OBJECTIVES

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

INTRODUCTION: CALCULATION OF PROFITABILITY

Profitability analysis is a component of enterprise resource planning (ERP)

that allows administrators to forecast the profitability of a proposal or optimize the

profitability of an existing project. 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 and payback period. The

methods that consider the time value of money involve the discounted cash flow rate

of return and net present worth (Peters, Timmerhaus, & West, 2003).

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.

1. Return on Investment (ROI)

After the income taxes have been deducted from the gross or pretax income,

the remainder, or net income is the amount that belongs free and clear to the

corporation and may be used for paying dividends, reinvesting, or spent for any other

purposes. This amount is also the basis for determining the simplest measure of the

profitability of an investment, the rate of return that the investment is generating:

net income per year

ROI=rate of return ( after taxes ) = ×100 ( Eq .1)
total investment

In general, ROI is a very simple concept that is easy to understand and apply,

and for many estimates that are in an early stage of development, or quite simple, it

may be all that is warranted. Every project should have an ROI estimate made on it,

even if the profit varies from year to year. In this case an average may be assumed, or
the profit after steady-state, or the hoped-for income a few years after start-up, is

achieved (Garrett, 1989).

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= × =15000 $ / yr
8 mi /gallon 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

An equally general, but perhaps more simplistic, piece of information that is

also desirable for every project is how rapidly the project will pay for itself, or return

the original investment. This "payback period" may be calculated as follows:

total plant investment

PBP= (Eq . 2)
averageannual cash flow after tax ( Aav )
 This equation assumes that the working capital is returned at the end of the

project life, and that there is no salvage value. Both of these assumptions are usually

correct. Thus, the shorter the payout period, the more attractive a project. It also

should be estimated for every project, no matter now complex (Garrett,1989).

Example No. 2 – Calculation Using PBP

A project with an initial investment of $1000 (all fixed) has the following series of

cash flow after taxes. What is the PBP of this project?

Period (year) Cash Flow ($)

0 -1000
1 475
2 400
3 330
4 270
5 200

The average annual cash flow is:

( 475+ 400+330+270+200 ) $ $
A av = =335
5 yrs yr

Hence,

1000 $
PBP= ≈ 3 years
$
335
yr

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

There is no one method for determining profitability satisfactorily; however,

the net present worth (NPW) or Net Present Value (NPV) is the one most companies
use since it has none of the disadvantages of other methods and treats the time value

of money and its effect on project profitability properly. The net present worth is the

algebraic sum of the discounted values of the cash flows each year during the life of a

project (Couper, 2003).

In the net present worth method, an arbitrary time frame, i.e., time zero, is

selected as the basis of calculation. Time zero, the present time, may occur when the

first funds are spent on the project or alternatively when project start-up commences.

If all projects are considered using the same basis, it makes no difference which time

zero is used since the ultimate decision will be the same; only the dollar values will be

different. Since consistency in the use of this method must be maintained, all projects

must be considered on the same basis. The NPW may be calculated as follows:
N
NPW =∑ An (1+i)−n−F (Eq .3)
n=1

where An stands for the net cash flow at each period n, i for the interest or discount

rate, and F for the total fixed cost.

Example No. 3 – Calculation Using NPW

Using the problem from Example No. 2, calculate for the NPW of the project at 10%.

Period (year) Cash Flow ($)

0 -1000
1 475
2 400
3 330
4 270
5 200

−1 −2 −3 −4 −5
NPW =$ 475 ( 1+0.1 ) + $ 400 ( 1+ 0.1 ) + $ 330 ( 1+0.1 ) +$ 270 ( 1+0.1 ) +$ 200 ( 1+0.1 ) −$ 1000=

2. Discounted Cash Flow Rate of Return (DCFRR)

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

from an investment in which all investments and cash flows are discounted. This is

also known as Internal Rate of Return (IRR). It is determined by setting the NPW

given by Eq. 3 equal to zero and solving for the discount rate that satisfies the

resulting relation. Thus,

N
NPW =∑ An (1+i)−n−F=0(Eq . 4 )
n=1

Specifically, the discounted cash flow rate of return is a hypothetical interest

rate such that when it is used to calculate the present value of all of the income cash

flow (income after tax plus the depreciation) for each year or period (these are

positive numbers) plus all of the capital expenditure or loss cash flows (these are

negative numbers), the present value is zero. In other words, it is the interest rate that

would be received if the same capital investment funds were to be placed in a bank for

a given period (the life of the plant) and earn the same amount as the cash flow

produced by the plant (Garrett, 1989).

Example No. 4 – Calculation Using DCFRR

Using again the problem from Example No. 2, calculate for the DCFRR of the

project.

Period (year) Cash Flow ($)

0 -1000
1 475
2 400
3 330
4 270
5 200
Let i = DCFRR = IRR
−1 −2 −3 −4 −5
NPW =$ 475 ( 1+i ) + $ 400 ( 1+i ) +$ 330 ( 1+i ) +$ 270 ( 1+i ) + $ 200 ( 1+i ) −$ 1000=0

Solving for i gives us

 i=0.2393=DCFRR=IRR

Example No. 5 – Choosing Between Company A and B

Assume Companies A & B make the same product, in same quantities and the same

gross income (revenues) GI of $100,000 per year. Annual expenses are $50,000/yr for

both. Company A produces products on a machine worth $200,000 and has a life of 5

years. Company B’s machine also costs $200,000, but has a useful life of 10 years.

The minimum acceptable rate of return (MARR) is 5% for both companies. The cash

flows for each company are tabulated below. Identify which company is better.

Company A Company B
n, year Cash Flow, $ n, year Cash Flow, $
0 -200,000 0 -200,000
1 45,000 1 35,000
2 45,000 2 35,000
3 45,000 3 35,000
4 45,000 4 35,000
5 45,000 5 35,000
6 35,000
7 35,000
8 35,000
9 35,000
10 35,000

For Company A,

NPW:

$ 45000 $ 45000 $ 45000 $ 45000 $ 45000

NPW = + + + + −$ 200000=−$ 5,173.55
(1+0.05) (1+0.05) (1+ 0.05) (1+0.05) (1+0.05)5
1 2 3 4

DCFRR/IRR (i):

$ 45000 $ 45000 $ 45000 $ 45000 $ 45000

NPW = 1
+ 2
+ 3
+ 4
+ 5
−$ 200000=0
(1+i) (1+i) (1+ i) (1+i) ( 1+i )

Solving for i gives us

i=0.04=4 =IRR

For Company B,
NPW:

$ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 3500

NPW = 1
+ 2
+ 3
+ 4
+ 5
+ 6
+ 7
+
(1+0.05) (1+0.05) (1+ 0.05) (1+0.05) (1+0.05) (1+0.05) (1+0.05) (1+0.0

DCFRR/IRR (i):

$ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $ 35000 $

NPW = 1
+ 2
+ 3
+ 4
+ 5
+ 6
+ 7
+ 8
+ 9
+
( 1+i) ( 1+i) (1+i) (1+i) ( 1+i) (1+i ) (1+i) (1+i) (1+i)

Solving for i gives us

i=0.12=12 =IRR

Therefore, Company B is better as shown in the profitability analysis. Higher cash

flow is not necessarily better. Profitability analysis should be used to select the better

alternative. A has “turned” more of its assets into cash but is using less efficiently

(shorter useful life).

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

Couper, J. (2003). Process engineering economics. New York, NY: Marcel Dekker,
Inc.
Garrett, D. (1989). Chemical engineering economics. New York, NY: Van Nostrand
Reinhold International Company Ltd.

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

January 2020