PROFITABILITY

Term used to measure the amount of

profit from a certain investment

Total Profit cannot be used as means

of comparing investments.
Example:
Investment
$ 100,000
$ 1,000,000

Profit
10,000$/yr
25,000$/yr

The second investment has a larger profit. However,

when the profit is compared to the investment, the
first investment looks better.

METHODS OF PROFITABILITY
EVALUATION
1) RATE OF RETURN (ROI)
Pr ofit After Taxes ( PAT )
TCI
ROI=
(If Depreciation is not included in PAT, use
CASH FLOW instead)

Since equipment depreciate, it is better

to use average values over the life of
the project.
Averaged Annual Pr ofit
Averaged TCI
ROI=
Averaged TCI = FCI -Salvage Value + Working Capital

RETURN BASED ON CAPITAL

RECOVERY WITH MINIMUM
PROFIT
Incorporate a certain Minimum Profit
desired as a fictitious expense

Income Expense Min.Pr ofit

TCI
ROI=
Return calculated in this manner gives the
RISK EARNING RATE
Caution: It is better to use CASH FLOW
instead of INCOME-EXPENSE
Return of Investment is a point value.
Calculations are done for a particular or
average year.
* No time value of money is included

ROI BASED ON DISCOUNTED

CASH FLOW
Assume
1) A loan at interest i is used to finance
the project.
2) The cash flow of the project is used
to pay principal and interest.
Then

ROI = i

EXAMPLE:
FCI = $100,000
WC = $ 10,000
VS = $ 10,000
n = 5 years

Year
1
2
3
4
5

CF
$ 30,000
$ 31,000
$ 36,000
$ 40,000
$ 43,000

We calculate the future worth of the

proceeds at the end of the 5 years (or the
cash flow of the project, compounded on
the basis of end-of-year income)
S = 30,000 (1+i)4 + 31,000(1+i)3 + 36,000 (1+i)2 +
+ 40,000 (1+i) + 43,000

S=

CF

a1

(1+ i)n-a

CFa : predicted cash flow for year a

We calculate now the amount of money
needed to pay the loan :
V= 110,000 (1+ i)5= TCI(1+ i)n
Therefore, the future worth of proceeds
corrected for salvage value and working
capital (recovered at the end) should be
equal to V
V=S+VS+WC
110,000 (1+ i)5 = 30,000 (1+ i)4 + 31,000 (1+ i)3 +
+36,000 (1+ i)2+40,000(1+ i)
+43,000+10,000+10,000
n

CF

TCI(1+i)n = a1

(1+i)n-a +VS+WC

This is a polynomial of degree n. Solve it,

i.e. find the root.
For the example i =0.207

ROI=20.7%

Note: i corresponds to zero future value of proceeds

as compared to the FCI.

DCF Referred to Present Time

Present Value of Investment =
Present Value of Cash Flows
n

CF

TCI = a1

(1+i)-a +(VS+WC)(1+i)-n

So, if the cash flow is equal for all years (the

simplest situation possible), then
n

TCI =CF a1 (1+i)-a +(VS+WC)(1+i)-n

NET PRESENT WORTH

Present value of annual cash flows initial investment.
EXAMPLE : Same data as before.
Assume the capital of the company is
normally put at 15% interest.
Year
1
2
3
4
5

Cash Flow
$ 30,000
$ 31,000
$ 36,000
$ 40,000
$ 43,000
+ $ 20,000

Present Value
$ 26,087 ( =30,000/(1+i))
$ 23,440 ( =31,000/(1+i) )
$ 23,670
$ 22,870
2

$ 31,332

TOTAL = 127,399
NET PRESENT WORTH = $127,399+
- $110,000 = $17,399
n 1

NPW=

(1+i)
a 1

CFa

CFn VS WC

(1+i)n

- TCI

CAPITALIZED COST
PROFITABILITY
Useful for comparing alternatives within a
single project. (Recall the stainless steel vs.
Mild steel reactor example)
BASIC EQUATION :

CR
K = CV + (1 i)n 1
But CV = CR+VS. Then

(1 i)n
CR (1 i)n 1
K=
+ VS
(1 i)n
(1 i)n 1 : Capitalized Cost factor.

K is the amount of money needed initially to

purchase equipment and perpetually
replace it.

Extension to include Operating Costs

Consider operating costs as a piece of
equipment that lasts for one year and
has zero scrap value.
Calculate the present value of each years
cost (as in net present worth method) and
then calculate the capitalized cost of these
annual cash expenses. (KO).

EXAMPLE : Assume i =15% and the

following Operating Costs.
Year
1
2
3
4
5

Op. Costs
$ 30,000
$ 30,000
$ 30,000
$ 30,000
$ 30,000

Present Value
$ 26,087
$ 22,684
$ 19,725
$ 17,153
$ 14,915

TOTAL = $ 100,565

(115
. )5
51
(
115
.
)
KO = $ 100,565
= $ 200,000

Therefore:
Net present worth of annual Op. Costs:
n

Ca

a 1

1
(1 i)a

Capitalized Cost of annual Op. costs

n
(1 i)n
1
C
n 1 a 1 a (1 i)a
(
1

i
)
KO=

If Ca is equal for all years, then :

(1 i)n
1
C
n
KO= (1 i) 1 1 i
General formula
Cap. Cost = K + KO+ Working Capital

PAYOUT PERIOD
Minimum length of time needed to
recover the investment in a form of
cash flow.
FCI
Payout = Average Cash Flow
Other names are: Payback, Payoff, Cash
Recovery period.

Inclusion of Interest
FCI Interest on TCI
Payout = Average Cash Flow
Interest on TCI is calculated as annual
cash flows discounted at interest rate I to
get an average annual value.

ACCEPTABLE RETURNS
Need to compare with other
investments and their risks
Investment

Return

Risk

Government
Bonds

5-7%

Almost
none

Preferred Stock

7-9 %

Some

Common Stock

>9 %

Higher

INVESTMENT COMPARISON
EXAMPLE
Investment
$ 1,200,000
$ 2,000,000

Profit
$ 240,000
$ 300,000

ROI
20 %
15%

Assume your minimum profitability is 10%

If amount of investment is not the issue, we
are faced with two options:
1) Invest 1,200,000 and put
$800,000 in some other place
2) Invest $2,000,000
INCREMENTAL INVESTMENT
Incremental investment =$800,000
Incremental profit
=$ 60,000.
This corresponds to a ROI of 7.5%.
Bad deal !! Put the $800,000 in some other
investment.

FOR-SAVINGS INVESTMENTS
EXAMPLE : Consider a heat exchanger
installation to recover energy. Assume there
are 4 alternatives.
ALT.
1
2
3
4

FCI
$10,000
$16,000
$20,000
$26,000

OPER.
COST
$100
$100
$100
$100

VALUE OF
HEAT SAVED
$4,100
$6,000
$6,900
$8,850

Assume a depreciation of 20%/yr and a minimum ROI

of 10 % Then

Savings=Value-depreciation-Operating costs

ALT.

SAVINGS

ROI

INCREMENTAL
(over ALT 1)

1
2
3
4

$2,000
$2,700
$2,800
$3,550

20 %
16.9%
14 %
13.6 %

11.7%
2.5%
8.5%

Pick Alternative 2