In this post, I want to share how to do projects economic evaluation. In my experience, doing project economic evaluation is not always daily activities of process engineers. However, when I involved in feasibility study project, we need to do projects economic evaluation. Also in my own experiences, as process engineers focused on creating several alternatives of process configuration, our team from industrial engineers did the projects economic evaluation. However, it will not hurt to understand general idea of project economic evaluations 😊
Since investing in chemical plants is done to make money, a system for evaluating project economic is required. For small projects, the decision-making process can typically be simplified by comparing the capital and operating expenses of various processing methods and pieces of equipment. When choosing between large, complicated projects, especially when the projects differ significantly in scope, time frame, and product type, more advanced evaluation procedures and economic factors are required. In this part, some of the more popular methods of economic analysis and the standards by which economic performance is evaluated are described.
In a large design organization, the evaluation would be carried out by a specialist group. Making major investment decisions in the face of the uncertainties that will undoubtedly exist regarding plant performance, costs, the market, government policy, and the state of the global economy is a difficult and complex task.
Project economics can be evaluated using several factors, such as:
- Cash flow and cash-flow diagram
- Tax and depreciation
- Discounted cash-flow
- Rate of Return (ROR)
- Discounted Cash-Flow Rate of Return (DCFRR)
- Pay-back Period (PBP)
Cash Flow and Cash-Flow Diagram
Any commercial organization depends on a constant cash flow. The financial resources required to fund R&D, plant design and construction, and plant operation are the inputs. The outputs are products for sale, and monetary returns from revenues are recycled back into the organization. The difference between earnings and expenses is referred to as “net cash flow” at any given period.
The projected cumulative net cash flow during a project’s lifetime is depicted in figure below. The cash flows are calculated using the most accurate projections of the project investment, operational expenses, sales volume, and sales price. An accurate representation of the resources needed for a project and the timing of the revenue is provided by a cash-flow diagram. These distinct regions of the figure can be identified:
A – B The investment required to design the plant
B – C The heavy flow of capital to build the plant, and provide funds for start-up
C – D The cash-flow curve turns up at C, as the process comes on stream and income is generated from sales. The net cash flow is now positive, but the cumulative amount remains negative until the investment is paid off, at point D.
The break-even point is designated as Point D, and the period required to get there is referred to as the pay-back period. The percentage of a plant’s capacity at which revenue and production costs are equal is referred to as the “break-even point” in a different context.
D – E In this region, the cumulative cash flow is positive. The project is earning a return on the investment.
E – F Due to rising operational costs, declining sales volume and prices, and a change in the slope of the curve, the rate of cash flow may tend to decline toward the end of the project life.
The point F gives the final cumulative net cash flow at the end of the project life.
Tax and Depreciation
Tax rates vary and are influenced by government policy. Depreciation rates are influenced by both governmental regulations and a company’s specific accounting procedures. When reviewing projects, especially those that are in different nations, it is imperative to take government policy into consideration at some point.
Discounted Cash Flow (Time Value of Money)
As soon as it becomes available, the money earned in any year can be put to work (reinvested) and begin to generate a return. Therefore, money made early in the project is worth more than money made later. The “time value of money” can be considered by modifying the well-known compound interest formula. At the beginning of the project, the net cash flow for each year is discounted at a predetermined compound interest rate to arrive at its “present worth.”
where r is the discount rate (interest rate) percent/100
t = life of project, years
The discount rate is chosen to reflect the earning power of money. If the money were invested, it would be nearly equivalent to the current interest rate.
Because of the time value of money and the pattern of profits across the project’s lifespan, the total NPW will be less than the total NFW.
Rate of Return
Cash-flow figures do not show how well the capital invested is being used, which can be similar between two projects with quite different capital costs. The effectiveness of the capital invested must be evaluated in some way. The ratio of annual profit to investment, or rate of return (ROR), is a straightforward indicator of how well an investment has performed. Although the ROR is a fundamentally straightforward idea, the fact that the annual profit (net cash flow) would fluctuate throughout the course of the project makes it more difficult to calculate. The most straightforward approach is to base the ROR on the average income across the project’s lifespan and the initial investment.
Based on figure, then:
- Cumulative income = F – C
- Investment = C
- Life of project = G
The rate of return is frequently calculated for the project’s best year, or the year with the highest net cash flow. It may also be based on the investment’s book value, which considers depreciation. The time value of money is not considered in simple rate of return estimates.
Discounted Cash-Flow Rate of Return (DCFRR)
Discounted cash-flow analysis, used to calculate the present worth of future earnings, is sensitive to the interest rate assumed.
r’ = the discounted cash-flow rate of return (percent/100)
NFW = the future worth of the net cash flow in year n
t = the life of the project, years
Finding an interest rate at which the total net present worth at the end of the project is zero can be done by calculating the Net Present Worth (NPW) for different interest rates. The “discounted cash-flow rate of return” (DCFRR) is a measurement of the highest rate that the project might incur while still breaking even by the end of the project’s life.
Trial-and-error calculations are used to determine the value of r’. Paying off a mortgage is similar to finding the discount rate that simply pays off the project investment throughout the course of the project. The higher DCFRR that a project can afford to pay depends on how profitable it is.
Independent of the quantity of capital utilized, the lifespan of the plant, or the actual interest rates in effect at any given time, DCFRR offers a useful method for assessing the performance of capital for various projects.
Internal rate of return and interest rate of return are other names for DCFRR.
The pay-back period is the amount of time needed once the project has begun to generate enough money to cover the initial expenditure. Pay-back time is a helpful metric for assessing initiatives with a limited lifespan or when funding is only available temporarily.
It is frequently used to evaluate minor upgrade efforts on running equipment. The typical pay-back period for such initiatives is between two and five years.
The performance of the project after the pay-back term is not taken into consideration when using pay-back time as a measure of investment performance.
The investing criteria covered above are listed in table below, along with the primary benefit and drawback of each.
There is no one single factor that is the best to use to evaluate an investment opportunity. Using the strategies covered in this section, a corporation will establish its own ways of economic evaluation and will have a “target” number of what to anticipate for the criterion utilized based on their experience with prior successful, as well as unsuccessful, initiatives.
A figure of 20 to 30% for the return on investment (ROR) can be used as a rough guide for judging small projects, and when decisions must be made on whether to install additional equipment to reduce operating costs. This is equivalent to saying that for a project to be viable the investment needed should not be greater than about 4 to 5 times the annual savings achieved.
Sinnot, R.K, “Chemical Engineering Design Volume 6”, Elsevier Butterworth-Heinemann, 2005.