UCL Department of Chemical Engineering

Economics

Economic evaluation of projects

Part of CENG0016 Economics
L4_V5

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Economic evaluation of projects - content

• Non-discounted methods
• Depreciation
• Time value of money
• Discounted methods
• Sensitivity analysis

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Non discounted methods – simple payback time

• Not the same as payback time on cash flow diagram
• Ratio of investment verses annual cash flow
• Can take various forms (e.g. after tax) depending on definitions of investment and cash flow
• Limitations of method for application to chemical plants
• Assumes all investment in year 0 and that revenues begin immediately
• Investment spread over few years and revenues begin once plant operational
• Usually neglects depreciation, taxes and time-value of money
𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Definition in simplest form: 𝑠𝑖𝑚𝑝𝑙𝑒 𝑝𝑎𝑦𝑏𝑎𝑐𝑘 𝑡𝑖𝑚𝑒 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 3

 UCL Department of Chemical Engineering

Non discounted method – Return on Investment (ROI)

• Evaluation of project in terms of annual or 𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
cumulative profit against total or initial 𝑅𝑂𝐼 = × 100%
𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
investment
𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
• Limitations 𝑅𝑂𝐼 = × 100%
𝑝𝑙𝑎𝑛𝑡 𝑙𝑖𝑓𝑒 × 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
‒ Pretax ROI, based on cash flow not profit,
does not include depreciation 𝑝𝑟𝑒𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝑝𝑟𝑒𝑡𝑎𝑥 𝑅𝑂𝐼 = × 100%
‒ After-tax ROI needs to include depreciation 𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
→ if include complexity of depreciation
then better to compute more meaningful For more guidance on simple payback and ROI see
economic criteria like net present value examples 9.2 and 9.3 in Towler & Sinnott (2012)

Source: Towler & Sinnott (2012) © UCL Chemical Engineering

UCL Department of Chemical Engineering

Depreciation
• Depreciation is a type of tax allowance
• It allows fixed capital investment to be deducted from taxable
income over a number of years
• Often thought of as allowance for ‘wear and tear’
• Once ‘book value’ of an asset is fully recovered through
depreciation, then depreciation can no longer be charged
• No money is physically transferred for depreciation, so depreciation
is added back to net income after taxes to give total cash flow

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Straight-line depreciation
• Simplest method of depreciation
• Depreciation charge is same every year
• Not as favourable as accelerated methods of depreciation
𝐶𝑑 𝑚𝐶𝑑 Cd = depreciable value, depreciated over n years
𝐷𝑖 = 𝐵𝑚 = 𝐶 − Di = annual depreciation charge in year i
𝑛 𝑛
Bm = book value of asset after m years of depreciation
C = Fixed capital investment value to be depreciated

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 6

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Accelerated method – Declining-balance depreciation

• Higher depreciation charges in the early years
• Improves project economics by giving higher cash flows in the early years of a project
• Annual depreciation is a fixed fraction of the book value rather than a constant value

𝐷𝑚 = 𝐶 1 − 𝐹𝑑 𝑚−1 𝐹 Fd = fraction of book value depreciated each year

𝑑
Dm = annual depreciation charge in year m
𝑚
Bm = book value of asset after m years of depreciation
𝐵𝑚 = 𝐶 1 − 𝐹𝑑 C = Fixed capital investment value to be depreciated

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 7

 UCL Department of Chemical Engineering

Modified Accelerated Cost Recovery System (MACRS)

• Combination of straight-line and declining-balance methods
• Declining-balance used until depreciation charge is less than it would be under straight-
line method → MACRS then switches and charges amount as for straight-line method
• Different recovery periods assigned to different
kinds of assets by IRS
• MACRS assumes property acquired mid-year
→ half of full year depreciation assigned in the
first and last year affecting schedule of
depreciation charges as in the table

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 8

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Depreciation - Example 9.1 Towler & Sinnott (2012)

• Fixed capital investment Cash flow after
$100 million Gross Taxable tax &
Profit ($ Depreciation income ($ Tax paid depreciation
• Annual Gross Profit $50 Year millions) ($millions) millions) ($millions) ($millions)
million, tax rate 35% 0 0 0 0 0 -100
1 50 10 40 14 36
• Calculate depreciation 2 50 10 40 14 36
charge, taxes paid and 3 50 10 40 14 36
after-tax cash flows for 4 50 10 40 14 36
first 10 years using 5 50 10 40 14 36
straight-line 6 50 10 40 14 36
depreciation 7 50 10 40 14 36
8 50 10 40 14 36
9 50 10 40 14 36
10 50 10 40 14 36

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 9

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Depreciation – Example 9.1 Towler & Sinnott (2012) cont.

• Fixed capital investment Cash flow after
$100 mil, Annual Gross Gross Taxable tax &
Profit $50 mil Profit ($ Depreciation income ($ Tax paid depreciation
• Calculate depreciation Year millions) ($millions) millions) ($millions) ($millions)
0 0 0 0 0 -100
charge, taxes paid and
after-tax cash flows for 1 50 20 30 0 50
first 10 years using 2 50 32 18 10.50 39.50
MACRS depreciation 3 50 19.2 30.8 6.30 43.70
with 5 year recovery 4 50 11.52 38.48 10.78 39.22
period 5 50 11.52 38.48 13.47 36.53
6 50 5.76 44.24 13.47 36.53
7 50 0 50 15.48 34.52
Values from Table 9.1 8 50 0 50 17.50 32.50
(slide 8) 9 50 0 50 17.50 32.50
10 50 0 50 17.50 32.50

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 10

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Time value of money

• Payback time & ROI do not capture cash flow 𝑓𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑛
time dependence 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑠𝑢𝑚 =
1+𝑖 𝑛
• Timing of cash flow is very important to
investors i = interest rate or discount rate, often set
as cost of capital
1. Not all capital must be financed
immediately
2. Capital that is repaid sooner can be 𝑖𝑐 = 𝐷𝑅 × 𝑖𝑑 + 1 − 𝐷𝑅 × 𝑖𝑒
reinvested elsewhere ic = cost of capital, id = interest rate due on debt,
• Time Value of Money → Value of money ie = cost of equity, DR = debt ratio
earned in early years of the project is
greater than in later years since it can be
reinvested

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Source: Towler & Sinnott (2012)
UCL Department of Chemical Engineering

Discounted methods – Net Present Value (NPV)

• Net Present Value (NPV) is the sum of all the present values of future cash flows
• Advantages
- Allows for time value of money
- Allows for annual variations in expenses and revenues
- Suitable when considering after-tax income using accelerated depreciation methods
• NPV is less than the total future worth of a project since discounting future cash flows
𝑛=𝑡 CFn = cash flow in year n
𝐶𝐹𝑛
𝑁𝑃𝑉 = ෍ 𝑛
t = project life in years
1+𝑖 i = interest rate (discount rate or cost of capital)
𝑛=1

Source: Towler & Sinnott (2012) © UCL Chemical Engineering 12

UCL Department of Chemical Engineering

Discounted cash flow rate of return (DCFROR)

• Discounted cash flow rate of return (DCFROR) is the interest rate at which NPV = 0
• Indicates the maximum interest rate a project could pay and still break even at the end of
the project
• Advantages
- Independent of project size, amount of capital used, life of plant, or actual interest rates
- Good metric for comparing capital for different projects → highest DCFROR indicates best project
- Investment criterion → expect DCFROR > cost of capital
• DCFROR is also known as internal rate of return (IRR)

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NPV & DCFROR – Example 9.4 Towler & Sinnott (2012)

Continue Example Cash flow Present
9.1 on slide 10, Gross Depre- Taxable after tax & value cash
Profit ciation income Tax paid depreciation Discount flow
estimate NPV at 12% Year ($millions) ($millions) ($millions) ($millions) ($millions) factor ($millions)
interest & DCFROR 0 0 0 0 0 -100 1 -100
1 1 50 20 30 0 50 0.89 44.64
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 = 𝑛 2 50 32 18 10.50 39.50 0.80 31.49
1+𝑖
3 50 19.2 30.8 6.30 43.70 0.71 31.10
𝐶𝐹𝑛 4 50 11.52 38.48 10.78 39.22 0.64 24.93
𝑃𝑉 = 𝑛 5 50 11.52 38.48 13.47 36.53 0.57 20.73
1+𝑖
6 50 5.76 44.24 13.47 36.53 0.51 18.51
Goal seek to find i if 7 50 0 50 15.48 34.52 0.45 15.61
NPV=0, DCFROR=40% 8 50 0 50 17.50 32.50 0.40 13.13
9 50 0 50 17.50 32.50 0.36 11.72
10 50 0 50 17.50 32.50 0.32 10.46
NPV 122.32
Source: Towler & Sinnott (2012) © UCL Chemical Engineering 14
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Further examples
• Recommend example 9.5 in Towler and Sinnott (2012) which considers
- Cash flow in each year of a project
- Simple payback period
- Net Present Value
- DCFROR

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Sensitivity analysis
• Economic analyses are based on estimates of investment needed and cash flows
• Sensitivity analyses can examine
• Impact of uncertainties in these estimates
• Robustness of key variables on economic health of the project
• First a ‘base case’ of most probable values is needed, then variations can be examined

wish to examine the economic robustness of

the project with respect to the price of
product(s) chosen

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Next …
• Continue to the next presentation
• Post any questions you may have on ‘Economics’ on the Appraise forum
• Prepare for Q&A, plan how your team will perform an economic evaluation of the
project
Thank you!

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