CHE 425 Engineering Economics and Design Principles Notes

Prof.
Adnan Alamer
Chemical Engineering Dept., KFUPM.
1
CHE 425
CHE 425
Engineering Economics and
Design Principles
Design Principles
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CHAPTER 8
CHAPTER 8
Profitability Analysis
Profitability Analysis
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A Typical Cumulative Cash Flow Diagram for
Evaluation of a New Project
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(cont.)
(cont.)
Project Life
Project Life
Required for evaluation of profitability of a project. Required for evaluation of profitability of a project.
Standardization of project life: Standardization of project life:
When comparing different projects. When comparing different projects.
Project lives of 10, 12 and 15 years are commonly used. Project lives of 10, 12 and 15 years are commonly used.
Time value of money has to be considered when

Time value of money has to be considered when
evaluating profitability.
evaluating profitability.
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Profitability Criteria for Project Evaluation
Profitability Criteria for Project Evaluation
3 Bases for Evaluation of Profitability
Time
Cash
Interest Rate i
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Profitability Criteria
Non-discounted method
do not take account of
time-value of money.
Not recommended for
evaluating new, large
projects
Profitability
Profitability
Criteria
Criteria
Discounted
Discounted
Non
Non
-
-
Discounted
Discounted
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Non
Non
-
-
Discounted Profitability Criteria
Time Criterion.
The shorter the PBP, the better.
Payback Period (PBP)
PBP = Time required, after start-up, to recover the
fixed capital investment, FCI
L
, for the project
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Non
Non
-
-
Discounted Profitability Criteria (cont.)
Cash Criterion.
Cumulative Cash Position (CCP)
CCP = Worth of the project at the end of its life
Cumulative Cash Ratio (CCR)
CCR > 1 implies that the project is potentially profitable.
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Non
Non
-
-
Interest Rate Criterion.
Rate of Return on Investment (ROROI)
The higher the value of ROROI, the better.
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Time Criterion
Time Criterion.
The project with the shortest DPBP is the most
desirable.
Discounted Payback Period (PBP)
DPBP = Time required, after start-up, to recover the
fixed capital investment, FCI
L
, required for the
project with all cash-flows discounted back to
time zero.
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Non
Non
-
-
Cash Criterion
Cash Criterion.
Net Present Value (NPV)
NPV = Cumulative discounted cash position at the end
of the project.
Present Value Ratio (PVR)
PVR > 1 implies that the project is potentially profitable.
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Non
Non
-
-

Discounted Cash Flow Rate of Return (DCFROR)
If DCFROR is higher than the internal discount rate,
then the project is considered profitable .
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Example 8.2 (cont.)
Example 8.2 (cont.)
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Example 8.2 (cont.)
Example 8.2 (cont.)
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Example 8.2 (cont.)
Example 8.2 (cont.)
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Example 8.2 (cont.)
Example 8.2 (cont.)
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Example 8.2 (cont.)
Example 8.2 (cont.)
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Example 8.3
Example 8.3
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Example 8.3 (cont.)
Example 8.3 (cont.)
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Example 8.3 (cont.)
Example 8.3 (cont.)
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Comparing Several Large Projects Comparing Several Large Projects- -Incremental Economic Analysis Incremental Economic Analysis
DCFROR tells us how efficiently we are using our

DCFROR tells us how efficiently we are using our
money.
money.
The higher the DCFROR, the more attractive the

The higher the DCFROR, the more attractive the
individual investment.
individual investment.
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Example 8.4
Example 8.4
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Example 8.4 (cont.)
Example 8.4 (cont.)
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Example 8.4 (cont.)
Example 8.4 (cont.)
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Example 8.4 (cont.)
Example 8.4 (cont.)
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Example 8.5
Example 8.5
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Example 8.5 (cont.)
Example 8.5 (cont.)
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Comparing Investment Alternatives
Comparing Investment Alternatives
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Algorithm for Incremental Investment Analysis
Algorithm for Incremental Investment Analysis
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The Concept of Risk
The Concept of Risk
Option 1
Option 1
Option 2
Option 2
A
A
new
new
product is to be
product is to be
produced which has
produced which has
never been made in
never been made in
large scale.
large scale.
A
A
second
second
plant is to be
plant is to be
built in another region to
built in another region to
meet increasing
meet increasing
demand.
demand.
Pilot plant tests have
Pilot plant tests have
been made and product
been made and product
sent to potential
sent to potential
customers.
customers.
Company has dominant
Company has dominant
market position for this
market position for this
product.
product.
The calculated rate of
The calculated rate of
return is 33%.
return is 33%.
The rate of return is to
The rate of return is to
be 12%.
be 12%.
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The Concept of Risk
The Concept of Risk
(cont.)
(cont.)
Items that Favor Option 1 Items that Favor Option 1 Items that Favor Option 2 Items that Favor Option 2
High return on the High return on the
investment investment
Well established market Well established market
Opens new product Opens new product
possibilities possibilities
Well Well - -known manufacturing known manufacturing
costs costs
Transportation costs will be Transportation costs will be
less less
Matured technology Matured technology
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The Concept of Risk
The Concept of Risk
(cont.)
(cont.)
The high rate of return of option 1 is

The high rate of return of option 1 is
associated with high
associated with high
risk
risk
.
.
VP
VP
s Decision: Consider option 2 due to

s Decision: Consider option 2 due to
concern for lost market position.
concern for lost market position.
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Evaluation of Equipment Alternatives
Evaluation of Equipment Alternatives
Factors to Consider
Factors to Consider
Capital Cost of the equipment.

Capital Cost of the equipment.
Operating cost of the equipment.

Operating cost of the equipment.
Lifetime of the equipment.

Lifetime of the equipment.
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Equipment with the Same Expected Operating Lives
Equipment with the Same Expected Operating Lives
When capital cost and operating cost are

When capital cost and operating cost are
different but equipment lives are the same, then
different but equipment lives are the same, then
make choice based on NPV.
make choice based on NPV.
The choice with the

The choice with the
least negative
least negative
NPV value
NPV value
will be the best choice.
will be the best choice.
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Example 8.6
Example 8.6
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Example 8.6 (cont.)
Example 8.6 (cont.)
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Equipment with Different Expected Operating Lives
Equipment with Different Expected Operating Lives
Three Methods. Three Methods.
Capitalized Capital Cost Method Capitalized Capital Cost Method
Equivalent Annual Operating Cost (EAOC) Method Equivalent Annual Operating Cost (EAOC) Method
Common Denominator Method Common Denominator Method
Effect of inflation is not considered in the above Effect of inflation is not considered in the above
methods. methods.
All of the methods consider both the capital and All of the methods consider both the capital and
operating cost in minimizing expenses, thus maximizing operating cost in minimizing expenses, thus maximizing
our profits. our profits.
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Capitalized Cost Method
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Example 8.7
Example 8.7
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Example 8.7 (cont.)
Example 8.7 (cont.)
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Equivalent Annual Operating Cost (EAOC) Method
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Example 8.8
Example 8.8
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Common Denominator Method
Common Denominator Method
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Example 8.9
Example 8.9
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Example 8.9 (cont.)
Example 8.9 (cont.)
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CHE 425
CHE 425
Design Principles
Design Principles
Prof. Adnan Al
Prof. Adnan Al
-
-
Amer
Amer
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Incremental Analysis for Retrofitting Facilities
Retrofitting
Retrofitting
: Improving the profitability of a
: Improving the profitability of a
process by adding a piece of equipment to
process by adding a piece of equipment to
an existing operating plant.
an existing operating plant.
Continuous
Types of Decision in
Retrofitting
Discrete
(Yes or No)
Combination
of Both
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Retrofitting Procedure
Retrofitting Procedure
Identify available alternatives A

Identify available alternatives A
1 1
, A
, A
2 2
A
A
n. n.
Know the project cost (PC) and yearly

Know the project cost (PC) and yearly
savings (YS) generated for each alternative.
savings (YS) generated for each alternative.
NOTE
NOTE
: The
: The
do nothing
do nothing
option, A
option, A
1 1
, has no
, has no
capital cost and no savings.
capital cost and no savings.
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For small retrofit projects,
non-discounted method
may be sufficient.
For larger retrofit projects,
discounted profitability
criteria should be used.
Profitability
Profitability
Criteria
Criteria
Discounted
Discounted
Non
Non
-
-
Discounted
Discounted
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Non
Non
-
-
Discounted Methods for Incremental Analysis
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Example
Example
8.10
8.10
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Example
Example
8.10 (cont.)
8.10 (cont.)
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Example
Example
8.10 (cont.)
8.10 (cont.)
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Example 8.11
Example 8.11
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Example
Example
8.11 (cont.)
8.11 (cont.)
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Example
Example
8.12
8.12
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Example
Example
8.13
8.13
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Example
Example
8.14
8.14
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Concept of risk in evaluation of profitability

Concept of risk in evaluation of profitability
is introduced.
is introduced.
Techniques to quantify risk are illustrated

Techniques to quantify risk are illustrated
See Table 8.1.

See Table 8.1.
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Forecasting Uncertainty in Chemical Processes
Forecasting Uncertainty in Chemical Processes
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Forecasting Uncertainty in Chemical Processes (cont.)
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Utilities - Refrigerated Water
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Quantifying Risk
Methods of
Methods of
Quantifying Risk
Quantifying Risk
Scenario
Scenario
Analysis
Analysis
Sensitivity
Sensitivity
Analysis
Analysis
Monte
Monte
-
-
Carlo
Carlo
Method
Method
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Scenario Analysis
Scenario Analysis
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Scenario Analysis
Scenario Analysis
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Sensitivity Analysis
Sensitivity Analysis
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Example 8.15
Example 8.15
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Example 8.15 (cont.)
Example 8.15 (cont.)
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Example 8.16
Example 8.16
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Example 8.16
Example 8.16
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Monte
Monte
-
-
Carlo Method (Algorithm)
Carlo Method (Algorithm)
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For processes using new technology,

For processes using new technology,
additional risks will be present.
additional risks will be present.
To account for the additional risk, assign

To account for the additional risk, assign
higher acceptable rate of return for projects
higher acceptable rate of return for projects
using new technology compared with those
using new technology compared with those
using matured technology.
using matured technology.
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Prof. Adnan Alamer
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Profit Margin (PM)
Profit Margin (PM)
If PM < 0, the process will not be

If PM < 0, the process will not be
profitable.
profitable.
A PM > 0 does not guarantee that the

A PM > 0 does not guarantee that the
process will be profitable but does suggest
process will be profitable but does suggest
that further investigation may be warranted.
that further investigation may be warranted.
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Example 8.17
Example 8.17

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Prof.

Time value of money has to be considered when

Interest Rate Criterion.

DCFROR tells us how efficiently we are using our

The higher the DCFROR, the more attractive the

The high rate of return of option 1 is

s Decision: Consider option 2 due to

Capital Cost of the equipment.

Operating cost of the equipment.

Lifetime of the equipment.

When capital cost and operating cost are

The choice with the

Identify available alternatives A

Know the project cost (PC) and yearly

Concept of risk in evaluation of profitability

Techniques to quantify risk are illustrated

See Table 8.1.

For processes using new technology,

To account for the additional risk, assign

If PM < 0, the process will not be

A PM > 0 does not guarantee that the

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