LECTURE 3
FINANCIAL MANAGEMENT (contd)
Nel Ch 15 (p.311)
Cost estimating (capital and operational)

New projects – affordability or viability is crucial

New technologies compete with established ones (fuel cells, solar
power)
The nature of costs (15.2)
Fixed costs
Cost
Volume
Variable costs
Cost
Volume
Semi-variable and unit costs

Semi-variable costs vary with volume, but not directly
so (e.g. maintenance, telephone costs)

Unit costs (costs per unit e.g. per ton)

Generally variable cost per unit are constant, but fixed
costs per unit decrease as volume increases
Unit cost = Total cost/no. of units
Direct and Indirect Costs

Direct – e.g. in production of product - costs associated with the
production – direct labour, raw material, packing
Labour costs include basic salary, fringe benefits, pension, etc.
Difficulty if some workers work on several products

Indirect – indirectly related to work done – salaries of
supervisors, quality control personnel, maintenance, selling &
distribution expenses, research & development, overhead costs
When a number of different products are sold, it is difficult to
apportion indirect costs
Capital Cost Estimation
Remember that capital is needed for equipment as well as working
capital
Estimating method is related to accuracy required
- from pre-design to detailed estimate
Estimating methods
Order of magnitude (ball-park) estimates (±30%)

Can be used to determine feasibility of project or to
screen several types of design.
e.g. End-product units – when historical data available.

E.g. For 1800 MW a new electricity from coal power
station cost R 20 bn – expect cost for 3600 MW facility
to be R 40 bn
Estimating methods (contd)
Scale of operations method
uses historically derived empirical equations
e.g. C2 = C1 x (Q2/Q1)y
(y = 0.6 – 0.8)
Takes into account economy of scale.
Estimating methods (contd)
Factor method (± 30%)
When specialized equipment forms major portion of total
project cost.
Multiply cost of major items of equipment by factor to
obtain total project cost.
Process plant equipment
Electric motors
Instruments
Columns, pressure vessels, pumps
Heat exchangers
Compressors
Centrifuges
Factors
8.5
4.8
4.0
3.5
2.5
2.0
Estimating methods (contd)
Pareto principle
20% items consume 80% of costs. Can be used if no
historical data is available.
Group method of estimating costs (± 20%)
Representatives from departments such as engineering,
purchasing, manufacturing & accounting produce a joint
estimate. Advantage – speed & pooling of information.
Estimating methods (contd)
Detailed and definitive estimates (± 5%)
List materials to be used (quantities)
Determine design time
Establish sequence of operations
List subcontractor work
List equipment required
List specialised tools & test equipment
required.
Cost indexes
Deal with change of costs of standard
equipment with time.
For examples
Chemical Engineering plant cost index (1959 =
100)
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝐶𝑜𝑠𝑡
= 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡
𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑡𝑖𝑚𝑒
𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑤ℎ𝑒𝑛 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 𝑤𝑎𝑠 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑
Direct and indirect costs
Direct- related to the
actual production facility
Indirect

Purchased equipment

Engineering costs

Installation

Supervision

Instrumentation

Security

Piping


Electrical equipment (motors,
switches, wiring,
Construction expenses
(site office, storage
yard)

Insurance

Buildings

Contractors’ fees

Yard improvements

Contingencies

Service facilities – utilities

Land (survey fees, property cost)
OPERATING COSTS
Direct production costs

Raw material

Direct operating labour

Supervisory and clerical labour

Plant maintenance & repairs,

Power, utilities & royalties
Fixed charges
Overhead costs

Medical expenses

Safety services

Payroll overheads (pension,
medical aid, life insurance)

Packaging

Depreciation

Restaurant (canteen) facilities

Property taxes (rates)

Warehouse &storage facilities,

Insurance

Quality control laboratories

Rent

Administrative

HR

R&D
Cost-volume-profit analysis (15.3)
also called break-even analysis
Income/Sales
Profit
Costs/
Revenue
Total Costs
Variable Costs
Fixed Costs
Loss
Breakeven
Number of units
Definitions
Income or sales = unit price x no. units sold
Total cost = fixed + variable costs
Variable cost = unit variable cost x no of units sold
Unit total cost = total cost/ no. of units sold
Profit = income – total cost
Breakeven units = fixed cost/(unit price – unit variable cost)
Example 1
Pete’s hotdog factory has a fixed cost of R 450 per month and
each unit (hot dog) has a variable production cost of R 1.70.
Each unit sells for R 2.50. Calculate:

Break-even volume per month (563)

The total profit (or loss) made per month when the following
number of units are sold: (a) 440 units (b) 940 units

The increase in profits if the monthly sales of 940 units is
increased by 10%.
Example 2
A colliery has a capacity to produce 120 000 tons run-of mine
anthracite (coal with high carbon content) per month. After
washing, about two-thirds of the run-of mine tonnage is sold as
prime. The colliery is currently producing 96 000 run-of-mine tons
per month. The fixed cost of the mine per month are R 4.2 million
and the variable cost per run-of mine ton amounts to R 45.
Assume a selling price of R 150 per ton of prime.
Calculate:

The current profit per month

The smallest number of prime tons that have to be sold every
month to avoid losses.

The increase in profit and volume (expressed as a percentage)
if the mine runs at full capacity.
FINANCIAL CALCULATIONS
Ch 16
INTEREST
Simple interest or compound interest
SI = Pni
[P = principal amount; n = no of investment periods; I = interest
rate %]
Calculate the interest if R 12500 is invested at 6.8% p.a. simple
interest for 8 months
Present Value (PV)
and Future Value (FV)
PV is the value of an asset at the moment
FV is the value of an asset when it has earned some interest
FV = PV + Interest
What is compound interest?
FV = PV (1+i)n
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Example 3

Determine the amount owing after 4 years and 7 months
if R15 800 were borrowed at the beginning of the first
year @ 15.5% p.a. compound interest, compounded
monthly.
Example 4

What amount must be invested now at 12.6% p.a.
compound interest (compounded monthly) to yield a lump
sum of R 50 000 at the end of 4 years 8 months?
1
PV = FV x
n
(1 + i )
Annuities
Series of equal payments (A) made at the
beginning or end of succeeding interest
periods. Compound interest assumed.
 (1 + i )n − 1
FV = A

i


Example 5

Calculate the total amount accumulated after 6 years at
8.5 % p.a. compounded annually if R 2500 are invested at
the beginning of each year.
Sinking Fund
An amount accumulated by several equal payments at a given
interest rate to cover (redeem, amortise) a wasting asset.
Example 6


i
A = FV 

n
 (1 + i ) − 1
A coal mine will have to spend R 2.5 million in 8 years’ time on
rehabilitation at closure. What uniform annual payments will
have to be made at the beginning of each year if interest is at
12%, compounded annually, to realize that amount.
Financial Analysis of a Project
What does that mean?
Information required
PROCESS DETAILS
Flowsheet incl. unit operations (heating/cooling, stirring, pumping,
tanks, separators, etc.)
Quantities (raw material, product, by-products, waste, catalysts,
etc)
Prices (raw material, product, by-products, waste, catalysts, etc)
INFRASTRUCTURE
Land
Buildings
Equipment
Utilities
Prices (of all the above)
Information required
CONSTRUCTION COSTS
Civil
Building
Mechanical
Electrical
Instrumentation
Effluent treatment facilities
Consulting & Project Management
PEOPLE
Operators
Artisans
Technical (engineers, technicians, chemists)
Managers
Admin staff
Cleaning staff
Project Cash Flow
What is a Cash Flow?
300
Cash Flow (R’mill)
Time
(years) R'mill
0
-450
1
26
2
110
3
150
4
130
5
170
200
100
Years
0
0
1
2
3
4
5
-100
-200
-300
-400
-500
What is the problem with straight addition
of Cash Flows?
Discounting
Money keeps losing its value. Why?
To take this into account, we discount its present value
The more time that elapses, the less the value
Discount rate k% p.a.
n
Ct
NPV = 
− I OR
t
t =1 (1 + k )
n
Ct

t
t = 0 (1 + k )
Discounting
Time (years)
0
1
2
3
4
5
R'mill
-450
26
110
150
130
170
136
PVIF (6%)
1.000
0.943
0.890
0.840
0.792
0.747
NPV
PV
-450
25
98
126
103
127
28
1
1.061
1
1.06 2
Repeat this calculation for k = 7.9% - what is the NPV?
IRR (internal rate of return) is the discount rate (k)
for which NPV = 0
Calculating IRR manually
Year
0
1
2
3
NPV
Discount
rate = 0%
-1500
900
800
500
700
Discount
rate = 15%
-1500
782.61
604.91
328.76
216.28
Discount
rate = 25%
-1500
720.00
512.00
256.00
-12.00
Discount
rate = 24%
-1500
725.81
520.29
262.24
8.34
Using EXCEL to determine
NPV & IRR
Col C
1
2
3
4
5
6
=IRR (D1:D6,0.1)
= NPV(0.06, D1:D6)
=NPV (0.06,D2:D6) + D1
=NPV(0.0908,D2:dD6) + D1
Cash Flows
R'mill
Col D
-452
113
85
187
102
94
129
9.08%
R 36.13
R 38.30
R 0.03
n
NPV = 
t =1
Ct
(1 + k )
t
Notice the difference