Page 171 - Sustainable On-Site CHP Systems Design, Construction, and Operations

144 T h e Fe a s i b i l i t y S t u d y

A cash flow diagram represents a cash flow table in a diagrammatic manner using
a horizontal line to represent the time periods, upward facing arrows for receipts (positive
cash flows), and downward facing arrows for payments (negative cash flows).

Time Value of Money
The premise of “time value of money” is that, due to escalation (inflation) and potential
interest earnings, the same money received in the future is worth less than that same
money received now. That is, $1000 today is worth more than $1000 in 10 years. There-
fore, an investment that will save $1000 in the initial year is worth more than the same
investment resulting in saving $1000 ten years later. If an 8 percent return on invest-
ment (the discount factor) is available for 10 years, then $1000 in 10 years is worth $463
in today’s dollars (or has a present value of $463). Conversely, if that same $463 was
invested at 8 percent for 10 years the final value will be $1000.

Discount Rate
The discount factor is one of the most important numbers used in life-cycle-cost analysis.
The number used in the discount factor equates future values with present values. That
is, the discount factor is the number used to determine the equivalent present dollar
value given some future dollar value. In general, the discount factor should equal the
long-term cost of money. Higher discount factors will “discount” future values even
more. That is, a greater discount factor will reduce the importance of future costs
(or savings) on the economic analysis.

Interest Rate
Interest rate is the rate paid by a borrower for the use of someone else’s money, or the
return a lender receives for deferring the use of their money to lend it to a borrower. If
the capital to construct a project is borrowed, the interest rate will be paid to the lender.
If the money is diverted from other possible investments or uses, then the interest rate
is the rate of return that could have otherwise been received for investing that money
(e.g., spending the capital to construct the plant versus purchasing a savings bond with
a return on investment of 3 percent).

Equivalence
Equivalence is the concept that allows for the economic comparison of different alterna-
tives by equating dissimilar factors such that the alternatives are compared on a “like-
for-like” basis, such as net present value or equivalent uniform annual cost. Economic
equivalence occurs when two cash flows (or two alternatives) have the same net effect
or monetary value, and therefore, the choice of either one would produce the same
economic outcome. The concept of equivalence can be used in engineering economics
to determine the “break even point” of a particular factor of the analysis. Economic
equivalence is therefore considered independent of the point of view, that is, it should not
matter whether you are looking from the point of view of the lender or the borrower.
Two basic assumptions are made when applying the equivalence concept to eco-
nomic analysis. First, it is assumed that any money not invested in the proposed project
would otherwise be invested at the prevailing interest rates. Secondly, the prevailing
interest rate for all alternatives considered is assumed to be the same.