OBJECTIVES

 To solve problems using different methods on the calculation of profitability

INTRODUCTION: CALCULATION OF PROFITABILITY

The calculation of profitability is generally performed with one of the methods

listed below. The methods that do not consider the time value of money include rate of

return on investment, payback period, and net return. The methods that consider the

time value of money involve the discounted cash flow rate of return and net present

worth.

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

For those methods that do not consider the time value of money, it is not

important what depreciation schedule is used in the evaluation. Therefore, straight-line

depreciation is often used for convenience. Any depreciation period that is less than or

equal to the evaluation period is usable for evaluations, although the recovery period

specified by the Internal Revenue Service (IRS) must be used for income tax purposes.

1. Return on Investment (ROI)

This profitability measure is defined as the ratio of profit to investment.

Although any of several measures of profit and investment can be used, the most

common are net profit and total capital investment. This can be expressed as

𝑁𝑝
𝑅𝑂𝐼 = (𝐸𝑞. 1)
𝐹

where ROI is the annual return on investment expressed as a fraction or percentage per

year, Np the annual net profit, and F the total capital investment. Gross profit, before

income taxes, or cash flow is sometimes used in place of net profit. Fixed-capital

investment can be used rather than total investment. Corporate policy or the preference

of the resource analyst determines the choice.

 Net profit usually is not constant from year to year for a project; total investment

also changes if additional investments are made during project operation. In such a case,

no one year is necessarily likely to be representative of the entire project life; therefore,

it becomes a question of what value to use for the net profit in Eq. 1. The recommended

procedure is to take the average ROI over the entire project life as given by

1
( 𝑁 ) ∑𝑁
𝑗=1(𝑁𝑝,𝑗 )
𝑅𝑂𝐼 = (𝐸𝑞. 2)
∑𝑁
𝑗=−𝑏(𝐹𝑗 )

where N is the evaluation period, Np,j the net profit in year j, -b the year in which the

first investment is made in the project with respect to zero as the startup time, and Fj

the total capital investment in year j. Note that for j > 0, that is, anytime after the original

investment, Fj may often be zero or at most small compared to the original investment,

and the denominator can be replaced by the initial total capital investment to simplify

Eq. 2 to

1
( 𝑁 ) ∑𝑁
𝑗=1(𝑁𝑝,𝑗 ) 𝑁𝑝,𝑎𝑣𝑒
𝑅𝑂𝐼 = = (𝐸𝑞. 3)
𝐹 𝐹

where Np,ave is the average value of net profit per year over the evaluation period.

Example No. 1 – Calculation Using ROI

Interest in converting trucks fueled by Diesel to run on compressed natural gas (CNG)

has been increasing in recent years. Studies have shown that 25% savings in fuel

cost/mile are achievable. The following information is available for a certain truck

being considered for such conversion. Calculate the expected ROI for this project:

Annual miles driven = 30,000 miles/year

Truck diesel fuel economy = 8 miles per gallon (MPG)

Cost of diesel fuel = $4 per gallon

Conversion hardware cost (tanks, valves, etc…) = $15,000

Solution:

30000 𝑚𝑖/𝑦𝑟 4$
𝐷𝑖𝑒𝑠𝑒𝑙 𝑓𝑢𝑒𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = × ⁄𝑔𝑎𝑙𝑙𝑜𝑛 = 15000 $/yr
8 𝑚𝑖/𝑔𝑎𝑙𝑙𝑜𝑛

𝐴𝑛𝑛𝑢𝑎𝑙 𝑓𝑢𝑒𝑙 𝑐𝑜𝑠𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 𝑤𝑖𝑡ℎ 𝐶𝑁𝐺 = 0.25 × $15000 = $3750

Therefore,

3750$
𝑅𝑂𝐼 = × 100 = 25% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
15000$/yr

In addition to cost savings, there are also environmental benefits.

2. Payback Period

The profitability measure of payback period, or 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

𝑉 + 𝐴𝑥
𝑃𝐵𝑃 = (𝐸𝑞. 4)
𝐴𝑗

where PBP is the payback period in years, V the manufacturing fixed-capital

investment, Ax the nonmanufacturing fixed-capital investment, V + Ax the fixed-capital

investment, and Aj the annual cash flow . This PBP represents the time required for the

cash flow to equal the original fixed-capital investment. It is subject to the fact that the

cash flow usually changes from year to year, thereby raising the question of which

annual values to use. A particular year can be selected, or the average of the Aj values

may be used to give

𝑉 + 𝐴𝑥 𝑉 + 𝐴𝑥
𝑃𝐵𝑃 = = (𝐸𝑞. 5)
1 (𝐴𝑗 )𝑎𝑣𝑒
( 𝑁 ) ∑𝑁
𝑗=1(𝐴𝑗 )

A PBP calculated from either Eq. 4 or Eq. 5 should be compared to a PBP

obtained from the minimum acceptable rate of return. Because V + Ax is approximately

equal to O.85F and (Aj)ave is equal to Np,ave + dj,ave = marF + 0.85F/N,

 0.85𝐹 0.85
𝑃𝐵𝑃 = = (𝐸𝑞. 6)
𝑚𝑎𝑟 𝐹 + 0.85𝐹/𝑁 𝑚𝑎𝑟 + 0.85/𝑁

3. Net Return

Another profitability measure 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. This quantity is calculated by subtracting the total amount earned at the

minimum acceptable rate of return, as well as the total capital investment, from the total

cash flow. Each of these quantities represents the total amount obtained over the length

of the evaluation period. The net return is given by

𝑁 𝑁 𝑁

𝑅𝑛 = ∑(𝑁𝑝,𝑗 + 𝑑𝑗 + 𝑟𝑒𝑐𝑗 ) − ∑ 𝐹𝑗 − 𝑚𝑎𝑟 𝑁 ∑ 𝐹𝑗 (𝐸𝑞. 7)

𝑗=1 𝑗=−𝑏 𝑗=−𝑏

where Rn is the net return in dollars and recj the dollars recovered from the working

capital and the sale of physical assets (equipment, buildings, land, etc.) in year j. By

noting that the sum of dj plus the sum of the recovered amounts is equal to the total

capital investment or the sum of Fj, the equation simplifies to

𝑁 𝑁

𝑅𝑛 = ∑ 𝑁𝑝,𝑗 − 𝑚𝑎𝑟 𝑁 ∑ 𝐹𝑗 (𝐸𝑞. 8)

𝑗=1 𝑗=−𝑏

and when divided by N, the equation becomes

𝑅𝑛,𝑎𝑣𝑒 = 𝑁𝑝,𝑎𝑣𝑒 − 𝑚𝑎𝑟 𝐹 (𝐸𝑞. 9)

where Rn,ave is the average net return in 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 the minimum acceptable rate. If Rn happens

to be equal zero, then the project is repaying the investment and matching the required

mar. Either result indicates a favorable rating for the project. A negative value for Rn,
however, indicates that the project obtains a return that is less than the mar, and therefore

the project should be unfavorably rated.

Example No. 2 – Calculation of Profitability Measures Not Considering Time

Value of Money

The research department of a large specialty monomer and polymer company has

developed and formulated a new product. Early tests have been encouraging regarding

the use of this product as a high-performance adhesive and sealant for cracks and joints

in new and old cured concrete. The company foresees a substantial, virtually

competition-free market in construction and repair if detailed product development and

marketing studies are successful and the company enters the market early.

A preliminary design study has just been completed. The estimated economic

parameters relevant to the project include the following items:

Production at 100 percent of capacity = 2 x 106 kg/yr

Batch process, total capital investment = $28 million

Fixed-capital investment = $24 million

Working capital = $4 million

Sum of the variable product costs at full capacity = $5 million/yr

Sum of the fixed costs (except for depreciation) = $1 million/yr

Company evaluation policies are as follows:

Use 5-year recovery period, half-year convention, MACRS depreciation with

all evaluation methods. Neglect working capital and salvage-value recovery.

Use a 35 percent per year income tax rate.

Use a 10-year evaluation period; base the calculations on 50 percent of rated

output the first year, 90 percent the second year, and 100 percent each year

thereafter.
 Assume that all the capital investment occurs at zero time.

Because of the high risk factor, a minimum acceptable return of 30 percent per

year is the profitability standard for this preliminary economic evaluation.

Calculate the product sales price that is required to achieve the mar obtained by using

the methods of return on investment, payback period, and net return.

Solution:

First calculate the quantities to be used in the calculation of the evaluation criteria.

 Return on Investment

For this method, Eq. 1 is used; so first calculate the average net profit

1
𝑁𝑝,𝑎𝑣𝑒 = [𝑝(18.8) − 81](1 − 0.35)(106 ) = (1.222𝑝 − 5.265)(106 )
10

where p is the unit price of the product in $/kg. Since F = $28x106,

(1.222𝑝 − 5.265)(106 )
𝑅𝑂𝐼 = 0.30 =
28 × 106

Solving for p gives

0.30(28) + 5.265
𝑝= = $11.18/kg
1.222

 Payback Period

The PBP corresponding to the given ROI of 30 percent is given by Eq. 6

 0.85
𝑃𝐵𝑃 = = 2.21 𝑦𝑒𝑎𝑟𝑠
0.3 + 0.85/10

Now, using Eq. 5 gives

24 × 106
2.21 =
𝑝(1.222)(106 ) − (5.265)(106 ) + (2.40)(106 )

Solving for p gives

24
+ 2.865
𝑝= 2.21 = $11.23⁄𝑘𝑔
1.222

 Net Return

The net return is given by Eq.7. Note that when the rate of return is fixed, the product

price must be such that the net return equals zero. Thus,

0 = 𝑝(12.22)(106 ) − (52.65)(106 ) + (24)(106 ) − (28)(106 )

− (0.30)(10)(28)(106 )

Solving for p gives

52.65 − 24 + 28 + 84 $11.51
𝑝= = ⁄𝑘𝑔
12.22

In summary, these three methods give results that are not identical, but they

agree well within the accuracy of the estimates. On the basis of these results, a product

price in the range of $11.20/kg to $11.50/kg would be a reasonable recommendation,

assuming no time value for money.

METHODS THAT CONSIDER THE TIME VALUE OF MONEY

The methods that do consider the time value of money include net present worth and

discounted cash flow rate of return. These methods account for the earning power of

invested money by the discounting techniques. They are the methods of economic

analysis most often used by large companies.

 1. Net Present Worth

The net present worth (NPW) is the total of the present worth of all cash flows

minus the present worth of all capital investments, as defined by

𝑁

𝑁𝑃𝑊 = ∑ 𝑃𝑊𝐹𝑐𝑓,𝑗 [(𝑠𝑗 − 𝑐𝑜𝑓 − 𝑑𝑗 )(1 − 𝛷) + 𝑟𝑒𝑐𝑗 + 𝑑𝑗 ]

𝑗=1

− ∑ 𝑃𝑊𝐹𝑣,𝑗 𝐹𝑗 (𝐸𝑞. 10)

𝑗=−𝑏

where NPW is the net present worth, PWFcf,j the selected present worth factor for the

cash flows in year j, sj the value of sales in year j, coj the total product cost not including

depreciation in yea rj, PWFv,j the appropriate present worth factor for investments

occurring in year j, and Fj the total investment in year j. An earning rate is incorporated

into the present worth factors by the discount rate used. Thus, the net present worth is

the amount of money earned over and above the repayment of all the investments and

the earnings on the investments at the discount (earning) 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

𝑟𝑚𝑎 = ln(1 + 𝑚𝑎𝑟 ) (𝐸𝑞. 11)

where rma is the minimum acceptable nominal rate for continuous compounding.

2. Discounted Cash Flow Rate of Return

The discounted cash flow rate of return, or DCFR, is the return obtained from

an investment in which all investments and cash flows are discounted. It is determined

by setting the NPW given by Eq. 10 equal to zero and solving for the discount rate that

satisfies the resulting relation. Thus,

 𝑁 𝑁

0 = ∑ 𝑃𝑊𝐹𝑐𝑓,𝑗 [(𝑠𝑗 − 𝑐𝑜𝑓 − 𝑑𝑗 )(1 − 𝛷) + 𝑟𝑒𝑐𝑗 + 𝑑𝑗 ] − ∑ 𝑃𝑊𝐹𝑣,𝑗 𝐹𝑗 (𝐸𝑞. 12)

𝑗=1 𝑗=−𝑏

The DCFR is only of concern when the project rates favorably compared to the

value of mar used in calculating the net present worth. Clearly, if the NPW that is

calculated equals zero, then the mar or ram used is the DCFR. However, if the NPW is

greater than zero, then the DCFR must be calculated from Eq. 11. Since the discount

rate appears in numerous exponents, it is generally impossible to solve for the discount

rate analytically and an iterative solution is required. As guidance, the discounted cash

flow rate of return will be greater than the mar or ram used. Thus, the mar or ram value

used is a good starting point. When the NPW is favorable, the DCFR will necessarily

be favorable and will be the actual earning rate of the investment. The two methods—

net present worth and DCFR—are nearly always used together.

Example No. 3 – Calculation of Profitability Measures Including Time Value of

Money

With the same economic information and company policies as supplied in Example No.

2, use discrete, year-end cash flows and discrete compounding to determine the product

price that will be required to provide a discretely compounded earning (discount) rate

of 30 percent per year. If a price of $11.50 is established for the product, determine the

discounted cash flw rate of return.

Solution:

Since the cash flows differ from year to year, the single-year discount factor, or the

present worth factor, must be applied to each year. The discount factor (P/Fi,j) = (1 + i)-
j
must be used. The PWFv,j is equal to 1 because all the investment is made at time zero.

Since the discount rate is fixed, the net present worth must be zero, and Eq. 12 is

applicable. Substitution of the production rates into this equation results in

 𝑁

0 = ∑(1 + 𝑖)−𝑗 [[𝑝(𝑃𝑟,𝑗 ) − 𝑐𝑜𝑓 − 𝑑𝑗 ](1 − 𝛷) + 𝑑𝑗 ] − 𝐹

𝑗=1

Where Pr is the product rate in kg/yr.

Note that (coj + dj) is the total product cost in year j. Since p is a constant, we

see that this equation may be rewritten in a more solvable and solving for p gives

𝐹 + ∑𝑁 −𝑗 𝑁 −𝑗
𝑗=1(𝑐𝑜𝑗 + 𝑑𝑗 )(1 + 𝑖) (1 − 𝛷) − ∑𝑗=1[𝑑𝑗 (1 + 𝑖) ]
𝑝=
∑𝑁 −𝑗
𝑗=1[𝑃𝑟,𝑗 (1 + 𝑖) (1 − 𝛷)]

Each of these summations is calculated in the table below; rows A, B. and C are from

the table in Example No. 2.

Substituting from the table into the preceding equation permits evaluation of the sales

price.

(28)(106 ) + (18.63)(106 ) − (12.34)((106 )

𝑝= = $9.97/kg
(3.44)(106 )

This value is considerably lower than the $11.20/kg to $11.50/kg sales price obtained

in Example No. 2 by using methods that do not consider the time value of money.

To determine the discounted cash flow rate of return when the product price is

established at $ll.50/kg requires an iteration of Eq. 12. Again, the data presented in

Example No. 2 are used to develop the required values as shown in the following table:
Substituting into Eq. 12 gives
𝑁 𝑁
6) −𝑗
0 = −(28 × 10 + 0.65 ∑(𝑠𝑗 − 𝑐𝑜𝑗 − 𝑑𝑗 )(1 + 𝑖) + ∑ 𝑑𝑗 (1 + 𝑖)−𝑗
𝑗=1 𝑗=1

For convenience, divide the equation by (28 x 106) so that all terms are of order 1. It is

known that i = 0.30 causes the sum to be zero when the price of the product is $9.97/kg,

so in the present case i must be greater than 0.30. Starting with i =0.35, several iterations

give a value for the normalized right-hand side of less than 0.001 for i = 0.3603. So, at

a price of$ 11.50/kg, the DCFR is 36.0 percent.

CONCLUSION: SELECTING A PROFITABILITY METHOD

The net present worth method, combined with the discounted cash flow rate of

return method, is strongly recommended for making economic decisions. These

methods not only include all the pertinent information of the other methods, but also

take into account the time value of money. In that way they give a more realistic picture

of the value of the earnings in relationship to the investment than do those methods that

do not include the time value of money.

References

Peter, M., Timmerhaus, K., & West, R. (2003). Plant design and economics for
chemical engineers (5th ed.). New York, NY: McGraw-Hill.
 University of Mindanao

In Partial Fulfillment of the Requirements in ChE 541 (8062) – Plant Design

WRITTEN REPORT

PROFITABILITY ANALYSIS

Submitted by:

Jocelyn G. Corpuz

Submitted to:

Engr. Crijamaica L. Oceña

December 2019