W6_BUD_Project Economic Evaluation using ERR

1.    Problem Definition

This blog posting is continuing from W5 blog post’s case study using different approach. In W5 blog posting, the economic evaluation performed using present worth (PW) and internal rate of return (IRR) method, whereas in this W5 blog will be performed using External Rate of Return (ERR) Method.

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 look for additional +2,000,000 barrel/year kerosene sales for industries.

4.    Acceptable Criteria

Acceptable criteria for economic evaluation using ERR Method is:

ERR > MARR

 

5.    Analysis and Comparison of the Alternatives

 

          IRR (I’ %) calculated using equation (5-8) Engineering Economic^[3]:

            Where:

R_k     = excess of receipts over expenses in period k,

E_k     = excess of expenses over receipts in period k,

N     = project life or number of periods, and

ε      = external reinvestment rate per period.

           $15,000 (F/P, i’%, 20) = $3,500 (F/A, 13%, 20)

                           (F/P, i’%, 20) = $283,314 / $15,000

                                  (1 + i’) ²⁰ = 18.9

                                                i’ = 15.8%

           Because ERR (15.8%) > MARR (13%), this project is economically justified.

6.    Select the Preferred Alternative

Based on Economic Evaluation using ERR, the project is economically justified so we can run the project.

2.    Performance Monitoring & Post Evaluation of Result

Project economic evaluation using PW and IRR (W5 Blog) and ERR shows identical result.

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