Introduction Poor power quality (PQ) can have a significant economic impact on the operation of many different types of facilities and a wide range of technologies exists for either mitigating the consequences or solving the resulting problems. The financial benefit of these technologies can be evaluated by estimating the improvement in the performance of the production facilities and the resulting cost reduction. In order to take investment decisions, it is crucial to evaluate the economic impact of poor PQ and to compare it to the costs of the various alternative improvement measures. In other words, it is necessary to perform a cost benefit analysis between different solutions. The process of evaluating these investments can be described in four basic steps: Characterise the present system’s power quality (PQ) performance Estimate the costs associated with poor PQ Characterise the different solutions in terms of their cost and effectiveness Perform a comparative economic analysis of the different solutions. This note is intended to give guidance on this process and, in particular, on the use of appropriate economic decision-making tools for comparing the different solutions. The focus will be on the review of different methods for performing comparative investment analysis. For the sake of simplicity, in the following chapters we will refer to investments in technologies for mitigating or solving PQ problems as ‘PQ investments’. Investment analysis Companies have many choices about how to spend capital in order to produce a return on their investment (there are always at least two: invest in a project or put the money into an investment account). Each option, including PQ investments, must compete with other investment opportunities for scarce capital. Therefore, the economic analysis of PQ investments should be conducted in the same way as the analysis of other capital investments, so that all options can be compared on an equal basis. This decision making process is called capital budgeting. A particular problem arises for PQ investment, which is typical for any investment in cost reduction. In the capital budgeting process, some investments are earmarked as ‘strategic’, i.e. they are needed for the survival and growth of the enterprise, and hence receive priority. Another group of investments is required by law; they have little or no return on investment, and the enterprise would never undertake them on economic criteria. Typical examples are investments to reduce environmental impact of operations. Once the needs of strategic and legislative investments have been met, there is usually very little capital budget remaining for cost reduction measures, such as PQ investments. These investments have then to be undertaken by business units, using operating income rather than capital. This results in a very short time perspective, so PQ investments are required to achieve 1-2 year payback, equivalent to a 50-100% return rate, much higher than the average return on assets. Therefore, the scarcity of capital for PQ investments and the requirement to finance from operating income lead to sub-optimum performance, and present an opportunity for third party financing. In this chapter a brief definition of capital budgeting principles and a short review of useful definitions will be given. Costs 1 Capital budgeting The decision whether to accept a project depends on the analysis of the cash flows resulting from the project. A capital budgeting decision process should satisfy the following criteria: It must consider all of the project’s cash flows (including working capital) It must consider the time value of money It must always lead to the correct decision when selecting from mutually exclusive projects over different investment horizons. The entire capital budgeting process relies on precise cash flow estimates and it is very important for the decision maker to obtain the most accurate forecasts possible. In order to do so, he must do two things: Identify all the variables that affect cash flows and determine which of those variables are critical to the success of the project Define the degree of forecasting accuracy required. In the following sections the most relevant capital budgeting decision rules will be presented with a clear distinction between deterministic and stochastic methods. An evaluation method is considered deterministic if each cash flow can be precisely estimated, whilst it will be defined stochastic when cash flows vary over a range and thus introduce a degree of uncertainty. The focus will be on deterministic methods, leaving in-depth coverage of stochastic methods to another section of this Guide. Project classifications When dealing with capital budgeting, projects can be classified as either independent or mutually exclusive. An independent project is a project where cash flows are not affected by the accept-reject decision of any other projects. Thus, all independent projects that meet the company’s capital budgeting criteria should be accepted. Mutually exclusive projects are a set of projects from which only one will be accepted, for example, a set of projects which each accomplish the same goal. Thus, when selecting from mutually exclusive projects, more than one project may satisfy the company’s capital budgeting criteria, however, only one, i.e. the best project, can be accepted. Cost of capital Discounted cash flow methods, described in the following paragraphs, measure cash flow in terms of a required rate of return (hurdle rate) to determine their acceptability. This hurdle rate can be taken as the company’s cost of capital. But how is the cost of capital defined? The company’s cost of capital is the discount rate which should be used in capital budgeting. The weighted average cost of capital (WACC) reflects the company’s cost of obtaining capital to invest in long term assets and is a weighted average of the company’s cost of debt (long-term and short-term) and cost of equity (preferred stock, common stock). In other words, the cost of capital represents the cost of funds used to acquire the total assets of the firm. Generally it refers to the rates of return expected by those parties contributing to the financial structure: preferred and common shareholders, as well as creditors. Thus, it is generally calculated as a weighted average of the costs associated with each type of liability included in the financial structure of the enterprise. With reference to capital budgeting, the concept underlying the definition of the cost of capital is that a company must manage its assets and select capital projects with the goal of obtaining a yield at least sufficient to cover its cost of capital. Financial management separates the investment decision from the financing decision. A company’s financial structure is considered as fixed, and yields a WACC figure.