che 425 engineering economics and design...

Prof. Adnan AlamerChemical Engineering Dept., KFUPM.

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CHE 425 CHE 425

Engineering Economics and Engineering Economics and Design PrinciplesDesign Principles


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CHAPTER 8CHAPTER 8

Profitability AnalysisProfitability Analysis


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A Typical Cumulative Cash Flow Diagram for A Typical Cumulative Cash Flow Diagram for Evaluation of a New ProjectEvaluation of a New Project


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A Typical Cumulative Cash Flow Diagram for A Typical Cumulative Cash Flow Diagram for Evaluation of a New ProjectEvaluation of a New Project (cont.)(cont.)

Project LifeProject 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 EvaluationProfitability Criteria for Project Evaluation

3 Bases for Evaluation of Profitability

Time

Cash

Interest Rate i


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Profitability CriteriaProfitability Criteria

Non-discounted method do not take account of time-value of money.

Not recommended for evaluating new, large projects

ProfitabilityProfitabilityCriteriaCriteria

DiscountedDiscounted NonNon--DiscountedDiscounted


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NonNon--Discounted Profitability CriteriaDiscounted 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, FCIL, for the project


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NonNon--Discounted Profitability Criteria (cont.)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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Interest Rate Criterion.

Rate of Return on Investment (ROROI)

The higher the value of ROROI, the better.


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Discounted Profitability CriteriaDiscounted Profitability Criteria

Time CriterionTime 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, FCIL, required for the project with all cash-flows discounted back totime zero.


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Cash CriterionCash Criterion.

Net Present Value (NPV)

NPV = Cumulative discounted cash position at the endof the project.

Present Value Ratio (PVR)

PVR > 1 implies that the project is potentially profitable.


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Interest Rate Criterion.Interest Rate Criterion.

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 8.3 Example 8.3


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Example 8.3 (cont.) Example 8.3 (cont.)


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Comparing Several Large ProjectsComparing Several Large Projects--Incremental Economic AnalysisIncremental 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 8.5Example 8.5


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Comparing Investment AlternativesComparing Investment Alternatives


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Algorithm for Incremental Investment AnalysisAlgorithm for Incremental Investment Analysis


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The Concept of RiskThe Concept of Risk

Option 1Option 1 Option 2Option 2

A A newnew 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 secondsecond 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 RiskThe Concept of Risk (cont.)(cont.)

Items that Favor Option 1Items that Favor Option 1 Items that Favor Option 2Items that Favor Option 2

High return on the High return on the investmentinvestment

Well established marketWell established market

Opens new product Opens new product possibilitiespossibilities

WellWell--known manufacturing known manufacturing costscosts

Transportation costs will be Transportation costs will be lessless

Matured technologyMatured technology


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The Concept of RiskThe 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 riskrisk..

VPVP’’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 AlternativesEvaluation of Equipment Alternatives

Factors to ConsiderFactors 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 LivesEquipment 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 negativeleast negative NPV value NPV value will be the best choice.will be the best choice.


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Equipment with Different Expected Operating LivesEquipment with Different Expected Operating Lives

Three Methods.Three Methods.Capitalized Capital Cost MethodCapitalized Capital Cost MethodEquivalent Annual Operating Cost (EAOC) MethodEquivalent Annual Operating Cost (EAOC) MethodCommon Denominator MethodCommon 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 MethodCapitalized Cost Method


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Equivalent Annual Operating Cost (EAOC) MethodEquivalent Annual Operating Cost (EAOC) Method


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Equivalent Annual Operating Cost (EAOC) MethodEquivalent Annual Operating Cost (EAOC) Method


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Common Denominator MethodCommon Denominator Method


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CHE 425 CHE 425

Engineering Economics and Engineering Economics and Design PrinciplesDesign Principles

Prof. Adnan AlProf. Adnan Al--AmerAmer


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Incremental Analysis for Retrofitting FacilitiesIncremental Analysis for Retrofitting Facilities

RetrofittingRetrofitting: 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)

Combinationof Both


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Incremental Analysis for Retrofitting FacilitiesIncremental Analysis for Retrofitting Facilities

Retrofitting ProcedureRetrofitting ProcedureIdentify available alternatives AIdentify available alternatives A11, A, A22…… AAn.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.

NOTENOTE: The : The ““do nothingdo nothing”” option, Aoption, A11, has no , has no capital cost and no savings.capital cost and no savings.


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Profitability CriteriaProfitability Criteria

For small retrofit projects, non-discounted method may be sufficient.

For larger retrofit projects, discounted profitability criteria should be used.

ProfitabilityProfitabilityCriteriaCriteria

DiscountedDiscounted NonNon--DiscountedDiscounted


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NonNon--Discounted Methods for Incremental AnalysisDiscounted Methods for Incremental Analysis


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ExampleExample 8.10 8.10


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ExampleExample 8.10 (cont.)8.10 (cont.)


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ExampleExample 8.128.12


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Discounted Methods for Incremental AnalysisDiscounted Methods for Incremental Analysis


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Discounted Methods for Incremental AnalysisDiscounted Methods for Incremental Analysis


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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 illustratedTechniques to quantify risk are illustrated

See Table 8.1.See Table 8.1.


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Forecasting Uncertainty in Chemical ProcessesForecasting Uncertainty in Chemical Processes


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Forecasting Uncertainty in Chemical Processes (cont.)Forecasting Uncertainty in Chemical Processes (cont.)


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Utilities - Refrigerated Water


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Quantifying Risk

Methods ofMethods ofQuantifying RiskQuantifying Risk

Scenario Scenario AnalysisAnalysis

Sensitivity Sensitivity AnalysisAnalysis

MonteMonte--CarloCarloMethodMethod


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Scenario AnalysisScenario Analysis


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Scenario AnalysisScenario Analysis


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Sensitivity AnalysisSensitivity Analysis


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MonteMonte--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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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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che 425 engineering economics and design...

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