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IETC EMWS Russell 2015 V02

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Christopher Russell

This document discusses issues with using simple payback as the sole criterion for evaluating capital projects. It notes that simple payback fails to account for the time value of money and does not consider the overall profitability of projects. The document advocates comparing investment options using internal rate of return to properly account for cash flows over time. It also emphasizes the importance of considering a company's overall financial performance and margins when deciding how to invest capital for maximum returns.

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SIMPLE PAYBACK: Tricks and Traps INDUSTRIAL ENERGY TECHNOLOGY CONFERENCE Energy Managers Workshop June 2015 Christopher Russell Visiting Fellow : American Council for an Energy Efficient Economy : crussell@aceee.org Principal : Energy Pathfinder Management Consulting : info@energypathfinder.com 息2015 Energy PathFINDER.com
Purpose for Today ≒ Business margins ≒ Payback addiction ≒ Coping with a payback habit 2息2015 Energy PathFINDER.com
MANUFACTURING EXAMPLE INCOME STATEMENT (000) Revenue $100,000 100% Cost of goods sold 63,000 Gross pro鍖t 37,000 37% Operating expense 29,300 EBIT* 7,700 7.7% Other income 150 Total income 7,850 Interest expense 960 Pre-tax profit $6,890 Income tax @17.5% 1,208 NOPAT** $5,682 5.6% OPERATING MARGIN: core business activity performance NET MARGIN: performance of capital invested in the business * Earnings before interest & taxes **Net operating profit after tax GROSS MARGIN: product & commodity market performance 3息2015 Energy PathFINDER.com
Business Margins: Performance Indicators ≒ Leveraging the difference between input commodity & product market prices ≒ Operating performance ≒ Equity performance (free cash flow) OPERATING MARGIN: internal opportunities NET MARGIN: return to shareholders GROSS MARGIN: external opportunities 4息2015 Energy PathFINDER.com
Free Cash Flow: Where does it go? 1. Working capital. Inputs for current operations 2. Capital investment. 1. Add production capacity 2. Make existing capacity more efficient 3. Outside investment. Mutual funds, deposits 4. Debt reduction, stock buy-back. 5息2015 Energy PathFINDER.com
$1,300,000 cost (after utility rebate) $380,000 1st-year savings Escalate energy prices 1.5%/yr SPB = COST/ ANNUAL SAVINGS SPB = 3.4 YEARS HURDLE = 2 YRS OR LESS. OUTCOME: REJECT. CAPEX PROJECT Simple Payback? 6息2015 Energy PathFINDER.com
Reject the energy project NOW WHAT will you do? Earnings have to go SOMEWHERE. How do you choose? By what criteria do you choose? 7息2015 Energy PathFINDER.com
INPUT $x REVENUE $x+N Operate 24/7 as long as you cover variable costs Any Profitable Business is a MONEY-MAKING MACHINE 8息2015 Energy PathFINDER.com
$1.00 INPUT $1.083 REVENUE EX: 7.7% operating margin $100,000 in revenue resulting from $92,300 expense input yields $7,700 operating income Based on 2014 financial results 9息2015 Energy PathFINDER.com = 8.3% rate of return on each $1 of inputs $7,700 $92,300
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Pre-Tax Return on Equity (ROE) CONSOLIDATED FINANCIALS INCOME STATEMENT ($000) REVENUE $100,000 COST GDS SOLD 63,000 OPERATING EXP. 29,300 EBIT $7,700 BALANCE SHEET ($000) FIXED ASSETS $76,000 LIABILITIES 25,802 EQUITY $56,648 EBIT REVENUE REVENUE ASSETS ASSETS EQUITY OPERATING MARGIN ASSET TURNOVER FINANCIAL LEVERAGE X X X X $7,700 $100,000 $100,000 $76,000 $76,000 $56,648 X X 8% 1.32 1.34X X = 13.6% PRE-TAX ROE = ROEPRE-TAX Dupont Identity 11息2015 Energy PathFINDER.com
Post-Tax Return on Equity OPERATING MARGIN ASSET TURNOVER FINANCIAL LEVERAGE X X INTEREST BURDEN X TAX BURDEN X CONSOLIDATED FINANCIALS INCOME STATEMENT ($000) REVENUE $100,000 COST OF GOOD SOLD 63,000 OPERATING EXPENSES 29,300 EBIT INTEREST PRE-TAX PROFIT NOPAT* $7,700 $960 $6,890 $5,682 BALANCE SHEET ($000) FIXED ASSETS $76,000 LIABILITIES 25,802 EQUITY $56,648 EBIT REVENUE REVENUE ASSETS ASSETS EQUITYX X X PRE-TAX PROFIT EBIT NOPAT* PRE-TAX PROFIT X $74,600 $100,000 $100,000 $76,000 $76,000 $56,648X X X $6,890 $7,700 $5,682 $6,890 X = 10.0% Post-tax ROE 0.077 1.316 1.342X X X 89.48%82.47% X *NOPAT = Net Operating Profit After Tax = ROE POST TAX 12息2015 Energy PathFINDER.com
PROBLEM: All other investment alternatives measured by RATE OF RETURN. CAPEX PROJECT rejected per 2-YR payback criterion 13 Note for this project: ≒ 29% IRR pre-tax ≒ 13% IRR after tax ≒ 25-yr economic life 息2015 Energy PathFINDER.com
Payback or Rate of Return? Apples to apples 1 PAYBACK YEARS PERCENT RATE OF RETURN = 1 PCT. RATE OF RETURN PAYBACK YEARS= and: 14息2015 Energy PathFINDER.com
0% 20% 40% 60% 80% 100% 120% 0 5 10 15 20 25 30 ONE-YEAR PAYBACK TWO-YEAR PAYBACK THREE-YEAR PAYBACK CAPEX PROJECT PRE-TAX IRR 29% or 3.4YR SPB RETURN ON OPERATIONS 8.3% or 12 YR SPBS&P 500 NDX FUND PRE-TAX 14.1% or 7.1 YR SPB PRE-TAX ROE 13.6% or 7.4 YR SPB CAPEX PROJECT POST-TAX IRR 13% or 7.7 YR SPB NET RETURN ON BUSINESS 5.6% or 17.9 YR SPB DEBT REDUCTION 4% or 25 YR SPB POST-TAX ROE 10% or 10 YR SPB SIMPLE PAYBACK IN YEARS RATEOFRETURN 15
Payback = CAPITAL VELOCITY or the TIME REQUIRED to: Double value of existing assets, post tax & finance Double existing equity investments, post tax Replenish expenditure on inputs Double the value of EXTERNAL investment (S&P 500 NDX) Double the value of incremental CAPEX (our example) Double the value of lent/borrowed capital STATUS QUO: Benchmark for current business returns DEFENSE: Reduce capital drain from debt PROACTIVE: Return on new investment 16息2015 Energy PathFINDER.com 17.9 yrs 10.0 yrs 12.0 yrs 25.0 yrs 7.1 yrs 3.4 yrs
ORDINAL RANKING OF OPTIONS PERCENT RATE OF RETURN SIMPLE PAYBACK (YRS) CAPEX PROJECT pre-tax 29.0% 3.4 S&P 500 FUND pre-tax avg yield10yrs 14.1% 7.1 RETURN ON EQUITY pre-tax 13.6% 7.4 CAPEX PROJECT post-tax 13.0% 7.7 RETURN ON EQUITY post-tax 10.0% 10.0 RETURN ON OPERATIONS 8.3% 12.0 NET BUSINESS RETURNS post tax & 鍖nance 5.6% 17.9 RETURN ON DEBT REDUCTION 4.0% 25.0 17息2015 Energy PathFINDER.com
U.S. INDUSTRY FINANCIAL MARGINS Sampled in January 2015 INDUSTRY n OPERATIONS NET MGN SPB-YRS MGN SPB-YRS Chemicals, specialty 103 14.4% 6.9 10.0% 10.0 Electronics, consumer & o鍖ce 28 7.1% 14.0 3.6% 28.1 Food processing 96 11.9% 8.4 6.9% 14.6 Pharmaceuticals 151 24.6% 4.1 16.0% 6.3 Tobacco 20 40.6% 2.5 22.4% 4.5 Green & renewable energy 26 18.5% 5.4 0.4% 277.8 Utility, general 21 16.0% 6.3 8.7% 11.5 Hospitals & healthcare facilities 56 13.4% 7.5 4.5% 22.2 Insurance, life 25 14.1% 7.1 8.2% 12.2 SOURCE: hjp://pages.stern.nyu.edu/~adamodar/New_Home_Page/data鍖le/margin.html 18息2015 Energy PathFINDER.com
SIMPLE PAYBACK If we MUST use it KNOW HOW TO COMPARE INVESTMENT RESULTS. 19息2015 Energy PathFINDER.com
Christopher Russell @ENERGYpathfndr THANK YOU! Questions? www.energypathfinder.com info@energypathfinder.com 20

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IETC EMWS Russell 2015 V02

  • 1. SIMPLE PAYBACK: Tricks and Traps INDUSTRIAL ENERGY TECHNOLOGY CONFERENCE Energy Managers Workshop June 2015 Christopher Russell Visiting Fellow : American Council for an Energy Efficient Economy : crussell@aceee.org Principal : Energy Pathfinder Management Consulting : info@energypathfinder.com 息2015 Energy PathFINDER.com
  • 2. Purpose for Today ≒ Business margins ≒ Payback addiction ≒ Coping with a payback habit 2息2015 Energy PathFINDER.com
  • 3. MANUFACTURING EXAMPLE INCOME STATEMENT (000) Revenue $100,000 100% Cost of goods sold 63,000 Gross pro鍖t 37,000 37% Operating expense 29,300 EBIT* 7,700 7.7% Other income 150 Total income 7,850 Interest expense 960 Pre-tax profit $6,890 Income tax @17.5% 1,208 NOPAT** $5,682 5.6% OPERATING MARGIN: core business activity performance NET MARGIN: performance of capital invested in the business * Earnings before interest & taxes **Net operating profit after tax GROSS MARGIN: product & commodity market performance 3息2015 Energy PathFINDER.com
  • 4. Business Margins: Performance Indicators ≒ Leveraging the difference between input commodity & product market prices ≒ Operating performance ≒ Equity performance (free cash flow) OPERATING MARGIN: internal opportunities NET MARGIN: return to shareholders GROSS MARGIN: external opportunities 4息2015 Energy PathFINDER.com
  • 5. Free Cash Flow: Where does it go? 1. Working capital. Inputs for current operations 2. Capital investment. 1. Add production capacity 2. Make existing capacity more efficient 3. Outside investment. Mutual funds, deposits 4. Debt reduction, stock buy-back. 5息2015 Energy PathFINDER.com
  • 6. $1,300,000 cost (after utility rebate) $380,000 1st-year savings Escalate energy prices 1.5%/yr SPB = COST/ ANNUAL SAVINGS SPB = 3.4 YEARS HURDLE = 2 YRS OR LESS. OUTCOME: REJECT. CAPEX PROJECT Simple Payback? 6息2015 Energy PathFINDER.com
  • 7. Reject the energy project NOW WHAT will you do? Earnings have to go SOMEWHERE. How do you choose? By what criteria do you choose? 7息2015 Energy PathFINDER.com
  • 8. INPUT $x REVENUE $x+N Operate 24/7 as long as you cover variable costs Any Profitable Business is a MONEY-MAKING MACHINE 8息2015 Energy PathFINDER.com
  • 9. $1.00 INPUT $1.083 REVENUE EX: 7.7% operating margin $100,000 in revenue resulting from $92,300 expense input yields $7,700 operating income Based on 2014 financial results 9息2015 Energy PathFINDER.com = 8.3% rate of return on each $1 of inputs $7,700 $92,300
  • 10. 10
  • 11. Pre-Tax Return on Equity (ROE) CONSOLIDATED FINANCIALS INCOME STATEMENT ($000) REVENUE $100,000 COST GDS SOLD 63,000 OPERATING EXP. 29,300 EBIT $7,700 BALANCE SHEET ($000) FIXED ASSETS $76,000 LIABILITIES 25,802 EQUITY $56,648 EBIT REVENUE REVENUE ASSETS ASSETS EQUITY OPERATING MARGIN ASSET TURNOVER FINANCIAL LEVERAGE X X X X $7,700 $100,000 $100,000 $76,000 $76,000 $56,648 X X 8% 1.32 1.34X X = 13.6% PRE-TAX ROE = ROEPRE-TAX Dupont Identity 11息2015 Energy PathFINDER.com
  • 12. Post-Tax Return on Equity OPERATING MARGIN ASSET TURNOVER FINANCIAL LEVERAGE X X INTEREST BURDEN X TAX BURDEN X CONSOLIDATED FINANCIALS INCOME STATEMENT ($000) REVENUE $100,000 COST OF GOOD SOLD 63,000 OPERATING EXPENSES 29,300 EBIT INTEREST PRE-TAX PROFIT NOPAT* $7,700 $960 $6,890 $5,682 BALANCE SHEET ($000) FIXED ASSETS $76,000 LIABILITIES 25,802 EQUITY $56,648 EBIT REVENUE REVENUE ASSETS ASSETS EQUITYX X X PRE-TAX PROFIT EBIT NOPAT* PRE-TAX PROFIT X $74,600 $100,000 $100,000 $76,000 $76,000 $56,648X X X $6,890 $7,700 $5,682 $6,890 X = 10.0% Post-tax ROE 0.077 1.316 1.342X X X 89.48%82.47% X *NOPAT = Net Operating Profit After Tax = ROE POST TAX 12息2015 Energy PathFINDER.com
  • 13. PROBLEM: All other investment alternatives measured by RATE OF RETURN. CAPEX PROJECT rejected per 2-YR payback criterion 13 Note for this project: ≒ 29% IRR pre-tax ≒ 13% IRR after tax ≒ 25-yr economic life 息2015 Energy PathFINDER.com
  • 14. Payback or Rate of Return? Apples to apples 1 PAYBACK YEARS PERCENT RATE OF RETURN = 1 PCT. RATE OF RETURN PAYBACK YEARS= and: 14息2015 Energy PathFINDER.com
  • 15. 0% 20% 40% 60% 80% 100% 120% 0 5 10 15 20 25 30 ONE-YEAR PAYBACK TWO-YEAR PAYBACK THREE-YEAR PAYBACK CAPEX PROJECT PRE-TAX IRR 29% or 3.4YR SPB RETURN ON OPERATIONS 8.3% or 12 YR SPBS&P 500 NDX FUND PRE-TAX 14.1% or 7.1 YR SPB PRE-TAX ROE 13.6% or 7.4 YR SPB CAPEX PROJECT POST-TAX IRR 13% or 7.7 YR SPB NET RETURN ON BUSINESS 5.6% or 17.9 YR SPB DEBT REDUCTION 4% or 25 YR SPB POST-TAX ROE 10% or 10 YR SPB SIMPLE PAYBACK IN YEARS RATEOFRETURN 15
  • 16. Payback = CAPITAL VELOCITY or the TIME REQUIRED to: Double value of existing assets, post tax & finance Double existing equity investments, post tax Replenish expenditure on inputs Double the value of EXTERNAL investment (S&P 500 NDX) Double the value of incremental CAPEX (our example) Double the value of lent/borrowed capital STATUS QUO: Benchmark for current business returns DEFENSE: Reduce capital drain from debt PROACTIVE: Return on new investment 16息2015 Energy PathFINDER.com 17.9 yrs 10.0 yrs 12.0 yrs 25.0 yrs 7.1 yrs 3.4 yrs
  • 17. ORDINAL RANKING OF OPTIONS PERCENT RATE OF RETURN SIMPLE PAYBACK (YRS) CAPEX PROJECT pre-tax 29.0% 3.4 S&P 500 FUND pre-tax avg yield10yrs 14.1% 7.1 RETURN ON EQUITY pre-tax 13.6% 7.4 CAPEX PROJECT post-tax 13.0% 7.7 RETURN ON EQUITY post-tax 10.0% 10.0 RETURN ON OPERATIONS 8.3% 12.0 NET BUSINESS RETURNS post tax & 鍖nance 5.6% 17.9 RETURN ON DEBT REDUCTION 4.0% 25.0 17息2015 Energy PathFINDER.com
  • 18. U.S. INDUSTRY FINANCIAL MARGINS Sampled in January 2015 INDUSTRY n OPERATIONS NET MGN SPB-YRS MGN SPB-YRS Chemicals, specialty 103 14.4% 6.9 10.0% 10.0 Electronics, consumer & o鍖ce 28 7.1% 14.0 3.6% 28.1 Food processing 96 11.9% 8.4 6.9% 14.6 Pharmaceuticals 151 24.6% 4.1 16.0% 6.3 Tobacco 20 40.6% 2.5 22.4% 4.5 Green & renewable energy 26 18.5% 5.4 0.4% 277.8 Utility, general 21 16.0% 6.3 8.7% 11.5 Hospitals & healthcare facilities 56 13.4% 7.5 4.5% 22.2 Insurance, life 25 14.1% 7.1 8.2% 12.2 SOURCE: hjp://pages.stern.nyu.edu/~adamodar/New_Home_Page/data鍖le/margin.html 18息2015 Energy PathFINDER.com
  • 19. SIMPLE PAYBACK If we MUST use it KNOW HOW TO COMPARE INVESTMENT RESULTS. 19息2015 Energy PathFINDER.com