THE PURPOSE OF ECONOMIC EVALUATION

Economic evaluation is a rational method for making choices .Any good commercial organization ought to be able to identify more viable investment opportunities than it has money to invest in ,so it has to choose which projects to fund.

Economic evaluation enables these choices to be made ,by using measures of financial return as an indication of each project's value to the organization.

The objectives of economic evaluation are :

- To decide which investments will make the best use of the organisation's money;
- To ensure that the optimum benefits are available from each of these investments;
- To minimise any risk to the organisation ;
- To provide a basis for the later analysis of the performance of each investment.

The process of economic evaluation :

- Produces measures of the financial improvement that each project could make to the business;
- Identifies the risks and uncertainties in each project;
- Defines the expected costs and benefits.

The decision maker can the use the results of the evaluation to choose between projects . Economic evaluation helps organisations make the right choices.However, as projects to improve energy efficiency are likely to be competing for funds against other projects ,what is really being evaluated is project's position within a list of possibilities .To give energy projects the best chance of being funded , an economic evaluation should be presented with the proposal ; the decision maker will then be able to compare the benefits of the energy project directly with the other investment proposals.

KEY STAGES IN ECONOMIC EVALUATION

Economic evaluation produce financial measures of the potential of each of the possible investments open to the organisation. These measures can then be used to decide which projects should be funded and the priority they should be given. Economic evaluation should not be considered as a technique for creating absolute values .It compares the merits of investing in various projects ,rather than deciding in isolation whether any one idea is worth supporting. Economic evaluation tries to show the benefits of projects in relation to their capital costs ;however ,it is often difficult to find any single parameter which measures this .There are many different measures that can be used for economic evaluation ,each of which highlights a different aspect of a project. No one measure is better than any other,and each as its strengths and weaknesses.

Cash - flow

The first step in any economic evaluation is to gather the information on the project costs and benefits and calculate the cash - flow .This gives a statement of how much money will be spent or will be earned in each year of the project.
To determine the cash - flow for a project ,the costs and savings must be collected for the years in which they occur .The cash flow for each year is found by adding the savings ( Positive amounts ) to the costs ( Negative amounts ) for that year .
According with the type of project, predict the cash-flows becomes more or less difficult. There are even cases where a quantitative estimation is almost impossible, and the economic evaluation unfeasible .

In our case study we considered fuel cells as an substitution investment. The cost savings ,namely the conservation and maintenance cost savings are known and they can be predicted with a satisfactory degree of accuracy .

Economic evaluation techniques

PayBack

The easiest financial parameter to calculate is simple payback ,which is defined as the capital cost divided by the average annual savings . Using Payback has some obvious benefits:

- it is easy to calculate;
- It is a tangible value ( years );
- It does not require any assumptions about the project timing and lifetime , or interest rates .

But Payback has some serious disadvantages :

- It takes no account of any savings after the Payback period;
- It takes no account of any income from reselling the capital asset later on;
- It takes no account of the effect of time on the value of money.

Payback is ,however ,a useful screening method for projects. A project with a Payback of a few months clearly deserves further investigation, whereas a project with a Payback of 10 years would usually have little chance to receiving funding.

Discounting

Stationary Fuel Cell projects will have long lifetimes ( usually 20 years ) and may require large investments ,so it is important for the time value of money to be taken into account during the project evaluations .This is done by discounting ( this is not the same as allowing for inflation, although it is one of the factors that can influence the discount rate ).

Choosing the discount rate.

The choice of discount rates varies according to the type of organisation and the commercial environment in which it operates ; for instance ,wheter it relates the choice of discount rate to the cost of borrowing money ,the value of bank deposits or the need to generate capital by issuing shares .

The discount rate used is often a composite figure which represents the average cost of capital weighted according to the funding sources ( e.g. shares ,loans ) used by the organisation .

Large organisations often specify the discount rate to be used for all economic evaluation .While discounting is an important procedure , it can be arbitrary in many organisations. The former experience within countries with low inflation rates and stabilized economies shows that discount rates in between 6% and 10 % are fairly reasonable.

Discounted Cash - flow

Discounting can be applied to all the parameters ( I.e. . Payback ) .This is done by discounting the cash flow before calculating any of the parameters .To calculate a discounted cash - flow , the net cash inflow or outflow in each year of the project is multiplied by a discount factor for that year , to give the Present Value of revenue in that year.

The process of discounting therefore overcomes one of the main disadvantages of the these 'static ' measures ,i.e. that they take no account of the effect of time on the value of money .

Net Present Value

Adding up the present values over the project's duration gives a number which would be called the Gross Present Value of the project. It is usual to go directly to the next step and deduct the capital cost from this figure to obtain the NPV.
The NPV is a financial parameter of particular interest to the financial manager , because it indicates the amount that the project will earn for the business over its expected lifetime in today's money .If the NPV is positive ,the project is viable. If the NPV has been calculated using a realistic discount rate , it can provide information on how to finance the project .

For example , the current interest rate to borrow the capital required could be used as a realistic discount rate .
If the NPV is negative ,it would not be worthwhile borrowing the money for the project .A positive NPV would show the project could repay the loan and still give the investing organisation a profit.

Internal Rate of Return.

Some organisations have no particular policy on which discount rate to use and in this cases it is not possible to calculate one NPV.
There is, however , an alternative called the Internal Rate of Return ( IRR ) which can be used to evaluate the project .
The IRR is the discount rate for which the total income from the project , once discounted ,equals the initial investment .
The IRR is the discount rate at which the NPV of the project is zero.

The IRR measures the project's profitability .It represents the rate of return that money would have to earn if invested outside ,or elsewhere in the organisation on another project ,to be a better investment than the project being proposed. The higher the IRR, the better the project.

As with NPV, the IRR can help assess ways of financing the project .The IRR can be compared with the current interest rate for borrowing the capital required .If the IRR is lower than this interest rate ,the project would lose money if it was financed by borrowing .If the IRR is greater than the cost of borrowing the capital ,the project will generate enough income to repay the loan and still provide profit.

Return of Investment ( ROI )

This method gives an idea on the return for each unit of capital invested and is an indicative value of how profitable is the investment made .
If :

ROI = 1 means that NPV = 0
ROI > 1 means that the is profitable
ROI < 1 means that for the discount rate used the NPV < 0 and the project is not profitable .

The choice of the method

The relative merits of using NPV,IRR,ROI or Payback to evaluate a project are often discussed ,because the results of the evaluation will sometimes vary depending on the method used. Fuel cells are long term investments with increasing cash - flows later on.
NPV favours this type of projects so must be preferred . The following thumb rules give an idea of the systematic to use with these parameters.

SYSTEMATIC OF USING THE ECONOMIC EVALUATION TECHNIQUES

Payback Must be preferred when the life duration of the project is known.

Net Present Value Must be preferred when :
- Projects demanding similar investments and with similar useful lives are compared with each others.
- The discount rate is known.

Internal Rate of Return Must be preferred when :
- The discount rate is unknown or questionable.
- Projects with different levels of investment and useful lives are compared with each others .The NPV must be determined complementarily .

How the spreadsheets work

The economic assessment model has three different workbooks linked with each other.

initdata.xls

In this workbook are introduced some of the most important economic parameters ( i.e.discount rate ). The final results from the evaluation techniques are immediately obtained to allow an immediate analysis of the effect of the changes. This workbook is linked to the other two workbooks.

analcus.xls

This workbook can be linked to other existing cost analysis spreadsheets or the data can be directly introduced by the potential users.For example electricity or natural gas bills can be directly introduced. In the case of a system consuming biogas the cost of producing this one has to be calculated by using appropriate software.

analrent.xls

In this workbook spreadsheets are built in the above mentioned economic evaluation techniques . The spreadsheets make a comparison between Fuel Cell economical performance and the one of the system that is in use.They also allow that another technology ( Diesel Engine,Gas turbine,etc ) economical performance is compared with the actual system. The annual cash-flows are obtained by comparing the costs of the two systems.If the costs of the alternative system are lower than those of the actual system there will be a saving on costs. The savings are multiplied by a discount factor that actualizes them to year 0.That is the present value of the cash-flow.

Download Financial analysis spreadsheets (Excel): (Initdata) (analcus) (analrent) All three spreadsheets should be downloaded as they are interdependent. These spreadsheets are sensitive to the application software: Use of these spreadsheets with Lotus is not recommended

References