ECE4363_Week 3-4

Last updated: 7/20/2016
FINANCIAL APPRAISAL AND ANALYSIS

(WEEK 3-4)
LLF0916 1
CONTACT HOURS
Total Student
Lecture Tutorial Self – Study Library Search Assignment Exam Learning Time
(hours)
6 6 12 12 2 NIL 38
LLF0916 2
LEARNING OUTCOMES
• Describe and Perform Cost Estimation of a Chemical Plant
• Describe and Evaluate Eonomics of projects in term of
- Cash Flow Diagram
- Discounted Cash Flow
- Rate of Return
- Discounted Case Flow Rate of Return
LLF0916 3
INTRODUCTION
 The purpose of investing money in chemical plant is to

earn money, some means of comparing the economic
performance of projects is needed.
 More sophisticated evaluation techniques and economic

criteria are needed when decisions have to be made
between large, complex engineering projects, particularly
when the projects differ widely in scope, time scale and
type of product.
•LLF0916 4
CASH FLOW AND CASH-FLOW DIAGRAMS
Cash Flow
 Life blood of any commercial organization
 Likened to the material flows in a process plant
 Cash needed to pay for research and development;

plant design and construction; and plant operation.
The outputs are goods for sale; and cash returns, are
recycled, to the organisation from the profits earned.
 The “net cash flow” at any time is the difference

between the earnings and expenditure.
•LLF0916 5
 A cash-flow diagram, such as that shown in pg 7, shows

the forecast cumulative net cash flow over the life of a
project.
 The cash flows are based on the best estimates of

investment, operating costs, sales volume and 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.
•LLF0916 6
CASH-FLOW DIAGRAMS Last updated: 7/20/2016
•A– B: Investment required to

design the plant
•B – C: The heavy flow of capital

to build the plant, and provide
funds for start-up
C – D: The cash-flow curve turns

up at C, as the process comes on
stream and income is generated
from sales. The net cash flow is
now positive but the cumulative
amount remains negative until the
investment is paid off, at point D.
•Point D is known as the break-

even point and the time to reach
the break-even point is called the
pay-back time. In a different
context, the term “break-even
point” is used for the percentage
of plant capacity at which the
income equals the cost for
production.
•R.K. Sinnot (2009). Coulson and Richardson’s Chemical Engineering Volume 6. Butterworth-Heinemann
•LLF0916 7
 D - E In this region the cumulative cash flow is positive. The

project is earning a return on the investment.
 E - F Toward the end of project life the rate of cash flow may
tend to fall off, due to increased operating costs and falling
sale volume and price, and the slope of the curve changes.
 The point F gives the final cumulative net cash flow at the
end of the project life.
•LLF0916 8
TAX AND DEPRECIATION
 In calculating cash flows, the project is usually considered

as an isolated system, and taxes on profits and the effect
of depreciation of the investment are not considered.
 Tax rates are not constant and depend on government
policy. In recent years, corporation (profits) tax has been
running at around 30 per cent and this figure can be used
to make an estimate of the cash flow after tax.
•LLF0916 9
TAX AND DEPRECIATION

 Depreciation rates depend on government policy.
 Also depends on accounting practices of the particular
company.
 At times, it has been government practice to allow higher
depreciation rates for tax purposes in development area.
 The effect of government policy must clearly be taken into
account at some stage when evaluating projects,
particularly when considering projects in different
countries.
•LLF0916 10
COMPOUNDING & DISCOUNTING
Method used to know
Compounding the future value of a
present amount
Present Future
Value Value
Determining the
present value of the
amount to be Discounting
received in future
•LLF0916 11
COMPOUNDING & DISCOUNTING
You have won $10,000 and has choice of below:

A: Receive $10,000 now
B: Receive $10,000 in three years
Which option you choose?
Present Value Future Value
A: $10,000 $10,000 + interest

B: $10,000 – interest $10,000
•LLF0916 12
COMPOUNDING & DISCOUNTING Last updated: 7/20/2016
• F= P (1+i)n
F= future value
P = present value
i = interest rate
n = periods
Future value = $10,000 (1 + 0.04)3

= $11,249
Present value = $10,000 (1+0.04)-3

= $8,890
•LLF0916 13
DISCOUNTING
• Often the benefits and costs of a project accrue at

different times. The technique used to deal with this
issue is discounting
• Discounting is a technique used to convert all benefits

and costs to a common point in time, usually the
present.
• The value of a project, expressed in terms of the

present, is called the Present Value.
•LLF0916 14
DISCOUNTING
• Discounting is based on the premise that a dollar of

benefit received today is worth more than a dollar of
benefit received in the future.
• Time value of money – money available at present time is

worth more than the same amount in future due to its
potential earnings capacity
• The bias arises because current resources can be

invested.
• Discounting is the opposite of compounding.
•LLF0916 15
DISCOUNTING
• The rate at which a current value is compounded
is called the interest rate.
• The rate at which a future value is discounted is

called the discount rate.
•LLF0916 16
DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)
 In figure 6.8 the net cash flow is shown at its value in the
year in which it occurred. So the figures on the ordinate
show the “future worth” of the project: the cumulative “net
future worth” (NFW).
 The money earned in any year can be put to work
(reinvested) as soon as it is available and start to earn a
return.
 Money earned in the early years of the project is more
valuable than that earned in later years. This “time value of
money” can be allowed for by using a variation of the
familiar compound interest formula.
•LLF0916 17
 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.
 Internal rate of return, IRR (r)- the rate of interest that
equates NPW to 0.
•LLF0916 18
 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.
 Most proprietary spreadsheets have procedures for
calculating the cumulative NPW from a listing of the yearly
net annual revenue (profit). Spreadsheets are useful tools for
economic analysis and project evaluation.
•LLF0916 19

What lump sum must be paid at the end of FIVE years if $10,000 is
borrowed from a bank at 12% annual interest rate compounded based
on the following interest rate period?
• annually;
• semiannually;
• monthly; and
• daily.
•LLF0916 20
F=P(1+i)n ……….[1]
• F is future worth amount, P is principal amount
• i is interest rate per period, n is number of interest

periods
•LLF0916 21
a) Annually
F  P(1  i ) n
where
i  0.12
n  1x5  5 periods ( years )
P  $10000
F  10000(1.12) 5
 $17,623.42
•LLF0916 22
b) Semiannually
F  P(1  i ) n
where
i  0.12 / 2  0.06
n  2 x5  10 periods
P  $10000
F  10000(1.06)10
 $17908.48
•LLF0916 23
c) Monthly
F  P(1  i ) n
where
i  0.12 / 12  0.01
n  12 x5  60 periods
P  $10000
F  10000(1.01) 60
 $18167
•LLF0916 24
d) Daily
F  P(1  i ) n
where
i  0.12 / 365  3.288 x10  4
n  365 x5  1825 periods
P  $10000
F  10000(1  3.288 x10  4 )1825
 $18219
•LLF0916 25

More Exercises:
1. You want to buy a latest smartphone which cost RM2500.
Instead, your father asked you to buy a less expensive
alternative which is equally good with all the common
functions available, but cost you less RM1000, at RM 1500,
and save the difference of RM1000 in an account earning
8% interest. How much will you get with this saving
accumulated for 30 years?
2. A rich man has made a will where all his grandchildren will
receive RM 50,000. While one of his grandsons, Tom plan
to squander some of it away, how much should he deposit
in an account earning 4% interest per year if he wish to still
having RM50,000 in around 10 years for his wedding plan?
•LLF0916 26
RATE OF RETURN (ROR) CALCULATIONS
 Cash-flow figures do not show how well the capital invested is being
used; two projects with widely different capital costs may give similar
cumulative cash-flow figures. Some way of measuring the
performance of the capital invested is needed.
 Rate of return (ROR), which is the ratio of annual profit to investment

is a simple index of the performance of the money invested.
 Though basically a simple concept, the calculation of the ROR is

complicated by the fact that the annual profit (net cash flow) will not
be constant over the life of the project. The simplest method is to
base the ROR on the average income over the life of the project and
the original investment.
•LLF0916 27
 In engineering economic studies, rate of return on

investment is ordinarily expressed on an annual percentage
basis. The yearly profit divided by the total initial investment
necessary represents the fractional return, and this fraction
times 100 is the standard percent return on investment.
 Profit is defined as the difference between income and
expense.
•LLF0916 28
LLF0916 29
 The rate of return is often calculated for the anticipated

best year of the project: the year in which the net cash
flow is greatest.
 It can also be based on the book value of the investment,
the investment after allowing for depreciation.
 Simple rate of return calculations take no account of the
time value of money.
LLF0916 30
DISCOUNTED CASH-FLOW RATE OF RETURN (DCFRR)
 Discounted cash-flow analysis, used to calculate the present

worth of future earnings, is sensitive to the interest rate
assumed. 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.
LLF0916 31
LLF0916 32
 The value of r’ is found by trial-and-error calculations.

Finding the discount rate that just pays off the project
investment over the project’s life is analogous to paying off a
mortgage. 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, or the actual interest
rates prevailing at any time.
 Other name: interest rate of return and internal rate of
return
LLF0916 33
PAYBACK TIME
 Pay-back time is the time required after the start of the

project to pay off the initial investment from income;
point D on Cash Flow Diagram.
 Pay-back time is a useful criterion for judging projects that
have a short life, or when the capital is only available for a
short time.
 It is often used to judge small improvement projects on
operating plant. Typically, a pay-back time of 2 to 5 years
would be expected from such projects.
LLF0916 34
INFLATION
• Inflation is the rate at which the general level of prices for
goods and services is rising and, consequently, the
purchasing power of currency is falling. Central banks
attempt to limit inflation, and avoid deflation, in order to
keep the economy running smoothly.
 Inflation depreciates money in a manner similar to, but
different from, the idea of discounting to allow for the time
value of money.
 The effect of inflation on the net cash flow in future years can
be allowed for in a similar manner to the net present worth
calculation (slide 18), using an inflation rate in place of, or
added to, the discount rate r.
 Inflation may well affect the sales price, operating costs and
raw material prices differently.
LLF0916 35
SUMMARY
 There is no one best criterion on which to judge an investment
opportunity. A company will develop its own methods of economic
evaluation, using the techniques discussed in this section, and will
have a “target” figure of what to expect for the criterion used, based
on their experience with previous successful, and unsuccessful,
projects.
 As well as economic performance, many other factors have to be

considered when evaluating projects.
 Safety.
 Environmental problems (waste disposal).
 Political considerations (government policies).
 Location of customers.
 Availability of labour.
 Availability of supporting services.
 Company experience in the particular technology.
LLF0916 36
Determination of rate of return on investment-consideration

of income-tax effects. 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.
•LLF0916 37
Determine the following:

(a) The annual percent return on the total initial investment before
income taxes.
(b) The annual percent return on the total initial investment after
income taxes.
(c) The annual percent return on the total initial investment before
income taxes based on capital recovery with minimum profit.
(d) The annual percent return on the average investment before

income taxes assuming straight-line depreciation and zero salvage
value. Assuming operating life of 5 years.
•LLF0916 38
EXAMPLE
A plant is producing 10,000 t/y of a product. The overall yield is 70 per
cent, on a mass basis (kg of product per kg raw material). The raw
material costs £10/t, and the product sells for £35/t. A process
modification has been devised that will increase the yield to 75 per cent.
The additional investment required is £35,000, and the additional
operating costs are negligible. Is the modification worth making?
 If the additional production given by the yield increase can be sold at

the current price, the earnings on each additional ton of production
will equal the sales price less the raw material cost.
 If the additional production cannot be readily sold, the modification

results in a reduction in raw material requirements, rather than
increased sales, and the earnings (savings) are from the reduction in
annual raw material costs.
LLF0916 39
EXAMPLE
 The second way gives the lowest figures and is the safest basis for
making the evaluation.
 At 10,000 t/y production
 Raw material requirements
 at 70 per cent yield = 10,000/0.7 = 14,286
 At 75 per cent yield = 10,000/0.75 = 13,333

 Saving = 953 t/y
 Cost savings, at £10/t, = 953 x 10 = £9530 per year

 ROR = (9530/35000)x 100% = 27%
 Payback year = 100/27 = 3.7 years (assume the cost savings are
constant)
LLF0916 40
EXAMPLE
 It is proposed to build a plant to produce a new product. The

estimated investment required is 12.5 million pounds and the timing
of the investment will be
Year Cost
Year 1 1.0 Million (Design)
Year 2 5.0 Million (Construction)
Year 3 5.0 Million (Construction)
Year 4 1.5 Million (Working Capital)
LLF0916 41
EXAMPLE
 The fixed operating costs are estimated to be:

 £400,000 per year up to year 9
 £500,000 per year from year 9 to 13
 £550,000 per year from year 13
 The variable operating costs are estimated to be:

 £10 per ton of product up to year 13
 £13 per ton of product from year 13
LLF0916 42
EXAMPLE
Calculate
 1. The net cash flow in each year.
 2. The future worth of the project, NFW.
 3. The present worth, NPW, at a discount rate of 15 per cent.
 4. The discounted cash-flow rate of return, DCFRR.
 5. The pay-back time.
No account needs to be taken of tax in this exercise; or the scrap value of the
equipment and value of the site at the end of the project life. For the
discounting calculation, cash flows can be assumed to occur at the end of the
year in which they actually occur
LLF0916 43
EXAMPLE
LLF0916 44
LLF0916 45

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Last updated: 7/20/2016

FINANCIAL APPRAISAL AND ANALYSIS

 The purpose of investing money in chemical plant is to

 More sophisticated evaluation techniques and economic

 Likened to the material flows in a process plant

 Cash needed to pay for research and development;

 The “net cash flow” at any time is the difference

CASH FLOW AND CASH-FLOW DIAGRAMS

 A cash-flow diagram, such as that shown in pg 7, shows

 The cash flows are based on the best estimates of

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

•A– B: Investment required to

•B – C: The heavy flow of capital

C – D: The cash-flow curve turns

•Point D is known as the break-

CASH FLOW AND CASH-FLOW DIAGRAMS

 D - E In this region the cumulative cash flow is positive. The

TAX AND DEPRECIATION

 In calculating cash flows, the project is usually considered

TAX AND DEPRECIATION

COMPOUNDING & DISCOUNTING

You have won $10,000 and has choice of below:

A: $10,000 $10,000 + interest

Future value = $10,000 (1 + 0.04)3

Present value = $10,000 (1+0.04)-3

• Often the benefits and costs of a project accrue at

• Discounting is a technique used to convert all benefits

• The value of a project, expressed in terms of the

• Discounting is based on the premise that a dollar of

• Time value of money – money available at present time is

• The bias arises because current resources can be

• Discounting is the opposite of compounding.

• The rate at which a future value is discounted is

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

 The discount rate is chosen to reflect the earning power of

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

• F is future worth amount, P is principal amount

• i is interest rate per period, n is number of interest

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

DISCOUNTED CASH FLOW (TIME VALUE OF MONEY)

RATE OF RETURN (ROR) CALCULATIONS

 Rate of return (ROR), which is the ratio of annual profit to investment

 Though basically a simple concept, the calculation of the ROR is

RATE OF RETURN (ROR) CALCULATIONS

 In engineering economic studies, rate of return on

RATE OF RETURN (ROR) CALCULATIONS

RATE OF RETURN (ROR) CALCULATIONS

 The rate of return is often calculated for the anticipated

DISCOUNTED CASH-FLOW RATE OF RETURN (DCFRR)

 Discounted cash-flow analysis, used to calculate the present

DISCOUNTED CASH-FLOW RATE OF RETURN (DCFRR)