Adama Science and Technology

University

Chemical Engineering Program

Plant Design and Economics(ChEg5193)
lecture 8&9
Engineering Economics (Cont’d)
 2
Depreciation
An analysis of costs and profits for any business operation

requires recognition of the fact that physical assets

decrease in value with age.
This decrease in value may be due to physical
deterioration, technological advances or economic changes
which ultimately will cause retirement of the property.
The reduction in value due to any of these causes is a

measure of the depreciation.

Chemical Engineering program, ASTU
 Cont’d 3

Since depreciation is measure of the decrease in value of

property with time, depreciation can immediately be

considered from a cost viewpoint.
Therefore, the total cost due to depreciation is the original

or new value of a property minus the value of the same

property at the end of the depreciation period.
The value at the end of the useful life is assumed to be the

probable Scrap or Salvage value of the components

making up the particular property.
Chemical Engineering program, ASTU
 Cont’d 4

Salvage value: Is the net amount of money obtainable from

the sale of used property over and above any charges involved in
removal and sale.

Present value of an asset may be defined as the value of the

asset in its condition at the time of valuation.

Book Value: is the difference between the original cost of a

property, and all the depreciation charges made to date is
defined as the book value (sometimes called unamor- tized cost).

Chemical Engineering program, ASTU

 Purpose of Depreciation as Cost 5

Consideration of depreciation as a cost permits

 Realistic evaluation of profits earned by a company and,

therefore, provides a basis for determination of Federal

income taxes.
 To set funds aside regularly to provide recovery of the

invested capital.
Therefore, the engineer should be familiar with Federal

regulations relative to depreciation and should follow these

regulations
Chemical Engineering program, ASTU
 Cont’d 6

Since depreciation rates are very important in

determining the amount of income tax, the Internal

Revenue Service has established allowable
depreciation rates.
The annual depreciation rate for machinery and

equipment ordinarily is about 10 percent of the

tied-capital investment.

Chemical Engineering program, ASTU

 7
Method for determining Depreciation
The Federal government has definite rules and

regulations concerning the manner in which

depreciation costs may be determined.
These regulations must be followed for income-tax

purposes as well as to obtain most types of

governmental support.
Depreciation costs can be determined by a number

of different methods
Chemical Engineering program, ASTU
1. Straight - line method 8

It is assumed that the value of the property decreases

linearly with time therefore, equal amounts are

charged for depreciation each year throughout the
entire service life of the property.
  The annual depreciation cost may be expressed as

Chemical Engineering program, ASTU

 9
Cont’d
The asset value (or book value) of the equipment at

any time during the service life may be determined

from the following equation:

Chemical Engineering program, ASTU

 10
2. Decline balance (fixed percentage) Method
In this method the annual depreciation cost is a fixed

percentage of the property value at the beginning of the

particular year.
The fixed-percentage (or declining-balance) factor
remains constant throughout the entire service life while
the annual cost for depreciation is different in each year.

Chemical Engineering program, ASTU

Cont’d 11

At end of first year the asset (book) value therefore

will be

At the end of second year

At the end of a years

At the end of n years (i.e at the end of service life)

Chemical Engineering program, ASTU

 12
Cont’d
Therefore,

 Comparison with the straight-line method shows that

declining-balance depreciation permits the investment to

be paid off more rapidly during the early years of life.
 13
Cash flow and cash-flow diagrams
The cash flows are based on the best estimates of:

 Investment

Operating costs

 Sales volume

 Sales price that can be made for the project.

A cash-flow diagram gives a clear picture of the resources

required for a project and the timing of the earnings

Chemical Engineering program, ASTU

14
Cont’d 15

Cash flow to the company, in the form of net profits after

taxes and depreciation charges, starts to accumulate and

gradually pays off the full capital investment.
 For the conditions shown in Fig, the full capital

investment is paid off in five years.

After that time, profits accumulate on the positive side of

the cumulative cash position until the end of the project

life at which time the project theoretically is shut down
and the operation ceases.
Chemical Engineering program, ASTU
Cont’d 16

At that time, the working capital is still available, and it is

assumed that the land can still be sold at its original value.
Thus, the final result of the cumulative cash position is a

net profit over the total life of the project, or a cash flow
into the company capital sink (in addition to the
depreciation cash flow for investment payoff) over the ten-
year period

Chemical Engineering program, ASTU

Tax and Insurance 17

Expenses for taxes and insurance play an important part in

determining the economic situation for any industrial process.

The transfer from estimating cash flow before taxes (CFBT)

to cash flow after taxes (CFAT) involves a consideration of

significant tax effects that may alter the final decision.
Therefore, it is essential for the chemical engineer to

understand the basic principles and factors underlying

taxation.

Chemical Engineering program, ASTU

 Cont’d 18

Taxes are levied to supply funds to meet the public needs of

a government, while insurance is required for protection

against certain types of emergencies or catastrophic
occurrences.
Some basic tax terms and relationships
 Gross income GI is the total income realized from all

revenue-producing sources of the corporation, plus any

income from other sources such as sale of assets, royalties,
and license fees.
Chemical Engineering program, ASTU
 19
Cont’d
 Income tax is the amount of taxes based on some form

of income or profit levied by the federal (or lower-level)

government.
 Operating expenses E include all corporate costs

incurred in the transaction of business. These expenses

are tax deductible for corporations. For engineering
economy alternatives, these are the ATPC (annual total
product cost)

Chemical Engineering program, ASTU

Cont’d 20

 Taxable income TI is the amount upon which income

taxes are based. For corporations, depreciation D and
operating expenses E (T.P.C), TI can be calculated as

Chemical Engineering program, ASTU

 21
Cont’d
 Tax rate T is a percentage, or decimal equivalent, of
TI owed in taxes.
The tax rate is graduated that is higher rates apply

as TI increases.

Chemical Engineering program, ASTU

 22
Cont’d
Different bases (and taxes) are used. The most

common is a basis of income (and income

taxes). Others are total sales (sales tax);
appraised value of property (property tax);
value-added tax (VAT); and retail value of items
imported (import tax).

Chemical Engineering program, ASTU

 23

Table

Chemical Engineering program, ASTU

 24
Cont’d
Many different types of insurance are available for protection

against property loss or charges based on legal liability.

1. Fire insurance and similar emergency coverage on buildings,

equipment, and all other owned, used, or stored property.

2. Public-liability insurance, including bodily injury and

property loss or damage, on all operations such as those
involving automobiles, elevators, ….

Chemical Engineering program, ASTU

 25
Cont’d
3. Business-interruption insurance the loss of income due to
a business interruption caused by a fire or other
emergency may far exceed any loss in property.
4. Marine and transportation insurance on all property in
transit.

5. Employee-benefit insurance, including life,

hospitalization, accident, health, personal property, and
pension plans.

Chemical Engineering program, ASTU

 26

Example

The original value of a piece of equipment is $22,000,

completely installed and ready for use. Its salvage value is
estimated to be $2000 at the end of a service life
estimated to be 10 years. Determine the asset (or book)
value of the equipment at the end of 5 years using:
(a) Straight-line method.
(b) Declining-balance method.
 27

Methods of Profitability
evaluation
 28

Profitability
Before capital is invested in a project or enterprise, it is

necessary to know how much profit can be obtained

The word profitability is used as the general term for the

measure of the amount of profit that can be obtained from

a given situation.
Therefore, Profitability is the common denominator for

all business activities.

Chemical Engineering program, ASTU

 29
Cont’d

In the process of making an investment decision,

the profits anticipated from the investment should

be considered in terms of a minimum profitability
standard.
Profitability standard can normally be expressed
on a direct numerical basis however, this can serve
only as a guide.

Chemical Engineering program, ASTU

 30
Bases for Evaluating Project Profitability
The basic aim of a profitability analysis is to give a measure of

the attractiveness of the project for comparison to other possible

courses of action.
Total profit alone cannot be used as the deciding profitability

factor in determining if an investment should be made.

For example: Suppose that two equally sound investments can

be made. One of these requires $100,000 of capital and will

yield a profit of $10,000/year, and the second requires $1
million of capital and will yield $25,000/year.
 31
Cont’d
The second investment gives a greater yearly profit than

the first, but the annual rate of return on the second

investment is only 2.5%

While the annual rate of return on the $100,000

investment is 10 percent.

Chemical Engineering program, ASTU

 32
Cont’d
Because reliable and conservative investments will yield

annual rates of return in the range of 6 to 9 percent, the $1

million investment in this example would not be very attractive
however, the 10 percent return on the $100,000 capital would
make this investment worthy of careful consideration.
Thus, for this example, the rate of return, rather than the total

amount of profit, is the important profitability factor in

determining if the investment should be made.

Chemical Engineering program, ASTU

 33
Mathematical Methods for Profitability
Evaluation
The most commonly used methods for profitability

evaluation can be categorized as

 Rate of return on investment

 Discounted cash flow based on full-life

performance
 Net present worth

 Pay payback period

Chemical Engineering program, ASTU

 34
Rate of Return on investment(ROR)
Rate of return on investment is ordinarily expressed on

an annual percentage basis.

The yearly profit divided by the total initial investment

necessary times 100 is the standard percent return on

investment.
Profits may be expressed on a before-tax or after-tax

basis therefore, conditions should be indicated.

Chemical Engineering program, ASTU

 Cont’d
A figure of 20 to 30 % for the return on investment

(ROR) can be used as a rough guide for judging small

projects, and
when decisions have to be made on whether to install

additional equipment to reduce operating costs.

This is equivalent to saying that for a project to be viable

the investment needed should not be greater than about 4

to 5 times the annual savings achieved.
Chemical Engineering program, ASTU
Example 35

A proposed manufacturing plant requires an initial fixed-capital investment

of $900,000 and $100,000 of working capital. It is estimated that the annual
income will be $800,000 and the annual expenses including depreciation
will be $520,000 before income taxes. A minimum annual return of 15
percent before income taxes is required before the investment will be
worthwhile. Income taxes amount to 34 percent of all pre-tax profits.

Determine the following:

(a) The annual percent return on the total initial investment before income
taxes. Ans = 28%

(b) The annual percent return on the total initial investment after income
taxes. Ans = 18.5%
 36
Discounted Cash Flow(Time value of money)
The method of approach for a profitability

evaluation by discounted cash flow takes into

account the time value of money.
The net cash flow in each year of the project is

brought to its "present worth" at the start of the

project by discounting it at some chosen
compound interest rate.
Chemical Engineering program, ASTU
 37
Cont’d

Where r = The discount rate (interest rate) percent

t = life of project, years

Chemical Engineering program, ASTU

 Cont’d 38

 The discount rate is chosen to reflect the earning

power of money.
 It would be roughly equivalent to the current interest

rate that the money could earn if invested.

The total NPW will be less than the total NFW, and

reflects the time value of money and the pattern of

earnings over the life of the project

Chemical Engineering program, ASTU

Discounted cash-flow rate of return
(DCFRR)
Discounted cash-flow analysis, used to calculate the

present worth of future earnings

Where r’ = the discounted cash-flow rate of return.

NFW = the future worth of the net cash flow in
year n,
t = the life of the project, years.
Chemical Engineering program, ASTU
 40
Cont’d
By calculating the NPW for various interest rates, it is

possible to find an interest rate at which the cumulative net

present worth at the end of the project is zero.
 This particular rate is called the "discounted cash-flow rate

of return" (DCFRR) and is a measure of the maximum rate

that the project could pay and still break even by the end of
the project life.
The value of r' is found by trial-and-error calculations.

Chemical Engineering program, ASTU

 41
Cont’d
The more profitable the project, the higher the DCFRR

that it can afford to pay.

DCFRR provides a useful way of comparing the

performance of capital for different projects; independent

of the amount of capital used and the life of the plant
Other names for DCFRR are interest rate of return and

internal rate of return.

Chemical Engineering program, ASTU

 42
Cont’d
To illustrate the basic principles involved in discounted-

cash-flow calculations and the meaning of rate of return

based on discounted cash flow, consider the case of a
proposed project for which the following data apply:

Initial fixed-capital investment = $100,000

Working-capital investment = $10,000

Service life = 5 years

Salvage value at end of service life = $10,000

Chemical Engineering program, ASTU
 43
Cont’d

Chemical Engineering program, ASTU

Cont’d 44
Pay- back Period 45

Pay-back period is the time required after the start

of the project to pay off the original capita

investment from income.
 Original capital investment means only the

original, depreciable, fixed-capital investment

Chemical Engineering program, ASTU

Cont’d 46
Total depreciable capital
Payback Period (PBP) 
Net earnings  annual depreciation
CTDC CTDC
 
(1  t )( S  C )  D cash flow
where
t  sum of federal and state income tax rates
S  annual sales revenues
C  annual production cost(annual total product cost)
CTDC  total depreciable capital

Typically, a pay-back period of 2 to 5 years would be

expected from projects.

Chemical Engineering program, ASTU
 47

Plant Site selection

 48
Plant site selection
The geographical location of the final plant can have

strong influence on the success of an industrial venture.

Considerable care must be exercised in selecting the plant

site, and many different factors must be considered.

A general consensus as to the plant location should be

obtained before a design project reaches the detailed

estimate stage

Chemical Engineering program, ASTU

1. Raw materials availability

2 .Factors
Marketsshould be considered in selecting a plant site

3 . Energy availability

4 . Climate

5 . Transportation facilities

6 . Water supply
7 .Cont’d
Waste disposal 50

8 . Labor supply

9. Taxation and legal restrictions

1 0 . Site characteristics

11. Flood and fire protection .

1 2 . Community factors
 51
Cont’d
For a preliminary survey, the first four factors

should be considered. Thus, on the basis of raw

materials, markets, energy supply, and climate,
acceptable locations can usually be reduced to
one or two general geographical regions.

Chemical Engineering program, ASTU

Thank You