Chapter 9 – Engineering

Economic Analysis

Chemical Engineering Department

West Virginia University

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 Outline

 Interest Rates
 Cash Flow Diagrams
 Annuities and Discount Factors
 Depreciation
 Taxation, Cash Flow, and Profit
 Inflation

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 Definitions
 P – Principal or Present Value (of an
investment)
 Fn – Future Value (of an investment)
 n – Years (or other time unit) between P
and F
 i – Interest Rate (based on time interval of
n) per anum
Basis premise: Money when invested earns
money
$1 today is worth more than $1 in the Future
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Interest
 Simple Interest – Annual Basis
 Interest paid in any year = Pis
 Pis – Fraction of investment paid as interest
per year
 After n years total interest paid = Pisn
 Total investment is worth = P + Pisn
 What is the drawback of simple interest?

We can earn interest on earned interest

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Interest
 Compound Interest
At time 0 we have P
At the end of Year 1, we have F1 = P (1 + i)
At the end of Year 2, we have F2 = P (1 + i)2

At the end of Year n, we have Fn = P (1 + i)n

or P = Fn / (1 + i)n

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Example
 How much would i need to invest at 8
% p.a. to yield $5000 in 10 years
i  0.08
n  10
F10  5000
5000
P  $2315.97
1  0.08 10

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 What if Interest Rate Changes
with Time?

n
Fn  P  (1  i j )  P 1  i1 1  i2  ....... 1  in  Eq. (9.7)
j 1

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Different Time Basis for
Interest Calculations
 Relates to statement “ Your loan is 6 %
p.a. compounded monthly”
 Define actual interest rate per
compounding period as r
 inom = Nominal annual interest rate
 m = Number of compounding periods per
year (12)

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Different Time Basis for
Interest Calculations cont.
 ieff = Effective annual interest rate
inom
r
m
 Look at condition after 1 year
m
 inom 
F1  P 1  ieff   P  1  
 m 
m
 inom 
ieff   1   1
 m 
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Example
 Invest $1000 at 10 % p.a. compounded
monthly. How much do I have in 1 year, 10
years?
m 12
 i   0.10 
F1  P  1  nom   1000  1    $1104.71
 m   12 
12
 0.10 
ieff  1    1  0.1047
 12 

 
10
F10  P 1  ieff  $2707.04
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Example cont.
 As m decreases ieff increases
 Is there a limit as m goes to infinity
 Yes – continuously compounded interest
 Derivation – in Chapter 9
 ieff (continuous) = e inom – 1

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Cash Flow Diagrams
 Represent timings and approximate
magnitude of investment on a cfd
 x-axis is time and y-axis is magnitude
 both positive and negative investments are
possible.
 In order to determine direction (sign) of
cash flows, we must define what
system is being considered.
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Consider a Discrete Cash Flow Diagram

 Discrete refers to individual cfds that

are plotted

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Example
 I borrow $20k for a car and repay as a
$400 monthly payment for 5 years.
For Bank For Me
$20,000

$400
123 60
12 3 60
$400
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Cumulative CFD
Cumulative CFD

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 Annuities

1 2 3 n
Uniform series of equally spaced – equal value cash flows
Note: The first payment is at the beginning of year 1 not at t = 0

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Annuities
 What is future value Fn = ?
n 1 n 2
Fn  A 1  i   A 1  i   ..... A

 Geometric progression
 1  i n  1 
Fn  Sn  A  
 i 
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Calculations with Cash Flow Diagrams

$5,000
$2,000
$1,000
4 7
0 1 3

$3,000

 Invest $5k, $1k, $2k at End of Years 0,

1, 3, and take $3k at End of Year 4
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 Example 1
 How much in account at end of Year 7 if i =
8% p.a.
F7  5,000 1  0.08   1000 1  0.08   2000 1  0.08 
7 6 4

3000 1  0.08 
3

F7  $9097.84
 What would investment be at Year 0 to get
this amount at Year 7
9097.84
P  5308.50
1.08 7
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Example 2
 What should my annual monthly car
payment be if interest rate is 8% p.a.
compounded monthly? A

$20,000

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 Example 2 cont’d
 Compare at n = 60
  0.08 60 
 1    1
F60  A  
12    73.47 A
 0.08 
 12 
 
 0.08 60 
F60  20,000  1     29,796.90
 12  
73.47 A  29,796.90  0
Interest paid = $4,331.80
A  $405.53
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 Discount Factors
 Just a shorthand symbol for a formula
in i and n F P 1  
P   , i, n  
1  i  n
F  1  i n

P   1 
 P  F  , i, n   F  
F   1  i  
n
 
See Table 9.1
P 
 A  P   , i, n  
1  i  n
1
A  i 1  i 
n

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 More Examples on Cash Flow
Calculations

You decide to start saving for a child’s college education

as soon as your child is born. You estimate that it will cost
a total of $18,000 per year for 4 years! How much should
you put away into an account that bears an average
interest rate of 7% pa in order to cover the costs of
education?
Assume that your child will start college at age 18, your
first investment occurs at year 1, and that payments are
made at the end of years 18, 19, 20, and 21. Also assume
that you continue to invest until he/she graduates.
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 More Examples on Cash Flow
Calculations
A

0 1 2 3 18 19 20 21

F  F 
A  , 0.07, 21  18, 000  , 0.07, 4 
A  A  $ 18,000

(1  0.07) 21  1 (1  0.07) 4  1
A  (18, 000)
0.07 0.07
(1  0.07) 4  1
A  (18, 000)  $1, 781.31
(1  0.07)  1
21

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 More Examples on Cash Flow
Calculations

How much would you need to invest in a lump sum at

the time of the birth of your child to pay for the
education?

What are the balances in the investment account in

years 18, 19, 20, and 21 just before the $18,000
withdrawals have been made?

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 More Examples on Cash Flow
Calculations
P

0 1 2 3 18 19 20 21

F  F 
P  , 0.07, 21  18, 000  , 0.07, 4 
P  A 
 (1  0.07) 4  1  $ 18,000
P(1  0.07) 21
 (18, 000)  
 0.07
 
 (1  0.07) 4  1 
A  (18, 000)   $19,301.48
 (0.07)(1  0.07) 21 
 
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 More Examples on Cash Flow
Calculations
F18
F19
P F20
F21

0 1 2 3 18 19 20 21

F 
F18  P  , 0.07,18   (19,301.48)(1  0.07)18  $65, 237.70 $ 18,000
P 
F19  (65, 237.70  18, 000)(1.07)  $50,544.33
F20  (50,544.33  18, 000)(1.07)  $34,822.44
F21  (34,822.44  18, 000)(1.07)  $18, 000.00
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Depreciation
 Total Capital Investment = Fixed
Capital + Working Capital
 Fixed Capital – All costs associated with
new construction, but Land cannot be
depreciated
 Working Capital – Float of material to start
operations cannot depreciate

TCI  FCI L  Land  WC

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Definitions
 Salvage Value, S
 Value of FCIL at end of project
 Often = 0
 Life of Equipment
 n – Set by IRS
 Not related to actual equipment life
 Total Capital for Depreciation
 FCIL - S
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3 Basic Methods for Depreciation
 Straight Line
 Sum of Years Digits (SOYD)
 Double Declining Balance (DDB)
 Modified Accelerated Cost Recovery
System (MACRS)

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 Straight Line

 FCI L  S 
SL
dk  
 n 

n = # of years over which depreciation is taken

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Sum of Years Digits (SOYD)

 n  1  k  FCI L  S 

d kSOYD 
1
n  n  1
2

SOYD

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Double Declining Balance (DDB)

Adjust final year

so that total
 k 1  depreciation is

2
DDB
dk   FCI L  d j FCIL - S
n 
 j  0 

Book value

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Example 9.21
FCI L  $150  10 6

S  $10  10 6

n7
1st Year  d SL  ?
150  10
d SL   20
7
Same for Years 1-7
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 Example 9.21 (cont’d)

Sum of Year’s Digits

 7  1  1 7
d SOYD ,1 
1
150  10  150  10  35
 7 8 28
2
 7  1  2 6
d SOYD ,2 
1
150  10  150  10  30
 7 8 28
2

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 Example 7.21 (cont’d)
Double Declining Balance
2
d DDB,1  150   42.9
7
2
d DDB,2  150  42.9   30.6
7

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 MACRS
Double declining balance method over 5, 7, 9 years (depends on
equipment use – most chemical processes are 5 yrs) with a ½
year convention and switching to SL over remaining years when
depreciation for SL method is greater than DDB.
Example for 5 year life – using a basis of 100
k dkDDB dkSL
1 2/5(100 – 0)(0.5) = 20
½ year
2 2/5(100 – 20) = 32 (100-20)/4.5 = 17.78
convention
3 2/5(100 – 52) = 19.2 (100 – 52)/3.5 = 13.71
4 2/5(100 – 71.2) = 11.52 (100 – 71.2)/2.5 = 11.52
5 2/5(100 – 82.72) = 6.91 (100 – 82.72)/1.5 = 11.52
6 (0.5)(100 – 94.24)/0.5 = 5.76
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MACRS
Year, i diMACRS
1 20.00 %
2 32.00 %
3 19.20 %
4 11.52 %
5 11.52 %
6 5.76 %

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Taxation, Cash Flow, and
Profit
 Tables 9.3 – 9.4
 Expenses = COMd + dk
 Income Tax = (R – COMd - dk)t
 After Tax (net)Profit =
(R – COMd –dk)(1 – t)
 After Tax Cash Flow =
(R – COMd – dk)(1 – t) + dk (+ Investment)

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Inflation
 $ Now Net Worth vs. $ Next Year
CEPCI  j  n   1  f  CEPCI  j 
n

 f = Average inflation rate between

Years j and n

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 Inflation
 Example
CEPCI 1993  359
CEPCI  2003  402
402
1  f 
10

359
0.1
 402 
f    1  0.0114 or 1.14%
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 Inflation
 Effect of Inflation on Interest Rate
f affects the purchasing power of the $
 Look at the purchasing power of future worth, then
F
F '
(1  f )n
 If this future worth was obtained by investing at a rate i, then the
inflation adjusted interest rate, i ’ is given by
n
F (1  i ) n
 1 i 
F 
'
 P  P 1 f   P (1  i ' n
)
(1  f ) n
(1  f ) n
 
1 i
i'  1  i  f
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 Summary
 Investment involves principal, interest rate, and
time
 The timing of transactions is conveniently shown on
a Cash Flow Diagram
 Depreciation of equipment value impacts the
amount of tax that one pays
 Inflation reduces the power of investment and
decreases the buying power of future investments.
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