W5_BUD_Project Economic Evaluation using PW and IRR

1.    Problem Definition

In 2010 the Indonesian government launched a conversion program from kerosene to LPG for household needs. As a result, Pertamina should reduce the production of kerosene and one of the alternatives is to convert kerosene to avtur (jet fuel). It is required to build a New Treatment Unit to run the program. Project economic evaluation is needed to ensure that the project is justified. 

2.    Feasible Alternatives

There are two alternatives:

1. Run the project if the project is economically justified.

2. Do not run the project if the project is not economically justified.

3.    Develop the Outcomes for each Alternative

1.  Run the project (Build a New Treatment Unit)

Parameters	Unit	Value*
Kerosene production	barrel/year	5,000,000
New Treatment Unit Capacity	barrel/year	2,000,000
Kerosene price	USD/barrel	68
Avtur price	USD/barrel	70
Additional operation cost to produce avtur	USD/barrel	0.25
Additional margin to produce avtur	USD/barrel	1.75
	(x1000) USD/year	3,500
Project estimate	(x1000) USD	12,000
Lifetime	year	20
Minimum Acceptable Rate of Return (MARR)	%	13

*) numbers are used only to illustrate economic calculation examples.

2.  Do not run the project: Pertamina must looking for additional +2,000,000 barrel/year kerosene sales for industries.

4.    Acceptable Criteria

a. Acceptable criteria for economic evaluation using Present Worth Method is:

Present Worth (PW) > 0 at MARR (Hurdle rate) = 13%

b. Acceptable criteria for economic evaluation using IRR Method is:

IRR > MARR (Hurdle rate)

5.    Analysis and Comparison of the Alternatives

 

 a. Present Worth Method:

                PW                  = PW cash inflows - PW cash outflows

                PW (13%)       = USD 3,500,000(P/A, 13%, 20) - USD 15,000,000

                                         = USD 24,587,000.

                Because PW (13%) > 0, this project is economically justified.

 b. IRR Method (calculate using Microsoft Excel IRR function):

 

 Because IRR (23%) > MARR (13%), this project is economically justified.

 

6.    Select the Preferred Alternative

Based on Economic Evaluation using Present Worth (PW) and IRR, the project is economically justified so we can run the project.

7.    Performance Monitoring & Post Evaluation of Result

To ensure the accuracy of project economic evaluation using PW and IRR, the result will be compared with economic evaluation using External Rate of Return (ERR) addressed for W6 blog posting.

References:

1.    Bhattarai, B. (2006). The Internal and external Rate of Return (IRR and ERR) Methods: A Look into Their Features and Relevance. Economic Journal of Nepal Vol.29, p. 30-37

2.    Lang, H.J. & Merino, D.N. (1993). The Selection Process for Capital Projects. Chapter 5, 7, 9, 10

3.    Sullivan, W.G., Wicks, E.M. & Koelling, C.P. (2012). Engineering Economic 15^th Edition: Chapter 5, p. 178-211