e-learning course on

Bio-energy for achieving MDGs

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Lecture 7:
Financial Analysis of Renewable Energy Projects
Prof. Ram M. Shrestha
School of Environment, Resources and Development
Asian Institute of Technology
Thailand
E-mail: ram@ait.ac.th
1
21 June 2007

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 Contents
 Characteristics of RE Projects
 Financial analysis vs. Economic Analysis
 Components of project costs and benefits
 Time Value of Money
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 Criteria for Financial Viability of Project

 Financial Analysis under Uncertainty
- Sensitivity Analysis
- Break-even analysis

- Scenario Analysis
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 Characteristics of RE Projects
 Most RE projects normally involve:
- High initial costs (capital intensive)
- Low operating cost
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- Environmental/climate benefits, cleaner than fossil

fuel technologies, e.g. biomass energy
- Local level employment generation (especially, from biomass
projects)
- Resource availability – site specific and subject to fluctuations
(especially in the case of solar, wind and hydro)
- Sustainable resource use

 RE projects also help to reduce national energy import dependency.

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 Current Status of Renewable Energy Technologies
Technology Capacity factor (%) Turnkey investment Current energy cost Potential future
costs (U.S.$/Kw) of new systems energy cost

Biomass Energy
Electricity 25 - 80 900 - 3,000 5 – 15 ¢/kWh 4 – 10 ¢/kWh
Heat 25 - 80 250 - 750 1 – 5 ¢/kWh 1 – 5 ¢/kWh
Ethanol 8 – 25 $/GJ 6 – 10 $/GJ
Wind Electricity 20 - 30 1,100 – 1,700 5 – 13 ¢/kWh 3 – 10 ¢/kWh
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Solar Photovoltaic 8 - 20 5,000 – 10,000 25 – 125 ¢/kWh 5 or 6 – 25 ¢/kWh

Electricity

Solar Thermal 20 - 35 3,000 – 4,000 12 – 18 ¢/kWh 4 – 10 ¢/kWh

Electricity

Low-temperature 8 - 20 500 – 1,700 3 – 20 ¢/kWh 2 or 3 – 10 ¢/kWh

Solar Heat
Hydroelectricity
Large 35 - 60 1,000 – 3,500 2 – 8 ¢/kWh 2 – 8 ¢/kWh
Small 20 - 70 1,200 – 3,000 4 – 10 ¢/kWh 3 – 10 ¢/kWh
Geothermal Energy 4
Electricity 45 - 90 800 – 3,000 2 – 10 ¢/kWh 1 or 2 – 8 ¢/kWh
Heat 20 - 70 200 – 2,000 0.5 – 5 ¢/kWh 0.5 – 5 ¢/kWh
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 What is Financial Analysis?
 Financial evaluation mainly focuses into
- Money aspects of the project, and
- Rewards and financial profitability to the investors.
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 The main objective of the financial analysis is to look into

the financial benefits, costs and profitability of the project
from the investor’s perspective.

 Financial analysis (FA) includes direct transfer payments

such as taxes, duties, subsidies in the evaluation.
 FA does not account for the externalities such as
environmental impacts and their costs.
 FA normally uses market prices of inputs and outputs 5

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 Financial Vs. Economical Analysis
 On the other hand, economic evaluation
- estimates project benefits and returns from the
perspective of national economy and assesses the
effects that the project will have on the overall
economy of the country.
- takes into account the social and environmental
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costs and benefits of the project.

- excludes transfer payments and
- uses border prices for traded goods and shadow
prices for non-traded goods and services.

 As the main focus of our discussion is on financial analysis, we will

try to put more concentration in this area rather than the economical
analysis in the later part of our presentation.
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 Financial Analysis in the Project Cycle
 The Project Cycle is the framework to design, prepare,
implement and supervise projects.
 The project cycle includes six stages such as,
 Identification
 Preparation
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 Appraisal
 Negotiation/Approval
 Implementation, and
 Evaluation.

 The Appraisal phase includes evaluation of financial,

economic, technical, institutional, environmental and
social aspects of the project. 7

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 Components of Project Costs
 Project Costs:
• Investment costs
• Operating costs

 Investment Costs: Include initial costs and replacement costs

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 Initial Costs, referred to as the first cost, which is usually made up of a

number of cost elements that do not recur after an activity is initiated. For
example, construction and commissioning, including land, civil works,
transportation, equipment & installations and other related initial expenditures

Initial cost is the major component of an RE project. Such cost is normally

higher in RE projects than in non-RE projects. As such, high initial cost
presents the major barrier to the adoption of RETs.

 Replacement Costs, refers to the cost of equipment and installations

procured during the operating phase of the project, to maintain its original
productive capacity.
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 Project Costs (Contd.)
 Operating Costs: Costs experienced continually over the
useful life of the project activity. They are of two broad
categories:
- Fixed Costs (FC)
- variable costs (VC)
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• Fixed Cost (FC): Group of costs whose value will remain relatively
constant throughout the range of operational activity or output level
of the project. FC includes the following cost items:
- maintenance
- insurance
- lease rentals
- interest payment on invested capital
- certain administrative expense, and
- research.

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 Project costs (contd.)

• Variable Costs (VC): Group of costs that vary with

the level of operational activity or output. In general,
VC includes costs of:
- labor,
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- materials,
- fuel cost*
- tax
*Biomass cost in the case of biomass energy
projects; none in solar, wind and hydro.

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 Project Benefits
 RE Project Financial Benefits include:
- Revenue earned from the output of the project
- Tax credits (if applicable)
- Subsidy (if applicable)
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- Carbon credits
(if the project is eligible for such benefits, e.g., under the clean
development mechanism (CDM); in the case of a biomass project, such
credits can be available only if biomass is produced on a sustainable basis)
 A RE investment tax credit is an immediate reduction in income tax equal
to a percentage of the installed cost of a new RE investment. Tax credits
for renewable energy technologies (RETs) can enhance after-tax cash flow
and promote RE investment.
 Often, governments may also provide subsidy on the cost of RETs
equipments to promote RE.

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 Flow Chart of Financial Analysis Under Certainty
Define the param eters of the project
e.g. Service life, Discount Rate, Size of the Project
,
Dem and, etc.

For a given size of the RE project

,
determ ine the cash inflow s and cash
outflow s for each Year

Calculate the total NPW or

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alternative financial indicator of

the project

Use of decision rule for

project investm ent

Investm ent
Decision

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 Time Value of Money
 Interest rate, or the rate of capital growth, is the rate of gain
received from an investment. For example, a 11% interest
rate indicates that for every dollar of money used, an
additional $0.11 must be returned as payment for the use of
that money.
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 The relationship between interest and time leads to the

concept of the time value of money.

 Money has an earning power. A dollar in hand now is worth

more than a dollar received n years from now. This is
because having the dollar now provides the opportunity for
investing that dollar for n years more than the dollar to be
received n years hence, i.e. this investment will earn a return.
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 Time Value of Money (Contd.)
 This can be illustrated as:
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 The purchasing power of a dollar changes through time. This is because

the future values are eroded by inflation.

 An entrepreneur expects to gain a premium on his investment, to allow for

the following three factors: inflation, risk taking and the expectation of a real 14
return.
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 Present Worth Calculation
 Present valuing (discounting) is central to the financial and
economical evaluation process. Since most of the project costs, as
well as benefits, occur in the future, it is essential that these should
be discounted to their present value (worth) to enable proper
evaluation.
 Hence, the present worth (P) of a future amount (say, Fn) in year n
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will be calculated as:

P = Fn x [1/(1+i)n]
That is,
Present Value (P) = Fn x Discount Factor
where, discount factor = 1/(1+i)n

 For example, if Fn = $1,000, i = 12% per year and n = 5 Years, then,

P = $1,000 x [1/(1 + 0.12)5] = $567.40 15

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 Future Worth Calculation
 Future worth analysis calculates the future worth of an
investment undertaken. Future value is simply the sum
to which a dollar amount invested today will grow given
some appreciation rate.
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 The future amount (Fn) in year n of a present principal

amount, P, is given by:
Fn = P(1 + i)n ….…. (1)

 For example, if P = $567.40, i = 12% per year and n = 5 Years,

then, Fn = $567.40 x (1 + 0.12)5= $1,000
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 Equivalence relationship between F and P
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 Capital Recovery Factor (CRF)
 A Capital Recovery Factor (CRF) converts a present
value into a stream of equal annual payments over a
specified time, at a specified discount rate (interest).

 The value of an equal payment (A) to be made in each of

n periods here is given by:
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A = P [i(1+i)n]/[(1+i)n-1]
That is, A = P x CRF
Where, CRF= capital recovery factor = [i(1+i)n]/[(1+i)n-1]

 The capital recovery factor can be interpreted as the

amount of equal (or uniform) payments to be received for
n years such that the total present value of all these
equal payments is equivalent to a payment of one dollar
at present, if interest rate is i. 18

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 Annuity factor
• Given uniform cash flow series (A), Find P.
Present value of the series in this case is given
by:
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P = A x Annuity factor
where, Annuity factor = 1/CRF

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 Example
 Given, P = $250,000, i = 8% per year, N = 6 years, find A.
$ 250,000
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Years
1 2 3 4 5 6
0

A A A A A A

Figure: A loan cash flow diagram

Here, CRF = 0.2163

A = $250,000x CRF = $54,075
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 Criteria for Financial Viability of a Project
 There are several alternative criteria for financial
evaluation. They are:
• Net Present Worth (NPW) (or Net Present
value)
• Annual Equivalent Worth (AE)
• Financial Internal Rate of Return (FIRR)
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• Benefit-Cost Ratio (B/C ratio)

• Payback Period (a simple but not sound
basis)

Net Present Worth (NPW): It is the difference

between the present value of cash inflows (revenues) and
the present value of cash outflows (costs) at the minimum
attractive rate of return of the project owner.
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 Basic procedure for net present worth calculation

1. Determine the interest rate that the firm wishes to earn on its
investments. This interest rate is often referred to as either a
required rate of return or a minimum attractive rate of return
(MARR).

2. Estimate the service life of the project.

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3. Estimate the cash inflow for each period over the project’s
service life.
4. Estimate the cash outflow over each service period.
5. Determine the net cash flows:
net cash flow = cash inflow – cash outflow

6. Find the present worth of each year’s net cash flow at the
MARR.
7. Add up all the present worth figures during the service life of the
project. The sum so obtained is the project’s NPW.
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 Net Present Worth Criterion (Contd.)
 A positive NPW means that the equivalent worth of the inflows is
greater than the equivalent worth of outflows, so the project makes a
profit.

 Therefore, the decision rule will be as follows:

• If NPW(i) > 0, accept the project for investment.
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• If NPW(i) = 0, remain indifferent.

• If NPW(i) < 0, reject the investment.

where, i = MARR.

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 Annual Equivalent Worth
 The annual equivalent worth (AE) criterion provides an alternative
basis for measuring the worth of an investment by determining equal
payments on an annual basis.

 To compute AE, first of all we have to find the net present worth
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(NPW) of the original series and then multiply this amount by the
capital recovery factor.
 The decision rule is as follows:
• If AE(i) > 0, accept the project for investment.
• If AE(i) = 0, remain indifferent to the investment.
• If AE(i) < 0, reject the project for investment.
 Note that, accepting a project that has a positive AE(i) is equivalent to
accepting a project that has a positive PW(i).

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 Financial Internal Rate of Return (FIRR)
 The FIRR is an indicator to measure the financial return on
investment of an income generation project and is used to make the
investment decision.

 The FIRR is obtained by equating the present value of investment

costs (as cash out-flows) and the present value of net incomes (as
cash in-flows) and thus finds out the break-even interest rate, i*.
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 In general, the decision rule is as follows:

• If FIRR > MARR, then, accept the project.
• If FIRR = MARR, then, remain indifferent.
• If FIRR < MARR, then, reject the project.

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 Benefit-Cost Ratio (B/C ratio)
 B/C ratio is the ratio of the total present value of
benefits during the service life of the project to the
total present value of the costs at the MARR.
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 A project is accepted for investment if B/C ratio is

greater than or equal to unity and rejected otherwise.

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 B/C Ratio (Contd.)
Let us consider an example of a hydropower
project as follows: Interest rate=12%, Life=50 years

A
Annual Benefit = 1000000 + 250000
+ 350000 + 100000

Initial cost $ 25
= $ 1700000
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Present value of benefit

= 1700000 *(annuity factor)

Annual benefit and = 1700000*18.2559

= $ 31035030

costs:
Then,
Present value of operating and maintenance cost = 200000 * 18.2559
= $ 3651180
Total cost (C) = 25000000+ 3651180

Power Sales
B/C ratio = 31035030 / (3651180 + 25000000) = 1.08
Since the B/C ratio is greater then unity, the project is accepted! $ 10 27

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 Payback Period
 The payback period is the time that a project is expected to take in
order to earn net revenue equal to the capital cost of the project.

 It is utilized for small investments, like improvements and energy

efficiency measures, since it is easy to understand by business
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managers.
 Drawbacks
- It tells the analyst nothing about the project earning rate after the
payback period and does not consider the total profitability or size of
the project.

- If a company makes investment decisions solely on the basis of the

payback period, it considers only those projects with a payback
period shorter than the maximum acceptable payback period. 28

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 Payback Period (Contd.)
 The payback period method ignores inflation and discriminates
against large capital-intensive infrastructure projects with long
gestation times. Therefore, it is a poor criterion in itself and it must
be used in conjunction with other criteria.

 The Pay- Back Period can be calculated as

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Pay-back period = Total Investment Cost – Subsidy amount

Annual Revenue – Annual Expenditure

If the subsidy amount is not given then we can exclude the subsidy
amount in the above example.

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 Flow Chart of Financial Analysis under Uncertainty
Define the parameters of the project
e.g. Service life , Discount Rate , Size of
the Project , Demand , etc .

For a given size of the RE project ,

determine the cash inflows and cash
outflows for each Year

Calculate the total NPW or

alternative financial
indicator of the project
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Sensitivity Analysis

Break -even Analysis

Scenario Analysis

Use of decision rule

for project investment

Investment
Decision

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 Financial Analysis under Uncertainty
 In the foregoing discussion, we assumed that all the parameters of the
project for financial evaluation are known for certainty. However, this is
not usually the case. From a practical point of view the project
parameters may face uncertainty and the actual value could vary.

 Projects that involve new technologies (renewable and clean-coal

technologies), or projects with lengthy lead times (nuclear and hydro-
power) involve a lot of investment and have more than the average level
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of risk.

 For example, the demand may not turn out to be as estimated, the tariff
is lower than expected, project execution may take more time and
involve more cost than planned.

 In RE projects, RE resource availability itself is subject to some

uncertainty and hence the uncertainty in RE output.

 Cost overruns, which are caused by project delays, or inaccuracies in

estimation do not only significantly change project costs but also
substantially reduce net benefits. 31

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 Financial Analysis under Uncertainty
(contd.)

Generally, there are several procedures to

analyze the project under uncertainty,
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such as:
• Sensitivity Analysis
• Break-Even Analysis
• Scenario Analysis

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 Sensitivity Analysis
 A sensitivity analysis reveals how much the NPW will
change in response to a given change in an input variable.

 This kind of analysis determines the effect on the NPW

with variations in the input variables such as revenues,
operating cost, and salvage value etc.
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 Sensitivity analysis sometimes also called as “what-if”

analysis.

 Sensitivity analysis begins with a base case situation,

which is developed by using the most likely values for
each input. Then the value of the specific variable of
interest is changed above or below its most likely value,
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while holding all other variables constant.
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 Sensitivity Analysis (Contd.)
 Next, a new NPW for each of the values are obtained.

 A convenient and useful way to present the results of a

sensitivity analysis is to plot sensitivity graphs.

 The slopes of the lines show how sensitive the NPW is to

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changes in each of the inputs.

 The steeper the slope, the more sensitive the NPW is to

a change in a particular variable. Sensitivity graphs
identify the crucial variables that affect the final outcome
most.
 Let us construct a sensitivity graph for five of the transmission
project’s key input variables such as unit price, product demand,
variable cost, fixed cost and salvage value. 34

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 Sensitivity Analysis (Contd.)
 The base case NPW is $40,169. We plot the base case NPW on the
ordinate of the graph with 0% deviation and then reduce the value of
the input variables by 5% of its base case value and recompute the
NPW with all other variables held at their base case value. We
repeat the process by either decreasing or increasing the
relative deviation from the base case.
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 From Figure 1, we can see that the project’s NPW is

- Very sensitive to the changes in product demand and
unit price,
- Fairly sensitive to changes in variable costs, and
- Relatively insensitive to changes in the fixed cost and the salvage
value.

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 Sensitivity Analysis (Contd.)
Sensitivity Analysis

90000
80000
70000
Unit Price
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60000
NPW (15%)

Demand
50000
Variable Cos t
40000
Fixed Cost
30000
Salvage Value
20000
10000
0
-20% -15% -10% -5% 0% 5% 10% 15% 20%
De viation
Figure 1: Sensitivity Graph 36

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 Break-Even Analysis
 When we perform a sensitivity analysis of a project, we are asking
how serious the effect of lower revenues or higher costs will be on
the project’s profitability. Sometimes the question may be instead
how much sales or revenue can decrease below forecasts before
the project begins to lose money. This type of analysis is known as
break-even analysis.
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 Break-even analysis is a technique for studying the effect of

variations in output on a firm’s NPW.

 Figure 2 shows the plot of the PWs of cash inflows and outflows
under various assumptions about annual sales. The two lines
crosses when sales are X1 units, the point at which the project has
a zero NPW. It is seen that as long as the sales are greater or
equal to X1 units the project has a positive NPW.

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 Break-even Analysis
Figure 2: Break – Even Analysis based
Y on net cash flow

NPW
(MARR %)

Inflow

Profit
Break - even point
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Outflow

Y2
Loss

X1 units
Y1

X1 38

0 Annual Sales Units (X)

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 Scenario Analysis
 A more comprehensive approach to deal with uncertainty than
sensitivity and break-even analysis is Scenario Analysis.
 Both Sensitivity and Break-even analysis are useful but they have
certain limitations. Often it is quite difficult to specify precisely the
relationship between a particular variable and the NPW. The
relationship is further complicated by interdependencies among the
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variables. It may also complicate the analysis too much to permit

movement in more than one variable at a time.

 Scenario Analysis is a technique that considers the sensitivity of

NPW both to changes in key variables and to the range of likely
values of those variables.
 For example, in its simplest form it involves selecting scenarios such
as, a “best-case” scenario, a “worst-case” scenario and the “most-
likely-case” scenario.
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 Scenario Analysis (Contd.)
 The best-case scenario will incorporate future parameters that are more
favorable to the project success than they appear at the time of evaluation.

 The worst-case scenario is the analysis with less favorable values such as
low unit sales, low unit price, high variable cost per unit, high fixed cost etc.

 The most-likely-case scenario (base case) is the analysis with the most
likely inputs and outputs from the point of view of the project evaluator.
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 The NPW under the worst and the best conditions are then calculated and
compared with the expected, or the base case, NPW.

 Generally, we find that the worst case produces a negative NPW, the best
case produces a large positive NPW and the most likely case produces a
positive NPW.

 But still by only observing all these results, it is not possible and easy to
interpret the scenario analysis or make a decision based on it.
 Clearly, we need estimates of the probabilities of occurrence of the worst
case, the best case and the most likely or base case and all the other
possibilities. 40

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 Concept of MARR
 The minimum attractive rate of return (MARR) is the
interest rate at which a firm can always earn or
borrow money under a normal operating
environment. It is generally dictated by management
and is the rate at which NPW analysis should be
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conducted.

 Usually the selection of the MARR is a policy

decision made by top management and it is possible
for the MARR to change over the life of the project.

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 Basis for Selecting the MARR:
• The Cost of Capital of a firm is the required rate of
return that makes an investment project worthwhile.

• The cost of capital of a firm investing in the project

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can be expressed as the weighted average cost of

capital if the firm mobilizes its fund through different
sources of financing, e.g., debt and equity.

• The cost of capital is normally considered as the rate

of return that a firm would receive if it invested its
money somewhere else with a similar risk.

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 Basis for Selecting the MARR (contd.)
• Any additional risk associated with the project also has to
be considered.

• If the project belongs to the normal risk category, the

cost of capital may already reflect the risk premium.
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• However, if we are dealing with a project with higher risk,

the additional risk premium may be added onto the cost
of capital.

• In total, the discount rate (or, MARR) to use for financial

evaluation would be equivalent to the firm’s cost of
capital for a project of normal risk, but could be much
higher if we are dealing with a risky project. 43

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 References
 Park, Chan S., Contemporary Engineering Economics, 4th edition,
Prentice-Hall, N.J., 2007.

 Hisham Khatib, Economic Evaluation of Projects in the Electricity

Supply Industry, IEE Power and Energy Series 44, London.
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 United Nations Development Programme, United Nations

Department of Economic and Social Affairs, World Energy Council,
2000, World Energy Assessment, Energy and the Challenge of
Sustainability.

 Intermediate Technology Development Group, 1997, Financial

Guidelines for Micro – Hydro Projects, Nepal.

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e-learning course

Thank you!

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