Commonly Used Tools

The tools most commonly used in formal capital budget analysis and presentation include:

• Simple payback analysis, which determines how many years of earnings (or savings) it will take to payback the investment.

• Simple rate of return (ROR) analysis, which determines the percentage or rate at which an investment will return.

• Discounted payback period analysis, which considers the time in which the present value of benefits equals the initial investment.

• Net present value (NPV) analysis, or sum of the discounted net cash flows (DCFs) over the life of the project, which measures the amount by which a project's stream of benefits exceed all costs, including the cost (or opportunity cost) of capital. Generally, the discount rate applied to the stream of benefits is equal to the cost (or opportunity cost) of capital.

• Internal rate of return (IRR) analysis, which determines the discount rate for which NPV is equal to 0.

• Savings investment ratio (SIR) analysis, which compares benefits and costs by dividing the present value of returns by the present value of the investment.

Each of these methodologies is presented with the assumption that an initial investment is made in Year 0. This is the full investment minus any offset costs. In retrofit applications, if the replaced equipment can be sold, it may have a salvage value. This value, minus any depreciation impact or other selling costs, can be subtracted from the initial investment to arrive at a net investment. Similarly, assets at the end of a contract term may have value and could possibly be sold. Costs that are avoided as a result of the investment should also be considered. For example, if equipment overhaul is required to allow a facility to continue to use existing equipment, that cost may be subtracted from the initial investment in the new equipment for analysis purposes. If the investment allows a facility to avoid installing new equipment, such as a new electric service substation to support growth requirements elsewhere in the facility, that too may be subtracted from the initial investment. Difficulties arise when replaced equipment remains in place and adds backup in the form of system redundancy. In some cases, this can be quantified based on the cost of an avoided outage, while in other cases it is relegated to qualitative benefit status.

One should conduct a similar analysis for ongoing operations, maintenance, and repair (OM&R) expenses. If costs are avoided as a result of the installation of new equipment, the investment analysis should consider only incremental operations costs. Generally, a savings of $1 per year of OM&R expenses equates to about $5 to $8 in capital savings. Thus, emphasis should be placed on operating cost savings.

Payback and simple ROR methods are generally reserved for preliminary screening analyses. They are too crude for proper evaluation of capital commitments because they do not adequately consider the time value of money. They are important, however, as practical tools used to limit a wide range of options and determine, on a preliminary basis, project potential.

Consider, for example, life-cycle feasibility analyses, as discussed in the previous chapter, and the level of detail required for more intensive capital budget analyses. The most efficient approach to project financial analysis may be to eliminate many or even most of the potential options through simple payback or ROR analyses, and then to apply the more rigorous IRR or NPV analysis to the remaining few options. It is important to remember that the more high-powered analyses may be equally as misleading as the simple analyses if the input assumptions are not reasonably accurate.

The annual positive net cash flow from a project is generally considered to be after-tax distributable cash. While most taxes are not paid at a project level (but at a corporate level), taxes are a cost of entering into the project and must be considered. Generally, the project is considered a full taxpayer by most corporations and tax benefits are assumed to be used in the year they are made available. The most commonly used tools in formal capital budget cash analysis and presentation include IRR, NPV, and its derivative, SIR, analyses. IRR is also a good tool for evaluating opportunities of different risk and for lease vs. buy (or various combinations of debt and equity) analysis. Other net income-oriented analyses are also used by some organizations, mostly publicly traded companies.

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