Introduction to Financial Figures of Merit

An investor, energy policy analyst, or developer may use a variety of figures of merit to evaluate the financia l attractiveness of a power project. The choice often depends on the purpose of the analysis. However, most begin with estimates of the project's capital cost, projected power output, and annual revenues, expenses, and deductions. A pro forma earnings statement, debt redemption schedule, and statement of after-tax cash flows are typically also prepared. Annual after-tax cash flows are then compared to initial equity investment to determine available return. For anothe r perspective, before-tax, no-debt cash flows may also be calculated and compared to the project's total cost. The four primary figures of merit are:

Net Present Value: Net Present Value (NPV) is the sum of all years' discounted after-tax cash flows. The NPV method is a valuable indicator because it recognizes the time value of money. Projects whose returns show positive NPVs are attractive.

Internal Rate of Return: Internal rate of return (IRR) is defined as the discount rate at which the after-tax NPV is zero. The calculated IRR is examined to determine if it exceeds a minimally acceptable return, often called th e hurdle rate. The advantage of IRR is that, unlike NPV, its percentage results allow projects of vastly different sizes to be easily compared.

Cost of Energy: To calculate a levelized cost of energy (COE), the revenue stream of an energy project i s discounted using a standard rate (or possibly the project's IRR) to yield an NPV. This NPV is levelized to a n annual payment and then divided by the project's annual energy output to yield a value in cents per kWh. The COE is often used by energy policy analysts and project evaluators to develop first-order assessments of a project's attractiveness. The levelized COE defines the stream of revenues that minimally meets the requirements for equity return and minimum debt coverage ratio. Traditional utility revenue requirement analyses are cost-based, ie. , allowed costs, expenses, and returns are added to find a stream of revenues that meet the return criteria. Market-based Independent Power Producer (IPP) and Generating Company (GenCo) analyses require trial-and-error testing to find the revenues that meet debt coverage and equity return standards, but their COE s likewise provide useful information.

Payback Period: A payback calculation compares revenues with costs and determines the length of time require d to recoup the initial investment. A Simple Payback Period is often calculated without regard to the time value o f money. This figure of merit is frequently used to analyze retrofit opportunities offering incremental benefits an d end-user applications.

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