University of Cape Town

Department of Electrical Engineering

EEE4115F 2021

FINANCIAL EVALUATION OF PROJECTS

1 Introduction
The time-value of money needs to be taken into account in the evaluation of different project
alternatives with different cash flows (investment and income) over the lifetime of the project.
Financial analysis of alternative schemes or alternative equipment should take into account
more than the initial cost. Operating, maintenance, upgrading, reinforcement and other
“lifetime” costs have to be included.

The basis of lifetime costing is the conversion or “discounting” of all future income and
expenditure to the “present value”. The net present value (NPV) of a project is the algebraic
sum of initial costs and discounted future costs and income. A project with a positive NPV is
viable and the project with the highest NPV is the most profitable.

The method of financial analysis is based on the concept that an investor will be indifferent as
to whether he receives R100 now and invests it with a return of 10 % per year or whether he
receives R110 in a year’s time.

Another approach to the financial evaluation of projects is the internal rate of return (IRR),
which is not described here.

2 Calculation of present value (PV)

The price of an item or service in n years’ time is:

C n = C 0 (1 + i) n
where

n is the number of years;

C0 is the price of the item or service today
Cn is the price of the item or service in n years’ time, expressed in current prices,
as if expended today;
i is the inflation rate (per unit per year).

The PV of a once-off future income or expense in year n is given by:

n
1 + i 
PV = Cn   (1)
1 + d 
where

d is the discount rate (per unit per year).

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For example, if the value of i is 0,12 (12 % per year) and the value of d is 0,2 (20 %), then a
once-off payment in two years’ time of R200 is equivalent to receiving a once-off payment of
R174.22 today (the present value):
2
 1 + 0,12 
PV = 200   = R174,22
 1 + 0,2 
The discount rate, also known as the required rate, cut-off rate, target rate or cost of capital, is
the assumed minimum desired rate of return. All expected future once-off cash flows are
discounted to the present by applying the above equation.

The factor r – 1 is called the net discount rate, which should not be confused with the discount
1 + d
rate d. Equation (1) can be simplified by using r = to give:
1 + i
Cn _
n
PV = n
= Cn r (2)
r
The PV of an expense incurred every year (such as a steady annuity - a fixed sum of money
paid to someone each year, rent, or operating cost), that inflates at i per year and is
discounted at rate d, is:

rn _ 1
PV = C a (3)
r n (r _ 1)
where

Ca is the annual cash flow in each of n years, expressed in current prices;

r is the net discount rate (p.u.) + 1.

For example, the PV of a maintenance expense, expressed in current prices of R1 000 per
year in each of the next three years, where the net discount rate is 8 %, can be calculated as:

(1,08 3 _ 1)
PV = R1 000 = R2 577
1,08 3 (1,08 _ 1)
Usually, as in equations (2) and (3), evaluation is simplified by using the net discount rate
instead of separate inflation and discount rates. This assumes that the costs of components
of the cash flow projection do not change in relation to other components in the analysis. If
some prices are changing in relation to other prices (for example if the cost of labour
increases faster than the cost of electronic equipment), the discount and inflation rates have
to be modified. All inflation and discounting can be treated separately, or inflation can be
expressed in relative terms, using the net discount rate. As long as both rates are expressed
in the same way (such as including or excluding general inflation), the resulting PV will be the
same.

The PV should be determined from a stream of costs and benefits expressed in current prices
and discounted at a net discount rate, unless significant differences in the inflation rates of
different components are expected to arise in the period being analysed. A fixed amount
received or paid in n years’ time without taking inflation into account, such as a future
payment defined in a contract, has a PV of:

PV = Cn 1+ d 
_
n

Since the inflation of this component is zero, its analysis in a stream of costs discounted at a
net discount rate must take the inflation rate into account. Therefore, expressed in terms of r
and i, the present value PV is:

1+ i 
_ _
n n
PV = Cn r

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3 Selection of the net discount factor
The calculation of the present value requires the use of a discount rate that reflects the
opportunity cost of capital. In developed countries, where investment risks are relatively low
and capital is readily available, net discount rates of 3 % to 6 % are commonly adopted.
However, developing countries have a scarcity of capital – a key constraint on development in
these countries. Also, investment risks are relatively high, for political and business reasons.
The World Bank recommends a net discount rate of at least 8% to 10% to justify capital
investment projects in developing countries. Higher real rates of return, for example even as
much as 15 %, are recommended where there are serious constraints on the availability of
capital. The electricity supply business has elements of commercial return and a net discount
rate of at least 10% should be used in present value analyses of electricity projects in South
Africa.

The net discount rate is not the real rate of interest (i.e. interest rate minus inflation rate),
although the real interest rate can, for short periods, be similar to the net discount rate. Net
discount rates generally exceed the real interest rate, which itself exceeds zero in stable
economic circumstances.

The net discount rate does not consist of components related separately to interest and risk.
It is a composite indicator of the opportunity cost of capital. Financial risk can be assessed by
a sensitivity analysis, using price changes in costs and benefits and modified projections to
ascertain the range of possible outcomes.

4 Financial and economic analysis

There is a difference between a financial and an economic analysis.

Financial analysis uses existing and projected market prices to evaluate benefits and costs. It
is based on cash flow and is entirely quantitative. Financial analysis is an assessment from
the viewpoint of the purchaser.

Economic analysis adjusts market prices that are distorted by factors such as price control,
taxes or unemployment, to their true value in the economy. The elements of a financial
analysis that are modified in an economic analysis can include unskilled labour, fuel and the
cost of land.

The details of these modifications fall outside the scope of this annex. However, their
relevance is indicated in the following simple example. Where diesel fuel is subsidized,
supply from an unsubsidized network connection may not appear to the user to be
competitive with a diesel-driven supply on a lifetime basis (financial analysis using the market
cost of fuel). However, from an economic analysis, where the cost of fuel without a subsidy is
used, the network supply can be economical for the country. The user would normally
choose the diesel-driven supply, but the choice could be influenced by the application of an
equivalent subsidy for the network alternative.

Economic analysis is important in energy policy formulation, but is less significant for a supply
utility or a consumer constrained to operate according to market prices.

5 Scope of analysis
In the analysis of a major electricity project, it is necessary to take into account
a) the capital investment costs,
b) all energy purchases and sales, and
c) all operating, administrative and maintenance costs
incurred over the lifetime of the project. Unless inconsistent with the application, projects
should be evaluated over 20 years or 25 years, since this is the average economic life of

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distribution equipment. Beyond 25 years, there is generally little significant effect. The NPV
of the project will reflect its financial desirability.

In a more restricted analysis, only the marginal capital investment and incremental cash flows
need be considered. An analysis of this type is illustrated below. If the project is expected to
show a short-term return, it can be assessed by a discounted payback period, instead of
analysis over 20 years.

In evaluating two alternatives that have different conditions at the end of the evaluation
period, it might be necessary to estimate the value of the continued use of the asset. In an
extreme but simple example, the use of entirely consumed materials such as candles,
compared with connection to a network, must be based on the lifetime of the network. If, in
this example, the comparison is made over a shorter period, a value must be assigned to the
remaining value of the network assets. Another situation arises more frequently where a
major investment can be deferred, but not replaced, by a temporary alternative scheme with a
useful life of only two to seven years, after which the same major investment is required. In
this case, the deferred investment should be given a residual value at the end of the
evaluation period, for example 20 % of its current price, to represent its unutilized capacity for
generating further returns.

6 Financial analysis examples

6.1 Analysis of incremental cash flow

6.1.1 Problem

A supply system is being planned. There are two options:

a) to invest R2 million now; or

b) to invest R1,5 million now and R800 000 (in today’s terms) in seven years’ time.
The difference in losses and other performance aspects is negligible and can be ignored.
Which investment option is more attractive if the net discount rate is 8 % per year?

C.6.1.2 Analysis

Eliminate the common costs (the difference between the two investments) so that the options
are reduced to

a) spending R500 000 now, or

b) spending R800 000 in seven years’ time.
The present value of option (b) is: PV = Cn/rn

800 000
= R466 792
(1 + 0,08)7

Therefore, it is attractive to defer the expenditure for seven years.

A sensitivity analysis shows that if the deferred expenditure were to exceed R857 000 (in
today’s terms), the alternative decision would be more attractive. The risk of the expenditure
exceeding the break-even amount needs to be assessed in risk analysis, quite separately
from the financial model.

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6.2 Discounted payback period

6.2.1 Problem

An expenditure of R20 000 now will reduce annual maintenance costs by R4 200 per year.
The simple payback period is 4.76 years. What is the discounted payback period, if the net
discount rate per year is 8 %?

6.2.2 Analysis

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Present cost 4 200 4 200 4 200 4 200 4 200 4 200 4 200

Present value 3 889 3 601 3 334 3 087 2 858 2 647 2 450

Cumulative PV 3 889 7 490 10 824 13 911 16 769 19 416 21 866

Therefore, the discounted payback period is approximately 6,24 years.

This analysis, being a constant annual sum (in present terms), could be treated as an annuity.
Where the annual sum changes, the tabular layout is necessary.

NOTE The relationship (where there is an annuity) between the simple and the discounted payback period,
say y and n respectively, can be derived from equation (C3) and is:

 1 
log  
 1 _ y ( r _ 1) 
 
n=
log r

Therefore, if the cost saving at present-day prices was R2 000, the simple payback period, y, would be ten
years and the discounted payback period would be

 1 
log  
 1 _ 10(1,08_ 1) 
 
n=
log 1,08

= 20,9 y ears

6.3 Cost of transformer losses

6.3.1 Problem

Assume that the maximum load on a transformer in a new installation will increase over five
years and then remain constant for the next fifteen years. What is the value of the losses?

6.3.2 Analysis

The no-load losses will be constant, but the load losses will increase with the load. The cash
flow is modelled in table 1 for a typical distribution transformer. Under the conditions
illustrated, the cost of no-load losses is R7 481/kW and that of load losses is R2 295/kW of
the rated loss. These costs per kilowatt are independent of the rating and losses of the
transformer but depend on the load conditions modelled, in particular the loading and loss
load factors and the tariff for demand and energy.

The loss load factor is the ratio of actual energy in relation to the load losses under typical
loading conditions to the relevant energy losses that would occur if the transformer was fully

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loaded at all times. The loss load factor LLF is empirically related to the load factor LF by the
relation:

LLF = aLF + ( 1_ a) LF 2

where

a typically has a value of between 0,1 and 0,4.

Research is being done on typical loss load factors for distribution. The costs of losses can
be used as capitalization factors in evaluating different transformers.

This type of model can also be used to evaluate the extra losses incurred when a transformer
is overloaded.

Table 1 − Cost of losses of a distribution transformer

Year 1 2 3 4 5 20 TOTALS
Load (p.u.) 0,216 0,4 0,56 0,696 0,8 0,8
Loss load factor 0,23 0,25 0,27 0,29 0,31 0,33
No-load loss (kW) 0,5 0,5 0,5 0,5 0,5 0,5
No-load energy (kWh) 4 380,0 4 380,0 4 380,0 4 380,0 4 380,0 4 380,0
Load loss (kW) 0,11 0,37 0,72 1,11 1,47 1,47
Load energy loss (kWh) 216,21 805,92 1 705,97 2 830,40 3 997,36 4 255,26
No-load costs
Demand 162,00 162,00 162,00 162,00 162,00 162,00
Energy 219,00 219,00 219,00 219,00 219,00 219,00
Total 381,00 381,00 381,00 381,00 381,00 381,00
PV 352,78 326,65 302,45 280,05 259,30 81,74 3 740,71
PV/kW of no load loss 7 481,43

Load costs
Demand 34,77 119,23 233,69 360,99 476,93 476,93
Energy 10,81 40,30 85,30 141,52 199,87 212,76
Total 45,58 159,53 318,99 502,51 676,80 689,69
PV 42,20 136,77 253,23 369,36 460,52 147,97 5 279,92
PV/kW of load loss 2 295,62
NOTE 1 Years 6 to 19 have been calculated but, to save space, they have not been included in the table.
NOTE 2 Factors used in table C.1:
Transformer rating: 160 kVA
No-load loss: 0,5 kW
Rated load loss: 2,3 kW
Demand cost: 324 R/kW per year
Energy cost: 0,05 R/kWh
Net discount rate: 8 % per year
Normal max. loading (p.u.): 0,8

A simplified approach to the cost of transformer losses

The capitalization of the cost of transformer losses estimates the financial value of future
energy losses reflected at the time of purchase of the transformer. The net present value
(NPV) of a transformer is given by:

N = A + Co Po + C1P1

where

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 N is the net present value NPV;
A is the installed cost of the transformer, in rands;
Co, C1 are the capitalized costs of no-load and load losses, per kilowatt of loss, in
rands;
Po, P1 are the no-load and load losses, in kilowatts.

6.4 Losses in a network

6.4.1 Problem

The implementation cost of a particular distribution network was estimated to be R14 560
lower than that of an alternative. The annual repayment on this amount was given as R2 326.

The additional losses related to the lower cost design were estimated to cost R1 815 per year
once the system is fully loaded.

The apparent saving by adopting the lower cost installation is R511 per year. However, if
energy costs increase by 10 % per year, the saving will disappear in year 4. However, the
cost of additional losses in the first three years is only 25 %, 50 % and 75 % because the
system is not yet fully loaded.
Assuming a net discount rate of 9 % and a life of 20 years, which installation is financially
more attractive?

6.4.2 Analysis

The relative cash flow of the more expensive installation is:

Year 0 Year 1 Year 2 Year 3 Years

4 to 20
R R R R R
Investment −14 560
Saving in losses at full load 0 1 815 1 815 1 815 1 815
Saving not realized 0 −1 362 −907 −453 0

The NPV of the losses is the PV of the saving in losses at full load over 20 years minus the
PV of the saving not realized during the early years. The PV of the annuity is:

rn_ 1  1,09 20 _ 1 
Ca = 1 815  
r n (r _ 1) 20
 1,09 (0,09) 

= 1 815  9,128

= 16 568

The PV of the saving not realized because of partial loading is:

_ _ _
, 2
1 362 1,09 907 109 453 1,09 3
_ _ _
= 1 250 763 350
_
= 2 363

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Therefore, the NPV of the whole investment model is:

_ _ _
14 560 + 16 568 2 363 = 355

6.4.3 Conclusions

The financial model indicates that the lower losses of the more expensive installation are
insufficient to justify the higher investment (the NPV is negative). If the system were fully
loaded from the first year, the more expensive system would be advantageous (NPV = R2
008).

Sensitivity analysis assesses the effects of cost variations on the financial decision. For
example, an increase of only 5 % in the value of annual losses of R1 815 per year would
change the NPV to a positive value and the more expensive network would be worthwhile.

6.5 Staging a project

The comparison of alternative schemes with different cash flows requires methods that take
into account the time-value of money. In most cases, payback period methods are mostly
insufficient for accurate analysis. NPV analysis is recommended for the evaluation of
investment projects.

For example, NPV analysis is useful in comparing the costs of a project that could be
implemented in stages. If, at present, a project is carried out in one stage, the NPV of the
project is equal to the actual cost. Alternatively, the project could be carried out in two stages,
with stage 1 costing C1 carried out immediately and stage 2 costing C2 carried out in n years’
time. With a discount rate of d % per year, the NPV is given by:

C2
NPV = C1 +
(1 + d) n
The financially more beneficial option will be the one with the lower NPV.

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