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Profitability Analysis

2 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.

activities.

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.

investment of capital and the choice of the best investment among

various alternatives are major goals of an economic analysis

3 The basic aim of a profitability analysis is to give a measure of the

attractiveness of the project for comparison to other possible courses of

action.

It is, therefore, very important to consider the exact purpose of a

profitability analysis before the standard reference or base case is

chosen.

project, a simple statement of total profit per year or annual rate of

return may be satisfactory. On the other hand,

which capital might be invested, the method of analysis should be such

that all cases are on the same basis so that direct comparison can be

made among the appropriate alternatives.

4 RATE OF RETURN ON INVESTMENT

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.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

%Rate of return = *100

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Example:

5

A proposed manufacturing plant requires an initial fixed-

capital investment of $900,000 and $100,000 of working

capital.

It is estimated that the annual income will be $800,000

and the annual expenses including depreciation will be

$520,000 before income taxes.

A minimum annual return of 15 percent before income

taxes is required before the investment will be worthwhile.

Income taxes amount to 34 percent of all pre-tax profits.

6 Determine the following:

(a) The annual percent return on the total initial investment before income

taxes.

(b) The annual percent return on the total initial investment after income

taxes.

(c) The annual percent return on the total initial investment before income

taxes

based on capital recovery with minimum profit.

(d)The annual percent return on the average investment before income

taxes

assuming straight-line depreciation and zero salvage value.

Solution:

7 (a)Annual profit before income taxes

= $800,000 - $520,000

= $280,000.

Annual percent return on the total initial investment before

income taxes

= [280,000/(900,000 + l00,000)](l00)

= 28 percent.

(b)Annual profit after income taxes

= ($280,000)(0.66)

= $184,800.

Annual percent return on the total initial investment after income

taxes

= [184,800/(900,000 + l00,000)* l00)

= 18.5 percent.

(c) Minimum profit required per year before income taxes

8 = ($900,000 +$l00,000)x(0.l5)

= $150,000.

Fictitious expenses based on capital recovery with minimum profit

=$520,000 + $150,000

= $670,000/year.

Annual percent return on the total investment based on capital

recovery with minimum annual rate of return of 15 percent before

income taxes

= [(800,000 - 670,000)/(900,000 + l00,000)] (l00)

= 13 percent.

(d)Average investment assuming straight-line depreciation and zero

salvage value

= $900,000/2 + $100,000 = $550,000.

Annual percent return on average investment before income taxes

= (280,000/550,000X100)

= 51 percent

9 Engineering Economy

A certain amount of Birr today is not worth the same

amount of Birr in the future.

Hence when cash flows occur at different points in time,

each must be brought to the same point in time before a

comparison is made.

Capital investment can only be depreciated in accordance

with a certain depreciated rate set by current tax law.

Cost Benefit Analysis (CBA)

10

CBA facilitates the comparison of alternatives in

terms of the monetary costs involved and the

benefits obtained.

environmental) must be quantified in monetary terms to the

maximum extent possible. Typically, CBA is used as a tool in

feasibility studies for selection of an alternative least cost project

among other projects.

of a potential investment for a plant design project.

11 Elements of CBA

Cash flow

Present value (PV)

Measures of Profitability

Payback Period

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index

Depreciation

Cash Flow

12

A Cash Flow is meant to represent incomes (“cash inflows”) and

expenses (“cash outflows”). Each arrow represents the time period

of a year in this case.

Cash Inflows

0 5

Cash Outflows

2,000

7,500. . . . . . . . . . . . . .. . . . …7,500

Cash Inflows

-2 -1 0 8

Cash Outflows

13 Present Value (PV)

money in the future.

A Birr today is worth more than a Birr in the future, because inflation

erodes the buying power of the future money, while money available

today can be invested to for generating more money and grow.

Calculation of the PV requires the use of “interest rate”.

Interest is the measure of the time value of money.

Interest rate is typically a percentage used to calculate the PV as it

reflects the time value of money.

Generally, this interest rate is taken as equal to the prevailing bank

interest rate.

14 example

years from now when the interest rate is

10%,

Payback Period

15

required to recover the cost of an investment.

payback period =

𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛

Drawbacks -

The payback period ignores the time value of money

The payback period ignores cash flows after the initial

investment has been recouped

16 example

If the initial cost of the investment is Birr 4,200,000 and the

annual net return is 1,200,000 Birr ; then

About 3.5 years

About 5.5 years

17

Net Present Value (NPV)

NPV may be defined as the difference between the total present value

of the cash inflows and the total present value of the cash outflows

considering the time value of money.

NPV compares the value of the Birr today versus the value of Money/

Birr in the future.

NPV = CFn n= 1, 2,---- n number of years

(1+r)n

If the NPV is positive (i.e. NPV > 0),Project is accepted

if the NPV is negative (i.e. NPV < 0), project should be rejected ,because

cash flows are negative

If the NPV is zero then it should probably be rejected or get a pass

mark as it generates exactly the return that is expected (i.e. NPV = 0)

Example: NPV; Let us calculate the NPV from a series of

18 cash flows.

$100,000 $150,000 $200,000

(positive cash flows)

0 3

(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods (n=3), r = interest rate (say,

10%)

(1+0.1)1 (1+0.1)2 (1+0.1)3

19 Internal Rate of Return (IRR)

The IRR method of analyzing a project or option allows one to find the

interest rate that is equivalent to the money returns expected from the

project or option.

Once you know the IRR, you can compare it to the rates you could earn

by investing your money in other projects or options.

If the IRR is less than the cost of borrowing used to fund the project, the

project will clearly be a money-loser.

However, usually a business owner will insist that in order to be

acceptable, a project must be expected to earn an IRR that is at least

several percentage points higher than the cost of borrowing, to

compensate the company for its risk, time, and trouble associated with

the project.

20 Internal Rate of Return (IRR)

The formula used for calculating the IRR is very similar to the formula used for

calculating the NPV.

IRR is the required return that results in zero NPV when it is used as the

discount rate.

There is no mathematical approach to finding IRR. The only way to find an

IRR is by trial and error

The main difference is that in the IRR formula, you must solve for the interest

rate “r”.

(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods, r = interest rate (to be

solved for)

21 Example: IRR

As an example of how IRR works, let us say you are looking at a

project costing $7,500 that is expected to return $2,000 per year

for five years, or $10,000 in total. The IRR calculated for the project

would be 10 percent.

If your cost of borrowing for the project is less than 10 percent, the

project may be worthwhile.

An investment should be further considered if the IRR exceeds the

required return. It should be rejected otherwise

If the cost of borrowing is 10 percent or greater, it will not make

sense to do the project (at least from a financial perspective)

because, at best, you will be breaking even.

22 Profitability Index (PI)

project's profitability index, or benefit/cost ratio

The PI is the ratio of the PV of future cash inflows by the PV of

cash outflows

PI = PV of cash inflows

PV of cash outflows

If the PI > 1, the project or option should be accepted

23

Reading assignment:

There are reasons why NPV is usually the best choice for

measuring project value. Discuss????

Depreciation

24

Depreciation is defined as the decline in the value of an asset with the

passage of time, due to general wear and tear or obsolescence.

Concept of depreciation is based on fact that physical properties and

facilities deteriorate and decline in usefulness with time, and thus, actual

“ value” of the facility decreases.

1. physical depreciation: change in value due to change in physical aspect

of property. For example: wear/ tear, corrosion, accidents, age

deterioration. ”serviceability” of property is reduced.

2. functional depreciation: due to reduction in value as a results factors

other than those physical depreciation.(1) obsolescence due to technological

advances. (2) decrease in demand for service.(3) abandonment of

enterprise.(4)inadequate or insufficient capacity of equipment.

25 Depreciable Investment

• All properties with limited useful life (> 1 year) used in trade,

business or production of income is depreciable.

Parameters for determination of depreciation

26 1. Current value : this is value and asset in its condition at time of

evaluation.

Book Value, or Unamortized Cost: The difference between the original

cost of a property, and all the depreciation charges made to date is

defined as the book value (sometimes called unamortized cost).

It represents the worth of the property as shown on the owner’s

accounting records.

Market value: price that an asset would fetch if sold in open market.

after its lifetime minus the cost for removal and transportation.

Scrap value: if property is not of any use, its value is called scrap value.

Recovery period (or service life): The period during which the use of a

property is economically feasible is known as the service life of the

property

ESTIMATION AND CALCULATION OF DEPRECIATION

27

Several method:

(1)straight line method (SLM),

is matter of Government policy.

28 SLM method

29 Case Study #1: Financial Analysis of a Cleaner Production Option

in a Bottle Washing Plant

Background

Bottle washing plant BWP utilizes a large quantity of water and caustic

soda for bottle washing and rinsing operations

As a cleaner production option, a certain percentage of the caustic soda

is to be recovered from the resulting caustic solution, through the use of

a membrane filtration (MF) system

The recovered caustic will then be resold at the prevailing market price

30 Case Study #1 - Calculations for the Value of Recoverable Caustic ($ / year)

Table 1: Volume of Volume of caustic Mass of caustic Value of caustic

caustic (m3) recovered per run* recovered recovered per

“A” (m3) per year** (kg/m3) year***

“B” = “A” X 0.65 “C” = “B” X 4 X ($ / year) = “C” X

25 0.5

Data

* The overall caustic recovered from the MF system is 65% by volume

** The number of recovery runs at BWP is 4 times a year and the

concentration of caustic by weight is 2.5% or 25 kg/m3

*** The cost of 1 kg of pure caustic solution is $0.5

Case Study #1 – Installation Cost for the MF System

31 Table 2

Membrane 7,000

Feed pump 800

High pressure pump 1,600

Cartridge and power 400

Permeate tank 200

Pipes, valves, etc. 8,000

Total investment: 18,000

membrane for the MF system will need to be replaced once in 3 years.

The associated cost for this will work out to be $7,500. The total life of

the MF system is 12 years.

32

Case Study #1 - Calculations for the Net Annual Uniform

Savings

Net annual uniform savings = Cost recovered from the sale of caustic

annually – annual depreciation cost of the MF system – annual operating

costs

Here, depreciation cost of the MF system (assuming nil salvage value at the

end of the 12 year period = (18,000 – 0) / 12 = $1,500

Also, annual operating costs = cost for power and the cartridge = $400

(from Table 2)

(approx.)

33 Case Study #1 – Cash Flow Diagram for the Proposed MF System

$4,925…………………………………………………………$4,925

0

12

Membrane replacement cost (once every 3 years) = $7,500

Net annual uniform savings = $4,925 / year

Case Study #1 – Calculation for NPV

34

12

PV of cash inflows = 4,925 1 = $33,557

t=1 (1 + 0.1)t

(1+0.1)3 (1+0.1)6 (1+0.1)9

= $33,557 - $31,049 = $2,508

Since the resultant NPV > 0, the cleaner production option is financially viable.

35 Case Study #1 – Calculation for IRR

12

0 = 4,925 1 – 18,000 – 7,500 – 7,500 – 7,500

t=1 (1+r)t (1+r)3 (1+r)6 (1+r)9

Taking r = 12% (i.e. 12/100 = 0.12), Left Hand Side (LHS) = 664.63

36 Case Study #1 – Solving for the Exact Value of IRR

r – 12 = 0 – 664.63

r – 14 -152.49-664.63

IRR = 12.63%

Since the IRR is greater than 10% (i.e. the rate of interest that the money would

earn in the bank, investing in this cleaner production option is worthwhile

37 Case Study #1 – Calculating the PI

PV of cash outflows 31,049

financially viable

Case Study #2: A Tweak on Case Study #1 (Pessimistic Scenario)

38

Background

The background for Case Study #2 stays the same as that for Case Study #1.

However, there will be one change… let us say, that the prevailing market price of

the recovered caustic falls to $0.35 per kg (previously, for Case Study #1, the said

value was $0.5 per kg).

Let us also say that the manufacturer’s claim for membrane replacement does not

hold true, and that the membrane requires replacement once every two years.

Let us examine the financial feasibility of installing the MF system for Case

Study #2.

Case Study #2 - Calculations for the Value of Recoverable

39

Caustic (Pessimistic Scenario)

Data

* The overall caustic recovered from the MF system is 65% by volume

** The number of recovery runs at BWP is 4 times a year and the concentration of

caustic by weight is 2.5% or 25 kg/m3

*** The cost of 1 kg of pure caustic solution is $0.35

Case Study #2 - Calculations for the Net Annual Uniform Savings

(Pessimistic Scenario)

40

Net annual uniform savings = Cost recovered from the sale of caustic annually – annual

depreciation cost of the MF system – annual operating costs

Here, depreciation cost of the MF system (assuming nil salvage value at the end of the 12 year

period = (18,000–0)/12 = $1,500 (same as Case Study #1)

Also, annual operating costs = cost for power and the cartridge = $400 (from Table 2, same as

Case Study #1)

So, net annual uniform savings = 4,778 – 1,500 – 400 = $2,878

(approx.)

Case Study #2 – Cash Flow Diagram for

41

the Proposed MF System (Pessimistic Scenario)

Membrane replacement cost (once every 2 years) = $7,500

Net annual uniform savings = $2,878/ year

Case Study #2 – Calculation for NPV (Pessimistic Scenario)

42

12

= 2,878 1 = $19,610

t=1 (1 + 0.1)t

PV of cash outflows

= 18,000 + 7,500 + 7,500 + 7,500 + 7,500 + 7,500 = $39,945

(1+0.1)2 (1+0.1)4 (1+0.1)6 (1+0.1)8 (1+0.1)10

= $19,610 - $39,945 = - $20,335 (i.e. negative)

Since the resultant NPV < 0, the cleaner production option is not financially viable.

Case Study #2 – Calculation for IRR (Pessimistic Scenario)

43

12

0 = 2,878 1 – 18,000 – 7,500 – 7,500 – 7,500 – 7,500 – 7,500

t=1 (1+r)t (1+r)2 (1+r)4 (1+r)6 (1 + r)8 (1 + r)10

Taking r = %, IRR =

Taking r = %, IRR =

Case Study #2 – Solving for the Exact Value of IRR

44 (Pessimistic Scenario)

r – 12 = 0 – 664.63

r – 14 -152.49-664.63

IRR = 12.63%

Since the IRR is greater than 10% (i.e. the rate of interest that the money

would earn in the bank, investing in this cleaner production option is

worthwhile.

Case Study #2 – Calculating the PI (Pessimistic Scenario)

45

PV of cash outflows 39,945

Since PI < 1, this cleaner production option cannot be accepted; i.e. it is not

financially viable

46 Summary – Discounted Cash Flow

Net present value

Difference between market value and cost

Accept the project if the NPV is positive

Has no serious problems

Preferred decision criterion

Internal rate of return

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return

Same decision as NPV with conventional cash flows

IRR is unreliable with non-conventional cash flows or mutually exclusive projects

Profitability Index

Benefit-cost ratio

Take investment if PI > 1

Cannot be used to rank mutually exclusive projects

May be used to rank projects in the presence of capital rationing

47 Summary – Payback Criteria

Payback period

Length of time until initial investment is recovered

Take the project if it pays back in some specified period

Does not account for time value of money, and there is an

arbitrary cutoff period

Discounted payback period

Length of time until initial investment is recovered on a

discounted basis

Take the project if it pays back in some specified period

There is an arbitrary cutoff period

48

potential projects can be chosen, e.g. acquiring an

accounting system.

Independent Projects: accepting or rejecting one project

does not affect the decision of the other projects.

not affected by the acceptance of the other.

Conversely, two projects are mutually exclusive if acceptance of

one impacts adversely the cash flows of the other; that is, at

most one of two or more such projects may be accepted.

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