15

Annual cash flow

$(1,000,000)

$125,000

$127,500

$130,050

$132,651

$135,304

$149,387

$1 64,935

Fig. 42-2 15 Year Cash Flow on $1 Million Investment with $125,000 First Year Net Annual Savings and 2% Inflation Rate.

Fig. 42-2 15 Year Cash Flow on $1 Million Investment with $125,000 First Year Net Annual Savings and 2% Inflation Rate.

assuming equal risk. However, when considering two projects that require different investment levels and/or have different useful project lives, additional information, such as what will be done after the life of the shorter project, would be required to make the best selection.

Consider two project options in which Option 1 had an NPV that was twice that of Option 2, but also required an investment that was three times greater. If the IRR of Option 2 was considerably greater than that of Option 1, Option 2 might be chosen despite having a lower NPV. It would tie up less capital (or available debt) and provide greater return per dollar invested. The evaluation of these investment options might also include an analysis of what else could be done with available capital if the lower cost investment is chosen. In this case, the combined NPV and IRR of Option 2 and another investment opportunity would be compared to Option 1. In some cases, the threshold discount rate might be greater for the larger investment. Additionally, the larger capital requirement may preclude another project and the profits or savings lost from that opportunity must be considered in the threshold discount rate.

Another factor that must be applied in capital budgeting analysis is risk rate. Simply put, if two options show the same NPV or IRR, and one is considered to have more risk, the other would be the logical choice. Consider an economical performance evaluation of a cogeneration system option with risk rate impact factors mitigated through manufacturer's warrantees and guaranteed OM&R contracts. Compare this option to capital allocations to a new product line. The new product option would have to display a significantly higher IRR to compensate for the greater risk of under-performance or failure.

SIR is another investment analysis tool used for evaluating energy operating cost savings projects. It is a variation of the NPV method, computed by dividing the PV of returns by the PV of the investment. Whereas NPV combines all benefits and costs, SIR compares benefits and costs. If the resulting ratio is greater than 1, it implies that returns exceed the investment. The greater the SIR, the more desirable the project. SIR is computed as:

PV of returns

PV of investment

Whereas IRR does not indicate the amount of profit to be earned from a project, and NPV does not indicate the amount of investment required for a project, SIR considers both. A greater SIR indicates a greater value of NPV for each dollar invested. Therefore, when several projects are being considered with either limited access to capital (and/or debt) or limited applications, the projects with the highest SIR would be the ones that will maximize the NPV for each dollar invested.

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