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Module Outline

Evaluating plant investments

Plant financing options

Plant ownership costs

Calculating ownership costs

Purchase versus hiring plant

2

Investment appraisal methods

1) Payback period

2) Average rate of return

3) Net present value

4) Internal rate of return

5) Benefit-Cost ratio (Profitability index)

3

A simple method popular for small businesses

The payback period = The time taken for an item of plant to

generate sufficient net cash flow to pay

for the original capital investment in its

entirety

Example:

A company considers purchasing an excavator for an

investment of $200,000 which is expected to provide annual

cash flow of $50,000.

The payback period would be four years.

Ignores the time value of money

Changes in the cash flows after the payback

period are ignored

4

Average annual profit you expect over the life of an investment

project, compared with the average amount of capital invested

(NIBusiness, 2004)

Average rate of return (ARR) =

Average investment cost

If ARR < the required rate of return investment rejected

Average investment =

Book value at beginning of year 1 +book value at end of useful time

2

Or

Example:

An excavator requires an average investment of $250,000 and

is expected to produce an average annual profit of $37,500.

The ARR would be 15 per cent.

The higher the ARR, the more attractive investment

ARR is based on profit rather than cash flow (affected by

subjective, non-cash items such as the rate of depreciation)

Fails to take into account the timing of profit

6

Takes into account the size of the cash inflows over the life

of the plant, but also makes adjustment for the timing of the

money

Present value (PV) =

F

n

(1+i)

i = interest rate

n = the number of years

Example:

present value of:

$100000

= $88999.64

2

(1+0.06)

incomes, over a period of N years:

n

A [(1+i) 1]

Present value (PV) =

n

i(1+i)

Net present value (NPV) = The sum of the present values (PVs)

of incoming (benefit) and outgoing

(cost) cash flows over a period of time

Net present value (NPV) = -PV (costs) + PV (benefits)

A cost is negative or outgoing cash flow

The higher the NPV the better (NIBusiness, 2004)

Example:

and with an interest rate of10%, the NPV for five years of cash flow

is $6,142.

5

$28000[(1+0.1) 1]

$100000= $6142

5

0.1(1+0.1)

The internal rate of return for an investment is the rate of return

(interest rate) that makes the present value of returns (benefits)

equal to the present value of costs

PV (costs) = PV (benefits) NPV=0

Example:

An investment of $100,000 is expected to generate an annual

return of $28,000 for 5 years. What is the IRR?

5

$28000[(1+r) 1]

= $100000

5

r(1+r)

Try

9

r = 10%

r = 20%

r = 12.5%

IRR 12.5%

or

5

(1+r) 1

= 3.57

5

r(1+r)

Factor = 3.79

Factor = 2.99

Factor = 3.56 close enough

5) Benefit-Cost ratio

Appropriate for situations where there is a limited capital

budget to be allocated to the most cost effective projects

Benefit-Cost ratio = Discounted value of benefits

Discounted value of costs

The greater the benefit cost ratio the more desirable the

project

Not useful when choosing between more than one project as

it measures the relative profitability of a project.

10

Owning equipment

Costs include:

Operating costs

Maintenance

Repairs

Inspections

Transportation

Storage

Long retain period

Escalate over the life

of the equipment

11

Renting equipment

capital tied up in fleet

Reduces the amount of

start-up capital

Reduces maintenance

costs, repairs,

inspections, transportation

and storage.

1) Cash Purchase

Plant supplier

100%

Construction

Company

2) Financing Lease:

Lease fee

Plant supplier

Construction

Company

Finance provider

Construction company:

Responsible for all maintenance, taxes and insurance

Can purchase the plant at the end of the lease period (at residual value)

Can renew/terminate the lease period

Lease fee

3) Operating Lease

12

Plant supplier

Construction

Company

Charges/lease period are usually lower than financing lease

Suitable for large or complex items of plant (skilled personnel for servicing

and maintenance provided by the lessor)

Factors influencing ownership cost

Purchase price

costs (freight, packing, and insurance)

13

cost and output

Measured in terms of operating hours (or in the case of trucks and

trailers in terms of kilometers)

Influenced by several factors:

- The physical condition and performance of the plant

- Shifts in economics for a company

- Physical deterioration concerns issues such as corrosion,

chemical decomposition and general wear and tear

- Changing economic conditions such as fuel prices, tax

investment incentives, and the rate of interest

14

Plant utilisation

An uncertainty even if a company has secure, fixed-term

contracts

Expected rate of utilisation past operational history of the

companys equipment (Agoos, 2012)

A simplified approach to calculate utilization:

Utilisation (%) =

Operating period

Standard industrial period

A practical guide:

Utilisation > 60-65% of the time owning is more cost

effective than renting

40% < Utilisation < 60% increase financial risk

15

Definition of terms:

Salvage or residual value

The price that equipment can be sold for at the time of its disposal

Often estimated as 10-20% of the initial purchase price

Insurance

A rough estimate of plant insurance cost : $10 for every $1,000 of

the average value (i.e.,1%)

If the actual insurance cost of the plant is known:

Estimated insurance cost / year = Average value 100

16

Depreciation

Decrease in plant value over time

Straight-Line depreciation

Accelerated depreciation

New price salvage price

No. of years used

Cost

Straight-LineDepreciation

Accelerated Depreciation

Year 1 Year 2 Year 3 Year 4 Year 5

17

Interest cost

Expected income if a company had invested money (e.g., in bank)

instead of buying plant

Method 1: Interest cost = Average value interest rate

New price + trade in value

Average value =

2

Method 2:

Interest cost = (Average annual investment (AAI)) (interest rate)

(PS)(N+1)

+S

AAI =

2N

P = Purchase price

S = Salvage value

N = Life in years

18

Storage cost

The cost associated with providing suitable facilities to store and

protect plant

Method 1: Storage cost = 0.5-1% of the price of new machine

Method 2:

Storage cost = (yearly depreciation of storage facility) x

(proportion of facility occupied by the machine)

Workshop cost

The cost the tools and workshop if plant is serviced and repaired

on company premises

Workshop cost = (proportion of workshop time used for plant) x (cost

(depreciation & interest) of workshop and tools)

Registration cost

19

cranes are going to be driven for short distances on the road

Summary

Owning equipment

contractor

Hourly rate is generally less than

hire plant

Owner has the choice of which

costing method to use

20

Renting equipment

Can be hired for short periods

Repairs and replacements are

the responsibility of the hire

company

Contractors do not have to worry

about plant utilization after the

job is finished

Plant can be hired on an all-in

basis including the operator.

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