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Introduction

The word profitability is used as the general term for the measure

of the amount of profit that can be obtained from a given

situation.

Before capital is invested in a project or enterprise, it is necessary

to know how much profit can be obtained and whether or not it

might be more advantageous to invest the capital in another form

of enterprise.

Thus, the determination and analysis of profits obtainable from

the investment of capital and the choice of the best investment

among various alternatives are major goals of an economic

analysis.

Profitability, therefore, is the common denominator for all

business activities

Profitability Standards

The profits anticipated from the investment of funds

should be considered in terms of a minimum

profitability standard.

A profitability standard is a quantitative measure of

profit with respect to the investment required to

generate that profit.

This profitability standard, which can normally be

expressed on a direct numerical basis, must be weighed

against the overall judgment evaluation for the project

in making the final decision as to whether or not the

project should be undertaken.

Thus, it must be recognized that the profit

evaluation is based on a prediction of future results

so that assumptions are necessarily included.

Many intangible factors, such as future changes in

demand or prices, possibility of operational failure,

or premature obsolescence, cannot be quantitized.

It is in areas of this type that judgment becomes

critical in making a final investment decision.

An obvious set of alternatives involves either making

the capital investment in a project or investing the

capital in a safe venture for which there is essentially

no risk and a guaranteed return.

Cost of Capital

Cost of capital is the amount paid for the use

of capital from such sources as bonds,

common and preferred stocks and loans.

The argument for using the cost of capital as a

basic profitability standard is that any project

must earn at least that rate to repay these

external capital sources.

Hence the simplest approach is to assume

that investment of capital is made at rate of

return equivalent to the total profit or rate of

return over the full expected life of the

particular project.

This method has the advantage of putting the

profitability analysis of all alternative

investments on an equal basis, thereby

permitting a clear comparison of risk factors.

Mathematical Methods of Profitability

Estimation

1. Rate of return on investment

2. Discounted cash flow based on full-life

performance

3. Net present worth

4. Capitalized costs

5. Payout period

Rate of Return on Investment

In engineering economic studies, rate of return

on investment is ordinarily expressed on an

annual percentage basis.

The yearly profit divided by the total initial

investment necessary represents the fractional

return, and this fraction times 100 is the

standard percent return on investment.

Profit is defined as the difference between

income and expense.

Therefore, profit is a function of the quantity of

goods or services produced and the selling

price.

The amount of profit is also affected by the

economic efficiency of the operation, and

increased profits can be obtained by use of

effective methods which reduce operating

expenses

To determine the profit, estimates must be made of

direct production costs, fixed charges including

depreciation, plant overhead costs, and general

expenses.

Profits may be expressed on a before-tax or after-tax

basis, but the conditions should be indicated. Both

working capital and fixed capital should be considered

in determining the total investment.

If the return is zero or larger, the investment will be

attractive. This method is sometimes designated as

return bused on capital recovery with minimum profit.

Return on investment

(Rate of return)

A simple measure of economic performance.

project also additional investment may be made during

the project life so we cannot take a particular year for

calculation of ROI. So we take average ROI over the

entire project life.

If ROI is calculated as an average over the

whole project then

investment)]*100

after the original investment may be very

small compared to the original investment so

we can ignore them and include average profit

per year.

Minimum Acceptable Rate of

Return(Mar)

It is the earning that must be achieved by an

investment in order for it to be acceptable to

the investor.

It is used as a fraction per year but often

expressed as percentage per year.

The Mar on generally is based on the highest

rate of earning on safe investment that is

available to the investor such as corporate bond

government bonds and loans.

Table: Suggested values for risk and minimum acceptable return on investments

Return(Mar)(after income

taxes)percent/year

opportunities or cost of capital

corporate market position

established market or new process

technology

application

marketing effort

Methods For Calculating Profitability

Methods that do not Consider Time Value of

Money

1) Rate of Return on Investment

2) Payback Period

3) Net Return

Pay-back time

A simple method for estimating pay back time is

to divide total initial capital (fixed plus working

capital ) by the average annual cash flow.

The payout period is the length of time

necessary for the total return to equal the

capital investment. The initial fixed capital

investment and annual cash flow are usually

used in this calculation

Simple pay back time = (total investment)/(average

annual cash flow)

The payout period is the length of time necessary for

the total return to equal the capital investment. The

initial fixed capital investment and annual cash flow

are usually used in this calculation so the equation is

manufacturing fixed capital investment, Ax the

nonmanufacturing fixed capital investment and Aj

the annual cash flow

But cash flow usually changes from year to

year so we have to include cash flow for each

year or average cash flow (Aj)ave in the

equation for PBP

Net Return

It is the amount of cash flow over and above that

required to meet the minimum acceptable rate of

return and recover the total capital investment.

amount capital investment, from the total cash flow.

obtained over the length of the evaluation period

The net return is given by:

recovered from the working capital and the sale of physical

assets (equipment, buildings, lands etc.) in year j.

The sum of dj plus the sum of the recovered amounts is equal

to total capital investment or the sum of Tj, the equation

simplifies to

and when divided by N, the equation becomes

dollars per year

Any positive value for Rn indicates that the

cash flow to the project is actually greater

than the amount necessary to repay the

investment and obtain a return that meets the

minimum acceptable rate. Therefore, it is

earning at a rate greater than minimum

acceptable rate.

If Rn happens to equal zero, then the project is

repaying the investment and matching the

required mar

Methods that Take Time Value of

Money into Account

Net present worth (NPW):

The net present worth is the total of the

present worth of all cash flow minus the

present worth of all capital investment, as

defined by

Where

NPW is the net present worth,

PWFcfj is the selected present worth factor for

the cash flow in year j,

sj the value of sales in year j,

coj the total product cost not including

depreciation in year j,

PWFv,j the appropriate present worth factor for

investment occurring in year j,

Tj is the total investment in year j.

An earning rate is incorporated into the

present worth factor by the discount rate

used.

Thus, the net present worth is the amount of

money earned over and above the repayment

of all the investment and the earning on the

investment at the discount rate used in the

present worth factor calculations.

The appropriate discount rate to use for

discrete compounding is the minimum

acceptable rate of return or mar originally

selected as the evaluation standard. For

continuous compounding the nominal interest

rate is used, as given by

nominal rate for continuous compounding.

The net present worth is the time value of

money equivalent of the net return.

If the net present worth positive, then the

project provides a return at a rate greater than

the discount rate used in the calculation.

In making comparisons of investment, the

larger the net present worth, the more

favourable is the investment

If the net present worth is equal to zero, then

the project provides a return that matches the

discount rate.

In either of these cases, the project is judged

as favourable compared to mar selected.

If the net present worth is less than zero, then

the project rates unfavourably with respect to

the mar standard.

The net present value is always less than the

total future worth of the project because of the

discounting of future cash flows.

The net present value is strong function of

interest rate and the time period studied.

Net present value is more useful economic

measure than the simple pay back and rate on

investment, since it allows for the time value of

money and also for annual variation in expenses

and revenues.

Time value of money

In cash flow diagram, the net cash flow is shown

at is value in the year in which it occurred .

So the number on the coordinate show the

future worth of he project. The cumulative value

is the net future worth(NFW).

The money earned in any year can be reinvested

as soon as it is available and can start to earn

return. So money earned in the early years of

the project is more valuable than the earned in

later years.

This time value of money can be allowed for by using

a variation of familiar compound interest formula.

The net cash flow in each year of the project is

brought to its present value at the start of the

project by discounting it at some chosen compound

interest.

The future worth of amount of money , P, invested at

interest rate i for n years is

Future worth in n years=P(1+i)^n

Hence present value of the sum is,

present value of the future sum=

(future worth in year n)/[(1+i)^n]

The interest rate used in the discounting

future values is called the discounting rate.

Discounting of the future cash flows should

not be confused with allowing for price

inflation.

Inflation is a general increase in prices and

costs, usually caused by imbalance between

supply and demand.

Discounting on the other hand is a means o f

comparing the value of money that is available

now (and can be reinvested) with money that

will become available at some time in the

future.

Rate of Return Based on Discount

Cash Flow

The method of approach for a profitability evaluation

by discounted cash flow takes into account the time

value of money and is based on the amount of the

investment that is unreturned at the end of each year

during the estimated life of the project.

The procedure has involved the determination of an

index or interest rate which discounts the annual cash

flows to a zero present value when properly compared

to the initial investment.

A trial-and-error procedure is used to establish a rate of

return which can be applied to yearly cash flow so that

the original investment is reduced to zero (or to salvage

and land value plus working-capital investment) during

the project life.

By calculating the net present value at various rates, it

is possible to find an interest rate at which the

cumulative net present value at the end of the project

is zero.

This particular rate is called the discounted cash flow

rate of return and is a measure of the maximum

interest rate that the project could pay and still break

even by the end of the project life.

=0

Where

The value of i is found by trial and error

calculations.

A more profitable project will be able to pay a

higher discounted cash flow rate of return.

Thus, the rate of return by this method is equivalent to

the maximum interest rate (normally, after taxes) at

which money could be borrowed to finance the project

under conditions where the net cash flow to the project

over its life would be just sufficient to pay all principal

and interest accumulated on the outstanding principal.

Designate the discounted-cash-flow rate of return as i.

This rate of return represents the after-tax interest rate

at which the investment is repaid by proceeds from the

project.

It is also the maximum after-tax interest rate at which

funds could be borrowed for the investment and just

break even at the end of the service life.

The discount factor for end-of year payments and annual

compounding is

D=1/[(1+i)^n]=discount factor

Where, i = rate of return

n = year of project life to which cash flow applies

This discount factor, d is the amount that would yield one

dollar after n years if invested at an interest rate of i.

The discounted-cash-flow rate of return can be

determined by the trial-and-error method where where

the annual cash flows are discounted by the appropriate

discount factor to a total present value equal to the

necessary initial investment

CAPITALIZED COSTS

The capitalized-cost profitability concept is

useful for comparing alternatives which exist

as possible investment choices within a single

overall project.

For example, if a decision based on

profitability analysis were to be made as to

whether stainless steel or mild steel should be

used in a chemical reactor as one part of a

chemical plant, capitalized-cost comparison

would be a useful and appropriate approach.

Capitalized cost related to investment

represents the amount of money that must be

available initially to purchase the equipment

and simultaneously provide sufficient funds for

interest accumulation to permit perpetual

replacement of the equipment.

If only one portion of an overall process to

accomplish a set objective is involved and

operating costs do not vary, then the

alternative giving the least capitalized cost

would be the desirable economic choice.

The basic equation for capitalized cost for

equipment is,

where

K = capitalized cost

C, = original cost of equipment

C, = replacement cost

V, = salvage value at end of estimated useful life

n = estimated useful life of equipment

i = interest rate

Where is capitalized cost factor

Example 5

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