Cost Issues

Module Outline
Evaluating plant investments
Plant financing options
Plant ownership costs
Calculating ownership costs
Purchase versus hiring plant
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Evaluating Plant Investments

Investment appraisal methods
1) Payback period
2) Average rate of return
3) Net present value
4) Internal rate of return
5) Benefit-Cost ratio (Profitability index)
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1) Payback period method

A simple method popular for small businesses
The payback period = The time taken for an item of plant to
generate sufficient net cash flow to pay
for the original capital investment in its
entirety
Example:
A company considers purchasing an excavator for an
investment of $200,000 which is expected to provide annual
cash flow of $50,000.
The payback period would be four years.
Ignores the time value of money
Changes in the cash flows after the payback
period are ignored
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2) Average rate of return (ARR)

Average annual profit you expect over the life of an investment
project, compared with the average amount of capital invested
(NIBusiness, 2004)

Average annual profit

Average rate of return (ARR) =
Average investment cost

If ARR = or > the required rate of return investment accepted

If ARR < the required rate of return investment rejected

Average investment =
Book value at beginning of year 1 +book value at end of useful time
2
Or

Average investment ~ initial investment cost

Example:
An excavator requires an average investment of $250,000 and
is expected to produce an average annual profit of $37,500.
The ARR would be 15 per cent.
The higher the ARR, the more attractive investment
ARR is based on profit rather than cash flow (affected by
subjective, non-cash items such as the rate of depreciation)
Fails to take into account the timing of profit
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3) Net present value (NPV)

Takes into account the size of the cash inflows over the life
of the plant, but also makes adjustment for the timing of the
money
Present value (PV) =

F
n
(1+i)

F = the future value

i = interest rate
n = the number of years
Example:

$ 100 000 in two years time, at a 6% rate of interest, has a

present value of:
$100000
= $88999.64
2
(1+0.06)

The PV of a series of uniform payments (Annuity, A), e.g. annual

incomes, over a period of N years:
n
A [(1+i) 1]
Present value (PV) =
n
i(1+i)

Net present value (NPV) = The sum of the present values (PVs)
of incoming (benefit) and outgoing
(cost) cash flows over a period of time
Net present value (NPV) = -PV (costs) + PV (benefits)
A cost is negative or outgoing cash flow
The higher the NPV the better (NIBusiness, 2004)
Example:

An investment of $100,000 generates annual cash flow of $28,000

and with an interest rate of10%, the NPV for five years of cash flow
is $6,142.
5
$28000[(1+0.1) 1]
$100000= $6142
5
0.1(1+0.1)

4) Internal rate of return (IRR)

The internal rate of return for an investment is the rate of return
(interest rate) that makes the present value of returns (benefits)
equal to the present value of costs
PV (costs) = PV (benefits) NPV=0
Example:
An investment of $100,000 is expected to generate an annual
return of $28,000 for 5 years. What is the IRR?
5
$28000[(1+r) 1]
= $100000
5
r(1+r)
Try
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r = 10%
r = 20%
r = 12.5%
IRR 12.5%

or

5
(1+r) 1
= 3.57
5
r(1+r)

Factor = 3.79
Factor = 2.99
Factor = 3.56 close enough

5) Benefit-Cost ratio
Appropriate for situations where there is a limited capital
budget to be allocated to the most cost effective projects
Benefit-Cost ratio = Discounted value of benefits
Discounted value of costs

The greater the benefit cost ratio the more desirable the
project
Not useful when choosing between more than one project as
it measures the relative profitability of a project.

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Plant Financing Options

Owning equipment
Costs include:
Operating costs
Maintenance
Repairs
Inspections
Transportation
Storage
Long retain period
Escalate over the life
of the equipment
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Renting equipment

Reduces the amount of

capital tied up in fleet
Reduces the amount of
start-up capital
Reduces maintenance
costs, repairs,
inspections, transportation
and storage.

 Plant financing options

1) Cash Purchase

Plant supplier

100%

Construction
Company

2) Financing Lease:
Lease fee

Plant supplier

Construction
Company

Finance provider

Construction company:
Responsible for all maintenance, taxes and insurance
Can purchase the plant at the end of the lease period (at residual value)
Can renew/terminate the lease period
Lease fee

3) Operating Lease

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Plant supplier

Construction
Company

Supplier (owner) is responsible for maintenance & taxes

Charges/lease period are usually lower than financing lease
Suitable for large or complex items of plant (skilled personnel for servicing
and maintenance provided by the lessor)

Plant Ownership Costs

Factors influencing ownership cost
Purchase price

Cost of standard & optional attachments, sales taxes, and delivery

costs (freight, packing, and insurance)

Economic life (ownership period)

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Period over which the equipment can operate at required levels of

cost and output
Measured in terms of operating hours (or in the case of trucks and
trailers in terms of kilometers)
Influenced by several factors:
- The physical condition and performance of the plant
- Shifts in economics for a company
- Physical deterioration concerns issues such as corrosion,
chemical decomposition and general wear and tear
- Changing economic conditions such as fuel prices, tax
investment incentives, and the rate of interest

Examples of ownership periods for some types of plant

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 Plant utilisation
An uncertainty even if a company has secure, fixed-term
contracts
Expected rate of utilisation past operational history of the
companys equipment (Agoos, 2012)
A simplified approach to calculate utilization:
Utilisation (%) =

Operating period
Standard industrial period

Industry-standard operating period: 22 days or 176 hours per month

A practical guide:
Utilisation > 60-65% of the time owning is more cost
effective than renting
40% < Utilisation < 60% increase financial risk
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Utilisation < 40% renting is almost always the best option

Calculating ownership costs

Definition of terms:
Salvage or residual value
The price that equipment can be sold for at the time of its disposal
Often estimated as 10-20% of the initial purchase price

Insurance
A rough estimate of plant insurance cost : $10 for every $1,000 of
the average value (i.e.,1%)
If the actual insurance cost of the plant is known:
Estimated insurance cost / year = Average value 100
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 Depreciation
Decrease in plant value over time
Straight-Line depreciation
Accelerated depreciation
New price salvage price
No. of years used

Cost

Straight-LineDepreciation

Accelerated Depreciation
Year 1 Year 2 Year 3 Year 4 Year 5
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No. of years used

 Interest cost
Expected income if a company had invested money (e.g., in bank)
instead of buying plant
Method 1: Interest cost = Average value interest rate
New price + trade in value
Average value =
2
Method 2:
Interest cost = (Average annual investment (AAI)) (interest rate)

Using straightline depreciation:

(PS)(N+1)
+S
AAI =
2N

P = Purchase price
S = Salvage value
N = Life in years
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 Storage cost
The cost associated with providing suitable facilities to store and
protect plant
Method 1: Storage cost = 0.5-1% of the price of new machine
Method 2:
Storage cost = (yearly depreciation of storage facility) x
(proportion of facility occupied by the machine)

Workshop cost
The cost the tools and workshop if plant is serviced and repaired
on company premises
Workshop cost = (proportion of workshop time used for plant) x (cost
(depreciation & interest) of workshop and tools)

Registration cost

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Where items of plant such as front end loaders or mobile

cranes are going to be driven for short distances on the road

Purchase vs. Hiring Plant

Summary
Owning equipment

Plant availability controlled by

contractor
Hourly rate is generally less than
hire plant
Owner has the choice of which
costing method to use

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Renting equipment
Can be hired for short periods
Repairs and replacements are
the responsibility of the hire
company
Contractors do not have to worry
about plant utilization after the
job is finished
Plant can be hired on an all-in
basis including the operator.