# Estimation of capital

Authors: Alex Chandel [2014] , Eric Jiang [2014] , Minwook Kim [2014] , Todor Kukushliev [2014] , William Lassman [2014] , and Watson Fu [2016]

Steward: Daniel Garcia, David Chen, and Fengqi You

Date Presented: 2/9/2014

## Introduction

One of the most important aspects of determining the overall economic viability of a chemical process is determining the capital cost. In addition to the purchase price of the equipment, capital costs include delivery and installation of equipment, preparation of land for construction, salaries of contractors and construction workers, and any other costs associated with building a chemical plant. For this reason, the cost associated with process equipment is not as straightforward as the sticker price.

## Components of Capital Cost

### Fixed Capital Investment

The fixed capital investment is the total cost associated with constructing the plant. This cost includes design, site remediation, purchasing process equipment, developing infrastructure, and contingency charges, and includes the raw material costs as well as labor. It is divided into four categories.

#### ISBL (Inside Battery Limits) Plant Costs

ISBL (Inside Battery Limits) plant costs are the cost of procuring and installing all process equipment. ISBL costs include purchasing and shipping costs of equipment, land costs, infrastructure, piping, catalysts, and any other material needed for final plant operation, or construction of the plant. ISBL costs also include any associated fees with construction such as permits, insurance, or equipment rental, even if these items are not needed once the plant is operational.

ISBL is often defined as the "inner" cost of the plant, in that it is the cost associated with building the plant itself, from unloading the raw materials to shipping final products. Any costs associated with developing the plant itself is considered ISBL. It is important and relatively straightforward to obtain an estimate for the ISBL of the plant, and as other costs are often estimated based on the result of the ISBL, it is critical that this value is as accurate as possible.

#### OSBL (Outside Battery Limits) Plant Costs

OSBL (Outside Battery Limits), or off-site costs, are still an important component of the plant cost, but deals with calculating costs associated with off-site developments that require the plant to run. For example, if water or electricity are being utilized from the main grid, and infrastructure needs to be expanded to accommodate the chemical plant's addition to these systems, these costs are considered OSBL because they are not directly associated with elements between the input and output of the chemical plant.

Other examples of OSBL costs include fencing and security, utilities such as steam or electricity generators, sewers and waste treatment, firefighting and emergency equipment, offices and laboratories, and employee amenities. These facilities and pieces of equipment are not directly affiliated with the process but are critical costs associated with constructing any work site, and are filed under OSBL cost.

OSBL costs are initially estimated as a percentage of the ISBL costs. If not a lot of information ins available, a rule of thumb is to use 40% of the ISBL costs as an estimate for OSBL. However, once detailed information such as the exact site and plant layout are known, OSBL costs can be calculated in a manner similar to the ISBL costs.

#### Engineering Costs

Many of the steps involved in designing detailed equipment or structures onsite fall outside the scope of chemical process design. Rather than having the plant engineer do these designs anyway, a contractor is usually hired to do this design. The costs associated with generating a design, and in some cases all the way through finished fabrication and installation of equipment is filed under engineering costs. Depending on the size of the project and the amount contracted to the outside, engineering costs may include 30% of the ISBL and up to all of the OSBL, or only 10% of the ISBL. This cost depends largely on the size of the parent company, and whether or not it has in-house capability to do detailed design of the many different processes and equipment within a chemical plant.

#### Contingency Charges

Once costs are determined, if one could instantaneously construct the plant, then there would be no need for contingency charges. Contingency charges exist though because prices change, unanticipated costs arise, and other unexpected events can cause changes in costs. Contingency charges ensure that there is enough capital on hand to deal with these unexpected changes. Usually, contingency charges are billed to the parent organization, or of the design is done by a contractor to the contracting organization directly at the start of the project, rather than asking for increased funding mid-project. An absolute minimum for contingency charges is 10% of the ISBL and OSBL, with a more realistic value being closer to 40%.

### Working Capital

The capital costs associated with purchasing, building, and starting up any chemical plant can be estimated with methods discussed in previous and later sections. The working capital is a distinct cost associated with maintaining operations in a plant (Towler). It is important to differentiate it with costs of outflows during design and construction. It is also different from the costs of feedstocks and utilities that are paid during normal operations of the plant. Many of these costs have high value, but have a characteristic of being illiquid. For example, an expensive reactor in a process may be worth 3 million USD, but it can not be sold quickly for this price in the event 3 million USD is needed.

The working capital of a plant provides liquidity and flexibility as it is cash kept in reserve. It can be thought of as money that is needed to address irregularities in process operation, that may or may not be spent. There are many aspects of plant operation that are considered when making an estimation for how much working capital is needed. The value of inventory, the value of products and by-products, magnitude of accounts payable, magnitude of accounts receivable, process equipment spare parts costs. When all of these factors are taken into account, a useful estimate of working capital needed is approximately seven weeks of productions costs minus two weeks of feedstocks costs (Towler). Another suggested estimation of working capital is 10-20% of annual operating costs (Garrett). Both of these should be used as initial estimates, but further analysis of the aforementioned factors will yield a more useful value for working capital.

But it must be noted that for chemical plants of different processes, the individual factors that affect working capital can have large variance, and the aforementioned estimate will not work well for all situations. A simple example of unique characteristic that affects the size of working capital is the seasonality of a product. The working capital for a plant that produces a seasonal product may have a far larger working capital than a company that is not seasonal but has similar annual production. This is because the needs during the time when the product is in season has a more significant impact on the sales. Therefore, it is vital to ensure needs are met during the season.

#### Working Capital Turnover

Optimization of working capital is a consideration that can greatly affect the success and growth of a company. If the working capital is too low, it may not cover the costs of operations during a particular period of time. If the working capital is too high, it can be considered cash that is not gaining interest or value. The working capital turnover is a metric that is used to determine how efficiently the working capital is managed. Simply stated:

$WCT = \frac{AR}{WC}$

WCT = Working capital turnover

AR = Annual revenues($) WC Working capital($)

The objective for any plant is to maximize the working capital turnover. There are two ways to accomplish this: increase annual revenues or decrease working capital. The second method is very simple to enact; rather than holding cash as working capital, it can be used in other aspects of the plant operations. There exists a relationship between revenue and working capital because of the aforementioned risk of being unable to address unexpected operations needs. In cases of low working capital, replacing faulty equipment may take long periods of time. This will correspond to down time for the process and decreased production and decreased revenues. Careful risk analysis will identify how to optimize the working capital turnover ratio. Below are different working capital turnover ratios for different companies over a 5-year period.

Example working capital turnover ratios
Date: Dec 31, 2014 Dec 31, 2013 Dec 31, 2012 Dec 31, 2011 Dec 31, 2010
Dow Chemical Co. 4.59 4.39 4.66 6.13 5.24
E. I. du Pont de Nemours & Co. 3.81 3.24 4.56 5.52 -
LyondellBasell Industries N.V. 7.35 4.85 6.31 7.95
Praxair Inc. 35.17 47.32 35.86 156.28 37.75

## Project Financing

Because of the magnitude of costs associated with the start-up and maintenance of a chemical plant, there are often different project financing methods required to cover the capital needs. The two main methods of project financing are debt and equity financing. Debt financing usually involves the issuing of bonds. Equity financing involves the issuing of common stock. However, most companies utilize a combination of these two methods to successfully finance a project.

### Debt Financing

As stated, the debt financing involves the issuing of bonds. Buyers of the bonds can be either individual investors or banks and others institutional investors. After the bond is sold, the company who sold the bond is now in debt to the buyer. The buyer is also known as a creditor, and has priority over a stockholder in the event of a bankruptcy in the company. Bonds can have a variety of different capital amounts, also known as bond principle. In addition, bonds can have a variety of different payback times and interest rates. An interesting application of debt financing is for seasonal products. A company could release short term bonds in order to make the stream of revenue more consistent. During times of low sales, they could sell bonds, and during times of high sales, they could pay back bonds.

### Equity Financing

Equity financing is accomplished through the sale of stock, also known as equity, in the company. In other words, the company is selling ownership interest in order to achieve a certain amount of funds. Equity financing occurs throughout the lifetime of a company. In the beginning and startup of the company, angel investors and venture capitalists are the major contributors to equity financing. Both give capital in order to obtain equity in the company. The chemical industry has angel investors and venture capitalists who operate as individuals, and there are groups of individuals with the same interests who pool money in order to have a larger ownership interest. As chemical companies grow, many decide to become publicly traded, or "go public". This involves an initial public offering (IPO) and the beginning of trading of the company's stock on stock exchanges. However, private companies can still sell stocks. Mergers and takeovers can occur when one company assumes majority ownership of another company.

### Quantitative Measures

The discussion of project financing is centered on some quantitative measures that are often used to understand the growth and profitability of a company. More importantly, these measures also give insight into the health of the company beyond common metrics of revenue and costs.

$DR = \frac{TD}{TA}$

DR = Debt ratio

TD = Total debt($) TA = Total assets($)

The debt ratio of the company can be used to understand how much risk there is on future earnings and cash flows of the company (Towler). As stated, the debt ratio is a comparison of the total debt and total assets of the company. For companies with large debt ratios, the interest that is deducted from earnings will be large because of the large amount of debt carried.

$ROE = \frac{NAP}{SE}$

ROE = Return on equity

NAP = Net annual profit($) SE = Stockholders equity($)

The return on equity can be used to understand how effectively the company is managed from a fiscal point of view. As stated, the return on equity is a comparison of net annual profit and stockholder's equity. Because of this, an increasing return on equity shows that more profit is being made relative to the amount of equity invested.

Another important measure is the cost of equity. This measure is the expected return for any given cost in a company. The expected return is a combination of the dividends the company pays and the growth of the company's stock price. The cost used in this calculation is usually the stock price of the company.

### Cost of Capital

With the quantitative measures discussed in the previous section, an overall cost of capital can be calculated. This value is an interest rate that is the effective rate at which all of the capital is raised. This is the most useful measure for the economic evaluation of capital needed for projects.

This rate can be written as:

$i_c = DR*i_d+(1-DR)*i_e$

where $i_c$ is the cost of capital, $DR$ is the debt ratio, $i_d$ is the interest at which bonds are issued, and $i_e$ is the cost of equity.

### Example of Project Financing: Sadara Integrated Chemicals Project

In 2013, one of the largest financing projects in the chemicals industry occurred in the petrochemical sector. Two of the companies that corroborated in this financing project were Dow Chemical and Saudi Aramco. At the time, Dow Chemical Co. had annual sales of over 57 billion USD and produced over 5000 products in varying sectors. Saudi Aramco was on of the largest oil companies in Saudi Arabia, and a leader in many aspects of the petrochemical sector including production, refining, shipping, and even hydrocarbon exploration.

The project financing for Sadara Chemical Company began in 2011 with the issuance of a sukuk, which often referred to as Islamic bonds. The bonds were sold at an interest rate of 2.95%. The term, or duration of the bond, was 15.75 years. In total, the sale of these bonds earned about 2 billion USD (Dewar). This was the debt financing aspect of the project financing.

Then in 2013, Dow Chemical and Saudi Aramco contributed about 17 billion USD total. In this case, the equity financing came from two well-established chemical companies. Currently, Sadara Chemical Company is evaluated at about 20 billion USD, and Saudi Aramco has 65% ownership and Dow Chemical Company has 35% ownership (Fletcher).

The next aspect of equity financing for Sadara Chemical Company will happen in 2016, when it is scheduled for Sadara to be traded publicly after an IPO. It is anticipated that about 30% ownership in the company will be floated, or traded actively (Fletcher).

Because the company is not currently traded, it is difficult to apply many of the quantitative measures to study the effectiveness of the project financing techniques. In addition, for companies that have recently been started, many of these quantitative measures may be skewed because of the heavy investment on research and growth. More specifically, chemical companies often do not start full production until 2-3 years after plant construction is completed. Sadara Chemical Company is planning full-scale production in mid-2016 (Fletcher). Sadara Chemical Company provides an insight into real world project financing. In addition, the magnitude of the project gained worldwide recognition.

## Accuracy and purpose of Capital Cost Estimates

The accuracy of the total cost of a project will become more accurate as the project continues. The Association for the Advancement of Cost Estimating International (AACE International) classifies five types of estimates of capital cost.

1. Order of Magnitude. (±30–50%) First estimation conducted for screening purposes based on cost of similar processes.
2. Preliminary Estimates. (±30%) Based on only a few design detail.
3. Definitive Estimates. (±10–30%) Improved estimation with incorporation of more equipment detail.
4. Detailed Estimates. (±5-10%) Incorporation of individual equipment cost.
5. Check Estimates. (±5–10%) Final estimation based on completed design.

## Order of Magnitude Estimates

For the early stages of the design process, it is often necessary to make quick capital cost estimates of total plant cost. The accuracy of these order of magnitude estimates are usually within ±50% accuracy. The quickest and most often employed order of magnitude process scales the cost of the new design based on the cost of similar processes.

Towler gives the following equation to estimate the new design cost based on values which can be found in Towler and Sinnott (2013) Table 7.1:

$C=aS^n$

C = cost of new plant

a = constants

S = size parameters, based on existing plants

n = exponent constant

## Estimating Purchased Equipment Costs

### Sources of Equipment Cost Data

Obtaining accurate and updated equipment costs is an important matter and there are a variety of sources to obtain this information.

• Engineering, Procurement, and Construction (Contractors) companies
• Cost engineering department (common in large companies)
• Catalog or list prices
• Cost estimation software
• Cost correlations
• Estimate total cost based on cost of components

### Cost Correlation

Cost curves can be used as preliminary estimation of equipment costs if updated cost data is not available.

$C_e=a+bS^n$

C_e = purchased equipment on a U.S. Gulf Coast basis

a,b = constants

S = size parameters

n = exponent constant

Correlations for constants can be found in Towler's Chemical Engineering Design (Towler and Sinnott, 2013).

Example: Estimate the cost of a 30 m^2 double pipe heat exchanger.
C_e = 1900 + 2500*S^1.0 for S = [1 m^2, 80 m^2]
C_e = \$76900


### Estimation based on component cost

If the process of design and construction of a piece of equipment is known, then it is preferred by professional cost estimators to estimate total cost based on the cost of materials, labor, and manufacturer profit. Estimation of cost based on component cost will allow an unbiased estimation of real cost, allowing accurate estimation as well as possible price negotiation.

## Estimating Installed Costs: The Factorial Method

Before the chemical plants can be built, capital cost estimates must be made. This is done by using the factorial method. Accuracy and the reliability of the estimate will heavily depend on the availability of the data and the level of the design at the time. Lang proposed capital cost equipment by given equation:

C = F * Sum(C_e)


C is the total capital cost, F is the installation factor also known as Lang factor, and C_e is the cost of major equipment. Lang factor is 3.1 for solid processing plant and 4.74 for fluids processing plant. Better estimate can be made when the different factors are used for corresponding equipment. Lang factor for different equipment can be found in calibrated data chart. Usually, the above method is used as a preliminary estimate. When more detail has been acquired, installation factor are more rigorously estimated. In detailed factorial estimates, other direct costs are compounded into the Lang factor. Installation factors are usually based on a specific material for its equipment, usually carbon steel. Failure to properly correct installation factors for materials of construction is one of the most common sources of error with the factorial method. Material factor, however, does not linearly scale with the installation factor since the transportation cost, labor cost, and fabricator’s cost does not scale with the material of the equipment. Many variations of the factorial method exist as different assumptions can be made which will determine the rigorousness and the accuracy of the estimate.

## Cost Escalation

Cost estimation is a method base that basis its calculation from historical data. The prices of the construction and the labor are subject to inflation; therefore, a method has to be used to update old cost data. The method relates present costs to past costs that are based on statistical digests. To get the best estimate, each job should be broken down into its components and separate indices should be used for labor and materials. A composite index for the United States process plant industry is published in the journal Chemical Engineering. For oil refinery and petrochemicals projects, the Oil and Gas Journal publishes the Nelson-Farrer Refinery Construction Index. Both indices are updated monthly and indices for forty types of equipment are updated quarterly. There are also other indices for building the plants offsite. All cost indices should be used with caution and judgment. They do not fully represent the true costs for any particular piece of equipment or plant, nor the effect of supply and demand on prices. The closer the date of the estimate made from the date of indices published, estimate is more reliable.

## Location Factors

Because of the abundance of chemical engineering plants in the U.S Gulf Coast, it is often the standard for plant and equipment cost. Cost of plant construction will differ based on:

• Construction Infrastructure
• Labor costs
• Transportation costs
• Tax Rates
• Exchange Rates

It is common to convert cost of construction to locations other than the U.S. Gulf Coast by applying a location factor around the U.S. Gulf Coast in which: $\mbox{Cost of Plant Construction} = (\mbox{Cost of Plant in Gulf Coast}) \mbox{X} (\mbox{Location Factor})$

Location Factors fluctuate with currency exchange rates and time. A rule of thumb is to that every 1000 miles away from the nearest major industrial center adds 10% to the location factor. Specific location factors can be found in the most recent edition of Aspen Richardson's International Construction Cost Factor Location Manual (Costdataonline.com).

## Estimating Offsite Capital Costs

As mentioned above, OSBL costs are usually estimated as a percentage of ISBL costs until detailed site information and site layout are available for design.

For new sites, the OSBL costs are often estimated as a higher percentage of the ISBL due to a greater need for remediation. Especially in cases involving handling solids, OSBL costs can be as high as 100% of the ISBL cost.

The other extreme is utilizing an existing, underused site with no solids handling requirement, when fabricating a low-volume specialty chemical. In these cases, OSBL will be as low as 20% of the ISLB. For most cases, however, a typical value is 40%, and will be slightly higher for new plants, lower for existing sites with high capacities.

Once requirements for onsite steam and electricity are determined, more detailed design can be done. Usually, specialized suppliers install the entire utilities system, or the entire fencing system, or provide the entire firefighting service, so many of the components of OSBL capital costs are simply negotiated with contractors.

If the scope of the project changes, or if the project undergoes "scope creep," it is often easier to add capacity buy purchasing additional utilities from the outside once existing utilities have been constructed. However, this can lead to rapid changes in utility costs and the engineer should be aware of scope creep, as it can quickly change a viable process into an economically undesirable one.

## Computer Tools for Cost Estimating

It is difficult for smaller companies that do not specialize in process design to maintain accurate data on process costs and perform the necessary analysis for this data to be useful. Instead, most companies use costing software and other computer tools to perform economic analysis.

Several computer tools by Aspen Tech are available for estimating capital costs. Aspen's Economic Evaluation Product Family builds off of its original ICARUS technology. In the aspenONE product suite, the primary capital estimation tool is Aspen Capital Cost Estimator. It couples with Aspen Economic Evaluation to provide capital evaluations during process design and operation.

Some issues that have arisen in the past utilizing ICARUS, or Aspen Capital Cost Estimator are as follows:

• Mapping equipment from process simulations to ICARUS can simplify design or map dummy equipment that is not real process equipment.
• It is good practice to include design factors for safety throughout the process. However, Aspen will map the equipment exactly as specified in HYSYS and therefore will not include an design factors in calculating the capital costs
• Pressure vessels are costed exactly according to ASME Boiler and Pressure Vessel Code Section VIII Division 1. However, in some cases, this may an inadequate pressure vessel design. In these cases, the design should be manually entered.
• Some processes require nonstandard components that HYSYS has no way of modeling correctly and for which ICARUS has no appropriate equipment category. Aspen has the capability to include non-standard equipment libraries which often can be obtained by equipment manufacturers. Adding these libraries allows use of the costing software for cost estimates.

## Validity of Cost Estimates

One thing to keep in mind is that cost estimates are inherently associated with relatively high uncertainty. By leaving many aspects of the plant unspecified, the error grows dramatically. This should be kept in mind when utilizing cost estimates to perform economic analysis of the chemical process. A process that appears viable but has 50% error associated with capital costs, may quickly become undesirable as the project evolves. For this reason, it is essential that cost estimates include the most detailed design data possible.

## Conclusions

While determining the capital cost of a chemical plant is difficult, it is an extremely vital aspect of determining of construction of a given plant is feasible given realistic financial constraints. For this reason, a number of tools have been developed to produce capital cost estimates at relatively early phases of plant construction including order of magnitude estimates, cost curve calculations, and more detailed costing of designed process equipment and other ancillary buildings and equipment.

## References

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Dewar, John. Sadara Project Sukuk: Heralding a New Era? N.p.: Butterworths Journal of International Banking and Financial Law, Mar. 2014.

"Dow Chemical Co. (DOW) Short-term (Operating) Activity Analysis." NYSE Stock Exchange Data. Web. 5 Feb. 2016.

Fletcher, Phillip, et al. Sadara – Redefining the Possible. N.p.: MILBANK TWEED HADLEY & MCCLOY LLP, Sept. 2013.

Garrett DE. Chemical Engineering Economics. 1st ed. New York: Van Nostrand Reinhold; 1989. p. 36-72.

Mecklenburgh JC. Plant Design and Economics for Chemical Engineers. New York: Halsted Press; 1985.

Peters MS, Timmerhaus KD, West RE. Plant Design and Economics for Chemical Engineers. 5th ed. New York: McGraw-Hill; 2002.

Towler G, Sinnott R. Capital Cost Estimating. In: Chemical Engineering Design: Principles, Practice and Economics of Plant and Process Design. 2nd ed. Boston: Elsevier; 2013. p. 307–354.