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Decisions to implement projects, including CHP systems, are made on the basis of financial analyses. These analyses require information from equipment capital and operating costs. Different companies use different financial criteria and different threshold for making their decisions. Some of the commonly used financial criteria are as follows:
Simple payback period for any equipment refers to the time it takes to recover the incremental installed cost/investment for that equipment by the annual savings, expected to be accrued, by its use. Therefore, when choosing between a conventional and a CHP system, one needs to estimate the incremental installed investment for the CHP system and annual operating cost savings expected by its use over that for a conventional system. Simple payback period is calculated by dividing the incremental investment with the annual projected operating cost savings.
For example, if the installed cost and annual operating costs of a conventional system are estimated to be $2,500,000 and $1000,000, respectively and their corresponding operating costs are estimated to be $4,500,000 and $4,000,000, the incremental investment for the CHP systems is $1,500,000 and the annual operating cost savings are $500,000. Therefore, the simple payback period for the CHP system will be three years.
Some argue that the simple payback period is not a fair criterion for evaluating various alternatives because savings in energy costs could continue to accrue through the equipment’s full useful life, which might extend much beyond the payback period. The simple payback period, though easy to calculate, could be misleading for evaluating various options because it neither considers the time-value of money nor does it consider net benefits of a product beyond the payback period.
The installed equipment cost for a CHP system is higher and its operating costs are lower than that for a comparable conventional system. The additional installed cost of the CHP system could be considered as an investment that brings in an additional return on that investment in the form of operating cost savings. This information can be used to calculate return on investment (ROI). The ROI should be at least equal to the prevailing interest rate for commercial loans. Generally, the ROI has to be better than a certain threshold value, usually set by the company making the investment. The absolute value of this threshold will depend on other investment opportunities available with comparable risk.
Life-cycle cost (LCC) of a system is the present value (PV) of all the costs associated with the project over its useful life. Calculations for LCC require the following information:
- Installed Equipment Cost
- Annual Operating Costs
- Useful Life Of The Equipment
- Equipment Replacement Cost
- Rate Of Interest/Cost Of Money
- Energy Cost Escalation
- General Inflation Rate
Installed equipment and annual operating costs (energy costs plus maintenance costs) have been discussed earlier in the section on economic analysis. When calculating LCCs for various alternatives, it is important to compare these costs over the same period of useful life. If one system has a useful life of 20 years and the other has a useful life of 10 years, the cost of replacing (replacement cost) the second system should also be included in the LCC for that system. Present value functions are available in all major spreadsheet programs. Some of the tools discussed later in this section also calculate LCC.
The internal rate of return (IRR), also called the time-adjusted rate of return, is the discount or interest rate that would yield zero present value for a stream of cash flows. In other words, it is the highest interest rate that would yield present value of all future incremental (difference between two alternatives) cash flow streams to equal the incremental installed equipment cost.
Generally, an IRR is considered attractive if it exceeds the company’s cost of capital. However, when evaluating various alternatives, an alternative with the highest IRR is the economically preferred alternative. Calculations for IRR require all of the same information, except interest rate, needed for calculating LCC.
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