Larry Guentert Purdue University Admin Computing October 4,
2012
Slide 2
Agenda Capital Budgeting Terminology Traditional Project
Calculations Comparisons of Methods Eco Building Considerations A
Proposed Approach Conclusion Questions
Slide 3
Capital Budgeting Large investment in plant or equipment with
returns over a period of time. Investment may take place over a
period of time A Strategic Investment Decision May include:
Expansion, Improvement, Replacement, R & D
Slide 4
Present Value The current worth of a future sum of money or
stream of cash flows given a specified rate of return. Future cash
flows are discounted at the discount rate, and the higher the
discount rate, the lower the present value of the future cash
flows. Explanation: The basis is that receiving $1,000 now is worth
more than $1,000 five years from now, because if you got the money
now, you could invest it and receive an additional return over the
five years PV = C1 / ( 1 + r) where c1 = is the cash flow of at
date 1 and r is the rate of return.
Slide 5
Cost of Capital The cost of capital determines how a company
can raise money (through a stock issue, borrowing, or a mix of the
two). This is the rate of return that a firm would receive if it
invested in a different vehicle with similar risk. It may reflect
risk in the investment.
Main Investment Rules Used Net Present Value (NPV) Internal
Rate of Return (IRR) Payback Return on Assets or Investment (RoA or
RoI) Profitability Index
Slide 8
Net Present Value The current worth of a future sum of money or
stream of cash flows given a specified rate of return. Future cash
flows are discounted at the discount rate, and the higher the
discount rate, the lower the present value of the future cash
Slide 9
NPV Equation NPV compares the value of a dollar today to the
value of that same dollar in the future, taking inflation and
returns into account. If the NPV of a prospective project is
positive, it should be accepted. However, if NPV is negative, the
project should probably be rejected because cash flows will also be
negative. (where Co is initial cost of project, r = rate, t = time
periods)
Slide 10
NPV Equation Treatment of depreciation in NPV analysis. -We
only use cash flows in investment appraisal. -Depreciation is not a
cash flow. -However, depreciation (capital allowances) is allowable
against tax (see income statement), which affects cash flow. For
cash flow, add depreciation back
Slide 11
Internal Rate of Return You can think of IRR as the rate of
growth a project is expected to generate. While the actual rate of
return that a given project ends up generating will often differ
from its estimated IRR rate, a project with a substantially higher
IRR value than other available options would still provide a much
better chance of strong growth Equation:
Slide 12
IRR Rule Accept the project if the IRR is greater than the
discount rate (cost of capital). Reject the project if the IRR is
less than the discount rate.
Slide 13
IRR Issues IRR cannot not be use to rate mutually exclusive
projects The IRR also cannot be use in the usual manner for
projects that start with an initial positive cash inflow,
Intermediate cash flows are never reinvested
Slide 14
Payback Method The length of time required to recover the cost
of an investment. The payback period of a given investment or
project is an important determinant of whether to undertake the
position or project, as longer payback periods are typically not
desirable for investment positions.
Slide 15
Payback Method Issues Ignores overall return (time value of
money) Ignores impact of large flows Ignores timing of flows
desirable for investment positions. It is not for very long
financing. Many times companies have to pay more than they actually
acquire
Slide 16
A regulation for evaluating whether to proceed with a project
or investment. The profitability index rule states: If the
profitability index or ratio is greater than 1, the project is
profitable and may receive the green signal to proceed. Conversely,
if the profitability ratio or index is below, the optimum course of
action may be to reject or abandon the project PI = Cash flows /
Initial Investment Profitability Index
Slide 17
Return on Assets A measure of profit per dollar of assets.
Return on Assets = Net Income / Total Assets Example: RoA = $363 /
$3588 = 10.12%
Slide 18
RoA, PI Issues: Do not consider the time value of money
Accounting Method Usage in Industry Source:
http://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf
(2002)http://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf
Slide 22
Green Building
Slide 23
23 IRR for LEED Building U.S. Green Building Council (USGBC)
reports that, projects that achieved LEED and Energy Star status
normally achieve an Internal Rate of Return (IRR) of 20% or more.
This is primarily from increased annual energy savings Source:
http://greeneconomypost.com/return-on-
investment-for-green-leed-projects-10962.htm
Slide 24
Eco Cost Facts PV panels decreasing in costs Negligible
degradation: actual modules appear to be degrading at 0.20.5% per
year (Chianese et al., 2003). Inverter reliability increasing and
inverter reliability and cost are both improving rapidly (Navigant,
2006; Mitchell, 2010; Heacox, 2010).
Slide 25
Eco Cost Facts Wind, other systems, high maintenance Lifespan
of mechanical systems < PV (CSP, Wind farms)
Slide 26
Eco Economic Considerations: PV is often considered too costly
But PV systems have long lifespan and negligible operating costs
PVs not considered by business because future cash flows do not add
to asset value What about depreciation? Definition of 'Modified
Accelerated Cost Recovery System - MACRS' The new accelerated cost
recovery system, created after the release of the Tax Reform Act of
1986, which allows for greater accelerated depreciation over longer
time periods.
Slide 27
PhotoVoltaic Panel Costs Source for below:
http://solarcellcentral.com/cost_page.html
Slide 28
Proposed Better Methods LCOE for electricity Use modified LCOE
for just certain components of a facility WLC for the complete
project
Slide 29
Proposed New Method For Energy: Levelized Cost of Electricity
(LCOE) A levelized cost of electricity(LCOE) is defined in any
operating year as the sum of all costs prior to and including that
year divided by the sum of all outputs. This is a levelized cost of
electricity with a zero discount rate which is not the traditional
metric. By Ken Zwiebel GWU
Slide 30
Proposed New Method: Levelized Cost of Electricity (LCOE)
Slide 31
Source: Ken Zwiebel, GWU
http://solar.gwu.edu/Presentations/KZSolarContract.pdf
Slide 32
Best Solution Found: Whole Life Costing and Performance Whole
Life Costing (WLC) is a powerful tool for calculating the lowest
cost options for the entire commercial life of a building. It
encourages the use of best value building designs and reduces the
costs and disruption of unplanned repairs and maintenance (Proposed
by the Building Research Establishment (BRE) U.K.)
Slide 33
WLC Whole Life Cost is the analysis of all relevant and
identifiable financial cash flows regarding the acquisition and use
of an asset. Uses NPV.
Slide 34
Activities in Sustainability
Slide 35
WLC Is A finance method to guide decision making Includes
Capital costs Includes Revenue costs Does it include end of life
cost for any project exceeding 10 years? Demolition is first cost
of next project How do I cost what I dont know Expressed as an
annual cash flow for the life of the asset
Slide 36
An Asset is Anything that we buy or construct Can be a facility
(building) Can be a component Any number of assets can be combined
The asset can be income generating or not.
Slide 37
Life Time Total Cost of Ownership
Slide 38
How Do We Measure WLC? Total whole life cost ~ TWLC Annualized
whole life cost ~ AWLC Discounted cashflow ~ DCF $s x % = a number
Net present value ~ NPV Discount rate What % should we use? Can be
used for non financial e.g. kWh
Slide 39
Recommendation for WLC Introduce and develop WLC in your
organization and your supply chain Take Small Steps - Progress
Slowly Understand What You Have Achieved Step back - see the Big
Picture Benchmark - process not answers Appropriateness &
Fitness - Every Project is Different
Slide 40
WLC Rules of thumb Spreadsheet Simple, easy to use, easy to
manipulate Proprietary Restrictive WLCF Uses WLCF view and is
supplier based Can be used for Buildings
