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Process Engineering Economics

MVJ19CH742
Module - III

Prepared By: Dr. Augusta Pachathu

Assistant Professor
Department of Chemical Engineering

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 Depreciation
▪ An analysis of costs and profits for any business operation requires recognition of the fact that physical assets
decrease in value with age
▪ This decrease in value may be due to physical deterioration, technological advances, economic changes, or
other factors which ultimately will cause retirement of the property
▪ The reduction in value due to any of these causes is a measure of the depreciation
▪ Means of distributing the original expense for a physical asset over the period during which the asset is in use.
▪ According to the viewpoint of the design engineer,
Depreciation = Original value of a property- value of the same property at the end of the depreciation period
▪ The difference between the estimated cost of new equivalent property and the appraised value of the present
asset is known as the appraised depreciation.

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 Types of Depreciation
▪ The causes of depreciation may be physical or functional.
▪ Depreciation, has a significant effect on corporate cash flow
▪ Physical depreciation is the term given to the measure of the decrease in value due to changes in the
physical aspects of the property
✓ Wear and tear, corrosion, accidents, and deterioration due to age or the elements are all causes of
physical depreciation.
▪ The serviceability of the property is reduced because of physical changes.
▪ Depreciation due to all other causes is known as functional depreciation
▪ Common type of functional depreciation is obsolescence.
✓ Caused by technological advances or developments which make an existing property obsolete

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 Other causes of functional depreciation could be
a. decrease in the demand for the product involved because of saturation of the market
b. shift of population center
c. changes in requirements of public authority
d. inadequacy or insufficient capacity for the service required
e. termination of the need for the type of service rendered
f. abandonment of the enterprise

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 Current Value
✓ Current value of an asset is the value of the asset in its condition at the time of valuation
✓ Book value is the difference between the original cost of a property and all the depreciation charged up
to a time
✓ The price that could be obtained for an asset if were sold on the open market is designated the market
value
Salvage Value
✓ salvage value is the net amount of money obtainable from the sale of used property over and above any
charges involved in removal and sale.
✓ The term salvage value implies that the property can be of further service.
✓ If the property is not useful, it can often be sold for material recovery.
✓ Income obtainable from this type of disposal is known as scrap value

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 Recovery Period
✓ The period over which the use of a property is economically feasible is known as the service life of
the property
✓ The period over which depreciation is charged is the recovery period
Modified Accelerated Cost Recovery System – (MACRS)

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 Methods for Calculating Depreciation
▪ Straight-Line Method
▪ Declining balance method
▪ Sum of the years digits method
▪ Modified Accelerated Cost Recovery System (MACRS)
Straight Line Method
✓ This method may be elected under the tax code as an alternative depreciation system
✓ It depreciates property less rapidly than does MACRS, and therefore, it would only be chosen for use
in tax computations under special circumstances.
✓ Example, a new company might wish to conserve depreciation deductions for use in the future when
its incremental tax rate is expected to be higher.

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 Problem 3.1
A company has purchased an equipment at a cost of Rs 1,00,000 with an estimated life of 8 years.
The estimated salvage value of the equipment at the end of its lifetime is 20000. Determine the
depreciation charge and book value at the end of various years using the straight-line method of
depreciation

𝑉 − 𝑉𝑠
𝑑=
𝑁
𝑚

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = 𝑉 − ෍ 𝑑𝑖
𝑖=1

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 End of the Year Depreciation charges Book value
0 1000000
1 10000 90000
2 20000 80000
3 30000 70000
4 40000 60000
5 50000 50000
6 60000 40000
7 70000 30000
8 80000 20000

Life of
Refinery – 25 Yrs; Reactor- 20 Yrs; Storage tank – 20 Yrs

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 Declining balance method
✓ Also known as reducing balance depreciation – loss in value of an asset over a period as a constant
fraction of the assets current book value
✓ This is also know as fixed percentage or uniform percentage method
✓ This method allows higher charges in the early year of a project
✓ Helps to improve project economics by higher cash flow in the early years
✓ Limitation
o unlike straight line method, this method does not automatically take account of the salvage value of
the asset
o Book value at the end of the life of the asset may not be exactly equal to the salvage value of the
asset

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 In declining balance method, the annual depreciation charge is a fixed fraction (𝐹𝑑 ) of the book value
𝑑1 = 𝑉𝐹𝑑
𝐵1 = 𝑉 − 𝑑1 = 𝑉 − 𝑉𝐹𝑑 = 𝑉(1 − 𝐹𝑑 )

𝑑2 = 𝐵1 𝐹𝑑 = 𝑉(1 − 𝐹𝑑 )𝐹𝑑
𝐵2 = 𝐵1 − 𝑑2 = 𝑉 1 − 𝐹𝑑 − 𝑉 1 − 𝐹𝑑 𝐹𝑑 = 𝑉(1 − 𝐹𝑑 ) 1 − 𝐹𝑑 = 𝑉(1 − 𝐹𝑑 )2
d- annual depreciation, INR/Year; V- Original investment in INR; B- Book value at the given year
In general
𝑑𝑚 = 𝑉(1 − 𝐹𝑑 )𝑚−1 𝐹𝑑
𝐵𝑚 = 𝑉(1 − 𝐹𝑑 )𝑚
𝐹𝑑 - must be equal to or less than 2/N where N is the depreciation life in Years

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 Problem 3.2
A company has purchased an equipment at a cost of Rs.1,00,000 with an estimated life of 8 years. The
estimated salvage life of the equipment at the end of its life time is Rs 20,000. Demonstrate the calculation of
the declining balance method. Take 𝐹𝑑 = 20%= 0.2
End of Year Depreciation charged Book value
0 1,00,000
1 20000 80000
2 16000 64000
3 12800 51200
4 10240 40960
5 8192 32768
6 6553.60 26214.40
7 5242.88 20971.52
8 4194.30 16777.22

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 Problem 3.3
A pump has an installed cost of Rs.40000 and a 10 years estimated life. The salvage value of pump is zero at
the end of 10 years. What is the pump value (Rupees) after depreciation by the double declining balance
method, at the end of 6 years?
Gate 2007
Problem 3.4
A process plant has a life of 7 years and its salvage value is 30%. For what minimum fixed percentage factor
will the depreciation amount for the second year, calculated by declining balance method be equal to that
calculated by the straight value depreciation method?
Gate 2011

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 Sum of Year Digits Method (SOYD)
✓ Another accelerated cost recovery method for calculating depreciation that allows for more
depreciation in the earlier year during the life of an asset
✓ Rate of depreciation charge for the first year is assumed as the highest and then it decreases
✓ The annual depreciation tare is computed by adding up all the integers from 1 to N and then fraction
of that each year
✓ If the plant depreciation life is N=5
SOYD = 1+2+3+4+5 = 15
✓ The rate of depreciation for all the years
First year- 5/15; Second year - 4/15; Third year - 3/15; Fourth year - 2/15 and fifth year -1/15

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 𝑌𝑒𝑎𝑟𝑠 𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔
𝑆𝑂𝑌𝐷 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑉 − 𝑉𝑠
𝑆𝑂𝑌𝐷
Depreciation in mth Year
𝑁−𝑚+1 𝑁−𝑚+1
𝑑𝑚 = 𝑉 − 𝑉𝑠 = 2 (𝑉 − 𝑉𝑆 )
𝑁 𝑁+1 𝑁 𝑁+1
2
Book value in mth Year
(𝑁 − 𝑚) (𝑁 − 𝑚 + 1)
𝐵 = 𝑉 − 𝑉𝑠 + 𝑉𝑠
𝑁 𝑁+1

✓ SOYD method assumes that the book value of the asset decrease at a decreasing rate
✓ Large amount are allowed to depreciate during the early life of property
✓ Allow the purchase price to decrease to zero at the end of the service life

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 Problem 3.5
A company has purchased an equipment at a cost of Rs 1,00,000 with an estimated life of 8 years. The
estimated salvage value of the equipment at the end of its lifetime is 20000. Demonstrate the calculation of the
Sum of Years Digits Method.
SOYD=N(N+1)/2
End of Year Depreciation Charged(Rs) Book value (Rs) Year Rate
0 100000 1 8/36
1 17777.77 82222.23 2 7/36
2 15555.55 66666.68 3 6/36
3 13333.33 53333.35 4 5/36
4 11111.11 42222.24 5 4/36
5 8888.88 33333.36 6 3/36
6 6666.66 26666.70 7 2/36
7 4444.44 22222.26 8 1/36
8 2222.22 20000.04
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 Modified Accelerated Cost Recovery System
✓ MACRS is the depreciation method used for most income tax purposes and for most economic
evaluations.
✓ This method was established by U.S. Tax reformed Act of 1986
✓ Combination of declining-balance method and the straight line method
✓ The value of the asset is completely depreciated even though there may be true value
✓ The recovery rate are based on starting out with a declining balance method and switching to straight
line method when it offers a faster write-off

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 Other Method Sinking fund method
✓ Assume that a uniform series of payment are deposit into an imaginary sinking fund at a given interest rate i.
✓ The amount of the annual deposit is calculated so that the accumulated sum at the end of the asset life, and at
the stated interest rate will equal the value of the asset depreciated (V-Vs)

𝑖
𝐴 = 𝑉 − 𝑉𝑠
(1 + 𝑖)2 −1

✓ The depreciation value at any year m is calculated as

𝑑𝑚 = 𝐴(1 − 𝑖)𝑚−1 , 𝑚 = 1,2, … . 𝑁

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 Profitability and Analysis
▪ Profitability is the measure of the amount of profit that can be obtained from a given situation
▪ Modern process design allows the development of optimal design solution both technically and economically
▪ Good project should ensure the rapid return of investment and good profitability over the expected lifetime
▪ Modern design- conceptual design itself incorporate the basic element of economic analysis
▪ During flow sheet synthesis when one consider alternative route , economic potential is used to eliminate
unfeasible route in early stage

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 Profitability standard
Profitability standard is a quantitative measure of profit with respect to the investment required to generate that
profit
▪ The cost of capital (basic)
Amount paid for the use of capital from such sources as stocks bonds and loans
▪ Minimum acceptable rate of return (commonly used)
Reasonable rate of return established for the evaluation and selection of alternative

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 METHODS FOR CALCULATING PROFITABILITY

Method- Do not
Method- Consider Annualized cost Variant of Net Present
consider time value of
time value of money method Worth
money
• Rate of return on • The discount cash • ACM • VNPW
investment (ROI) flowrate of return
• Payback Period (DCFROR)
(PBP) • Net present
• Net return worth/value
(NPW/NPV)

Purpose- Preliminary Purpose- More detail Purpose - Preliminary

quick analysis analysis quick analysis

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 Rate of return on investment (ROI)
▪ Not important what depreciation schedule is used in the evaluation
▪ Straight is often used for convenience

𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑁𝑝

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑂𝐼 = =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑇𝐶𝐼
Depending on corporate policy or decision maker
✓ Gross profit may be used in the place of Net profit
✓ Fixed capital investment may be used in the place of TCI
✓ Total investment may change if additional investment are made during project operation, average of ROI
over entire project life can be consider
✓ TCI for particular year is small in such case denominator can be replaced with initial TCI

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 Turn over ratio
𝐺𝑟𝑜𝑠𝑠 𝑆𝑎𝑙𝑒𝑠
𝑇𝑢𝑟𝑛 𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 =
𝐹𝑖𝑥𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
✓ The ratio of Turn over ratio is called capital ratio
✓ For Chemical industries the turn over ratio is one and goes up to 5 for very efficient process
✓ Reducing the fixed capital can increase the turnover ratio

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 Payback Period (PBP)
Payback Period or Payout period is the length of time necessary for the total returnto equal the capital investment

𝑇𝐶𝐼
𝑃𝑎𝑦 𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝐿𝑜𝑤

𝐹𝐶𝐼 𝑉 + 𝐴𝑥
𝑃𝑎𝑦 𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝐿𝑜𝑤 𝐴𝑗
V= Manufacturing FCI
𝐴𝑥 = Non manufacturing FCI
𝐴𝑗 =Annual Cash flow
✓ PBP represent the time required for the cash flow to equal the original FCI
✓ Usually working capital is 15% of TCI
𝑉 + 𝐴𝑥 = 0.85(TCI)

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 ✓ PBP can be identified on a cash flow diagram as the interval from the plant first production to the break
even point
✓ For large plant like petrochemical and refineries the PBP should be between 7 and 1 years
✓ The measure is smaller for chemical and biotechnology (2-3 years)
Problem:
A proposed chemical plant will require a fixed capital investment of INR 10 crore. It is estimated that the
working capital will be 25% of the total investment. Annual depreciation costs are estimated to be 10% of
the FCI. If the annual profit will be 3 crore, determine the percent return on the total investment and the
payout period.
TI=FCI+Working capital

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 Net Return
Net return is the amount of cash flow over and above that required to meet the minimum acceptable rate of
return and recover the total capital investment
Net Return = Total cash flow- TCI- Total amount earned at MARR

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 Net present worth
✓ Net Present worth/value analysis evaluate project by converting all future cash flow into their present equivalent
✓ NPV= Total of the present worth of all cash flow- present worth of all capital investment

𝐶𝐹𝑛
𝐶𝐹𝑛,0 =
(1 + 𝑖)𝑛
✓ By NPV analysis the cash flow earned in different year n is brough to present value 𝐶𝐹𝑛,0 by using compound interest
formula

𝐶𝐹𝑛
𝑁𝑃𝑉 = ෍ − 𝑇𝐶𝐼
(1 + 𝑖)𝑛

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 Discounted cash flow rate of return
✓ It is a measure of the maximum interest rate a project could afford just by paying the TCI at the end of its
life.
✓ DCFROR can be determine as the interest rate for which the NPV at the end of the project lifetime
becomes zero

𝐶𝐹𝑛
𝑁𝑃𝑉 = ෍ − 𝑇𝐶𝐼 = 0
(1 + 𝑖)𝑛
✓ Discount rate appear exponent impossible to solve for the discount rate analytically but can be determine
numerically or graphically (iteration solution)
✓ Higher DCFROR mean profitable project

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 Annualized cost method

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 Variant of Net Present Worth

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