Académique Documents
Professionnel Documents
Culture Documents
.
[
]
with
Operations
costs
Time studies (e.g. Methods-Time
Measurement, MTM)
Supplier information
Expert opinion of operators and
supervisors
.
Downtime
costs
Which revenue is lost per hour of asset
outage for your company? OR: What does
provision of a backup solution cost per
hour of downtime? This defines the
penalty per hour (in )
Total yearly downtime as recorded by
operations or estimated by experts
.
Table 3 Typical information sources and cost estimation methods and practices for some common cost types.
EXAMPLE: With the data provided in Table 1 and the results of his cost estimation efforts, Leonard starts
building his cash flow model, the result of which is shown in the Excel-file ECI_LCC.xlsx attached to this
Application Note. Look at the first worksheet Exercise and for now look only to rows 1 to row 21 and at the
yellow colored input parameter cells below. Make sure you understand how each of the cells in the first 21
rows is defined. Now look at the worksheet Graph 1, where you can see the summated cash flows for the
three options over the different years (i.e. row 19, 20 and 21).
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RECAP THE THIRD STEP OF LCC ANALYSIS: GATHER DATA AND DERIVE COST ESTIMATES
DERIVE A QUICK & DIRTY LCC ESTIMATE
Focus on the most important cost components
MAP YOUR INFORMATION SOURCES
Collect and critically evaluate historical data and expert opinions
CHOOSE APPROPRIATE COST ESTIMATION METHODS
Parametric or analytical: make a trade-off between effort and accuracy
START CALCULATING COSTS (Make a cash flow model)
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STEP 4 CALCULATE KEY FINANCIAL INDICATORS
After reading this chapter you will know the three Key Financial Indicators that can be used to express LCC, and
you will be able to calculate and interpret them. You will be convinced that it is necessary to take the time value
of money into account. For this youll have a pragmatic approach at hand to determine an appropriate discount
rate.
A Life Cycle Costing Analysis is made to facilitate a decision: which alternative is the best choice from a long-
term perspective? To help you make this type of judgment, this chapter introduces three Key Financial
Indicators: Net Present Value (NPV), Discounted Payback Time (DPBT) and Internal Rate of Return (IRR). But
before we go on, there is one important concept we need to clarify: the time value of money.
The time value of money prohibits you from simply adding up costs that occur in different years. It is not the
same as inflation, which is the rise in the general level of prices for goods and services. The time value of
money is the reason why everybody prefers having 500 today and not in five years time, even if the same
amount of goods and services could be bought with it at that point. During these five years, this amount can
be invested in several profitable ways and not doing so costs money as well.
Each cost that occurs in the future will have a Present Value (PV) that is different from its Future Value (FV).
The relation between the PV (in year 0) and the FV (in year k) is given by the following formula:
Application of this formula is called discounting, and the most important parameter to determine is the
discount rate i, that will define how big the difference is between FV and PV. Lets say you receive a sum of
500 in 10 years and apply a discount rate of 8%, then its Present Value is:
22
With a discount rate of 15%, the Present Value of the 500 received in 10 years will only be:
12
The three Key Financial Indicators introduced in this Application Note namely Net Present Value (NPV),
Discounted Payback Time (DPBT) and Internal Rate of Return (IRR) all make use of this basic formula, for
which a discount rate should be chosen. Determining i is a difficult but important decision and the next
section will help you in doing this.
CHOOSING YOUR DISCOUNT RATE
The discount rate represents the time value of money, but we have seen that another phenomenon, inflation,
also contributes to the fact that money loses value over time. Youll have to decide whether you will or will not
include inflation in your analysis. If you do, youll calculate the time value of money with a nominal discount
rate. If you dont, youll use a real discount rate. The real discount rate will always be smaller than the nominal
discount rate, unless in the rare case of deflation (i.e. a decrease in the general price level). When a choice
needs to be made between different alternatives, inflation often has about the same influence on each of
them, so it can be discarded. But some specialists will advise you to not only use nominal discount rates but
also apply different inflation rates for different types of costs (e.g. energy inflation versus wage inflation). In
our opinion, this might give the false impression that inflation is a predictable phenomenon. Therefore, we
think it is more straightforward to add the uncertainty about the inflation of energy prices in the energy prices
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themselves and not in the discount rate. Including uncertainty in your LCC model is the topic of Application
Note 2. For the time being, we advise you to use a real discount rate.
Many specialists agree that the real discount rate should reflect the investors opportunity cost of capital.
Opportunity cost of capital reflects that capital employed now to make an investment in energy efficiency
measures does not come for free: either it is borrowed capital (debt) or own capital (equity). Both debtors and
shareholders will expect a certain return from their money and will only keep providing you with funds when
you meet their expectations.
An accepted benchmark for the opportunity cost of capital and thus for the discount rate is the Weighted
Average Cost of Capital (abbreviated as WACC). WACC is calculated as the rate that your company should pay
on average to the owners of its capital. For a company with only shareholders and debtors WACC is calculated
as follows:
In this formula,
E represents the market value of the equity
D is the total debt
R
d
is the interest paid on debt
t is your companys tax rate (expressing the fact that interests on loans are tax deductible)
R
e
is the return that your shareholders expect (the most difficult parameter to determine)
In a risky business context, a companys WACC will be bigger since both shareholders and debtors expect a
greater return, while in a stable business context, a companys WACC will be smaller. Since WACC depends
heavily on the risk level of your activities, a company that operates in different industries can have a different
WACC per industry.
This formula appears simple, but the great challenge lies in determining R
e
. A popular approach among
financial experts is the Capital Asset Pricing Model (CAPM), in which R
e
is determined as
,
with R
0
the risk free rate (e.g. 10-year German treasury bonds, around 2% in December 2011), the company-
specific Beta-factor and R
P
a risk premium of typically 3 to 5%. The Beta-factor reflects how the returns of your
company correspond to market fluctuations. Explaining CAPM more in detail will lead us too far; therefore, we
limit ourselves here to saying that WACC calculations are not an exact science: different specialists might come
up with a different R
e
(and thus a different WACC) for the same company.
This Application Note has tried to give you some essential insights into WACC. We are not suggesting that
WACC is easy to apply in real life. You have two main options:
1. If your company is publicly listed on a stock market, your financial department should have an
estimate for your companys WACC, since it can be calculated from financial data they are required to
publish.
2. If your company is not publicly listed, you can try to determine WACC yourself by collecting
information about the parameters used in the formula above. However, you will probably not have
the time or the background to carry out this complex financial analysis. If your financial department
cannot help, we suggest the following pragmatic approach:
The absolute minimum WACC is around 4%, the so-called social discount rate applicable for
long-term social planning. In general, a WACC is seldom below 7% or above 20%.
The WACC of similar companies active in the same industry and with a similar risk profile can be
indicative, as WACC is somewhat comparable within industries. Some industry-wide estimates for
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cost of capital determined by Professor Damodaran of NYU Stern Business School are provided in
Table 4. This 2009 data is based on U.S. companies only. Take this value as a benchmark and
increase it by a few % if you estimate that your company has a higher risk profile than average, or
decrease it if the opposite is true. You can also find examples of companies listed on U.S. stock
markets on this website: http://thatswacc.com/.
Exercise: Try finding the WACC for Apple Inc. (AAPL), Coca-Cola Company (KO) and U.S. Steel (X). How would
you have intuitively ranked them ordered by increasing WACC?
Aerospace/Defense 8.51% Drug 8.52%
Auto & Truck 8.58% Food Processing 7.16%
Auto Parts 9.91% Paper/Forest Products 9.24%
Beverage 8.15% Petroleum (Integrated) 8.63%
Building Materials 8.57% Petroleum (Producing) 8.48%
Chemical (Basic) 8.70% Steel (Integrated) 10.27%
Chemical (Diversified) 9.10% Steel (General) 9.54%
Chemical (Specialty) 8.88%
Table 4 Average cost of capital for some selected industrial sectors.
(Source: http://pages.stern.nyu.edu/~adamodar/)
NET PRESENT VALUE (NPV)
The Net Present Value (NPV) of your Energy Efficiency Project is the most important Key Financial Indicator. It
is defined as the sum of the present values (PVs) of the individual cost components, whereby each instance of
each cost component is discounted according to the year in which it occurs. An NPV value can be calculated for
each time series of costs and/or revenues, but in the context of LCC it is a way to evaluate the total, long-term
cost of each alternative or, in other words, the total size of the iceberg. NPV allows you to compare your
different options in monetary terms. Lets presume that, for one of your alternatives determined in Step 1, you
have calculated all relevant cost components so that C
k
is the sum of all costs occurring in year k and C
0
is the
initial investment (in year 0). Than the NPV (total LCC) of this alternative can be calculated as:
In this formula, T represents the time horizon and i represents the discount rate. NPV can be calculated
directly in MS Excel by applying the function NPV, which has as syntax =NPV(rate,value1,value2, ...). In this
formula rate is the discount rate and value1, value2 is a row or column of all the cash flows in different
years, starting from year 1 (Be careful not to start in year 0! You should always add C
0
separately).
You can determine the NPV for each of your alternatives. This will give you an idea of the total cost impact of
every alternative, taking the full time horizon into account. With that information at hand, youll be able to
EXAMPLE: Leonards company is not publicly listed. He decides to call Bill from the accounting department.
Whats his companys WACC? Bill has no idea and is not willing to make an effort. Leonard looks up the
WACCs of companies in the same industry on www.thatswacc.com. He finds that Exxon Mobil (XOM) has a
WACC of 7.83% (an absolute minimum, he thinks), BP has a WACC of 11.55% and the industry-wide average
cost of capital is around 8.5%. Leonard adds one percent risk premium and chooses a value of 9.5% for his
company. He is not very confident about this estimates accuracy, but 9.5% seems to be the most sensible
choice for now
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make your decision. The most attractive alternative will obviously be the one with the lowest NPV, thus the
lowest LCC.
To highlight the saving potential of your Energy Efficiency Project, youll often want to compare your different
active scenarios (e.g.: purchase system A or purchase system B) to the base case scenario. For this, youll first
have to calculate the NPV of the total cost of each alternative, just like we did above. Then you can subtract
the NPV of alternative A from the NPV of the base case, and thus you derive the total cost saving of that
alternative over the base case (if it is positive) or the total additional cost (if negative).
DISCOUNTED PAYBACK TIME (DPBT)
While NPV is expressed in monetary units, you can also make a comparison in temporal terms. Your central
question is then: What is the payback period for this investment? A simple way to find an answer is to
subtract year by year the realized savings from the initial investment cost until you reach zero. That is the
breakeven situation and the corresponding period is the (regular) payback time (PBT). For example, if you
invest 1500 in year 0 and from the first year on you save 500 per year, the regular PBT will be 3 years.
But regular PBT, which simply adds up costs that occur in different years, does not take the time value of
money into account. Therefore, we advise you not to use regular but only discounted payback time (DPBT).
DPBT subtracts discounted costs from the initial investment amount until you reach zero. We recognize the
difficulties in finding a good discount rate, but ignoring the time value of money altogether is always worse
than applying an over- or underestimated discount rate.
Intuitively, you will prefer projects with a short DPBT. But should you always choose the project with the
shortest DPBT? The answer is no. Often the DPBT and NPV criteria will rank your alternatives in the same way
but, in some cases, there might be differences because DPBT has a shorter time horizon than NPV. NPV takes
into account all factors over the complete time horizon, while DPBT looks only at the costs and savings that
occur in the years before the breakeven point is reached. It neglects everything that happens afterwards.
EXAMPLE: Using the cash flow model weve worked on before, try to calculate the NPV of the total cost of
each of Leonards alternatives. You can use the first worksheet Exercise of the Excel file ECI_LCC.xlsx. In
Cells L19 L20 L21 you should fill in your formulas (use the Excel NPV function, but beware of year 0!).
Then look at rows 23-24 and 26-27. Make sure you understand how these numbers are calculated. Calculate
in cells L23 L24 and L26 L27 the total discounted cost savings of alternatives A and B over the base case.
We added row 24 and 27 only to demonstrate how the NPV function in Excel works, so you should end up
with the same number in L24 as in L23 and in L26 as in L27. Which alternative would you choose? You can
check your answers with the worksheet Solution and Graph 2 in the same Excel file and the discussion at
the end of this chapter.
EXAMPLE: Starting with your NPV calculation sheet, try to determine the DPBT of each of Leonards options.
Compare it with the corresponding regular PBT. You can use the first worksheet Exercise of the Excel file
ECI_LCC.xlsx. Use the data in rows 25 and 28. Make sure you understand how the values in these rows are
calculated. Rank the alternatives according to DPBT and compare this ranking with the one based on NPV
analysis. You can check your answers with the worksheet Solution in the same Excel file and the discussion
at the end of this chapter. In Graph 3 we have provided a visualization of the cumulative discounted savings
over time. Here you can see that the DPBT is the moment in time when the savings line crosses zero
(indicating break even).
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INTERNAL RATE OF RETURN (IRR)
The third Key Financial Indicator to express LCC is the Internal Rate of Return (IRR). The IRR is the discount rate
that makes the NPV of your project 0. In mathematical terms, this means:
so that
with
C
BCk
representing the cost of the base case in year k
C
k
the cost of the alternative under consideration in year k
By calculating the IRR you determine what the maximal discount rate is which still allows you to have a
profitable investment. A high IRR means that the project is more interesting: even if the future savings are
discounted with this IRR, it would still not induce a loss. In general, the IRR of a particular project should be
greater than the cost of capital (WACC) in order for the project to be interesting.
The easiest way to calculate IRR is using the IRR function in MS Excel. The syntax of this function is
=IRR(value
0
,value
1
,value
k
, guess), with value
j
being the cash flow in year j and guess your initial guess for
the IRR. If this initial guess is not entered in the formula, 10% is chosen by default. This formula can only be
applied if there is a discount rate for which the NPV reaches zero. If not, MS Excel will present you the #NUM!
error value. Try this simple example yourself in MS Excel:
100;
0;
2;
1 and