Guidance on Financial Analysis of

Cleaner Production Options

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 1

 What will we learn here?

Guidance on Financial Analysis of Cleaner Production Options

Introduction: The Need for Financial Analysis
Objectives of this Presentation
Use of Cost Benefit Analysis in Financial Analysis
Introduction to Cost Benefit Analysis
Elements of Cost Benefit Analysis
Case Study #1
Case Study #2
Criteria for Selection of Projects

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 2

Introduction: The Need for Financial Analysis

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Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 3

 Introduction: The Need for Financial Analysis

Cleaner production options not only avoid and

reduce waste generation, but also offer a direct cost
advantage to the business.

However, cleaner production options are typically

long term, involving medium to high investment,
and hence are perceived as a larger business risks
than end-of-pipe solutions. The crux of the problem
is that this risk is often not clearly quantified and
predicted.

Thus, financial analysis of cleaner production

options becomes necessary.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 4

 Objectives of this Presentation

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Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 5

 Objectives of this Presentation

To understand the basics of financial analysis

To implement fundamental principles of financial analysis

for cleaner production options

To screen cleaner production options based on financial

aspects

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 6

Introduction to Cost Benefit Analysis (CBA)

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Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 7

 Introduction to Cost Benefit Analysis (CBA)

• CBA facilitates the comparison of alternatives

in terms of the monetary costs involved and the
benefits obtained.

• The costs and benefits (environmental, social or economic) must be

quantified in monetary terms to the maximum extent possible.
Typically, CBA is used as a tool in feasibility studies for selection of
an alternative together with for e.g., life cycle assessment, audits, etc.

• Thus, CBA is used in financial analysis to estimate the

profitability of a potential investment for a cleaner production
option.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 8

 Elements of CBA

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Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 9

 Elements of CBA

Cash flow
Present value (PV)
Measures of Profitability
Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index
Depreciation

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 Cash Flow

A Cash Flow is meant to illustrate incomes (“cash inflows”) and expenses (“cash
outflows”). They may be conventional and non-conventional. Each arrow represents the
time period of a year in this case.
Conventional Cash Flow
$600 $600 $600 $600 $600
Cash Inflows
0 5
Cash Outflows
$2,000

Non-Conventional Cash Flow

$7,500. . . . . . . . . . . . . . $7,500
Cash Inflows
-2 -1 0 8
Cash Outflows

$12,000 $10,000 $8,000 $3,900 $2,600

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 Present Value (PV)

PV is a way of comparing the value of money now with the value of money in
the future. A dollar today is worth more than a dollar in the future, because
inflation erodes the buying power of the future money, while money available
today can be invested to grow.

Calculation of the PV requires the use of “interest rate”. Interest rate is

typically a percentage used to calculate the PV. It reflects the time value of
money. Generally, this interest rate is taken as equal to the prevailing bank
interest rate.

Assuming an interest rate of 10%, the PV of $100 three years from now is
approximately $133.

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 Payback Period

As the name suggests, the Payback Period is the length of time required to
recover the cost of an investment.

It is calculated with the formula below:

Payback period = $ Invested
$ Return per year

Drawbacks -
The payback period ignores the time value of money
The payback period ignores cash flows after the initial investment has been
recouped

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 13

 Payback Period

If the initial cost of the investment or $ invested = $

20,000 and the net savings or $ return per year = $ 2,200;
then

Payback period = 20,000 / 2,200 = 9.09 years

(say 9.1 years)

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 Net Present Value (NPV)

NPV may be defined as the difference between the total present value of the cash
inflows and the total present value of the cash outflows.

NPV compares the value of the dollar today versus the value of that same dollar in
the future, after taking inflation and returns into account.

If the NPV of a prospective project is positive then it should be accepted (i.e. NPV
> 0)

However, if the NPV of a prospective project is negative, then the project should be
rejected because cash flows are negative (i.e. NPV < 0)

If the NPV of a prospective project is zero then it should probably be rejected as it

generates exactly the return that is expected (i.e. NPV = 0)

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 Net Present Value (NPV)

Let us calculate the NPV from a series of cash flows. The formula is given below.
$100,000 $150,000 $200,000
(positive cash flows)
0 3

$500,000 (negative cash flow)

NPV = -CFo + CF1 + CF2 + CF3 + CFn

(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods (n=3), r = interest rate (say,
10%)

NPV = -500,000 + 100,000 + 150,000 + 200,000 = -$134, 861

(1+0.1)1 (1+0.1)2 (1+0.1)3

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 Internal Rate of Return (IRR)

The IRR method of analyzing a project or option allows one to find the interest rate
that is equivalent to the dollar returns expected from the project or option.

Once you know the IRR, you can compare it to the rates you could earn by investing
your money in other projects or options.

If the IRR is less than the cost of borrowing used to fund the project, the project will
clearly be a money-loser.

However, usually a business owner will insist that in order to be acceptable, a project
must be expected to earn an IRR that is at least several percentage points higher than
the cost of borrowing, to compensate the company for its risk, time, and trouble
associated with the project.

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 Internal Rate of Return (IRR)

As an example of how IRR works, let us say you are looking at a

project costing $7,500 that is expected to return $2,000 per year for
five years, or $10,000 in total. The IRR calculated for the project
would be 10 percent.

If your cost of borrowing for the project is less than 10 percent,

the project may be worthwhile.

If the cost of borrowing is 10 percent or greater, it will not make

sense to do the project (at least from a financial perspective) because,
at best, you will be breaking even.

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 Internal Rate of Return (IRR)

The formula used for calculating the IRR is very similar to the formula
used for calculating the NPV.

The main difference is that in the IRR formula, you must solve for the
interest rate “r”.

0 = -CFo + CF1 + CF2 + CF3 + CFn

(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods, r = interest rate

(to be solved for)

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 Profitability Index (PI)

The PI is the ratio of the PV of future cash inflows by the PV of

cash outflows

PI = PV of cash inflows
PV of cash outflows

If the 0 < PI < 1, the project or option should be rejected

If the PI > 1, the project or option should be accepted

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 20

 Depreciation

Depreciation is defined as the decline in the value of an asset with the

passage of time, due to general wear and tear or obsolescence

Depreciation is a part and parcel of cash flow calculations

Depreciation may be accounted for in the net annual savings of a cleaner

production option

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 21

 Case study #1

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Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 22

 Case Study #1: Financial Analysis of a Cleaner Production Option
in a Bottle Washing Plant

Background

Bottle washing plant BWP utilizes a large quantity of water and caustic soda
for bottle washing and rinsing operations
As a cleaner production option, a certain percentage of the caustic soda is to
be recovered from the resulting caustic solution, through the use of a
membrane filtration (MF) system
The recovered caustic will then be resold at the prevailing market price

Let us examine the financial feasibility of installing the MF system

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 23

 Case Study #1 - Calculations for the Value of
Recoverable Caustic ($ / year)

Table 1:

Volume of Volume of caustic Mass of caustic recovered Value of caustic

caustic (m3) recovered per run* (m3) per year** (kg/m3) recovered per year***
“A” “B” = “A” X 0.65 “C” = “B” X 4 X 25 ($ / year) = “C” X 0.5
210 136.5 13,650 6,825

Data
* The overall caustic recovered from the MF system is 65% by volume
** The number of recovery runs at BWP is 4 times a year and the concentration of caustic by
weight is 2.5% or 25 kg/m3
*** The cost of 1 kg of pure caustic solution is $0.5

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 24

 Case Study #1 – Installation Cost for the MF System

Table 2
System component Cost ($)
Membrane 7,000

Feed pump 800

High pressure pump 1,600

Cartridge and power 400

Permeate tank 200

Pipes, valves, etc. 8,000

Total investment: 18,000

In addition to the initial investment, the manufacturer states that the membrane for the MF
system will need to be replaced once in 3 years. The associated cost for this will work out to be
$7,500. The total life of the MF system is 12 years.

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Case Study #1 - Calculations for the Net Annual Uniform Savings

Net annual uniform savings =

Cost recovered from the sale of caustic annually – annual depreciation
cost of the MF system – annual operating costs

Here, depreciation cost of the MF system (assuming nil salvage value at the
end of the 12 year period = (18,000 – 0) / 12 = $1,500

Also, annual operating costs = cost for power and the cartridge = $400
(from Table 2)

So, net annual uniform savings = 6,825 – 1,500 – 400 = $4,925

(approx.)

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 26

Case Study #1 – Cash Flow Diagram for the Proposed MF System

Cash Inflows (Net annual Uniform Savings)

$4,925…………………………………………………………$4,925
0
12

$18,000 $7,500 $7,500 $7,500

Cash Outflows (Initial Investment and Replacement Cost)

Initial one-time investment = $18,000

Membrane replacement cost (once every 3 years) = $7,500
Net annual uniform savings = $4,925 / year

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 Case Study #1 – Calculation for NPV

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows

12
= 4,925  1 = $33,557
t=1 (1 + 0.1)t

PV of cash outflows
= 18,000 + 7,500 + 7,500 + 7,500 = $31,049
(1+0.1)3 (1+0.1)6 (1+0.1)9

NPV = PV of cash inflows – PV of cash outflows

= $33,557 - $31,049 = $2,508

Since the resultant NPV > 0, the cleaner production option is financially viable.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 28

 Case Study #1 – Calculation for IRR

IRR would need to be solved through iteration:

12
0 = 4,925  1 – 18,000 – 7,500 – 7,500 – 7,500
t=1 (1+r)t (1+r)3 (1+r)6 (1+r)9

Taking r = 12% (i.e. 12/100 = 0.12), Left Hand Side (LHS) = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49

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 Case Study #1 – Solving for the Exact Value of IRR

Taking r = 12% (i.e. 12/100 = 0.12), LHS = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49

Solving for the exact value of IRR through interpolation:

r – 12 = 0 – 664.63
r – 14 -152.49-664.63

IRR = 12.63%

Since the IRR is greater than 10% (i.e. the rate of interest that the money
would earn in the bank, investing in this cleaner production option is
worthwhile.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 30

 Case Study #1 – Calculating the PI

Calculating for the PI:

PI = PV of cash inflows = 33,557 = 1.08

PV of cash outflows 31,049

Since PI > 1, this cleaner production option can be accepted; i.e. it

is financially viable

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 31

 Case study #2

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Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 32

 Case Study #2: A Tweak on Case Study #1 (Pessimistic Scenario)

Background

The background for Case Study #2 stays the same as that for Case Study #1.
However, there will be one change… let us say, that the prevailing market
price of the recovered caustic falls to $0.35 per kg (previously, for Case Study
#1, the said value was $0.5 per kg).
Let us also say that the manufacturer’s claim for membrane replacement does
not hold true, and that the membrane requires replacement once every two
years.

Let us examine the financial feasibility of installing the MF system for

Case Study #2.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 33

 Case Study #2 - Calculations for the Value of Recoverable Caustic
(Pessimistic Scenario)

Table 3:

Volume of Volume of caustic Mass of caustic recovered Value of caustic

caustic (m3) recovered per run* (m3) per year** (kg/m3) recovered per year***
“A” “B” = “A” X 0.65 “C” = “B” X 4 X 25 ($ / year) = “C” X 0.35
210 136.5 13,650 4,778

Data
* The overall caustic recovered from the MF system is 65% by volume
** The number of recovery runs at BWP is 4 times a year and the concentration of caustic by
weight is 2.5% or 25 kg/m3
*** The cost of 1 kg of pure caustic solution is $0.35

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 34

 Case Study #2 - Calculations for the
Net Annual Uniform Savings (Pessimistic Scenario)

Net annual uniform savings =

Cost recovered from the sale of caustic annually – annual depreciation
cost of the MF system – annual operating costs

Here, depreciation cost of the MF system (assuming nil salvage value at the
end of the 12 year period = (18,000–0)/12 = $1,500 (same as Case Study #1)

Also, annual operating costs = cost for power and the cartridge = $400
(from Table 2, same as Case Study #1)

So, net annual uniform savings = 4,778 – 1,500 – 400 = $2,878

(approx.)

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 35

 Case Study #2 – Cash Flow Diagram for
the Proposed MF System (Pessimistic Scenario)

Cash Inflows (Net annual Uniform Savings)

$2,878…………………………………………………………$2,878
0
12

$18,000 $7,500 $7,500 $7,500 $7,500 $7,500

Cash Outflows (Initial Investment and Replacement Cost)

Initial one-time investment = $18,000

Membrane replacement cost (once every 2 years) = $7,500
Net annual uniform savings = $2,878/ year

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 36

 Case Study #2 – Calculation for NPV
(Pessimistic Scenario)

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows

12
= 2,878  1 = $19,610
t=1 (1 + 0.1)t

PV of cash outflows
= 18,000 + 7,500 + 7,500 + 7,500 + 7,500 + 7,500 = $39,945
(1+0.1)2 (1+0.1)4 (1+0.1)6 (1+0.1)8 (1+0.1)10

NPV = PV of cash inflows – PV of cash outflows

= $19,610 - $39,945 = - $20,335 (i.e. negative)

Since the resultant NPV < 0, the cleaner production option is not financially viable.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 37

 Case Study #2 – Calculating the PI
(Pessimistic Scenario)

Calculating for the PI:

PI = PV of cash inflows = 19,610 = 0.49

PV of cash outflows 39,945

Since PI > 1, this cleaner production option cannot be accepted;

i.e. it is not financially viable

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 40

 Other Scenarios

Similarly, it is possible that there may be other pessimistic scenarios

In fact, there could be a permutation-combination of pessimistic scenarios,

depending on the market and in-house conditions

The World Wide Web provides certain tools to calculate the NPV and IRR values

Thus the CBA becomes a very important tool is assessing the financial feasibility of
the cleaner production project / option

Such analysis will help all concerned (CPC, business / enterprise / industry,
financial institution, stakeholders in the option) decide on further steps to be
taken for making a bankable project.

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 41

 Thank you

Presentation 14 – Guidance on Financial Analysis of Cleaner Production Options 42