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WORKSHOP ON FINANCIAL AND ECONOMIC ANALYSIS OF TRANSMISSION PROJECTS For the Southeast Europe and Black
WORKSHOP ON FINANCIAL AND ECONOMIC ANALYSIS OF TRANSMISSION PROJECTS For the Southeast Europe and Black

WORKSHOP ON FINANCIAL AND ECONOMIC ANALYSIS OF TRANSMISSION PROJECTS

For the Southeast Europe and Black Sea Regional Transmission Planning Projects

Balkans and Regional Energy Market Partnership Program

Cooperative Agreement EEE-A-00-02-00054-00

Kyiv, Ukraine July 7-8, 2009

WORKSHOP ON FINANCIAL AND ECONOMIC ANALYSIS OF TRANSMISSION PROJECTS For the Southeast Europe and Black Sea Regional Transmission Planning Projects

Prepared for:

Balkan and Regional Energy Market Partnership Program

By:

Patrick D. Miller

&

The Energy Institute of Croatia

Cooperative Agreement EEE-A-00-02-00054-00

United States Energy Association 1300 Pennsylvania Avenue, NW Suite 550, Mailbox 142 Washington, DC 20004

+1 202 312-1230 (USA)

These training materials are made possible by the support of the American people through the United States Agency for International Development (USAID). The contents are the responsibility of the United States Energy Association and do not necessarily reflect the views of USAID or the United States Government

WORKSHOP ON FINANCIAL AND ECONOMIC ANALYSIS OF TRANSMISSION PROJECTS For the Southeast Europe and Black Sea Regional Transmission Planning Projects

Table of Contents

Introduction

1

Cash Flow Diagrams

2

Exercise #1

3

Time Value of Money

4

Simple Interest

5

Compound Interest

5

Equivalence Calculations

6

Single Payment Compound Interest Formulas

7

Exercise #2

7

Exercise #3

7

Uniform Series Compound Interest Formulas

8

Exercise #4

9

Exercise #5

9

Exercise #6

9

Exercise #7

10

Solving Problems using an Excel Spreadsheet

10

Exercise #8

11

Exercise #9

11

Net Present Value Analysis

11

Non-Uniform series of cash flows

12

Discounted Cash Flow Analysis & NPV

12

Exercise #10

13

Cost-Benefit Ratio Analysis

15

Selecting a MARR

16

Putting it all together

16

Exercise #11

16

Exercise #12

18

Sensitivity Analysis

18

Additional NPV and IRR Exercises Exercise #13 Exercise #14

20

Appendix A –Spreadsheet Examples

Appendix B – Compound Interest Tables

Appendix C – Putting it all together Spreadsheet

Appendix D – Transmission Line Proposal Spreadsheet

Appendix E – IRR Solutions and Sign Changes

Appendix F – Additional NPV and IRR Exercise Solutions

Workshop on Financial & Economic Analysis – Patrick D. Miller

Economic Analysis in Transmission Network Planning – Energy Institute of Croatia

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Engineering Economic Analysis Workshop Notes Introduction

Engineering Economic Analysis Workshop Notes

Introduction

This two day workshop has been designed as an introduction to Finance and Economic Analysis for engineers who don’t have a background in accounting or finance. Generally, economics is the study of how to efficiently manage the use of scarce resources in a world of unlimited demand for those resources. Engineering economics in this workshop will apply many of the tools of economics to engineering problems so that the economic viability of each potential solution can be considered along with the technical aspects of the solution. Our discussions will focus on costs, revenues, and benefits that occur at different times. Nearly everything that engineers design calls for spending money in the design and building stages, and only after completion do revenues or benefits occur – usually for years. Thus the economic analysis of costs, benefits, and revenues occurring over time is what we will call engineering economic analysis. In this workshop, we will see how engineering economic analysis can be used to answer questions relating to electric transmission systems such as:

Which engineering projects are worthwhile?

Which engineering projects should have a higher priority?

How should the engineering project be designed in order to optimize the benefits in relation to the costs?

The specific objectives of the workshop are that the participants:

Understand the time value of money and be able to apply the concept to problem solutions.

Be able to construct a cash-flow diagram and apply it to engineering economic situations.

Be able to determine the equivalence of various financial transactions.

Understand the concepts of cost - benefit analysis for engineering design projects.

Be able to calculate Present Values (PV), Future Values (FV) and Payment or Receipts (A) of cash flows using formulas, Compound Interest Tables and Microsoft Excel.

Be able to perform discounted cash flow analysis using Net Present Value (NPV) and Internal Rate of Return (IRR) techniques.

Begin to understand the challenges of gathering reliable explicit and implicit financial and economic data for these learned techniques.

financial and economic data fo r these learned techniques. Balkans and Regional Energy Market Partnership Program
financial and economic data fo r these learned techniques. Balkans and Regional Energy Market Partnership Program

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects • Gain an understanding of the financial and

Gain an understanding of the financial and economic analyses used by international financial institutions to appraise potential transmission projects.

Cash Flow Diagrams

The costs and benefits of engineering projects occur over time and are often summarized on a cash flow diagram (CFD). Specifically, the CFD illustrates the size, sign, and timing of individual cash flows. In this way the CFD is the basis for engineering economic analysis.

The CFD is created by first drawing a segmented time-based horizontal line, divided into time units. The time units of the CFD can be years, months, quarters, or any other consistent time unit. Then at each time at which a cash flow will occur, a vertical arrow is added – pointing down for costs and up for revenues or benefits.

In the example below, time zero is today and time 1 through 5 are at the end of the period. Revenue will be positive () and Costs will be negative ().

Time

Category

Amount

 

0 Revenue

$100

 

1 Cost

($100)

 

2 Revenue

$100

 

3 Cost

($150)

 

4 Cost

($150)

 

5 Revenue

$50

Table 1

The CFD for this set of revenues and costs looks like the following:

$100 $100 $50 $150 $150 $100
$100
$100
$50
$150
$150
$100
looks like the following: $100 $100 $50 $150 $150 $100 Balkans and Regional Energy Market Partnership
looks like the following: $100 $100 $50 $150 $150 $100 Balkans and Regional Energy Market Partnership

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects During the workshop, we will solve many proble

During the workshop, we will solve many problems using a spreadsheet. The cash flows from Table 1 can be entered into a spreadsheet as follows:

Year

Costs

Revenue

0

$100

1

($100)

2

$100

3

($150)

4

($150)

5

$50

Notice that costs are entered as negative cash flows and revenues as positive cash flows. Using the spreadsheet capabilities, a stacked bar chart can be prepared that looks very much like the CFD illustrated above.

$150 $100 $50 $0 123456 ($50) ($100) ($150) ($200)
$150
$100
$50
$0
123456
($50)
($100)
($150)
($200)
Revenue Costs
Revenue
Costs

Exercise #1 – Your Company is considering the purchase of a machine that will cost $20,000 to buy. After 7 years its salvage value will be $2,000. An overhaul of the machine costing $5,000 will be required in year 4 and the Operating and Maintenance costs will be $2,500 per year. Prepare a table of cash flow and a graph using a spreadsheet.

Prepare a table of cash flow and a graph using a spreadsheet. Balkans and Regional Energy
Prepare a table of cash flow and a graph using a spreadsheet. Balkans and Regional Energy

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects The Table of cash flow as entered into

The Table of cash flow as entered into an Excel spreadsheet is as follows:

Year

Costs

Revenue

0

($20,000)

1

($2,500)

2

($2,500)

3

($2,500)

4

($7,500)

5

($2,500)

6

($2,500)

7

($2,500)

$2,000

Notice that all costs are negative and that the two cost categories of year 4 (O&M costs and Overhaul costs) have been added together. The graph of this input from the spreadsheet is as follows:

$5,000 $0 ($5,000) Revenue ($10,000) Costs ($15,000) ($20,000) ($25,000) 12345678 Revenue $2,000 Costs
$5,000
$0
($5,000)
Revenue
($10,000)
Costs
($15,000)
($20,000)
($25,000)
12345678
Revenue
$2,000
Costs
($20,000)
($2,500)
($2,500)
($2,500)
($7,500)
($2,500)
($2,500)
($2,500)

Time Value of Money

During this workshop, we will demonstrate techniques for comparing the value of money that is received or spent at different points in time, which is the foundation of engineering economic analysis. We must be able to compare, for example, a low-cost pump with a higher-cost pump. If there were no other consequence, we would prefer the low-cost one. But what if the higher-cost pump is more efficient and/or more durable? Then we must consider whether to spend more money now to reduce future power costs and/or to postpone the future cost of a replacement pump. This workshop will present the methods for comparing the alternatives to determine which pump is preferred in the example above, or generally which engineering alternative is most economically attractive.

which engineering alte rnative is most economically attractive. Balkans and Regional Energy Market Partnership Program 4
which engineering alte rnative is most economically attractive. Balkans and Regional Energy Market Partnership Program 4

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects There is a time value of money because

There is a time value of money because of the willingness of banks, businesses, markets and people to pay interest for the use of various sums. For example, even is we could be assured that we would get $5,000 five years from now, we would all prefer to receive $5,000 now. This is because if we get the $5,000 now we can invest the funds, or deposit the funds in a bank, for five years and, at 8% simple interest, would have $7,000 five years from now.

Simple Interest, as used in the example above, is computed only on the original sum, not on accrued interest. The formula for simple interest is:

F = P (1 + in)

Where “F” is the future amount including interest, “P” is the present amount invested, “i” is the interest rate and “n” is the number of periods “P” is invested. In our example:

Compound Interest

F

= $5,000 (1 + .08 x 5)

F

= $7,000

Simple interest is not normally used in engineering economic analysis. In practice, interest is computed by the compound interest method. For a loan, any interest owed but not paid at the end of the year is added to the balance due. Then the next year’s interest is calculated on the unpaid balance due, which includes the unpaid interest from the preceding period. In this way, compound interest can be thought of as interest on top of interest. All of our calculations will assume that compound interest is being used.

To demonstrate the impact of compound interest, we will use 8% compounded on an annual basis in the example above. The following table shows how the calculation is done:

year

Principal (P) on which Interest is calculated for n years

Interest (i) owed at the end of year (n)

Total amount due at end of year (n) & new total Principal for year n+1

 

1 $5,000

$5,000 x .08 = 400

$5,000 + 400 = 5,400

 

2 $5,400

$5,400 x .08 = 432

$5,400 + 432 = 5,832

 

3 $5,832

$5,832 x .08 = 467

$5,832 + 467 = 6,299

 

4 $6,299

$6,299 x .08 = 504

$6,299 + 504 = 6,803

 

5 $6,803

$6,803 x .08 = 544

$6,803 + 544 = 7,347

  5 $6,803 $6,803 x .08 = 544 $6,803 + 544 = 7,347 Balkans and Regional
  5 $6,803 $6,803 x .08 = 544 $6,803 + 544 = 7,347 Balkans and Regional

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects The total amount due at the end of

The total amount due at the end of the fifth year is $7,347. This is $347 more than when we calculated the future sum using simple interest. This is because of the effect of interest being earned on top of interest.

Equivalence Calculations

To understand the usefulness of equivalence calculations, consider the following engineering situation:

Year

Alternative “A” Lower Initial Cost Higher Operating Cost

Alternative “B” Higher Initial Cost Lower Operating Cost

0

-$600

-$850

1

-115

-80

2

-115

-80

3

-115

-80

4

-115

-80

5

-115

-80

6

-115

-80

7

-115

-80

8

-115

-80

9

-115

-80

10

-115

-80

Total

-$1,750

-$1,650

Table 2

Is the least-cost alternative the one with the lower initial cost and higher operating cost or the one with the higher initial cost and lower operating cost? Because of the time value of money, one cannot simply add up sums of money at different points in time. It is not sufficient to compare the initial $600 against the $850, nor the $1,750 against the $1,650. Instead we must compute equivalent values that may be validly compared.

To facilitate equivalence computations, a series of compound interest formulas will be presented. We will use the following notation:

i = interest rate per interest period (stated as a decimal)

n

= number of interest periods

P

= a present value (or sum) of money

F

= a future value (or sum) of money

We can say that the future sum “F” is an amount, “n” interest periods from the present, that is equivalent to “P” with interest rate “i”.

that is equivalent to “P” with interest rate “i”. Balkans and Regional Energy Market Partnership Program
that is equivalent to “P” with interest rate “i”. Balkans and Regional Energy Market Partnership Program

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Single Payment Compound Interest Formula Single payment

Single Payment Compound Interest Formula

Single payment compound interest calculations are not common in engineering economic analysis. The next section discusses uniform series problems and the use of compound interest tables, which are more useful in engineering economics. However, the single payment compound interest formula is briefly presented here as an introduction to the uniform series and non-uniform series problems we will discuss later in the day. The single payment compound interest formula is:

F = P (1+ i) n

Again, we can say that the future sum “F” is an amount, “n” interest periods from the present, that is equivalent to “P” with interest rate “i”.

Exercise #2 - If $500 is deposited in a bank savings account, how much would be in the account 3 years from now if the bank pays 6% interest compounded annually? If we use a calculator and do the math, using the single payment compound interest formula, we get:

F = 500(1 + .06) 3 = $595.50

Long ago, before modern calculators and computers were readily available, Compound Interest Tables were prepared so that complicated calculations would not be necessary to solve engineering economic problems. Full sets of these tables are readily available on line and have been published in many forms. These tables contain all of the end-of- period compound interest factors needed and are included here in Appendix B.

If we use the single payment “compound amount factor” from the chart in Appendix B, the formula in functional notation is:

F = P (F/P, i, n)

Where F/P is the “compound amount factor” from Appendix B, “i” is the interest rate and “n” is the number of years. Finding these numbers on the chart we have:

F = 500(1.191) = $595.50

Exercise #3 – You wish to have $800 in a savings account at the end of 4 years, and 6% interest will be paid annually, how much should you put into the savings now?

paid annu ally, how much should you put into the savings now? Balkans and Regional Energy
paid annu ally, how much should you put into the savings now? Balkans and Regional Energy

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects P = F 1 = F (1+i )

P = F

1 = F (1+i ) n

+

i )

n

(1

P

= 800 (1+.06) 4 = $633.68

If we elect to use the compound interest tables we will not have to calculate a number to a negative power as follows:

P

= F (P/F, i, n)

P

= 800 (.7921) = $633.68

Uniform Series Compound Interest Formulas

As we have said, single payment compound interest calculations are not common in engineering economic analysis. Most of the time we find a series of cash flows and sometimes it will be a uniform series of receipts or disbursements such as loans or if we are dealing with future costs and benefits of an engineering problem. Since most engineering economy problems define a “period” as one year, the uniform cash flow is an annual cash flow denoted by “A”. “A” is equal to an end-of-period cash receipt or disbursement in a uniform series, continuing for “n” periods.

The uniform series compound interest Formulas are:

F

P

= A

= A

(1

+ i

)

n

1

i

(1

+ i

)

n

1

i

(1 +

i

)

n

At this point it is apparent that the calculations become more complex, even for uniform series problems. They are even more complex for non-uniform series problems so from this point forward we will use the compound interest tables or spreadsheets to solve problems.

compound in terest tables or spreadsheets to solve problems. Balkans and Regional Energy Market Partnership Program
compound in terest tables or spreadsheets to solve problems. Balkans and Regional Energy Market Partnership Program

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects The formulas in functional notation are shown below

The formulas in functional notation are shown below along with the appropriate compound interest factors that are listed in Appendix B.

F = A (F/A, i, n)

where F/A is the “compound amount factor”. We can also solve for “A” and “P” using the following:

A = F (A/F, i, n)

where A/F is the “sinking fund factor”.

A = P (A/P, i, n)

where A/P is the “capital recovery factor”.

P = A (P/A, i, n)

where P/A is the “present worth factor”.

Exercise #4 – An energy efficient machine costs $5,000 and has a life of 5 years.

interest rate is 8%, how much must be saved every year to recover the cost of the capital

invested in it?

If the

A = P (A/P, i, n) = 5,000(.2505) = $1,252

Exercise #5 – In Exercise #4 above, what is the Present Value of a $1,252 savings each year for 5 years if the cost of capital is 8%?

P = A (P/A, i, n) = 1,252 (3.993) = $5,000

Exercise #6 – What is the Present Value of the cash flow stream of costs shown as Alternative “A” in Table 2 (page 6) if the interest rate is 8% and n=10 years?

P = 600 + A (P/A, i, n) = 600 + 115(6.710) = $1,372

Note that the present value of $600 spent now is $600; there is no time value of this money since it is the amount spent at this moment in time.

money since it is the amount spent at this moment in time. Balkans and Regional Energy
money since it is the amount spent at this moment in time. Balkans and Regional Energy

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Exercise #7 – What is the Present Value

Exercise #7 – What is the Present Value of the cash flow stream of costs shown as Alternative “B” of Table 2 (page 6) if the interest rate is 8% and n=10 years?

P = 850 + A (P/A, i, n) = 850 + 80(6.710) = $1,387

Now we see that option “A” is a slightly better option than option “B” since these are costs and we would want to select the least cost option. However, the present value of costs for these options is very close and sensitive to the interest rate we chose. What would our least cost option be if our cost of capital was 6%?

Option A:

P = 600 + A (P/A, i, n) = 600 + 115(7.360) = $1,446

Option B:

P = 850 + A (P/A, i, n) = 850 +

80(7.360) = $1,438

Now Option B is the least cost option at the lower 6% interest rate. To find the interest rate where the two options are exactly equal, set the two cash flows equal to each other and solve for P/A (Present Worth Factor) as follows:

600 + 115(P/A) = 850 + 80(P/A) P/A = 250/35 = 7.143

Using the Compound Interest Tables and interpolation, we find that a Present Worth Factor of 7.143, with n = 10 years, is an interest rate of 6.46%. This example illustrates that the answers we get in engineering economic analysis can be sensitive to the interest rate (or cost of capital) that we select. We will discuss this more when we consider the selection of the Minimum Attractive Rate of Return (the MARR) in a later section.

Solving Problems using Microsoft Excel

Spreadsheets are used in most real-world applications of engineering economic analysis. As we have seen, using a spreadsheet we can construct tables of cash flows and make graphs for analysis and presentation. We now discuss the use of the Excel annuity functions that can calculate P, F, A, n, or i. In this workshop, we will concentrate mostly on calculating present values (P) since most engineering economic problems require this calculation.

To find the equivalent Present Value we use the formula –PV (i, n, A)

In Exercise #4 (page 9), what is the Present Value of a $1,252 savings each year for 5 years if the cost of capital is 8%?

savings each year for 5 years if the cost of capital is 8%? Balkans and Regional
savings each year for 5 years if the cost of capital is 8%? Balkans and Regional

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Using our Excel spreadsheet and the fx bu

Using our Excel spreadsheet and the fx button, we enter:

The spreadsheet calculates the Present Value of a uniform series of $1,252 each year for

5 years to be $4,998.87 (compared to the $5,000 answer in Exercise #5).

-PV (.08, 5, 1252)

Note that we can also find “A”, as requested in Exercise #4, using:

PMT (i, n, P) = PMT (.08, 5, 5000) = $1,252.28

Exercise #8 - What is the Present Value of the cash flow stream of costs shown as Alternative “A” in Table 2 (page 6) if the interest rate is 8% using the Excel spreadsheet?

PV = 600 + PV (.08, 10,115) = 600 + 771.66 = 1,371.66

Exercise #9 - What is the Present Value of the cash flow stream of costs shown as Alternative “B” of Table 2 (page 6) if the interest rate is 8% using the Excel spreadsheet?

PV = 850 + PV (.08, 10, 80) = 850 + 536.81 = 1,386.81

Net Present Value Analysis

So far we have discussed Uniform Series Compound Interest Formulas. But in real life most series are not uniform. Prior to the common use of the computer and spreadsheets, the uniform series assumption coupled with the Arithmetic Gradient adjustment was thought to be good enough (Note: we have not covered the Arithmetic Gradient in this workshop). However, today engineers can calculate Net Present Values using the spreadsheet NPV Block Function for any configuration of cash flows occurring at regular intervals that might exist. Handheld calculators are also available for such calculations such as the hp12c calculator.

The formula for calculating Net Present Value (NPV) is:

NPV = CF 0 +

CF

1

(

1

+

i

) 1

+

CF

2

(

1

+

i

) 2

+ ……. +

CF

n

(

1+ i

) n

where “CF” is the cash flow in the period “n” at an interest rate “i”. In discounted cash flow analysis, the interest rate “i” is sometimes referred to as the rate of return, cost of capital or the minimum attractive rate of return (MARR). While the NPV could be calculated by hand, it is obvious that the task would be tedious and time consuming. Today, the spreadsheet and the calculator are the tools of choice.

the spreadsheet and the calc ulator are the tools of choice. Balkans and Regional Energy Market
the spreadsheet and the calc ulator are the tools of choice. Balkans and Regional Energy Market

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects To begin, let’s once more consider the investme

To begin, let’s once more consider the investment choices presented in table 2 on page 6. This example is a uniform series but we will use the NPV block function to solve it and then look at a non-uniform series later. The function is expressed as:

NPV (i, values)

For our example in table 2, the formula for Net Present Value as shown in the spreadsheet (Appendix A; Example A) will be:

NPV = CF 0 + NPV (i, Values 1 thru 10)

and the calculated NPV’s are identical to our previous calculations. Once we have built the data block, we are free to see what might happen to our decision if we change a variable such as the interest rate. Changing the interest rate from 8% to 6% yields the same results as found in Exercise 7 (see Appendix A; Example B). And, what if our

further research revealed that Option “B” costs actually increased in the last three years

of its life from $80 to $90, $95 and $100? We can change the costs in the data block with

a few clicks of the mouse and find that the NPV at 6% is now -$1,465 and is not the

preferred choice under these new conditions (see Appendix A; Example C).

Discounted Cash Flow Analysis and NPV Calculations

In the NPV calculations we have just performed to find out which engineering option is

best, Option “A” or Option “B” detailed in table 2, we found that one is better than the other depending on the assumptions. But how do we know if even the best option is a good business decision? Discounted cash flow analysis will tell us if the investment meets our return requirements. Once we have established a Minimum Attractive Rate of Return (MARR) and use that rate as the “i” in the NPV calculation, the following applies:

If NPV is positive, the financial value of the investor’s assets would be increased:

the investment is financially attractive.

If NPV is zero, the financial value of the investor’s assets would not change: the investor is indifferent toward the investment.

If NPV is negative, the financial value of the investor’s assets would be decreased: the investment is not financially attractive.

A comparison of the NPV’s of alternative investment possibilities indicates which of

them is most desirable; the greater the NPV the greater the increase in the financial value

of the investor’s assets. The analysis also will tell us if the investment yield meets, or

exceeds, our MARR requirement.

the investment yield meets, or exceeds, our MARR requirement. Balkans and Regional Energy Market Partnership Program
the investment yield meets, or exceeds, our MARR requirement. Balkans and Regional Energy Market Partnership Program

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Exercise #10 that follows presents a new se

Exercise #10 that follows presents a new set of assumptions for our analysis. Assume that only one of the projects can be approved and that the 13% MARR is not negotiable in this situation.

Exercise #10 – Two opportunities for investment have come before your company for consideration as shown below. We see that Project “A” has an $80,000 investment cost but has a positive return in the second year. Project “B” has a $60,000 investment cost but never makes a positive return over the 5 years of the project life. Both projects will be sold at the end of the 5 th year for an estimated $130,000. Using Discounted Cash Flow Analysis, calculate the NPV of these competing cash flows if our Minimum Attractive Rate of Return (MARR) is 13%.

Year

Project A

Project B

 

0 ($80,000)

($60,000)

 

1 ($500)

($5,000)

 

2 $4,500

($3,000)

 

3 $5,500

($2,000)

 

4 $4,500

($1,000)

 

5 $130,000

$130,000

We solve for the NPV for each project by putting the numbers in a data block as shown on Appendix A, Example “D”. Remembering that the project investments made in year zero are already a present value, we find the NPV function using the fx button. Generally, our function will be:

NPV = CF 0 + NPV (i, Values 1 thru 5)

The spreadsheet calculates the NPV’s to be:

$212.18

Project B = $1,785.15

Project A =

Our conclusion is that, while both projects add value above the MARR of 13%, Project B is more attractive than Project A. An added advantage of the spreadsheet is that we can do “what-if” calculations very easily. For example, we can change the MARR to 9% with one click of the mouse and find that:

Project A = $15,255 Project B = $15,126

mouse and find that: Project A = $15,255 Project B = $15,126 Balkans and Regional Energy
mouse and find that: Project A = $15,255 Project B = $15,126 Balkans and Regional Energy

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Now, Project A has a very small advantage

Now, Project A has a very small advantage or we could say they are about the same. We can also easily change any of the assumptions in any year to see the impact. This type of “Sensitivity Analysis” can show us which variables have the highest impact on the calculated result. Knowing which variables are most important allows us to concentrate on the accuracy of the assumptions used in quantifying those important variables.

Discounted Cash Flow Analysis and IRR Calculations

The Internal Rate of Return (IRR) is the interest rate at which the benefits are equal to the costs. This occurs when the NPV of the cash flow is equal to zero. In Exercise #10 we found that both projects had positive values of NPV and so we knew that both have returns above the MARR of 13%. But, some might ask, what exactly is the return of each project? Using the spreadsheet IRR function that can be found using the fx button, and using the same data block as we used for the NPV calculations, we can answer this question. The function inputs for IRR are:

IRR (values)

Using the IRR function we find that the Internal Rate of Return (IRR) for each project is:

Project A = 13.06% Project B = 13.61%

We now know exactly how much each project exceeds the MARR of 13%. Many organizations prefer to establish a MARR hurdle rate and then calculate the IRR of the project cash flow to see if the project meets or exceeds that hurdle rate. The IRR is simple to calculate using an Excel spreadsheet (but more difficult to calculate any other way) and provides organizations with one number that is readily understood for evaluating projects. IRR analysis also eliminates the difficulties in selecting a suitable interest rate to use in NPV analysis. For these reasons, IRR analysis is the most frequently used method in industry.

However, two cautions on the use of IRR analysis should be understood as follows:

When deciding between several alternatives, NPV analysis should be used; not IRR analysis. In certain cases the highest NPV project (and most economically attractive) will not have the highest IRR. IRR analysis will yield the correct alternative if Incremental Analysis is used.

Most engineering cash flow problems contain one sign change; from cost to income or income to cost. However, in cases where 2 or more sign changes occur, the IRR solution could have more than one positive answer. In such

solution could have more than one positive answer. In such Balkans and Regional Energy Market Partnership
solution could have more than one positive answer. In such Balkans and Regional Energy Market Partnership

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects cases, the spreadsheet can be used to calcu

cases, the spreadsheet can be used to calculate a table of NPV vs. interest rates and a graph can be drawn to show all the valid points where the NPV is equal to zero (Appendix E illustrates this technique).

Cost – Benefit Ratio Analysis

The cost – benefit ratio is used almost exclusively in public investment analysis. One of the primary reasons for its popularity is that the technique is very simple to calculate, discuss and understand. The ratio is formed by calculating the NPV of the projects costs divided by the NPV of the projects benefits. The Cost – Benefit Ratio (C/B) can be shown as follows:

NPV cos ts (C/B) = NPVbenefits

Using the numbers we have already calculated in Exercise #10, we calculate the following C/B ratios for Project A and Project B using the spreadsheet:

Project A:

NPV of costs

=

71,188

NPV of Benefits = 91,140

C/B Ratio

= .7811

Project B:

NPV of costs

= 60,862

NPV of Benefits =115,044

C/B Ratio

= .5290

Since we are looking for the project that minimizes costs in relation to benefits, we select the lowest C/B ratio. As with NPV calculations and IRR calculations in Exercise #10, Project B is most desirable at the MARR of 13%. However, like IRR calculations, when deciding between several alternatives, NPV analysis should be used; not C/B ratio analysis. In certain cases the highest NPV project will not have the lowest C/B ratio. C/B ratio analysis will yield the correct alternative if Incremental Analysis is used. Today, some academic experts suggest that the cost to benefit (C/B) ratio should be expressed as the benefit to cost (B/C) ratio. This helps us concentrate on maximizing the benefits relative to costs and should yield a number greater than 1. In our example, the B/C ratio for project “A” is 1.28 and for project “B” is 1.89.

for project “A” is 1.28 and for project “B” is 1.89. Balkans and Regional Energy Market
for project “A” is 1.28 and for project “B” is 1.89. Balkans and Regional Energy Market

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Selecting a Minimum Attracti ve Rate of Return

Selecting a Minimum Attractive Rate of Return (MARR)

In Exercise #7, page10, we saw that the best option at an MARR of 8% was not the best option at an MARR of 6%. In many problems the answers we get will be sensitive to the MARR that we select. So, how do we choose an MARR and who should choose it? In most cases, high level financial people determine the MARR for capital projects (not the transmission engineer). This problem is complicated when projects cross country boarders or involve more than one transmission company. Understanding these complexities and realizing that the engineer will not be making these decisions, we present an outline of the important factors involved in MARR selection.

The Minimum Attractive Rate of Return should be the largest of:

The cost of borrowed money

The cost of capital

Or, the opportunity costs

Cost of Borrowed Money – The cost to borrow money can be as low as the Prime Rate, that is, the interest rate that banks charge their best and most sought-after customers. All other firms are charged an interest rate that is higher by several percentage points.

Cost of Capital – The cost of capital (sometimes referred to as the Weighted Average Cost of Capital or the WACC) is the cost of all of the firm’s overall capitalization. Overall capitalization is made up of bank loans, Bonds and Common Stock.

Opportunity Costs – It is often the case that a firm has more investment opportunities than it has investment funds available. In such a case, the opportunity cost of a selected project might be the rate of return on the best rejected project. Obviously, we want to ensure that all the selected projects are better than the best rejected project.

Risk and Uncertainty – We know that things don’t always happen as we expect them to. When we know the probabilities of the things that could happen in the future, we have risk. When the probabilities of the things that could happen in the future are unknown, we have uncertainty. All projects have some level of normal business risk and uncertainty. In these cases, the MARR is used without adjustment. For projects with greater than average risk or uncertainty, most firms increase the MARR.

Exercise #11 - Putting it all together

We are trying to decide which of two projects to construct in order to reduce costs. Both projects have useful lives of 5 years and no salvage value. Project “X” costs $1,000 and

years a nd no salvage value. Project “X” costs $1,000 and Balkans and Regional Energy Market
years a nd no salvage value. Project “X” costs $1,000 and Balkans and Regional Energy Market

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects can be expected to result in $300 savings

can be expected to result in $300 savings annually. Project “Y” costs $1,350 and will provide cost savings of $300 in the first year, but savings will increase by $50 annually, making the second year savings $350, the third year savings $400, and so forth. With the MARR equal to 7% which project should the firm fund?

Step 1: Construct the data block in the Excel spreadsheet and build a time line using the Excel charting option (See Appendix C). The data block will look like the following:

Year

Alternative

Alternative

X

Y

0

(1000)

(1350)

1

300

300

2

300

350

3

300

400

4

300

450

5

300

500

Step 2: Since we are deciding which of the two projects we should fund, we will use the NPV cash flow analysis using the spreadsheet. We find the following result:

Alternative “X” NPV = 230 Alternative “Y” NPV = 262

Alternative “Y” is the best choice at the MARR of 7%. If we were to make this decision using IRR analysis or C/B ratio analysis, we would get the wrong answer (See Appendix C). We would get the right answer if we used incremental analysis for the IRR and C/B ration calculations.

Step 3: Having selected Alternative “Y”, we can calculate the IRR for “Y” and the C/B ratio for “Y” using the spreadsheet with the following results:

Alternative “Y” IRR = 13.4% Alternative “Y” C/B = .837

As expected from the positive NPV result, we find an IRR above the MARR of 7% and a C/B ratio of less than 1. This looks like an economically attractive project.

than 1. This looks li ke an economically attractive project. Balkans and Regional Energy Market Partnership
than 1. This looks li ke an economically attractive project. Balkans and Regional Energy Market Partnership

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Exercise #12 – New Electric Transmission Line Proposal

Exercise #12 – New Electric Transmission Line Proposal

We propose to build a new transmission line that will cost $2,000,000 to design and build and it will take one year to complete the project. The new line will generate $300,000 per year in new revenue, will reduce losses on our system by $100,000 per year and will cost $120,000 per year for Operations and Maintenance. This line will not be useful after 15 years of operation. If our MARR is 8%, does this proposal add value to our transmission company?

Step 1: We set up the schedule of cash flows as shown in Appendix D, making sure that we assign the minus sign (-) to costs and positive signs (+) to revenues and savings.

Step 2: The NPV is calculated to see if the project can meet, or exceed, the assigned MARR of 8%. We use the fx button on the spreadsheet to enter the NPV data and find:

NPV = 211 Since this value is positive, we know that our rate of return is greater than 8%.

Step 3: To find out exactly what the rate of return is, we calculate the IRR using the fx button on the spreadsheet to enter the IRR data and find:

IRR = 9.70% Significantly above the MARR of 8%.

Step 4: Finally, we calculate the Cost – Benefit Ratio (C/B) since this may be a meaningful measure to some that we discuss our project with. We calculate the NPV of costs (2,215) and the NPV of benefits (2,531) with the result of:

C/B =

2,215 = .875

2,531

Well below the hurdle of 1.000.

Sensitivity Analysis

Based on the calculated results above, our project looks pretty good. But, how good are our assumptions that produced these results and what if everything does not go as planned? We can calculate results under several “what if” assumptions as follows:

1. “What if” design and construction cost overruns of 10% are realized?

NPV = 19

IRR = 8.14%

C/B ratio = .951

Now the project is just barely above the MARR of 8%. Our results are sensitive to the cost to build the project.

Our results are sensitive to the cost to build the project. Balkans and Regional Energy Market
Our results are sensitive to the cost to build the project. Balkans and Regional Energy Market

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects 2. “What if” we experience an average of

2. “What if” we experience an average of 3% per year inflation of costs over the 15 year

period? (This assumes that our costs increase 3% while our revenues and savings do not

increase).

IRR = 8.18%

Again, the project is just barely above the MARR of 8%. Our results are sensitive to the impact of inflation on our costs over the 15 years

NPV = 22

C/B ratio = .906

3. “What if” we have over-estimated the savings from losses by 20%?

NPV = 59

IRR = 8.48%

C/B ratio = .892

Our results are impacted, but not to the extent that construction costs and inflation

impacted our results.

You can imagine other “what if” questions that could be asked and answered. We could also do a plus and minus analysis on each important variable to see “what if” the variable went up and went down. When we have all of the “what if” questions asked and answered, we can construct a sensitivity analysis table that would look something like this:

Variable

Base Case

What If #1

What If #2

What If #3

Design & Construction cost

2,000,000

2,200,000

2,000,000

2,000,000

Time to Construct

1 Year

1 Year

1 Year

1 Year

Added Transmission Revenue

300,000

300,000

300,000

300,000

Reduced Line Losses

100,000

100,000

100,000

80,000

Increased O&M

120,000

120,000

120,000

120,000

Inflation of Cost Items

0%

0%

3%

0%

NPV

211

19

22

59

IRR

9.70%

8.14%

8.18%

8.48%

C/B

.875

.951

.906

.892

% 8.18% 8.48% C/B .875 .951 .906 .892 Balkans and Regional Energy Market Partnership Program 19
% 8.18% 8.48% C/B .875 .951 .906 .892 Balkans and Regional Energy Market Partnership Program 19

Workshop on Financial and Economic Analysis of Transmission Projects

on Financial and Economic Analysis of Transmission Projects Additional NPV and IRR Exercises Exercise #13 –

Additional NPV and IRR Exercises

Exercise #13 – Your company has been presented with an opportunity to invest in a project. The facts regarding the project are as follows:

Investment Required

$60,000,000

Salvage Value after 10 years

0

Gross Income per year

$20,000,000

Annual Operating Costs Labor Materials Fuel & Other Costs Maintenance Costs

$2,500,000

$1,000,000

$1,500,000

$500,000

The project is expected to operate for 10 years as shown. If management expects to make 25% on its investment, would you recommend this project? (See Appendix F for the solutions).

Exercise #14 – Two alternatives are being considered for recovering aluminum from garbage. The first has a capital cost of $100,000, a first year maintenance cost of $9,000, with maintenance increasing by $500 per year for each year after the first.

The second has a capital cost of $120,000, a first year maintenance cost of $3,000 with maintenance increasing by $1,000 per year after the first.

Revenues from the sale of aluminum are $20,000 in the first year, increasing $2,000 per year for each year after the first. Life of both alternatives is 10 years and there is no salvage value. The MARR is 10%. Which alternative is preferred? (See Appendix F for the solutions).

rnative is preferred? (See Appendix F for the solutions). Balkans and Regional Energy Market Partnership Program
rnative is preferred? (See Appendix F for the solutions). Balkans and Regional Energy Market Partnership Program

Appendix A: Spreadsheet Examples

Appendix A: Spreadsheet Examples

8%

Interest Rate

 

6%

Interest Rate

 
 

Costs

Costs

 

Costs

Costs

Year

(Option A)

(Option B)

Year

(Option A)

(Option B)

0 -600

 

-850

0

-600

-850

1 -115

 

-80

1

-115

-80

2 -115

 

-80

2

-115

-80

3 -115

 

-80

3

-115

-80

4 -115

 

-80

4

-115

-80

5 -115

 

-80

5

-115

-80

6 -115

 

-80

6

-115

-80

7 -115

 

-80

7

-115

-80

8 -115

 

-80

8

-115

-90

9 -115

 

-80

9

-115

-95

10 -115

 

-80

10

-115

-100

Net Prestent Value

($1,371.66)

($1,386.81)

Net Prestent Value

($1,446.41)

($1,465.13)

Example A

   

Example C

   

6%

Interest Rate

 

13.0%

MARR

 
 

Costs

Costs

 

Cash Flow

Cash Flow

Year

(Option A)

(Option B)

Year

(Project A)

(Project B)

0 -600

 

-850

0

(80,000)

(60,000)

1 -115

 

-80

1

(500)

(5,000)

2 -115

 

-80

2

4,500

(3,000)

3 -115

 

-80

3

5,500

(2,000)

4 -115

 

-80

4

4,500

(1,000)

5 -115

 

-80

5

130,000

130,000

6 -115

 

-80

     

7 -115

 

-80

Net Prestent Value

212.18

1,785.15

8 -115

 

-80

Example D

   

9 -115

 

-80

IRR

13.06%

13.61%

10 -115

 

-80

     
     

NPV Cost

($71,188.03)

($60,861.63)

Net Prestent Value

($1,446.41)

($1,438.81)

NPV Benefits

$91,139.77

$115,044.25

Example B

         
     

C/B Ratio

-0.7811

-0.5290

     

B/C Ratio

-1.2803

-1.8903

Appendix B: Compound Interest Tables

Appendix C: Putting it all together Spreadsheet

Appendix C: Putting it all together Spreadsheet

7% MARR Alternative "X" Year Alternative "X" Alternative "Y" Delta 0 -1000 -1350 -350
7%
MARR
Alternative "X"
Year
Alternative "X"
Alternative "Y"
Delta
0
-1000
-1350
-350
400
1
300
300
0
200
2
300
350
50
0
3
300
400
100
123456
4
300
450
150
-200
5
300
500
200
Alternative "X"
-400
Year
-600
NPV
230.06
262.39
-800
IRR
15.2%
13.4%
9.4%
-1000
-1200
NPV Cost
1000.00
1350.00
350.00
NPV Benefits
1230.06
1612.39
382.33
Alternative "Y"
C/B Ratio
0.813
0.837
0.915
1000
500
0
Alternative "Y"
123456
Year
-500
-1000
-1500

Appendix D: Transmission Line Proposal Spreadsheet

Appendix D: Transmission Line Proposal Spreadsheet

8%

MARR

         

($ x 1000)

               

0%

Inlation

                             

Item

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

Desgin & Construct

1000

1000

         

00000000000000

               

Incr. Trans. Revenue

0

0

300

300

300

300

300

300

300

300

300

300

300

300

300

300

               

0000000000000

               

Reduced Line Losses

0

0

100

100

100

100

100

100

100

100

100

100

100

100

100

100

               

0000000000000

               

Increases O&M

0

0

120

120

120

120

120

120

120

120

120

120

120

120

120

120

Net Cash Flow

1000

1000

280

280

280

280

280

280

280

280

280

280

280

280

280

280

NPV

211

                             

IRR

9.70%

                             

NPVCost

2,215

                             

NPVBenefit

2,531

                             

C/B Ratio

0.875

                             

Appendix E: IRR Solutions and Sign Changes

Appendix E: IRR Solutions and Sign Changes

Two Roots One Root i NPV I i NPV 0 -180 -40% ($120.16) -700 0
Two Roots
One Root
i
NPV
I
i
NPV
0 -180
-40%
($120.16)
-700
0
$150.00
1 -30%
50
$221.80
100
2%
$102.07
2 -20%
50
$190.51
175
4%
$58.01
3 -10%
50
$114.73
250
6%
$17.42
4 0%
50
$50.10
325
8%
($20.03)
5 10%
50
$1.89
10%
($54.65)
6 20%
50
($33.24)
7 -70
30%
($59.01)
IRR
6.91%
40%
($78.23)
50%
($92.87)
IRR
10.45%
Two Roots
One Root
$300.00
$200.00
$250.00
$150.00
$200.00
$150.00
$100.00
$100.00
NPV
$50.00
NPV
$50.00
$0.00
$0.00
0%
5%
10%
15%
($50.00)
($50.00)
-60%
-40%
-20%
0%
20%
40%
60%
($100.00)
($150.00)
($100.00)
Interest
Rate (i)
Interest Rate (i)
NPV
NPV

Appendix F: Additional NPV and IRR Exercise Solutions

Appendix F: Additional NPV and IRR Exercise Solutions

25%

MARR

 

Exercise #13

           
       

(

$ x 1000)

           

Description

0

1

2

 

3

4

5

6

7

8

9

10

Investment

(60,000)

                   

Gross Income

 

20,000

20,000

 

20,000

20,000

20,000

20,000

20,000

20,000

20,000

20,000

Total Operating Costs

 

(5,500)

(5,500)

 

(5,500)

(5,500)

(5,500)

(5,500)

(5,500)

(5,500)

(5,500)

(5,500)

Total Cash Flow

(60,000)

14,500

14,500

 

14,500

14,500

14,500

14,500

14,500

14,500

14,500

14,500

NPV

(8,228)

                   

IRR

20.39%

                   

10%

MARR

-500

Exercise #14 - Alt. 1

           
       

(

$ x 1000)

           

Description

0

1

2

 

3

4

5

6

7

8

9

10

Investment

(100,000)

                   

Revenue

 

20,000

22,000

 

24,000

26,000

28,000

30,000

32,000

34,000

36,000

38,000

Maintenance

 

(9,000)

(9,500)

 

(10,000)

(10,500)

(11,000)

(11,500)

(12,000)

(12,500)

(13,000)

(13,500)

Net Cash Flow

(100,000)

11,000

12,500

 

14,000

15,500

17,000

18,500

20,000

21,500

23,000

24,500

NPV

1,927

                   

IRR

10.39%

                   

10%

MARR

-1000

Exercise #14 - Alt. 2

           
       

(

$ x 1000)

           

Description

0

1

2

 

3

4

5

6

7

8

9

10

Investment

(120,000)

                   

Revenue

 

20,000

22,000

 

24,000

26,000

28,000

30,000

32,000

34,000

36,000

38,000

Maintenance

 

(3,000)

(4,000)

 

(5,000)

(6,000)

(7,000)

(8,000)

(9,000)

(10,000)

(11,000)

(12,000)

Net Cash Flow

(120,000)

17,000

18,000

 

19,000

20,000

21,000

22,000

23,000

24,000

25,000

26,000

NPV

7,349

                   

IRR

11.30%

                   

Appendix A: Spreadsheet Examples

8%

Interest Rate

 

6%

Interest Rate

 
 

Costs

Costs

 

Costs

Costs

Year

(Option A)

(Option B)

Year

(Option A)

(Option B)

0 -600

 

-850

0

-600

-850

1 -115

 

-80

1

-115

-80

2 -115

 

-80

2

-115

-80

3 -115

 

-80

3

-115

-80

4 -115

 

-80

4

-115

-80

5 -115

 

-80

5

-115

-80

6 -115

 

-80

6

-115

-80

7 -115

 

-80

7

-115

-80

8 -115

 

-80

8

-115

-90

9 -115

 

-80

9

-115

-95

10 -115

 

-80

10

-115

-100

Net Prestent Value

($1,371.66)

($1,386.81)

Net Prestent Value

($1,446.41)

($1,465.13)

Example A

   

Example C

   

6%

Interest Rate

 

13.0%

MARR

 
 

Costs

Costs

 

Cash Flow

Cash Flow

Year

(Option A)

(Option B)

Year

(Project A)

(Project B)

0 -600

 

-850

0

(80,000)

(60,000)

1 -115

 

-80

1

(500)

(5,000)

2 -115

 

-80

2

4,500

(3,000)

3 -115

 

-80

3

5,500

(2,000)

4 -115

 

-80

4

4,500

(1,000)

5 -115

 

-80

5

130,000

130,000

6 -115

 

-80

     

7 -115

 

-80

Net Prestent Value

212.18

1,785.15

8 -115

 

-80

Example D

   

9 -115

 

-80

IRR

13.06%

13.61%

10 -115

 

-80

     
     

NPV Cost

($71,188.03)

($60,861.63)

Net Prestent Value

($1,446.41)

($1,438.81)

NPV Benefits

$91,139.77

$115,044.25

Example B

         
     

C/B Ratio

-0.7811

-0.5290

     

B/C Ratio

-1.2803

-1.8903

Appendix C: Putting it all together Spreadsheet

7% MARR Alternative "X" Year Alternative "X" Alternative "Y" Delta 0 -1000 -1350 -350
7%
MARR
Alternative "X"
Year
Alternative "X"
Alternative "Y"
Delta
0
-1000
-1350
-350
400
1
300
300
0
200
2
300
350
50
0
3
300
400
100
123456
4
300
450
150
-200
5
300
500
200
Alternative "X"
-400
Year
-600
NPV
230.06
262.39
-800
IRR
15.2%
13.4%
9.4%
-1000
-1200
NPV Cost
1000.00
1350.00
350.00
NPV Benefits
1230.06
1612.39
382.33
Alternative "Y"
C/B Ratio
0.813
0.837
0.915
1000
500
0
Alternative "Y"
123456
Year
-500
-1000
-1500

Appendix D: Transmission Line Proposal Spreadsheet

8%

MARR

         

($ x 1000)

               

0%

Inlation

                             

Item

0

1

2

3

4

5