4.

COST BENEFIT ANALYSIS (CBA)

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Subtopics
 Cash flow
 Measure of profitability
 Pay back period(PBP)
 Rate of Return(ROR) or Return on Investment(ROI)
 Present value(PV) or Net present worth(NPW)
 Discounted cash flow rate of return (DCFROR)
 Profitability index(PI)
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Cost-Benefit Analysis
• The process of isolating and estimating costs and benefits
- in order to do a cost-benefit analysis, two sides of the
ledger(commercial accounts) must be considered
- system costs
- benefits from the system
- if a system is economically feasible, then the benefits should
outweigh the system costs within a defined period of time
acceptable to the user/client

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 The costs and benefits (financial, economic, social and

environmental) must be quantified in monetary terms to
the maximum extent possible.
 Typically, CBA is used as a tool in feasibility studies for
selection of an alternative least cost project among other
projects
 Thus, CBA is used in financial analysis to estimate the
profitability of a potential investment for a plant design
project
 Faculty of Chemical and Food Engineering

Cash Flows
 Is the net amount of cash and cash-equivalents being transferred into
and out of a business.
 At the most fundamental level, a company’s ability to create value
for shareholders is determined by its ability to generate positive cash
flows, or more specifically, maximize long-term free cash flow
 A Cash Flow is meant to illustrate incomes (“cash inflows”) and
expenses (“cash outflows”).
 Cash Inflows - amount of funds flowing into the firm
 Cash Outflows – amount of funds flowing out of the firm
 Net Cash Flow - equals cash inflows – cash outflows

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Time value of money

Is important when one is interested either in investing or borrowing
the money.
If a person invests his money today in bank savings, by next year
he will definitely accumulate more money than his investment. This
accumulation of money over a specified time period is called as time
value of money.
Similarly if a person borrows some money today, by tomorrow he
has to pay more money than the original loan. This is also explained by
time value of money.
The time value of money is generally expressed by interest amount.
The original investment or the borrowed amount (i.e. loan) is known as
the principal.

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 The amount of interest indicates the increase between

principal amount invested or borrowed and the final amount
received or owed
 In case of an investment made in the past, the total amount
of interest accumulated till now is given by;
Amount of interest = Total amount to be received – original
investment (i.e. principal amount)

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Faculty of Chemical and Food Engineering

Profitability, Alternative Investments, and Replacement

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.
Before capital is invested in a project or enterprise, it is
necessary to know how much profit can be obtained and
whether or not it might be more advantageous to invest the
capital in another form of enterprise.
Thus, the determination and analysis of profits obtainable
from the investment of capital and the choice of the best
investment among various alternatives are major goals of an
economic analysis
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Bases For Evaluating Project Profitability

 A certain amount of Birr today is not worth the same amount of Birr in the future.

 Hence when cash flows occur at different points in time, each must be brought to the
same point in time before a comparison is made.

 If the purpose is to present the total profitability of a given project, a simple statement
of total profit per year or annual rate of return may be satisfactory.

 On the other hand, if the purpose is to permit comparison of several different

projects, the method of analysis should be such that all cases are on the same basis
so that direct comparison can be made among the appropriate alternatives.
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Steps In Investment Analysis

1. Identify potentially profitable investment alternatives
2. Collect relevant data on:
Capital outlays
Costs
Returns

3. Use an appropriate method to analyze the data.

4. Decide whether to accept or reject the investment or select the top
ranking among mutually exclusive projects.
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Profitability Criteria
• Non-Discounted methods do not account for the time value of money,
and are of little value in comparing alternatives, except in the case of
equal project lives.
• Needed for project evaluation:
– Time (discounted payback period)
– Cash (discounted cumulative cash position, net present value
[NPV], or net present worth)
– Interest rate (discounted cash flow rate of return on investment,
DCFROR)
• Discount rate for which the NPV is zero
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Mathematical Methods for Profitability Evaluation

The most commonly used methods for profitability
evaluation, can be categorized under the following
headings:
PayBack Period (PBP)
Rate of Return(ROR) or Return on Investment(ROI)
Net present worth (NPW) or Present Value(PV)
Discounted Cash Flow Rate of Return (DCFROR)
Profitability index (PI)
 Faculty of Chemical and Food Engineering

Payback Period (PBP)

The objective of this method is to calculate the amount of time
that will be required to recover the depreciable fixed capital
investment from the accrued cash flow of a project.

Payout period is often used in conjunction with other measures

of profitability
The denominator may be the averaged annual cash flows or the
individual yearly cash flows.
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Disadvantage of POP

This method is simple to use and has served as a historical

measure of profitability, comparing POP of proposed projects
with those in the past.
There are some disadvantages to using the method:
Since no consideration is given to cash flows that occur
after the capital is recovered; therefore, this method
cannot be considered as a true measure of profitability
It neglects the time value of money and is only accurate
when the interest rate is zero
The method makes no provision for including land or
working capital.
 Faculty of Chemical and Food Engineering

Using Payback In Decision Making

Although it is uncommon for firms to make investment decisions
based solely on the payback, surveys suggest that some businesses
do in fact use payback as their primary decision mechanism.
In those situations where payback is used as the primary criterion for
accepting or rejecting projects, a maximum acceptable payback
period is typically set.
Projects that payback their initial investment sooner than this
maximum are accepted, and projects that do not are rejected.
The shorter the PBP/POP, the better.
 Faculty of Chemical and Food Engineering

Rate of Return(ROR) or Return on Investment(ROI)

In engineering economic studies, rate of return on investment
is ordinarily expressed on an annual percentage basis.

ROI

 To determine the profit, estimates must be made of direct production costs,

fixed charges including depreciation, plant overhead costs, and general
expenses.
 Profits may be expressed on a before-tax or after-tax basis, but the conditions
should be indicated
 Both working capital and fixed capital should be considered in determining
the total investment
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Disadvantage of ROI

Although this method is simple to use and relates to accepted

accounting methods, it has some serious disadvantages:
The time value of money is ignored
A basic assumption in this method is that all projects are
similar in nature to each other.
The project will last the estimated life and this is often
not true.
Equal weight is given all income for all years and that is
not always true.
 The higher the value of ROR/ROI, the better.
 Faculty of Chemical and Food Engineering

INTEREST RATE

When money is borrowed, it has to be paid back.

In addition to the amount of the loan, an extra amount of money is paid
to the lender for the use of money during the period of a loan, just as you
pay a rent on a house or a car.

The rate of interest ‘I’ is the percentage of the money you pay
for its use over a time period. The interest rate is referred to by
different names such as rent, cost of money, and value of money.

In investment terminology, it is called the minimum acceptable rate of

return or MARR.
If you borrow A dollars at yearly interest rate i, at the end of the year, the
interest is Ai, and the total amount you have to pay back to the lender is
A+Ai.
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Present Value (PV)

PV is a way of comparing the value of money now with

the value of money in the future.
A dollar today is worth more than a dollar in the future,
because inflation erodes the buying power of the future
money, while money available today can be invested to grow.

Calculation of the PV requires the use of “interest rate”.

Interest rate is typically a percentage used to calculate the
PV. It reflects the time value of money. Generally, this
interest rate is taken as equal to the prevailing bank interest
rate.
 Faculty of Chemical and Food Engineering

Birr 100 is the PV of Birr 133.1 of three years from now when
the interest rate is 10%.
Present Value: P,
Future Value: F,
Interest Rate per year: r
Future Value after 1 year: F = P*(1+r)
After 2 years: F2 = P*(1+r)*(1+r) = P*(1+r)2
After n years: Fn = P*(1+r) n
Present Value of F: Pn = Fn / (1+r)n
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Net Present Value (NPV)

 NPV may be defined as the difference between the total present
value of the cash inflows and the total present value of the cash
outflows considering the time value of money.
NPV compares the value of the Birr today versus the value of Money/
Birr in the future.

Net present value is a more useful economic measure than simple

24
payback and ROI, since it allows for the time value of money and also
for annual variation in expenses and revenues.
 Faculty of Chemical and Food Engineering

Net Present Value (NPV)

Let us calculate the NPV from a series of cash flows.
$100,000 $150,000 $200,000
(positive cash flows)
0 3
(negative cash flow)
$500,000

NPV = -CFo + CF1 + CF2 + CF3 + CFn

(1+r)1 (1+r)2 (1+r)3 (1+r)n
where CFX = cash flow in year x, n = number of periods (n=3),
r25= interest rate (say, 10%)
NPV = -500,000 + 100,000 + 150,000 + 200,000 = -$134, 861
(1+0.1)1 (1+0.1)2 (1+0.1)3
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The NPV is the one most companies use since it has none of the
disadvantages of other methods and treats the time value of money and its
effect on project profitability properly.
If the NPV is positive (i.e. NPV > 0),Project is accepted.
If the NPV is negative (i.e. NPV < 0), project should be rejected ,because
cash flows are negative.
If the NPV is zero then it should probably be rejected or get a pass mark
as it generates exactly the return that is expected (i.e. NPV = 0)
In general, A project with high NPV will produce a greater future worth
to a company.
 Faculty of Chemical and Food Engineering

Discounted Cash Flow Rate Of Return (DCFROR)

This is yet another useful method for comparing the financial
advantages of alternative systems using the cash flow diagram.
When the NPV is calculated at various interest rates, it is possible to
find an interest rate at which the cumulative net present value at
the end of the project is zero.
This particular rate is called the discounted cash flow rate of return
(DCFROR).
Where
 CFn= cash flow in year n;
 t= project life in years;
 i= the discounted cash flow rate of return (percent/100).
 Faculty of Chemical and Food Engineering

 If this rate is higher than the minimum rate that satisfies the investor or the project
manager, then the project is acceptable.
 This minimum rate is also called the Minimum Acceptable Rate of Return (MARR).
 The value of ‘i’ is found by trial-and-error calculations or by using the appropriate
function in a spreadsheet.

A more profitable project will be able to pay a higher

DCFROR.
 So, to determine ROR, we have to try several values for i* and see which one
makes NPW = 0.
 DCFROR can also be compared directly with interest rates. Because of this, it is
sometimes known as the interest rate of return or internal rate of return (IRR).
 Faculty of Chemical and Food Engineering

Profitability Index (PI)

 The PI is the ratio of the present value of the after-tax
cash inflows to the present value of the cash outflows or
capital items.

PI = PV of cash inflows
PV of cash outflows
 If the 0 < PI < 1, the project or option should be
rejected
 If the PI > 1, the project or option should be accepted
29

It is also called Net Present Worth Index (NPWI)

 Faculty of Chemical and Food Engineering

Alternatives
• When only one alternative is to be selected from multiple
alternatives, the alternatives are said to be mutually
exclusive.
• When comparing mutually exclusive investment
alternatives,
(1) establish the minimum acceptable ROR/ROI,
(2) calculate the NPV for each,
(3) eliminate any projects with negative NPVs, then
(4) chose the alternative with the greatest positive NPV.
 Faculty of Chemical and Food Engineering

SUMMARY
There is no single best criterion for economic evaluation of projects.
Each company uses its own preferred methods and sets criteria for the
minimum performance that will allow a project to be funded.
The design engineer must be careful to ensure that the method and
assumptions used are in accordance with company policy and that
projects are compared on a fair basis.
Projects should always be compared using the same economic criterion
but do not have to be compared on the exact same basis, since in a
global economy there may be significant regional advantages in feed
and product pricing, capital costs, financing, or investment incentives.
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 Faculty of Chemical and Food Engineering

As well as economic performance, many other factors have to

be considered when evaluating projects, such as the following:

1. Safety
2. Environmental problems (waste disposal);
3. Political considerations (government policies);
4. Location of customers and suppliers (supply chain);
5. Availability of labor and supporting services;
6. Corporate growth strategies;
7. Company experience in the particular technology.
 Faculty of Chemical and Food Engineering

DEPRECIATION
Types Of Depreciation
Physical: Wear and Tear, corrosion, accidents,
age deterioration.

Functional: All other causes.

Obsolescence: Due to technological advances.

Depletion: Loss due to materials consumed. Applicable to

Natural Resources (timber, mineral, oil deposits)
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SERVICE LIFE: The period during which the use of a

property is economically feasible.
SALVAGE VALUE: 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.
If a property is capable of further service, its salvage
value may be high.

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 Faculty of Chemical and Food Engineering

 If the property cannot be disposed of as a useful unit, it can often be dismantled and
sold as junk to be used again as a manufacturing raw material.
 The profit obtainable from this type of disposal is known as the scrap or junk value.

Methods For Determining Depreciation

In general, depreciation accounting methods may be divided

into two classes:
1.Arbitrary methods giving no consideration to interest costs
(Straight-line, declining-balance, and sum-of-the-years-digits
methods)
2.methods taking into account interest on the investment
(sinking-fund and the present-worth methods)
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STRAIGHT-LINE METHOD
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TAXES

TYPES OF TAXES
Taxes may be classified into three types:
(1) property taxes
 (2) excise taxes, and
 (3) income taxes.
These taxes may be levied by the Federal government, state
governments, or local governments
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Property Taxes
 Local governments usually have jurisdiction over property
taxes, which are commonly charged on a county basis
 Vary widely from one locality to another, but the average
annual amount of these charges is 1 to 4 percent
Excise Taxes
 Federal excise taxes include charges for import customs duties,
transfer of stocks and bonds, and a large number of other similar
items Manufacturers’ and retailers’ excise taxes are levied by
Federal and state governments on the sale of many products such as
gasoline and alcoholic beverages
Taxes of this type are often referred to as indirect since they can be
passed on to the consumer
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Income Taxes

 Are based on gross earnings, which are defined as the difference

between total income and total product cost.
 Revenue from income taxes is an important source of capital for
both Federal and state governments

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