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Financial & economic Evaluation

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.

 Profitability, therefore, is the common denominator for all business


activities.

 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
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.

 If the purpose is merely to present the total profitability of a given


project, a simple statement of total profit per year or annual rate of
return may be satisfactory. On the other hand,

 if the purpose is to permit comparison of several different projects in


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

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.

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

Money, when invested, makes money.


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.

• The costs and benefits (financial, economic, social and


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.

• Thus, CBA is used in financial analysis to estimate the profitability


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.

600 600 600 600 600


Cash Inflows
0 5
Cash Outflows
2,000

7,500. . . . . . . . . . . . . .. . . . …7,500
Cash Inflows
-2 -1 0 8
Cash Outflows

12,000 10,000 8,000 3,900 2,600


13 Present Value (PV)

PV is a way of comparing the value of money now with the value of


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

Birr100 is the PV of Birr 133.1 of three


years from now when the interest rate is
10%,
Payback Period
15

As the name suggests, the Payback Period is the length of time


required to recover the cost of an investment.

𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑓𝑖𝑥𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡


payback period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛

Where; annual net return = avg profit/yr + avg depreciation/yr

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

Payback period = 420,000 / 120,000 = 3.36


About 3.5 years

When the annual net return is 800,000 Birr ; then

Payback period = 4,200,000 / 80,000 = 5.25


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

$500,000 (negative cash flow)

NPV = -CFo + CF1 + CF2 + CF3 + CFn


(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%)

NPV = -500,000 + 100,000 + 150,000 + 200,000 = -$134, 861


(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”.

0 = -CFo + CF1 + CF2 + CF3 + CFn


(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)

Another method used to quickly evaluate a project is by looking at a


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 0 < PI < 1, the project or option should be rejected


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.

• All physical facilities are depreciable.

• Working capital/startup costs are not depreciable.

• Inventories held for sale are not depreciable.

• Depreciation is not subject to inflation.


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.

2. Salvage value (Vs): net amount of money obtained by sale of property


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),

(2) double-declining balance.

(3) Declining-Balance (or Fixed Percentage) Method

(4) modified accelerated cost recovery system (MACRS).

The rate and length of time during which depreciation is charged


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

Let us examine the financial feasibility of installing the MF system


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

210 136.5 13,650 6,825

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

System component Cost ($)


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

In addition to the initial investment, the manufacturer states that the


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)

So, net annual uniform savings = 6,825 – 1,500 – 400 = $4,925


(approx.)
33 Case Study #1 – Cash Flow Diagram for the Proposed MF System

Cash Inflows (Net annual Uniform Savings)


$4,925…………………………………………………………$4,925
0
12

$18,000 $7,500 $7,500 $7,500

Cash Outflows (Initial Investment and Replacement Cost)

Initial one-time investment = $18,000


Membrane replacement cost (once every 3 years) = $7,500
Net annual uniform savings = $4,925 / year
Case Study #1 – Calculation for NPV
34

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1),

12
PV of cash inflows = 4,925  1 = $33,557
t=1 (1 + 0.1)t

PV of cash outflows = 18,000 + 7,500 + 7,500 + 7,500 = $31,049


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

NPV = PV of cash inflows – PV of cash outflows


= $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

IRR would need to be solved through iteration:


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

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49


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

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

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49

Solving for the exact value of IRR through interpolation:


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

Calculating for the PI:

PI = PV of cash inflows = 33,557 = 1.08


PV of cash outflows 31,049

Since PI > 1, this cleaner production option can be accepted; i.e. it is


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)

Initial one-time investment = $18,000


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

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows


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

NPV = PV of cash inflows – PV of cash outflows


= $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

IRR would need to be solved through iteration. Solving for “r”:


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)

Taking r = 12% (i.e. 12/100 = 0.12), IRR = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), IRR = -152.49

Solving for the exact value of IRR through interpolation:


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

Calculating for the PI:

PI = PV of cash inflows = 19,610 = 0.49


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

Mutually Exclusive Projects: only one of several


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.

In general: Projects are independent if the cash flows of one are


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.