Economics and Profitability

Basic Steps in the Feasibility Evaluation of a Process Design Develop the conceptual design and flowsheet for the process. Calculate the capital investment needed to build the plant. Calculate the operational investment needed to run the plant. Perform an economic analysis and calculate the break even point and internal return on investment Compare the investment with other investment options

Economic Analysis Concepts Terminology Present Worth (P), Future Worth (F), Annuity (A) Annual or Nominal Interest Rate (i), Number of Years (n) Interest on Capital Simple Interest Compound Interest Cash Flow Diagrams Discrete Cumulative Capital Depreciation & Taxes

Simple Interest Only the principal amount earns revenue

Compound Interest The principal and the interest earned both generate revenue. (i=annual or nominal interest rate n=# years) Compounded Annually Compounded Quarterly Compounded Monthly

Discrete Cash Flow Diagram Inward flow of cash (+ cash flow) years 1 2 3 4 5 Outward flow of cash (- cash flow)

Cumulative Cash Flow Diagram Net inward / positive flow of cash years 1 2 3 4 5 Net outward / negative flow of cash

Time Value of Money Cash inflow today is better than inflow of the same amount of cash next year. When cash flow occurs at different times, each time the cash must be brought forward or backwards to the same point in time and then compared. Any point in time can be used for comparison

Example (Find x for a cumulative cash value of 0 at the end of year 7) Rate of interest is 8% compounded annually Bring forward all the cash flow to the end of the 7th year: 1.2 K 1.5 K 1 K 5 7 1 2 3 2 K X = ?

Example (Find x for a cumulative cash value of 0 at the end of year 7) Rate of interest is 8% compounded annually Bring back all the cash flow to the end of the 1th year: 1.5 K 1.2 K 1 K 5 7 1 2 3 2 K X = ?

Annuities are a Uniform Series of Cash Transactions An annuity is a fixed payment or revenue at the end of a year for n consecutive years The future and present worth of an annuity is: Discount Factor (F/A,i,n) Converts A to F Discount Factor (P/A,i,n) Converts A to P

Commonly Used Discount Factors

Depreciation of Capital Fixed Capital = all the costs associated with the plant construction. (This can be fully depreciated excluding the land purchase) Working Capital = amount of capital required to start up plant. (This is can not be depreciated) Rule of Thumb Working Capital ~ 15 – 20 % of Fixed Capital Various methods of depreciation are available Total Capital Investment = Fixed Capital + Working Capital

Definitions Fixed capital investment FCIL =Cost to build the plant - Cost of land (ie depreciable part of the investment) Salvage value S = The value of the plant at the end of the plant life; Salvage value for equipment is typically zero Equipment Life n = A number specified for accounting which doesn’t necessarily reflect the real life Total capital for depreciation D = FCIL – S Yearly depreciation dk=amount deducted in the kth year Book Value is the amount of depreciable capital that has not been depreciated

Depreciation Methods Straight Line (SL) Uniform depreciation !

Depreciation Methods Double Declining Balance (DDB) Decreasing deprecation ! Largest amount depreciated in first year

Usual Depreciation Method Depreciates Capital ASAP Modified Accelerated Cost Recovery System (MACRS) Uses a half year convention Most chemical plant equipment has a depreciation life of 9.5 years Can use SD or DDB over 9.5 years (SD OK for projects) Can use also use MACRS (Uses DDB initially and then switches to SD for optimal depreciation) In general best to depreciate ASAP

Taxation, Cash Flow, Profit

A Typical Cash Flow Diagram for a New Project Land FCIL Working Capital (WC) Depreciation Allowance Ceases Project Completed Project Life (for economic comparisons) 0 1 2 3 4 5 6 7 8 9 10 11 12 Land + Working Capital +Salvage

Evaluation of Profitability Time value of money needs to taken into account (i.e. Discounted Cash Flow) Discounted PayBack Period (DPBP) = Time required after start up to recover Fixed Capital Investment, (FCIL) for the project with all cash flows discounted to time zero. Alternative definitions use Total Capital Investment (TCI = FCIL + WC + Land) for DPBP. Break Even Point = Time required for cumulative cash flow to equal zero. (Break Even = DPBP for use of Total Capital Investment) We will use the Break Even Point in our economic and profitability analysis

Discounted Interest Rate Criterion Discounted cash flow rate of return (DCFROR) = Rate of interest at which all the cash flows much be discounted in order for the net present value (future worth at the end of the project ) be equal to zero. We will use this in our economic and profitability analysis as Internal Return on Investment! (IRR) or Return on Investment (ROI)

Reasonable Assumptions for Projects Interest Rate = 6% Plant Life = 10 years Tax Rate = 25% Working Capital = 15% of FCI Salvage = 0 Construction Period = 2 years Straight Line Depreciation Required Internal Rate of Return = 20% Note: You can make your own assumptions for your projects