Engineering Economic Analysis

Dr. Rakesh Kumar

Comparing Alternative Equipment
Purchases
• Present Worth
• In the present-worth technique, all of the costs and revenues are discounted
to calculate the present worth of each alternative.
Example: Two alternative pumps, A (carbon steel) and B (aluminum), have different
installed and maintenance costs, salvage values, and anticipated service lives, as indicated. It
is desired to select one of the pumps on the basis of present worth when the effective interest
rate is 10%.
 Capitalized Cost
• Another method for comparing alternatives, which leads to conclusions
identical to those of present worth, is to compute capitalized costs.

• This involves the creation of a perpetuity in which periodic replacements

continue indefinitely for each alternative.

• The capitalized cost, K, is defined as the original cost/Installed cost, CI , plus

the present value of the perpetuity for an infinite number of replacements
made every nR years.

• When a replacement is made, it is common to assign a salvage value, Sequip.

• The replacement cost is constant at CR = CI −Sequip.

• The investment must provide a future worth, F, every nR years, sufficient to
pay for the replacement of the equipment item and replace the principal, P,
so that it can be reinvested for another nR years.

• Fny = CR + P = P(1+i)nR , Therefore, Perpetuity P = CR / (1+i)nR -1

• Capitalized cost K = CI + P = CI + CR / {(1+i)nR -1}

 Example
• To use capitalized costs when annual operating costs are also required it is
appropriate to discount the operating cost payments to present worth,
using the annuity equation and to add this to the equipment installed cost

• For pump A, the initial adjusted installed cost is

• The capitalized cost for pump A

• For pump B, initial adjusted installed cost is

• The capitalized cost for pump B

• Pump B has the lower capitalized cost, a result consistent with present
worths. In fact, PA/PB equals KA/KB
Approximate profitability measures
• Return on Investment (ROI)

• Payback Period (PBP)

• The payback period is the time required for the annual earnings to equal the
original investment.
• Payback period is also called payout time, payout period, payoff period, and
cash recovery period.
• Venture Profit (VP): is the annual net earnings in excess of a minimum
acceptable return on investment, imin.

• Annualized Cost (CA): It is the sum of the production cost and a reasonable
return on the original capital investment where, again, the reasonable return
on investment, imin, is taken here as 0.2.
 Example
• A process, projected to have a total depreciable capital, CTDC, of $90 million,
with no allocated costs for outside utilities, is to be installed over a 3-yr
period (2014–2016). Just prior to startup, $40 million of working capital is
required. At 90% of production capacity (projected for the third and
subsequent operating years), sales revenues, S, are projected to be $150
million∕yr and the total annual production cost, excluding depreciation, is
projected to be $100 million∕yr. Also, the plant is projected to operate at 0.5
of 90% and 0.75 of 90% of capacity during the first and second operating
years. Thus, during those years, S = $75 million∕yr and $113 million∕yr,
respectively. Take straight-line depreciation at 8%/yr. Using the third
operating year as a basis, compute
(a) Return on investment (ROI)
(b) Payback period (PBP)
 Cost Data for MCB Process
• For the MCB separation process estimate the annual production cost, C,
where products will be used in-house, with a total annual sales, S. Base your
estimate on:
Example
• For the MCB process calculate
(a) Return on investment (ROI)
(b) Payback period (PBP)
(c) Venture profit (VP)
 Example
• The total bare-module cost for the column and its auxiliaries = $4,820,000.
The annual heating steam cost for the reboiler = $2,180,000∕yr. The annual
cooling water cost for the two condensers = $90,000∕yr. The annual
electricity cost for the reflux pump = $48,000∕yr. The total utility cost =
$2,318,000∕yr.
• Compute the annualized cost.

• CA = $2,318,000 + 0.20($4,820,000) = $3,282,000∕yr.

 Gate 2016

• Two design options for a distillation system are being compared

based on the total annual cost. Information available is as follows:

The annual fixed charge amounts to 12% of the installed cost. Based on the above
information, what is the total annual cost (Rs in lakhs /year) of the better option?
(A) 40 (B) 42.4 (C) 92 (D) 128
 Depreciation
• Depreciation: Depreciation is the reduction in value of an asset. a
company is allowed to treat depreciation as a cost of production, thereby
reducing its income tax liability

• Total Capital Investment = Fixed Capital + Working Capital

• Fixed Capital – All costs associated with new construction, but Land
cannot be depreciated

• Working Capital – Float of material to start operations cannot

depreciate
Definitions
• Salvage Value, S

• Value of FCI at end of project

• Often = 0

• Life of Equipment
• n – Set by IRS
• Not related to actual equipment life

• Total Capital for Depreciation

• FCI - S
 Basic Methods for Depreciation
• Straight Line
• Double Declining Balance (DDB)
• Sum of Years Digits (SOYD)
• Modified Accelerated Cost Recovery System (MACRS)

Straight Line Method: An equal amount of depreciation is charged each

year over the depreciation period allowed

n = # of years over which depreciation is taken

 Double Declining Balance (DDB)
• In the declining balance method, the amount of depreciation each year is a constant
fraction of the book value, BV .
k–1

• The word double in DDB refers to the factor 2 in Equation given below.

• Values other than 2 are sometimes used; for example, for the 150% declining balance
method, 1.5 is substituted for the 2 in the Equation

Adjust final year

so that total
depreciation is
FCIL - S

Book value
Sum of Years Digits (SOYD)

• The method gets its name from the denominator of the Equation, which is equal to
the sum of the number of years over which the depreciation is allowed

SOYD
Example: The fixed capital investment (excluding the cost of land) of a new project
is estimated to be $150.0 million, and the salvage value of the plant is $10.0 million.
Assuming a seven-year equipment life, estimate the yearly depreciation allowances using
the following:
a. The straight-line method
b. The sum of the years digits method
c. The double declining balance method

The Sample calculations for year 2 give the following:

For straight-line depreciation

For Sum of Year’s Digits

Double Declining Balance

 MARCS
• In this method All equipment is assigned a class life, which is the period over which the
depreciable portion of the investment may be discounted.

• Most equipment in a chemical plant has a class life of 9.5 years with no salvage
value.

• This means that the capital investment may be depreciated using a straight-line method
over 9.5 years.

• Alternatively, a MACRS method over a shorter period of time may be used, which is five
years for this class life.

• In general, it is better to depreciate an investment as soon as possible. This is

because the more the depreciation is in a given year, the less taxes paid.

• The MACRS method uses a double declining balance method and switches to a
straight-line method when the straight-line method yields a greater depreciation
allowance for that year.
MACRS
• The half-year convention assumes that the equipment is bought midway
through the first year for which depreciation is allowed. In the first year,
the depreciation is only half of that for a full year.

• Likewise in the sixth (and last) year, the depreciation is again for one-
half year

• Example for 5 year life – using a basis of 100

k dkDDB dkSL
½ year
1 2/5(100 – 0)(0.5) = 20
2 2/5(100 – 20) = 32 (100-20)/4.5 = 17.78
convention
3 2/5(100 – 52) = 19.2 (100 – 52)/3.5 = 13.71
4 2/5(100 – 71.2) = 11.52 (100 – 71.2)/2.5 = 11.52
5 2/5(100 – 82.72) = 6.91 (100 – 82.72)/1.5 = 11.52
6 (0.5)(100 – 94.24)/0.5 = 5.76
MACRS

Year, i diMACRS
1 20.00 %
2 32.00 %
3 19.20 %
4 11.52 %
5 11.52 %
6 5.76 %
 Taxation, Cash Flow, and Profit

• Expenses = COMd + dk

• Income Tax = (S – COMd - dk)t

• After Tax (net)Profit = (S – COMd –dk)(1 – t)

• After Tax Cash Flow =

(S – COMd – dk)(1 – t) + dk (+ Investment)
Gate Problems
• Gate 2007: A pump has an installed cost of Rs. 40,000 and a 10 year
estimated life. The salvage value of the pump is zero at the end of 10
years. The pump value (in rupees), after depreciation by the double
declining balance method, at the end of 6 years is.

• (A) 4295 ( B) 10486 (C) 21257 (D) 37600

• Gate 2008: For the case of single lump-sum capital expenditure of Rs.
10 crores which generates a constant annual cash flow of Rs. 2 crores
in each subsequent year, the payback period (in years), if the scrap
value of the capital outlay is zero is
• (A) 10 (B) 20 (C) 1 (D) 5

• PB = 10/2 = 5
• Gate 2008: A reactor has been installed at a cost of Rs. 50,000 and is
expected to have a working life of 10 years with a scrap value of Rs.
10,000. The capitalized cost (in Rs.) of the reactor based on an annual
compound interest rate of 5% is
• (A) 1,13 ,600 (B) 42,000 (C) 52,500 (D) 10,500

• K = Cv + (Cv-S)/(1+i)n-1 = 50000+ 40000/(1.05)10 – 1 = 113600

• Gate 2008: The total fixed cost of a chemical plant is Rs. 10.0 lakhs;
the internal rate of return is 15%, and the annual operating cost is Rs.
2.0 lakhs. The annualized cost of the plant (in lakhs of Rs.) is

• (A) 1.8 (B) 2.6 (C) 3.5 (D) 4.3

• CA = 2 + 0.15 * 10 = 3.5
• Gate 2010: A reactor needs to be lined with a corrosion resistant lining.
One type of lining costs Rs. 5 lakh, and is expected to last for 2 years.
Another type of lining lasts for 3 years. If both choices have to be
equally economical, with the effective interest rate being 18%,
compounded annually, the price one should pay for the second type of
lining is,
• (A) Rs. 6.1lakhs (B) Rs. 6.5 lakh (C) R,. 6.9lakhs (D) Rs. 7.6 lakhs

• K1 = Cv + (Cv-S)/(1+i)n-1 = 5 + 5/(1.18)2 - 1
• K2 = Cv + (Cv-S)/(1+i)n-1 = Cv + Cv/(1.18)3-1

• Both choices have to be equally economical; K1 = K2

• Gate 2011: A continuous fractionator system is being designed. The
following cost figures are estimated for a reflux ratio of 1.4.

• The annualised fixed charge is 15 % of the fixed cost. The total

annualised cost (in Rs.) is
• (A) 10.8 x 106 (B) 13.35 x 106 (C) 15.9 X 106 (D) 3.15 x 106

• Annulized cost CA = (8+1)*106+ 0.15(6+2+4)*106 = 10.8*106

• Gate2016: A vertical cylindrical tank with a flat roof and bottom is to be
constructed for storing 150 m3 of ethylene glycol. The cost of material and
fabrication for the tank wall is Rs 6000 per m2 and the same for the roof
and the tank bottom are Rs 2000 and Rs 4000 per m2, respectively. The cost
of accessories, piping and instruments can be taken as 10% of the cost of
the wall. 10% of the volume of the tank needs to be kept free as vapour
space above the liquid storage. What is the optimum diameter (in m) for
the tank?
• (A) 3.5 (B) 3.9 (C) 7.5 (D) 7.8

• volume of liquid = 150 m3

• Gate 2014: A foundry has a fixed daily cost of Rs 50,000 whenever it
operates and a variable cost of Rs 800Q, where Q is the daily
production in tonnes. What is the cost of production in Rs per tonne
for a daily production of 100 tonnes?

• Fixed cost = Rs. 50,000

• Variable cost = Rs. 800 Q
• Q = daily production in tones
• For 100 tonnes of production daily, total cost of production
• = 50,000+800×100 = 130,000
• So, cost of production per tonne of daily production
• 130,000/100 = Rs.1300.