ChE/MGMT 597

Financial Analysis and

Management of Projects

Value Creation Revisited and

Pro Forma Cash Flows
3/25/2020
Charlie Smith

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 Introduction

Mr. Charlie Smith

B.S. Chem Eng Purdue University, 1980

(317) 432-4285
Charlie4129@yahoo.com

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 Value Creation Revisited
Basic Research

Process Development

Pilot Demonstration
Maintenance

New Facility
Expansion /
Upgrade

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 Basic Research
Basic Research

• Example: National Science Foundation

• Stated goal of the National Science
Foundation: "To promote the progress of
science; to advance the national health,
prosperity, and welfare; and to secure the
national defense."

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 Example: CISTAR

Center for Innovative and Strategic

Transformation of Alkane Resources
$12 million Initial Grant by NSF
Vision
To create a transformative engineered system to convert
light hydrocarbons from shale resources to chemicals and
transportation fuels in smaller, modular, local, and highly
networked processing plants.

https://nsf.gov/awardsearch/showAward?AWD_ID=1647722

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NSF Example: CISTAR

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 CISTAR Goal:
• New scientific and engineering discoveries will produce novel catalysts
and separation systems with transformative new performance
properties.
• The CISTAR team will develop innovative process designs for economic
production of chemicals and transportation fuels from shale gas
hydrocarbons.
– Researchers also will explore novel approaches for converting methane to
chemical intermediates, which can then be used as a feedstock for conversion
to liquid fuels.
• New materials and fundamental understanding will be transferred
from initial, proof of concept lab-scale experiments to full-size pilot
scale operations with economic evaluations using systems-level
lifecycle and environmental impact analysis to guide research and scale
these innovative processes to field demonstrations with industrial
partners.

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 Value Proposition

• Investors: US Government, Industry Sponsors,

Academia
• Value Proposition: Advance basic science to
create new science breakthroughs for turning
light alkanes into fuels
• Expected Return: None for US Government
• What does Academia and Industry get out of
the deal?

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 Value Spectrum from R&D to Capital Maintenance

Sponsors / Probability of
Activity Investors Objective Value Creation Payback Period Success
Improved society,
Achieve policy
Gov't, Academia,
objectives, Patents,
Basic Research Large Companies, Scientific Breakthrough Long to Never Low
Foot in the door for
Entrepreneurs
large companies &
Entrepreneurs
Academia, Large
Create IP for specific Patents, Spawn New
Process Development Companies, Years / Decades Low
applications Ventures
Entrepreneurs
Prove long term Commercialization of
Pilot Demonstration Entreneprenuers Many Years Low to Medium
operability / scale-up New Technology
Enter new business line
Impliment new large or Significantly expand
New Facility Companies Years Medium to High
scale process capacity, relocate
production
Increase capacity or
Expansion / Upgrade Operating Companies Improve yields & / or Increase sales / Profits Years High
lower costs
Maintenance Operating Companies Fix / Repair Equipment Stay in Business Months / Years Very High

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Companies Always Expect a Return on Its Activities

Basic Research and Development is highly risky yet can yield great
returns. It is often sponsored, at the early stages, by sponsoring
governments.

It can, if successful redefine a company. Example is Eli Lilly & Co.

(Polio vaccine, Insulin, Prozac, Cialis)

Payouts can be elusive, which is why a company must balance its

R&D efforts with its other business enterprises.

Governments, on the other hand, sponsor fundamental R&D for the

greater good with expectations of progress and favorable outcomes
even without monetary returns.

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Pro Forma Cash Flows

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Pro Forma Cash Flows Drive NPV Modelling

• Typically done in Excel, or company created software.

• Captures the essential drivers of the cash flow
statement.
• Differs from “Generally Accepted Accounting
Principles”.
– Cash vs. Book Depreciation and therefore taxes.
– Costs may or may not reflect opportunity costs.
– Should not reflect sunk costs.
– May reflect operating costs that might be capitalized
during project execution.

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 Key Elements
• Includes
– Capital Costs
– Operating Costs
– Selling, General, and Administrative Costs
– Feedstock / Raw Material Costs
– Product Values
– Input & output Quantities
• May Include
– Interest and Insurance During Construction
– Cost of Project Debt and Repayment Terms
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 Capital Costs

• Capital costs always include the cost of

materials and labor to implement the project.
• Can be uncertain, (+/- 30% or more) until
detailed engineering has been completed.
– For large plants with custom engineering packages,
engineering can cost 10% of the total project cost.
• Should be in as spent dollars! Often, projects
are not complete until years after costs are first
estimated. Be sure to use costs adjusted for
inflation.
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 Capital Costs, Cont’d

• Due to the time value of money, timing of

spend is critical for determining Net Present
Value.
– Large projects spend horizon typically requires a
few years from start to finish.
• Opportunity costs should be considered.
– Typically business underestimates the opportunity
costs such as limited real estate. It may be free
since it is already owned, but once it is used, it is
gone.

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 Operating Costs
• Direct Costs
– Incremental labor costs, including “burden”
– Remember, labor may have to be hired in advance of production
for training
– Incremental professional / management costs (Some companies
categorize this as indirect costs)
– Utilities
– Catalyst / chemicals
– Ongoing repairs
– Office space / rent
– Routine maintenance
– License fees
– Feedstock and Product transportation

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 Selling, General & Administrative Costs

• Indirect Costs (Not typically assigned to

product costs).
– Selling costs
– Property taxes, less abatements
– Administrative costs
• Focus on incremental costs due to the project,
not overhead costs that may be allocated.

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 Feedstock and Product Values

• Typically a highly leveraging aspect of the project

economics. Typically more uncertain than capital
costs.
• Be sure to get values delivered to the plant to
markets, consistent with the price assumption.
– Freight, shrinkage, taxes & fees
• Costs should reflect correct pricing relationships,
perhaps obtained from a supply or marketing
organization.
• Volumes should be taken from proper material
balances for the project.
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 Depreciation & Taxes

• Capital cost recovery after project start-up

– Not book depreciation, but cash depreciation.
• Lowers taxable income, therefore income tax.
• Depreciation schedules are usually available
from accounting or finance. Ask them!
• Income taxes on incremental profits.
– Typically use a combined rate for state and federal
taxes. Ask finance!

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 Tricks and Pitfalls

• Beginning of year discounting

• Leverage
• Inflating costs and margins (profits)
• Assigning Terminal Values reflecting the
project into perpetuity.

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 Beginning of Year Discounting

Discount Rate, % 5.0%

Year 0 1 2 3 4 5
Cash Flow, $MM $ (50.0) $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0
End of Year Discount Factor 1.000 0.952 0.907 0.864 0.823 0.784
Discounted Values, $MM $ (50.0) $ 14.3 $ 13.6 $ 13.0 $ 12.3 $ 11.8
Total Net Present Value, $MM $ 14.94

Discount Rate, % 5.0%

Year 0 1 2 3 4 5
Cash Flow, $MM $ (50.0) $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0
Beginning of Year Discount Factor 1.050 1.000 0.952 0.907 0.864 0.823
Discounted Values, $MM $ (52.5) $ 15.0 $ 14.3 $ 13.6 $ 13.0 $ 12.3
Total Net Present Value, $MM $ 15.69

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 Leverage

• Corporate debt is typically a Treasury function, to

minimize cost of capital.
• Cost of debt is typically lower than cost of equity
and therefore lower than the discount rate.
• Borrowing money at a rate lower than the
discount rate does what to the Net Present Value?

If this is needed to justify a project, you

probably should not do the project.

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 Inflating Costs and Margins (profits)

Year 0 1 2 3 4 5 6 7
Capital $ (50.0)
Revenue $ 60.0 $ 60.0 $ 60.0 $ 60.0 $ 60.0 $ 60.0 $ 60.0
Expenses $ 45.0 $ 45.0 $ 45.0 $ 45.0 $ 45.0 $ 45.0 $ 45.0
Margin $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0

Assuming 3% Inflation
Inflation Factor 1.000 1.030 1.061 1.093 1.126 1.159 1.194 1.230
Capital $ (50.0)
Revenue $ 61.8 $ 63.7 $ 65.6 $ 67.5 $ 69.6 $ 71.6 $ 73.8
Expenses $ 46.4 $ 47.7 $ 49.2 $ 50.6 $ 52.2 $ 53.7 $ 55.3
Margin $ 15.5 $ 15.9 $ 16.4 $ 16.9 $ 17.4 $ 17.9 $ 18.4

Margin Increase $ 0.45 $ 0.91 $ 1.39 $ 1.88 $ 2.39 $ 2.91 $ 3.45

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 Terminal Values Reflecting the Project into Perpetuity

• When does a project end?

– Some projects have discreet lifetimes, i.e. oil wells
– Some have two lives, defined period under patent
(strong pricing power) & post patent years (limited
pricing power).
– Others have more indefinite time frames
(commodity processing facilities).

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 Terminal Values, Cont’d

• Classic treatment of extended project

lifetimes:
– End cash flows. Typically involves extended model
timeframe, say 15 years, to capture all values
mathematically material after discounting. Thi sis
the most conservative.
– Project the cash flows into perpetuity, then
discount them.
– Synthesize a terminal value somewhere in
between.

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Pro Forma Construction

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 Pro Forma Cash Flow
Example 1
2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Terminal Value
Volumes
Feedstocks, MMLbs 100 150 200 200 200 200 200 200 100 100
Product, MMLbs 80 120 160 160 160 160 160 160 80 80
By-Product, MMLbs 20 30 40 40 40 40 40 40 20 20

Values
Feedstocks, $/Lb $ 10.00 $ 10.20 $ 10.40 $ 10.61 $ 10.82 $ 11.04 $ 11.26 $ 11.49 $ 11.72 $ 11.95 $ 12.19 $ 12.43
Product, $/Lb $ 15.00 $ 15.30 $ 15.61 $ 15.92 $ 16.24 $ 16.56 $ 16.89 $ 17.23 $ 17.57 $ 17.93 $ 18.28 $ 18.65
By-Product, $/Lb $ 8.00 $ 8.16 $ 8.32 $ 8.49 $ 8.66 $ 8.83 $ 9.01 $ 9.19 $ 9.37 $ 9.56 $ 9.75 $ 9.95

Sales Revenues, MM$ $ - $ - $ 1,415 $ 2,165 $ 2,944 $ 3,003 $ 3,063 $ 3,124 $ 3,187 $ 3,251 $ 1,658 $ 1,691
Feedstock Costs, MM$ $ - $ - $ 1,040 $ 1,592 $ 2,165 $ 2,208 $ 2,252 $ 2,297 $ 2,343 $ 2,390 $ 1,219 $ 1,243
Gross Margin $ - $ - $ 375 $ 573 $ 779 $ 795 $ 811 $ 827 $ 844 $ 860 $ 439 $ 448

Capital Costs, MM$ $ (200.0) $ (1,200.0)

Operating Costs, MM$

Labor $ 25.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0 $ 50.0
Utilities $ 15.0 $ 22.5 $ 30.0 $ 30.0 $ 30.0 $ 30.0 $ 30.0 $ 30.0 $ 15.0 $ 15.0
Materials $ 5.0 $ 7.5 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 5.0 $ 5.0
Other $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0
Total Direct Costs $ 25.0 $ 73.0 $ 83.0 $ 93.0 $ 93.0 $ 93.0 $ 93.0 $ 93.0 $ 93.0 $ 73.0 $ 73.0
Indirect Costs
SG&A $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0
Other $ 5.0 $ 5.0 $ 5.0 $ 5.0 $ 5.0 $ 5.0 $ 5.0 $ 5.0 $ 5.0 $ 5.0
Total Indirect Costs $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0
Total Costs $ 25.0 $ 88.0 $ 98.0 $ 108.0 $ 108.0 $ 108.0 $ 108.0 $ 108.0 $ 108.0 $ 88.0 $ 88.0

Operating Income $ (25.0) $ 286.5 $ 475.1 $ 671.4 $ 686.9 $ 702.8 $ 719.1 $ 735.6 $ 752.5 $ 350.8 $ 359.6

Depreciation (Cash Taxes)

7 Yr MACRS Rates 14.29% 24.49% 17.49% 12.49% 8.93% 8.93% 8.93% 4.45%
Depreciation, MM$ $ (200.1) $ (342.9) $ (244.9) $ (174.9) $ (125.0) $ (125.0) $ (125.0) $ (62.3)

Pre-Tax Income $ 486.6 $ 817.9 $ 916.2 $ 861.8 $ 827.9 $ 844.1 $ 860.6 $ 814.8 $ 350.8 $ 359.6
Income Taxes (40%) $ (194.6) $ (327.2) $ (366.5) $ (344.7) $ (331.1) $ (337.6) $ (344.2) $ (325.9) $ (140.3) $ (143.8)

Project Cash Flow, MM$ -200.0 -1225.0 91.9 147.9 304.9 342.2 371.7 381.4 391.3 426.6 210.5 215.8 0.0
Discount Factors (10%) 1 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319
Discounted Cash Flows, MM$ -200.0 -1113.6 76.0 111.1 208.2 212.5 209.8 195.7 182.6 180.9 81.2 75.6 0.0
NPV@10% as of 1/1/20 219.9 27
Rate of Return 13%
 Example 2

• Testimony from International Arbitration in

Stockholm, 2001.
• Lost profits dispute between TMR Energy
Limited and The State Property Fund of
Ukraine.
• Reflects Ukrainian accounting and taxation
conventions at the time of the project.

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ChE 597 Lecture 2 29
ChE 597 Lecture 2 30
ChE 597 Lecture 2 31
ChE 597 Lecture 2 32
ChE 597 Lecture 2 33
ChE 597 Lecture 2 34
ChE 597 Lecture 2 35
A Note About Spreadsheet “Hygiene”

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Questions

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