Basics of Financial Analysis for Engineering Projects
Engineering decisions have a significant impact on the total cost of owning a building: they influence the cost of new constructions and renovations, as well as operation and maintenance expenses in existing facilities. The most challenging decisions are normally those that raise some costs while reducing others; for example, using LED fixtures instead of fluorescent tubes raises the upfront cost of the lighting system, but drastically reduces energy and maintenance expenses in the long run.
If you are involved in engineering design or consulting, financial analysis is one of the most powerful complementary skills you can master. Financial analysis grants engineers and firms some distinctive advantages over competitors who only focus on technical aspects:
- Ability to “speak the same language” as business executives, bankers and investors.
- Adding an extra dimension to engineering analysis: After proposing a technical solution, it can be complemented with an analysis of different purchasing options – upfront payment, financing the project with a loan, leasing equipment, etc.
The benefits offered by an engineering project are strongly determined by the performance characteristics of the proposed system, but the way in which the project is financed also plays an important role.
First Step: Creating a Cash Flow Projection
A cash flow projection is the basis of financial analysis, and it answers the following questions:
- What is the upfront cost of the project?
- What are the net yearly savings?
- Will a loan be used to cover the upfront cost? If so, what are the terms?
- What is the service life of the project?
The approach is slightly different for new constructions and major renovations, compared with existing buildings.
- In the case of new constructions and major renovations there is already a baseline cost to assume, which can’t be avoided. Therefore, any proposed project must be assessed compared to how much it raises or reduces the baseline cost.
- The baseline cost has already been assumed in existing buildings. Therefore, the full project cost is considered in this scenario.
To illustrate this, assume a heat pump with a cost of $1500 is being considered as an alternative to a $900 resistance heater. In a new project the resistance heater represents a baseline cost, so the real upgrade cost is only the price difference of $600. On the other hand, in an existing building the cost of the resistance heater has already been assumed, and the upgrade must be assessed based on the full price of $1500.
In simple terms: you should consider the cost difference for installations that haven’t been built, and the full upgrade cost for existing installations. This is the reason why energy efficiency and renewable energy measures offer a higher return per dollar spent in new projects.
For yearly savings and expenses, the approach is the same in both scenarios: they are compared with the expected baseline cost in new projects, and with the current operating cost in existing buildings.
Return on Investment (ROI)
The return on investment, or ROI, can also by defined best though a question: What percentage of the initial investment does the project yield each year?
ROI(%)= (Net Yearly Savings (USD/year))/(Initial Investment (USD)) x 100%
Return on Equity (ROE) – Alternate Analysis when Debt Financing is Involved
Assume the HVAC systems in the example above was purchased with $500,000 from the client’s capital and with a $1,000,000 loan at a yearly interest rate of 4%. In this case, there is an interest payment of $40,000 for the first year, reducing net savings to $210,000. The ROE would be:
ROE(%)=(Net Savings After Interest (USD/year))/(Client's Equity in Project (USD))=($210,000/year)/$500,000 x100%=42%
Internal Rate of Return (IRR)
The internal rate of return (IRR) can best be described as the interest rate the project would yield if it was a stock portfolio or bank account. Therefore, a project with an IRR of 10% would perform better than an investment yielding 8% interest per year, but would be surpassed by another option yielding 12% per year.
Like the NPV, the IRR is not limited by variable cash flows and loan payments, and can be calculated directly with Microsoft Excel with the following formula:
=IRR (Select all yearly cash flows, including the upfront cost)
Financial analysis can add considerable value to engineering design and consulting services, since the client can rest assured that the proposed solutions make sense from both the technical and financial standpoint. For contractors, it can also be a powerful marketing tool – a client is more likely to carry out a project if the numbers can prove it is a good business decision.