Financial Evaluation of Capital Projects

When considering whether to undertake a large capital expenditure for your plant, whether it is an onsite power generation system or a renewable energy installation, you no doubt will perform an economic valuation to justify the expenditure. There are several methods of performing these evaluations. Each has its pros and cons and each has its…

When considering whether to undertake a large capital expenditure for your plant, whether it is an onsite power generation system or a renewable energy installation, you no doubt will perform an economic valuation to justify the expenditure.

There are several methods of performing these evaluations. Each has its pros and cons and each has its proponents and critics. I will not attempt to detail how to perform these evaluations, since the whole textbooks are written on the subject. I will only point out a few key ideas that will hopefully further some further research on your part.

There are several methods of such analysis that are currently popular. I will focus on the two methods which are more commonly used. These are:
• Simple payback analysis
• Discounted cash flow analysis

The simple payback calculation is probably the most commonly used because it is, well, simple. It is easy to calculate and easy to understand. The simple payback is the period of time it takes to recover the original investment in the project. For instance, if the project is a cogeneration & onsite power production system, the simple payback is calculated by taking the total estimated cost of the project and dividing that number by the expected annual net returns from the steam and onsite power production. Some companies will have investment “rules of thumb”. An example is that a simple payback for an auxiliary power system of two years or less gets funded. A three year payback is questionable, and anything beyond is probably not going to happen.

A simple payback calculation can be useful as a screening tool. It can weed out the obvious. If you have a group of 2, 3 and 4 year payback onsite power generation projects under consideration, it makes little sense to even consider further development of a 12 year payback project. However, simple payback does nothing to answer the question, “Do any of these projects make economic sense at all?”

The discounted cash flow method uses the time value of money to compare alternatives to the investment. It can answer questions such as, “Is it better to invest in a cogeneration & onsite power production system, or put the same money into a bank savings account?” Or, “Which is better, invest in an onsite power generation system, or put the money toward buying another business?”

The discounted cash flow method incorporates the time value of money in its calculations to develop metrics such as net present value and internal rate of return. These metrics give you an idea of ​​what the expected return of the project is in relation to alternative uses for the money. I have seen extreme cases where a project was thought to be a great project because it had a simple payback of 2 or 3 years. Discounted cashflow analysis could show, however, that it does not meet the internal rate of return test, and, therefore, should not be done at all. Simple payback analysis alone will not reveal this fact.

There are times when emotion is used as a justification to green-light a project. In other words, “I am going to do this project because I just want to do it.” If all the facts are known and properly disclosed, I have no problem with that. And at times, there can be regulatory or safety / environmental reasons to do a project. No problem there, either. However, if the intention is to fund discretionary projects, such as an onsite cogeneration system, it should be based on a true economic analysis. One should then use discounted cash flow analysis or one of its variants for the best financial results.