Basics of Financial Analysis for Engineering Projects
Engineering decisions have a significant impact on the total cost of ownership of a building: they influence the cost of new construction and renovations, as well as operation and maintenance expenses at existing facilities. The most challenging decisions are typically those that increase some costs and reduce others; for example, using LED fixtures instead of fluorescent bulbs increases the initial cost of the lighting system but drastically reduces long-term energy and maintenance expenses.
If you're involved in engineering or consulting projects, financial analysis is one of the most powerful complementary skills you can master. Financial analysis grants engineers and companies some distinct advantages over competitors who focus solely on technical aspects:
- Ability to “speak the same language” as business executives, bankers and investors.
- Add an extra dimension to the engineering analysis: Once a technical solution has been proposed, it can be complemented with an analysis of different purchase options – cash payment, project financing with a loan, equipment rental, etc.
The benefits offered by an engineering project are strongly determined by the performance characteristics of the proposed system, but the way 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 answers the following questions:
- What is the initial cost of the project?
- What are the net annual savings?
- Will a loan be used to cover the initial cost? If so, what are the terms?
- What is the useful life of the project?
The approach is slightly different for new construction and major renovations compared to existing buildings.
- In the case of new construction and major renovations there is already a basic cost to be assumed, which cannot be avoided. Therefore, any proposed project must be evaluated against how much it increases or reduces the base cost.
- The base cost has already been assumed in existing buildings. Therefore, the total cost of the project is considered in this scenario.
To illustrate this, suppose a heat pump costing $1,500 is being considered as an alternative to a $900 resistance heater. In a new design, the resistance heater represents a base cost, so the cost The actual upgrade cost is only the $600 price difference. On the other hand, in an existing building the cost of the resistance heater has already been assumed, and the upgrade must be evaluated based on the total price of $1500. Likewise, when planning financial strategies for savings, it is vital to examine all aspects of potential investments, such as through GreenState Union's certified account, which offers competitive CD rates and benefits in streamlining your personal or business financial management.
In simple terms: you must consider the difference in cost for facilities that have not been built and the total cost of upgrading for existing facilities. This is why energy efficiency and renewable energy measures offer a higher return per dollar spent on new projects.
For annual savings and expenses, the approach is the same in both scenarios: they are compared to the expected base cost in new projects and the current operating cost in existing buildings.
Return on Investment (ROI)
Return on investment, or ROI, can also be best defined by asking a question: What percentage of the initial investment does the project yield each year?
ROI (%) = (Annual Net Savings (USD/year))/(Initial Investment (USD)) x 100%
Return on Equity (ROE) – Alternative Analysis When Debt Financing Is Involved
Assume the HVAC systems in the example above were purchased with $500,000 of customer equity and a $1,000,000 loan at a 4% annual interest rate. In this case, there is an interest payment of $40,000 in the first year, reducing the net savings to $210,000. The ROE would be:
ROE(%)=(Net savings after interest (USD/year))/(Client equity in the 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 earn if it were a stock portfolio or a bank account. Therefore, a project with a 10% IRR would outperform an investment that yields 8% interest per year, but would be outperformed by another option that yields 12% per year.
Like NPV, 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 annual cash flows including initial cost)
Final Observations
Financial analysis can add considerable value to engineering and consultancy project services, as the client can be sure that the proposed solutions make sense from both a technical and financial point of view. For contractors, it can also be a powerful marketing tool – a client is more likely to undertake a project if the numbers can prove it was a good business decision.
