Process economics II

H82PLD - Plant Design Econ II - 2

Lecture outline
Time value of money
Project cash flow
Comparing alternatives
Project cash flow
Profitability analysis
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Time value of money
Interest is the manifestation of the time value of money.
From the perspective of a saver, a lender, or an investor,
interest earned is over a specific period of time is know as
rate of return (ROR).
Interest period is the time unit for rate of return.
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Simple interest
Simple interest is calculating using principle only,
ignorin any interest accrued in preceding interest
period.
Simple interest = (Principle)(no of periods)(interest rate)
Example:
A load of $1000 for 3 years at 5% per year simple interest.
How much is the value after 3 years.
Total Due = $1000 + $1000(3 yr)(0.05/yr) = $1150
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Compound interest
Compound interest is the interest accrued for each interest
period.
It is the interest on top of interest (principal + total amount
of interest accumulated in all previous periods).
Compound interest = (Principle + All accrued interest) x
(Interest rate)
Example:
A load of $1000 for 3 years at 5% per year compound interest. How
much is the value after 3 years.
Total Due (Year 1) = $1000 (1 + 0.05/yr) = $1050
Total Due (Year 2) = $1050 (1 + 0.05/yr) = $1102.5
Total Due (Year 3) = $1102.50 (1 + 0.05/yr) = $1157.63
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Terminology & symbols
P = value or amount money at a time designated as
present time 0; present worth (PW), present value
(PV), net present value (NPV), etc.
F = value or amount money at some future time;
future worth (FW) and future value (FV).
A = series of consecutive , equal , end-of-peridod
amounts of money; annual worth (AW); dollar per
year, dollar per month and etc.
n = number of interest period; year, month, days.
i = interest rate
t = time, stated in period; year, month, days.
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Time value of money
For single payment
Given compound interest of i:
Future value (FV) = Present value (PV) x (1 + i)
n
Given nominal interest rate per year, r = im
where m is the number of times per year to calculate
interest
Effective discrete annual compound interest rate, i
eff
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Time value of money
Annuity factors for uniform-series payments at
compound interest.
Uniform-series sinking-fund deposit factor,
Uniform-series compound-amount factor,
Uniform-series capital recovery factor,
Uniform-series present-worth factor ,
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Comparing Alternative
Present worth analysis
All the costs and revenues are discounted to calculate
present worth of each alternatives.
Capitalised Costs (K)
Original cost, TC
I
+ present value of the perpetuity for
an infinite number of replacements made every n
R
years.
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Working session
Two alternative pumps, A (carbon steel) and B (aluminium),
have different installed and maintenance costs, salvage
values and anticipated service life, as indicated as below.
Based on present worth analysis and capitalised cost, it is
desired to select one of the pump when the effective
interest rate is 10%.
A B
Installed cost $18,000 $25,000
Uniform end of year
maintaenance
$4,000 $3,000
Salvage value $500 $1,500
Service life 2 yr 3 yr
Working session
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Working session
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Working session
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Incremental Investment Return
Make an investment based on various alternatives.
Comparing the increased saving associated with
additional investment required.
Working session:
Given interest rate of 10%, select one of the three
alternatives below (minimum ROI = 20%):
A B C
Installation cost $5000 $8,000 $ 10,000
Annual saving $3,500 $3,900 $3,600
Service life 2 yr 3 yr 4 yr
H82PLD - Plant Design
Working session
Year 0 1 2 3
A
$5,000
$3,500 $3,500
Econ II - 15 H82PLD - Plant Design Econ II - 16
B
$8,000
$3,900 $3,900 $3,900
Working session
Year 0 1 2 3
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Working session
Year 0 1 2 3 4
C
$10,000
$3,600 $3,600 $3,600 $3,600
H82PLD - Plant Design Lecture 12 - 18
Working session
Comparison of A & B:
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Project cash flow
A
B
C
D
E
F
G
H
L
0
Cumulative
cash flow
Time (year)
K
Payback time
Preliminary
work
Investment in
buildings, plant &
equipment
Working capital
Production
starts
Full
production
Project
breakeven
point
Cash flow
decrease
End of the
project
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Project cash flow diagram
Point A: cash is spent without any immediate return.
A B: the early stages of the project which consist of development,
design & other preliminary work
B C: main phase of capital investment in buildings, plant &
equipment
C D: working capital is spent to commission the plant
Point D: production starts, where revenue from sales begins
D E: the rate of production is likely to be below design conditions
until full production is achieved at E
Point F: the project breakeven point
Point G: net rate of cash flow decreases owing to increasing
maintenance costs, a fall in the market price for the product, etc.
Point H: the end of the project, the plant might be permanently shut
down or given a major revamp. If the plant is shut down, working
capital is recovered
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Payback time & ROI
Payback time:
Definition: time that elapses from the start of the project to the
breakeven point shorter payback time = more attractive project
Retrofit case: calculated as time to recoup the retrofit capital
investment from mean annual improvement in operating costs
Return on Investment (ROI):
Definition: Ratio of average yearly income over the productive life
of the project to the total initial investment, expressed as %
From previous diagram:
Note: Payback & ROI take no account of cash flow pattern
during a project
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Net present value
Indices that take into account of the project net cash flow
pattern with time & time value of money: NPV & DCFRR
Net present value (NPV):
Since $$ can be invested to earn interest, money received now has a
greater value than $$ if received at some time in the future
The NPV of a project = (present values of each individual cash
flow). (Note: present = start of a project)
Time is taken into account by discounting the annual cash flow
(A
CF
) with the rate of interest to obtain the annual discounted cash
flow (A
DCF
)
At the end of year 1:
At the end of year 2:
At the end of year n:
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DCFRR
Discounted cash flow rate of return (DCFRR):
Definition: discount rate i which makes the NPV of a
project to zero:
NPV = A
DCF
= 0
Can be found graphically or trial-an-error
Cumulative
cash flow
Time (year)
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Investment criteria
Higher NPV & DCFRR values mean the project is
more attractive
DCFRR:
The absolute minimum acceptable value is the market
interest rate.
If DCFRR < market interest rate put money in bank
If DCFRR > market interest rate the project will show
a profit
Essential distinction between NPV & DCFRR:
NPV measures profit but does not indicate how
efficiently capital is being used
DCFRR measures how efficiently capital is being used
but gives no indication of how large the profits will be
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Example 3: Economic evaluation
A company has the alternative of investing either in project
A or project B, both with capital cost of $10 million.
Predicted annual cash flows are shown below.
Capital is restricted, and a choice is be made on the basis of
DCFRR, base on a 5-year lifetime.
Year Cash flows ($ 10
6
)
Project A Project B
0 10 10
1 1.6 6.5
2 2.8 5.2
3 4.0 4.0
4 5.2 2.8
5 6.4 1.6
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Example 3 Solution
Project A DCF = 20% DCF = 30% DCF = 22.4%
Year A
CF
A
DCF
A
DCF
A
DCF
A
DCF
A
DCF
A
DCF
0 -10 -10.00 -10.00 -10.00 -10.00
1 1.6 1.33 -8.67 1.23 -8.77
2 2.8 1.94 -6.72 1.66 -7.11
3 4 2.31 -4.41 1.82 -5.29
4 5.2 2.51 -1.90 1.82 -3.47
5 6.4 2.57 0.67 1.72 -1.75
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Example 3 Solution
Project B DCF = 20% DCF = 40% DCF = 38.4%
Year A
CF
A
DCF
A
DCF
A
DCF
A
DCF
A
DCF
A
DCF
0 10 -10.00 -10.00 -10.00 -10.00
1 6.5 5.42 -4.58 4.64 -5.36
2 5.2 3.61 -0.97 2.65 -2.70
3 4.0 2.31 1.34 1.46 -1.25
4 2.8 1.35 2.69 0.73 -0.52
5 1.6 0.64 3.34 0.30 -0.22