Rate of return

1. Rate of return

2. Sensitivity analysiscoated membrane template • Level 2 analysis • Raw material costs = $100,000 • Purchased equipment costs = $250,000 • Lang factors at lowest value of the range Snapshot of TPC Case I tab

3. What is the sensitivity of TPC to raw material cost variations? • ± 10%, one standard deviation of raw material costs (bulk chemicals); • Standard deviation levels • ± 1 standard deviation = 50% of the range • ± 2 standard deviations = ~95% of the range • For this case, ± 2 standard deviations of raw material costs would give $80,000 and $120,000 as the raw materials cost range • Change raw materials costs on bill of materials Tab; read TPC result on TPC Case I Tab

4. TPC vs. raw material costs± 2 standard deviations; 10% = one standard deviation;notice the TPC sensitivity to raw materials costs

5. What is the sensitivity of TPC to PEC cost variations? • Capital cost estimates are within 35% of actual (we take this to be 2 standard deviations) • Change PEC costs on PEC Tab; read TCI result on TCI Tab or read TCI, TPC results on TPC Case I Tab

6. TCI, TPC vs PEC

7. How can you use sensitivity plots during design? • Evaluate high-cost elements for the process, focus on reducing these • Rapidly eliminate alternatives that exceed cost quality accuracy • Refine cost estimates to evaluate alternatives that have costs within the expected accuracy of the costing methods

8. Money has a time value • A business expects to receive a return on money invested • The amount of the return is related to the degree of risk that the entire investment may be lost Costs due to interest on investment

9. Various investment cost elements • Borrowed capital vs. owned capital • Interest on owned capital cannot be charged as a true cost • Interest effects in a small business • $20,000 invested in a start-up – FCI + WC • Profit = $8,000 • Owned capital: profit = $8,000 • Borrowed capital (10% interest): profit = $8,000 – 0.1*$20,000 = $6,000

10. Interest effects in a large business • New capital can come from issued stocks and bonds, borrowing from banks or insurance companies, depreciation funds set aside, profits not distributed to shareholders,…

11. Including cost of capital in economic analysis • Capital is charged at a low interest rate – it could be used for alternative investments, i.e., it could pays off funded debts or be invested in risk-free loans • Interest is paid on owned capital at a rate equal to the presetn return on all the company’s capital • Design practice for interest and investment costs-alternatives • No interest costs are included – all necessary capital comes from owned capital • Interest is charged on the total capital investment at a set interest rate

12. Property taxes • Local government jurisdiction – county or city • Excise taxes • Charges for import customs, transfer of stocks and bonds • Gasoline, alcoholic beverages • Indirect, as they are passed to the consumer • There may be local excise taxes • Income taxes • Based on gross earnings = total income – total product cost • Federal and state governments (0 – 5% of gross income) Taxes

13. Corporate taxes • Normal tax – federal government • Surtax – 2nd federal income tax based on gross earnings above a certain limit • > $100,000: 34% tax rate • Capital gains tax – tax on profits made for the sale of capital assets (land, buildings, equipment); long-term if held more than a year, short-term if held more than a year • Contributions – tax deductible up to 10% of taxable income • Carry-back, carry-forward of losses – 3 year window

14. Investment credit – deduction for new investments in machinery, equipment • Taxes and depreciation – discussion to follow • Excess-profits tax – (national emergencies) • Tax returns • Cash basis – only money received or paid out during the period • Accrual basis – income and expenses included when they occur even if money is not yet received or sent

15. Arbitrary, does not include interest costs • Straight-line • Declining balance • Sum-of-the-years digits • Accounts for interest on the investment • Sinking fund • Present worth methods • Case study: Harsh’s car • V = $20,000 • Vs = $500 • A = 15 years Depreciation methods

17. Quantifiable standards only operate as guides to decisions • Profit evaluation is based on prediction of future results [“…it is hard to make predictions, especially about the future.” – Yogi Berra] • A primary factor in evaluations is the consideration of alternatives • Typical choices • Capital investment in a project with high risk • Capital investment in a safe venture Profitability standard

18. Rate of return on investment • Discounted cash flow on full-life performance • Net present worth • Capitalized costs • Payout period Five common methods for profitability evaluations

19. 1. Rate of return (RoR) • Annual RoRon TCI, before taxes = annual profit/(TCI + WC) • Annual RoR on TCI, after taxes. • Modify annual profit by taxes • Annual RoR, capital recovery with minimal profit • Generate fictitious expenses at min profit, divide by (TCI+WC)

20. Example: Rate of return on investment

21. RoR advantages disadvantages • TCI, WC, income, expenses • No time value of money • Assumes constant costs for projects • Depreciation may vary • Maintenance costs increase with time • Sales volume may increase or decrease

22. 2. Discounted cash flow rate of return • We determine an index (i), or interest rate, that discounts the annual flows to a zero present value at the end of the project life, when properly compared to the initial investment • What does i represent? • The after-tax interest rate at which the investment is repaid by proceeds from the project, or • The maximum after-tax interest rate at which funds could be borrowed for the investment and just break even at the end of the service life.

23. Discounted cash flow rate of returnWhat is the interest at which this project will pay principal + interest at end of life? • Addresses time value of money • Computes amount of investment unreturned @ each year over the project life • Trial-and-error solution: vary RoR so that the initial investment goes to zero at the end of the project ife • It gives the maximum interest rate at which capital can be borrowed when net cash flow just pays all the principle and interest

24. Estimated cash flow to project

25. 3. Net present worth • Complementary to DCC RoR • Substitutes the cost of capital at an interest rate, i, for the discounted cash flow rate of return • For the data provided in the DCC ROR problem, we set the interest rate, say 15%, and compute the difference between the present value of the annual cash flows and the initial required investment

27. Source: Peters, Timmerhaus, West Spreadsheet structure for DCF of present value and net present worth

31. 4. Capitalized costs • This method is useful for comparing alternatives within a single overall project. • Capitalized costs related to investment: • Money for initial purchase of equipment, and • Generating sufficient funds via interest accumulation to permit perpetual replacement (i.e., sustainability) • Example: one process section has alternatives + low or no differences in operating costs, then the alternative giving the least capitalized cost would be the desirable economic choice.

32. Capitalized costs K = capitalized cost V = initial equipment cost Vreplace = equipment replacement cost n = estimate useful life, years i = interest rate Capitalized cost factor

33. Capitalized costsinclusion of operating costs • Operating costs can be included by adding an additional capitalized cost to cover operating costs during the project life • Each annual operating cost is considered as equivalent to a piece of equipment that lasts one year • Procedure: • Find present (discounted) value of each year’s costs by the prior method (discount factor is applied, d=1/(1+i)n) • SPviis capitalized by multiplying by the capitalization factor for the initial investment. The total capitalized costs is the sum of this value + operating costs + working capital.

34. 5. Payout period • Minimum length of time necessary to recover the original capital investment via cash flow to the project, based on total income minus all costs except depreciation • Interest effects are neglected

35. Rate of return on investment • Discounted cash flow on full-life performance • Net present worth • Capitalized costs • Payout period Comparison of alternative investments:5 profitability methods 3 investments with: different TCI, WC different service lives different cash flow and expenses

36. 3 investments

37. 1. Rate of return on initial investment

38. Investment 1

39. Investment 2

40. Investment 3

41. Summary table Which do we choose? All have similar average rates of return? All are above the ‘minimum’ 15% return.

42. Average RoR, incremental investment • We can also compare these investments to each other as follows: • The project investment follows the order, 1,2, and 3 • Pairwise, find the ratio of the profit difference to the initial investment difference • The investment with the highest value is preferred

43. Differential rate of return Project 2 is better than project 1; Project 2 is better than project 3 (less efficient use of capital for 3)

44. Minimum payout period No interest charge

45. Minimum payout period no interest charge Investment 1 has the lowest payout period, and is recommended

46. Discounted cash flow RoR

50. DCF RoR • DCD RoR’s are similar: 20.7%, 22.8%, and 21.4% • This method works well when the service lives of the projects are the same; with different service lives, the net present worth method is better • Approximate method, narrow range of service lives • Pair-wise comparison: base time is the longer service life