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Many attractive investment projects – for instance in energy efficiency – are not carried out for various reasons (lack of capital, information, manpower…). Companies find it difficult to come up with a well-informed, satisfactory answer to the essential question: which projects are the most profitable in the long-term? What they need is a practical working method that is straightforward to use and produces reliable investment guidance. Life cycle costing is just such a method. Life cycle costing (LCC) compares project cost estimates over the lifetime of a project. This application note shows how you can perform a rational LCC analysis by following a simple, 6-step procedure. The procedure uses common spreadsheet tools, so it’s time-efficient, and it teaches you how to derive numbers from a limited set of input variables, numbers that are good enough to make an informed decision.

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Many attractive investment projects – for instance in energy efficiency – are not carried out for various reasons (lack of capital, information, manpower…). Companies find it difficult to come up with a well-informed, satisfactory answer to the essential question: which projects are the most profitable in the long-term? What they need is a practical working method that is straightforward to use and produces reliable investment guidance. Life cycle costing is just such a method. Life cycle costing (LCC) compares project cost estimates over the lifetime of a project. This application note shows how you can perform a rational LCC analysis by following a simple, 6-step procedure. The procedure uses common spreadsheet tools, so it’s time-efficient, and it teaches you how to derive numbers from a limited set of input variables, numbers that are good enough to make an informed decision.

- 1. APPLICATION NOTE LIFE CYCLE COSTING – THE BASICS Forte June 2015 ECI Publication No Cu0146 Available from www.leonardo-energy.org
- 2. Publication No Cu0146 Issue Date: June 2015 Page i Document Issue Control Sheet Document Title: Application Note – Life Cycle Costing – The Basics Publication No: Cu0146 Issue: 03 Release: Public Author(s): Forte Reviewer(s): Bruno De Wachter, Hans De Keulenaer Document History Issue Date Purpose 1 July 2004 Initial publication of a paper on Investment Analysis for Power Quality Solutions 2 February 2012 Complete rewrite into a broader introductory paper on Life Cycle Costing 3 June 2015 Publication of an adapted version after review Disclaimer While this publication has been prepared with care, European Copper Institute and other contributors provide no warranty with regards to the content and shall not be liable for any direct, incidental or consequential damages that may result from the use of the information or the data contained. Copyright© European Copper Institute. Reproduction is authorised providing the material is unabridged and the source is acknowledged.
- 3. Publication No Cu0146 Issue Date: June 2015 Page ii CONTENTS Summary ........................................................................................................................................................ 1 Introduction.................................................................................................................................................... 2 Step 1 – Define the Scope of the Analysis ....................................................................................................... 4 Objectives ...............................................................................................................................................................4 Time Horizon ..........................................................................................................................................................5 System Boundaries .................................................................................................................................................5 Step 2 – Identify Relevant Cost Components .................................................................................................. 6 Step 3 – Gather Data and Derive Cost Estimates............................................................................................. 7 Make a First Rough LCC Estimate ...........................................................................................................................7 Identify Your Available Information Sources..........................................................................................................7 Choose an Appropriate Cost Estimation Method for Each Cost Component.........................................................8 Start to Calculate Costs...........................................................................................................................................9 Step 4 – Calculate Key Financial Indicators ................................................................................................... 11 Choosing your Discount Rate................................................................................................................................11 Net Present Value (NPV).......................................................................................................................................13 Discounted Payback Time (DPBT).........................................................................................................................14 Internal Rate of Return (IRR) ................................................................................................................................14 Conclusion and Solution to the Exercise ....................................................................................................... 17
- 4. Publication No Cu0146 Issue Date: June 2015 Page 1 SUMMARY Many attractive investment projects – for instance in energy efficiency – are not carried out for various reasons (lack of capital, information, manpower…). Companies find it difficult to come up with a well- informed, satisfactory answer to the essential question: which projects are the most profitable in the long- term? What they need is a practical working method that is straightforward to use and produces reliable investment guidance. Life Cycle Costing is just such a method. Life Cycle Costing (LCC) compares project cost estimates over the lifetime of a project. This Application Note shows how you can perform a rational LCC analysis by following a simple, 6-step procedure. The procedure uses common spreadsheet tools, so it’s time-efficient, and it teaches you how to derive numbers from a limited set of input variables, numbers that are good enough to make an informed decision. While this generic method can be used for any investment decision, in this application note we will focus on energy efficiency projects in particular.
- 5. Publication No Cu0146 Issue Date: June 2015 Page 2 INTRODUCTION Energy Efficiency Projects are often described as the ‘low-hanging fruit’ for reducing greenhouse gas emissions because, on top of their obvious environmental benefits, they are in many cases profitable without additional financial incentives. A lot of this ready-to-pick but easily-overlooked fruit is not being harvested because of various market and technical barriers. This Application Note focuses on Life Cycle Costing (LCC), a method that allows you to objectively compare various investment opportunities over their technical or economic lifetime. An LCC analysis enables you to come up with a well-informed, satisfactory answer to the essential question: which projects are the most profitable from a long-term perspective? Life Cycle Costing (LCC) is a generic method that enables comparative cost assessments over a project’s lifetime. LCC has widespread applications, but we will focus on the financial evaluation of energy efficiency projects in particular. The word ‘life cycle’ refers to the total time period between the acquisition of an asset and the moment that it is either fully depreciated (economic or accounting lifetime), or discarded as waste or sold on the second-hand market (technical lifetime). A widely-used metaphor to explain the essence of LCC is the ‘iceberg phenomenon’, depicted in Figure 1. At the moment of purchase, the decision maker, seated in the boat, has a clear view of only that part of the iceberg above the water surface, which merely represents the initial capital investment. Typically, when a product consumes energy and requires maintenance, the capical cost represents only a small fraction of the life cycle cost. Moreover, small savings on capital costs can lead to dramatic increases in operating costs, and hence become very expensive from a life cycle perspective. Figure 1 – The iceberg phenomenon, a commonly-used metaphor to explain the essence of LCC. Reliable decision-making doesn’t always need technical expertise and specialized financial models. In most cases, the use of widely available spreadsheet tools can suffice. This guide enables you to perform an LCC analysis in a time-efficient way. It teaches you how to derive numbers that are good enough for making an informed decision, starting from a limited set of input variables. For many projects in many companies, this is still a considerable improvement in the prevailing decision-making process. Academics around the world are puzzled by the limited uptake of LCC or related concepts such as Total Cost of Ownership (TCO) in industrial practice. Estimates indicate that only 3 to 25% of all companies apply these techniques and this regrettable situation does not arise from the complexity of LCC analysis. The following 6-step procedure will help you analyze the financial viability of your projects: 1. Define the scope of the analysis 2. Identify relevant cost components 3. Gather data and derive cost estimates 4. Calculate Key Financial Indicators 5. Perform a risk and uncertainty analysis 6. Take the best decision
- 6. Publication No Cu0146 Issue Date: June 2015 Page 3 The first four steps will be explained in this Application Note, at the end of which you’ll be able to perform a deterministic LCC analysis. Deterministic means that, at this point, we’ll assume your inputs are 100% certain and invariable. Therefore, the result of a deterministic LCC analysis will be one single number. Obviously, in the case of energy efficiency investments, inputs are seldom this straightforward. Many of the input parameters in your model will be quite uncertain and/or variable, like energy prices, maintenance expenses or usage intensity, to name but a few. Therefore, all specialists highly recommend including a risk and uncertainty analysis in each LCC analysis. This requires a stochastic LCC approach, which forms the subject of a separate Application Note (Advanced Life Cycle Costing – Dealing with Uncertainty and Variability). But let’s start with the basics; the first four steps in the procedure. Throughout this tutorial we will work with a realistic example that will allow us to illustrate each of the steps, introduced in the text box below. INTRODUCTION OF THE RUNNING EXAMPLE: Leonard works for a medium-sized petrochemical company, ABC Inc., and has read that pumping systems account for over 50% of the annual electricity bill of his employer. He considers replacing ABC’s current pump with an estimated 10 years of lifetime remaining with a state-of-the-art system with Variable Frequency Drive (VFD). He can choose between two alternatives, A and B, with the following characteristics: CURRENT PUMP ALTERNATIVE A ALTERNATIVE B Remaining lifetime 10 years 15 years 20 years Investment €0 €19,000 €35,000 Annual maintenance cost €4,800 (+50% after year 5) €5,200 (+50% after year 5) €4,000 Full motor power 13 kW 12 kW 10.3 kW Motor efficiency 75.5% 91% 96% Estimated yearly availability 98.7 % 99.5 % 99.93 % Annual training expenses €480 €500 €520 Annual operational expenses 1 operator supervises 20 pumps 1 operator supervises 20 pumps 1 operator supervises 20 pumps Salvage value at the end of the lifetime €500 €500 €500 Table 1 – Characteristics of the three alternatives. Which decision should Leonard take? Should he keep the old system running or replace it with alternative A or B?
- 7. Publication No Cu0146 Issue Date: June 2015 Page 4 STEP 1 – DEFINE THE SCOPE OF THE ANALYSIS Any analysis should start with a definition of its scope: what are you trying to achieve and in which context? The scope of an LCC analysis should include its objectives (What do you want to determine? 0), the time horizon (Just how long is your long-term perspective? 0) and the system boundaries (On which assumptions does your analysis rest? 0). Let’s discuss these three elements one by one and apply the guidelines on the running example. OBJECTIVES Life Cycle Costing (LCC) or any cost analysis can be made for two reasons. One possible objective is to determine accurate financial forecasts or comprehensive cost estimates for accounting purposes. In that case, we need an accounting model, including all possible cost factors that contribute to the total economic impact of the product or project under consideration. A second possible objective, and the most common one in the context of Energy Efficiency Projects, is to facilitate a particular decision. Such ad hoc models do not take all cost factors into account, but only those that are different between the alternatives under consideration. Once the decision for an ad hoc rather than an accounting LCC model is made, you should identify a set of mutually exclusive alternatives and your decision criterion. The alternatives are, for example, different systems that can be purchased from different suppliers. Or maybe upgrading or retrofitting an existing installation. Often, one of the alternatives is to do nothing: it’s ‘business as usual’. This is known as the ‘base case scenario’. In the running example, this means not investing in option A or B but keeping the old pump running for another ten years. With the alternatives defined, you should state explicitly the single criterion that will allow you to identify the best option. For LCC analysis, ‘minimum total cost’ is the most common criterion. But in other cases – where LCC analysis is not appropriate – other criteria can be considered, such as: maximum availability, maximum quality or minimum environmental impact. The techniques in this Application Note can be applied to two criteria, namely ‘minimum total cost’ or ‘maximum profit’. However, in the latter case your model should include both life cycle costs and life cycle revenues (which can be done by inserting negative and positive cash flows in your cash flow model, cf. section 0). EXAMPLE: In Leonard’s case, an ad hoc LCC model can suffice. He doesn’t need cost estimates that can be used in his company’s accounting system; he needs information to underpin his choice for one of three available alternatives: 1. Keep the current pump working for 10 years (base case scenario) 2. Purchase system A 3. Purchase system B Leonard decides to choose the lowest total cost option from these three alternatives. Although he has firmly stated the objective of his LCC model, Leonard is still in doubt. The old pump will need to be replaced after 10 years, so maybe he should split the base case scenario into two alternatives: replacing the old pump in 10 years with system A or by system B? Will they still be available at that time? If so, will they have the characteristics of today? He notices that the relevance of these questions depends on the length of his time horizon.
- 8. Publication No Cu0146 Issue Date: June 2015 Page 5 TIME HORIZON As we’ve seen in the Introduction, LCC analysis is all about making decisions that are optimal from a long-term rather than a short-term perspective, so it’s important to define just how long your time horizon is. The following four guidelines will help you define your time horizon: 1. Whatever time horizon you choose, you’ll need to use the same for each alternative. 2. The time horizon is restricted by the longest physical lifetime amongst the alternatives. 3. The time horizon is restricted by the investment horizon of the decision maker. Some companies have a standard investment analysis period, e.g. 3, 5 or 10 years. Companies that are subject to considerable risks will generally have a shorter investment horizon than companies in very stable business settings. 4. The time horizon is shorter than the functional lifetime, which is the total time period that the functional need exists for which the product is used. SYSTEM BOUNDARIES After you’ve determined your objective and time horizon, it is advisable to write down explicitly the most important assumptions on which your analysis rests. These assumptions define your system boundaries: they determine which factors will be taken into account. EXAMPLE: Leonard uses the four guidelines to make his decision on the time horizon (T): 1. He needs one single time horizon for each of the three alternatives, so he is NOT allowed to calculate the LCCbase case over 10 years, LCCA over 15 years and LCCB over 20 years. 2. With 20 years, pump B is the alternative with the longest physical lifetime. So Leonard’s time horizon will not be longer than that. 3. He checks with Bill from the accounting department whether there is a standard investment period in the company. After two days, Bill gets back to him: “Well, certainly less than 10 years: who knows whether our company will still exist by then?” 4. He checks with his boss how long the need for this pumping system exists, since it is highly specific for the current production process. The answer surprises him: the pump should be operational for only 9 more years. After that time, a part of the plant will be put out of operation and it’s unclear whether the specific process pump will still be of use. Leonard decides to restrict the time horizon to 9 years. The problem of replacing the old pumping system after 10 years has lost its relevance, but maybe he should correct the salvage value of alternatives A and B, since they would not be even halfway through their lifetime at the end of the time horizon? EXAMPLE: These are some of the important assumptions Leonard identifies: 1. He will consider this pumping system a separate unit. He’ll acknowledge a fixed penalty cost of €50 per hour of downtime, which represents the cost of providing a backup solution, but will not consider the pump’s influence on other parts of the production process. 2. He will only recognize two states: a fully operational pump or a fully down one. A running pump with reduced throughput is not a possibility Leonard is taking into account. He will consider the flow rate and loading factor as fixed over the entire time horizon. 3. He doesn’t take into account consequences of unlikely events such as fire, lightning, inundation. 4. He assumes the salvage value of option A to be €4,000 and of option B €4,500 after 9 years.
- 9. Publication No Cu0146 Issue Date: June 2015 Page 6 STEP 2 – IDENTIFY RELEVANT COST COMPONENTS Once the scope of your LCC model is defined, you’ll need to list all the cost components that you will take into account. In this step there is one important rule: only include costs that differ significantly between the alternatives. Cost components can be organized into a tree structure or Cost Breakdown Structure (CBS) in which each node of the tree represents a certain phase in the life cycle of the asset. Each node has a number of sub-nodes, until you reach the lowest level of detail necessary for your study. Figure 2 shows some commonly considered cost components for an Energy Efficiency Project, organized according to the three main phases in the life cycle of the asset under consideration: the initial investment (1), the use phase (2) and the End-Of-Life (EOL) phase (3). In this Application Note we do not focus on the calculation of taxes, therefore depreciation of the initial investment price over the time horizon is not included. Figure 2 – Generic Cost Breakdown Structure including typical cost components for an Energy Efficiency Project. EXAMPLE: Leonard has identified the following cost components to be relevant in his case: Initial Investment Maintenance Costs Active Energy Consumption Downtime Costs Salvage Value Since all the other costs are about the same for the three options, Leonard will not bother about them.
- 10. Publication No Cu0146 Issue Date: June 2015 Page 7 STEP 3 – GATHER DATA AND DERIVE COST ESTIMATES Now that you have determined the scope of your LCC model and the relevant cost components to take into account, it’s time to start calculating these costs for each year of the time horizon. We suggest a 4-step approach: 1. Make a first rough LCC estimate 2. Identify your available information sources 3. Choose an appropriate cost estimation method for each cost component 4. Start to calculate costs MAKE A FIRST ROUGH LCC ESTIMATE Before you start gathering actual cost data, it is always helpful to derive a quick and dirty LCC estimate. This will give you an initial idea of how the different cost components relate to each other. At this time it is not even necessary to take the time value of money or inflation into account (which will be explained in Step 4). You can just multiply the annual expenses by the number of years in the time horizon and add them to the initial investment cost and any other one-off expenses. The sole purpose of this first estimate is to guide your data-gathering efforts. You wouldn’t want to spend 90% of your time estimating a cost component that accounts for less than 1% of the total cost. IDENTIFY YOUR AVAILABLE INFORMATION SOURCES Which information do you have at hand to estimate the different cost components? The answer will depend on your specific case but, in general, the following distinctions hold: You have either historical data or an expert opinion at your disposal. Your information originates from either an internal source (within your company) or an external one. Each of the four possible combinations of these dimensions has its specific challenges. It’s wise to remember some general warnings, based on practical experience: 9 [𝑦𝑒𝑎𝑟𝑠] × 𝑚𝑜𝑡𝑜𝑟 𝑝𝑜𝑤𝑒𝑟[𝑘𝑊] × 8,760 [ℎ𝑜𝑢𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟] × 0.12 [€/𝑘𝑊ℎ] EXAMPLE: Leonard makes a first quick and dirty LCC estimate (no discounting applied – cf. chapter 0 p.11): BASE CASE ALTERNATIVE A ALTERNATIVE B Investment €0 0.0% €19,000 8.9% €35,000 18.9% Maintenance €52,800 23.2% €57,200 26.8% €36,000 19.5% Downtime €51,246 22.5% €19,710 9.2% €11,826 6.4% Energy consumption €122,990 54.1% €113,530 53.2% €97,446 52.7% Salvage value €500 0.2% €4,000 1.9% €4,500 2.4% Table 2 – First Quick & Dirty LCC Estimate. Can you find the same numbers? Try to do this based on the information given in Table 1. Leonard approximates the yearly energy consumption by assuming the motor runs continuously at full power and thus the total energy costs over nine years are calculated as Based on results of this assessment, he concludes that his focus will be on the energy, downtime and maintenance costs for the different options, and he will not waste too much time on estimations for the salvage value.
- 11. Publication No Cu0146 Issue Date: June 2015 Page 8 Beware of the quality of historical data, such as maintenance reports, time sheets, etc. In many practical LCC studies we have found this type of data to be far less detailed or systematically recorded than initially suggested. Try to have a clear view on what is recorded and how accurately this is done before using the data in your model. Keep an eye on the representativeness of your information. For an estimate of maintenance costs, there may be historical data on the number of failures there were in products of the previous generation. But if the products you are considering to buy at this moment include new technologies or improved designs, you should think about a way to correct the historical data for your assessment. The correction you decide on will be one of the assumptions on which your LCC model rests. Given the widespread absence of reliable and representative historical data, in many cases you will find yourself to be dependent on expert opinions. Here you face a particular problem that academics call ‘estimator bias’, which means that some of the experts you consult will be overly pessimistic while others will be overly optimistic. Feel free to interpret or ‘weigh’ the expert opinions you’re collecting. If you are dealing with external experts, this estimator bias can be the result of commercial considerations: in some cases, suppliers might give you overly optimistic parameters to positively influence their sales process. Always try to find out how a specific parameter was determined and on which assumptions it rests. Another psychological factor to take into account is that some experts will produce parameter estimates with the pretended infallibility of a papal decree, while others might be circumstantially excusing themselves for their inaccurateness before giving the requested numbers. Do not assume that the self-assurance of an expert is a quality meter for the information he or she provides. Choose a trustworthy and knowledgeable expert for your specific question. Often the best experts are the ones who have an advanced technical understanding of the asset, a neutral viewpoint in relation to your decision and/or an experience of working with the asset on a daily basis (e.g. service technicians). CHOOSE AN APPROPRIATE COST ESTIMATION METHOD FOR EACH COST COMPONENT The first rough LCC estimate has taught you which cost components you should focus on. You have collected and critically evaluated the available information. Now it is time to find a way to make use of it. You need to determine an appropriate cost estimation method for each cost component. There are basically two approaches: a parametric or an analytical one. Parametric cost estimation means that you estimate a cost approximately by applying a parametric relation between the cost and a limited set of input parameters. Example: when estimating the repair cost of a specific car, you might know of an equation that allows you to calculate the cost in function of the number of kilometers driven per year (X), the number of snow days in one year (Y) and the average length of each ride you make (Z). This equation allows you to express the annual repair cost as 𝐾 = 𝐴 × 𝑋 + 𝐵 × 𝑌 + 𝐶 × 𝑍. In this case you are looking top-down at your car and make an abstraction of all the nits and grits under the hood; you simply relate the cost to these three parameters. That’s why parametric cost estimation is also known as ‘top-down’ cost estimation. Analytical cost estimation means that you analyze all the elements that contribute to the total cost. Example: when determining the repair cost of a car, you could try to identify every possible failure mode of every single component, find data on the likelihood and the cost impact of each failure EXAMPLE: At this point in the running example we assume that the data provided in Table 1 are 100% reliable expert estimates. This is, of course, an overly optimistic assumption, but we will only start to worry about that in the second Application Note, when we include uncertainties into LCC analysis.
- 12. Publication No Cu0146 Issue Date: June 2015 Page 9 mode, and then add everything up to derive an estimate for the total repair cost. Since you analyze the complete underlying system up to its smallest component, analytical cost estimation is also known as the ‘bottom-up’ approach. One famous type of analytical cost estimation method is Activity Based Costing (ABC), an approach directed at analyzing the resource-consuming activities that contribute to cost. Which of these approaches should you choose? The previous descriptions clearly indicate that parametric cost estimation is quicker, easier but in general less accurate than analytical cost estimation. The accuracy of parametric cost estimation depends very much on the quality of the parametric relation employed. In other words: you can only apply parametric cost estimation reliably when you know of a fairly accurate equation with which to calculate a limited set of parameters. Where can you get this? Well, parametric relations can either be derived from technical literature or be based on an analytical cost estimation that you or somebody else has performed before. START TO CALCULATE COSTS You’ve decided which cost components you’ll focus on (0), you’ve identified your information sources and have collected data (0), and you’ve determined the appropriate estimation method (parametric or analytical) for each cost component (0). Now it’s time for the real work. You should construct a cash flow model in a spreadsheet (e.g. MS Excel). A cash flow model lists each instance of every cost component (or revenue) in every year it occurs. Revenues and costs should have a different sign (+/-). Now you should make a worksheet with a separate column for each year of your time horizon (cf. 0) and dedicate a row for each cost component. In each cell enter the value of the cost incurred in that year for that particular cost component. To conclude this chapter, Table 3 gives an overview of some widely-used information sources and cost estimation methods for the most common cost components in the context of Energy Efficiency Projects. Cost type Typical information sources Applicable cost estimation methods and practices Energy costs Energy measurements type 1: measure consumption (in kWh) during one week or one month with a separate kWh- meter Energy measurements type 2: measure reference consumption for different standard cycles of operation with a power analyzer (e.g. Fluke, Chauvin Arnoux, etc.) Information furnished by suppliers With energy measurements type 1 = consumption measured during one month * 12 = yearly consumption (but beware: is measured consumption representative for the rest of the year? Take care of seasonal effects or unrepresentative production patterns and correct the formula if necessary.) With energy measurements type 2 = consumption during standard cycle of operation * number of cycles per year In general energy measurement type 2 is more accurate but requires extensive measurements (for each type of 𝑌𝑒𝑎𝑟𝑙𝑦 𝐸𝑛𝑒𝑟𝑔𝑦 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 [𝑘𝑊ℎ] = (𝐹𝑢𝑙𝑙 𝐿𝑜𝑎𝑑 𝑀𝑜𝑡𝑜𝑟 𝑃𝑜𝑤𝑒𝑟 ) (𝑀𝑜𝑡𝑜𝑟 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦) × (𝐿𝑜𝑎𝑑 𝐹𝑎𝑐𝑡𝑜𝑟) × (𝐴𝑛𝑛𝑢𝑎𝑙 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝐻𝑜𝑢𝑟𝑠) 𝑌𝑒𝑎𝑟𝑙𝑦 𝐷𝑜𝑤𝑛𝑡𝑖𝑚𝑒 𝐶𝑜𝑠𝑡𝑠 = (100 − 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑖𝑙𝑖𝑡𝑦 [%]) × (𝑃𝑒𝑛𝑎𝑙𝑡𝑦 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟) × (𝐴𝑛𝑛𝑢𝑎𝑙 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝐻𝑜𝑢𝑟𝑠) EXAMPLE: For obtaining a more accurate estimate of the yearly energy cost, Leonard applies parametric cost estimation, making use of this formula that he has found in technical literature: With 𝐿𝑜𝑎𝑑 𝐹𝑎𝑐𝑡𝑜𝑟 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑓𝑢𝑙𝑙 𝑙𝑜𝑎𝑑 𝑝𝑜𝑤𝑒𝑟. A good estimate for this factor is 65%, he thinks. Thus, he obtains a yearly energy consumption of about 98,000 kWh for the base case, 75,000 kWh for alternative A, and 61,000 kWh alternative B. This number can be multiplied by 0.12 €/kWh to estimate the annual energy cost. For the downtime costs, he also applies parametric cost estimation, by using this formula:
- 13. Publication No Cu0146 Issue Date: June 2015 Page 10 Information from technical literature kWh-price for your company operation cycle) Parametric relation found in technical literature Distinction is often made between active power consumption (during operation of the asset) and standby power consumption (during idleness) Maintenance costs Historical records of maintenance interventions (beware of quality, cfr. Section 3.2) Quotation of maintenance contracts proposed by supplier (be careful: is everything covered?) Expert opinion of maintenance personnel Yearly maintenance cost = certain percentage of purchase price of the asset (approximation) Maintenance cost = Preventive cost + Corrective cost with 𝑃𝑟𝑒𝑣𝑒𝑛𝑡𝑖𝑣𝑒 𝑐𝑜𝑠𝑡 = 𝐶𝑜𝑠𝑡𝑖𝑛𝑡𝑒𝑟𝑣𝑒𝑛𝑡𝑖𝑜𝑛 × (𝑁𝑟. 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑠) 𝐶𝑜𝑟𝑟𝑒𝑐𝑡𝑖𝑣𝑒 𝑐𝑜𝑠𝑡 = ∑ [𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦𝑓𝑎𝑖𝑙𝑢𝑟𝑒 × 𝐶𝑜𝑠𝑡 𝑟𝑒𝑝𝑎𝑖𝑟]𝑎𝑙𝑙 𝑓𝑎𝑖𝑙𝑢𝑟𝑒 𝑚𝑜𝑑𝑒𝑠 with 𝐶𝑜𝑠𝑡 𝑟𝑒𝑝𝑎𝑖𝑟 = 𝐶𝑜𝑠𝑡𝑙𝑎𝑏𝑜𝑟 + 𝐶𝑜𝑠𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 + 𝐶𝑜𝑠𝑡 𝑡𝑟𝑎𝑛𝑠𝑝𝑜𝑟𝑡 Operations costs Time studies (e.g. Methods-Time Measurement, MTM) Supplier information Expert opinion of operators and supervisors 𝐶𝑜𝑠𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 = (𝑁𝑟. 𝑜𝑓 𝑠𝑢𝑝𝑒𝑟𝑣𝑖𝑠𝑖𝑜𝑛 ℎ𝑜𝑢𝑟𝑠) × (𝐿𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟) Downtime costs Which revenue is lost per hour of asset outage for your company? OR: What does provision of a backup solution cost per hour of downtime? This defines the penalty per hour (in €) Total yearly downtime as recorded by operations or estimated by experts 𝐶𝑜𝑠𝑡 𝑑𝑜𝑤𝑛𝑡𝑖𝑚𝑒 = (𝑁𝑟. 𝑜𝑓 𝑑𝑜𝑤𝑛𝑡𝑖𝑚𝑒 ℎ𝑜𝑢𝑟𝑠) × (𝑃𝑒𝑛𝑎𝑙𝑡𝑦 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟) Table 3 – Typical information sources and cost estimation methods and practices for some common cost types. EXAMPLE: With the data provided in Table 1 and the results of his cost estimation efforts, Leonard starts building his cash flow model, the result of which is shown in the Excel-file “ECI_LCC.xlsx” attached to this Application Note. Look at the first worksheet ‘Exercise’ and for now look only to rows 1 to row 21 and at the yellow colored input parameter cells below. Make sure you understand how each of the cells in the first 21 rows is defined. Now look at the worksheet ‘Graph 1’, where you can see the summated cash flows for the three options over the different years (i.e. row 19, 20 and 21).
- 14. Publication No Cu0146 Issue Date: June 2015 Page 11 STEP 4 – CALCULATE KEY FINANCIAL INDICATORS A Life Cycle Costing Analysis is made to facilitate a decision: which alternative is the best choice from a long- term perspective? To help you make this type of judgment, this chapter introduces three Key Financial Indicators: Net Present Value (NPV), Discounted Payback Time (DPBT) and Internal Rate of Return (IRR). But before we go on, there is one important concept we need to clarify: the time value of money. The time value of money prohibits you from simply adding up costs that occur in different years. It is not the same as inflation, which is the rise in the general level of prices for goods and services. The time value of money is the reason why everybody prefers having €500 today and not in five years’ time, even if the same amount of goods and services could be bought with it at that point. During these five years, this amount can be invested in several profitable ways and not doing so ‘costs’ money as well. Each cost that occurs in the future will have a Present Value (PV) that is different from its Future Value (FV). The relation between the PV (in year 0) and the FV (in year k) is given by the following formula: 𝑷𝑽 = 𝑭𝑽 (𝟏 + 𝒊) 𝒌 Application of this formula is called ‘discounting’, and the most important parameter to determine is the discount rate i, that will define how big the difference is between FV and PV. Let’s say you receive a sum of €500 in 10 years and apply a discount rate of 8%, then its Present Value is: 𝑃𝑉8% = 500 (1+0,08)10 = €232 With a discount rate of 15%, the Present Value of the €500 received in 10 years will only be: 𝑃𝑉15% = 500 (1+0,15)10 = €124 The three Key Financial Indicators introduced in this Application Note – namely Net Present Value (NPV), Discounted Payback Time (DPBT) and Internal Rate of Return (IRR) – all make use of this basic formula, for which a discount rate should be chosen. Determining ‘i’ is a difficult but important decision and the next section will help you in doing this. CHOOSING YOUR DISCOUNT RATE The discount rate represents the time value of money, but we have seen that another phenomenon, inflation, also contributes to the fact that money loses value over time. You’ll have to decide whether you will or will not include inflation in your analysis. If you do, you’ll calculate the time value of money with a nominal discount rate. If you don’t, you’ll use a real discount rate. The real discount rate will always be smaller than the nominal discount rate, unless in the rare case of deflation (i.e. a decrease in the general price level). When a choice needs to be made between different alternatives, inflation often has about the same influence on each of them, so it can be discarded. But some specialists will advise you to not only use nominal discount rates but also apply different inflation rates for different types of costs (e.g. energy inflation versus wage inflation). In our opinion, this might give the false impression that inflation is a predictable phenomenon. Therefore, we think it is more straightforward to add the uncertainty about the inflation of energy prices in the energy prices themselves and not in the discount rate. Including uncertainty in your LCC model is the topic of Application Note 2. For the time being, we advise you to use a real discount rate. Many specialists agree that the real discount rate should reflect the investor’s ‘opportunity cost of capital’. Opportunity cost of capital reflects that capital employed now to make an investment in energy efficiency measures does not come for free: either it is borrowed capital (debt) or own capital (equity). Both debtors and
- 15. Publication No Cu0146 Issue Date: June 2015 Page 12 shareholders will expect a certain return from their money and will only keep providing you with funds when you meet their expectations. An accepted benchmark for the opportunity cost of capital – and thus for the discount rate – is the Weighted Average Cost of Capital (abbreviated as WACC). WACC is calculated as the rate that your company should pay on average to the owners of its capital. For a company with only shareholders and debtors WACC is calculated as follows: 𝑾𝑨𝑪𝑪 = 𝑫 𝑬 + 𝑫 𝑹 𝒅(𝟏 − 𝒕) + 𝑬 𝑬 + 𝑫 𝑹 𝒆 In this formula, E represents the market value of the equity D is the total debt Rd is the interest paid on debt t is your company’s tax rate (expressing the fact that interests on loans are tax deductible) Re is the return that your shareholders expect (the most difficult parameter to determine) In a risky business context, a company’s WACC will be bigger since both shareholders and debtors expect a greater return, while in a stable business context, a company’s WACC will be smaller. Since WACC depends heavily on the risk level of your activities, a company that operates in different industries can have a different WACC per industry. This formula appears simple, but the great challenge lies in determining Re. A popular approach among financial experts is the Capital Asset Pricing Model (CAPM), in which Re is determined as 𝑹 𝒆 = 𝑹 𝟎 + 𝜷 × 𝑹 𝒑, with R0 the risk free rate (e.g. 10-year German treasury bonds, around 2% in December 2011), β the company- specific Beta-factor and RP a risk premium of typically 3 to 5%. The Beta-factor reflects how the returns of your company correspond to market fluctuations. Explaining CAPM more in detail will lead us too far; therefore, we limit ourselves here to saying that WACC calculations are not an exact science: different specialists might come up with a different Re (and thus a different WACC) for the same company. This Application Note has tried to give you some essential insights into WACC. We are not suggesting that WACC is easy to apply in real life. You have two main options: 1. If your company is publicly listed on a stock market, your financial department should have an estimate for your company’s WACC, since it can be calculated from financial data they are required to publish. 2. If your company is not publicly listed, you can try to determine WACC yourself by collecting information about the parameters used in the formula above. However, you will probably not have the time or the background to carry out this complex financial analysis. If your financial department cannot help, we suggest the following pragmatic approach: The absolute minimum WACC is around 4%, the so-called ‘social discount rate’ applicable for long-term social planning. In general, a WACC is seldom below 7% or above 20%. The WACC of similar companies active in the same industry and with a similar risk profile can be indicative, as WACC is somewhat comparable within industries. Some industry-wide estimates for cost of capital determined by Professor Damodaran of NYU Stern Business School are provided in Table 4. This 2009 data is based on U.S. companies only. Take this value as a benchmark and increase it by a few % if you estimate that your company has a higher risk profile than average, or decrease it if the opposite is true. You can also find examples of companies listed on U.S. stock markets on this website: http://thatswacc.com/.
- 16. Publication No Cu0146 Issue Date: June 2015 Page 13 Exercise: Try finding the WACC for Apple Inc. (AAPL), Coca-Cola Company (KO) and U.S. Steel (X). How would you have intuitively ranked them ordered by increasing WACC? Aerospace/Defense 8.51% Drug 8.52% Auto & Truck 8.58% Food Processing 7.16% Auto Parts 9.91% Paper/Forest Products 9.24% Beverage 8.15% Petroleum (Integrated) 8.63% Building Materials 8.57% Petroleum (Producing) 8.48% Chemical (Basic) 8.70% Steel (Integrated) 10.27% Chemical (Diversified) 9.10% Steel (General) 9.54% Chemical (Specialty) 8.88% Table 4 – Average cost of capital for some selected industrial sectors. (Source: http://pages.stern.nyu.edu/~adamodar/) NET PRESENT VALUE (NPV) The Net Present Value (NPV) of your Energy Efficiency Project is the most important Key Financial Indicator. It is defined as the sum of the present values (PVs) of the individual cost components, whereby each instance of each cost component is discounted according to the year in which it occurs. An NPV value can be calculated for each time series of costs and/or revenues, but in the context of LCC it is a way to evaluate the total, long-term cost of each alternative or, in other words, the total size of the iceberg. NPV allows you to compare your different options in monetary terms. Let’s presume that, for one of your alternatives determined in Step 1, you have calculated all relevant cost components so that Ck is the sum of all costs occurring in year k and C0 is the initial investment (in year 0). Than the NPV (total LCC) of this alternative can be calculated as: 𝑵𝑷𝑽 = 𝑪 𝟎 + ∑ 𝑪 𝒌 (𝟏 + 𝒊) 𝒌 𝑻 𝒌=𝟏 In this formula, T represents the time horizon and i represents the discount rate. NPV can be calculated directly in MS Excel by applying the function NPV, which has as syntax ‘=NPV(rate,value1,value2, ...)’. In this formula ‘rate’ is the discount rate and ‘value1, value2 …’ is a row or column of all the cash flows in different years, starting from year 1 (Be careful not to start in year 0! You should always add C0 separately). You can determine the NPV for each of your alternatives. This will give you an idea of the total cost impact of every alternative, taking the full time horizon into account. With that information at hand, you’ll be able to make your decision. The most attractive alternative will obviously be the one with the lowest NPV, thus the lowest LCC. To highlight the saving potential of your Energy Efficiency Project, you’ll often want to compare your different active scenarios (e.g.: purchase system A or purchase system B) to the base case scenario. For this, you’ll first have to calculate the NPV of the total cost of each alternative, just like we did above. Then you can subtract EXAMPLE: Leonard’s company is not publicly listed. He decides to call Bill from the accounting department. What’s his company’s WACC? Bill has no idea and is not willing to make an effort. Leonard looks up the WACCs of companies in the same industry on www.thatswacc.com. He finds that Exxon Mobil (XOM) has a WACC of 7.83% (an absolute minimum, he thinks), BP has a WACC of 11.55% and the industry-wide average cost of capital is around 8.5%. Leonard adds one percent ‘risk premium’ and chooses a value of 9.5% for his company. He is not very confident about this estimate’s accuracy, but 9.5% seems to be the most sensible choice for now…
- 17. Publication No Cu0146 Issue Date: June 2015 Page 14 the NPV of alternative A from the NPV of the base case, and thus you derive the total cost saving of that alternative over the base case (if it is positive) or the total additional cost (if negative). DISCOUNTED PAYBACK TIME (DPBT) While NPV is expressed in monetary units, you can also make a comparison in temporal terms. Your central question is then: ‘What is the payback period for this investment?’ A simple way to find an answer is to subtract year by year the realized savings from the initial investment cost until you reach zero. That is the ‘breakeven’ situation and the corresponding period is the (regular) payback time (PBT). For example, if you invest €1500 in year 0 and from the first year on you save €500 per year, the regular PBT will be 3 years. But regular PBT, which simply adds up costs that occur in different years, does not take the time value of money into account. Therefore, we advise you not to use regular but only discounted payback time (DPBT). DPBT subtracts discounted costs from the initial investment amount until you reach zero. We recognize the difficulties in finding a good discount rate, but ignoring the time value of money altogether is always worse than applying an over- or underestimated discount rate. Intuitively, you will prefer projects with a short DPBT. But should you always choose the project with the shortest DPBT? The answer is no. Often the DPBT and NPV criteria will rank your alternatives in the same way but, in some cases, there might be differences because DPBT has a shorter time horizon than NPV. NPV takes into account all factors over the complete time horizon, while DPBT looks only at the costs and savings that occur in the years before the breakeven point is reached. It neglects everything that happens afterwards. INTERNAL RATE OF RETURN (IRR) The third Key Financial Indicator to express LCC is the Internal Rate of Return (IRR). The IRR is the discount rate that makes the NPV of your project 0. In mathematical terms, this means: 𝑰𝑹𝑹 = 𝒊 so that EXAMPLE: Using the cash flow model we’ve worked on before, try to calculate the NPV of the total cost of each of Leonard’s alternatives. You can use the first worksheet ‘Exercise’ of the Excel file ECI_LCC.xlsx. In Cells L19 – L20 – L21 you should fill in your formulas (use the Excel NPV function, but beware of year 0!). Then look at rows 23-24 and 26-27. Make sure you understand how these numbers are calculated. Calculate in cells L23 – L24 and L26 – L27 the total discounted cost savings of alternatives A and B over the base case. We added row 24 and 27 only to demonstrate how the NPV function in Excel works, so you should end up with the same number in L24 as in L23 and in L26 as in L27. Which alternative would you choose? You can check your answers with the worksheet ‘Solution’ and ‘Graph 2’ in the same Excel file and the discussion at the end of this chapter. EXAMPLE: Starting with your NPV calculation sheet, try to determine the DPBT of each of Leonard’s options. Compare it with the corresponding regular PBT. You can use the first worksheet ‘Exercise’ of the Excel file ECI_LCC.xlsx. Use the data in rows 25 and 28. Make sure you understand how the values in these rows are calculated. Rank the alternatives according to DPBT and compare this ranking with the one based on NPV analysis. You can check your answers with the worksheet ‘Solution’ in the same Excel file and the discussion at the end of this chapter. In Graph 3 we have provided a visualization of the cumulative discounted savings over time. Here you can see that the DPBT is the moment in time when the savings line crosses zero (indicating break-even).
- 18. Publication No Cu0146 Issue Date: June 2015 Page 15 𝑵𝑷𝑽 = (𝑪 𝑩𝑪𝟎 − 𝑪 𝟎) + ∑ (𝐂 𝐁𝐂𝐤 − 𝐂 𝐤) (𝟏 + 𝒊) 𝒌 = 𝟎 𝑻 𝒌=𝟎 with CBCk representing the cost of the base case in year k Ck the cost of the alternative under consideration in year k By calculating the IRR you determine what the maximal discount rate is which still allows you to have a profitable investment. A high IRR means that the project is more interesting: even if the future savings are discounted with this IRR, it would still not induce a loss. In general, the IRR of a particular project should be greater than the cost of capital (WACC) in order for the project to be interesting. The easiest way to calculate IRR is using the IRR function in MS Excel. The syntax of this function is ‘=IRR(value0,value1,…valuek, guess)’, with ‘valuej’ being the cash flow in year j and ‘guess’ your initial guess for the IRR. If this initial guess is not entered in the formula, 10% is chosen by default. This formula can only be applied if there is a discount rate for which the NPV reaches zero. If not, MS Excel will present you the #NUM! error value. Try this simple example yourself in MS Excel: 𝐶 𝐵𝐶0 − 𝐶0 = −100; 𝐶 𝐵𝐶1 − 𝐶1 = 50; 𝐶 𝐵𝐶2 − 𝐶2 = 25; 𝐶 𝐵𝐶3 − 𝐶3 = 35; 𝐶 𝐵𝐶4 − 𝐶4 = 15 and 𝐶 𝐵𝐶5 − 𝐶5 = 10. Which IRR can you find? [Answer = 14.4%] Now how can you apply IRR? Some companies have a benchmark B and will approve a project only if its IRR exceeds B. In some cases this benchmark is the same as the WACC, so that a project is only approved if it can cover the cost of capital. In other cases the benchmark is higher than the WACC. In that case investment projects are only approved if they exceed the expectations of the capital holders, and effectively add value for your company. The IRR criterion is mainly useful to evaluate single Energy Efficiency Projects. It helps you answer the question: ‘Is this project worth investing in?’ Many companies use IRR for comparing and ranking different alternatives, although this application is less advisable. The rankings of projects based on IRR and NPV will sometimes differ, and in that case the NPV criterion always makes more sense. IRR tends to favor projects with less capital investment in the beginning, while NPV balances costs that occur at different moments by discounting the actual cost of capital, and thus permits you to make a better, more comprehensive decision. This is illustrated in the example below. EXAMPLE: Using the same worksheet ‘Exercise’ of the Excel file ECI_LCC.xlsx, now try to find the IRR of alternatives A and B. Do this by inserting the IRR function in cells G34 – H34. If the WACC is chosen as IRR benchmark, would both alternatives be approved? And what if the benchmark were 25%? You can check your answers with the worksheet ‘Solution’ in the same Excel-file. In Figure 3 the ‘NPV profile’ of alternatives A and B is presented. This is a graphical representation of the link between NPV and IRR, with the discount rate on the X-axis and the corresponding NPV on the Y-axis. The IRR is the discount rate for which the NPV profile passes through zero. In this example, alternative B has a higher NPV for almost every discount rate, but alternative A still has a higher IRR. This specific illustration emphasizes the fact that the NPV criterion is preferable over the IRR criterion to rank and compare different projects.
- 19. Publication No Cu0146 Issue Date: June 2015 Page 16 Figure 3 – The NPV profile for alternatives A and B depicts how the NPV evolves in function of the discount rate.
- 20. Publication No Cu0146 Issue Date: June 2015 Page 17 CONCLUSION AND SOLUTION TO THE EXERCISE Table 5 provides an overview of the three Key Financial Indicators that can be used to evaluate the long-term profitability of your Energy Efficiency Project, together with the main characteristics of each criterion. Key Financial Indicator Net Present Value (NPV) Discounted Payback Time (DPBT) Internal Rate of Return (IRR) Is calculated by … …adding up the initial investment of an alternative with the discounted cost savings in comparison to the base case over the complete time horizon. …identifying the moment in time when the initial investment of one alternative is redeemed by the discounted cost savings over the base case. …finding the discount rate for which the NPV of the total savings of one alternative over the base case becomes zero. Useful for … …checking whether the alternative is profitable (if NPV > 0) …comparing and ranking alternatives …obtaining an intuitive measure for how risky the investment is, expressed in a number of years. …comparing the profitability of a project with a preset company-specific benchmark, expressed as a percentage. Less useful for … …expressing LCC or profitability in non-monetary terms …ranking and comparing alternatives …ranking and comparing alternatives Table 5 – Main characteristics of the 3 Key Financial Indicators discussed in this Application Note. Of these three criteria, NPV is the most important one. It is very useful for comparing and ranking the economic potential of different alternatives of Energy Efficiency Projects from a long-term perspective. RECAP – THE FOURTH STEP OF LCC ANALYSIS: CALCULATE KEY FINANCIAL INDICATORS MAKE SURE YOU TAKE THE TIME VALUE OF MONEY INTO ACCOUNT Apply discounting and choose your WACC CALCULATE NPV, DPBT AND IRR FOR EACH ALTERNATIVE Compare to company defined benchmarks PRIMARILY LOOK AT THE OPTION WITH THE HIGHEST NPV OF THE TOTAL SAVINGS NPV is always the best criterion!
- 21. Publication No Cu0146 Issue Date: June 2015 Page 18 EXAMPLE: After calculating the Key Financial Indicators for the different alternatives under consideration, Leonard obtains the values in Table 6. Make sure you understand how each of them was calculated by investigating the worksheet ‘Solution’ of the Excel file ECI_LCC.xlsx in detail, and try to complete the worksheet ‘Exercise’ so that you get the same results as in the ‘Solution’ sheet. BASE CASE ALTERNATIVE A ALTERNATIVE B Life Cycle Cost (NPV) €135,634 €120,588 10,5% €109,228 22,8% Savings over base case (NPV) €0 €15,046 €26,406 Discounted Payback Time Not Applicable 4.06 years 4.68 years Internal Rate of Return Not Applicable 27.1% 25.2% Table 6 – Key Financial Indicators for both alternatives. Based on these calculations, Leonard draws the following conclusions: The NPV of the Life Cycle Cost (including investment, maintenance, energy and downtime costs) of the three options are all between €109,000 and €136,000, which is significantly greater than the initial investment costs of these options (which is a max of €35,000). The part of the iceberg under the water surface is thus definitely larger than its tip, and Leonard has made a good decision to apply LCC to guide his investment decision. Both alternatives A and B are profitable according to the NPV criterion. When comparing the discounted savings to the base case, the total discounted savings are around €15,000 and €26,000 respectively. According to the NPV criterion, alternative B should be chosen over A since it implies more than 70% extra savings. Since a DPBT can be found, this criterion confirms that both alternatives are profitable. But the DPBT of the alternatives is relatively high (over 4 years), so Leonard expects some questions from his management. Maybe they will find both investments too risky for their company, since they take so long to be redeemed. The regular payback time, which a lot of managers use although it omits the time value of money, is almost one year shorter. That’s logical; with a positive discount rate the DPBT will always be longer than the regular PBT. The IRR is higher than the cost of capital, so this criterion indicates that both A and B are profitable too. Although IRR and DPBT are both better for alternative A than for alternative B, Leonard understands that NPV is the most sensible criterion to rank the different alternatives. Based on NPV, he chooses alternative B. Still, Leonard has some doubts over certain input parameters in his model. He must admit some of them were guesswork: there is quite some uncertainty in all the assumptions and estimates he has made. What happens with the NPV of both options if he changes the discount rate to 15%, the energy price to 0.1 €/kWh and the availability of option A to 99.0% and option B to 99.1%? Suddenly both options look less attractive. Leonard is convinced he needs to include uncertainty and variability in his model to obtain a more balanced view on the profitability of his projects. This is the subject of a next Application Note.