CEM Energy Economics and Financial Analysis 1 — Questions and Answers
Question 1: A lighting retrofit costs $50,000 and saves $10,000 per year in energy costs. What is the simple payback period?
- 3 years
- 5 years (Correct answer)
- 7 years
- 10 years
Correct answer: 5 years
Simple payback period = Initial investment / Annual savings = $50,000 / $10,000 = 5 years.
Question 2: Which statement about Net Present Value (NPV) is correct when evaluating energy projects?
- A positive NPV means the project will not recover its costs
- NPV does not consider the time value of money
- A positive NPV indicates the project generates more value than its cost of capital (Correct answer)
- NPV is calculated without considering a discount rate
Correct answer: A positive NPV indicates the project generates more value than its cost of capital
A positive NPV means the present value of cash inflows exceeds the present value of costs, indicating the project creates value above the required return.
Question 3: In energy project financial analysis, the discount rate is used to:
- Calculate utility bill demand charges
- Convert future cash flows to present value (Correct answer)
- Determine equipment depreciation schedules
- Estimate future energy price escalation
Correct answer: Convert future cash flows to present value
The discount rate reflects the time value of money by converting future cash flows into their equivalent present-day value.
Question 4: Life Cycle Cost (LCC) analysis differs from simple payback analysis primarily because LCC:
- Only considers initial capital costs
- Ignores maintenance and operating costs
- Accounts for all costs over the entire life of the equipment (Correct answer)
- Uses current energy prices without escalation
Correct answer: Accounts for all costs over the entire life of the equipment
Life Cycle Cost analysis includes all costs over the equipment's lifetime: initial capital, operating, maintenance, energy, and disposal costs.
Question 5: The Internal Rate of Return (IRR) of an energy project is best defined as:
- The annual interest rate on project financing
- The discount rate at which the NPV equals zero (Correct answer)
- The project's simple payback period expressed as a percentage
- The ratio of energy savings to capital cost
Correct answer: The discount rate at which the NPV equals zero
IRR is the discount rate that makes the NPV of all cash flows from a project equal to zero, representing the project's effective rate of return.
Question 6: An energy project analysis uses a 3% annual energy cost escalation rate and a 6% nominal discount rate. The approximate 'real' discount rate is:
- 9%
- 3%
- 6%
- 2.9% (Correct answer)
Correct answer: 2.9%
Real discount rate ≈ (1 + nominal rate)/(1 + escalation rate) − 1 = (1.06/1.03) − 1 ≈ 2.91%, accounting for the offsetting effect of energy price inflation.
Question 7: An energy conservation measure has a Benefit-Cost Ratio (BCR) of 1.8. This means:
- The project will pay back in 1.8 years
- For every dollar invested, $1.80 in present value benefits are generated (Correct answer)
- The project's IRR is 1.8%
- The project costs 1.8 times more than the savings
Correct answer: For every dollar invested, $1.80 in present value benefits are generated
A BCR of 1.8 means the present value of benefits is 1.8 times the present value of costs, so each dollar invested returns $1.80 in benefits.
CEM Energy Economics and Financial Analysis 1
A lighting retrofit costs $50,000 and saves $10,000 per year in energy costs.
What is the simple payback period?