Greater use of wood residue fuels through improved financial planning: A case study in Alabama

Biomass and Bioenergy Vol. 4, No. 4, pp. 211-216, 1993 Printed in Great

0961-9534/93 $6.00 + 0.00

Britain. All rights reserved

G 1993Pergamon Press Ltd

GREATER USE OF WOOD RESIDUE FUELS THROUGH IMPROVED FINANCIAL PLANNING: A CASE STUDY IN ALABAMA C. DAVID BILLINGS,* M. CARL ZIEMKE* and RALPH STANFoRDt *University of Alabama in Huntsville, College of Administrative Science, Huntsville AL 35899, U.S.A. tAlabama Department of Economic and Community Affairs, STE Division, P.O. Box 2539, Montgomery, AL 3610550935, U.S.A. (Received

1 September

1992; revised received 28 December

1992; accepted 30 December

1992)

Abstract-As the world reacts to environmental concerns relating to fossil energy usage, emphasis is again placed on greater use of renewable fuels such as wood residues. Realistically, however, decisions to utilize such fuels are based on economic factors, rather than desires to improve U.S. energy independence and/or protect the environment. Because Alabama has a large forest products industry, state authorities have long sought to assist potential users of wood residue fuels to better use biomass fuels instead of the usual alternative: natural gas. State agency experience in promoting commercial and industrial use of wood residue fuels has shown that inadequate financial planning has often resulted in rejection of viable projects or acceptance of non-optimum projects. This paper discusses the reasons for this situation and suggests remedies for its improvement. Keywords--Wood,

residues, boiler fuel, economics, financial planning.

1. INTRODUCTION

The energy crises of 1973 and 1979 as well as the 1992 National Energy Plan have focused attention on the need for expanded use of renewable fuels. The potential for this substitution is considerable.‘,’ In 1978, it was estimated that 102 million dry metric tons of forest products went unused in America.’ This situation is probably worse today according to a study by the Alabama Forestry Commission.4 Although both ethanol and methanol can be made from wood residues, most of these common industrial alcohols are made from natural gas in the U.S. today for economic reasons. Thus one of the most practical ways to utilize wood residue as a fuel is by direct combustion, wherein it usually competes well with natural gas or oil.’ This cost-effective use of wood as a boiler or furnace fuel applies to quite small installations down to the size of 490 kW (50 boiler horsepower) heat output. Because of the many small wood products industries in Alabama that produce unutilized wood residues, the state of Alabama has subsidized the use of these residues for fuel as part of the state energy plan. This paper discusses the problems in financial planning for wood energy projects within small state business operations as revealed by the state biomass energy program.

2. THE ALABAMA BIOMASS FUEL PROGRAM

Approximately two-thirds of the area of the state of Alabama is covered with commercial forests and the forest products industry is a major source of state jobs. Alabama state officials have sought to improve the economic well-being of this large industrial sector to increase the use of wood residue fuels6,’ The Biomass Fuel Development Program was begun in 1983 and continues to operate. Its major function is to promote commercial/industrial use of biomass fuels by offering loan interest subsidies of up to $75,000 per project to encourage the selection of wood-fueled equipment. Uses of other types of biomass fuel are also permitted but in only one instance has such a project been proposed. The state biomass fuel program requirements for an acceptable project include submission of a simple feasibility study for the project, including a financial plan. About one-half of the applicants were initially unwilling or unable to submit an acceptable plan, so they were sent a “model” financial analysis similar to Table 1 to let them know what was wanted. Most were then able to make an analysis. A more sophisticated financial plan would have been preferable but this was clearly beyond the capabilities of 271

C. D. BILLINGS e/ cd

272

most of the clientele, which consists largely of small, family-owned sawmills or veneer mills. 3. BASIC FINANClAL

PLANNING

Before critiquing the methods used by our clientele to justify state project interest subsidies, it is worthwhile to review the financial analysis methods currently in widespread use in the U.S. These methods include simple payback, minimum attractive rate of return, internal rate of return, and net present value. 3.1. Simple payback The simple payback method of individual and comparative analysis of the value of proposed financial undertakings is still widely used, despite significant shortcomings. It is also called the cash payback method and consists of dividing the initial cost of a project by its net annual earnings or “payback”.8 The payback period is the number of years needed for a project’s net annual earnings to recover its initial cost. The major attractiveness of this method is its simplicity. However, it fails to take account of the time value of money or the economic lifetime of purchased capital equipment. This method works best when payback periods of two to three years or less are the maximum allowed, so that interest rates are not a major factor of concern. 3.2. Minimum

attracthe

rate of’return

The minimum attractive rate of return on investment (MARR) is an important concept in most methods of financial analysis except simple payback. The MARR is the least return on investment that the owner of a given business will accept.’ Although the MARR usually exceeds the cost of capital, in some cases it may not. Often the MARR used in financial planning exceeds the average return on investment (ROI) of the industry in question. Usage of MARRs in excess of 20% for planning within manufacturing industries is common although the average ROI for all manufacturing in the U.S. in 1985 (a boom year) was 13.6%.” The family-owned business may provide a special situation in estimation of the MARR. We have found that the typical family-owned forest products business employs one to six members of the immediate family of the owner. Thus, although the owner could safely invest excess capital in bonds or money markets’ instruments to get an 8% return, he might con-

sider an investment in his business with a prospective return of less than 8% if the investment results in creation of another job or two for family members. However, these assumptions are largely academic in that most of our clientele did not use the MARR concept in their financial planning.

3.3. Internal

rate @‘return

Many firms depend on a calculation of the percentage of internal rate of return (IRR) in evaluating the desirability of prospective investments. The IRR is the interest rate that equates a project’s net cash inflows to its net cash outflows over the project life.” The IRR may be compared to the ROI. Of course, the actual annual rate of return of any investment is calculated after the end of each year and is rarely the same from one year to the next. Today. the probable future average IRR is easily calculated using a business calculator costing less than $100 or a microcomputer with standard business software. The usual assumption is that an IRR greater than the MARR denotes an acceptable project and the best of two or more projects is the one with the highest IRR.

3.4. Net present

calue

Engineering economics texts and similar publications have long used the present worth (PW) method to compare the value of competing projects. In this method, all future costs or benefits in terms of cash flow are converted to present worth. using standard interest or annuity tables. A modern version of this discounted cash flow method is called net present value (NPV). This method subtracts the initial cost of the project from its present worth, providing the net present value. This calculation requires the use of an interest rate, which is the MARR. Thus a project with a positke NPV is acceptable. There is a connection between the IRR and NPV of an investment in that when the IRR is used as the MARR to calculate NPV. the NPV becomes zero. Some financial analysts prefer the NPV method over that of the IRR when choosing an investment from among several alternatives. One reason is that alternatives with similar or identical IRRs will commonly have different NPVs. Usually. the proposal with the highest positive NPV is chosen because it yields the largest return within the stated MARR.

Wood residue fuels 4. OVERALL

PROJECT

PLANNING

As mentioned earlier, in the financial analyses for 30 state project applications, not one listed the overall value of the project to the firm as a basis for considering it. Instead, this value was taken as a “given” and wood-fueled projects were only evaluated in terms of their ability to reduce use of costly fuel (see net fuel savings in Table 1). Most of these projects were in the cost range of $150,000 to $800,000. These are large investments for small, family-owned businesses. Apparently, the firm owners were acting on a “seat-of-the-pants” feeling that the project would adequately pay for itself in increased business or efficiency. Two aspects of project planning should be used, opportunity cost and sensitivity analysis. 4.1. Opportunity

cost

What project planners have failed to do is to assess the cost of failing to do the project.” This “opportunity cost” is usually calculated with discounted cash flow methods just discussed. If the investment is anticipated to increase business the procedure also may require knowledge of the given business and the market it serves. The determination of opportunity cost through proper financial analysis can be somewhat involved. However, an estimate of the opportunity cost can sometimes be done simply, as is shown in the following example. A producer of yellow pine dimension lumber in the Southeast does a business volume of 1 x lo6 m3 (423.7 x lo6 board-feet) annually, based on 230 working days. The raw material (timber) is purchased from loggers after which it is sawn, kiln-dried and planed on site. The average selling price is $212 per m3 ($500 per 1000 board-feet) of which 2.5% or $5.30 per m3 is net profit after taxes. The owners of this firm believe that they can sell enough additional lumber at the present price to utilize the 25% excess capacity that exists in the sawmill and planing mill. However, the steam boiler and associated high temperature steam kilns are operating at nearly 100% capacity; so new lumber drying equipment would he necessary to increase production. The present drying equipment is five years old. The sawing and planing mills cost more than twice as much as the boiler and kiln drying facility. Thus it is conservatively assumed that increasing the plant capacity 25% by purchasing additional drying equipment will increase annual profits by at least 25%, equival-

213

ent to $1,325,000. A more precise and probably larger figure could have been obtained by detailed calculations of the new production costs associated with adding personnel in the sawmill and planing mill plus an estimate of the unit cost of new drying equipment. However, the estimated annual increase in net profit is significant enough to encourage the owners to determine the actual cost of the most economical drying equipment available (the basis for Table 1) and then use these figures to recalculate a more accurate opportunity cost before making a final decision on the project. 4.2. Sensitivity

analysis

There are three processes involved in planning the investment in a business project: (1) cash flow estimation, (2) discounting process such as use of NPV and IRR, and (3) a risk-uncertainty description process. In this last process, it is often worthwhile to perform a “sensitivity analysis”, a type of risk analysis. It is beyond the scope of this paper to describe the sensitivity analysis in detail but it involves the determination of the sensitivity of changes to the original basic assumptions for the project financial analysis in terms of how these factors may vary and the mathematical probability of their doing so. As an example, in the previous section, it was assumed that prices of saw logs would remain constant as would prices of finished lumber. Based on past experience, it may well be possible to assign probabilities to incremental changes in these unit costs or prices. In this way, the levels of risk that the project will not earn acceptable revenues may be determined.

5. SELECTION

OF EQUIPMENT

One of the deficiencies of most applications for the Alabama Biomass Fuel Development Program has been that most applicants performed a financial analysis of only one type of lumber drying equipment. The most common combination of equipment selected was a low pressure wood-fueled boiler serving a high temperature steam-coil type kiln. However, there are several other means of drying lumber of wood veneers, and we have seen most of these used in our state-subsidized projects. These options should be reviewed in order to select the lowest cost equipment suitable for the intended application.

C. D. BILLINGS ef ul.

274

5.1. Equipment

options

Applicable types of lumber drying equipment include: (1) Standard low-pressure, wood-fueled boiler with steam-coil dry kiln. (2) Direct-fired wood-fueled furnace heating kiln with stack gases. (3) Direct-fired wood-fueled furnace with stack gas heat exchanger in kiln. (4) Wood-fueled furnace with low pressure oilfilled coils serving kiln heat exchanger. None of systems (2) through (4) utilize a boiler, so the continual presence of a boiler operator is not required. The system in example (2) dries the lumber with a mixture of hot stack gases and outside air so lumber may become somewhat soiled by soot. However, this discoloration cleans up in the planing mill. The system in (3) is similar to (2) except that a kiln heat exchanger eliminates the soot problem. System (4) uses the European Konus type hot oil system. Although there are coils in the furnace similar to steam coils, they contain a non-boiling oil that reaches about 232°C (450°F) and is pumped to oil coils in the kiln. This system also eliminates the need for water treatment and the risk of boiler explosion. 5.2. Used equipment

Small, low-pressure steam boilers and steam heated dry kilns have changed little in design or efficiency during the past 50 years. Furthermore, the minimum useful economic life of such equipment is 20 to 40 years. Thus there is considerable utility in purchasing good used equipment of this type. There are large numbers of old coal-fired boilers available because of the effect of air quality standards on the operation of boilers fired by high-sulfur coal. Companies such as McCain Boiler and Engineering in Birmingham, Alabama regularly convert used Table

I. Financial

analysis

I. 2. 3. 4. 5. 6.

Net fuel savings Depreciation. taxes Labor Maintenance Utilities Net cash: (Note:

Line 6 = lines

Simple payback

5.3. Equipment

$94,000 7920 12,000

11,000 8000 70,920

cost comparisons

In Table 1, the equipment selected was that required to dry 1090 m3 of green pine lumber per day. Based on 230 workdays per year, this selection would provide the 25% increase in lumber drying capacity needed for the example used in Section 4. For this example, the major equipment items are a 2940 kW (300 bhp) low pressure wood-fueled boiler, with a fuel storage silo and high temperature steam-coil type kiln that produces a load of dried lumber every 24 h. Note that the simple payback period of this system is in excess of four years. Some of our clients reject out of hand any proposed project that exceeds four years in simple payback. In the example just cited, this decision would be premature. The payback period of interest should be that associated with the overall project,

of wood-fueled boiler $300.000

1

Years

coal-fired boilers to burn wood residues. Such firms can certify rebuilt and inspected boilers to meet the applicable codes of the American Society of Mechanical Engineers so that boiler insurance requirements are met. Such rebuilt equipment will likely have an economic life of at least 20 years and can be purchased for about 5&60% of the cost of new equipment. An even greater saving can be had in the area of furnace fuel storage if the business in question has a “teepee” type wood residue burner on site. Such conical incinerators were commonly used at sawmills and other forest products plants until about 15 years ago, when air pollution regulations shut down most of them. Because of low scrap value, many teepee burners still exist on site and can be converted to dry storage of wood residue fuels by the addition of a cap section and a mechanical flail system. This equipment can be converted to store wood residue fuel at a cost of about 30% of that required for the next cheaper alternative: a concrete silo.”

and

steam-coil

type

wood

kiln costmg

2

3

4

5

$94,000 13,860 12.000 I 1,000 8000 76,860

$94,000 11,880 12.000 11,000 8000 74,880

$94,000 9000 12.000 I I .ooo 8000 72,900

$94,000 9900 I2.000 11,000 8000 72,900

I and 2 minus lines 3, 4, and 5)

= 4 years + ($300,000 - 4 years’ net cash)/%h year net cash = 4.06 years = 4 years + (.$300,000 - $295,560)/$72,900

Wood Table

2. Financial

Equipment

Capital cost (S)

type

215

300,000 270.000 204;OOO

Payback (years) 4.06 3.38 2.91

capable

of drying

Internal rate of return (%)

Net present value (S)

17.49 23.16 27.70

21,523 63.954 75,778

Minimum attractive rate of return = 15%. analysis period for internal rate of return and net present value = 5 years, after which equipment is sold at 50% of capital cost

*Identical

with Table

1.

which has an estimated opportunity cost of $1,325,000 per year, an amount several times that of the proposed investment of $300,000. Thus the real object of the equipment analysis is to see if the equipment selected in Table 1 was the most economical for the application. The five year maximum evaluation period of Table 1 is typical of those used in the forest products industry. One reason for this choice is general reluctance to accept simple payback periods of more than four to five years. Another reason is the nature of the business. Sales of lumber, plywood, veneer and similar wood products closely track national economic cycles. There have been nine U.S. business cycles, including the present one, since the end of World War II.16 The average length of the expansion portions is 40 months. The TRR and NPV for Table 1 would both be much greater if calculated over the minimum economic lifetime (20 years) of the equipment involved but firms in the forest products industry may be reluctant to use this longer period. The financial analysis shown in Table 1 was recalculated using different equipment selections (see Table 2). For the first alternative, a directfired, wood-fueled furnace/kiln combination was chosen. Both capital and operating costs were lower, resulting in a simple payback period of 3.38 years. A second alternative considered was the choice of a used wood-fueled boiler and conversion of an existing teepee burner to fuel storage. A new kiln identical to that of the first example was used. The result was a 35% reduction in the capital cost of the initial project and a further reduction of payback time to 2.97 years (see Table 2). 6.

fuels

analysis of three types of equipment 1090 m’ of lumber in 24 h

*New boiler/kiln Direct-fired kiln Used boiler/kiln Note:

residue

RESULTSANDCONCLUSIONS

In this study, we have sought to illustrate two weaknesses in project financial planning that

appear to be common with small operators in the forest products industry of the Southeastern U.S. The first weakness is the failure to perform proper overall financial planning, including estimation of project opportunity cost. The second is failure to consider all practical alternatives, including that of used equipment when selecting the most cost-effective equipment available. Personal experience gathered from analysis of more than 30 project applications indicates that these weaknesses in financial planning have probably resulted in rejection of projects that would be economically viable according to conventional business practices, even without subsidies. The projects just mentioned had capital costs between $150,000 and $800,000. A total of 18 projects were actually subsidized and built. Some viable projects were withdrawn by the applicants because they lacked confidence in their own financial planning. Occasionally a project was rejected by the state because it was uneconomically planned. REFERENCES aspects I. J. F. Peters and M. C. Ziemke, Socio-economic of a major U.S. biomass alcohol fuel program. Proceed-

ings ofInternational Solar Energy Societ!’ Siher Jubilee Congress, Atlanta, GA (1979). T. F. Mitchell et a/., Biomass fuels: A national plan. Chemtech.. DD. 242-249 (Aoril. 1983). Biomass energy success’ stories. U.S. Department of Energy HCPjTO 2R5-01 (1978). Alabama Forestry Commission Report No. 30-7 (July 20, 1992). M. C. Ziemke et al., A methodology for procurement of the most economical biomass boiler fuels. Institute qf Gas Technology Symposium: Energy ,fiom Btomas.7 and Wastes (1984).

Wood energy for 6. M. C. Ziemke and G. Guinn. Alabama. CAS Research Report No. 90~~2-1. pp. 3-5. University of Alabama in Huntsville (1990). M. C. Ziemke and G. Guinn, Effects of state subsidies on biomass fuel installations. Pro{,. Ninth Annual Southern Forest Biomass Workshop, pp. 1755185 (1987). Small Business Management, N. C. Siropolis, pp. 360-361. Houghton Mifflin Co., Boston (1982). E. P. DeGarmo et al., Engineering Economy, 8th edn, p. 143. MacMillan Publishing Co.. New York (1988).

216

C. D. BILLINGSet al.

10. E. Pomice, Apparel, shoes and textiles. Forbes, Jan. 13, p. 64 (1986). 11. DeGarmo, ibid, pp. 154-164. 12. N. N. Parish, Economic Analysis, pp. 51-57. McGrawHill Book Co., Inc.. New York (1962). 13. Ibid, pp. 45116.

14. G. Salvendy, Handbook of Indusfrial Engineering. pp. 9.5.1-9.5.2 I. John Wiley & Sons, New York (1982). 15. M. C. Ziemke, Converting teepee burners to fuel storage. Biologue 7(2), 31-32 (1990). 16. U.S. business cycles. The Wall Street Journal, p. A5 (Nov. 5, 1990).