In this example, I want to show you a simple example on how to do projects economic evaluation. As mentioned previously, there are several parameters that can be used to do projects economic evaluation, such as:
- Net present worth
- Rate of return (ROR)
- Discounted cash-flow rate of return
- Pay-back time
In this example we will use ROR and pay-back time.
A plant is producing 12,000 ton per year product. The overall yield is 70%, on a mass basis (kg of product per kg raw material). The raw material cost $12 per ton, and the product sells for $37 per ton. A process modification has been devised that will increase the yield to 75%. The additional investment required is $35,000, and the additional operating costs are negligible.
Is the modification worth making?
There are two ways of looking at the earnings to be gained from the modification:
- If the additional production given by the yield increase can be sold at the current price, the earnings on each additional ton of production will equal the sales price less the raw material cost.
- If the additional production cannot be readily sold, the modification results in a reduction in raw material requirements, rather than increased sales, and the earnings (savings) are from the reduction in annual raw material costs.
The second way gives the lowest figures and is the safest basis for making the evaluation. At 12,000 ton per year production:
- Raw material requirements 70% yield = 12,000 / 0.7 = 17,143 ton raw material per year
- Raw material requirements 75% yield = 12,000 / 0.75 = 16,000 ton raw material per year
- Raw material saving = 17,143 – 16,000 = 1143 ton per year
- Cost saving at $12 per ton raw material = 1143 × $12 = $ 13,174 per year
- Rate of Return (ROR) = $13,174 / $35,000 = 39.18%
- Pay-back time (as the annual savings are constant, the pay-back time will be the reciprocal of the ROR) = 100/39.18 = 2.6 years
On this figures, the modification would be considered worthwhile.