as shown below, we have to find out the net
present value after 5 years. Discount rate is assumed to be 8%.
Internal rate of return Method
In some situation if, the discount rate were reduced there would come a point
when the net present value would become zero. The discount rate which achieves a
net present value of zero is known as internal rate of return(IRR). Higher the
internal rate the more attractive the project.
Steps
Find the discount rate and net present value at different rate of interest
Find one negative and positive NPV
Using below formula find internal rate of return

Where,
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PDR- Discount rate which gives positive NPV
NDR- Discount rate which gives negative NPV
Pos NPV / neg NPV - value of +Ve and –Ve NPV
Problem

A proposed project requires an initial capital investment of Rs.20

000. The cash flows generated by the project are shown in the table

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Find out the internal rate of return for the project?
Life Cycle Costing
Life-cycle cost analysis is a process for evaluating the total
economic worth of a usable project segment by analyzing initial
costs and discounted future costs.
Life cycle costing is a system that tracks and accumulates the actual
costs and revenues attributable to cost object from its invention to

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its abandonment.
Life cycle costing involves tracing cost and revenues on a product
by product base over several calendar periods.
Life cycle costing is defined as the total cost throughout its life
including planning, design, acquisition & support costs & any other
costs directly attributable to owning / using the asset.
Category of LCC Capital assets:
•Initial costs
•Operating costs
•Disposal costs
Characteristics of Life Cycle Costing:
1) Product life cycle costing involves tracing of costs and revenues of
a product over several calendar periods throughout its life cycle.

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2) Product life cycle costing traces research and design and
development costs and total magnitude of these costs for each
individual product and compared with product revenue.
3) Each phase of the product life-cycle poses different threats and
opportunities that may require different strategic actions.
4) Product life cycle may be extended by finding new uses or users or
by increasing the consumption of the present users.
Stages of Product Life Cycle Costing:
Following are the main stages of Product Life Cycle:
Market Research
Specification
Design
Prototype Manufacture
Development
Tooling
Manufacture
Selling
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Distribution
Product support
Decommissioning
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Market Research: It will establish what product the customer wants, how much he is prepared
to pay for it and how much he will buy.
Specification: It will give details such as required life, maximum permissible maintenance costs,
manufacturing costs, required delivery date, expected performance of the product.
Design: Proper drawings and process schedules are to be defined.
Prototype Manufacture: From the drawings a small quantity of the product will be manufactured.
These prototypes will be used to develop the product.
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testing and changing is development. When a product is made for the first time, it rarely meets
the requirements of the specification and changes have to be made until it meets the
requirements.
Tooling: Tooling up for production can mean building a production line, buying the necessary
tools and equipment’s requiring a very large initial investment.
Manufacture: The manufacture of a product involves the purchase of raw materials and
components, the use of labour and manufacturing expenses to make the product.
Decommissioning: When a manufacturing product comes to an end, the plant used to build the
product must be sold or scrapped.
Benefits of Product Life Cycle Costing:

Following are the main benefits of product life cycle costing

1) It results in earlier action to generate revenue or lower costs than
otherwise might be considered. There are a number of factors that
need to be managed in order to maximise return in a product.
2) Better decision should follow from a more accurate and realistic
assessment of revenues and costs within a particular life cycle stage.
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3) It can promote long term rewarding in contrast to short term
rewarding.
4) It provides an overall framework for considering total incremental
costs over the entire span of a product.
Life Cycle Costing Process

Life cycle costing is a three-staged process.

The first stage is life cost planning stage which includes planning LCC
Analysis, Selecting and Developing LCC Model, applying LCC Model
and finally recording and reviewing the LCC Results.
The Second Stage is Life Cost Analysis Preparation Stage followed by
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third stage Implementation and Monitoring Life Cost Analysis.
 Stage 1: LCC Analysis Planning:
The Life Cycle Costing process begins with development of a plan,
which addresses the purpose, and scope of the analysis.
Stage 2: Life Cost Analysis Preparation:
The preparation of the Life Cost Analysis involves review and
development of the LCC Model as a “real-time” or actual cost control
mechanism.

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Stage 3: Implementing and Monitoring:
Implementation of the Life Cost Analysis involves the continuous
monitoring of the actual performance of an asset during its operation
and maintenance to identify areas in which cost savings may be made
and to provide feedback for future life cost planning activities.
For example, it may be better to replace an expensive building
component with a more efficient solution prior to the end of its useful
life than to continue with a poor initial decision.
Life Cycle Cost

LCC is the total discounted (present worth) cash flow for an investment with
future costs during its economic life.
LCC = K + R + M + EC - SV
Where:
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K = capital cost (capital, labor, overhead)
R =Replacement cost {Σ K/ (1+r) n } where r= interest rate
M= maintenance cost,
EC= energy cost
SV = Salvage Value (in year t)
● LIFE CYCLE COST OF SOLAR THERMAL PLANT
The major components of this system to be considered in calculating
life cycle cost are:
Heat energy Collectors
Boiler
Steam turbine
Electric generator

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The costs of the above mentioned components are listed in the table.
● Let us say interest rate i=10% (analyze for 20 years) .Then the life cycle
cost per KW is
● Capital Cost per KW= Cost of (heat energy collectors + boiler + steam
turbine + electric generator + accessories) =25000+13900+5500+1000
● =Rs.45400
●

●
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● Maintenance cost = 1% of total capital cost per year = Rs. 3865.15
● Therefore,
● Life cycle cost per KW = 45400+8725.4+3865.15=Rs.57990.55
● Wind Energy System
● The major components of a wind energy system are :
● 1. Wind mill
● 2. Gear box
● 3. Controller
●

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5. Electric generator

● The costs of the above mentioned components are given in Table

● Now let us say interest rate i =10%
● Then the life cycle cost per KW is calculated as follows :
● Capital Cost = 30000 + 3000 + 2500 + 12000 + 6000 + 2000 = Rs.
55500

●
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●

● Maintenance cost = 1% of total capital cost per year = Rs. 4725

● Therefore, Life cycle cost per KW = Rs. (55500 + 8921 + 4725) = Rs.
69146.
SOLAR PV SYSTEM

To calculate the life cycle cost per KWh the basic components of a
PV system are considered as follows.
PV panels
Batteries
Inverters
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Charge controllers
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Maintenance Cost:As we are considering only from generating point of view
maintenance cost is negligible part. Energy Cost: It does not require any external
energy (because the system uses sun energy) to produce the electrical energy.
LIFE CYCLE COST OF BIOMASS PLANT
The major components of Biogas plant are listed as follows.
Gassifier
Piping
Sand filter
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Diesel engine
Electric Generator
The costs of different components of Biogas plant are specified in the
table.
Now let us say interest rate i=10%
Then the life cycle cost is calculated as follows:
Capital Cost =127700+8300+4150+37700+78150+20750+16550
=Rs.293300

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Maintenance cost = 1% 0f total capital cost per year = Rs. 24970.28 Therefore, Life

cycle cost =293300+40533.6+24970.58 = Rs.358803.8

Computer Aided Energy Management
Various Energy Management Softwares (EMS) are available for
computer aided energy management.
EMS is a general term and category referring to a variety of energy-
related software applications which may provide
● Utility bill tracking
Real-time metering
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●

● Building HVAC and lighting control systems

● Building simulation and modeling
● Carbon and sustainability reporting
● IT equipment management
● Demand response
● Energy audits
Energy management software often provides tools for
reducing energy costs and consumption for buildings or
communities.
EMS collects energy data and uses it for three main
purposes: Reporting, Monitoring and Engagement.
Reporting may include verification of energy data,
benchmarking, and setting high-level energy use
reduction targets.
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Monitoring may include trend analysis and tracking
energy consumption to identify cost-saving opportunities.
Engagement can mean real-time responses (automated or
manual), or the initiation of a dialogue between
occupants and building managers to promote energy
conservation.
One engagement method that has recently gained
popularity is the real-time energy consumption display
available in web applications or an onsite energy
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Load models for the residential end-uses calculate hourly
electricity consumption in a housing unit, which helps
in designing optimal load shifting strategies.
The load shifting algorithm determines load shifting and
appliance scheduling based on the price, load, and
temperature data, along with customer preferences.
It decides operational settings for residential appliances, e.
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g. thermostat setting of a central air conditioner.
The user interface allows the user to set operational
preferences for appliances, conveys the current level
of appliance control to the customer, and controls the
controller hardware.
The controller hardware performs the actual control of
the appliances.
It consists of a programmable controller which
interfaces to a personal computer and incorporates
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two-way transmission of power line signals.
A main controller sends control signals over existing
electric wiring to the receiver modules dedicated to
each appliance, which execute the commands.