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SCHOOL OF CIVIL, ENVIRONMENTAL & CHEMICAL ENGINEERING

PROC2089 PROCESS PLANT DESIGN & ECONOMICS

CASH FLOW ANALYSIS - SENSITIVITY ANALYSIS

SENSITIVITY ANALYSIS

Most of the information used in the economic evaluation is in the form of forecasts or
estimates. Depending on the nature of the information and the way it is used in
economic evaluation, there will be varying degree of economic risk for a project
associated with this uncertainty. The economic risk is that the project might turn out to
have larger investment or operating costs or lower income compared with the original
forecasts and estimates. Three types of uncertain situations exist:
1. Risk situation - one where the complete range of possible outcomes for a project
can be foreseen and their relative chances estimated with reasonable confidence.
1. Uncertain situation - one where complete range of possible outcomes can be
identified but their relative chances are not known.
2. Partial ignorance situation is the one where all possible outcomes cannot be even
be identified with any confidence.

A crude way of accounting for the uncertainty and the resulting risk in economic
evaluation of projects is to adjust the acceptable values of profitability measures such
as NPV and DCFR so that even a more risky project must be potentially more
profitable to be accepted.

To make a detailed economic evaluation of a project incorporating the uncertainty and

consequent economic risk in the project, sources of uncertainty in forecasts and
estimates have to be identified and their effects have to be traced quantitatively.
Sensitivity analysis is used for such an evaluation.

A sensitivity analysis
points out how the changes in the components of cash flow effects the economic
viability of the project
indicates the areas which are more critical in terms of uncertainty
helps to study the effect of changes in factors such as capital investment
expenditure, market volume, start-up period, scale of operation, fixed and variable
operating costs on overall economic viability of the project

Although a sensitivity analysis is used to investigate the effect of uncertainty in

different areas of a project on its economic viability, it does not quantify the
uncertainty. The interpretations of the sensitivity analysis results are subjective and
qualitative.
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CASH FLOW ANALYSIS SENSITIVITY ANALYSIS

Tutorial Question

Capital requirement for the production of a chemical using a High Investment (HI)
project is shown in Table 1.
Table 1. Capital investment in $million
Production plant cost $8.4
Building cost $1.2
Working capital $0.8

The plant construction would take two years from investment decision. The plant and
building costs would be incurred in two equal yearly instalments and the working
capital all in second year. The working capital is fully recovered at the end of the
plants productive life.

Production costs estimates comprise the annual fixed costs (independent of production
rate) and variable costs (directly proportional to production rate). The fixed production
costs are estimated as $2.0 million p.a. and the variable production costs are $105 per
tonne of the product. Depreciation is excluded in the estimation of production costs.

Cash inflows result from the sales of the product and a by-product. The selling prices
of the product and the by-product are $315 and $40 per tonne, respectively. The design
capacity of the plant is 30,000 t.p.a. However, the total production in the first year is
expected to be only 15,000 tonnes. Beyond the first year, the production rate increases
attaining design rate in the second year and some additional production in subsequent
years without further investment. The production pattern is shown in Table 2.

Table 2. Production pattern

Year of production Production rate, t.p.a.
1 15,000
2 30,000
3 32,000
4 34,000
5 to 10 36,000

The operating life of the plant is estimated to be 10 years. It is assumed that, at the end
of the operating life, the scrap value of the plant will be 5% of the initial plant cost and
that of the buildings will be 20% of the initial building cost.

The following tax and grant situations are applicable to the project:
a) An investment grant of 25% of plant and buildings costs is received from the
government a year after the investment is made.
b) Tax is paid one year in arrears of expenditure and earnings.
c) Corporate tax is 39% of annual profits.
d) Annual depreciation on the plant is calculated using reducing balance method at a
rate of 20% and a scrapping allowance on the residue at the end of 10 years.
e) There is an annual tax depreciation allowance of 4% on the initial cost of building
less the grant.
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f) Since 100% depreciation tax allowance is given on the initial plant investment, the
plant scrap value is subject to tax. However, this does not apply to the building
scrap value.

An alternative Low Investment (LI) project is also available for the producing the
chemical mentioned above. The fixed capital, building costs and working capital for the
project are $3.0, $0.5 and $0.5 millions, respectively. The fixed costs are $0.92 million
p.a. and the variable production costs are $225 per tonne. There is no by-product
production in this project.

By performing absolute and relative sensitivity analyses, determine which one of the
above two alternatives is economically attractive.

Solution

Cash Flow Analysis for the HI Project

Investment related cash flows

Year 1:
First year of construction
Fixed capital spent = (0.5 $8.4) millions + (0.5 $1.2) millions = $4.8 millions.
Annual capital related expenditure ATC = $4.8 millions.
Annual cash flow ACF = ANCI ATC = 0 - $4.8 millions = $4.8 millions.

Year 2:
Second year of construction.

Cash outflow = (0.5 $8.4) millions + (0.5 $1.2) millions + $0.8 millions = $5.6
millions.
Cash inflow = Investment grant which is equal to 25% of the capital spent in Year 1 =
0.25 $4.8 millions = $1.2 millions.
Annual capital related expenditure ATC = Cash outflow Cash inflow = $5.6 millions -
$1.2 millions = $4.4 millions.
Annual cash flow ACF = ANCI ATC = 0 - $4.4 millions = -$4.4 millions.

Year 3:
Cash inflow = Investment grant which is equal to 25% of the capital spent in Year 2 =
0.25 $4.8 millions = $1.2 millions.

Year 12: (Last year of production)

Scrap value of the plant (which is a cash inflow) = 0.05 $8.4 millions = $0.42
millions.
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Scrap value of the buildings (which is a cash inflow) = 0.02 $1.2 millions = $0.24
millions
Annual capital related expenditure ATC = Cash outflow Cash inflow = 0 ($0.42 +
$0.24 + $0.8) millions = - $1.46 millions.

Year 13:
One year after the end of the plant life. Tax is paid for the cash inflows received in year
12.
Cash inflow received in the form of plant scrap value = $0.42 millions.
Tax to be paid = $0.42 millions 0.39 = $0.1638 millions.
Annual capital related expenditure ATC = Cash outflow Cash inflow = $0.1638
millions - 0 = $0.1638 millions.

Before-tax cash flows

Year 3:
First year of production.
Production rate = 15,000 tonnes/year

Annual sales income = Production rate Sales price = 15,000 tonnes/year ($315 per
tonne of product + $40 per tonne of by-product) = $5.325 millions.

Annual variable expenses AVE = 15,000 t.p.a $105 per tonne = $1.575 millions.

Annual fixed expenses AFE = $2.0 millions.

Annual total expenses ATE = ($1.575 + $2) millions = $3.575 millions.

Year 4:
Second year of production.
Production rate = 30,000 tonnes/year

Annual sales income = Production rate Sales price = 30,000 tonnes/year ($315 per
tonne of product + $40 per tonne of by-product) = $10.65 millions.

Annual variable expenses AVE = 30,000 t.p.a $105 per tonne = $3.15 millions.

Annual fixed expenses AFE = $2.0 millions.

Annual total expenses ATE = ($3.15 + $2) millions = $5.15 millions

Year 4:
Third year of production.
Production rate = 32,000 tonnes/year

Annual sales income = Production rate Sales price = 32,000 tonnes/year ($315 per
tonne of product + $40 per tonne of by-product) = $11.36 millions.
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Annual variable expenses AVE = 32,000 t.p.a $105 per tonne = $3.36 millions.

Annual fixed expenses AFE = $2.0 millions.

Annual total expenses ATE = ($3.36 + $2) millions = $5.36 millions

Calculations of before-tax cash flows for other years can be carried out similarly.

Depreciation Tax Allowance

Depreciation on Plant:
Depreciation method = Reducing balance method
Depreciation factor f =0.2.
Annual depreciation da = V(1-f)a-1f
Where V = depreciated capital = Fixed capital Investment grant = $8.4
million 0.25 $8.4 million = $6.3 millions.

Depreciation in year 1 of production da1 = $6.3 millions (1 0.2)1-1 0.2 = $1.26

millions.

Depreciation in year 2 of production da2 = $6.3 millions (1 0.2)2-1 0.2 = $1.008

millions.

Depreciation for other years except the last of production can be calculated similarly.

Depreciation in the last of production da10 = Scrapping of residual value = $6.3 millions
(da1 + da1 + + da9) = $0.846 millions.

Depreciation on buildings:
(investment grant is to be subtracted before the depreciation allowance is calculated)

Depreciation in year 1 of production db1 = 0.04($1.2 0.25 $1.2) millions = $0.036

millions.
db1 = db2 = db3 = da10= $0. 036 millions.
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Total depreciation allowance ATD

ATD = Depreciation allowance for the plant + Buildings

For year 1,
ATD = $1.008 millions + $0.036 millions = $1.044 millions.

Tax

For year 1, AIT = 0

For year 2, AIT = Tax on profit made in year 1
and so on

Cash flow analysis for the HI project is shown in Table 1.

Cash flow analysis for the LI project is shown in Table 2.
HI NPV
projec calculati
t TABLE 1 on
Tax rate
Fixed capital = $8.4 million = 39%
Working capital
= $0.8 million
Building costs $1.2 million
Operating life= 10years
Production
capacity = 30000t.p.a.
Fixed operating
costs= $2.000 million
Variable
operating costs= $105.0 per tonne
Discount rate = 15%
Selling price of the main
product = $315 per tonne
Selling price of the by-
product = $40 per tonne
Depreciation rate
factor= 20%
Cash Flow
Analysis
(All figures are in
$millions)
Investment related cash Before tax cash
flows flow
Year Plant Buildin Workin Investm Total AS AFE AVE ATE ACI = AS-
fixed gs g ent annual ATE
capital capital grant capital
investmen
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t ATC
1 4.2 0.6 0 0 4.8 0 0 0 0 0
2 4.2 0.6 0.8 1.2 4.4 0 0 0 0 0
1.575
3 0 0 0 1.2 -1.2 5.325 $2.0 0 3.575 1.75
3.150
4 0 0 0 0 0 10.65 $2.0 0 5.15 5.5
3.360
5 0 0 0 0 0 11.36 $2.0 0 5.36 6
3.570
6 0 0 0 0 0 12.07 $2.0 0 5.57 6.5
3.780
7 0 0 0 0 0 12.78 $2.0 0 5.78 7
3.780
8 0 0 0 0 0 12.78 $2.0 0 5.78 7
3.780
9 0 0 0 0 0 12.78 $2.0 0 5.78 7
3.780
10 0 0 0 0 0 12.78 $2.0 0 5.78 7
3.780
11 0 0 0 0 0 12.78 $2.0 0 5.78 7
3.780
12 -0.42 -0.24 -0.8 0 -1.46 12.78 $2.0 0 5.78 7
13 0 0 0 0 0

Depreciation (tax) Discounted cash

allowances Tax Net cash flow flow
Discount
factor for
Total 15%,
Depreciation
(tax) AIT=(ACI- ANCI=ACI- ACF=ANCI- fD = 1/ ADCF =
PlantBuildings allowance, ATD ATD)T AIT ATC ACF (1+i)^n ACF*fD ADCF
0.0 0.000 -4.8 -4.8 0.8696 -4.174 -4.174
0.0 0.000 -4.4 -9.2 0.7561 -3.327 -7.501
1.26
0 0.036 1.296 0.0 1.750 2.950 -6.25 0.6575 1.940 -5.561
1.00
8 0.036 1.044 0.177 5.323 5.323 -0.93 0.5718 3.043 -2.518
0.80
6 0.036 0.842 1.738 4.262 4.262 3.34 0.4972 2.119 -0.399
0.64
5 0.036 0.681 2.011 4.489 4.489 7.82 0.4323 1.941 1.542
0.51
6 0.036 0.552 2.269 4.731 4.731 12.55 0.3759 1.778 3.320
0.41
3 0.036 0.449 2.515 4.485 4.485 17.04 0.3269 1.466 4.786
0.33
0 0.036 0.366 2.555 4.445 4.445 21.48 0.2843 1.264 6.050
0.26
4 0.036 0.300 2.587 4.413 4.413 25.90 0.2472 1.091 7.141
0.211 0.036 0.247 2.613 4.387 4.387 30.28 0.2149 0.943 8.084
0.84
6 0.036 0.462 2.634 4.366 5.826 36.11 0.1869 1.089 9.173
2.714 -2.714 -2.714 33.40 0.1625 -0.441 8.732
NPV
TABLE 2
Alternatice LOW COST project
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Tax
Fixed capital = $3.0 million rate = 39%
Working
capital = $0.5 million
Building
costs $0.5 million
Operating life= 10years
Production
capacity = 30000t.p.a.
Fixed
operating
costs= $0.920 million
Variable
operating
costs= $225.0 per tonne
Discount rate = 15%
Selling price of the
main product = $315 per tonne
Selling price of the
by-product = $0 per tonne
Depreciation
rate factor= 20%
Cash Flow
Analysis
(All figures are in
$millions)
Investment related Before tax
cash flows cash flow
Total
Plant Worki annual
fixed ng Invest capital
capit Buildi capit ment investme
Year al ngs al grant nt ATC AS AFE AVE ATE ACI = AS-ATE
1 1.5 0.25 0 0 1.75 0 0 0 0 0
2 1.5 0.25 0.5 0.4375 1.8125 0 0 0 0 0
3.37
3 0 0 0 0.4375 -0.4375 4.725 $0.9 504.295 0.43
6.75
4 0 0 0 0 0 9.45 $0.9 00 7.67 1.78
7.20
5 0 0 0 0 0 10.08 $0.9 00 8.12 1.96
7.65
6 0 0 0 0 0 10.71 $0.9 00 8.57 2.14
8.10
7 0 0 0 0 0 11.34 $0.9 00 9.02 2.32
8.10
8 0 0 0 0 0 11.34 $0.9 00 9.02 2.32
8.10
9 0 0 0 0 0 11.34 $0.9 00 9.02 2.32
8.10
10 0 0 0 0 0 11.34 $0.9 00 9.02 2.32
8.10
11 0 0 0 0 0 11.34 $0.9 00 9.02 2.32
8.10
12 -0.15 -0.1 -0.5 0 -0.75 11.34 $0.9 00 9.02 2.32
0.058
13 5 0 0 0 0.0585
Discounted cash
Depreciation (tax) allowances Tax Net cash flow
flow
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Total
Deprecia AIT=( ACF= Discount
A =
Buildings tion (tax) ACI- ANCI=ACI-AIT ANCI- ACF factor, fD = DCF ADCF
allowanc ATD)T ACF*fD
Plant ATC 1/(1+i)^n
e, ATD
-
0.0 0.000 -1.75 -1.75 0.8696 -1.522
1.522
- -
-
0.0 0.000 1.812 3.562 0.7561 -2.892
1.371
5 5
0.450 0.015 0.465 0.0 0.430 0.868 -2.70 0.6575 0.570 -2.322
0.360 0.015 0.375-0.014 1.794 1.794 -0.90 0.5718 1.026 -1.296
0.288 0.015 0.303 0.548 1.412 1.412 0.51 0.4972 0.702 -0.594
0.230 0.015 0.245 0.646 1.494 1.494 2.00 0.4323 0.646 0.052
0.184 0.015 0.199 0.739 1.581 1.581 3.59 0.3759 0.594 0.646
0.147 0.015 0.162 0.827 1.493 1.493 5.08 0.3269 0.488 1.134
0.118 0.015 0.133 0.841 1.479 1.479 6.56 0.2843 0.420 1.554
0.094 0.015 0.109 0.853 1.467 1.467 8.02 0.2472 0.363 1.917
0.075 0.015 0.090 0.862 1.458 1.458 9.48 0.2149 0.313 2.230
0.302 0.015 0.317 0.870 1.450 2.200 11.68 0.1869 0.411 2.642
- -
0.781 -0.781 10.84 0.1625 2.505
0.840 0.136
NPV
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Sensitivity Analysis

Tables 3 and 4 in the following pages show the effect of variations of the following
forecast factors on the NPV of the HI and LI projects:
1. Plant investment
1. Fixed costs
2. Product selling price
3. Annual plant capacity

The results in the tables show the effect of varying these input factors from +25% to
-25% on project NPV. The input factors were varied one at a time. Figures 1 and 2
show the plots of results in Tables 3 and 4. These sensitivity diagrams show relative
effect of the various input factors on NPV. The steeper the slope of the line for an input
factor, the more sensitive is the NPV to that factor. These graphs also indicate which of
the input factors have to be accurately estimated during the economic evaluation so
that the project profitability is less prone to fluctuations.

Tables 5 and 6 show the relative sensitivity of the project NPV for the two alternative
proposals under consideration. Figures 3 to 6 show the plot of relative sensitivities for
each of the input factors used. In each of these plots the % variation of NPVs of the
two alternatives is plotted against % variation in each input factor. From these figures,
it can be seen that HI project (squares) is more robust whereas the LI project
(diamonds) is adversely sensitive to some of the input factors.

Sensitivity analysis can be performed to investigate the effects of other relevant factors
such as
length of the project
tax rates
inflations rates
SENSITIVITY
ANALYSIS
Table 3 Sensitivity of NPV values to various factors Table 5. Percent variation from
for HI project, NPV in $millions base value, HI project
Discount rate Discount rate
used = 15% used = 15%
% Fixe Annual % Fixe Annual
Variati Plant d Selli plant Variati Plant d Sellin plant
on in investm cost ng capacit on in invest cost g capacit
factor ent s price y factor ment s price y
17.9
-25 7.181 7.138 0.928 1.985 -25 18.69 8 -84.66 -67.19
14.3
-20 6.955 6.92 1.953 2.798 -20 14.96 8 -67.72 -53.75
10.7
-15 6.729 6.703 2.977 3.611 -15 11.22 9 -50.79 -40.31
-10 6.502 6.485 4.001 4.424 -10 7.47 7.19 -33.87 -26.88
-5 6.276 6.267 5.026 5.237 -5 3.74 3.59 -16.93 -13.44
0 6.05 6.05 6.05 6.05 0 0.00 0.00 0.00 0.00
-
5 5.824 5.832 7.074 6.863 5 -3.74 3.60 16.93 13.44
-
10 5.597 5.615 8.099 7.676 10 -7.49 7.19 33.87 26.88
15 5.371 5.397 9.123 8.489 15 -11.22 - 50.79 40.31
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10.7
9
-
10.14 14.3
20 5.145 5.18 7 9.302 20 -14.96 8 67.72 53.75
-
11.17 17.9
25 4.919 4.962 2 10.115 25 -18.69 8 84.66 67.19

Table 4 Sensitivity of NPV values to various factors Table 6. Percent variation from
for LI project, NPV in $millions base value, LI project
Discount rate Discount rate
used = 15% used = 15%
% Fixe Annual % Fixe Annual
Variati Plant d Selli plant Variati Plant d Sellin plant
on in investm cost ng capacit on in invest cost g capacit
factor ent s price y factor ment s price y
-
- 23.0 242.0
-25 2.893 3.082 3.559 0.772 -25 15.49 3 8 -69.18
-
- 18.4 193.6
-20 2.816 2.967 2.346 1.119 -20 12.42 4 5 -55.33
-
- 13.8 145.2
-15 2.738 2.851 1.134 1.465 -15 9.30 1 7 -41.52
-10 2.66 2.736 0.079 1.812 -10 6.19 9.22 -96.85 -27.66
-5 2.583 2.62 1.292 2.159 -5 3.11 4.59 -48.42 -13.81
0 2.505 2.505 2.505 2.505 0 0.00 0.00 0.00 0.00
-
5 2.427 2.39 3.718 2.852 5 -3.11 4.59 48.42 13.85
-
10 2.35 2.274 4.931 3.198 10 -6.19 9.22 96.85 27.66
-
13.8 145.2
15 2.272 2.159 6.144 3.545 15 -9.30 1 7 41.52
-
18.4 193.6
20 2.194 2.044 7.357 3.891 20 -12.42 0 9 55.33
-
23.0 242.0
25 2.117 1.928 8.569 4.238 25 -15.49 3 8 69.18