Process Plant Design and Economics

(CB407)

Chemical and Biochemical Engineering

Indian Institute of Technology Patna

Atanu K Metya
atanu.metya@iitp.ac.in
 Process Plant Design and Economics

Profitability, Alternative Investments,

and Replacements
 Process Plant Design and Economics

Measures of profitability
• A profitability standard is a quantitative measure of profit with respect to
the investment required to generate that profit.

• Cost of capital is the amount paid for the use of capital from such sources
as bonds, common and preferred stock, and loans.

• The minimum acceptable rate of return is a rate of earning that must be

achieved by an investment in order for it to be acceptable to the investor.
 Process Plant Design and Economics
The cost of capital
chapter 8
and the rate of earnings on alternative investments are generally
Profitability, Alternative Investments, and Replacements
expressed as a single, end-of-the-year amount after income taxes, calculated as a % per
year of the capital obtained or invested.
Table 8-1 Suggested values for risk and minimum acceptable return on investment

Minimum acceptable return mar

Investment description Level of risk (after income taxes), percent/year

Basis: Safe corporate investment Safe 4-8

opportunities or cost of capital
New capacity with established Low 8-16
corporate market position
New product entering into established Medium 16-24
market, or new process technology
New product or process in a High 24-32
new application
Everything new, high R&D and Very high 32-48+
marketing effort
 Process Plant Design and Economics

• Methods for calculating profitability:

• Do not consider the TVM

• Payback period
• Rate of return on investment
• Net return

• Consider the TVM

• Discounted cash flow rate of return
• Net present worth.
 Process Plant Design and Economics

• What is the Payback time for a project that involves an original

investment of $91,000 and provides an annual profit (positive
cash flow) of $34,000 per year over the first three years and no
depreciation.
• Consider the following cash flow:
year Cash flow
($)
0 -8000
1 3000
2 4000
3 5000
4 5000
 Process Plant Design and Economics
Example. The research department of a large specialty monomer and polymer company
has developed and formulated a new product.
A preliminary design study has just been completed. The estimated economic parameters
relevant to the project include the following items:
• Production at 100% of capacity = 2 x 106 kg/yr
• Batch process, total capital investment = $28 million
• Fixed-capital investment = $24 million
• Working capital = $4 million
• The variable product costs at full capacity = $5 million/yr
• The fixed costs (except for depreciation) = $1 million/yr
 Process Plant Design and Economics

• Company evaluation policies are as follows:

• Use a 5-year recovery period, half-year convention, and MACRS
depreciation with all evaluation methods. Neglect working capital and
salvage-value recovery. Use a 35% per year income tax rate.
• Use a 10-year evaluation period; base the calculations on 50% of rated output
the first year, 90% the second year, and 100% each year thereafter.
• Assume that all the capital investment occurs at zero time.
• Because of the high risk factor, a minimum acceptable return of 30% per year
• Calculate the product sales price that is required to achieve the mar obtained by
using the methods of payback period, return on investment, and net return.
Process Plant Design and Economics
 Process Plant Design and Economics

• Net Present Value (NPV)

Example: Many projects generate revenue at varying rates over time. For
example, consider a project that costs $1,000 and will provide three cash
flows of $500, $300, and $800 over the next three years. Assume there is no
salvage value at the end of the project and the required rate of return
(discount rate) is 8%. Calculate the NPV of the project.
 Applicable recovery periods: 3, 5, 7, 10, 15, 20 years
Process Plant Design
Applicable and
convention: Economics
half-year

• Example. A chemical plant with a fixed capital investment of Recover

$100 million generates an annual gross

Recovery
3-yearprofit of $50 million. 7-year
5-year
Assume the plant is built
yearat time zero and begins operation at full Depreciat
rate in year 1. Assume the rate of corporate income tax is 35%,
1 33.33 20.00 14.29
and taxes must be paid 2based on the44.45 previous year’s income. 24.49
32.00
Estimate the NPV at a 12% 3 interest rate14.81
and the DCFROR19.20for the 17.49
project, using the MACRS 4 depreciation method with
7.41 a 7-year 12.49
11.52
recovery period. 5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
9
10
 Process Plant Design and Economics

• Calculate the NPV for this project at 15% time value of money
and the discounted cash flow rate of return (DCFRR) for this
project
Period Cash Flow PV of cash Cumulative
($) flow ($) sum of PV ($)
0 -91,093
1 20,000
2 40,000
3 40,000
4 40,000
5 30,000
 Process Plant Design and Economics

• HW. With the same economic information and company policies as

supplied in the previous example, use discrete, year-end cash flows and
discrete compounding to determine the product price that will be required
to provide a discretely compounded earning (discount) rate of 30% year.
• If a price of $11.50 is established for the product, determine the discounted
cash flow rate of return.
 Process Plant Design and Economics

We have learned the following profitability evaluation criteria:

• Rate of return on investment (ROI)
• Payback period (PBP)/ Payback time (PBT)
• Net return
• Net present worth (NPW)/ Net present value (NPV)
• Discounted cash flow rate of return DCFRR/ DCFIRR
 Process Plant Design and Economics

Example: A company has three alternative investments that are being considered.
The risk factors are the same for all three cases. Company policies, based on the
current economic situation, dictate that a minimum annual return on the original
investment of 15% after taxes be predicted for any unnecessary investment.
Company policies also dictate that straight-line depreciation be used over the service
life of the investment with accounting for the salvage value. For time-value-of-money
calculations, continuous cash flow and continuous compounding relationships are to
be used. Land value and pre start-up costs can be ignored.
Use the following data to determine the following profitability evaluation criteria:
(a) Rate of return on investment (b) Payback period (c) Net return
(d) Net present worth (e) Discounted cash flow rate of return
 Process Plant Design and Economics
Investment Total WC Salvage value at Service Annual earnings
Number initial FCI investment end of service life, year after taxes
life
1 100,000 10,000 10,000 5 See yearly tabulation
2 170,000 10,000 15,000 7 42,000 (constant)
3 210,000 15,000 20,000 8 48,000 (constant)
For investment 1
Year Annual earnings flow to project
1 30,000
2 31,000
3 36,000
4 40,000
5 430000
 Process Plant Design and Economics

• Example: A chemical company is considering adding a new

production unit that will require a total investment of $1,200,000
and yield an annual after-tax profit of $240,000. An alternative
addition has been proposed requiring an investment of $2 million
that will yield an annual after-tax profit of $300,000. The
company executives feel that equally sound investments can be
made with at least a 14% annual after-tax rate of return.
Therefore, the minimum acceptable rate of return for the new
investment is 14% after taxes.
 Measures of profitability
Process Plant Design and Economics
Profitability

Comparison of alternatives
Calculate the DCFRR for the following cash flows
• Calculate the DCFRR for the following cash flows and which one
is better? Which one is better?
year 0 1 2 3
A -1000 750 390 180
Cash flows B -1000 350 470 660
C -1000 533 467 400

From Humphreys, Jelen’s Cost and Optimization Engineering, page 117

55
 Process Plant Design and Economics

• What is
compare
the best Comparison
value for the investment?of alternatives
We’ll come
• Do you select Project A, B or None? back to these
What is the best value for the investment? two columns
• MARR = 10%
MARR = 10%
Period, n Project A Project B Project (B-A) Invest in
MARR
0 -$1000 -$5000 -$4000 -$4000
1 +$2000 +$7000 $5000 $4400
DCFRR 100% 40% 25% 10%
NPV at i=10% $818 $1364 $545 $0

Problem: NPV is an absolute measure

 Process Plant Design and Economics

• What is the best value for the investment?

• Do you select Project A, B or None?
• MARR = 10%
 Process Plant Design and Economics

• Mutually exclusive alternatives

• Using discounted cash flow as the basis:
• Calculate the DCFRR for the lowest investment; accept if DCFRR >
MARR. If not, take next largest investment. Continue until one has been
accepted.
• Calculate the DCFRR on the incremental investment for the next largest
investment, accept only if incremental DCFRR > MARR
• Continue until all investments have been considered.
 (Data fromProcess
Park et. al (2001)
Plant DesignContempary Engineering Econom
and Economics

• What is the best value for the investment?

MARR
• Do you select Project = None?
A, B or 10%
• MARR = 10%

year Project A Project B B-A

0 -3000 -12000 -9000

1 1350 4200 2850
2 1800 6225 4425
3 1500 6330 4830

DCFRR
IRR 25% 17% 15%
 Process Plant Design and Economics

• Example: Consider two investments. The first costs $1 today and

returns $2 in one year. The second costs $1000 and returns $1900
in one year. Which is the preferred investment based on IRR?
Your MARR is 70 percent.
 Process Plant Design and Economics
Example: Monster Meats can buy a new meat slicer system for $50000. The
company estimates it will save $11000 per year in labour and operating costs.
The same system with an automatic loader is $68000, and will save
approximately $14000 per year. The life of either
C H A P Tsystem
E R 5 C o mis
p a rthought
i s o n M e t h o d to
s P abe
rt 2 eight
133
years. Monster Meats has three feasible alternatives:

Alternative First Cost Annual Savings

“Do nothing” $ 0 $ 0
Meat slicer alone 50 000 11 000
Meat slicer with automatic loader 68 000 14 000

Monster Meats uses a MARR of 12% for this type of project. Which alternative
is betterMonster
based on IRR?
Meats uses a MARR of 12 percent for this type of project. Which alterna-
tive is better?
the process is then Process
selected asPlant
the best overall alternative.
Design and EconomicsFigure 5.5 on page 137 summa
rizes the incremental investment analysis for the mutually exclusive projects.
Example: Fly-by-Night Aircraft must purchase a new lathe. It is
5.6considering
(REPRISE OF EXAMPLE
one of 4.4)
four new lathes, each of which has a life of 10
years withAircraft
Fly-by-Night no scrap value. aGiven
must purchase a MARR
new lathe. of 15%,
It is considering one which
of four ne
lathes, each of which
alternative hasbe
should a life of 10 years with no scrap value. Given a MARR of 15 per
chosen?
cent, which alternative should be chosen?

Lathe 1 2 3 4
First cost $100 000 $150 000 $200 000 $255 000
Annual savings 25 000 34 000 46 000 55 000

The alternatives have already been ordered from lathe 1, which has the smallest fir
cost, to lathe 4, which has the greatest first cost. Since one lathe must be purchased
accept lathe 1 as the current best alternative. Calculating the IRR for lathe 1, althoug