ECONOMICS FOR CHEMICAL ENGINEERS

ICH 2219
Authorization and Optimization
The essential idea of investing is to give up something valuable now for the expectation of
receiving something of greater value later. An investment may be thought of as an exchange of
resources now for an expected flow of benefits in the future. Business firms, other organizations,
and individuals all have opportunities to make such exchanges. A company may be able to use
funds to install equipment that will reduce labour costs in the future. These funds might
otherwise have been used on another project or returned to the shareholders or owners. An
individual may be able to study to become an engineer. Studying requires that time be given up
that could have been used to earn money or to travel. The benefit of study, though, is the
expectation of a good income from an interesting job in the future.

Not all investment opportunities should be taken. The company considering a labour saving
investment may find that the value of the savings is less than the cost of installing the equipment.
Not all investment opportunities can be taken.

Engineers play a major role in making decisions about investment opportunities. In many cases,
they are the ones who estimate the expected costs of and returns from an investment. They then
must decide whether the expected returns outweigh the costs to see if the opportunity is
potentially acceptable. They may also have to examine competing investment opportunities to
see which is best. Engineers frequently refer to investment opportunities as projects. Throughout
most of this text, the term project will be used to mean investment opportunity.

In this module, we deal with methods of evaluating and comparing projects, sometimes called
comparison methods. We start in this module with a scheme for classifying groups of projects.
This classification system permits the appropriate use of any of the comparison methods. We
then turn to a consideration of several widely used methods for evaluating opportunities. The
present worth method compares projects by looking at the present worth of all cash flows
associated with the projects. The annual worth method is similar, but converts all cash flows to
a uniform series—that is, an annuity. The payback period method estimates how long it takes
to “pay back” investments.

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We have made six assumptions about all the situations presented in this module

1. We have assumed that costs and benefits are always measurable in terms of money. In
reality, costs and benefits need not be measurable in terms of money. For example,
providing safe working conditions has many benefits, including improvement of worker
morale. However, it would be difficult to express the value of improved worker morale
objectively in dollars and cents. Such other benefits as the pleasure gained from
appreciating beautiful design may not be measurable quantitatively.

2. We have assumed that future cash flows are known with certainty. In reality, future cash
flows can only be estimated. Usually the further into the future we try to forecast, the less
certain our estimates become.

3. We have assumed that cash flows are unaffected by inflation or deflation. In reality, the
purchasing power of money typically declines over time.

4. Unless otherwise stated, we have assumed that sufficient funds are available to
implement all projects. In reality, cash constraints on investments may be very important,
especially for new enterprises with limited ability to raise capital.

5. We have assumed that taxes are not applicable. In reality, taxes are pervasive.

6. Unless otherwise stated, we shall assume that all investments have a cash outflow at the
start. These outflows are called first costs. We also assume that projects with first costs
have cash inflows after the first costs that are at least as great in total as the first costs. In
reality, some projects have cash inflows at the start, but involve a commitment of cash
outflows at a later period. For example, a consulting engineer may receive an advance
payment from a client—a cash inflow—to cover some of the costs of a project, but to
complete the project the engineer will have to make disbursements over the project’s life.

Relations Among Projects

Companies and individuals are often faced with a large number of investment opportunities
at the same time. Relations among these opportunities can range from the simple to the

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complex. We can distinguish three types of connections among projects that cover all the
possibilities. Projects may be 1. Independent, 2. Mutually exclusive, or 3. Related but not
mutually exclusive. The simplest relation between projects occurs when they are
independent.

1. Two projects are independent if the expected costs and the expected benefits of each
project do not depend on whether the other one is chosen. When two or more projects are
independent, evaluation is simple. Consider each opportunity one at a time, and accept or
reject it on its own merits.

2. Projects are mutually exclusive if, in the process of choosing one, all other alternatives
are excluded. In other words, two projects are mutually exclusive if it is impossible to do
both or it clearly would not make sense to do both.

3. The third class of projects consists of those that are related but not mutually exclusive.
For pairs of projects in this category, the expected costs and benefits of one project
depend on whether the other one is chosen. For example, Klamath Petroleum may be
considering a service station at Fourth Avenue and Main Street as well as one at Twelfth
and Main. The costs and benefits from either station will clearly depend on whether the
other is built, but it may be possible, and may make sense, to have both stations.

Therefore, in the remainder of this module we consider only independent and mutually
exclusive projects.

Minimum Acceptable Rate of Return (MARR).

A company evaluating projects will set for itself a lower limit for investment acceptability
known as the minimum acceptable rate of return (MARR). The MARR is an interest rate that
must be earned for any project to be accepted. Projects that earn at least the MARR are
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 desirable, since this means that the money is earning at least as much as can be earned
elsewhere. Projects that earn less than the MARR are not desirable, since investing money in
these projects denies the opportunity to use the money more profitably elsewhere.

The MARR can also be viewed as the rate of return required to get investors to invest in a
business. If a company accepts projects that earn less than the MARR, investors will not be
willing to put money into the company. This minimum return required to induce investors to
invest in the company is the company’s cost of capital.

Therefore, the next discussion shows how the MARR is used in calculations involving the
present worth, annual worth, or internal rate of return to evaluate projects.

Understanding Continuous Cash Flow Analysis

Continuous Cash Flow Analysis is a financial evaluation technique used to determine the present
and future worth of cash flows that occur continuously over time rather than at discrete intervals.
This is particularly useful when dealing with processes or investments that generate revenue or
incur costs continuously rather than at fixed periods (e.g., monthly or yearly).

Instead of treating cash flows as lump sums received at specific intervals, continuous cash flow
assumes a constant, uninterrupted stream of money, making it more realistic for industries like
chemical engineering, manufacturing, and energy production.

Mathematical Representation
In continuous cash flow analysis, interest is compounded continuously, meaning the value of
money changes at every infinitesimally small moment. The fundamental equations used are:

Present worth (PW)

The present worth at time t = 0 for a continuous cash flow C over time T is given by:

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Future worth (FW)
The future worth at t = T (6 years) for a continuous cash flow C is given by:

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Example 1:
Find the future worth at the end of the cash flow period and the present worth at the beginning of
the cash flow period of a constant, continuous cash flow of $450,000 per year for 6 years. Use a
continuously compounded interest rate of 8 percent per year.
Determine the future worth and present worth, using the simplest approach. Also tabulate the
cash flow a year at a time.

Example 2:
A petrochemical plant is evaluating the installation of a catalytic converter that enhances reaction
efficiency, resulting in annual raw material cost savings of $600,000 for the next 10 years. Given
a continuously compounded interest rate of 7% per year, use the present worth evaluation
method to assess whether this investment is financially viable.

Comparing projects using the present worth analysis

Introduction to Present Worth Analysis
Present Worth (PW) analysis, also known as Present Value (PV) analysis, is a financial
evaluation technique used in engineering economics to compare different projects by
bringing all cash flows to a single point in time (present time) using a specified discount
rate.

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 Importance in Chemical Engineering
In chemical engineering, project selection is crucial due to high capital costs, long
lifespans, and uncertainties in operating costs and revenue generation. Present Worth
Analysis helps in:

 Comparing alternative designs for chemical plants

 Evaluating equipment replacement decisions
 Assessing the financial feasibility of process improvements
Decision Criteria for Project Selection
 If PW > 0, the project is financially viable.
 If PW < 0, the project is not recommended.
 If comparing two projects, the one with higher PW is preferred.
Worked Examples
1. A company is considering investing in a heat exchanger that costs $600,000 and will save
$90,000 per year in energy costs for 8 years. If the required return is 10%, determine if
the investment is justified using the Present worth (PW) analysis.
Solution:

2. A chemical plant is considering replacing an old reactor with a new one. The old reactor
has 5 years of remaining life and incurs an annual maintenance cost of $50,000. The new
reactor costs $400,000 and has a lifespan of 10 years with a maintenance cost of $20,000
per year. The salvage value of the old reactor is $50,000, and the new reactor's salvage

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 value is $70,000. Assume a 12% interest rate. Should the company replace the old reactor
using Present Worth (PW) analysis?
Present Worth of Keeping the Old Reactor

Present Worth of Buying the New Reactor

Since PW (old) = -151,880 and PW (new) = -490,460, keeping the old reactor is more cost-
effective. The company should not replace the reactor.

3. A heat exchanger upgrade costs $400,000 but is expected to reduce annual operating
costs by $60,000 per year for 10 years. If the company requires a 10% return on
investment, should it proceed with the upgrade using the Present worth (PW) method?

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Sinking Fund Concept
A sinking fund is a method of setting aside money periodically to accumulate a specified future
sum. This is commonly used in chemical plant maintenance, equipment replacement, and
environmental compliance costs.

Capital Recovery Concept

The capital recovery factor is used to convert an initial investment into an equivalent series of
uniform annual cash flows. It helps in determining whether a project generates enough annual
income to justify the initial capital.
Capital Recovery Factor Formula

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Worked Examples
Problem:
A chemical plant needs to replace a reactor in 8 years at an estimated cost of $1.2 million. If the
company sets up a sinking fund earning 5% annually, how much should be deposited each year?

Solution:

Problem:
A company installs a distillation unit for $800,000 with an expected life of 10 years. If the
company wants to recover its investment using an 8% capital recovery rate, what should be the
annual revenue requirement?

Solution:

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Revision questions
1. A new petrochemical plant costs $50 million to build. The expected lifetime is 20 years,
and the interest rate is 6%. What should be the annual cash inflow required to recover the
capital investment?
2. A refinery expects to spend $10 million in 15 years on environmental compliance
upgrades. If a sinking fund earns 4% interest, how much should be deposited annually?

3. A chemical plant needs to install a $500,000 storage tank in 5 years. The company has
two financing options:

i. Sinking Fund: Set aside annual deposits at a 6% interest rate to accumulate the
needed funds.
ii. Loan Option: Take a 5-year loan at 8% interest, repaid in equal annual installments.
Which option is cheaper, assuming the plant has the choice to invest in a sinking fund
or take a loan?
4. A distillation column costs $500,000 and has a lifespan of 10 years. If the interest rate is
8%, what is the annual cost recovery using the Capital Recovery Factor (CRF)?

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 Comparing Chemical Engineering Projects Using Net Present Value (NPV)

Net Present Value (NPV) is a fundamental financial evaluation method used to compare
different chemical engineering projects. It helps determine whether a project is profitable by
discounting future cash flows to the present time and summing them up.

Why NPV is Important in Chemical Engineering?

 Used for evaluating chemical plant expansions, process modifications, or new equipment
investments.
 Helps in selecting the most cost-effective design for chemical production.
 Accounts for the time value of money, making it more accurate than methods like
Payback Period.

The NPV of a project with multiple cash flows is given by:

Decision Rule for NPV Analysis

If NPV > 0, the project is profitable and should be accepted.

If NPV < 0, the project should be rejected.
If comparing multiple projects, choose the one with the highest NPV.

Worked examples
Example 1: A chemical plant is considering upgrading its reactor, requiring an investment of
$500,000. The expected cash inflows over the next 5 years are $150,000 per year. The
discount rate is 10% per year. Calculate the NPV.

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Example 2:

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The Payback Period

The simplest method for judging the economic viability of projects is the payback period
method. It is a rough measure of the time it takes for an investment to pay for itself. More
precisely, the payback period is the number of years it takes for an investment to be recouped
when the interest rate is assumed to be zero. When annual savings are constant, the payback
period is usually calculated as follows:

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For example, if a first cost of $20 000 yielded a return of $8000 per year, then the payback
period would be

If the annual savings are not constant, we can calculate the payback period by deducting each
year of savings from the first cost until the first cost is recovered. The number of years required
to pay back the initial investment is the payback period.

For example, suppose the saving from a $20 000 first cost is $5000 the first year, increasing by
$1000 each year thereafter. By adding the annual savings one year at a time, we see that it would
take just over three years to pay back the first cost (5000 + 6000 + 7000 + 8000 = 26 000). The
payback period would then be stated as either four years (if we assume that the $8000 is received
at the end of the fourth year) or 3.25 years (if we assume that the $8000 is received uniformly
over the fourth year). According to the payback period method of comparison, the project with
the shorter payback period is the preferred investment.

A company may have a policy of rejecting projects for which the payback period exceeds some
preset number of years. The length of the maximum payback period depends on the type of
project and the company’s financial situation. If the company expects a cash constraint in the
near future, or if a project’s returns are highly uncertain after more than a few periods, the
company will set a maximum payback period that is relatively short. As a common rule, a
payback period of two years is often considered acceptable, while one of more than four years is
unacceptable.

Practicing Problems

1. Elyse runs a cottage soap business out of her home where she manufactures and sells the
washing soap. Her cottage business is becoming quite successful and she is considering
purchasing an upgrade to her molding machine that will give her more reliable uptime.
The cost is $50000. She expects that the investment will bring about an annual savings of
$20000, due to the fact that her machine will no longer suffer long failures and thus she
will be able to sell more soap. What is the payback period on her investment, assuming
that the savings accrue over the whole year?

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 The payback period method has four main advantages:

 It is very easy to understand. One of the goals of engineering decision making is to

communicate the reasons for a decision to managers or clients with a variety of
backgrounds. The reasons behind the payback period and its conclusions are very
easy to explain.

 The payback period is very easy to calculate. It can usually be done without even
using a calculator, so projects can be very quickly assessed.

 It accounts for the need to recover capital quickly. Cash flow is almost always a
problem for small to medium-sized companies. Even large companies sometimes
can’t tie up their money in long-term projects.

 The future is unknown. The future benefits from an investment may be estimated
imprecisely. It may not make much sense to use precise methods like present worth
on numbers that are imprecise to start with. A simple method like the payback period
may be good enough for most purposes.

But the payback period method has three important disadvantages:

 It discriminates against long-term projects. No houses or highways would ever be built if

they had to pay themselves off in two years.

 It ignores the effect of the timing of cash flows within the payback period. It disregards
interest rates and takes no account of the time value of money. (Occasionally, a
discounted payback period is used to overcome this disadvantage)

 It ignores the expected service life. It disregards the benefits that accrue after the end of
the payback period.

The Internal Rate of Return

Investments are undertaken with the expectation of a return in the form of future earnings. One
way to measure the return from an investment is as a rate of return per dollar invested—in other
words, as an interest rate. The rate of return usually calculated for a project is known as the
internal rate of return (IRR). The adjective internal refers to the fact that the internal rate of
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return depends only on the cash flows due to the investment. The internal rate of return is that
interest rate at which a project just breaks even. The meaning of the IRR is most easily seen with
a simple example.

Suppose $100 is invested today in a project that returns $110 in one year. We can calculate the
IRR by finding the interest rate at which $100 now is equivalent to $110 at the end of one year:

Where P is the plant cost, where is the internal rate of return.

Solving this equation gives a rate of return of 10 percent. In a simple example like this, the
process of finding an internal rate of return is finding the interest rate that makes the present
worth of benefits equal to the first cost. This interest rate is the IRR.

Drafted by Patrick Mulindwa ([Link]@[Link])

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