03 Capital Investment

Training Services
Capital Investment
Evaluation
2003 ENGINEERING DESIGN SEMINAR – LIMITED DISTRIBUTION: This material is UOP LLC technical information of a confidential
nature for use only by personnel within your organization requiring the information. The material shall not be reproduced in any manner or EDS 2003/CI-1
distributed for any purpose whatsoever except by written permission of UOP LLC and except as authorized under agreements with UOP LLC.
Outline
n Time Value of Money

n Investment Evaluation Tools
– Net Present Value (NPV)
– Breakeven analysis
– Internal Rate of Return (IRR)
n Project Ranking
– Simple payout
– Mutually exclusive projects
– Sensitivity analysis
– Present value ratio
n Cash Flow Analysis
– Examples
n Class Problems
Time Line Concept
Income, $ 50 50 50 50 50
Investment
or Cost, $ 100 100
Year 0 1 2 3 4 5
Time Line Concept
Income, $ 0 50 50 50 50 50
- Cost, $ -100 -100 0 0 0 0
Cash Flow -100 -50 50 50 50 50
Year 0 1 2 3 4 5
Definition of Cash Flow
Gross revenue or savings

- Operating costs
- Tax costs
- Capital costs
= Cash flow
Time Value of Money - Example
Putting Money to Work
n Invest $100 in Bank A and $100 in Bank B

n Bank A pays 20% simple interest at the end of
three years
n Bank B pays 10% compound interest for three
years
Time Value of Money
Bank A
100*1.2=
-$100 $120
Year 0 1 2 3
Time Value of Money
Bank B
100*1.1= 110*1.1= 121*1.1=
-$100 $110 $121 $133
Year 0 1 2 3
Investment Evaluation
Investment evaluation will show us if

an investment gives us a good return
on our money.
Cost of Capital
The Cost of Capital (or money) is the rate of

return that could be realized on similar
alternative investments of equivalent risk.
This foregone rate of return is the standard to

which we compare all our investments.
Investment Evaluation Tools
n Net Present Value (NPV)

n Breakeven Analysis
n Internal Rate of Return (IRR)
Net Present Value (NPV)
Net Present Value is the total value of a project,

revenues minus costs, brought backward to the
first year at a specified rate of interest per year.
(continued)
NPV = Σ Cj / (1 + i) j
where 0 < j < n
j = Period of time, usually a year

Cj = Cash flow in the time period j
I = Interest rate ( = cost of capital)
n = Number of time periods, years
(continued)
I want to have $2,000 at the end of 5 years.

The interest rate is 12%.
How much do I have to invest in year 1?
(continued)
Income, $ 0 0 0 0 0 2000
- Cost, $ NPV 0 0 0 0 0
Cash Flow -NPV 0 0 0 0 2000
Year 0 1 2 3 4 5
NPV = 2000 / (1+0.12)5

NPV = $1135 (to be invested at the beginning of the year)
(continued)
Another way to look at it:
Income, $ 0 0 0 0 0 2000
- Cost, $ X 0 0 0 0 0
Cash Flow -X 0 0 0 0 2000
Year 0 1 2 3 4 5
To make 12% on my investment:
-X + 2000 / (1+0.12)5 = 0
X = $1135
This is also called the Breakeven Price
Net Present Value – Example
Income, $ 0 50 40 30 20
- Cost, $ 100 0 0 0 0
Cash Flow -100 50 40 30 20
Year 0 1 2 3 4
What is the NPV of this project using a cost of capital of

15%? What is the Breakeven Investment cost?
Worksheet for NPV Example
NPV = Σ Cj / (1 + i) j
NPV = -100 / (1+0.15)0 +

50 / (1+0.15)1 +
40 / (1+0.15)2 +
30 / (1+0.15)3 +
20 / (1+0.15)4
NPV = -100 + 43 + 30 + 20 + 11
NPV = $4
At the beginning of year 1, the value of this project is
$4 at a 15% rate of interest. This means I make
15% interest on my $100 investment over a 4 year
period, plus $4 extra. The interest rate on this
investment is, therefore, greater than 15% per year.
Breakeven Analysis
Breakeven analysis is determining the value of

any parameter which allows a specified rate of
return to be achieved from an investment.
The parameter may be the initial investment

cost, project lifetime, annual revenue, selling
price of a product, or % utilization of plant.
Breakeven Investment Cost
Income, $ 0 50 40 30 20
- Cost, $ X 0 0 0 0
Cash Flow -X 50 40 30 20
Year 0 1 2 3 4
NPV = 0 = -X / (1+.15)0 + 50 / (1+.15)1 + 40 / (1+.15)2

+ 30 / (1+.15)3 + 20 / (1+.15)4
0 = -X + 43 + 30 + 20 + 11
X = $104
For a Rate of Return of 15% on this investment,
I could invest up to $104. This is then the
Breakeven Investment Cost for this particular
project. Any additional cost would lower the
Rate of Return to less than 15% which would not
be acceptable.
What is the NPV at 20%?
Income, $ 0 50 40 30 20
- Cost, $ 100 0 0 0 0
Cash Flow -100 50 40 30 20
Year 0 1 2 3 4
NPV = -100 / (1+.20)0 + 50 / (1+ .20)1 + 40 / (1+ .20)2

+ 30 / (1+ .20)3 + 20 / (1+ .20)4
= -100 + 42 + 28 + 17 + 10
= - $3
The IRR is between 15% and 20%.

Internal Rate of Return (IRR)
n Rate of Return or interest rate of a project
n Calculated through trial and error
Internal Rate of Return (IRR)
(continued)
0 = Σ Cj / (1 + r) j
where 0 < j < n

Cj = Cash flow in time period j
r = Internal Rate of Return unknown
n = Number of periods, usually years
Assume a value for “r” and calculate formula.

The project’s IRR is the value of “r” that gives
an answer of zero NPV.
What is the IRR of this project?
Income, $ 0 100 100 120 140
- Cost, $ -200 -150 0 0 0
Cash Flow -200 -50 100 120 140
Year 0 1 2 3 4
at r = 15%
- 200/(1+.15)0 - 50/(1+ .15)1 + 100/(1+ .15)2
+ 120/(1+ .15)3 + 140/(1+ .15)4
- 200 - 43 + 76 + 79 + 80 = - $8
at r = 10%
- 200/(1+.10)0 - 50/(1+ .10)1 + 100/(1+ .10)2
+ 120/(1+ .10)3 + 140/(1+ .10)4
- 200 - 45 + 83 + 90 + 96 = + $24
Example – What is the IRR of the
following project?
Income, $ 0 30 40 50
- Cost, $ 100 0 0 0
Cash Flow -100 30 40 50
Year 0 1 2 3
What is the IRR of this Project?
Calculation
at r = 15%
-100/(1+.15)° + 30/(1+.15)1 + 40/(1+.15)2 + 50/(1+.15)3
-100 + 26 + 30 + 33 = - $11
at r = 10%
-100/(1+.10)° + 30/(1+.10)1 + 40/(1+.10)2 + 50/(1+.10)3
-100 + 27 + 33 + 38 = - $2
at r = 8%
-100/(1+.08)° + 30/(1+.08)1 + 40/(1+.08)2 + 50/(1+.08)3
-100 + 28 + 34 + 40 = + $2
The internal rate of return is 9%
Project Ranking
n Simple Payout
n Mutually Exclusive Projects
n Sensitivity Analysis
n Present Value Ratio
Simple Payout
Simple payout is the number of years it will take

to pay back an investment at the initial operating
gross margin. Simple payout takes no account of
inflation, nor of the time value of money.
Example:
– Gross margin in year 1 = $700 MM/year
– Total investment in project = $1,400 MM
– Simple payout = $1,400/$700 = 2 years
Payout Example #1
Project A
Cash Flow -100 50 50 50
Year 0 1 2 3
NPV @ 15% minimum rate of return = $15

and the IRR ∼ 23%
Payout = 2 years
Payout Example #2
Project B
Cash Flow -100 100 0 0
Year 0 1 2 3
NPV @ 15% min rate of return = - $13

and the IRR = 0%
Payout = 1 year
Simple Payout
n Simplest economic evaluation method
n Takes NO account of the time value of money
n Penalizes long term projects
n Benefits quick projects
Project Ranking
n Mutually exclusive alternatives

– Only 1 project can be accepted
n Non-mutually exclusive alternatives

– Ranking several projects
Mutually Exclusive Alternatives
n The goal is to choose the one project that gives

the investors the largest return on their money
– The project with the largest NPV using the
minimum rate of return
– The project with the highest incremental IRR
• Calculate each project’s individual IRR; must be
higher than the minimum rate of return
• Calculate the incremental IRR between projects;
this too must be higher than the minimum rate of
return
• The project which has the highest incremental
IRR will give the largest return on the investment
Project A
Income, $ 0 50 60 70
- Cost, $ 100 0 0 0
Cash Flow -100 50 60 70
Year 0 1 2 3
Project B
Income, $ 0 0 0 370
- Cost, $ 200 0 0 0
Cash Flow -200 0 0 370
Year 0 1 2 3
Net Present Value
Project A
at r = 15%
-100/(1+.15)° + 50/(1+.15)1 + 60/(1+.15)2 +
70/(1+.15)3 -100 + 43 + 45 + 46 = + $34
Project B
at r = 15%
-200/(1+.15)° + 370/(1+.15)3 -200 + 243 = + $43
Minimum rate of return is 15%
Internal Rate of Return
Project A
at r = 30%
-100/(1+.30)° + 50/(1+.30)1 + 60/(1+.30)2 + 70/(1+.30)3
-100 + 38 + 36 + 32 = + $6
at r = 35%
-100/(1+.35)° + 50/(1+.35)1 + 60/(1+.35)2 + 70/(1+.35)3
-100 + 37 + 33 + 28 = - $2
at r = 33%
-100/(1+.33)° + 50/(1+.33)1 + 60/(1+.33)2 + 70/(1+.33)3
-100 + 38 + 34 + 30 = + $2
Internal Rate of Return
Project B
at r = 20%
-200/(1+.20)° + 370/(1+.20)3 -200 + 214 = + $14
at r = 25%
-200/(1+.25)° + 370/(1+.25)3 -200 + 189 = - $11
at r = 23%
-200/(1+.23)° + 370/(1+.23)3 -200 + 199 = - $1
Project B
Cash Flow of B -200 0 0 370
Year 0 1 2 3
Project A
Cash Flow of A -100 50 60 70
Cash Flow B-A -100 -50 -60 300
Year 0 1 2 3
Incremental Rate of Return
Project B - Project A
at r = 15%
-100/(1+.15)° - 50/(1+.15)1 - 60/(1+.15)2 + 300/(1+.15)3
-100 - 43 - 45 + 197 = + $9
at r = 20%
-100/(1+.20)° - 50/(1+.20)1 - 60/(1+.20)2 + 300/(1+.20)3
-100 - 42 - 42 + 174 = - $10
Therefore, the incremental rate of return is approximately

17%, which is above our minimum rate of return. Project B
is the project that will give the highest return on our money.
Project Comparison
Project Project Project

Year A B B-A
0 -100 -200 -100
1 50 0 -50
2 60 0 -60
3 70 370 300
Net Income 80 170 90

NPV @ 15% 35 43 8
IRR 34% 23% 17%
Best Best Winner
IRR NPV is B
Sensitivity Analysis
Project Project Project
Year A B B-A
0 -100 -200 -100
1 50 0 -50
2 60 0 -60
3 70 370 300
Net Income 80 170 90

NPV @ 15% 35 43 8
IRR 34% 23% 17%
Discount Rate Sensitivity Analysis

NPV NPV NPV
5% 62.5 119.6 57.1
10% 47.6 78.0 30.3
15% 34.9 43.3 8.4
20% 23.8 14.1 -9.7
25% 14.2 -10.6 -24.8
30% 5.8 -31.6 -37.4
Sensitivity Analysis
(continued)
120
100
80
60
40
20
0
-20
-40
5% 10% 15% 20% 25% 30%
Project A Project B Project B-A
Non-Mutually Exclusive Alternatives
n The goal is to rank several potential projects

by economic return to give higher priority to
the projects with highest return on investment
– Present Value Ratio = NPV / PWNC

• NPV = Net Present Value
• PWNC = Present Worth Net Cost
(calculated at the minimum rate of return)
Present Worth Net Cost (PWNC)
PWNC = Σ Εj / (1 + i) j
where 0 < j < n

E = Expenditure in time period j
I = Interest rate ( = cost of capital)
n = Number of time periods, years
Present Worth Net Cost (PWNC)
Income, $ 0 50 110 120

- Cost, $ -100 -100 0 0
Cash Flow -100 -50 110 120
Year 0 1 2 3
PWNC = +100/(1+.15)° + 50/(1+.15)1

PWNC = $143
Income, $ 0 50 110 120

- Cost, $ -100 -100 0 0
Cash Flow -100 -50 110 120
Year 0 1 2 3
NPV = -100/(1+.15)° - 50/(1+.15)1 + 110/(1+.15)2 + 120/(1+.15)3

NPV = -100 - 43 + 83 + 79
NPV = + $19
Present Value Ratio
Income, $ 0 50 110 120

- Cost, $ -100 -100 0 0
Cash Flow -100 -50 110 120
Year 0 1 2 3
Present Value Ratio = Net Present Value / Present Worth Net Cost
Present Value Ratio = 19 / 143 = 0.13
Non-Mutually Exclusive Alternatives
n To rank several projects, order the projects

by their present value ratio
Present
Project Value Ratio Rank
A 0.13 3
B 1.21 1
C 0.37 2
D 0.04 4
Project Ranking Example
Project Project Project Project

Year E F G H
0 -2000 -2000 -2000 -2000

1 1000 0 20000 0
2 1000 2000 -21000 1000
3 5000 5000 0 100000
Net Income 5000 5000 -3000 99000
NPV @ 15% 2,913 2,800 (488) 64,508

IRR 68.2% 60.1% 19.2% 273%
Payout, years 2 2 0.1 3

PV ratio 1.46 1.40 -0.03 >32
Cash Flow Analysis
Cash Flow Analysis
Net Income or Gross Margin

- Expenses
- Taxes
Costs
- Interest
- Capital charges
= Net Cash Flow
Sample Economic Evaluation
$MM(U.S.)
Year 0 1 2 3 4 5 6 7 8 9 10 1
Net Cash Flow (350) (500) (79) 365 378 396 367 381 397 367 383 479
Cum. Cash Flow (350) (850) (929) (564) (185) 211 578 959 1,356 1,723 2,106 2,585
Economic Evaluation:
Net Present Value
Interest rate, i 5% 10% 15% 20% 25% 30% 35%
NPV at i, $MM 1,604 968 542 250 45 (102) (209)
Internal Rate of Return 26%
Simple Payout 4.5 years
Financial Functions in Excel
n Net Present Value (NPV)

= NPV (interest rate, cash flow range)
+ cash flow in year 0
Notes: do not discount the cash flow for year 0
cash flow range is for years 1 to n
n Internal Rate of Return (IRR)

= IRR (cash flow range, guess of IRR)
Note: cash flow range is for years 0 to n
Financial Functions in Lotus
n Net present value (NPV)

= @ NPV (i, range) + cash flow in year 0
where i = the minimum rate of return and
range = the cash flows in years 1 to n
n Internal Rate of Return

= @ IRR (i, range)
where i = a starting guess for the IRR and
range = the cash flows in years 0 to n
UOP’s Electric Mop Project
n Pilot Production and Test Marketing
– Period of 1 year
– Investment of $125,000
– 50% chance of success
n Build Production Plant
– Investment of $1,000,000
– Annual cash flow of $250,000
– or only $75,000 if the test fails
– 20 year project life
n High Risk Project
– Use 25% discount factor
Is This A Good Project?

NPV Analysis
Cash Flows, $000 Expected

Year 0 -125 - 125
Year 1 50% of -1000 and 50% of 0 - 500
Year 2 50% of 250 and 50% of 0 125
Year 3 50% of 250 and 50% of 0 125
…
Year 21 50% of 250 and 50% of 0 125
NPV = -125 - ( 500 / 1.25 ) + Σ ( 125 / 1.25^t )

NPV = -129.6
Negative NPV = Not A Good Project?

Decision Tree Analysis
t = 20
Invest 1,000 in NPV = - 1,000 + Σ ( 250 / 1.15 ^t )
Full Scale Plant t=1
NPV = 565
Success
(50%) Don’t Invest Stop NPV = 0
Test
(Invest 125) Invest 1,000 in
Full Scale Plant t = 20
Failure NPV = - 1,000 + Σ (75 / 1.15 ^t )
t=1
(50%) NPV = - 531
Don’t Test
Stop
Don’t Invest Stop NPV = 0
Actual NPV = (-125) + (0.5 * 565)/(1.25) = $101


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Training Services

n Time Value of Money

- Cost, $ -100 -100 0 0 0 0

Cash Flow -100 -50 50 50 50 50

Gross revenue or savings

n Invest $100 in Bank A and $100 in Bank B

100*1.1= 110*1.1= 121*1.1=

-$100 $110 $121 $133

Investment evaluation will show us if

The Cost of Capital (or money) is the rate of

This foregone rate of return is the standard to

n Net Present Value (NPV)

Net Present Value is the total value of a project,

j = Period of time, usually a year

I want to have $2,000 at the end of 5 years.

How much do I have to invest in year 1?

Cash Flow -NPV 0 0 0 0 2000

NPV = 2000 / (1+0.12)5

Cash Flow -X 0 0 0 0 2000

Cash Flow -100 50 40 30 20

What is the NPV of this project using a cost of capital of

NPV = -100 / (1+0.15)0 +

Breakeven analysis is determining the value of

The parameter may be the initial investment

NPV = 0 = -X / (1+.15)0 + 50 / (1+.15)1 + 40 / (1+.15)2

NPV = -100 / (1+.20)0 + 50 / (1+ .20)1 + 40 / (1+ .20)2

The IRR is between 15% and 20%.

n Rate of Return or interest rate of a project

n Calculated through trial and error

j = Period of time, usually a year

Assume a value for “r” and calculate formula.

The internal rate of return is 9%

n Mutually Exclusive Projects

n Present Value Ratio

Simple payout is the number of years it will take

NPV @ 15% minimum rate of return = $15

NPV @ 15% min rate of return = - $13

n Simplest economic evaluation method

n Takes NO account of the time value of money

n Penalizes long term projects

n Benefits quick projects

n Mutually exclusive alternatives

n Non-mutually exclusive alternatives

n The goal is to choose the one project that gives

Minimum rate of return is 15%

Therefore, the incremental rate of return is approximately

Project Project Project

Net Income 80 170 90

Net Income 80 170 90

Discount Rate Sensitivity Analysis

n The goal is to rank several potential projects

– Present Value Ratio = NPV / PWNC

j = Period of time, usually a year

Income, $ 0 50 110 120

PWNC = +100/(1+.15)° + 50/(1+.15)1

Income, $ 0 50 110 120

NPV = -100/(1+.15)° - 50/(1+.15)1 + 110/(1+.15)2 + 120/(1+.15)3

Income, $ 0 50 110 120

n To rank several projects, order the projects

Project Project Project Project

0 -2000 -2000 -2000 -2000

Net Income 5000 5000 -3000 99000

NPV @ 15% 2,913 2,800 (488) 64,508

Payout, years 2 2 0.1 3

1001.1= 1101.1= 121*1.1=