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Many of the projects in the electrical power industry are forced on the planner and are beyond his control; examples are building new power plants to meet load increase and providing new facilities to enhance security of supply, rural

Coal

Nuclear

Wind Natural gas combined cycle

Fixed costs Capital costs 2020

Coal Nuclear

Wind Natural gas combined cycle

0 5 10

2035

Variable costs, including fuel Incremental transmission costs

Figure 5.1 Levelised costs of electricity in the US for years 2020 and 2035 [Source: Reference [9]]

electrification, etc. Therefore, many decisions in the electrical power industry are restricted to the choice of the least-cost solution. With the privatisation of utilities and market economies, a more thorough analysis of the profitability of investment is also becoming essential. Projects are carried out because they are needed, they are the least-cost solution and they are profitable. It is now becoming increasingly necessary not only to weigh the benefits of the investment through a cost–benefit analysis, but also to carry out financial profitability projections. This includes forecasting three summary statements: (i) the pro forma income statement, (ii) the pro forma balance sheet and (iii) the pro forma fund flow statement [10]. Such statements will allow assessment of financial profitability to owners.

In this section, we are concerned with the traditional cost–benefit analysis of projects to assess their acceptability to utilities, governments, investment bankers and development funds, as well as investors. There are several ways of assessing whether the project is worth undertaking. The most useful of these are

1. computing the internal rate of return;

2. evaluating the net present value of the project;

3. calculating the benefit/cost ratio; and

4. other criteria (payback period, profit/investment ratio, commercial return on equity capital).

All the above criteria, except the last, involve discounting.

The case of independent power projects undertaken by private investors is discussed in section 5.5.

5.3.1 Internal rate of return

Calculating the internal rate of return (IRR) is a popular and widely used method in the evaluation of projects. The IRR is the discount rate that equates the two streams of costs and benefits of the project. Alternately, it is the rate of return r that the project is going to generate provided the stream of costs (Cn) and stream of benefits (Bn) of the project materialises. It is also the rate, r, that would make the NPV of the project equal to zero, i.e. IRR is such that

X½Cn=ð1 þ rÞⁿ ¼X

Bn=ð1 þ rÞⁿ

½ 

If IRR is equal to or above the opportunity cost for a private project, or the social discount rate (as set by the government) in public projects, then the project is deemed worthwhile undertaking. Utilities, governments and development funds set their own criteria for the opportunity cost of capital and for the social discount rate below which they do not consider providing funds. Such criteria depend on the amount and availability of required funds. The criteria also depend on the presence and expected return of alternative projects in other sectors of the economy, the market rate of interest and the risk of the project. In Chapter 4, the concepts that govern the choice and fixing of the discount rate have been discussed. For some investors, the discount rate can be viewed as the minimum acceptable rate of return below which a project is rejected. Therefore, if the IRR is equal to or above the Financial evaluation of projects 73

minimum acceptable rate of return, then the project is considered to be worthwhile undertaking. The IRR can be calculated by trial and error calculations, through the utilisation of the above equation until r is found or can be interpolated. However, preferably, it can be calculated through the use of a computer program or a modern financial calculating machine.

Alternately, it can be computed using a graphical method. Two points may be plotted on the graph (Figure 5.2) and joined by a straight line. The point at which this line cuts the horizontal axis (i.e. where the NPV is zero) gives the IRR. The IRR for the example in Table 5.3 is shown.

The IRR concept has certain minor weaknesses that have been explained in the literature [6, 11, 12] and can sometimes be defective as a measure of the relative merits of mutually exclusive projects. It also contains an important underlying assumption, that all recovered funds can be reinvested at an interest rate equal to the IRR, which is not always possible. However, the IRR is a widely understood concept and it largely represents the expected financial and economic returns of the project. Also most of the weaknesses referred to do not normally occur in the electrical power industry. The main merit of the IRR is that it is an attribute of the

9%

–2 –1 0 2 3 4 5 6 7 8 9 10 NPV (£)

1

10% 11% 12% 13%

IRR

Figure 5.2 Calculating the IRR by interpolation Table 5.3 Calculating benefits

Year Cost Income Net benefits Net benefits discounted at 10%

1 40 – 40 44

0 100þ 10 40 70 70.00

1 10 40 30 27.27

2 10 40 30 24.79

3 10 40 30 22.54

4 – 70 70 47.81

Net present value: £8.41

project evaluation. Its calculation does not involve an estimation of a discount rate.

Therefore, the evaluator avoids the tedious analysis of Chapter 4. It is satisfactory to calculate the IRR and compare it with the test rate conceived, which is a superficial attractiveness. Therefore, it is a widely used means of assessing the return of the project in the ESI.

5.3.2 Net present value

The concept of net present value (NPV) has already been explained in detail. The method discounts the net benefits (cash flows), i.e. project income minus project costs to their present value through the already assigned discount rate. If the net result is higher than zero, this proves that the project will provide benefits higher than the discount rate and is worthwhile undertaking.

For example consider the same project as given in Table 3.1, with the fol-lowing present-day costs (investment £140, annual running cost £10) and income (benefits) of £40. The project is expected to last four years and the prevailing discount rate of 10 per cent is used.

Calculating the IRR: Since the NPV at 10 per cent is positive, the discount rate is greater than 10 per cent. Trying 12 per cent, the NPV is £1.76; at 13 per cent the NPV equals1.47. The IRR is, therefore, around 12.5 per cent. Since it is higher than the minimum acceptable return of 10 per cent, the project is acceptable.

Finally, we consider the NPV: Since the NPV> 0, the project is acceptable.

The NPV is a powerful indicator of the viability of projects. However, it has its weaknesses, in that it does not relate the net benefit gained to the capital investment and to the time taken to achieve it. In the above example, it does not matter if £8.41 were obtained through investing £100 or £1 000, or obtained over 4 years or 40 years. However, it is very useful in choosing the least-cost solution, since it is the alternative that fulfils the exact project requirements and has the higher NPV that is preferred.

5.3.3 Benefit/cost ratio

This method compares the discounted total benefits of the project to its discounted costs:

B=C ¼X

n

B=ð1 þ rÞⁿ=X

n

C=ð1 þ rÞⁿ

Only projects of B/C 1 are adopted. This criterion is popular and, in some applications, is more useful than the net present value, in that it relates the benefits to costs of the projects. It has also a useful application for capital constraint, when the industry has a lot of feasible projects but limited investment budget. In this case projects are ranked in accordance with their B/C ratio and are adopted accordingly until their combined costs equal the capital investment budget. Therefore, it is useful in comparative analysis.

It has to be remembered that B/C is a ratio, while NPV is a measure of absolute value.

Financial evaluation of projects 75

In the example of Table 5.3:

value of discounted benefits¼ 40 þ 36:36 þ 33:06 þ 30:05 þ 47:81 ¼ £187:28 value of discounted costs¼ 44 þ 110 þ 9:09 þ 8:26 þ 7:51 ¼ £178:86 B=C ratio ¼ 187:28=178:86 ¼ 1:047

5.3.4 Other non-discount criteria for evaluation

There are many other criteria for evaluating the project’s worth and return of investments. The most common methods are the payback period and profit/

investment ratio calculation.

5.3.4.1 Payback period

The payback period is defined as the time after initial investment until accumulated net revenues equal the investment, i.e. the length of time required to get investment capital back. The method is used as an approximate measure of the rate at which cash flows is generated early in the project life. It is utilised for small investments, like improvements and energy efficiency measures, since it is easy for business managers to understand. However, in isolation, it tells the analyst nothing about the project earning rate after payback and does not consider the total profitability or size of the project. It also ignores inflation and discriminates against large capital-intensive infrastructure projects with long gestation times. Payback is an ad hoc rule. Therefore, it is a poor criterion in itself and it must be used in conjunction with other criteria.

In the previous example of Table 5.3 the payback period is higher than three years.

5.3.4.2 Profit/investment ratio

The profit/investment ratio is the ratio of the project’s total net income to total investment. It describes the amount of the profit generated per pound invested, and is sometimes referred to as profitability index. The idea is the selection of the project that maximises the profit per unit of investment. The ratio is easy to cal-culate, but does not reflect the timing at which revenues are received and profits generated. Therefore, it does not reflect the time value of money. Correspondingly, it is not a proper evaluation measure. In the example of Table 5.3 the profit/

investment ratio is £50/£140¼ 35.7 per cent.

5.4 Owner’s evaluation of profitability: commercial annual