Page 299 - Chemical engineering design

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CHEMICAL ENGINEERING
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The value of r is found by trial-and-error calculations. Finding the discount rate that
just pays off the project investment over the project’s life is analogous to paying off a
mortgage. The more profitable the project, the higher the DCFRR that it can afford to pay.
DCFRR provides a useful way of comparing the performance of capital for different
projects; independent of the amount of capital used and the life of the plant, or the actual
interest rates prevailing at any time.
Other names for DCFRR are interest rate of return and internal rate of return.
6.10.6. Pay-back time

Pay-back time is the time required after the start of the project to pay off the initial
investment from income; point D on Figure 6.7. Pay-back time is a useful criterion for
judging projects that have a short life, or when the capital is only available for a short time.
It is often used to judge small improvement projects on operating plant. Typically, a
pay-back time of 2 to 5 years would be expected from such projects.
Pay-back time as a criterion of investment performance does not, by definition, consider
the performance of the project after the pay-back period.

6.10.7. Allowing for inflation

Inflation depreciates money in a manner similar to, but different from, the idea of
discounting to allow for the time value of money. The effect of inflation on the net
cash flow in future years can be allowed for in a similar manner to the net present worth
calculation given by equation 6.9, using an inflation rate in place of, or added to, the
discount rate r. However, the difficulty is to decide what the inflation rate is likely to be
in future years. Also, inflation may well affect the sales price, operating costs and raw
material prices differently. One approach is to argue that a decision between alternative
projects made without formally considering the effect of inflation on future earnings will
still be correct, as inflation is likely to affect the predictions made for both projects in a
similar way.

6.10.8. Sensitivity analysis
The economic analysis of a project can only be based on the best estimates that can be
made of the investment required and the cash flows. The actual cash flows achieved in
any year will be affected by any changes in raw-materials costs, and other operating costs;
and will be very dependent on the sales volume and price. A sensitivity analysis is a way
of examining the effects of uncertainties in the forecasts on the viability of a project. To
carry out the analysis the investment and cash flows are first calculated using what are
considered the most probable values for the various factors; this establishes the base case
for analysis. The cash flows, and whatever criteria of performance are to be used, are then
calculated assuming a range of error for each of the factors in turn; for example, an error
of, say, š10 per cent on the sales price might be assumed. This will show how sensitive
the cash flows and economic criteria are to errors in the forecast figures. It gives some
idea of the degree of risk involved in making judgements on the forecast performance of
the project.