+

Rate of return

+Sensitivity analysiscoated membrane template

Level 2 analysis Raw material costs = $100,000 Purchased equipment costs = $250,000 Lang factors at lowest value of the range

Snapshot of TPC Case I tab

+What is the sensitivity of TPC to raw material cost variations? ± 10%, one standard deviation of raw material costs

(bulk chemicals); Standard deviation levels

± 1 standard deviation = 50% of the range ± 2 standard deviations = ~95% of the range

For this case, ± 2 standard deviations of raw material costs would give $80,000 and $120,000 as the raw materials cost range

Change raw materials costs on bill of materials Tab; read TPC result on TPC Case I Tab

+TPC vs. raw material costs± 2 standard deviations; 10% = one standard deviation;notice the TPC sensitivity to raw materials costs

+What is the sensitivity of TPC to PEC cost variations? Capital cost estimates are within 35% of actual (we

take this to be 2 standard deviations) Change PEC costs on PEC Tab; read TCI result on TCI

Tab or read TCI, TPC results on TPC Case I Tab

+TCI, TPC vs PEC

+How can you use sensitivity plots during design? Evaluate high-cost elements for the process, focus on

reducing these Rapidly eliminate alternatives that exceed cost quality

accuracy Refine cost estimates to evaluate alternatives that

have costs within the expected accuracy of the costing methods

+

Costs due to interest on investment

Money has a time value A business expects to receive a

return on money invested The amount of the return is related

to the degree of risk that the entire investment may be lost

+Various investment cost elements Borrowed capital vs. owned capital

Interest on owned capital cannot be charged as a true cost

Interest effects in a small business $20,000 invested in a start-up – FCI + WC Profit = $8,000 Owned capital: profit = $8,000 Borrowed capital (10% interest): profit = $8,000 –

0.1*$20,000 = $6,000

+

Interest effects in a large business New capital can come from issued stocks and bonds,

borrowing from banks or insurance companies, depreciation funds set aside, profits not distributed to shareholders,…

Source of capital

Interest, dividend %/year

Actual interest, dividend before taxes, %/yr

Actual interest, dividend after taxes, %/yr

Bonds 6 6 4Bank loans 7 7 4.6Preferred stock 7 10.6 7Common stock 0 13.6 9

+Including cost of capital in economic analysis Capital is charged at a low interest rate – it could be

used for alternative investments, i.e., it could pays off funded debts or be invested in risk-free loans

Interest is paid on owned capital at a rate equal to the presetn return on all the company’s capital

Design practice for interest and investment costs-alternatives No interest costs are included – all necessary capital comes

from owned capital Interest is charged on the total capital investment at a set

interest rate

+

Taxes

Property taxes Local government jurisdiction –

county or city Excise taxes

Charges for import customs, transfer of stocks and bonds

Gasoline, alcoholic beverages Indirect, as they are passed to the

consumer There may be local excise taxes

Income taxes Based on gross earnings = total

income – total product cost Federal and state governments (0

– 5% of gross income)

+Corporate taxes

Normal tax – federal government Surtax – 2nd federal income tax based on gross earnings

above a certain limit > $100,000: 34% tax rate

Capital gains tax – tax on profits made for the sale of capital assets (land, buildings, equipment); long-term if held more than a year, short-term if held more than a year

Contributions – tax deductible up to 10% of taxable income

Carry-back, carry-forward of losses – 3 year window

+

Investment credit – deduction for new investments in machinery, equipment

Taxes and depreciation – discussion to follow Excess-profits tax – (national emergencies) Tax returns

Cash basis – only money received or paid out during the period

Accrual basis – income and expenses included when they occur even if money is not yet received or sent

+

Depreciation methods

Arbitrary, does not include interest costs Straight-line Declining balance Sum-of-the-years digits

Accounts for interest on the investment Sinking fund Present worth methods

Case study: Harsh’s car V = $20,000 Vs = $500 A = 15 years

+

+

Profitability standard

Quantifiable standards only operate as guides to decisions

Profit evaluation is based on prediction of future results [“…it is hard to make predictions, especially about the future.” – Yogi Berra]

A primary factor in evaluations is the consideration of alternatives

Typical choices Capital investment in a project

with high risk Capital investment in a safe

venture

+

Five common methods for profitability evaluations

1. Rate of return on investment

2. Discounted cash flow on full-life performance

3. Net present worth

4. Capitalized costs

5. Payout period

+1. Rate of return (RoR)

Annual RoR on TCI, before taxes = annual profit/(TCI + WC)

Annual RoR on TCI, after taxes. Modify annual profit by taxes

Annual RoR, capital recovery with minimal profit Generate fictitious expenses at min profit, divide by

(TCI+WC)

+Example: Rate of return on investment

+RoR

TCI, WC, income, expenses No time value of money Assumes constant costs for

projects Depreciation may vary Maintenance costs

increase with time Sales volume may

increase or decrease

advantages disadvantages

+2. Discounted cash flow rate of return We determine an index (i), or interest rate, that

discounts the annual flows to a zero present value at the end of the project life, when properly compared to the initial investment

What does i represent? The after-tax interest rate at which the investment is repaid

by proceeds from the project, or The maximum after-tax interest rate at which funds could

be borrowed for the investment and just break even at the end of the service life.

+Discounted cash flow rate of returnWhat is the interest at which this project will pay principal + interest at end of life? Addresses time value of money Computes amount of investment unreturned @ each

year over the project life Trial-and-error solution: vary RoR so that the initial

investment goes to zero at the end of the project ife It gives the maximum interest rate at which capital can

be borrowed when net cash flow just pays all the principle and interest

+Estimated cash flow to project

year Cash flow to project0 (110,000) = -(TCI+WC)1 30,0002 31,0003 36,0004 40,0005 43,000

+3. Net present worth

Complementary to DCC RoR Substitutes the cost of capital at an interest rate, i, for the

discounted cash flow rate of return For the data provided in the DCC ROR problem, we set the

interest rate, say 15%, and compute the difference between the present value of the annual cash flows and the initial required investment

+

+

Spreadsheet structure for DCF of present value and net present worth

Source: Peters, Timmerhaus, West

+4. Capitalized costs

This method is useful for comparing alternatives within a single overall project.

Capitalized costs related to investment: Money for initial purchase of equipment, and Generating sufficient funds via interest accumulation to

permit perpetual replacement (i.e., sustainability)

Example: one process section has alternatives + low or no differences in operating costs, then the alternative giving the least capitalized cost would be the desirable economic choice.

+Capitalized costs

K = capitalized costV = initial equipment costVreplace = equipment replacement costn = estimate useful life, yearsi = interest rate

Capitalized cost factor

+Capitalized costsinclusion of operating costs

Operating costs can be included by adding an additional capitalized cost to cover operating costs during the project life

Each annual operating cost is considered as equivalent to a piece of equipment that lasts one year

Procedure: Find present (discounted) value of each year’s costs by the

prior method (discount factor is applied, d=1/(1+i)n) S Pvi is capitalized by multiplying by the capitalization factor

for the initial investment. The total capitalized costs is the sum of this value + operating costs + working capital.

+5. Payout period

Minimum length of time necessary to recover the original capital investment via cash flow to the project, based on total income minus all costs except depreciation

Interest effects are neglected

+

Comparison of alternative investments:5 profitability methods3 investments with:• different TCI, WC• different service lives• different cash flow and

expenses

1. Rate of return on investment

2. Discounted cash flow on full-life performance

3. Net present worth

4. Capitalized costs

5. Payout period

+3 investments

+1. Rate of return on initial investment

+Investment 1

+Investment 2

+Investment 3

+Summary table

Which do we choose? All have similar average rates of return? All are above the ‘minimum’ 15% return.

+Average RoR, incremental investment We can also compare these investments to each other

as follows: The project investment follows the order, 1,2, and 3 Pairwise, find the ratio of the profit difference to the initial

investment difference The investment with the highest value is preferred

+Differential rate of return

Project 2 is better than project 1;Project 2 is better than project 3 (less efficient use of capital for 3)

+Minimum payout periodNo interest charge

+Minimum payout period no interest charge

Investment 1 has the lowest payout period, and is recommended

+Discounted cash flow RoR

+DCF RoR

DCD RoR’s are similar: 20.7%, 22.8%, and 21.4% This method works well when the service lives of the

projects are the same; with different service lives, the net present worth method is better

Approximate method, narrow range of service lives Pair-wise comparison: base time is the longer service life

+Net present worth

+Net present worth

Investment 1 = $17,400 Investment 2 = $45,700 Investment 3 = $51,200

Project 3 is preferred

+Capitalized costs

+Capitalized cost method

Determine the capitalized cost for the original investment such that we could achieve an indefinite number of replacements + the capitalized present value of the cash expenses + working capital

Method Get the present value of the annual cash expenses Determine the capitalized present value These are computed at the target interest rate, 15%

+

ANALYSIS: 5 METHODS

1. Rate of return on investment: project 2 preferred

2. Discounted cash flow on full-life: project 3 preferred

3. Net present worth: project 3 preferred

4. Capitalized costs: project 3 preferred

5. Payout period: project 1 preferred

+CRITIQUE

RoR, initial investment: does not include the time value of money

Minimum payout period: does not include the time value of money

DCF RoR, net present worth, capitalized costs: All include the time value of money While project 3 is preferred over project 2, the choice is narrow A more accurate evaluation is needed

Go from straight line to a more realistic depreciation method Go from end-of-year costs to continuous interest compounding Variations in prestart-up costs between alternatives may be a

factor to consider

+

Some heuristics for profitability

Select smallest investment for needed service that gives the required return for the company

Challenge the accuracy of your estimates: service life for example

Consider process risk, particularly if you select a project with a larger-than-necessary investment

Turbulent times = usually invest minimum capital

Perceived value: green processes can have significant marketing advantages

Other factors: gut feel, beat your competition, expand an existing plant,…

+

Rate of return

GOOD LUCK!!!