You have learnt how to estimate the project investment required for the scheme selected. In this section we consider the concerns of the appraising authority, i.e., financing institutions. You must appreciate that for Indian Utilities,approaching the financing institutions for funding the power distribution networks is a new phenomenon. So far many networks were maintained/expanded based on customer demand. Therefore it is essential to begin with the simplest way of convincing the financing institutions though there are many proven appraisal methods to ascertain worthiness of the project for funding.
We choose a suitable techno-economic parameter to apply, i.e., payback period (PBP) as the one for this purpose. There are various other measures of assessing techno-economic viability of any project ranging from the humble payback period to sophisticated discounted cash flow (DCF) technique based parameters like net present value (NPV) and internal rate of return (IRR), etc.We give below the reasons for choosing the payback period as the parameter for DPR preparation in the power distribution sector (Box).
Box : Reasons for Choosing Payback Period
1. It is a quickly applicable parameter and easily understandable by the appraisal authority.
2. The workforce involved in executing the project is hard-core technical.Thus a simple-to-digest financial concept and the simplicity of payback are best suited for this purpose.
3. The sophisticated DCF based technique has an essential pre-requisite of assessing the “almost correct” economic life of the group of assets being installed under the project. Now you know the typical nature of power distribution projects in which new assets are blended with old assets, and also the over strenuous nature of work cycle that Indian T&D networks are subjected to. You will agree that it is difficult to assess the economic life of the projects with a fair degree of accuracy.
Moreover, assuming anything based on bookish concepts will amount to serious oversimplification of facts and lead to misjudgements of techno-economic viability.To sum-up, the simplicity and easy understandability on the one hand and bottlenecks in exploring certain necessary inputs for other techniques makes payback period as the best option for our analysis in power distribution sector.How do we calculate the payback period? Let us begin with the copybook definition (Box) .
Box : Payback Period as Defined
“Payback period is the length of time required by the cumulative net cash in-flows to cover-up the fixed capital investments”.
The commoner’s concept of payback goes something like this Payback period = Total capital investment Total cash inflows / year
Although, many a times the payback calculated through the above relationship resembles quite closely the correctly calculated one, nevertheless, these are mere coincidences owing to typical financial environment of the project and may lead to serious errors in cases where financial terms are a bit complicated.
Box : Lacunae in Copybook PBP Definition
a) The “total capital investment” in the above definition may be construed as a combination of fixed capital and working capital.Although the power distribution projects are typically field augmentation schemes, the role of working capital is insignificant.However, it is important to know for clarity of concepts that payback deals exclusively with “fixed capital” and not the working capital which is recoverable at the end of project life theoretically.
b) The fixed investments are often misunderstood as sum of purchase cost of assets and erection costs thereof and overlook other aspects of project cost leading to underestimation of costs.
c) Total benefits are normally not subjected to corrections for financial costs and taxes. There were historical reasons for it since so far money was to come from the Government having practically no costs to it; the Utilities continuing under spiralling losses were never tax paying entities. But now it would be necessary to account for these aspects as the new investments would be expected to be based on sound economic fundamentals conforming to a viable business model. Becoming viable and profitable would be a necessity for utilities rather than coincidence. Therefore, benefits have to be computed with due considerations to these aspects.So, corrections overcoming these lacunae in copybook PBP definition have to be made. The desired formula for payback period is given in Box.
Box : Desired PBP formula PBP = Total fixed capital expenses Net benefits / yr
Gross Benefits
The detailed account of components of benefits by way of annual kWh saved due to implementation of particular scheme under considerations has to be ascertained. These annual units saved are converted to monetary values by multiplying with net tariff that the board charges to the customers. This benefit so calculated is the gross benefit and has to be adjusted for interest and tax
liabilities in the process of calculating the payback period.
We explain the calculation of PBP in Box .
Box : Calculation of Payback Period
In order to calculate the net benefits, the interest burden every year is required to be calculated as follows:
(Interest) n = (Outstanding Debt) n x Rate of Interest
where n = the year of calculation
Outstanding debt = (Previous year outstanding debt) – (current year repayments of loan)
The interest so calculated is deducted from gross benefits to give the “taxable benefits”. These are again deducted for tax liabilities at the applicable tax rate to give net benefits:(Net benefit) =
[Gross benefit – (Interest)] x (1 – tax rate in %)
The net benefits so arrived at are cumulated and compared till the time they total-up to match the “total fixed cost”. The number of such years taken for the cumulative net benefits to exactly match the total fixed cost is the payback period:
PBP= Total fixed costs PBP/n Σ (net benefits) n =1
Graphically, this process is depicted in Fig.
We choose a suitable techno-economic parameter to apply, i.e., payback period (PBP) as the one for this purpose. There are various other measures of assessing techno-economic viability of any project ranging from the humble payback period to sophisticated discounted cash flow (DCF) technique based parameters like net present value (NPV) and internal rate of return (IRR), etc.We give below the reasons for choosing the payback period as the parameter for DPR preparation in the power distribution sector (Box).
Box : Reasons for Choosing Payback Period
1. It is a quickly applicable parameter and easily understandable by the appraisal authority.
2. The workforce involved in executing the project is hard-core technical.Thus a simple-to-digest financial concept and the simplicity of payback are best suited for this purpose.
3. The sophisticated DCF based technique has an essential pre-requisite of assessing the “almost correct” economic life of the group of assets being installed under the project. Now you know the typical nature of power distribution projects in which new assets are blended with old assets, and also the over strenuous nature of work cycle that Indian T&D networks are subjected to. You will agree that it is difficult to assess the economic life of the projects with a fair degree of accuracy.
Moreover, assuming anything based on bookish concepts will amount to serious oversimplification of facts and lead to misjudgements of techno-economic viability.To sum-up, the simplicity and easy understandability on the one hand and bottlenecks in exploring certain necessary inputs for other techniques makes payback period as the best option for our analysis in power distribution sector.How do we calculate the payback period? Let us begin with the copybook definition (Box) .
Box : Payback Period as Defined
“Payback period is the length of time required by the cumulative net cash in-flows to cover-up the fixed capital investments”.
The commoner’s concept of payback goes something like this Payback period = Total capital investment Total cash inflows / year
Although, many a times the payback calculated through the above relationship resembles quite closely the correctly calculated one, nevertheless, these are mere coincidences owing to typical financial environment of the project and may lead to serious errors in cases where financial terms are a bit complicated.
Box : Lacunae in Copybook PBP Definition
a) The “total capital investment” in the above definition may be construed as a combination of fixed capital and working capital.Although the power distribution projects are typically field augmentation schemes, the role of working capital is insignificant.However, it is important to know for clarity of concepts that payback deals exclusively with “fixed capital” and not the working capital which is recoverable at the end of project life theoretically.
b) The fixed investments are often misunderstood as sum of purchase cost of assets and erection costs thereof and overlook other aspects of project cost leading to underestimation of costs.
c) Total benefits are normally not subjected to corrections for financial costs and taxes. There were historical reasons for it since so far money was to come from the Government having practically no costs to it; the Utilities continuing under spiralling losses were never tax paying entities. But now it would be necessary to account for these aspects as the new investments would be expected to be based on sound economic fundamentals conforming to a viable business model. Becoming viable and profitable would be a necessity for utilities rather than coincidence. Therefore, benefits have to be computed with due considerations to these aspects.So, corrections overcoming these lacunae in copybook PBP definition have to be made. The desired formula for payback period is given in Box.
Box : Desired PBP formula PBP = Total fixed capital expenses Net benefits / yr
Gross Benefits
The detailed account of components of benefits by way of annual kWh saved due to implementation of particular scheme under considerations has to be ascertained. These annual units saved are converted to monetary values by multiplying with net tariff that the board charges to the customers. This benefit so calculated is the gross benefit and has to be adjusted for interest and tax
liabilities in the process of calculating the payback period.
We explain the calculation of PBP in Box .
Box : Calculation of Payback Period
In order to calculate the net benefits, the interest burden every year is required to be calculated as follows:
(Interest) n = (Outstanding Debt) n x Rate of Interest
where n = the year of calculation
Outstanding debt = (Previous year outstanding debt) – (current year repayments of loan)
The interest so calculated is deducted from gross benefits to give the “taxable benefits”. These are again deducted for tax liabilities at the applicable tax rate to give net benefits:(Net benefit) =
[Gross benefit – (Interest)] x (1 – tax rate in %)
The net benefits so arrived at are cumulated and compared till the time they total-up to match the “total fixed cost”. The number of such years taken for the cumulative net benefits to exactly match the total fixed cost is the payback period:
PBP= Total fixed costs PBP/n Σ (net benefits) n =1
Graphically, this process is depicted in Fig.
 |
| Calculating Payback Period |
The Cut-off
Having calculated the payback, it is time to compare it with the target or benchmark payback as decided by approving/sanctioning authorities (Fig.)
Having calculated the payback, it is time to compare it with the target or benchmark payback as decided by approving/sanctioning authorities (Fig.)
 |
| Comparison with Benchmark Payback |
This is how the total payback computation cycle works.
Based on this exercise the schemes may have to be suitably optimized
to come to acceptable levels of payback period that is normally less than five years or so, beyond which would require extraordinary justifications for funding the DPR on bankable terms.In DPR models explained above, most concepts may sound quite complex. In the years to come, all the stakeholders have to get into the performance net in the regulatory regime. The skill and competency lies in drawing up the “DPR Specifications” with clarity about equipment quality, timely delivery, system performance and its bankability.
to come to acceptable levels of payback period that is normally less than five years or so, beyond which would require extraordinary justifications for funding the DPR on bankable terms.In DPR models explained above, most concepts may sound quite complex. In the years to come, all the stakeholders have to get into the performance net in the regulatory regime. The skill and competency lies in drawing up the “DPR Specifications” with clarity about equipment quality, timely delivery, system performance and its bankability.
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