Analysis of Alternatives, Selections, and Replacements

A decision is made between alternatives or the selection is based in this chapter on applying the economic indicators presented before in Chapters 6 and 7.

8.1 INTRODUCTION

This technique of analysis of alternatives and selection can assume many different aspects.

Typical example are: the choice among alternative processes proposed for enhanced oil recovery in oil fields, the choice among alternative methods of cooling process streams in gas plants or the choice among alternative designs of heat exchangers, waste-heat boilers, pumps, or any piece of equipment.

A SELECTED CASE (EXAMPLE 8.1)

An oil company is offered a lease of a group of oil wells in which primary production is getting to an end, and the major condition of this offer is to undertake a secondary recovery project (water injection) by the end of the 5th year. The capital investment of this project is estimated to be $650,000. In return, the revenue in the form of cash flow realized from this lease is as follows:

• • $50,000/year for the 1st 4 years
• • $100,000/year for the 1st 4 years from the 6th to 20th years

A comparison has to be made between the two alternatives: To invest or not to invest? In other words, should the project be accepted or not?

SOLUTION

Such a situation could be handled by using the annual cost/present worth economic approach as will be explained later.

Economic alternatives can be classified into two main categories: ^{• [1]}

• To choose among alternative assets or equipment doing the same job. where mutually exclusive choices are considered and decision is made by technical people. Mutually exclusive projects imply that when two alternatives are compared, one project or the other is selected (but not both).

Many cases of alternative analysis can be handled with the "differential technique” or finding the “rate of return on the extra investment”, for the difference between two alternate investments. The following methods are presented:

• 1. Differential approach (Д approach) or return on extra investment (R.O.E.I.)
• 2. Total equivalent annual cost (T.E.A.C.)/present value method
• 3. Total capitalized method

To identify the problem at hand is of prime importance to identify the problem at hand to be either income expansion, or cost reduction:

• • Profit or income expansion: where revenues (cash flows) are generated, and maximization of the profit is required, or
• • Cost reduction: where no cash flows are given; instead expenses are known and reduction in costs is the criterion.

Replacement analysis, on the other hand, can be considered some sort of alternative analysis for investment tied up with an old asset versus an additional or (a replacement) investment. This situation is encountered to replace worn, inadequate or obsolete equipment, and physical assets.

8.2 DIFFERENTIAL APPROACH (A APPROACH),

OR RETURN ON EXTRA INVESTMENT (R.O.E.I.)

The differential approach is a concept, which could be applied for selection among alternatives for a group of equipment, plants, processes, or oil-related venture projects. The principle of minimum capital investment is applied in this method in the following sense: For a set of alternatives needed for a given job and doing the same function, choose the minimum investment as the base one on base plan.

The differential approach to be used as a criterion for selecting alternatives is summarized by the following procedure: ^[2]

3. Calculate the rate of R.O.E.I. as follows:

• Check to see that the preferred choice should have an R.O.E.I. greater than a minimum value prescribed by management.

For alternatives involving small increments in capital investment, the best (most economical) alternative is arrived at by either graphic or analytical solutions.

The following solved examples illustrates these principles.

Example 8.2

In the alkanolamine sweetening process of natural gas, two types of coolers have been suggested for the amine solvent: type A and type B. Using the data given next (Table 8.1) recommend which alternative should be used if both types are acceptable technically. The minimum rate of return on money invested is 15% and the economic lifetime is 10 years for the coolers.

SOLUTION

Use straight-line depreciation of 10% of C.l.

The problem is a cost-reduction type.

TABLE 8.1

Data for Example 8.2

FIGURE 8.1 Change of A.% saving versus lifetime of type B.

Example 8.3

Insulation thickness is important for heat exchangers in the oil industry. One situation was encountered in the sulfur recovery plant from hydrogen sulfide gas (H,S) (which has to be removed from natural gas). A heat exchanger was designed and recommendation was made for four possible thicknesses of insulation. The costs and savings related to these cases are as follows. Which one is recommended for 15% minimum R.O.I.?

ILLUSTRATION OF SOLUTION IS GIVEN IN TABLE 8.2

For 15% minimum R.O.I., calculations indicate that all four proposals are acceptable, since they generate R.O.I. > 15%, each. Now, we can apply the differential approach as indicated above. However, let us use the graphic analysis technique, since the problem involves small-investment increments. Referring to Figure 8.2, the annual savings/C.I. curve is drawn as shown using the above data. As can be seen, by increasing the C.I., the annual savings are increased until we hit the optimum point, M, which represents the maximum savings. Then, by drawing

FIGURE 8.2 Graphical presentation of differential solution (Example 8.3).

TABLE 8.2

Data for Example 8.3

" Based on $0.3 per million Btu of (he heat recovered and 300 working days per year. ^b Based on 10-year lifetime.

our tangent line at P, we can achieve an R.O.E.I. of about 17% when using C.l. of nearly $1,600, or an insulation of 2-inch thickness.

The R.O.E.I. or differential method has one big drawback if applied to alternatives with different economic lifetimes. This puts a constraint on using it for these situations, which can be handled by other methods to be discussed next. Figure 8.2 illustrates this case.

Conclusion: Design 2 is recommended; it gives more profit than design 1.

While, R.O.E.I. is 17%, which is >15% (minimum).

Figures 8.3 and 8.4 are graphical plots to illustrate the results obtained in solving this example.

FIGURE 8.3 Change of R.O.I. savings versus types.

FIGURE 8.4 Comparison between types of pumps.

8.3 TOTAL EQUIVALENT ANNUAL COST (T.E.A.C.)/PRESENT VALUE METHOD

In this method, all costs incurred in buying, installing, operating, and maintaining an asset are put on the some clcitum: that is, on annual basis. Generally, the annual equivalent costs are brought to the present value for all alternatives.

Specifically, the T.E.A.C. is the sum of the annual cost of capital recovery (initial capital plus interest on it) and other annual operating costs. (Remember that depreciation costs cannot be included with the annual operating costs. They are taken care of in the cost of capital recovery.)

Where:

Example 8.4

Recommend which arrangement to select out of the following two cases, where energy saving is required by using higher capital investment:

Assume i = 10% and the salvage value is negligible.

TABLE 8.3

Data for Example 8.4

Assume i = 10% and the salvage value is negligible. Which design is to be recommended?

System II is recommended, since T.E.A.C. is less than for system I. Figure 8.4 represents the results.

Figure 8.4 is a graphical plot to illustrate such results.

SOLUTION IS GIVEN IN TABLE 8.3

Example 8.5

Given: Assume the same two heat exchangers given in Example 7.2 with the same annual costs, economic lives, salvage values, and investments, and with the cost of capital once again 8%.

Wanted. Compare the two alternatives using the present worth values for each of the possibilities, as well as total equivalent capital at the "present" time of consideration of purchase of heat exchangers.

SOLUTION

Using the present value method, a series of known uniform annual costs are reduced to an equivalent present value. This allows one to estimate the dollar value at the present time that is equivalent to the amount of annual costs for some fixed years of service by two alternatives. But uniform annual costs must first be determined, and this is what the present value method does. (The annual cost method does not determine uniform annual costs.)

TABLE 8.4

Data for Example 8.6

Now, for each of the possibilities, the present values of installations and the salvage values must be added and deducted, respectively, to current value of annual costs for 10 years in order to get total equivalent capital requirements.

The following calculations are carried out to find the the equivalent capital at 8% Table 8.4 illustrates the solution.

A comparison of the calculations for equivalent capital involved, $95,959 for possibility A and $85,165 for possibility В for the present time on an economic basis, indicates $10,794 less favoring possibility B. In other words, a savings of $1,610 in annual costs, as given by the annual cost method, favoring possibility В is reflected in a $10,794 reduction in equivalent present value of possibility В when annual costs are uniform and determined with the use Total "present" equivalent capital at 8%: of the present value method.

Under conditions of low interest rates, the present or current value of possibility B, which is $40,000, can still be less than the current worth of $15,000 for possibility A. Thus, the interest rate is important in order to determine the present value. Lower interest rates, such as say 5% instead of 8%, favor even more the use of higher initial investments, in this case the $40,000 stainless steel heat exchanger rather than the $15,000 steel-copper exchanger, because the relative cost for the use of money is lower. Example 8.7 confirms these results. A summary of the solution using excel is given next, followed by a graphical chart as shown in Figure 8.5.

Example 8.6: (summary)

FIGURE 8.5 Change of total annual costs for different types of H.E.

Example 8.7

Compare the relative annual costs and current present values of the two alternatives in Examples 8.5 and 8.6 for 10 years of service if money is worth 5% instead of 8%.

SOLUTION

a. For the annual cost method at 5%:

Compared to the costs when the interest rate is 8% (see Example 7.2, total annual costs for each possibility are lower when the interest rate is 5%. But the difference in annual costs is greater when the interest rate is lower. At 8%, the difference is $1,610 less in favor of possibility B, whereas at 5% it is $2,002 in favor of possibility B. Thus, lower costs of borrowing favor alternatives with large investment amounts more than alternatives with lower investment amounts.

b. For the present value (present worth) at 5%:

At 5%, the equivalent capital for purchase possibility В is $16,234 ($108,129 - $91,895) less than purchase possibility A. With lower interest rates, differences in equivalent capital are greater: $16,234 between alternatives at 5% and $10,794 between alternates at 8%. However, total present equivalent capital amounts are greater with lower interest rates: Totals at 5% are $108,129 and $91,895 for possibilities A and B, respectively, and at 8% are $95,959 and $85,165.

A comparison of these results and those obtained when money is worth 8% shows that (a) the time-money series is equivalent to larger capital requirements, and (b) the difference in equivalent present value is greater in favor of purchase possibility В than it is for A when money is worth only 5%.

Example 8.8

The overhead condenser in a stabilization unit of a natural gasoline plant has to be made of corrosion-resistant material. Two types are offered; both have the same capacity (surface areaj; however, the costs are different because of different alloying materials:

If money can be invested at 8%, which condenser would you recommend based on the T.C.C.?

Therefore, condenser type A is selected (lower K).

Example 8.9

Solve Example 8.5 using the capitalized cost technique for 8% and 5% annual interest rates.

SOLUTION

Two methods are presented:

1. Using the relationship givenbefore, (direct application): a. For i = 8%:

2. Using step-by-step procedure (detailed):

a. Capital requirements through capitalization, with interest at 8%, are as follows:

b. Capital requirements through capitalization, with interest at 5%, are as follows:

It is clear that both the direct and detailed methods give the same final answer; however, one would be reluctant to use the latter approach.

At the lower interest rate of 5%, the capitalized cost is $42,060 less for possibility В ($280,060 - $238,000]. The results illustrate the peculiar effect of the interest rate and emphasize the potential difficulties in comparing alternates on either a present value or a capitalized cost basis. When cost of capital is high, total capitalized costs become lower, but differences between capitalized costs of higher and lower investment amounts favor higher investments more when cost of capital (interest rate) is lower.

The interest rate is the determining factor, although the relative size of such individual items as initial costs, annual labor costs, annual material, repairs, maintenance, and other costs, when compared to capital recovery costs, can affect total equivalent capital involved.

The important point is that the interest based on the going value of money is always lower than the rate for a venture involving a risk. The engineer using the going rate for interest will bias his comparisons in favor of the alternative equivalent to oil capital requirements. Because of this, the annual cost method is preferred, but the service lives of the alternatives should be equal and annual costs of alternatives should be uniform. When different service lives are involved, or where nonuniform annual expenditures must be compared for alternatives, it is better to use the present value method and put all costs on a comparable basis in order to get accurate results and avoid "distortions" of costs.

8.4 REPLACEMENT ANALYSIS

In the oil industry, the usual experience is that assets are retired while they are still physically capable of continuing to render their service either in the oil field, in transportation systems or in the refining operations. The question is: how can we make the decision to replace an asset?

The decision to make such replacement should generally be made on the grounds of economy along with engineering fundamentals applicable to oil operations. That is, replacing a worn, obsolete, or inadequate asset can be translated into the language of economics.

Reasons behind a replacement can be defined either as “a must”, that is, we have to replace, otherwise the operation will come to a halt, or “optional” in w'hich case the asset is functioning, but there is a need for a more efficient or modern type. Such a classification is illustrated in Figure 8.6.

The principles governing replacement are best explained by using the word “defender” to stand for the old asset and the word “challenger” to identify the possible new candidate that will make the replacement. In order to utilize the challenger/ defender analogy for replacement comparison, the following factors must be considered (Valle-Riestra, 1983):

All input/output of cash flows associated with the asset have to be known or estimated. This applies in particular to maintenance and operating costs of both defender and challenger.

Cost estimation of the value of the defender (market value/book value) must be made.

FIGURE 8.6 Replacement analysis.

Methods recommended earlier for the comparison of alternatives such as T.E. A.C., present worth or Д approach could be applied. In other words, no new' techniques are provided. Tax obligations or credits should be considered.

Example 8.10

A tank farm is receiving crude oil through a pipeline. Periodic measurements of the crude oil level are made. The annual labor cost for the manual operation is estimated to be $50,000. However, if an automated level-measuring system is installed, it will cost $150,000. Maintenance and operating expenses of the system are $15,000 and $5,000, respectively. The system will be operated for 5 years.

Should the automated level-measuring system be installed? Assume interest rate is 10%.

SOLUTION

Two alternatives must be compared:

Alternative 1: Manual operation

Alternative 2: Automated level-measuring system The manual operation, alternative 1, is less expensive.

Example 8.11

An oil company has an existing steam-generation unit. Its cost when new is $30,000, its lifetime is 10 years and it has a salvage value of zero. The annual operating cost is $22,000. After it has been in use for 5 years, the estimated book value of the unit is found to be $6,000. The remaining lifetime now is only 3 years.

It has been proposed to replace this unit by another new one. Its cost is $40,000, lifetime 10 years, operating costs $15,000/yr and zero salvage value. $hould we continue using this unit or go for the replacement?

The company requires 10% R.O.I.

SOLUTION

Now, take these 3 years for comparison:

Therefore, savings = 24,000 - 19,000 = $5,000/yr.

If replacement takes place, R.O.E.I. = (5,000/$34,000)100 = 14.7%.

Example 8.12

Consider a control valve that becomes obsolete 3 years before it has been fully depreciated. When fully depreciated, the valve will have a salvage value of $400, but at this time (3 years before], it has a trade-in (or resale) value of $1,000. If the book value (original cost - total depreciation to date) is $760, there is a favorable "bonus" to management of $240 in trade-in.

But the bonus of $240 is irrelevant as a sunk cost. If a minimum rate of return is assumed as 10% before taxes, the question is whether the obsolete control valve with 3 years to go before being fully depreciated should be replaced now by a new valve. Calculations are needed to compare the old valve with a new valve, which would cost $5,000 and have an eventual salvage value of $500 and a service life of 10 years.

SOLUTION

By comparing the old control valve with the new valve, we can see that purchasing the new valve now would mean an annual savings of $384 or ($2,166 - $1,782). If the old valve is depreciated out, only the salvage value of $400 could be allowed on capital recovery.

• [1] To choose among different ways to invest money not necessarily toaccomplish the same job, in which case the decision is influenced bymanagement rather than by technical people;
• [2] Select the minimum capital investment (C.I.) as our base plan, computeДС.1. (difference in capital investment) for the alternatives. 2. Compute Aprofit (difference in cash income) for the alternatives, for theincome-expansion problem, and Asaving (difference in annual costs) forthe alternatives, for the cost-reduction problem.