Analysis of Project Economics

© Dr. B. C. Paul 2002

Economic Analysis Begins with Project Definition Project Definition sets parameters for

engineering design Needed for obtaining accurate cost

estimates Also influences how project will be

capitalized and amortized– Not always equally sensitive to capital and

operating cost.

Costs Normally Divided Into Capital and Operating Cost estimating has given us costs by center Pneumatic Conveyor

– Air Supply Center $1,536,000– Electric Power Center $430,000– Pipes and Shafts $849,000– Feed Injection $564,000– Solid Air Separation $390,000– Control System $224,000– General Costs $653,000– Total Capital Cost $4,646,000

Common Models for Setting Up Capital Costs

Initial Capital Cost

Annual Operating Costs

Annual Savings or Earnings

The Straight Discounted CashFlow Model

DecisionPoint

Solution - Discount All Money Back to the Point ofDecision and Count up the Total NPV or Calculate anIRR

The NPV Model

A positive NPV indicates a good investment A 0 NPV indicates a satisfactory investment A negative NPV indicates an unsatisfactory

investment To work you need a good costs, earnings, and

savings projection and a discount rate Discount rate is the cost to get money from

investors, credit or both (has form of an interest rate)

The Per Unit Cost Model

Convert the Initial Capital Cost to an Annual Cost

Get a Total Annual Cost

Divide by Annual Tonnage toget a cost per ton figure

Unit Cost Model Use

NPV model is used for a evaluating investments

Unit cost is often used for a support service needed by an operation but which actually costs something to provide

Often more one evaluation technique is used to allow evaluator to determine what is really important.

Unit Cost Model Need

Need to be able to convert a capital cost item into an equivalent annual cost– Requires a life and– An annual cost

Example - Pneumatic Conveyor $4,646,000– Use 7 year life– Assume cost of money is 9%– $4.646M* A/P9,7 (0.1987) = $923,160

– Cost/ton $923,160/2,250,000 = 41 cents/ton

Increasing Model Sophistication General Project Costs

– Cost Estimate Explained to date had detailed list of costs– There are general costs above this for any specific project

Contingency Cost– If project may lag from estimate time to build time may

add contingency for cost increase– May be used to handle specific add ons or system

interfaces– May be used to handle omissions

The Use and Abuse of Contingency

The omissions problem– Order of Magnitude to Pre-feasibility

may have general idea of ratio of missing systems to those readily costed out by curves and factored cost estimates

Example - Elbows and fittings added to piping as a percentage of the cost of the piping

May have interconnection parts that would require more detailed engineering to place a specific cost

– Example some of the steel supports for equipment in pneumatic system

Abuse and Omissions

In Feasibility and Budget Authorization Work– People use CYA factor so they won’t come in

over budget Problem with CYA factors

– designed to make person look good at the expense of project

People who only want to build slam dunks so they will always look successful

Miss opportunities that owed the company

Abuse of Contingency Why a factor for missed items when list is suppose to

be thorough and well thought out– Sloppy work– Inexperience taking engineer beyond level of competence -

Ethics problem Need to identify areas of uncertainty

– Contingency linked to something specific with experience and judgement not an abuse

– May want to consider it as a line item in a cost center instead general contingency so things don’t get lost or double counted.

Contingency for Add ons and Undefined System Interfaces Usually will have some minor cost items to

connect something that not practical to design in detail– Example - Chemical company needs an

engineering drawing for a new door handle on a port (build wasteful delays and costs into system)

– These things should be linked to cost centers and even line items on cost centers

better as line items than contingency

The inflation and cost shift contingency Type of contingency needed at budget

authorization– Project will have delays, expired quotes, field fit

problems only seen when you build Contingency needed because board is voting

money– coming up short of being able to finish has major

implications for company security companies fail over payments and costs in wrong spot even

when over-all balance is good

When to use inflation cost shift contingency Not really make sense at Pre-feasibility

– most quotes too loose to be worried about shifts Feasibility Study

– It may be several years before build– But Feasibility studies are to determine whether

something makes sense now– If someone takes 1996 study and uses it for budget

authorization in 2002 he/she is stupid enough to deserve what they get

The Point

Use the right type of contingency for the right type of study

Do your work right - use contingency to cover legitimate things beyond your control or the depth of the investigation you are charged with doing

Contingency should never be used for personal CYA at the expense of a fair evaluation of a project

Try to Put General Contingency on Pneumatic Conveyor Uncertainties - we don’t know exactly how this

conveyor is to lay out relative to mine– we have vendor quotes on major cost items– well checked factored cost estimates on things we

can’t design in detail– field fit and things needed by workforce are

uncertainties Self Examination - Are these things fair for this estimate

and the likely way it will be used or do they mean we need to do more work?

A Big or Little Contingency Numbers like 5 to 20% are often seen in

contingency– If they put conveyor in way different from our

layout and add other components could get 20% Should we use 20%?

– If we have a good list they can see what we have included - if they alter it they can adjust - not our job to cover others incompetence (especially when we don’t even know it’s a problem)

Putting in our contingency

$4,000,000 conveyor– Add 5% contingency to handle uncertainty in

how it will be fit to the mine $200,000

New Cost with Contingency $4,200,000

Other General Costs

Good Feasibility Study line items components– actually building will require additional

engineering design work at feasibility study stage some engineering work still has

to be done - it is a cost that can be avoided by not pursuing project - it is therefore appropriate to add

at budget authorization stage some engineering is a sunk cost should not be charged (a cost against companies over-all need to make a “profit”)

More General Costs

Project will require supervision to build– most cost centered line item costs relate to that

equipment and the people putting it in– There is a real supervision cost

often in range 3% to 30% if there is extensive engineering and supervision

External firms have to build overhead and profit into actual supervision and engineering costs

Going to suggest this internal project with 7% for additional engineering and supervision

Adding in Engineering and Supervision Fees $4,193,000 * 0.07 = $293,000 Project cost is $4,486,000 An additional cost sometimes added is for a

spare parts inventory– Usually 3 to 7%– $4,000,000 * 0.03 = $120,000– had a low value because we have built in spares on

feeders and blowers– $4,646,000

Project Finance Cost

Most projects have to obtain money– If company has internal money available relatively

easy to get but requires firms required rate of return be used in discounting

Often high compared to project specific finance

– If company must raise new equity then cost of stock or bond issue plus required rate of return

– Debt or leveraged financing requires loan initiation often hiring separate engineer - bankers engineer

Do I include Finance Cost?

Depends on charge– Engineers often ask to bring well thought out

engineered projects - have other people that do money cost evaluation (don’t add it)

Depends on detail available– project finance is often a special manipulation -

do you know enough about financial structure to do it

– We don’t

EPC Cost versus All in Cost

EPC is Engineering, Procurement, and Construction– Engineers often do the EPC cost estimates

Project Financing Costs– All in Cost– Has details and riders from the accountants– Building a new power plant is about $1,100/KW

EPC and $1,400 to $1,700/KW all in

The Pneumatic Conveyor

We’ll do an EPC cost - project finance is well beyond the scope of this work– We do know that project capital is regularly

available for improvements to existing concerns at 7 to 9%

– We’ll pick 9% as our annual cost of capital

Capital and Operating Costs in a NPV model In NPV you simply put down costs when they

occur– Not directly important which is a capital and operating

cost– Money going down before a result is produced is

normally the capital cost - it is money that must be put down and placed at risk before any result is returned

Problem with NPV model– What if this is just a cost item - like say handling and

moving material

NPV model problem

If everything is a cost - money made is from something else it will always be negative– negative NPV means don’t do project– essential support service cannot be dumped as

unprofitable without dumping profitable functions

Would force one to look at whole project Often this is more than the charge for a project to

provide specific support to a mine

The Life Cycle Cost TrickPoint of Decision

Discount Everything Back to Decision Point LikeDoing an NPV

The Life Cycle Cost Trick

Equivalent costat Point ofDecision

Now Convert this to a series of annual loan payments

The Resulting Annual Payment is the Annual Life Cycle Cost

Capital and Operating Costs in a Unit Cost Problem Subtle Change in Capital Cost

– Capital Cost normally is the at risk capital placed down to make project ready

– Operating Costs are the costs for supplies expended when unit is operated

Problem occurs when an initial cost item is consumed as a function of production– May allow item to appear on both the capital and

operating cost list– Double accounting risk or at least confusing

Pneumatic Conveyor Example

Pick a Classic Capital Cost– Air supply center and power supply

These items are life of the project - won’t wear out or be consumed from production

Let Life of Western Reserve be 15 years– Capital costs

Anything that has to be bought up front and is used for the life of the project regardless of production

Air Supply $1,536,000 Power Center $430,000

More Capital Costs

Air Shafts and Pipe?– Some of stuff move every 5 years– Permanent Stuff $523,000

Feed Injection– Have equipment that wears out from use– Equipment that re-installs every 5 years but

lasts life of operation– Just life of mine equipment $378,000

More Capital Costs

Air Solids Separation– Has 5 year move and replace stuff– Has permanent stuff $333,000

Control System– Has some sensors that will be replaced every 5

years with move– Other equipment that is life mine - or will it be

technology Life? Say 8 years - $135,000

More Capital Cost

General Cost Center $653,000 Total of 15 year Life Equipment

– Air Supply $1,536,000– Electrical Supply $430,000– Air Shafts $523,000– Feed Injection $378,000– Air Solids Separation $333,000– General Cost Center $653,000– Total $3,853,000

Annual Cost of 15 year equipment 3,853,000 * 0.1241 = $478,000 per year Also have equipment that is assumed to

become obsolete every 8 years– Mostly in the control area.– Cost $135,000

Getting Annual cost– $135,000 * 0.1807 = $24,400 per year

Characteristics of Capital Costs in a Unit Cost Problem They are expenses for things that last the life of

the project and are not used up by production– Our equipment that lasted the life of the Mine– Our controllers that lasted the life span of the

technology Operating costs are costs for equipment and

things that are used up by the act of producing coal

Operating Costs

Electric Power– Blowers are the main load 6 blowers running at 710 HP

each (based on manufacture curves)– Also have 15 HP in rotary feeders - motors on short

conveyors and bunkers, and roll crusher (use 100 HP for now)

– Total HP = 710*6+115 = 4375 HP– Convert to KW 4375 * 0.746 = 3264 KW

Price per KWH 4.5 cents– 3264 * 0.045 = $147/hr

Operating Costs Continued Conveyor runs at 600 tph

– $147/600 = 24.5 cents/ton Considering other maintenance, electric power is

about 75% of operating costs for pneumatic mine conveyors– about 8 cents/ton other maintenance costs

Operating Cost is 32.5 cents/ton But there are capital goods being used up in the

course of production (we mine out panel in 5 years)

Problem Child Operating Costs

Have a capital cost character but are consumed in proportion to production

Designed Conveyor for 2.25 M tons/year– 5 years - 11.25 M tons

Some dispute on how to handle– vendors often like to take cost divided by tonnage– problem when several years life is that time value

of money becomes an issue

This Class Method of Dealing With Take 5 year costs

– New Pneumatic Lift Shafts $325,000– Eaten up Feed Injection Equipment $186,000– 5 year footings and supports for air separation equipment

$57,100– Sensors worn out or abandoned with relocation of

pneumatic shaft $89,000– Total $657,100

Break it into an annual cost– $657,100*0.2571 = $169,000

Additional Cost/ton $169,000/2,250,000 = 7.5 cents Confusion Issue

– I just handled an operating cost exactly like a 5 year capital cost

– Big difference 8 year equipment become obsolete in 8 years regardless

Panel was mined out in 5 years only subject to a specific production rate

Do need to add some costs for advancing pipe through mains - doing instead of conveyor

Advancing Pipe

Wabash advanced mains about 0.3 miles per year– 1540 ft– Pipe at $51/ft = $78,540– assume double for install light concrete protect– $157,000

Costs for Distributed Pneumatic Conveyor Capital Cost

– 15 year Capital $478,000/year– 8 year Capital $24,400/year

Operating Cost– Power/ Maintenance/ Operation 32.5 cents

2,250,000 * 0.325 = $732,000

– 5 year consumables $169,000– Pipe Advance $157,000

Total $1.56 million/year

Cost Offsets from Using Pneumatic Conveyor Free up 4 mine inspectors

– about $120,000 in wages and benefits each– save $480,000

Stop Rock Dusting Haulage Ways– about 2.5 cents/ton– 2,250,000 tpy * 0.025 = $56,250

Change in Belt Availability due to access and avoided roof falls

Belt Availability Present Availability about 95%

– with pneumatic overland to plant is disconnected with stock piles

– about 99%– Marginal coal is about $9.50/ton savings– 250 days per year * 16 hours/day = 4,000 hours– 5% down time is 200 hours– 1% down time is 40 hours– 160 extra hours running at 600 tph– $912,000

Other Savings

Savings running slope belt at 10 cents/ton– 2,250,000*0.1 = $225,000

Savings on buying and advancing main line belt– at $1,000,000/mile for 54 inch underground belt– $292,000/year

Savings on Beltway Support– at 15 cents/ton– $337,000/year

Savings on Surface Conveyer Main over UG at 10 cents/ton– $225,000

Cost of Pneumatic System

Savings on processing? Costs for surface right away compared to UG? Defined Savings

– $480,000 inspectors– $56,250 rock dusting– $912,000 belt availability– $225,000 eliminated slope belt– $292,000 advancing main line belt– $337,000 savings on beltway support– $225,000 savings from surface conveyor over U.G.– Total $2,527,250 per year

Net Cost $455,000/year– $455,000/2,250,000 = 20 cents/ton

Impact of System

Offset Costs Exceed Expenditures Can Evaluate on Payback Period

– Direct Operating Cost $732,000 per year– Leaves savings of $1,795,250 per year to offset

initial purchase– Payback is $4,000,000/$1,795,250 = 2.22 years– (There are reinvest costs that come into play

later)