Part 2 Financial Metrics and Rates of Return
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1 Part 2 Financial Metrics and Rates of Return Christopher Russell Energy PathFINDER (443) crussell@energypathfinder.com
2 Spare no expense to save money on this one. Samuel Goldwyn ( ) (c)2009 Energy Pathfinder Mangement Consulting, LLC 2 2
3 Outline for Part 2 1. EXAMPLE PROJECT 2. RETHINKING SIMPLE PAYBACK 3. RATE OF RETURN EXPLAINED 4. CASH FLOW EXPLAINED & UTILIZED 5. INVESTMENT PERFORMANCE METRICS 3
4 $1,500,000 cost $150,000 rebate (YR1) $200,000 downpayment Cap. recovery: 25 YRS/8% $1,300,000 borrowed 20YRS/4% 25 YR economic life 1.5% energy price escal. Declining balance CCA (4%) $0.17/CM natural gas $0.05/kWh electricity $30,000 O&M saving/yr BOILER / STEAM UPGRADE BEFORE AFTER ELEC kwh GAS Cu M ANNUAL O&M $72,000 $42,000 4
5 About Financial Metrics Simple Payback Return on Investment Life Cycle Cost Net Present Value Internal Rate of Return Rates of Return, Discount, etc. Save or buy? Cost of doing nothing Break-even analysis Budget for additional analysis 5
6 Simple Payback? $1,500,000 cost $251,300 1 st -year savings SPB = COST/ ANNUAL SAVINGS SPB = 6 YEARS HURDLE = 2 YRS OR LESS. OUTCOME: REJECT. 6
7 Simple Payback! Keep pushing the same buttons, Keep getting the same results 7
8 Outline for Part 2 1. EXAMPLE PROJECT 2. RETHINKING SIMPLE PAYBACK 3. RATE OF RETURN EXPLAINED 4. CASH FLOW EXPLAINED & UTILIZED 5. INVESTMENT PERFORMANCE METRICS 8
9 Make the case: What do business leaders want to know? What s the benefit? How many dollars? How quickly do the dollars accrue? What s the risk of investing? What s the risk of NOT investing? What s the most that I should pay for it? per current investment criteria How does this compare to other ways to use money? 9
10 Capital investment goals. Assumption: investors want to grow their business The business already produces returns at some velocity Additional capital investments should improve the business overall rate of capital recovery Principles for any CAPEX project 10
11 Simple payback Ignores value accruing after the investment pays for itself Payback cost of capital rate of return over time investment comparison metric Says nothing about value lost when refusing to invest 11
12 Do you. use simple payback to measure mutual fund performance? 12
13 Outline for Part 2 1. EXAMPLE PROJECT 2. RETHINKING SIMPLE PAYBACK 3. RATE OF RETURN EXPLAINED 4. CASH FLOW EXPLAINED & UTILIZED 5. INVESTMENT PERFORMANCE METRICS 13
14 Investment returns are a ratio measure. Value = ratio of benefits to investment For lenders, value = interest received from a loan For investors, value = new cash flow generated Real returns are after-tax cash flow (ATCF) ATCF INVESTMENT = RATE OF RETURN (VALUE!) 14
15 CAPEX Investment Questions OPERATING PERFORMANCE Improve production costs? ECONOMIC PERFORMANCE Improve the firm s capital recovery rate? FINANCIAL PERFORMANCE Beneficial terms of finance? 15
16 A MONEY-MAKING MACHINE $ INPUTS POWER HOUSE Production Facility $1.00 REVENUE Example: 8% Rate of Return 16
17 MUTUAL FUNDS 3% YOUR COMPANY 8% COST TO BORROW 4% BEST COMPETITOR 10% RELATIVE RATES OF RETURN 17
18 YES to any Investment that Increases the VELOCITY of Total Invested Capital. $ INPUTS POWER HOUSE Production Facility $1.00 REVENUE 18
19 Outline for Part 2 1. EXAMPLE PROJECT 2. RETHINKING SIMPLE PAYBACK 3. RATE OF RETURN EXPLAINED 4. CASH FLOW EXPLAINED & UTILIZED 5. INVESTMENT PERFORMANCE METRICS 19
20 Annual Cash Flow Elements OPERATING PERFORMANCE ECONOMIC PERFORMANCE FINANCIAL PERFORMANCE ENERGY SAVINGS (+/-) NET CHANGE, O&M OPERATING INCOME DEPRECIATION CHARGES INCOME TAX INTERNAL CAPITAL RECOVERY NET INCOME DEBT SERVICE FREE CASH FLOW 20
21 Cash Flow Elements - Purpose OPERATING PERFORMANCE ECONOMIC PERFORMANCE FINANCIAL PERFORMANCE IMPACT ON BUDGET? IMPACT ON FIRM S CAPITAL PRODUCTIVITY? IMPACT ON CASH FLOW? 21
22 Cash Flow Elements - Answers OPERATING PERFORMANCE PRE-TAX RESULTS COMPARE TO INTERNAL PROJECTS ECONOMIC PERFORMANCE POST-TAX RESULTS CAPITAL PERFORMANCE PRIOR TO DISTORTION BY LENDER S TERMS FINANCIAL PERFORMANCE RETURNS AFTER ACCOMMODATING LENDERS 22
23 Cash Flow Elements - IMPACTS OPERATING PERFORMANCE METRICS SIMPLE PAYBACK ACCOUNTING ROI IMPACT PRODUCTION COST, BUDGET ECONOMIC PERFORMANCE FINANCIAL PERFORMANCE DISCOUNTED CASH FLOW ANALYSIS INTERNAL CAPITAL INVESTED BORROWED CAPITAL 23
24 CAPEX Investment Strategy OPERATING PERFORMANCE Escalate energy prices? Account for non-energy benefits? ECONOMIC PERFORMANCE Expense from revenue budget? Invest internal capital? Amortize? At what rate? All up front? FINANCIAL PERFORMANCE Borrow at what terms (APR, years)? CAPITAL SOURCES? REVENUE/EXPENSE INTERNAL CAPITAL BORROWED CAPITAL TOTAL PROJECT COST REBATES TOTAL BASIS FOR DEPRECIATION 24
25 Cash Flow Elements - Example A B C = A+B D E F G H I J K L = C-D = E x Tax = D+E-F-G = H-I+J+K FIRST YEAR RESULTS ENERGY SAVINGS O&M COST SAVINGS.. OPERATING INCOME. DEPRECIATION. TAXABLE INCOME INCOME TAX (35%).. CAPITAL RECOVERY (8%/25) NET INCOME. DEBT SERVICE.. TAX SAVINGS ON INTEREST. REBATE FREE CASH FLOW $281,300 $30,000 $311,300 $27,000 $284,300 $99,505 $18,524 $193,271 $94,533 $17,924 $150,000 $266,663 25
26 Project Cash Flow AFTER TAX NET INCOME OUTLAY AFTER FINANCE NOMINAL OPERATING DEBT FREE CASH YR INVESTMENT INCOME SERVICE FLOW 0 -$1,000,000 -$200,000 1 $150,000 $311,300 $193,271 -$94,533 -$76,609 $266,663 2 $0 $315,520 $205,086 -$94,533 -$77,227 $127,859 3 $0 $319,802 $207,129 -$94,533 -$77,870 $129,259 4 $0 $324,149 $209,243 -$94,533 -$78,539 $130,705 5 $0 $328,562 $211,429 -$94,533 -$79,235 $132, $0 $432,119 $443,432 $0 $0 $443,432 26
27 $500,000 $400,000 $300,000 $200,000 $100,000 $0 $100,000 $200,000 $300,000 INCREMENTAL ANNUAL CASH FLOW Undiscounted Cash Flow Resulting from Project Finance & Implementation TAX ADJUSTED_DEBT_SERVICE FREE_CASH_FLOW $4,500,000 $4,000,000 $3,500,000 $3,000,000 $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 $500,000 CUMULATIVE FREE CASH FLOW Undiscounted Free Cash Flow After Project Finance CUMULATIVE_CASH_FLOW 27
28 About Cash Flow Elements ENERGY PRICES ENERGY SAVINGS VOLUME DEPRECIATION CHARGE CAPITAL RECOVERY TAX RATE FREE CASH FLOW CHANGE ANNUALLY CONSTANT 28
29 Outline for Part 2 1. EXAMPLE PROJECT 2. RETHINKING SIMPLE PAYBACK 3. RATE OF RETURN EXPLAINED 4. CASH FLOW EXPLAINED & UTILIZED 5. INVESTMENT PERFORMANCE METRICS 29
30 Return on 1 st Year Operating Investment ROI = Income $311,300 Total Nominal $1,350,000 = 23% PROS Investment Easy to understand Good for comparing the attractiveness of two or more projects CONS Results vary with cash flow elements over successive years ROI is confined to the project only; contribution to overall profitability or wealth is not measured Analysis does not clearly isolate the impact of individual variables Fails to measure the cost of NOT doing the project 30
31 Life Cycle Cost LCC = total cost of ownership Acquisition Energy inputs Maintenance Insurance, licenses, disposal. Maintenance (1%) Energy (97%) Capital (2%) 31
32 Life-Cycle Cost Total cost of ownership, including capital, operating costs and energy consumption. PROS Good for comparing the total ownership for two or more similar purpose projects. CONS Difficult to implement as a practical management metric; no single person of department clearly owns responsibility for life-cycle costs No indication of wealth created by the project or variability in profitability Not useful for comparing dissimilar projects Fails to measure the cost of NOT doing the project 32
33 Life-Cycle Costs (Example) THIRD PARTY CAPITAL. $1,300,000 0% INTERNAL CAPITAL $200,000 0% CURRENT EXPENSE. $0 0% INTEREST $1,022,152 0% COSTS YR SUM, O&M COSTS.. $1,050,000 0% 25-YR SUM, ENERGY. $2,777,633, % TOTAL LIFE-CYCLE COST $2,781,037, % 33
34 Net Present Value (NPV) T Annual Cash Flow t (1+r) t-1 t - Cash Flow In Year 0 PROS Captures full measure of value added by the project s returns Reflects risk by incorporating the time-value of money Excellent tool for ranking two or more options by the value they generate CONS Entire calculation relies on a series of guesses about future returns Analysis fails isolate variables that can be linked to specific responsibilities Fails to measure the cost of NOT doing the project 34
35 Internal Rate of Return Cash Flow IRR = r so that: + T t-1 Cash Flow t In Year 0 = 0 (1+r) t Where T = economic life of the project in years t represents each individual year in the project s economic life indicates summation across all t years PROS Captures full measure of value added by the project s returns Reflects risk by incorporating the time-value of money Excellent tool for ranking two or more options by the value they generate CONS Fails to measure the absolute value of wealth created Entire calculation relies on a series of guesses about future returns Analysis fails isolate variables that can be linked to specific responsibilities Fails to measure the cost of NOT doing the project 35
36 HORSEPOWER PAYLOAD How much muscle? How much volume? IRR NPV 36
37 Profitability index (PI) PI = DISCOUNTED VALUE OF AFTER-TAX BENEFITS DISCOUNTED VALUE OF ALL PROJECT INVESTMENTS 37
38 Profitability index (PI) ANNUAL YR INVESTMENT AND REBATES NET INCOME CUMULATIVE PI 0 $1,500, $150,000 $193, $0 $205, $0 $207, $0 $209, $0 $211, $0 $443,
39 Profitability index (PI) PI = $2,396,038 $1,361,111 = 1.8 THRU 25 YRS $1,044,927 in additional capital created by end of year 25 Future values discounted at 8% 39
40 Capital Goes SOMEWHERE Every choice offers a rate of return 100% - 75% - 50% - 25% - 0% -? Energy project: After-tax rate of return Core business: cost of internal capital Stocks/mutual funds compare to Cost to borrow 40
41 Investor s Rates of Return (Thru 25 Yrs) EXAMPLE: PROJECT COST: ECONOMIC LIFE: $1,500, YRS 6-YR Payback Operating Results 100% - IRR = 96% AFTER TAXES AND FINANCE 75% - 50% - 25% - 0% - IRR = 23.8% BEFORE TAXES COST OF INTERNAL CAPITAL = 8% MUTUAL FUNDS = 4% COST TO BORROW = 3% 41
42 Energy Investment Outcomes Say No to Energy Efficiency Live with inefficiencies. Live with cash drain. Compensate for cash flow losses HOW? Say Yes to Energy Efficiency Create supplemental cash flow Subsidize other investment opportunities Expand the range of potential investment opportunities 42
43 BC Hydro Investment Calculator Simple Payback Accounting Return on Investment Life-Cycle Cost Profitability Index Internal Rate of Return Pre- and Post-Tax Results 43
44 QUESTIONS? HASTINGS STREET, VANCOUVER 1967
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