JIMMA UNIVERSITY(JU)

JIMMA INSTITUTE OF TECHNOLOGY(JIT)

SCHOOL OF CHEMICAL ENGINEERING

PLANT DESIGN AND ECONOMICS(ChEg5193)

Financial and Economic Evaluation/ of projects

By Ermias G (Ass. Professor).

Financial and Economic Evaluation
 Economics is the science that deals with the production and consumption
of goods and services and the distribution and rendering of these for
human welfare.
 Or Economics is the study of how people and society choose to
employ scarce resources that could have alternative uses in order to
produce various commodities and to distribute them for
consumption, now or in the future.
 Engineering economics is the application of economic principles and
techniques to engineering problems or the evaluation of design and
engineering alternatives.
 It deals with the concepts and techniques of analysis useful in evaluating
the worth of systems, products, and services in relation to their costs.

 For example in comparing the comparative costs of two alternative capital

projects or in determining the optimum engineering course from the cost
aspect.
 The role is to assess the appropriateness of a given project, estimate its
value, and justify it from an engineering standpoint.
 Flow in an Economy

Fig. 4.1 Flow of goods, services, resources and money payments in a simple economy.
 Flow in an Economy

 Business organizations use various economic resources like land,

labour and capital which are provided by households to produce
consumer goods and services which will be used by them.

 Business organizations make payment of money to the households

for receiving various resources.

 The households in turn make payment of money to business

organizations for receiving consumer goods and services.

 This cycle shows the interdependence between the two major

entities in a simple economy.
 CONCEPT OF ENGINEERING ECONOMICS

 Science is a field of study where the basic principles of different physical

systems are formulated and tested. Engineering is the application of
science.
 Efficiency of a system is generally defined as the ratio of its output to
input. The efficiency can be classified into technical efficiency and
economic efficiency.
1. Technical efficiency
It is the ratio of the output to input of a physical system. The physical system
may be a diesel engine, a machine working in a shop floor, a furnace, etc.
In practice, technical
efficiency can never be
more than 100%. This is
mainly due to frictional
loss and incomplete
combustion of fuel,
which are considered to be
unavoidable phenomena
in the working of a diesel
engine.
 CONCEPT OF ENGINEERING ECONOMICS

2. Economic efficiency
Economic efficiency is the ratio of output to input of a business system.

 ‘Worth’ is the annual revenue generated by way of operating the business

and ‘cost’ is the total annual expenses incurred in carrying out the
business. For the survival and growth of any business, the economic
efficiency should be more than 100%.
 Economic efficiency is also called ‘productivity’. There are several ways of
improving productivity.
 Increased output for the same input
 Decreased input for the same output
 Less proportionate increase in output is more than that of the input.
 Through simultaneous increase in the output with decrease in the
input.
 When proportionate decrease in input is more than that of the output.
 Why Financial and Economic Evaluation

 An efficient functioning of any business organization would enable

it to provide goods/services at a lower price.
 In the process of managing organizations, the managers at different
levels should take appropriate economic decisions which will help in
minimizing investment, operating and maintenance expenditures
besides increasing the revenue, savings and other related gains of the
organization.
 Engineering economics definition: It deals with the methods that
enable one to take economic decisions towards minimizing costs
and/or maximizing benefits to business organizations.

NB: We all must be able to apply basic concepts of economics

because economics plays an important role in every engineering
decision.
Why Financial and Economic Evaluation or
Analysis of Plant Design is needed ??
 Engineering economics is important to all fields of
engineering because no matter how technically sound an
engineering project is, it will fail if it is not economically
feasible.
 Engineering economic analysis is often applied to various
possible designs for an engineering project in order to
choose the optimum design, thereby taking into account
both technical and economic feasibility.
 Special emphasis is placed on the economic and engineering
principles involved in the design of chemical plants and
equipment.
 An understanding of these principles is a prerequisite for
any successful chemical engineer, no matter whether the
final position is in direct design work or in production,
administration, sales, research, development, or any other
related field.
Why Financial and Economic Evaluation or
Analysis of Plant Design is needed ?
 A project is economically feasible when it is more
profitable than other competing projects, and financially
feasible when management can raise the capital for its implementation.
 Although calculations may show that a given project could be extremely
profitable, the capital requirements may strain the financial capabilities of
the organization.
 In this case, the project may be abandoned unless partners can be found
to share the risk.
 The economic evaluation of a process proceeds in several steps. These
are:
1. Preparing A Process Flow Diagram
2. Calculating Mass And Energy Flows
3. Sizing Major Equipment
4. Estimating The Capital Cost
5. Estimating The Production Cost
6. Forecasting The Product Sales Price
7. Estimating The Return On Investment.
 The Need for Financial Analysis
 Initially, sufficient capital must be committed to construct all aspects of the
facility necessary for the plant. Since net profit equals total income minus all
expenses, it is essential that the chemical engineer be aware of the various
types of costs associated with each manufacturing step.
 Funds must be available for direct plant expenses, such as those for raw
materials, labor, and utilities, and for indirect expenses, such as
administrative salaries, product sales, and distribution costs.
 Plant design should offer a direct cost advantage and must give profit to
the investing organ.

 Plant design projects are typically continuous and long term, involving
investment, and hence are perceived as a business risks or success.

 Thus, Financial and Economic Evaluation/Analysis becomes

necessary to clearly quantify and predict Financial and Economic
risks or success of various alternative Plant Design Projects.
 Why Economics with Design?

 An understanding of engineering and economics principles is a

prerequisite for direct Plant design work as well as plant
operation.

 The expression plant design always aimed at industrial

applications; consequently, the Birr flow &balance must
always be kept in mind when carrying out the design of a plant
and its operation.

 The theoretical and practical aspects of plant engineering are

important, but, in the final analysis, the answer to the question
“Will we realize a profit from this venture?”almost
always determines the fate and true value of design.
 the engineer, therefore, should know that the fate Of his plant
design is determined by the financial & economic return
and viability.
 Objectives of financial and Economic analysis

 Engineering economic analysis of chemical

processes with particular emphasis on:
 cost estimation
 time value of money and depreciation
 profitability and financial analysis
 methods for decision making among
alternatives
 To implement fundamental principles of financial
and Economic analysis for plant design
projects.
 To screen plant design projects based on financial
profitability and Economic analysis.
 Estimation of Total Capital Investment, TCI = FCI + WC

• Capital: “a stock Of accumulated or saved

wealth” that may be used for investment or financing
projects to further the production of other goods and
services.
 Cash flow is the stream of monetary (dollar) values—
costs (inputs) and benefits (outputs)—resulting from a
project investment.
It is the sum of money recorded as receipts or
disbursements in a project’s financial records.
The difference between several receipts and
disbursements that occur within a given interest period is
called the net cash flow.
 Types of Capital Cost Estimates
There are five generally accepted classifications of capital cost estimates that are
most likely to be encountered in the process industries.

1. Order-of-magnitude estimate (ratio estimate/Feasibility) based on similar

previous cost data(Built plant): probable accuracy of estimate over (±30%).
Diagrams: Normally requires only a block flow diagram
2. Study estimate (factored estimate) ;This type of estimate utilizes a list of the
major equipment found in the process (±25%).

3. Preliminary estimate (budget authorization estimate; scope estimate) based on

sufficient data to permit the estimate to be budgeted (±20%). This type of
estimate requires more accurate sizing of equipment than used in the study
estimate.
4. Definitive estimate (project control estimate) based on almost complete data but
before completion of drawings and specifications (±10%).

5. Detailed estimate (contractor’s estimate) based on complete engineering

drawings, specifications, and site surveys: probable accuracy of estimate within
(±5 %).
 Types of Capital Cost Estimates
Table 4.1 Classification of cost estimate
 Types of Capital Cost Estimates
In Table 4.1, the accuracy range associated with each class of estimate and
the costs associated with carrying out the estimate are ranked relative to the
most accurate class of estimate (Class 1). In order to use the information in
Table 4.1, it is necessary to know the accuracy of a Class 1 estimate.
a. For the cost estimation of a chemical plant, a Class 1 estimate (detailed
estimate) is typically (vary) +6% to –4% accurate.

This means that by doing such an estimate, the true cost of building the plant
would likely be in the range of 6% higher than and 4% lower than the
estimated price. Likewise, the effort to prepare a Class 5 estimate for a
chemical process is typically in the range of 0.015% to 0.30% of the total
installed cost of the plant.
b. For a Class 4 estimate, from Table 4.1 the expected accuracy
range is between 3 and 12 times that of Class 1 estimate.
 Cost of Estimate & degree of Accuracy

5 5
Cost of Estimate
and Time 4
3
Cost 3
2
1

Accuracy
 When a chemical engineer determines costs for any type of
commercial process, these costs should be of sufficient
accuracy to provide reliable decisions.
5

3
3
2
1
Total capital Investment

The figure tells us the

capital inputs and out
puts for an industrial
operation using a tree
growth analogy.
 Before an industrial plant can be put into
operation, a large sum of money must be
supplied to purchase and install the necessary
machinery and equipment.
Factors Affecting Investment And Production Costs
Operating Time and Rate of Production
 The ideal plant should operate under a time schedule which gives the
maximum production rate while maintaining economic operating methods.

 If the production capacity of the process is greater than the sales demand, the
operation can be carried on at reduced capacity or periodically at full capacity.
As indicated in this figure below, the fixed costs remain constant and the total
product cost increases as the rate of production increases.

 When equipment stands idle for an extended period of time, the labor costs
are usually low; however, other costs, such as those for maintenance,
protection, and depreciation, continue even though the equipment is not in
active use.

 No production of a product and sales no revenue, downtime should be kept to

a necessary minimum(main source of poor profitability in process plant).
 The point where the total product cost equals the total income is known as
the break-even point
 BREAK-EVEN ANALYSIS

The main objective of break-even analysis is to find the cut-off production volume
from where a firm will make profit.
a) Break-even point occurs (or is the percentage of plant capacity) when the total
annual product cost equals the total annual sales. i.e:
b) Total Annual Product Cost = Total Annual Sales (total income from all products
sold).This is shown by Figure below
 BREAK-EVEN ANALYSIS CONT’
In a different context, Break-even point is the time reached at which all the investment has
been paid off and the plant begins to make profit as shown in Figure 4.4.

Figure 4-4: Project Cash Flow Diagram

 BREAK-EVEN ANALYSIS CONT’
 A-B The 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.
 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.
 BREAK-EVEN ANALYSIS

 The linear plots of the above two equations are shown in Fig. 4.3.
 The intersection point of the total sales revenue line and the total
cost line is called the break-even point.
 The corresponding volume of production on the X-axis is known as
the break-even sales quantity.
 At the intersection point, the total cost is equal to the total
revenue. This point is also called the no-loss or no-gain situation.
 For any production quantity which is less than the break-even
quantity, the total cost is more than the total revenue.
 Hence, the firm will be making loss.
 For any production quantity which is more than the break-even
quantity, the total revenue will be more than the total cost. Hence,
the firm will be making profit.
BREAK-EVEN ANALYSIS
BREAK-EVEN ANALYSIS

Fig. 4.3 Break-even chart.

 BIRR

X 1000

 In manufacturing engineering, a method called break-even analysis is often used.

This is used to determine the percent capacity for the manufacturing operation at
which cost is equal to income.
 A company could use the break-even analysis method to determine the minimum
amount it must produce in a month to turn a profit.
EXAMPLE 4.1 ELFORA poultry farm/ Associates has the following details:

Fixed cost = Birr 2,000,000, Variable cost per unit = 100Birr/unit, Selling price per
unit = 200Birr/unit
Find
(a) The break-even sales quantity, (b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.
Solution
FC 2,000 000
(a) Break - even quantity    20,000units
s - v 200 - 100
FC 2,000,000* 200
(b)Break - even sales  *s   Birr4,000,000
s-v 200  100
(c) (i) Contribution  Sales – Variable cost
 s * Q  v * Q  Q (s  v)
 60,000 (200  100)  Birr600,000.00
EXAMPLE 4.1 ELFORA poultry farm/ Associates has the following details:

(ii) Margin of safety M.S.  Sales – Break - even sales

METHOD I  60,000* 200 – 4,000,000
 12,000,000– 4,000,000 Birr8,000,000
METHOD II
Profit
M.S.  * Sales
Contribution

Profit  Sales – (FC  v Q)
 60,000* 200 – (2,000,000 100 * 60,000)
 Birr4,000,000
4,000,000*12.000,000
M.S   Birr8,000,000
6,000,000

8,000,000
M.S. as a per cent of sales  *100  67%
12,000,000
EXAMPLE 4.2 Bedele Brewery share company has the following details:

The annual direct production costs for a plant operating at 70 %

capacity is $ 280,000 while the sum of the annual fixed charges,
overhead costs and general expenses is $ 200,000. What is the
break-even point in units of production per year if the total
annual sales are $ 560,000 and the product sells at $ 40 per
unit?
(ii) What are the annual gross earnings and net profits for this

plant at 100 % capacity in the year 2010 when corporate
income taxes required 22 %, normal tax on the total gross
earnings plus 26 % surtax on gross earnings above $ 25,000?
SOLUTION 4-2
Units sold per annum × selling price per unit = total annual sales
Units sold = $ 560,000 per yr. / $ 40 per unit = 14,000 units
Total product cost per unit = $ 280,000/14,000 = $ 20 per unit
EXAMPLE 4.2 Bedele Brewery share company has the following details:

At break-even,
Total product cost per annum = Total annual sales
$ 200,000 + 20x = 40x
Where x is the units required to break-even
x = 10000 units
Therefore at break-even, 10,000 units will be produced.
(ii) Gross annual earnings = total annual sales – total annual

product cost
= 14,000 units × $ 40 per unit/0.70 – ($ 200,000 + (14,000 units
× $ 20per unit/0.7))
= $ 200,000
Net annual earnings
= $ 200,000 – [0.22(200,000) + 0.26(175,000)]
= $ 110,500
 Governmental Policies
Law and regulations and restrictions which have a direct effect
on industrial costs. Some of these are;
 import and export
tariff regulations,
 restrictions on permissible depreciation rates,
 income-tax rules, and
environmental regulations and safety regulation
The sum of the fixed-capital investment
and the working capital is known as the
total capital investment (TCI).
 Fixed-capital Investment Items For A Chemical Process

Table 4-1 provides a checklist of items for a new facility and is an invaluable
aid in making a complete estimation of the FCI.
Direct Costs
1. Purchased equipment
All equipment listed on a complete flow sheet, Spare parts and non installed
equipment spares, Surplus equipment, supplies, and equipment allowance
Inflation cost allowance, Freight charges, Taxes, insurance, duties
Allowance for modifications during startup
2. Purchased-equipment installation
Installation of all equipment listed on complete flow sheet
Structural supports, insulation, paint
3. Instrumentation and controls
Purchase, installation, calibration, computer tie-in
4. Piping
Process piping-carbon steel, alloy, cast iron, lead, lined, aluminum, copper,
ceramic, plastic, rubber, reinforced concrete, Pipe hangers, fittings, valves.
Insulation-piping, equipment
Fixed-capital Investment Items For A Chemical Process cont’d

5. Electrical equipment and materials

Electrical equipment -switches, motors, conduit, wire, fittings, feeders,
grounding, instrument and control wiring, lighting, panels, Electrical
materials and labor.
6. Buildings (including services)
 Process buildings-substructures, superstructures, platforms, supports,
stairways, ladders, access ways, cranes, monorails, hoists, elevators.
 Auxiliary buildings-administration and office, medical or dispensary,
cafeteria, garage, product, warehouse, parts warehouse, guard and
safety, fire station, change house, personnel building, shipping office
and platform, research laboratory, control laboratory, Maintenance
shops-electric, piping, sheet metal, machine, welding, carpentry,
instrument, Building services-plumbing, heating, ventilation, dust
collection, air conditioning, building lighting, elevators, escalators,
telephones, intercommunication systems, painting, sprinkler
systems, fire alarm
 Fixed-capital Investment Items For A Chemical Process cont’d

7. Yard improvements
Site development-site clearing, grading, roads, walkways, railroads, fences, parking
areas, wharves and piers, recreational facilities, landscaping
8. Service facilities
 Utilities-steam, water, power, refrigeration, compressed air, fuel, waste
disposal.
 Facilities-boiler plant incinerator, wells, river intake, water treatment, cooling
towers, water storage, electric substation, refrigeration plant, air plant, fuel
storage, waste disposal plant, environmental controls, fire protection.
 No process equipment-office furniture and equipment, cafeteria equipment,
safety and medical equipment, shop equipment, automotive equipment, yard
material-handling equipment, laboratory equipment, locker-room equipment,
garage equipment, shelves, bins, pallets, hand trucks, housekeeping
equipment, fire extinguishers, hoses, fire engines, loading stations. Distribution
and packaging-raw-material and product storage and handling equipment,
product packaging equipment, blending facilities, loading stations.
9. Land
Surveys and fees and Property cost
Fixed-capital Investment Items For A Chemical Process cont’d

Indirect costs
1. Engineering and supervision
 Engineering costs-administrative, process, design and general
engineering, drafting, cost engineering, procuring, expediting, reproduction,
communications, scale models, consultant fees, travel
 Engineering supervision and inspection
2. Construction expenses
 Construction, operation and maintenance of temporary facilities, offices,
roads, parking lots, railroads, electrical, piping, communications, fencing
 Construction tools and equipment
 Construction supervision, accounting, timekeeping, purchasing,
expediting
 Warehouse personnel and expense, guards
 Safety, medical, fringe benefits
Permits, field tests, special licenses
Taxes, insurance, interest
3. Contractor’s fee
4. Contingency
 Working Capital(WC)

The total amount of money invested in:

1. Raw materials and supplies carried in stock,

2. Finished products in stock and semi finished products in the
process of being manufactured,
3. accounts receivable,
4. cash kept on hand for monthly payment of operating expenses,
such as salaries, wages, and raw-material purchases,
5. accounts payable
6. taxes payable

The estimate of the purchase cost at a later date is obtained by

multiplying the cost from an earlier date by the ratio of a cost
Index.
 Cost indexes can be used to give a
Time increases – cost increases (inflation) general estimate, but no index can
Inflation is measured by cost indexes take into account all factors, such as
special technological advancements or
local conditions

Some of these can be used for

estimating equipment costs; others
apply specifically to labor,
construction, materials, or other
specialized fields.

Effect of Time
 Cost Indexes
 Marshall & Swift Equipment Cost Indexes
 all-industry equipment index - arithmetic average of indexes for 47
different types of industrial, commercial, and housing equipment based
on an index value of 100 for the year 1926
 account for cost of machinery and major equipment plus costs for
installation, fixtures, tools, office, and minor equipment.
 Engineering News-Record Construction Cost Index
 Relative construction costs at various dates can be estimated by the
use of this method.
 indicates variance in labor rates and materials costs for industrial
construction
 On one of three basis’ used: 100 for 1913, 1949 or 1967
 Nelson-Farrar Refinery Construction Cost Index
• This will determine the petroleum industry
construction costs. The total index percentages are
weighted as follows: skilled labor, 30; common labor,
30; iron and steel, 20;
 An index value of 100 is used for the base year of 1946
 Chemical Engineering Plant Cost Index$ based on 1957-1959 =
100.
 Chemical Engineering Plant Cost Index from 1950 to 2008
700

600 y = 1E-07x6 - 0.0014x5 + 6.8648x4 - 17771x3 + 3E+07x2 - 2E+10x + 6E+12

R² = 0.9947

500

400

300

200

100

0
1950 1960 1970 1980 1990 2000 2010
Chemical Engineering Plant Cost Index
 Unfortunately, all cost indexes are rather artificial; two
indexes covering the same types of projects may give
results that differ considerably.
 The most that any index can hope to do is to reflect
average changes.

 For use with process-equipment estimates and chemical

plant investment estimates, the Marshall and Swift
equipment cost indexes and the Chemical Engineering
plant cost indexes are recommended. These two cost
indexes give very similar results.
 Engineering News-Record construction cost index, relative with
time, has increased much more rapidly than the other two because it
does not include a productivity improvement factor.
 Nelson-Farrar refinery construction index has shown a very
large increase with time and should be used with caution
and only for refinery construction.
Component
costs as
percentages
of fixed
capital
investment
 Example 4.2 Estimation of fixed-capital investment
Make a study estimate of the fixed-capital investment for a process plant if the purchased-
equipment cost is $100,000. Use the ranges of process-plant component cost outlined in (Table
4 ) for a process plant handling both solids and fluids with a high degree of automatic controls
and essentially outdoor operation. Solution: Generally, when all the percentages are added,
they will not total to 100%. Therefore, all percentages must be normalized to a total of 100 by
dividing each percentage by the total sum over 100. The estimated cost for a component is
then calculated as $100,000 multiplied by the normalized percentage for the
equipment. Components Selected % of FCI Normalized % of FCI Estimated cost
Purchased equipment 25 23.0 $100,000
Purchased-equipment installation 9 8.3 36,000
Instrumentation (installed) 7 6.4 28,000
Piping (installed) 8 7.3 32,000
Electrical (installed) 5 4.6 20,000
Buildings (including services) 5 4.6 20,000
Yard improvements 2 1.8 8,000
Service facilities (installed) 15 13.8 60,000
land 1 0.9 4,000
Engineering and supervision 10 9.2 40,000
Construction expense 12 11.0 48,000
Contractor’s fee 2 1.8 8,000
Contingency 8 7.3 32,000
Total 109 100 $436,000.00
Estimation of Purchased Equipment Costs
The cost of purchased equipment is the basis of several predesign methods for
estimating capital investment.
 Sources of equipment prices,
 methods of adjusting equipment prices for capacity, and
 methods of estimating auxiliary process equipment are therefore essential to the
estimator in making reliable cost estimates.
the various types of equipment
1. processing equipment
2. raw-materials handling and storage equipment, and
3. finished-products handling and storage equipment.

The most accurate method for determining process equipment costs is to

obtain firm bids from fabricators or suppliers. Often, fabricators can supply;
1. quick estimates which will be very close to the bid price
2. Need not involve too much time.
3. cost values from the file of past purchase orders. When used for pricing
new equipment, purchase order prices must be corrected to the
current cost index.
 Estimating Purchased Equipment Cost
 Use previous cost on similar equipment and scale for time and size
 Less accurate
Corrected to the current cost index
beware of large extrapolation
beware of foreign currency
 Use cost estimating charts and scale for time
 Reasonably accurate
Convenient
 Vendor quote
 Most accurate
 based on specific information
 requires significant engineering
 A grass-roots plant is defined as a complete plant erected on a
new site.
 Investment includes all costs of land, site development, battery
limit facilities, and auxiliary facilities. A geographical boundary
defining the coverage of a specific project is a battery limit.
 Estimating Equipment Costs by Scaling
 Good results can be obtained by using the logarithmic relationship
known as the six-tenths-factor rule, if the new piece of equipment is
similar to one of another capacity for which cost data are available.
 capac. equip. a  0.6 
Cost of equip. a  cost of equip. b   
 capac. equip. b  
Effect of Size(Capacity)
n According to this rule, if the cost of a given unit
Ca  Aa 
   at one capacity is known, the cost of a similar
Cb  Ab  unit with X times the capacity of the first is
approximately (X)0.6 times the cost of the initial
 C  purchased cost
unit.
 n cost exponent, typically 0.4-0.8
 Often use n = 0.6, then refer 6/10ths rule can be used to scale up an entire process
 a  unit with required attribute and b unit with base attribute
 Order-of-Magnitude estimate
 A  equipment cost attribute
 Exponents tabulated in numerous sources, such as Perry's Chemical Engineer's
Handbook.
 In general, the larger the equipment, the lower the cost of equipment
per unit of capacity
 Estimating Equipment Costs by Scaling
 The preceding equation indicates that a log-log plot of capacity
versus equipment cost for a given type of equipment should be a
straight line with a slope equal to 0.6. Application of "six-tenth
factor" rule to costs for U-tube heat exchangers.

 However, the application of the 0.6 rule of thumb for most

purchased equipment is an oversimplification of a valuable cost
concept since the actual values of the cost capacity factor vary from
less than 0.2 to greater than 1.0 as shown in Table 5. Because of
this, the 0.6 factor should only be used in the absence of other
information.

 In general, the cost-capacity concept should not be used beyond a

tenfold range of capacity, and care must be taken to make certain
the two pieces of equipment are similar with regard to type of
construction, materials of construction, temperature and
pressure operating range, and other pertinent variables.
Estimating Equipment Costs by Scaling
Example 4.3: Estimating cost of equipment using scaling factors and cost
index.
The purchased cost of a 50-gal glass-lined, jacketed reactor (without
drive) was $8350 in 1981. Estimate the purchased cost of a similar
3OO-gal, glass-lined, jacketed reactor (without drive) in 1986. Use the
annual average Marshall and Swift equipment-cost index (all industry)
to update the purchase cost of the reactor.
Solution :Marshall and Swift equipment-cost index
• (From table 3)for 1981 721
• (From table 3) for 1986 798
• From Table 5, the equipment vs. capacity exponent is given as 0.54:
• In 1986, cost of reactor = $8350(798/721)(300/50)0.54= $24,319.56
• Purchased-equipment costs for vessels, tanks, and process- and
materials handling equipment can often be estimated on the basis
of weight.
Cont’d
 Example 4.4:Problem Statement
4. Recently a cast iron leaf pressure filter with 100m2was
purchased for clarifying an inorganic liquid stream for $15,000.
In a similar application, the company will need a 450m2 cast iron
leaf pressure filter. The size exponent for this type filter is 0.6.
Estimate the purchased price of the 450m2 unit.
 Example 4.5
A New Plant Ordered a Set of Floating Head Heat
Exchangers (Area = 100 m2) cost Birr 920,000.
What Would Cost be for a Heat Exchanger for
Similar Service if Area = 50 m2 and n = 0.44 ?
Solution n
 Aa 
0.44
 50 
Ca  920,000   67,816.4 C a  Cb  
 100   Ab 

100 m2 Exchanger is not twice as expensive as a

50 m2 exchanger, Economy of Scale Ca = Birr
67,816.4
 Example 4.5:Equipment Sizing
1. Process design of a shell-and-tube heat
exchanger. An oil at a rate of 490,000lb/hr is to
be heated from 100 to 170oF with 145,000lb/hr
of kerosene at initially at 390oF from another
plant unit. The oil stream enters at 20psig and
the kerosene stream at 25psig. The physical
properties are:
Oil 0.85 sp. gr.; 3.5cP at 135 F; 0.49 sp.ht.
Kerosene 0.82 sp.gr.; 0.4cP; 0.61 sp.ht.
Estimate the cost of an all carbon steel
exchanger in late 2002. Assume a counter flow
1–2 shell-and-tube heat exchanger.
Example 4.5:Equipment Sizing
Example 4.5:Equipment Sizing
Example 4.5:Equipment Sizing
 Effect of Time on Purchased Equipment Cost
 When one depends on past records or published correlations
for price information, it is essential to be able to update these
costs to take changing economic conditions (inflation) into
account. This can be achieved by using the following
expression:

where C = Purchased cost

I = Cost index
Subscripts: 1 refers to base time when cost is known
2 refers to time when cost is desired
Time increases – cost increases (inflation)
 Inflation is measured by cost indexes
Chemical Engineering Plant Cost Index (CEPCI)Marshall and
Swift Process Industry Index
Table 4.4 Values for the Chemical Engineering
Plant Cost Index and the Marshall and Swift
Equipment Cost Index from 1991 to 2006
Table 4.6 Several Cost Index from 1995 to 2010
 Unless otherwise stated, the Chemical Engineering Plant Cost Index (CEPCI) will
be used in this text to account for inflation. This is a composite index, and the
items that are included in the index are listed in Table 4.5. A comparison between
these two indices is given in Example 4.6.
 Table 4.5 The Basis for the Chemical Engineering Plant Cost Index
 Example 4.6
The purchased cost of a heat exchanger of 500m2 area in 1992 was
$25,000.
a. Estimate the cost of the same heat exchanger in 2006 using the
two indices introduced above.
b. Compare the results.
 Solution From Table 4.4
Year 1992 2006
Marshal and Swift Index 943 1302
Chemical Engineering cost index 358 500

a. Marshal and Swift: Cost = ($25,000)(1302/943) = $34,518

Chemical Engineering: Cost = ($25,000)(500/358) = $34,916
b. Average Difference: (($34,518 – 34,916)/(($34,518 + 34,916)/2)(100)
= –1.1%
Example 4.7: Cost of vessel in 1993 was 25,000, what is estimated cost
today (Sept 2003 – CEPCI = 402)?
Solution
 Example 4.8: Accounting for Time and Size
 2 heat exchangers, 1 bought in 1990 and the other
in 1995 for the same service.

What is the Cost of a 80 m2 Heat Exchanger Today?

(Cost index= 402)
Example 4.9: Accounting for Time and Size
1. A process vessel was purchased in the United
states for our plant in the Ethiopia in 1993. A
similar vessel, but of different capacity, was
purchased in 1998. From the data given below,
estimate the cost in U.S.$ of a vessel of 120 m3
capacity purchased 2007 (assume the current
CEPCI = 500).
Date Vessel Purchased cost (P. Exchange rate
Capacity(m3) sterling)

1993 75 7,800 $1.4/P.S

1998 155 13,800 $1.65/P.S

2007 120 $2.00?P.S

 Exercise 4.1
1.You have been hired at Bedele Brewery factory as a consultant
to a legal firm. Part of your assignment is to determine the size of
a storage tank purchased in 1988 (CEPCI = 343), before
computerization of records. Many records from this era were
destroyed in a fire (not in the plant, but in a distant office building).
The tank was replaced every 10 years, and the sizes have
changed due to plant capacity changes. You have the information
in the table below. Estimate the original capacity of this vessel.
Date Vessel Purchased cost ($) CEPCI
Capacity(m3)

1988 ? 25,000.00 343

1998 120 35,500.00 390

2008 85 48,600.00 575

 Total instrumentation cost depends on the amount of control
required and may amount to 6 to 30 percent of the purchased cost
for all equipment. Computers are commonly used with controls and
have the effect of increasing the cost associated with controls..,

 Analyses of the total installed costs of equipment in a number of

typical chemical plants indicate that the cost of the purchased
equipment varies from 65 to 80 percent of the installed cost
depending upon the complexity of the equipment and the type of
plant in which the equipment is installed.
 Installation costs for equipment, therefore, are estimated to
vary from 25 to 55 percent of the purchased-equipment cost.
 In most situations, cost information will not be available for the
same process configuration; therefore, other estimating
techniques must be used.
 Estimating the Total Capital Cost of a Plant
In most situation, cost information will not be available for the same
process configuration, therefore, other estimating techniques must
be used, which some are:
1. Lang Factor Technique
2. Module Costing Technique
3. Bare Module Cost for Equipment at Base Conditions
4. Bare Module Cost for Non base Case Conditions
5. Grass Roots and Total Module Cost
 Table 4.10 Factor affecting the costs associated
with evaluation of capital cost of chemical plants
 Table 4.10 Factor affecting the costs associated
with evaluation of capital cost of chemical plants(cont….)
 Module Costing Technique
 The equipment module costing is a common technique to
estimate the cost of new chemical plant.

 It is the best method for making preliminary cost Estimates

 The costing technique relate all costs back to the purchased

cost of equipment evaluated for some conditions.

 Deviations from base conditions are handled by using

multiplying factors that depend on the following:
1. The specific equipment type
2. The specific system pressure
3. The specific materials of construction
 Module Costing Technique
 The bare module cost for each piece of equipment can be
calculated by:

(where: CBM = bare module equipment cost: direct indirect cost

for each unit

FBM = bare module cost factor: multiplication factor to account

for the items in Table 4.10
Cp = purchased cost for base conditions: equipment made of the
most common material, usually carbon steel and operating at
near ambient pressures
 Bare Module Cost for Equipment at
Base Conditions
 Bare module equipment cost represents the sum of direct and
indirect costs shown in Table 4.10
 The conditions specified for the base case are
 Unit fabricated from most common material, i.e. carbon
steel
 Unit operated at near-ambient temperature
The bare module factor for base condition is given by :

The values for the bare module cost multiplying factors vary between
equipment modules.
Table 4.11 Equations for Evaluating Direct,
Indirect, Contingency & Fee Cost
 Example 4.10
The purchased cost for a carbon steel heat exchanger operating at
ambient pressure is RM 10,000. For a heat exchanger module, the
following cost information:

Using the information given above, determine the equivalent cost

multiplier given in Table 4.11 and the following:
a. Bare module cost factor, FBM
b. Bare module cost, C
Example 4.10 cont.….
 Methods for Estimating Capital Investment
 Various methods can be employed for estimating capital investment.
The choice of any one method depends upon
a) the amount of detailed information available and
b) the accuracy desired
 The Seven methods are outlined with in each method requiring
progressively less detailed information and less preparation time.
 Consequently, the degree of accuracy decreases with each succeeding
method
A. Detailed-Item Estimate
B. Unit Cost Estimate
C. Percentage Delivered-Equipment
D. Lang Factors for Approximation of Capital Investment
E. Power factor Applied to Plant/Capacity ratio
F. Investment cost per unit capacity
G. Turnover ratio
 A. Detailed-Item Estimate : Accuracy of (±5%)
 Each individual Equipment and material needs as determined
from completed drawings and specifications are priced either from
current cost data or preferably from firm delivered quotations.
 Estimates of installation costs are determined from accurate labor
rates, efficiencies, and employee-hour calculations.
 Accurate estimates of engineering, drafting, field supervision
employee-hours, and field-expenses must be detailed in the same
manner. Complete site surveys and soil data must be available to
minimize errors in site development and construction cost
estimates.
 Because of the extensive data necessary and the large amounts of
engineering such a detailed-item estimate, this type of estimate is
almost exclusively only prepared by contractors bidding on lump-sum
work from finished drawings and specifications. A maximum accuracy
within approximately ±5 percent of the actual capital investment can be
obtained with method A.
 B Unit Cost Estimate:10-20% accuracy
 This method results good estimating accuracies for FCI provided
accurate records have been kept of previous cost experience. And
also this method, which is frequently used for preparing definitive
and preliminary estimates, also requires detailed estimates of
purchased price obtained either from quotations or index-corrected
cost records and published data.
 Equipment installation labor is evaluated as a fraction of the
delivered-equipment cost.
 Costs for concrete, steel, pipe, electrical, instrumentation,
insulation, etc., are obtained by take-offs from the drawings and
applying unit costs to the material and labor needs.
 A unit cost is also applied to engineering employee-hours, number
of drawings, and specification.
 A factor for construction expense, contractor’s fee, and contingency
is estimated from previously completed projects and is used to
complete this type of estimate.
A cost equation summarizing Unit Cost method is given by

where Cn = new capital investment

E = purchased-equipment cost
EL = purchased-equipment labor cost
fx = material unit cost, e.g., fP = unit cost of pipe
Mx= specific material quantity in compatible units
fy = specific material labor unit cost per employee-hour
ML = labor employee-hours for specific material
fe = unit cost-for engineering
He= engmeermg employee-hours
Fd = unit cost per drawing or specification
fF = construction or field expense factor always greater than 1
 C: % Purchased Equipment Cost: 20-30% accuracy
 This method for estimating the fixed or total-capital investment requires
determination of the purchased or delivered-equipment cost.
(Quotation, Index cost, Internet).
 The other items included in the total direct plant cost are then estimated
as percentages of the delivered-equipment cost.
 The additional components of the capital investment are based on
average percentages of the total direct plant cost, total direct and
indirect plant costs, or total capital Investment.

• Where f1f2...= multiplying factors for piping, electrical, instrumentation,

etc.
• f1 = indirect cost factor always greater than 1.
 The percentages used in making an estimation of this type should be
determined on the basis of the type of process involved, design
complexity, required materials of construction, location of the plant, past
experience, and other items dependent on the particular unit under
consideration.
 Estimating by percentage of delivered-equipment cost is commonly used
for preliminary and study estimates.
 C: % Purchased Equipment Cost: 20-30% accuracy
Example 4.10 Estimation of fixed-capital investment by percentage of delivered equipment
cost. Prepare a study estimate of the fixed-capital investment for the process plant described
in Example 4.2 if the delivered-equipment cost is $100,000.

b. Estimate working capital(WC) and total capital Investment(TCI)

 C: % Purchased Equipment Cost: 20-30% accuracy
 The method presented by Mr. Lang was based on a study of fourteen
(14) plant estimates of various sizes and types.
 The three process plant types, solid processing plants, solid-fluid
processing plants, and fluid processing plants. He defined these as
follows: “a distillation unit would be classified as a typical fluid
process plant, a coal briquetting plant as a typical solid processing
plant, and a solvent extraction plant complete with bean preparation
and meal processing facilities as a typical solid-fluid processing plant.”
 The method presented required an estimate of the plant equipment
delivered to the site and one of three factors (f) applied to this
delivered-to-site equipment (Equip) cost. Table 4.5 Lang Factors
for the Estimation of Capital Cost for Chemical Plant.
Types of chemical plant Lang Factor = Flang
Solid process plants 3.10
Solid-fluid process plants 3.63
Fluid process plants 4.74
Lang Factor Technique

FLang = Lang factor (from Table 4.5)

RATIO FACTORS FOR ESTIMATING FII/TCI BASED ON of Purchased Equipment Cost
 Exercise 4.2
1. The purchased cost of equipment for a solid-processing plant is $500,000.
Estimate the total capital investment and the fixed-capital investment for the
plant. What percentage and amount of the fixed-capital investment is due to
cost for land and contractor’s fee?
2. The purchased-equipment cost for a plant which produces pentaerythritol
(solid- fuel-processing plant) is $300,000. The plant is to be an addition to
an existing formaldehyde plant. The major part of the building cost will be
for indoor construction, and the contractor’s fee will be 7 percent of the
direct plant cost. All other costs are close to the average values found for
typical chemical plants. On the basis of this, estimate the following:
a) The total direct plant cost.
b) The fixed-capital investment.
c) The total capital investment.
3. A company is considering an investment in an aldehyde facility. The
engineering department has estimated that the battery-limits fixed capital
investment to be $19M. Land allocated for the project is $500,000 and start-up
expenses to be capitalized are expected to be $900,000. The company
normally uses 15% of the total capital investment for working capital. Determine
the estimated amount of working capital for this project.
 D. Lang Factorial method for FCI
 The fixed capital cost of the project is given as a function of
the total purchase equipment cost by the equation:
FCI = FL F*PEC
where FCI= fixed capital cost,
PEC — the total delivered cost of all the major equipment
items: storage tanks, reaction vessels, columns, heat
exchangers, etc.,
FL-FCI = the “ FCI Lang factor", which depends on the type of
process.
FL-FCI =3.1 -3.9 for predominantly solids processing plant
= 4.7-4.8 for predominantly fluids processing plant
=3.6 -4.1 for a mixed fluids-solids processing plant
 D. Lang Factorial method for TCI
 A simple technique to estimate the capital cost of a chemical
plant is the Lang Factor method.
 The Total capital cost of the project is given as a function of the total
purchase equipment cost by the equation:
TCI = FL T*PEC
where TCI= Total capital cost,
PEC — the total purchased delivered cost of all the major equipment
items:
FL-TCI = the “ TCI Lang factor" depends on the type of process.
FL-FCI =4.6 for predominantly solids processing plant
= 5.7 for predominantly fluids processing plant
=4.9 for a mixed fluids-solids processing plant
 The cost determined from the Lang Factor represents the cost
to build a major expansion to an existing chemical plant.
 D: Lang Factors for Approximation of Capital Investment
 To obtain order-of-magnitude estimates.
 FCI/TCI are approximately obtained by multiplying the
Purchased equipment cost by some factors known as Lang
Factors as indicated below
 The total cost is determined by multiplying the total purchased
cost for all the major items of equipment by a constant.
 This technique originally proposed by LANG has been used in
the past for quick-order of magnitude cost estimate for
process plants.
 Lang suggested multiplying the delivered cost of the
equipment by the factors sated in the above table to obtain the
FCI and TCI.
 E:POWER FACTOR APPLIED TO PLANT/CAPACITY RATIO
This method for study to obtain order-of-magnitude
estimates relates the FCI of a new process plant to the FCI
of similar previously constructed plants by an exponential
power ratio.
 FCI/Cn are obtained by relating the fixed-capital investment of a
new process plant(Cn) to the fixed-capital investment of similar
previously constructed plants (C) by an exponential power ratio (x):

fe is the cost index at the time of cost Cn to that at the time of C.

R is Capacity ratio = Capacity of new process plant(Cn) / capacity
of the old(C)
= Cn/C
F: Investment cost per unit capacity
 G: Turnover ratio

 This is a rapid, simple method for estimating the fixed capital

investment but is one of the most inaccurate.

 The annual gross sales figure is the product of the annual

production rate and the selling price per unit of production. A
basic assumption is that all product made is sold. Turnover
ratios range from 0.2 to 4 (rule of thumb for chemical
industry: turnover ratio =1). Values less than 1.0 are for large
volume, capital-intensive industries and those greater than
1.0 are for processes with a small number of equipment
items.
The reciprocal of this ratio is the so-called capital ratio or the
investment ratio
G: Turnover ratio Table 4.9,
 Example 4.5: Problem Statement:
1. Estimatethe fixed capital investment for a 1500 ton/day
ammonia plant using the turnover ratio. The current gross selling
price of ammonia is $150/ton. The plant will operate at a 95%
stream time. From Table 4.11, the TOR for an ammonia plant is
0.65.

solution:
 Example 4.5: Problem Statement:
4. A company is considering the manufacture of ethylene oxide as
an intermediate for its polymer division. The process to be used is
the direct oxidation of ethylene. The company built a similar unit in
2001 that had a rated capacity of 100,000 tons annually for
$66,000,000. The projected production of the new facility is to be
150,000 tons annually. Estimate the fixed capital investment in
late 2007 dollars to produce the required ethylene oxide.
Solution:CE Index for 2001 = 396.5
CE Index for late 2007 = 426.8
0.67
 capacity150   CEI 2007 
Cost150 (2007)  cost100 (2001)   
 capacity100   CEI 2001
0.67
 150   396.5 
Ca150  $60,000     67,816.4
 100   426.8 
 Example 4.10: Detailed item estimate
Initial design work was done for a chemical plant to revamp the
process in order to recover valuable product from an effluent gas
stream. The gas will be scrubbed with a solvent in a packed
column and the recovered product and solvent separated by
distillation. The solvent will then be cooled and recycled. The
major items of equipment required and their purchased costs in
Birr are:
Absorption column: Column purchased cost = 19,800
Cost of column packing = 6,786
Recovery column: Column purchased cost = 45,000
Cost of 30 sieve trays = 8,670
Reboiler: Cost of reboiler = 7,600
Condenser: Purchased cost = 4,800
Recycle solvent cooler: Cost of cooler = 2,550
Storage tank: Cost of tank = 7,790
 Example 4.10: Detailed item estimate
The relevant component factors for this processing plant are;
f1: equipment erection = 0.40
f2: piping = 0.70
f3: Instrumentation = 0.2
f4: electrical = 0.10
f10: design and engineering = 0.30
f12: contingencies = 0.20
Estimate the total capital investment for the project, if the
working capital can be taken as 10 % of the fixed capital cost.
Answer : Working capital= Birr 37,079.00
Total capital Investment= Birr 407,864.00
 Estimation of total product cost
 Determination of the necessary capital investment is only one part
of a complete cost estimate. Another equally important part is the
estimation of costs for operating the plant and selling the products.
 Total Production Cost is divided into two classifications
1 .Manufacturing Costs and (2) General Expenses
All expenses directly connected with the manufacturing operation or the
physical equipment of a process plant itself are included in the
manufacturing costs. Classified into three
MC =Direct Production Costs + Fixed Costs(charges) + plant overhead costs
 Direct production costs include expenses directly associated with the
manufacturing operation. This type of cost involves expenditures for raw
materials (including transportation, unloading, etc.,); direct operating
labor; supervisory and clerical labor directly connected with the
manufacturing operation; plant maintenance and repairs; operating
supplies; power; utilities; royalties; and catalysts.
 Estimation of total product cost
• Fixed charges are expenses which remain practically
constant from year to year and do not vary widely with
changes in production rate. Depreciation, property taxes,
insurance, and rent require expenditures that can be
classified as fixed charges.

 plant-overhead costs are for hospital and medical services;

general plant maintenance and overhead; safety services;
payroll overhead including pensions, vacation allowances,
social security, and life insurance; packaging, restaurant and
recreation facilities, salvage services, control laboratories,
property protection, plant superintendence, warehouse and
storage facilities, and special employee benefits.

 These costs are similar to the basic fixed charges in that they
do not vary widely with changes in production rate.
 Estimation of total product cost
 2. General Expenses:- these general expenses may be classified as (1)
administrative expenses, (2) distribution and marketing expenses, (3)
research and development expenses, (4) financing expenses, and (5)
gross-earnings expenses.
 Administrative expenses include costs for executive and clerical
wages, office supplies, engineering and legal expenses, upkeep on
office buildings, and general communications.
 Distribution and marketing expenses are costs incurred in the
process of selling and distributing the various products. These costs
include expenditures for materials handling, containers, shipping,
sales offices, salesmen, technical sales service, and advertising.
 Research and development expenses are incurred by any progressive
concern which wishes to remain in a competitive industrial position.
 Financing expenses include the extra costs involved in procuring
the money necessary for the capital investment.
 Gross-earnings expenses are based on income-tax laws.
 Table 4.7 Factors Affecting the Cost of
Manufacturing ( COM) for a Chemical Product
 Table 4.7 Factors Affecting the Cost of
Manufacturing ( COM) for a Chemical Product
Total Production(Operating) Cost /TPC (TOC)
 Estimation of Manufacturing Costs
All expenses manufacturing expenses are divided into
three classifications
1.Direct Costs
 Vary with production rate but not necessarily directly
proportional
2.Fixed Costs
 Do not vary with production rate but relate “directly”
to production function
3.General Expenses
 Functions to which operations must contribute –
overhead burden
Table 4.8 Multiplication Factors for Estimating Manufacturing Cost*
 Cost of Manufacture (COM)
COM = DMC + FMC + GE
 COM is the sum of Direct (DMC) and Fixed (FMC) Manufacture Costs and
General Expenses (GE)

 Cost of Manufacture (COM) estimated from:

fixed capital investment (FCI):(CGR or CTM),
cost of operating labor (COL),
cost of utilities (CUT),
cost of waste treatment (CWT), and
cost of raw materials (CRM).
 Manufacture (Operating) Cost

COM

GE

FMC

DMC
 Cost of Manufacture
FCI, COL, CUT, CWT, and CRM are typically determined
from:
material and energy balances,
a knowledge of the type of plant being considered,
the size of the facility,
the nature of the raw materials and their commodity
costs, etc.
 Direct Manufacture Costs (DMC)
 The cost items for each of the three categories are added
together to provide the total cost for each category.
 The equations for estimating the costs for each of the
categories are as follows:
1. DMC = CRM + CWT + CUT + 1.33COL + 0.069FCI +
0.03COM
2. FMC = 0.708COL + 0.068FCI + depreciation
3. GE = 0.177COL + 0.009FCI + 0.16COM
We can obtain the total manufacturing cost by adding these three
cost categories together and solving for the total
manufacturing cost, COM. The result is
COM =1.23(CRM+CWT+CUT) + 2.73 COL + 0.280 FCI …………………………(4.1)
In Equation (4.1), the depreciation allowance of 0.10FCI is added
separately.
 Direct Manufacture Costs (DMC)
1. DMC = CRM + CUT + 1.33 COL + 0.03 COM + 0.069
FCI + CWT
 CRM; Raw materials
 CUT; Utilities,
 COL Operating labor
 direct supervisory & clerical labor, CSC = aSCCOL ( aSC = 0.18)
 maintenance/repair, CMR = aMRFCI (aMR = 0.06)= 0.06FCI
 operating supply, COS = aOSCMR = aOSaMRFCI (aOS = 0.15)
 laboratory charges, CLC = aLCCOL (aLC = 0.15)
 patents/royalties, CPR = aPRCOM (aLC = 0.03)
 Waste treatment CWT,
 Fixed Costs (FMC)
FC = 0.708 COL + 0.068 FCI + dep
Factors not affected by production rate
 Depreciation
 CDEP = aDEP FCI (just as easy to use MACRS)
 local taxes and insurance
 CTI = aTI FCI (aTI = 0.032)
 plant overhead costs
 CPO = aPO (COL + CSC + CMR); (aPO = 0.6)
= aPO (COL + aSC COL + aMR FCI)
 General Expenses (GE)
GE = 0.177 COL + 0.009 FCI + 0.16 COM
 administration costs
COL = aAD (COL + CSC + CMR); (aAD = 0.15)
 distribution and sales costs
CDS = aDS COM; (aDS = 0.11)
 R&D
CRD = aRD COM; (aRD = 0.05)
 Cost of Manufacture (COM)
COM = DMC + FMC + GE
COM =CRM + CWT + CUT + 1.33 COL + 0.03COM + 0.069 FCI + 0.708 COL +
0.068 FCI + dep + 0.177 COL + 0.009FCI + 0.16 COM

COM =1.23(CRM+CWT+CUT) + 2.73 COL + 0.280 FCI

The cost of manufacture without depreciation, COMd, is (The

subscript in COMd indicates depreciation has not been
included in the cost.)

COMd =1.23(CRM+CWT+CUT) + 2.73 COL + 0.180 FCI ………………..(4.2)

 Example 4.9
The following cost information was obtained from a design for a
92,000 tonne/year nitric acid plant. Determine
a. The manufacturing cost in $/yr and $/tonne of nitric acid
b. The percentage of manufacturing costs resulting from each
cost category given in Tables 4.7 and 4.8
Fixed capital investment $11,000,000

Raw material cost $7,950,000/yr

Waste treatment cost $1,000,000/yr

Utilities $356,000/yr

Direct labor cost $300,000/yr

Fixed costs $1,500,000/yr

 Example 4.9 cont’
Solution Using Equation 4.2,
a) COMd = 0.180 FCI +2.73 COL + 1.23(CRM+CWT+CUT)
= (0.180)($11,000,000) + (2.73)($300,000) +(1.23)($356,000
+ $1,000,000 + $7,950,000) = $14,245,000/yr
$/tonne =COMd / plant capacity = ($14,245,000/yr)/(92,000 tonne/yr)
= $155/tonne

From the relationships given in Table 4.8,

Direct Manufacturing Costs = DMC = CRM + CUT + 1.33 COL +
0.03 COM + 0.069 FCI + CWT
 $7,950,000 + $1,000,000 + $356,000 + (1.33)($300,000) +
(0.069)($11,000,000) + (0.03)($14,245,000) = $10,891,000
1. Percentage of manufacturing cost = (100)(10.891)/14.25 = 76%
Fixed Manufacturing Costs =FMC = 0.708COL + 0.068FCI +
depreciation (0.708)($300,000) + (0.068)($11,000,000) = $960,000
 Percentage of manufacturing cost = (100)(0.960)/14.25 = 7%
 Example 4.9 cont’
1. General Expenses =GE = 0.177COL + 0.009FCI + 0.16COM
 (0.177)($300,000) + (0.009)($11,000,000) + (0.16)($14,245,000)
= $2,431,000
 Percentage of manufacturing cost = (100)(2.431)/14.25 = 17%
From the result we conclude that in the direct costs were shown
to dominate the manufacturing costs, accounting for about
76% of the manufacturing costs.
 Of these direct costs, the raw materials cost, the waste
treatment cost, and the cost of utilities accounted for more than
$9 million of the $10.9 million direct costs.
 These three cost contributions are not dependent on any of the
estimating factors provided in Table 4.8. Therefore, the
manufacturing cost is generally insensitive to the estimating
factors provided in Table 4.8. The use of the midrange values is
acceptable for this situation.
 Stream Factor
 Operating hours per year divided by total hours per year
 Typical 8000 Operating Hours
 0.9 – 0.95 Typical
8000/8760 = 0.913
Note - Flows on PFD are kmol/operating hour not kmol/hour –
why?
Raw Material Costs
 RM$ = (use rate)  ($ / unit consumption)
 Use rate comes from material/energy balance
 Unit consumption cost based on market value
 Chemical Market Reporter
 cost basis should be considered (f.o.b., barge, rail)
 Must apply stream factor to PFD rates to account for down
time
 SF = operating days / 365
 Cost of Operating Labor (COL)
 The technique used to estimate operating labor requirements
is based on data obtained from five chemical companies. The
operating labor requirement for chemical processing plants is
given by

N OL  6.29  31.7 P  0.23N np
2

0.5

 COL is estimated based on the # of operators per shift (NOL),

 Equation above was derived for processes with, at most, two
solid handling steps. For processes with a greater number of
solid handling operations, this equation should not be used.

 P is the number of processing steps involving the handling of

particulate solid- for example, transportation and distribution,
particulate size control, and particulate removal. Nnp is the
number of non particulate processing steps and includes
compression, heating and cooling, mixing, and reaction.
 Cost of Operating Labor (COL)
 The value of NOL in Equation above is the number of operators
required to run the process unit per shift. A single operator
works on the average 49 weeks a year (3 weeks’ time off for
vacation and sick leave), five 8-hour shifts a week.

 Four and one-half operators are hired for each operator needed
in the plant at any time. This provides the needed operating
labor but does not include any support or supervisory staff.
 Cost of Operating Labor (COL)
 In general, for the processes considered in this text, the value
of P is zero, and the value of Nnp is given by

N np   equipmen
c ompre ssors
t owe rs
re ac t ors
he at e rs
e x c hange rs

4.5 shifts/day (round up)

$59,371/year/operator (2005)
 Utility Costs
 Utility$ = (use rate)  ($ / unit consumption)
 Use rate comes from material/energy balance
 Unit consumption cost basis presented (and in some cases
calculated) in text
 Utilities may include:
Air, Steam, Cooling tower water, Electrical, Fuels, Refrigeration,
Thermal systems (hot oil, molten salt, etc)
Utilities – Fuel and Electricity
 Fuel for Fired Heaters
PFD gives process load ( energy balance) but total flow is
more due to efficiency – 70-90% from.
Fuel Costs may vary wildly
 Electricity for pumps and compressors
Shaft Power – Fluid Power/Efficiency
Power to Drive – Shaft Power/Drive Efficiency
* PFD usually gives Shaft Power – but be careful!
 Waste Treatment Costs
 WT$ = (production rate) ($ / unit treatment)
Unit production cost based on treatment cost
on-site vs. off-site
Cost magnitude dictated by nature of the waste and the
treatment process
Ton of hazardous ($200-$2000) vs non ($36)
1000 m3 of waste water by primary($41),
secondary($43), or tertiary($56) treatment methods
Production rate comes from material balance
Example 4.10: The cost of manufacture for the production of
benzene via the toluene HDA process
1. Calculate the cost of manufacture without depreciation (COMd) for the
toluene hydrodealkylation process. Block Flow Process Diagram for the
Production of Benzene is shown below.

 Flow rate of toluene = 10,000 kg/h (Stream 1)

 Flow rate of benzene = 8210 kg/h (Stream 15)
 Cost of toluene = $0.648/kg and Cost of benzene = $0.657/kg
 Assume a stream factor of 0.95, and note that the flowrates given on the
PFD are in kilograms per stream hour.
Table 4.10 Summary of Utility Requirements for the Equipment in
the Toluene Hydrodealkylation Process.

A utility summary for all the equipment is given in Table 4.10, from which we
find the total yearly utility costs for this process:
• Steam(S) = $ 3,412,000/yr Cooling Water (CW)= $ 165,000/yr
Fuel Gas(FG) = $2,771,000/yr Electricity(E) = $37,400/yr
Total Utilities = $6,385,000/yr=S + CW + E+ FG
 Example 4.10 cont.’
 Raw Material Costs from the PFD
a) Yearly cost of toluene= (24)(365)(10,000)(0.648)(0.95)
= $53,927,000/yr
b. Hydrogen = $6,622,000/yr (based on a value of $0.118/std m3)
Total Raw Materials = a + b = $60,549,000/yr
c. There are no waste streams shown on the PFD, so
Waste Treatment = $0.0/yr
d. COL = (14)(52,900) = $741,000/yr

e. Yearly consumption of toluene = (24)(365)(10,000)(0.95) / 1000

= 83,200 tonne/yr.
f. Yearly revenue from benzene sales=
(24)(365)(8210)(0.657)(0.95) = $44,889,000/yr.
 Example 4.10 cont.’
 Table 4.11 Results for the Estimation of Operating Labor
Requirements for the Toluene Hydrodealkylation Process Using the
Equipment Module Approach


NOL  6.29  31.7(0)  0.23(11)
2

0.5
 2.97
 The number of operators required per shift = 2.97.
 Operating Labor = (4.5)(2.97) = 13.4 (rounding up to the
nearest integer yields 14 operators)
Labor Costs (2001) = 14 × $52,900 = $740,600/yr
 Example 4.10 cont.’
 The fixed capital investment (CGR) for the process is
FCI = $ 11.7 × 106
 Finally, using the following formula the total manufacturing cost is
estimated to be
COMd = 0.180 FCI +2.73 COL + 1.23(CRM+CWT+CUT)
= (0.180)(11.7 × 106) + 2.73 (741,000) + 1.23 (6,385,000 +
60,549,000 + 0)
= $ 86.46 × 106/yr
 Exercise 4.3
1. The total capital investment for a conventional chemical plant is
$1,500,000, and the plant produces 3 million kg of product annually. The
selling price of the product is $0.82/kg. Working capital amounts to 15
percent of the total capital investment. The investment is from company
funds, and no interest is charged. Raw-materials costs for the product are
$0.09/kg, labor $O.O8/kg, utilities $O.O5/kg, and packaging $O.O08/kg.
Distribution costs are 5 percent of the total product cost. Estimate the
following:
(a) Manufacturing cost per kilogram of product.
(b) Total product cost per year.
(c) Profit per kilogram of product before taxes.
(d) Profit per kilogram of product after taxes (use current rate).
2. A process plant making 2000 tons per year of a product selling for $0.80
per lb has annual direct production costs of $2 million at 100 percent
capacity and other fixed costs of $700,000. What is the fixed cost per pound
at the break-even point? If the selling price of the product is increased by 10
percent, what is the dollar increase in net profit at full capacity if the income
tax rate is 34 percent of gross earnings?
 Exercise 4.3 cont.…
3. A company has direct production costs equal to 50 percent of total
annual sales and fixed charges, overhead, and general expenses equal to
$200,000. If management proposes to increase present annual sales of
$800,000 by 30 percent with a 20 percent increase in fixed charges,
overhead, and general expenses, what annual sales dollar is required to
provide the same gross earnings as the present plant operation?
What would be the net profit if the expanded plant were operated at
full capacity with an income tax on gross earnings fixed at 35 percent?
what would be the net profit for the enlarged plant if total annual sales
remained the same as at present? What would be the net profit for the
enlarged plant if the total annual sales actually decreased to $700,000?
 Interests and investment cost
 Engineers define interest as the compensation paid for the use of
borrowed capital. This definition permits distinction between profit
and interest.
 TYPES OF INTEREST
 Simple Interest: In economic terminology, the amount of capital on
which interest is paid is designated as the principal, and rate of
interest is defined as the amount of interest earned by a unit of
principal in a unit of time. The time unit is usually taken as one year.
• The simplest form of interest requires compensation payment at a
constant interest rate based only on the original principal.
• the entire amount S of principal plus simple interest due after n
interest periods is S = P + Z = P(1 + i*n)
 If P represents the principal, n the number of time units or interest
periods, and i the interest rate based on the length of one interest
period, the amount of simple interest Z during n interest periods is
 Money, when
invested, makes
money.

Money today is
worth more than
money in the
future.
 Interests and investment cost
Compound Interest: In the payment of simple interest, it
makes no difference whether the interest is paid at the end of each
time unit or after any number of time units.
 The same total amount of money is paid during a given length of
time, no matter which method is used. Under these conditions,
there is no incentive to pay the interest until the end of the total
loan period.
 Interest, like all negotiable capital, has a time value.
 the total amount of principal plus compounded interest due after n
interest periods and designated as S

s = P(1 + i)n
The term (1 + i)” is commonly referred to as the discrete single-
payment compound-amount factor.
 Compound Interest
 At the end of each interest period the interest is added to the
principal.
 Interests and investment cost
 In common engineering practice, it is usually preferable to deal with
effective interest rates rather than with nominal interest rates. The
only time that nominal and effective interest rates are equal is when
the interest is compounded annually.
 the interest rate based on the length of one interest period is r/m,
and the amount S after 1 year is

 the effective interest rate in terms of the nominal interest rate and
the number of periods per year:
 Example 4.11
1. Applications of different types of interest. It is desired to borrow
$1000 to meet a financial obligation. This money can be borrowed
from a loan agency at a monthly interest rate of 2 percent.
Determine the following:
a) The total amount of principal plus simple interest due after 2 years
if no intermediate payments are made.
b) The total amount of principal plus compounded interest due after 2
years if no intermediate payments are made.
c) The nominal interest rate when the interest is compounded
monthly.
d) The effective interest rate when the interest is compounded
monthly.
 Exercise -4.4
1. For total yearly payments of $5000 for 10 years, compare the compound
amount accumulated at the end of 10 years if the payments are ;
a) end-of-year
b) weekly
c) continuous. The effective (annual) interest is 20 percent and payments
are uniform.
d) determine the present worth at time zero for each of the three types of
payments i.e. (a, b and c)
2. An original loan of $2000 was made at 6 percent simple interest per year
for 4 years. At the end of this time, no interest had been paid and the loan
was extended for 6 more years at a new, effective, compound-interest rate of
8 percent per year. What is the total amount owed at the end of the 10 years
if no intermediate payments are made?
3. An annuity due is being used to accumulate money. Interest is compounded
at an effective annual rate of 8 percent, and $1000 is deposited at the
beginning of each year. What will the total amount of the annuity due be after
5 years?
 Exercise -4.4 cont.…
3. Upon graduation, you start your first job at $50,000/yr. You decide to
set aside 10%, or $5000/yr, for retirement in 40 years’ time, and you
assume that you will live 20 years after retiring. You have been offered
an investment that will pay you $67,468/yr during your retirement
years for the money you invest.
a. How much money would you have per year in retirement if you had
saved the money, but not invested it, until retirement?
b. How does this compare with the investment plan offered?
c. How much money was produced from the investment?
 CONTINUOUS INTEREST
 The concept of continuous interest is that the cost or income due to
interest flows regularly, and this is just as reasonable an assumption
for most cases as the concept of interest accumulating only at
discrete intervals.
 The reason why continuous interest has not been used widely is
that most industrial and financial practices are based on methods
which executives and the public are used to and can understand.
 continuous interest compounding at a nominal annual interest rate
of r, the amount S an initial principal P will compound to in n years
is? S = Pern = P(l + ieff)n
 Future worth = present worth x compound interest factor
S = PC
 present worth=Future worth x discount factor
P = SF
• Discount factor = F =(1/compound interest factor)=1/C
 Cont’d
 The overall concept of interest evaluations is simplified by the use of the less-
complicated nomenclature where designated factors are applied. Thus,
expressing both SF = P would mean that F is e-rn for the continuous interest
case of (1 + i)-n for the discrete interest case.
Example 4.13 Calculations with continuous interest compounding. For the case of
nominal annual interest rate of 20%, determine:
a) The total amount to which one dollar of initial principal would accumulate
after one 365day year with daily compounding.
b) The total amount to which one dollar of initial principal would accumulate
after one year with continuous compounding.
c) The effective annual interest rate if compounding is continuous.
 CONTINUOUS CASH FLOW AND INTEREST COMPOUNDING
 Let r represent the nominal interest rate with m conversions or
interest periods per year so that i = r/m and the total number of
interest periods in n years is mn. With m annuity payments per year,
let R represent the total of all ordinary annuity payments occurring
regularly and uniformly throughout the year so that R/m is the
uniform annuity payment at the end of each period.

 PRESENT WORTH OF AN ANNUITY

 The present worth of un annuity is defined as the principal which
would have to be invested at the present time at compound interest
rate i to yield a total amount at the end of the annuity term equal to
the amount of the annuity. Let P represent the present worth of an
ordinary annuity.
For compound interest: For continuous interest:
 Example 4 .14 Determination of present worth and discount.
1. A bond has a maturity value of $1000 and is paying discrete
compound interest at an effective annual rate of 3 percent. Determine
the following at a time four years before the bond reaches maturity
value:
a) Present worth.
b) Discount.
c) Discrete compound rate of effective interest which will be
received by a purchaser if the bond were obtained for $700.
d) Repeat part (a) for the case where the nominal bond interest is 3
percent compounded continuously.
Solution : a)

d)
 Present Worth of an Annuity
 It is defined as the principal which would have to be invested at the
present time at compound interest rate i to yield a total amount at
the end of the annuity term equal to the amount of the annuity.
for the case of discrete interest compounding,

For the case of continuous cash flow and interest

compounding,
 Example 4.15 Application of annuities in determining amount of
depreciation with discrete interest compounding
1. A piece of equipment has an initial installed value of $12,000.
It is estimated that its useful life period will be 10 years and its
scrap value at the end of the useful life will be $2000. The
depreciation will be charged as a wst by making equal charges each
year, the first payment being made at the end of the first year. The
depreciation fund will be accumulated at an annual interest rate of
6 percent. At the end of the life period, enough money must have
been accumulated to account for the decrease in equipment value.
Determine the yearly cost due to depreciation under these
conditions. (NOTE: This method for determining depreciation k
based on an ordinary annuity and is known as the sinking-fund
method.)
Solution. This problem is a typical case of an ordinary annuity. Over a
period of 10 years, equal payments must be made each year at an
interest rate of 6 percent. After 10 years, the amount of the annuity
must be equal to the total amount of depreciation.
 Example 4.15 Application of annuities in determining amount of
depreciation with discrete interest compounding
Amount of annuity = S
Total amount of depreciation S = $12,000 - $2000 = $10,000
Equal payments per year = R = yearly cost due to depreciation
Number of payments = n = 10
Annual interest rate = i = 0.06.

 i 
R  S *  R  10000*  0.06 
 1  i   1    $759 / year
n

 1  0.06  1
10

Yearly cost due to depreciation = $759

a) Repeat Example 4.15 with continuous cash flow and nominal
annual interest of 6 percent compounded continuously.

Yearly cost due to depreciation = $730

 PERPETUITIES AND CAPITALIZED COSTS
• Perpetuity is an annuity in which the periodic payments continue
indefinitely. This type of annuity is of particular interest to engineers,
for in some cases they may desire to determine a total cost for a
piece of equipment or other asset under conditions which permit the
asset to be replaced perpetually without considering inflation or
deflation.
• If perpetuation is to occur, the amount S accumulated after n periods
minus the cost for the replacement must equal the present worth P.
Therefore, letting CR represent the replacement P- S – C
• Cost then present worth given as

• The capitalized cost is defined as the original cost of the equipment

plus the present value of the renewable perpetuity. Designating K
as the capitalized cost and CV as the original cost of the equipment
then capitalized cost of the equipment is given as:
 Exercise 4.5
1. A heat exchanger has been designed for use in a chemical
process. A standard type of heat exchanger with a negligible scrap
value costs $4000 and will have a useful life of 6 years. Another
proposed heat exchanger of equivalent design capacity costs
$6800 but will have a useful life of 10 years and a scrap value of
$800. Assuming an effective compound interest rate of 8 percent
per year, determine which heat exchanger is cheaper by
comparing the capitalized costs.
2. A new storage tank can be purchased and installed for $10,000. This tank
would last for 10 years. A worn-out storage tank of capacity equivalent
to the new tank is available, and it has been proposed to repair the old
tank instead of buying the new tank. If the tank were repaired, it would
have a useful life of 3 years before the same type of repairs would be
needed again. Neither tank has any scrap value. Money is worth 9
percent compounded annually. On the basis of equal capitalized costs for
the two tanks, how much can be spent for repairing the existing tank?
 Exercise 4.5
3. Two pieces of equipment are being considered for
an identical service. The installed costs and yearly
operating costs associated with each piece of
equipment are as follows.
a) If the internal hurdle rate for comparison of
alternatives is set at 15% p.a., which piece of
equipment do you recommend be purchased?
b) Above what internal hurdle rate would you
recommend project A?
 TAXES AND INSURANCE
 Expenses for taxes and insurance play an important part in
determining the economic situation for any industrial process.
 Because Federal, state, and local taxes may amount to a major
portion of a concern’s earnings, it is essential for the chemical
engineer to understand the basic principles and factors underlying
taxation.

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.
1. Property Taxes
Local governments usually have jurisdiction over property taxes, which are
commonly charged on a county basis. In addition to these, individual cities and
towns may have special property taxes for industrial concerns located within
the city limits.
 TAXES AND INSURANCE
2. Excise Taxes: are levied by Federal and state
governments. Federal excise taxes include charges for import
customs duties, transfer of stocks and bonds, and a large number
of other similar items.
3. Income taxes: In general, income taxes are based on gross earnings,
which are defined as the difference between total income and total product
cost.
Taxes and Depreciation
 In determining the influence of depreciation costs on income
taxes, it should be clear that depreciation costs represent a
deduction from taxable gross earnings. Thus, if d is the
depreciation cost for the year and ø is the fractional tax
rate: Tax “credit” for depreciation = ød
 Funds set aside for depreciation, although they represent a
cost, normally go directly into the corporation treasury.
 TAXES AND INSURANCE
Therefore, if S represents the total annual income or revenue
and C represents the total annual costs with the exceptions of
depreciation and taxes,
Net annual cash flow to company after taxes:
= (S – C - d)(1 - ø) + d = (S - C)(1 - ø) + ød

 What is INSURANCE?
Insurance is a legal contract that transfers risk from a
policyholder to an insurance provider.

 The annual insurance cost for ordinary industrial concerns is

approximately 1 percent of the capital investment. it is
necessary to consider insurance requirements carefully to
make certain the economic operation of a plant is protected
against emergencies or unforeseen developments.
 TYPES OF INSURANCE
 Many different types of insurance are available for protection against property loss
or charges based on legal liability. Despite every precaution, there is always the
possibility of an unforeseen event causing a sudden drain on a company’s finances,
and an efficient management protects itself against such potential emergencies by
taking out insurance.
 The major insurance requirements for manufacturing concerns can be classified as
follows:
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.
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. Power-plant, machinery, and special-operations hazards.
5. Workmen’s-compensation insurance.
6. Marine and transportation insurance on all property in transit.
7. Comprehensive crime coverage.
8. Employee-benefit insurance, including life, hospitalization, accident, health,
personal property, and pension plans.
 legal responsibilities
 It is a concern can obtain insurance to protect itself against loss of
property owing to any of a number of different causes.
 In case a property loss occurs and the loss is covered by insurance,
payment will be made for the damage even though the loss was
caused by the owner’s negligence.
 Protection against unforeseen emergencies, other than direct
property loss, can also be obtained through insurance.
 An assumed liability is one which the concern accepts in the form of
a written contract or statement, while a Legal liability is always in
effect whether or not it is stated in writing. Legal liabilities include
civil responsibility for events occurring because of damage or injuries
due to negligence.
 A stronger type of legal liability is known as criminal liability. This is
involved in cases where gross negligence or reckless disregard for the
life and property of others is claimed.
 Financial & economic Evaluation

Profitability Analysis

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.
 Mathematical Methods for Profitability
Evaluation
 The most commonly used methods for profitability evaluation can
be categorized under the following headings:
1. Rate of return on investment
2. Discounted cash flow based on full-life performance
3. Net present worth
4. Capitalized costs
5. Payout period
 RATE OF RETURN ON INVESTMENT
 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. Therefore,
profit is a function of the quantity of goods or services produced and the
selling price. The amount of profit is also affected by the economic
efficiency of the operation, and increased profits can be obtained by use of
effective methods which reduce operating expenses.

 To obtain reliable estimates of investment returns, it is necessary to make

accurate predictions of profits and the required investment. Profits may be
expressed on a before-tax or after-tax basis, but the conditions should be
indicated. They do not consider the time value of money, and they do not
account for the fact that profits and costs may vary significantly over the
life of the project.
 Return on Investment
annual net profit(earnings)after taxes
ROI  *100
total capital investment
 There are several variations of this method; for example, the
numerator might be net earnings before taxes and the denominator
could be fixed capital investment or fixed and working capital.
 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 averaging of profits permits laxity in forecasting.
 It does not consider timing of cash flows.
 It does not consider capital recovery.
 Example 4.16
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. 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.
(a)
Solution
Annual profit before income taxes = $800,000 - $520,000 = $280,000.
Annual percent return on the total initial investment before income taxes =
[280,000/(900,000 + l00,000)](lOO) = 28 percent.
(b) Annual profit after income taxes = ($280,000)(0.66) = $184,800.
• Annual percent return on the total initial investment after income taxes =
• [184,800/(900,000 + lOO,OOO)]lOO) = 18.5 percent.
(c) Minimum profit required per year before income taxes = ($900,000 +
• $lOO,OO0 *(0.l5) = $150,000.
• Fictitious expenses based on capital recovery with minimum profit =
• $520,000 + $150,000 = $670,OOO/year. Annual percent return on the total
• investment based on capital recovery with minimum annual rate of return of
• 15 percent before income taxes = [(8OO,OOO - 670,000)/(900,000 +
• lOO,OOO)](lOO) = 13 percent.
(d) Average investment assuming straight-line depreciation and zero salvage value
• = $900,000/2 + $100,000 = $550,000.
• Annual percent return on average investment before income taxes =
• (280,000/550,000X100) = 51 percent.
 Engineering Economy

 Money, when invested, makes money.

 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.
 Capital investment can only be depreciated in accordance with a
certain depreciated rate set by current tax law.
 Change in the amount of money (due to the impact of interest or
cost of money) over time is called time value of money.
Impact of Interest
 Money has a time value because it can earn more money over time
(earning power).

 Money has a time value because its purchasing power changes over
time (inflation).

 Time value of money is measured in terms of interest rate.

 Interest is the cost of money—a cost to the borrower and an earning
to the lender.

 The changes in the value of a sum of money over time can become
extremely significant when we deal with large amounts of money,
long periods of time, or high interest rates.
 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.
 Profitability is the common denominator for all business activities.
EXAMPLES FOR SIMPLE ECONOMIC ANALYSIS
The concept of simple economic analysis is illustrated using suitable
examples in the following areas:
 Material selection for a product
 Design selection for a product
 Design selection for a process industry
 Building material selection for construction activities
 Process planning/Process modification
Material Selection for a Product/Substitution of Raw
Material
The cost of a product can be reduced greatly by substitution of
the raw materials. Among various elements of cost, raw material
cost is most significant and it forms a major portion of the total
cost of any product. So, any attempt to find a suitable raw
material will bring a reduction in the total cost in any one
 Material Selection for a Product/Substitution of Raw
Material
or combinations of the following ways:
 Cheaper raw material price
 Reduced machining/process time
 Enhanced durability of the product
Therefore, the process of raw material selection/substitution will result
in finding an alternate raw material which will provide the necessary
functions that are provided by the raw material that is presently used.
In this process, if the new raw material provides any additional benefit,
then it should be treated as its welcoming feature.
EXAMPLE 4.1 In the design of a jet engine part, the designer has a
choice of specifying either an aluminum alloy casting or a steel
casting. Either material will provide equal service, but the aluminum
casting will weigh 1.2 kg as compared with 1.35 kg for the steel
casting.
 EXAMPLE 4.1 Substitution of Raw Material cont’

The aluminum can be cast for Birr80.00 per kg. and the steel one for
Birr35.00per kg. The cost of machining per unit is Birr150.00 for
aluminum and Birr170.00 for steel. Every kilogram of excess weight
is associated with a penalty of Birr 1,300 due to increased fuel
consumption. Which material should be specified and what is the
economic advantage of the selection per unit?
Solution (a) Cost of using aluminum metal for the jet engine
part: Weight of aluminum casting/unit = 1.2 kg
Cost of making aluminum casting = Birr 80.00 per kg
Cost of machining aluminum casting per unit = Birr 150.00
Total cost of jet engine part made of aluminum/unit
= Cost of making aluminum casting/unit + Cost of machining
aluminum casting/unit
= 80 x 1.2 + 150 = 96 + 150 = Birr 246
 EXAMPLE 4.1 Substitution of Raw Material cont’

(b) Cost of jet engine part made of steel/unit:

Weight of steel casting/unit = 1.35 kg
Cost of making steel casting = Birr 35.00 per kg
Cost of machining steel casting per unit = Birr 170.00
Penalty of excess weight of steel casting = Birr 1,300 per kg
Total cost of jet engine part made of steel/unit
= Cost of making steel casting/unit + Cost of machining steel
casting/unit + Penalty for excess weight of steel casting
= 35 x 1.35 + 170 + 1,300(1.35 – 1.2)
= Birr412.25
DECISION The total cost/unit of a jet engine part made of aluminum
is less than that for an engine made of steel. Hence, aluminum is
suggested for making the jet engine part. The economic advantage of
using aluminum over steel/unit is Birr412.25 – Birr246 = Birr166.25
 EXAMPLE 4.3 Design selection for a process industry

The chief engineer of refinery operations is not satisfied with the

preliminary design for storage tanks to be used as part of a plant
expansion programme. The engineer who submitted the design was
called in and asked to reconsider the overall dimensions in the light of
an article in the Chemical Engineer, entitled “How to size future
process vessels?” The original design submitted called for 4 tanks 5.2
m in diameter and 7 m in height. From a graph of the article, the
engineer found that the present ratio of height to diameter of 1.35 is
111% of the minimum cost and that the minimum cost for a tank was
when the ratio of height to diameter was 4 : 1. The cost for the tank
design as originally submitted was estimated to be
Birr 900,000. What are the optimum tank dimensions if the volume
remains the same as for the original design? What total savings may
be expected through the redesign?
 EXAMPLE 4.3 Design selection for a process industry cont’

Solution (a) Original design

Number of tanks = 4, Diameter of the tank = 5.2 m
Radius of the tank = 2.6 m, Height of the tank = 7 m
Ratio of height to diameter = 7/5.2 = 1.35
d 2
v  Ah  * h  r 2h  22 / 7 * 2.6 * 7  148.72m
(b) New design 4
Cost of the old design = 111% of the cost of the new design (optimal
design)
Optimal ratio of the height to diameter = 4:1
h:d=4:1
4d = h
d = h/4
r = h/8
 EXAMPLE 4.3 Design selection for a process industry cont’

(b) New design

Cost of the old design = 111% of the cost of the new design (optimal
design)
Optimal ratio of the height to diameter = 4:1
h : d = 4 : 1, 4d = h
d = h/4, r = h/8
Volume = (22/7)r2h = 148.72 (since, the volume remains the same)
(22/7)(h/8)2h = 148.72

148.72  Therefore, Diameter of the new

h 
3
* 64  3,028.48 design = 1.81x 2 = 3.62 m
22 / 7  Cost of the new design
h  14.47m = 900,000 (100/111)= Birr 810,810.81
h  Expected savings by the redesign
r   1.81m = Birr 9,00,000 – Birr 810,810.81
8 = Birr 89,189.19
A Typical Cumulative Cash Flow Diagram for Evaluation of a New Project

Cumulative Cash Position

 Cash flow diagram.
 operating income:
Cash operating
expenses(C) are
subtracted from the
revenue (R): R – C
 gross profit(GP): R – C – D
 income taxes become:
= 35%(R – C – D)= 35%*GP
 The net income (profit) after
taxes: (1 -t)(R – C - D)
Where t is income taxes rate
 After-tax cash flow, by
definition, is the net income
after taxes plus depreciation
or
Cash flow (CF)
=D + (1 -t)(R – C – D)
This equation may be rearranged The term tD is the contribution to cash flow from
algebraically: depreciation and(1 -t)R and (1 – t)C are
CF=tD +(1 - t)R – (1 – t)C contributions to cash flow from the revenues and
the cash operating expenses, respectively.
When two cash flow cases are compared may be modified as
follows:
∆CF = t(∆D)+(1 - t)(∆R) – (1 – t)(∆C) where
∆CF = difference in cash flow $
∆D = difference in depreciation and depletion $
∆R = difference in revenue $
∆C = difference in cash operating expenses $
There are some cases when revenue is not affected by a process;
then
∆R = 0: An example would be comparing the cash flow for two
processes making the same product. Since the amount of product
manufactured would be the same, ∆R = 0.
In Example 4.10, the use of the cash flow model is demonstrated.
It is advisable to first draw the cash flow model, label all streams,
and then proceed with the problem solution using a tabular
format.
 Remark: Cash flow is not a measure of profitability but is a component in
evaluating profitability of a venture.
 Example 4.10
Problem Statement:
A company is considering the manufacture of a new specialty chemical for
a limited market. To build the new plant, land must be acquired that is
estimated to be $350,000. A design–construction firm estimated the fixed
capital investment for the project to be $12,000,000. Approximately $1,500,000
working capital will be required initially. The 1986 MACRS depreciation rules
apply and the company will elect to use the half-year convention. The federal
income tax rate is 35%. The product is estimated to have an 11-year life and
the projected sales data are as follows:
Calculate the summary of capital
requirements and the yearly cash
flow of the venture using the cash
flow model.
Solution:
 Example 4.10 Solution:
Summary of Capital Requirements
Land $350,000
Working capital $1,500,000
Fixed capital requirements $12,000,000
Total capital requirements $13,850,000

 For the yearly cash flow, According to Depreciation Class Lives and Modified
Accelerated Cost Recovery System (MACRS)Recovery Periods the recovery
period is 5 years and the class life is 9.5 years for the equipment to manufacture
this product.
 As an alternate to the MACRS, straight-line depreciation may be used. No salvage
value may be claimed under MACRS.

 Note that the decrease in cash flow is significant beginning in year 6, and
thereafter depreciation is not applicable in years 7–11.

 The cash flow diagram, is helpful for envisioning how cash flows in a project during
the first year of operation only. For subsequent years, a similar diagram may be
developed.
Cash Flow Table for Example 4.10
Cash flow diagram for Example 4.10
(first year of operation)
 CUMULATIVE CASH POSITION PLOT
 Frequently, we are interested in the flow of funds for a single project and not the
entire company. The cash flows may be shown over a project’s life on a cumulative
cash position plot. To develop this plot, an arbitrary time frame is selected.
 There are normally two choices—time zero being when the plant starts up and
produces a salable product or when the first expenditure is made.
 In Figure 4.10, time zero is selected as start-up. Expenditures for land and
equipment in this case are made prior to time zero and represent a negative cash
flow. At time zero, working capital is charged to the project, representing a further
negative cash flow.
 As the plant begins to operate, revenues are generated from the sale of product
and positive cash flows occur. Figure 4.10 represents a historical flow of cash and
the cumulative effect of cash flow for the project, hence the name cumulative cash
position plot.
 When the project terminates, the land and working capital are recovered by the
company. For this case, these capital items may be regarded as interest-free loans
to the project.
 In the previous paragraph, time zero was selected as start-up. As an alternative, it
may be more convenient to select time zero when the first funds are spent.
 The former approach is useful for cases when a new project is being considered.
The latter approach is frequently more convenient for cases when equipment is
being added to or an expansion of an already existing plant is to be made.
A typical cumulative cash position plot
 Example 4.11
1. Small plastics, Inc. is considering the manufacture of novelty items for a
given market. Land may be purchased adjacent to their existing operation
for $425,000. An estimate of the fixed capital investment for the proposed
operation is $3,600,000. At start-up, $550,000 will be required as working
capital. It will take 2 years to prepare the land site, purchase and install the
necessary equipment. At the end of project, the land and working capital
are recovered. For this 11-year project, the following income and cash
operating expenses have been estimated: The 5-year MACRS depreciation
with half-year convention will be used and the federal income tax rate is
35%.
a) Return on investment (ROI)
b) Payback Period(PBP)
c) Develop a cash flow summary table
d) IRR
e) NPV
f) PV
g) PI
Solution:
Table 4.4 contains the major elements of a cash flow analysis. Across the top of the
table are the project years starting with -2 years and ending with the eleventh year when
the capital is recovered. In the left-hand column are the items that contribute to the cash
flow so that they may be considered properly at the proposed time. Beneath the total
capital investment are the individual entries constituting the profit–loss statement. At the
bottom left are the items after-tax cash flow, capital recovery, and cumulative cash flow.

average annual net profit after taxes

ROI  *100
Total capital investment
 average annual net profit after taxes
ROI  *100
Total capital investment
6355/11
ROI  *100  12.63%
4575

Fixed capital investment

PBP 
Average annual after - tax cash flow

3,600
PBP   3.978year
9,955
11
This template is constructed so that systematically various entries from Example 4.11
are entered in the appropriate places. This template may be thought to lie behind Table
4.4 and may be used for subsequent cases.

sum of h=6,355
Sum of I=9,955
 Capital budgeting techniques
(Investment appraisal criteria)
 Capital budgeting techniques under certainty can also be
divided into following two groups:
1. Non-Discounted Cash Flow Criteria: -
These are also known as traditional techniques
(a) Pay Back Period (PBP)
(b) Accounting Rate Of Return (ARR)
2. Discounted Cash Flow Criteria: -
(a) Net Present Value (NPV)
(b) Internal Rate of Return (IRR)
(c) Profitability Index (PI)
Discounted Cash Flow Criteria:
 These are also known as modern or time adjusted techniques
because all these techniques take into consideration time
value of money.
 Cost Benefit Analysis (CBA) of cleaner
production option
• 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.
•Cost-benefit analysis is a set of practical procedures for
guiding public expenditure decisions.
•CBA facilitates the comparison of alternatives in terms of the
monetary costs involved and the benefits obtained.
•Project evaluation usually requires comparing costs and
benefits from different time periods
 Elements of CBA
Cash flow
Present value (PV)
Measures of Profitability
(Project Evaluation Techniques)
Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index
Depreciation
 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
investment appraisal: A means of assessing whether an
investment project is worthwhile or not.
 The profit goal of a company is to maximize income above the cost
of the capital which must be invested to generate the income. If the
goal were merely to maximize profits, any investment would be
accepted which would give a profit, no matter how low the return or
how great the cost.
 Profitability Criteria cont’d
 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 $25,0OO/year. The second investment gives a greater
yearly profit than the first, but the annual rate of return on the
second investment is only ($25,000/$1,000,000) x (100) = 2.5
percent
 while the annual rate of return on the $100,000 investment is 10
percent. Because reliable bonds and other 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
 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 ROROI, (2) calculate the NPV for
each, (3) eliminate any projects with negative NPVs, then (4) chose
the alternative with the greatest positive NPV.
 Cash Flow

A Cash Flow is meant to illustrate incomes (“cash inflows”) and expenses

(“cash outflows”). Each arrow represents the time period of a year in this case.

$600 $600 $600 $600 $600

Cash Inflows
0 5
Cash Outflows
$2,000

$7,500. . . . . . . . . . . . . . $7,500
Cash Inflows
-2 -1 0 8
Cash Outflows

$12,000$10,000 $8,000 $3,900 $2,600

 Cash Flow
 The term cash flow is in common use today in the news media and in
company financial statements.
 Cash flow may be expressed on the basis of before taxes or after taxes
but the basis must be stated.
 The after-tax cash flow is defined as net income (profit) after taxes plus
depreciation and depletion.
 Accountants use the concept of funds or money flow that includes cash
flow and other noncash items. Cash flow is important to people preparing
financial and engineering cost analyses.
 The sums of money recorded as receipts or disbursements in a project's
financial records are called cash flows. Examples of cash flows are
deposits to a bank, dividend interest payments, loan payments, operating
and maintenance costs, and trade-in salvage on equipment. The
horizontal (time) axis is marked off in equal increments, one per period, up
to the duration of the project. Receipts are represented by arrows directed
upward.
 Disbursements are represented by arrows directed downward. The arrow
length is approximately proportional to the magnitude of the cash flow. Two
or more transfers in the same period are placed end to end, and these
may be combined.
 Example
consider a mechanical device that will cost $20,000 when
purchased. Maintenance will cost $1000 each year. The device
will generate revenues of $5000 each year for five years, after
which the salvage value is expected to be $7000. The cash flow
diagram is shown in Fig. 4.1(a), and a simplified version is
shown in Fig.4.1(b)
 In order to evaluate a real-world
project, it is necessary to present
the project's cash flows in terms
of standard cash flows that can
be handled by engineering
economic analysis techniques.
 The standard cash flows are
single payment cash flow, uniform
series cash flow, and gradient
series cash flow.
 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.
Present value = P/( 1 + i)n
P = value of an item after n periods
i = interest rate per period
 Example-1: Birr100 is the PV of Birr133.1 of three years
from now when the interest rate is10%.
 Present Value (PV)
 Future value measures the nominal future sum of money
that a given sum of money is "worth" at a specified time in the
future assuming a certain interest rate (or more generally,

 
rate of return).
FV  R 1  r
T
R=initial investment amount
r=rate of return on investment
(1+r)-T is the discount factor
T=years of investment
The future value (FV) of the investment is:
R
R=amount to be received in future
PV 
r=rate of return on investment/ discount rate
T=years of investment 1 r 
T

The present value (PV) of the investment is:
This is the increase in firm’s market value by the project.
R1 R2 RT
PV  R0   ...
1  r  1  r 2 1  r T
A firm’s business involves capital investments (capital budgeting),
The objective is to increase the firm’s current market value.
 Present Value (PV)
Private Sector Project Evaluation
Suppose there are two projects, X and Y
Each entails certain benefits and costs, denoted as BX, CX, BY, and CY.
Need to ask:
Is the project admissible?
Admissible: Are the benefits greater than the costs?
Is the project preferable?
Preferable: Are the net benefits the highest? Most projects involve a
stream of benefits and costs over time.

present value of project i is:

 B1i  C1i  ...  BTi  CTi 


PV  B  C
i i
0  1  r
i
0 
1  r  T

B 
t
i
Benefits from project i at time t
Cti  Costs from project i at time t
 Present Value (PV)
The present value criteria for project evaluation are that:
A project is admissible only if its present value is positive
When two projects are mutually exclusive, the preferred project is the
one with the highest present value. The internal rate of return, ρ, is
defined as the ρ that solves the equation:

0   B0  C0  
 B1  C1 
...
 BT  CT 
1    1   T
•The IRR is the discount rate that would make the present
value of the project equal to zero.
– Admissible if ρ>r
– The flawed analysis would choose an admissible project
with the higher internal rate of return, ignoring scale
Government decision making about public projects
involves present value calculations
 Present Value (PV)
Example -2 Calculate the present value (PV) of a $2,000 gift
that will be received after 10 years have passed. Assume money
is worth 6% per year.
PV= P/( 1 + i)n= 2000/(1+0.06)10 = $1,116.79

or

where PV = present value of an annuity

X = payment per time period (made at end of period)
i = rate of interest per period
Example-3:The utilities for a chemical plant cost $2,000 per
month. What is their present value if money is worth 15%
compounded monthly? Do this for plants that last 10
years and 50 years. Utilities bills are paid after the energy has
been used; therefore, from Equation (4)
NPV=Cumulative discounted cash position at the end of the
project
 Payback Period
 As the name suggests, the Payback Period is the length of
time required to recover the cost of an investment. it time
required, after start-up, to recover the FCI, for the project
 Payback period = Total Investment
annual net return
 The Rule: An investment is acceptable if its calculated
Payback period is ____________ some pre-specified
number of years.

A project accepted based on the payback

 Drawbacks - criteria may not have a positive NPV
The payback period ignores the time value of money
The payback period ignores cash flows after the initial
investment has been recouped
 Payback Period
 If the initial cost of the investment is Birr 420,000 and the
annual net savings or net return is 125,000 Birr ; then
Payback period = 420,000 / 125000 = 3.36 About 4years
Cash Criterion : The criterion used here is cumulative cash
position (CCP). Because CCP depends on the size of project,
it is better to use the cumulative cash ratio, CCR.

Advantages and Disadvantages of Payback

 Advantages  Disadvantages
 Easy to understand  Ignores the time value of money
 Requires an arbitrary cutoff point
 Adjusts for uncertainty of
 Ignores cash flows beyond the cutoff date
later cash flows  Biased against long-term projects, such as
 Biased towards liquidity research and development, and new projects
Illustration of Non-Discounted Profitability Criteria
 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. The cash flows are discounted at the firm’s required
rate of return or cost of capital.
 NPV = PV of future cash flows – Investment
 NPV compares the value of the Birr today versus the value of Money/
Birr in the future.
NPV = CF0 + CFn n= 1, 2,---- n number of years
(1+r)n
 NPV Decision Rule: If 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). For Mutually exclusive investments,
Select the project with the largest NPV. If the NPV is positive
(i.e. NPV > 0), Project is accepted.
 Net Present Value (NPV)
NPV > 0 means:
 Project is expected to add value to the firm
 Will increase the wealth of the owners
NPV is a direct measure of how well this project will meet the
goal of increasing shareholder wealth.

 Difference between market value and cost

 Has no serious problems
 Preferred decision criterion
 NPV = ∑ Present Value (Cash Benefits) - ∑ Present Value (Cash Costs)
 Net Present Value (NPV)
In order to compute the NPV of a project, we need to analyze
1. Cash flows
2. Discount rates
3. Strategic options.

1. Cash Flow Calculations

 Use cash flows, not accounting earnings.
 Use after-tax cash flows.
 Use cash flows attributable to the project (compare firm value
with and without the project)
 Use incremental cash flows.
 Forget sunk costs: bygones are bygones.
 Include investment in working capital as capital
expenditure.
 Include opportunity costs of using existing facilities.
 Net Present Value (NPV)
 The net present value of a project is what is obtained when
the sum of the present values of all expenditures is
subtracted from the sum of the present values of all
incomes.
 Whenever the net present value (NPV) is positive this means the
project will yield more money than if the money expended had
been invested at the interest rate initially.
 A positive value, then, means the plant appears to be a winner.
value is negative the project should be dropped.
When alternatives are compared, the one with largest positive
net present value is supposedly the best.
Example -6: An engineer is considering whether he should buy a stainless-
steel pump that will cost $6,000 installed and will last 5 years or a carbon-
steel pump that will cost $3,000 installed and last 2 years. The cost of
replacing the pumps is $5,000 and $2,500 respectively for the stainless-steel
and carbon-steel pumps. Money is worth 9% per annum. Which pump is best,
considering the lift of the project to be (a) infinite; (b) 7 years.
 Example -10
Compare the following two plants, which have a present value of
$11,100,000 in year 1 at interest rates of 5% and 20%. Their profits are
given below. Year Plant 1 Plant 2
1 $1,ooo,ooo $4,000,000
2 $3,ooo,ooo $4,000,000
3 $5,ooo,ooo $4,000,000
4 $6,ooo,ooo $4,000,000
5 $6,ooo,ooo $4,000,000
The net present value of plant 1 is NPV = -CFo + CF1 + CF2 + CF3 + CFn
(1+r)1 (1+r)2 (1+r)3 (1+r)n
=-11,100,000+1,000,000 + 3,000,000 + 5,000,000 + 6,000,000 + 6,000,000
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5

The net present value of plant 2 is = -CFo + CF1 (1-(1+i)-5)

i
i= 0.05, NPV of plant 1 = $6,317,906.68, For i=0.20 NPV of plant 1 = $0.00
NPV of plant 2 = $5,730,000 NPV of plant 2 = $962,448.56
(or plant 1 appears best) (or plant 2 appears best)
 Net Present Value (NPV)
 Two different answers can be obtained for Example 10 because as the
interest rate increases the net present value of money earned in future
years decreases. This means that high interest rates favor projects that
have large initial incomes and low initial costs. Low interest rates favor
projects with low initial earnings and high initial outlays.
 NPV is GOOD PROFITABILITY MEASURE
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)

NPV = the sum of the present
$500,000
NPV = -CFo + CF1 + CF2 + CF3 + CFn value of all benefits minus the
(1+r)1 (1+r)2 (1+r)3 (1+r)n present value of costs
where CFX = cash flow in year x, n = number of periods (n=3), r =
interest rate (say, 10%) If benefits > cost, NPV will be positive and the
project is acceptable. If benefits < cost, NPV will be negative and the
project is unacceptable because it destroys firm value
NPV = -500,000 + 100,000 + 150,000 + 200,000= -$134, 861
(1+0.1)1 (1+0.1)2 (1+0.1)3
 RATE OF RETURN(IRR)
 It is another good profitability measure. The only way of knowing is to
determine the interest rate that gives a net present value of zero. This
interest rate is known as the rate of return.
 The project with the largest return is considered the best. This is also known
as the yield on investment method.

 Where the calculation of the net present value was straightforward, the
determination of the rate of return requires a trial-and-error procedure.
 An interest rate is chosen and then the net present value is determined.
 If it is not zero, another interest rate is chosen and the net present value is
recalculated. This is continued until a zero net present value is obtained. IRR
is unreliable with non-conventional cash flows or mutually exclusive projects.
 IRR is defined as that interest rate (r) which equates the sum of the present
value of cash inflows with the sum of the present value of cash outflows for a
project. This is the same as defining the IRR as that rate which satisfies each
of the following expressions:

 ∑ PV cash inflows - ∑ PV cash outflows = 0

 NPV = 0 for r ∑ PV cash inflows = ∑ PV cash outflows
 RATE OF RETURN(IRR)
 The IRR method is evaluating projects in the opposite way to the NPV
method. It enables you to calculate the interest rate equivalent to the
return expected from the project over its lifetime.
 When this rate is known, it can be compared to the rates you would
receive if you invested the money elsewhere. Generally, if the IRR is
higher than cost for a loan, then the project is financially viable.

 Calculation of IRR is based on the same equation as NPV, but now

the equation is solved for r.

 0 = -CF0 + CF1 + CF2 + CF3 + ... + CFn

(1+r)1 (1+r)2 ( 1+r)3 ……… (1+r)n
 The Rule: An investment is acceptable if the IRR exceeds the
__________________________. It should be rejected otherwise.
IRR: It is discount rate that makes the NPV = 0
Accept the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
 RATE OF RETURN(IRR)
Example-9: Calculate the expected rate of return for a plant that has a present value of
$18,000,000 at startup. The proceeds are expected to be:
Solution: Year Proceeds
The net present value is
1 $3,000,000
NPV = -CFo + CF1 + CF2 + CF3 + CFn 2 $5,000,000
(1+r)1 (1+r)2 (1+r)3 (1+r)n 3 $6,000,000
NPV = -18,000,000 + CF1 + CF2 + CF3 + CFn 4 $6,000,000
(1+r)1 (1+r)2 (1+r)3 (1+r)n 5 $6,000,000
6 $6,000,000
 For i=10%, 4,550,000
 For i=15%, 1,350,000
For i=17%, 0, The rate of return is between 17% and 18%. To attempt to come
closer than 1% for a preliminary estimate is not worth while, since the
estimated values do not warrant that accuracy. The rate of return is thus 17%.
 EXPECTED RETURN ON THE INVESTMENT
 Most chemical companies aim at making about a 10% profit on all
sales. This means that the pretax profits must be around 20%. Since
new products involve a large amount of risk and cost uncertainty, a
new process is generally not considered unless at least 30%
average profit is expected before paying federal corporate income
taxes.
 Example 12: A 100,000 ton/yr polyethylene plant costs $8,500,000 to
construct. If polyethylene sells for 0.08$/lb, what is the return on
investment for this plant if a 10% profit is to be expected after taxes?
Profit per year = 0.10 (100,000 tons/yr X 2,000lb/ton X $0.08/lb)
= $1,600,00O/yr
Assume the working capital is 25% of the fixed capital
R.O.I. =1,600.000/(8,500,000*1.25) = 15%
NPV vs. IRR IRR: Enter NPV = 0, solve for IRR.
NPV: Enter r, solve for NPV n
CFt
 0
n
CFt

t  0 (1  R)
t
 NPV t  0 (1  IRR )
t
 Profitability Index (PI)
It is defined as the ratio of the sum of the present value of future
benefits to the sum of the present value of the future capital
expenditures and costs.
Measures the benefit per unit cost, based on the time value of money
The PI is the ratio of the PV of future cash inflows by the PV of cash
outflows its initial cost(absolute value) of project. Also called a
benefit-cost ratio.
Net present value ratio (NPVR) = PI = PV of cash inflows
investment PV of cash outflows or PV of
Decision Rule
 If the 0 < PI < 1, the project or option should be rejected
 If the PI > 1, the project or option should be accepted
 If a project has a positive (negative) NPV, the PI will be greater (less)
than 1.
 Profitability Index (PI)
Decision Criterion Using PI

 For independent projects: Accept all projects with PI greater than

one (this is identical to the NPV rule)
 For mutually exclusive projects: Among the projects with PI greater
than one, accept the one with the highest PI.
PI gives the same answer as NPV when:
(1) There is only one cash outflow, which is at time 0
(2) Only one project is under consideration.
 Profitability Index (PI)

For conventional CF Projects:

n
CFt
PV(Cash Inflows) 
t  1 (1  r )
t
PI 
CF0
Absolute Value of Initial Investment(CF0)

Advantages and Disadvantages of Profitability Index

Advantages
• Closely related to NPV, generally • Disadvantages
leading to identical decisions
• May lead to incorrect
• Considers all CFs
decisions in comparisons
• Considers TVM
• Easy to understand and
of mutually exclusive
communicate investments (can conflict
• Useful in capital rationing with NPV)
 Depreciation
 Depreciation and amortization are means of recovering your
investment in property that has a useful life of more than a year
and is used in your trade or business or held for the production
of income.
 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
i. physical deterioration (Wear and tear, corrosion, accidents),
ii. technological advances (obsolescence)
iii. Functional: All other causes.
iv. Depletion: Loss due to materials consumed. Applicable to Natural
Resources (timber, mineral, oil deposits)
v. Economic changes, or other factors which ultimately will cause
retirement of the property.
Depreciation is defined as the decline in the value of an asset with the passage
of time, due to any of these causes. Because the engineer thinks of
depreciation as a measure of the decrease in value of property
with time, depreciation can immediately be considered from a
cost viewpoint.
 Depreciation
 Depreciation may be accounted for in the net annual savings
of a cleaner production option.
 Suppose a piece of equipment had been put into use 10 years
ago at a total cost of $31,000. The equipment is now worn out
and is worth only $1000 as scrap material.
 The decrease in value during the 10-year period is $30,000;
however, the engineer recognizes that this $30,000 is in reality
a cost incurred for the use of the equipment.
 This depreciation cost can be spread over a period of 10
years, to replace the purchased equipment cost10 years, to
replace the purchased equipment cost.
 Salvage value is the net amount of money obtained from the
sale of a used property over and above any charges involved
in the removal and sale of the property
 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).

Straight-Line Method
 The value of the property decreases linearly with time.
 Equal amounts are charged for depreciation each year
throughout the entire service life of the property.

 Depreciation is considered as an internal expense or an

allowance for tax purposes and is retained within the company.
 Straight-Line Method
Example 4.20: A person started a small business by purchasing a
machine. The first cost of machine is $25,000. The useful life
of the machine is 5 years and the salvage value is $5,000.
Make a straight-line depreciation schedule showing the
depreciation on each year.
Solution:
 METHODS FOR DETERMINING DEPRECIATION
Straight-Line Method
 The annual depreciation cost may be expressed in equation
form as follows: V V
d  s

n
where d = annual depreciation, $/year
V = original value of the property at start of the
service life period, completely installed and ready
for use, dollars
Vs = salvage value of property at end of service life, dollars
n = service life, years
 The asset value (or book value) of the equipment at any time
during the service life may be determined from the following
equation: Va= V - ad, where Va, = asset or book value, dollars,
and a = the number of years in actual use.
 METHODS FOR DETERMINING DEPRECIATION
 Declining-Balance (or Fixed Percentage) Method is used,
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 of the property, while the annual cost for
depreciation is different each year. Under these conditions, the
depreciation cost for the first year of the property’s life is Vf, where f
represents the fixed-percentage factor.
 At the end of the first year: Asset value: Va = V(1 - f)
 At the end of the second year: Va = V(1 - f)2
 At the end of a years: Va = V(1 - f)a
 At the end of n years (i.e., at the end of service life)
Va = V(1 - f)n =Vs 1/ n
 Vs 
Therefore, f  1  
V 
This equation represents the textbook method for determining
the fixed percentage factor, and the equation is sometimes
 The difference between initial cost and the salvage value divided by
the total years of useful life gives the annual cost due to depreciation.
 The annual depreciation rate for machinery and equipment ordinarily
is about 10 percent of the tied-capital investment, while buildings are
usually depreciated at an annual rate of about 3 percent of the initial
cost.
 SERVICE LIFE( Economic )or useful 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. 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.
 Book Value, or Unamortized Cost
 The amount of the depreciable capital that has not yet been
depreciated. BVk = FCI -Σdj
 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 unamortized cost).
 It represents the worth of the property as shown on the owner’s
accounting records
 Life of the Equipment (n): represents time allowed for equipment for
depreciation. Chemical process equipment currently has depreciation
of 9.5 years
 Market Value: the price which could be obtained for an asset if it
were placed on sale in the open market.
 Replacement Value: the cost necessary to replace an existing
property at any given time with one at least equally capable of
rendering the same service.
 Definition: Book (noncash) method to represent decrease in value
of a tangible asset over time. Two types: book depreciation and tax
depreciation
 Book depreciation: used for internal accounting to track value of
assets.
 Tax depreciation: used to determine taxes due based on tax laws
 Book value BVt: Remaining undepreciated capital investment in year
 Market value MV: Amount realizable if asset were sold on open
market
 Salvage value S: Estimated trade-in or MV at end of asset’s useful life
 Depreciation rate dt:Fraction of first cost or basis removed each year
t
 Personal property: Possessions of company used to conduct business
 Real property: Real estate and all improvements (land is not
depreciable)
 Half-year convention: Assumes assets are placed in service in midyear
SL depreciation rate is constant for each year: d = dt = 1/n
• BVt = B - tDt
• Where: BVt = book value after t years
Example 4.21: An argon gas processor has a first cost of $20,000 with a
$5,000 salvage value after 5 years. Find (a) D3 and (b) BV3 for year
three. Solution: (a ) D3 = (B – S)/n = (20,000 – 5,000)/5 = $3,000
b) BV3 = B – tDt = 20,000 – 3(3,000) = $11,000
 The intent of depreciation is to allow a business to recover the cost
of an asset over a period of time.
Example 4.22: A used piece of depreciable property was bought for
$20,000. If it has a useful life of 10 years and a salvage value of $5,000,
how much will it be depreciated in the 9th year, using the 150%
declining balance schedule?
 Depreciable?
Property is depreciable if it must:
 be used in business or held to produce income
 have a determinable useful life which is longer than one year
 wear out, decay, get used up, become obsolete, or lose value from
natural causes
 not be inventory, stock in trade, or investment property

When Depreciation Starts And Stops

 Depreciation starts when property is placed in service for use in
business or for production of income
 Property is considered in service when ready and available for
specific use, even if not actually used yet
 Depreciation stops when cost of placing it in service is removed or it
is retired from service. Or when the cost of the asset has been fully
recovered.
 Depreciation Models
1. Basic (traditional) models are:
 Straight-Line Method (SL),
Sum-of-the-Years Digits Method (SYD),
Declining Balance Method (DB).
2. Today, the MACRS Method (a form of declining balance-
modified).
Depreciation Concepts
n = depreciable life of the asset in years
B = cost basis, including allowable adjustments
dk = annual depreciation deduction in year k (1< k <n)
dk* = cumulative depreciation through year k
BVk = book value at the end of year k
BVn = book value at the end of the depreciable (useful) life
SVn = salvage value at the end of year n
R = the ratio of depreciation in any one year to the BV at the beginning of the year
 Declining Balance Method (DB)
 DBM is an accelerated depreciation method;
 Provides greater depreciation amounts in the early time periods over
the SL method
 Requires assuming a DB rate (R)
 dk for year k is found by multiplying the beginning of time period
book value by the rate (R)
 The maximum DB rate set by law is:
 By law, the maximum rate for DB is specified to RMAX=2(1/n), or
twice what the straight rate would be
 If R = 1.5 (SL rate), it is termed the 150% DB rate
 Assumed depreciation is fixed percentage of BV at beginning of year
d1 = B ( R ) , d k* = B [ 1 - (1 - R ) k] , dk = B(1 - R)k - 1 ( R ), BVk = B ( 1 - R ) k
BVn = B ( 1 - R ) n Because declining balance method never reaches
BV = 0, it’s permissible to switch from this to straight-line method
 Sum of the Years Digits
Depreciation Method

The method gets its name from denominator, which equal

to the sum of no. of years :1+2+3… + n = (n)(n+1)/2
 Example 4.23
2. 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
 Example 4.24
 Determination of depreciation by straight-line and declining-balance
methods. 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)Textbook declining-balance method.
(c) Double declining-balance (200 percent) method (i.e., the declining-
balance method using a fixed-percentage factor giving a
depreciation rate equivalent to twice the minimum rate with the
straight-line method).
Example 4.24 cont’….
Example 4.24 cont.’….
 Exercise
1. Bedele Brewery Share Company bought equipment for birr 55,000.
The company estimates that the equipment’s period of useful life
will be 5 years. After 5 years the residual value is Birr 11,000.
Calculate depreciation expense and complete a depreciation
schedule.

2. MACRS
3. Depreciate 0
4. Recovery Period = Class Life
5. 1/2 Year Convention
6. Multiply percentage in table by the initial cost
 Depreciation by Sinking Fund Method
Sinking Fund Method is a depreciation method where in funds will
accumulate for replacement purposes. The formulas for Sinking Fund
Method of Depreciation are:
 Annual depreciation (A) = [ (FCI -Vs) (i) ] / [ (1 + i)^(n) -1 ]
 Total depreciation after x years = A [(1 + i)^x - 1] / I
 Book Value = FC -Total depreciation
Example :4.25:A machine costs Birr 300,000 with a salvage value of Birr
50,000 at the end of its life of 10 years. If money is worth 6% annually,
use Sinking Fund Method and determine the depreciation at the 6th
year. Solution
Annual depreciation (A) = [ (FCI -Vs) (i) ] / [ (1 + i)^(n) -1 ]A = [ (300,000 -
50,000) (0.06) ] / [ (1 + 0.06)^10 -1 ] = Birr18966.98956
Solve for the depreciation in the 6th year.? Total depreciation after x
years = A [(1 + i)^x - 1] / i
Total dep. = (18966.98956) [(1 + 0.06)^6 - 1] / 0.06 = Birr132,300.7939
 MACRS Method
 MACRS was derived from the 1981 ACRS system and went into effect
in 1986. Everything else equal, the greater the depreciation charges,
the lower the taxes paid by the firm. Depreciation is a noncash
expense.
 Assets are depreciated (MACRS) on one of eight different property
classes. Generally, the half-year convention is used for MACRS.
 Defines statutory recovery (depreciation) percentages
 Percentages were derived from the DB method with a switch to SL at
the optimal time and incorporates the half-year convention.
 The MACRS approach assumes a salvage value of “0” even though
that might not be the case!
 By current law – MACRS assumes all assets depreciated by this
method will have a “0” salvage value at the end of the recovery life
 To calculate depreciation expense using MACRS, taxpayers multiply
the MACRS basis of the property by a percentage taken from an IRS-
 The Half-Year Convention
 During a tax year, assets are purchased and installed throughout the first year.
 The half-year convention assumes that assets(applies when at least 60% of the
MACRS basis of personal property) are placed in service or disposed of in midyear,
regardless of when these events actually occur during the year(first nine months of
the year).
 under the half-year convention, taxpayers get one-half year’s depreciation in the
first and last years, regardless of how long the taxpayer actually owned the
property in those years
 Under past laws, the first year of depreciation had to be prorated by the number of
months remaining in the tax year.
 Under current federal tax law the first year is handled using the half-year
convention.
 If asset is disposed of before the full recovery period is used, only half of the
normal depreciation deduction can be taken for that year.
 Real property includes real estate and all improvements
– office buildings manufacturing structures, warehouses, apartments, and other
structures. Land itself is considered real property, but it is not depreciable
because it has an infinite life – land can never be depreciated for tax purposes.
 Straight-Line Method

Straight-Line Method

half-year convention does not apply to nonresidential real and

residential rental property . Straight-line depreciation is used for
financial reporting such as annual reports.
Figure 4-12: MACRS Table for 5- and 7-Year
Classes Using the Half-Year Convention

*Switching to straight-line results in the maximum depreciation deduction

 MACRS Recovery Periods
 For Personal Property the following MACRS recovery periods apply:
 3- years,5-years,7-years,10-years,15-years and, 20-years.
 Property Classes
• 27.5-Year Property: (Real Property)
• Residential rental property (homes and mobile homes).
• 39-Year Property (Real Property)
• Nonresidential real property attached to the land, but NOT the land
itself.
• Personal property is the income-producing, tangible possessions of a
corporation used to conduct business. Not to be confused with an
individual’s personal property like clothes, furniture, etc. it Includes
the most manufacturing and service industry property vehicles,
manufacturing equipment, materials handling devices, computers,
and networking equipment, telephone equipment office furniture,
refining process equipment, and much more
MACRS Personal Property Recovery Rates
Recovery

Based on 200%
DB.
Note, for each
life
category there
are N+1
percentage
values where
N is the class
life.
 Example 4.23
1. To meet increased sales, a large dairy is planning to purchase
10 new delivery trucks. Each truck will cost $18,000. Compute
end-of-year book value and the depreciation schedule for each
truck, using the modified accelerated cost recovery system
(MACRS) method, if the recovery period is 5 years.
end-of-year book value Solution
 BVk+1 = BVk – dk+1
 BV1 = 18,000 – 3,600=14,400
 BV2 = 14,400 – 5,760=8,640
 BV3 = 8,640 – 3,456=5,184
 BV4 = 5,184 - 2073.60=3,110.4
 BV5 = 3,110.4 - 2073.60=1,036.8
 BV5 = 1,036.8 - 1036.80= 0.00

Exercise 4.6 : A front-end loader cost $70,000 and has a depreciable

salvage value of $10,000 at the end of its 5- year useful life. Compute the
depreciation schedule and book value of the tractor using MACRS
depreciation.
 N+1 Rule
 Note, for each life category there are N+1 percentage values where N
is the class life
 Why is this the case?
 The actual recovery of a given class life assumes a half-year
convention.
 That is, it is assumed by law that an asset is placed in-service at the
middle of the first year.
 It does not matter when it is actually placed in-service; So, only a ½
year of recovery is permitted in the first year.
Property Classes – Examples
3-Year Property: Special manufacturing and handling devices, tractors
and racehorses.
5-Year Property: Computers and peripherals, Duplicating equipment,
Automobiles, trucks, buses, Cargo containers, Some manufacturing
equipment.
 7-Year Property Class:
 Office furniture, Some manufacturing equipment, Railroad cars, engines
and tracks, Agricultural machinery, Petroleum equipment and natural gas
equipment,
 All property not in another class!
 The 7-year class is the ‘default’ class!
10-Year Class:
Water transportation equipment, Petroleum refining, Agricultural processing
equipment, Durable goods manufacturing equipment, Ship building
15-Year Class:
• Land improvements, Landscaping, Pipelines, Nuclear power production
equipment, Telephone distribution and switching equipment.
20-Year Class:
• Municipal sewers, (developers), Farm buildings, Telephone switching
equipment, Power production equipment, Water utilities equipment.
 taxpayers that do not wish to use the regular MACRS (accelerated) method can
elect to use either straight-line MACRS or the Alternative Depreciation System
(ADS).
 Straight-line MACRS: Straight-line MACRS uses the straight-line method instead of
the accelerated method. Straight-line depreciation spreads the cost evenly over the
MACRS recovery period. When the taxpayer elects the straight-line method, the
recovery periods and averaging conventions continue to apply.
 Example 4.23: June 5, 2011, a taxpayer places in service used 5-year property
costing $10,000. The half-year convention applies to all personal property placed in
service that year. The taxpayer sells the property on January 14, 2014. A
comparison of regular (accelerated) MACRS and straight-line MACRS follows. Since
the property purchased was used property, bonus depreciation was not taken on
the property.

Year Regular MACRS Straight-line MACRS

2011 $10,000 × 20% $2,000 $10,000 × 1/5 ×1/2 $1,000
2012 $10,000 × 32% 3,200 $10,000 × 1/5 $2,000
2013 $10,000 × 19.2% 1920 $10,000 × 1/5 2,000
2014 $10,000 ×11.52% *1/2 576 $10,000 × 1/5 ×1/2 1,000
total $7,696 $6,000
Example 4.24:Hoppy Hops, Inc. purchased hop harvesting machinery
for $150,000 four years ago. Due to a change in the method of
harvesting the machine was recently sold for $37,500. Determine the
MACRS deprecation schedule for the machinery for the four years of
ownership. Assume a five-year property class. What is the recaptured
depreciation or loss on the sale of the machinery?

Notes: Disposal before

end of MACRS recovery
period results in ½-yr
depreciation in disposal
yr.
 The Alternate Depreciation System
 The IRS offers what is termed the Alternate Depreciation System –
ADS.
 It is a modified form of the MACRS system. Applies a straight-line
approach with the half-year convention.
 Generally used by small or growing firms that do not have sufficient
taxable income now and in the immediate future.
 Some firms may not be generating sufficient profits to take advantage
of the more accelerated depreciation rates that the MACRS-GDS
provides.
 Thus, if GDS is elected, the firm may be losing deductions in the early
years.
 ADS provides some relief for firms in this situation.
• The SL methods writes off the asset in equal amounts over the
recovery period. The DB method permits greater depreciation
amounts in the early years, and hence reduces the book value faster
than the SL method. Likewise for the MACRS method!
 ADS vs GDS
 For both the ADS and the GDS:
 For a given tax year the firm elects either the:
 ADS system for all assets placed in service for the current tax year or,
 The GDS (accelerated method) for all assets placed in service for the current tax
year.
 The firm cannot mix ADS with GDS within the tax year! (It must be one or the
other.)
 In engineering economy analysis of industrial projects:
• Most analysis will be accomplished using the GDS – accelerated depreciation rates.
ADS applies a form of the straight-line method with the half-year
convention.
• Assume 5-Year Property Class;
• N = 5, R = 0.20 per year except in the first year and in the last year (N=6)
• Year 1: R1 = ½(0.20) = 0.10 or 10% of B
• Years 2-5 = 0.20 or 20% of B;
• Remaining amount – 10% flows over to the last year, k= 6.
 Information Needed To Calculate MARCS Depreciation
1. The cost basis
2. The date the property was placed in service
3. The property class and recovery period
4. The MACRS depreciation used (GDS or ADS)
5. The time convention that applies (half year)
 SL book values decline in a linear fashion down to a specified salvage value.
 The DB method allows the book value to accelerate faster since the DB plot of
book value is below the SL book values
 MACRS also permits accelerated book values, but is not as good as the pure DB
method permits.
 MACRS uses the 200% declining balance method to recover the costs of 3-, 5-, 7-,
and 10-year property. The 150% declining balance method is used for 15-year
property. MACRS switches to he straight-line method when straight-line
depreciation yields a greater deduction.
 MACRS ignores salvage value. Instead, taxpayers multiply the percentage from the
table by the property’s MACRS basis to compute their MACRS deduction.
 Example 4.24
1. An asset will cost $1,750 when purchased this year. It is further
expected to have a salvage value of $250 at the end of its five
year depreciable life. Calculate complete depreciation schedules
giving the depreciation charge, D(n), and end-of-year book value,
B(n), for straight-line (SL), sum of the years digits (SOYD), double
declining balance (DDB), and modified accelerated cost recovery
(MACRS) depreciation methods. Assume a MACRS recovery
period of 5 years.
 Case Study #1: Financial Analysis of an Option
in a Bottle Washing Plant
Background
 Bottle washing plant BWP utilizes a large quantity of water and caustic soda for
bottle washing and rinsing operations
 As a cleaner production option, a certain percentage of the caustic soda is to be
recovered from the resulting caustic solution, through the use of a membrane
filtration (MF) system
 The recovered caustic will then be resold at the prevailing market price
 Let us examine the financial feasibility of installing the MF system
 Case Study #1 - Calculations for the Value of
Recoverable Caustic ($ / year)
Table 1:
Volume of Volume of caustic Mass of caustic recovered Value of caustic
caustic (m3) recovered per run* (m3) per year** (kg/m3) recovered per year***
“A” “B” = “A” X 0.65 “C” = “B” X 4 X 25 ($ / year) = “C” X 0.5

210 136.5 13,650 6,825

Data
* The overall caustic recovered from the MF system is 65% by volume
** The number of recovery runs at BWP is 4 times a year and the concentration of
caustic by weight is 2.5% or 25 kg/m3
*** The cost of 1 kg of pure caustic solution is $0.5
 Case Study #1 – Installation Cost for the MF System

Table 2
System component Cost ($)

Membrane 7,000

Feed pump 800

High pressure pump 1,600

Cartridge and power 400

Permeate tank 200

Pipes, valves, etc. 8,000

Total investment: 18,000

In addition to the initial investment, the manufacturer states that the membrane
for the MF system will need to be replaced once in 3 years. The associated cost for
this will work out to be $7,500. The total life of the MF system is 12 years.
Case Study #1 - Calculations for the Net Annual Uniform Savings

Net annual uniform savings =

Cost recovered from the sale of caustic annually – annual depreciation
cost of the MF system – annual operating costs

Here, depreciation cost of the MF system (assuming nil salvage

value at the end of the 12 year period = (18,000 – 0) / 12 = $1,500

Also, annual operating costs = cost for power and the cartridge =
$400 (from Table 2)

So, net annual uniform savings = 6,825 – 1,500 – 400 = $4,925

(approx.)
Case Study #1 – Cash Flow Diagram for the Proposed MF System

Cash Inflows (Net annual Uniform Savings)

$4,925…………………………………………………………$4,925
0
12

$18,000 $7,500 $7,500 $7,500

Cash Outflows (Initial Investment and Replacement Cost)

Initial one-time investment = $18,000

Membrane replacement cost (once every 3 years) = $7,500
Net annual uniform savings = $4,925 / year
 Case Study #1 – Calculation for NPV

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows

12
= 4,925  1 = $33,557
t=1 (1 + 0.1)t

PV of cash outflows
= 18,000 + 7,500 + 7,500 + 7,500 = $31,049
(1+0.1)3 (1+0.1)6 (1+0.1)9

NPV = PV of cash inflows – PV of cash outflows

= $33,557 - $31,049 = $2,508

Since the resultant NPV > 0, the option is financially viable.

Calculating for the PI:
PI = PV of cash inflows = 33,557 = 1.08
PV of cash outflows 31,049
Since PI > 1, then
The option can be accepted; i.e. it is financially viable
 Example
 The investment cost for a 120,000,000kg/year plant is estimated at
Birr15,000,000. The working capital is Birr 3,000,000. From the unit
ratio material balance, the energy balance, and an estimation of the
labor, the following costs per pound of product were determined:
 Raw materials…………………………. Birr8/kg (1)
 Utilities …………………………….Birr1.2/kg (2)
 Labor …………………………….Birr1.5/kg (3)
 Packaging ……none(shipped in bulk quantities)
 Royalties …….none(design by company engineers)
 Waste treatment charges….none (pollution included in capital cost
What must be the selling price if the return on the investment before
taxes of the fully operating plant is to be 30%? Assume that the plant is
to be fully depreciated in 12 years using a straight-line method.
 Example
 Consider an investment that costs $100,000 and has a cash inflow of
$25,000 every year for 5 years. The required return is 9%, and
payback cutoff is 4 years.
 What is the payback period?
 What is the discounted payback period?
 What is the NPV?
 What is the IRR?
 Should we accept the project?
 What method should be the primary decision rule?
 When is the IRR rule unreliable?
ANS
 Payback period = 4 years
 The project does not pay back on a discounted basis.
 NPV = -2758.72
 IRR = 7.93%
 AN EXAMPLE TO ILLUSTRATE PRINCIPLES OF ALTERNATIVE
INVESTMENT ANALYSIS
 In making a choice among various alternative investments, it is
necessary to recognize the need to compare one investment to
another on a mutually exclusive basis in such a manner that the
return on the incremental investment is satisfactory. The following
example illustrates this principle.
 An existing plant has been operating in such a way that a large amount of heat is
being lost in the waste gases. It has been proposed to save money by recovering
the heat that is now being lost. Four different heat exchangers have been designed
to recover the heat, and all prices, costs, and savings have been calculated for each
of the designs. The results of these calculations are presented in the following:
 AN EXAMPLE TO ILLUSTRATE PRINCIPLES OF ALTERNATIVE
INVESTMENT ANALYSIS
 The company in charge of the plant demands at least a 10 percent
annual return based on the initial investment for any unnecessary
investment. Only one of the four designs can be accepted. Neglecting
effects due to income taxes and the time value of money, which (if
any) of the four designs should be recommended?
 The first step in the solution of this example problem is to determine
the amount of money saved per year for each design, from which the
annual percent return on the initial investment can be determined.
The net annual savings equals the value of heat saved minus the sum
of the operating costs and fixed charges; thus,
 For design No. 1, Annual savings = 4100 - (0.2)(10,000) - 100 = $2000
 Annual percent return =[2000/10000]*(lOO) = 20%
 For design No. 2, Annual savings = 6000 - (0.2)(16,000) - 100 = $2700
 Annual percent return =[2700/16000]*(lOO) = 16.9%
 AN EXAMPLE TO ILLUSTRATE PRINCIPLES OF ALTERNATIVE
INVESTMENT ANALYSIS
 For design No. 3, Annual savings = 6900 - (0.2)(20,000) - 100 = $2800
 Annual percent return =[2800/20000]*(lOO) = 14%
 For design No. 4, Annual savings = 8850 - (0.2)(26,000) - 100 = $3550
 Annual percent return = [3550/26000](100) = 13.6%
 Because the indicated percent return for each of the four designs is above
the minimum of 10 percent required by the company, any one of the four
designs would be acceptable, and it now becomes necessary to choose one
of the four alternatives.
 If design No. 1 is taken as the starting basis, comparison of design No. 2 to
design No. 1 shows that the annual saving of $2700 -$2000 = $700 results
by making an additional investment of $16,000 - $10,000= $6,000. Thus, the
percent return on the incremental investment is [700/6000](100) =11.7 %
and design No. 2 is acceptable by company policy in preference to design
the choice of design No. 2 as the final recommendation:
 No. 2, and design No. 2 is the alternative that should be recommended.
 Exercise
1. Ethiopian-plastic manufacturing company is considering the
expansion of its plastics operation. To meet sales demand, a new
molding machine must be installed. An economic analysis based
upon cash flow will have to be made using the following data:
Machine A Machine B
Installed fixed investment $285,000 $197,000
Annual cash operating expenses 42,000 38,000

Depreciation may be taken as 5 years by the straight-line method. The

federal income tax rate is 35%. Determine:
a) Cash flow analysis for installing machine A.
b) Cash flow analysis for installing machine B.
c) Using the difference method, compare Machine A with Machine B.
d) On the basis of cash flow, which machine is to be preferred?
Use cash flow diagrams for this analysis.