UNIT II

PROJECT PROFITABILITY AND FINANCIAL RATIOS

Estimation of project profitability, Sensitivity analysis, Investment alteratnatives, Income statement and financial
ratio’s, Balance sheet preparation – Problems.

Invested Capital and Profitability

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. 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.

Investments may be made for replacing or improving an existing property, for developing a completely new
enterprise, or for other purposes wherein a profit is expected from the outlay of capital. For cases of this sort, it is
extremely important to make a careful analysis of the capital utilization.

PROFITABILITY STANDARDS

In the process of making an investment decision, the profits anticipated from the investment of funds should
be considered in terms of a minimum profitability standard. Many intangible factors, such as future changes in
demand or prices, possibility of operational failure, or premature obsolescence, cannot be quantitized. It is in areas of
this type that judgment becomes critical in making a final investment decision. A primary factor in the judgment
decision is the consideration of possible alternatives. For example, the alternatives to continuing the operation of an
existing plant may be to replace it with a more efficient plant, to discontinue the operation entirely, or to make
modifications in the existing plant. An obvious set of alternatives involves either making the capital investment in a
project or investing the capital in a safe venture for which there is essentially no risk and a guaranteed return.

Cost of Capital

Although the management and stockholders of each company must establish the company’s characteristic cost
of capital, the simplest approach is to assume that investment of capital is made at a hypothetical cost or rate of return
equivalent to the total profit or rate of return over the full expected life of the particular project. This method has the
advantage of putting the profitability analysis of all alternative investments on an equal basis, thereby permitting a
clear comparison of risk factors. This method is particularly useful for preliminary estimates, but it may need to be
refined further to take care of income-tax effects for final evaluation.

Minimum Acceptable Rate of Return: MARR; (mar Minimum acceptable rate of return /Minimum attractive rate of
return): It is the rate of earning that must be achieved by an investment in order for it to be acceptable for the investor.

BASES FOR EVALUATING PROJECT PROFITABILITY

Total profit alone cannot be used as the deciding profitability factor in determining if an investment should be
made. The profit goal of a company is to maximize income above the cost of the capital which must be invested to
generate the income. If the goal were merely to maximize profits, any investment would be accepted which would
give a profit, no matter how low the return or how great the cost. The rate of return, rather than the total amount of
profit, is the important profitability factor in determining if the investment should be made.

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.

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Methods for Profitability Evaluation

Classified into two types:

Traditional techniques:

1. Payback period,
2. average rate of return

Discounting method:

1. Net present value,

2. profitability index
3. Internal rate of return.

1. Payback period: Measures the number of years required for the cash inflow to payback to original
outlay required in an investment proposal.
PBP= Cash outflow/ Annual cash inflow

Criteria: Lesser payback period better the project

2. Average rate of return (ARR): It is based on accounting information rather than cash flow.
Estimated in two different methods:
(i). On original investment:
(Average annual profits after depreciation and tax/ original invest) x 100

(ii). On average investment:

(Average annual profits after depreciation and tax/ average investment) x 100

Average investment = ((cost of project – scrap)/2) + working capital + scrap

Criteria: higher the ARR, better the project.

3. Net present value (NPV): summation of the present value of cash proceeds(CFAT) minus present values
of cash outflows. (NPV= PV of cash inflow – PV of cash outflow

It is the difference between discounted cash inflows and initial investment.

Criteria: NPV > zero, accept the project

NPV < zero, reject the project

4. Profitability Index: Profitability index is the ratio between the present value of cash inflows and the present
value of cash outflows. It is used to indicate the profitability at a glance.

If the profitability index is less than one, the proposal has to be rejected, if it is equal to one the project is just break
even, if it is higher than one, then the project is profitable.

(PI) measures the present value of returns per rupee invested = PV of cash inflows/ PV cash outflows

Criteria: PI > 1 , accept the project

PI < 1, reject the project.

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5. Internal rate of returns: rate of return that a project earns. It is defined as the discount rate which
equates the aggregate PV of the net cash inflow with the aggregate present value of cash out flows of a
project. Or it is that rate which gives the project NPV of zero. Estimated on trial and error method.
F=I/C, where I is original investment and C is the cash inflow, to identify the interest rate range and find out
the exact IRR.

Criteria:
IRR > cut-off rate, accept the project
IRR < cut-off rate , reject the project.
Higher the IRR, better the project.

Problem: Gupta & Co. is planning for an investment plan. For that you are asked to suggest the selection of
any one of the investment proposals using NPV and Profitability Index method at 10 %.

proposals Expected Expected cash flows

investment I year II year III year IV year V year
X 5,00,000 1,55,000 1,50,000 1,30,000 1,50,000 1,10,000
Y 4,50,000 1,10,000 1,30,000 1,50,000 1,20,000 50,000

Solution:

155000 110000 0.909091 140909.09 100000

150000 130000 0.826446 123966.94 107438.017
130000 150000 0.751315 97670.92 112697.22
150000 120000 0.683013 102452.02 81961.6146
110000 50000 0.620921 68301.35 31046.0662
533300.32 433142.92
500000 450000
NPV 33300.32 - 16857.16.08
PI 1.066600642 0.86628583

PROJECT PROFITABILITY:

A project is defined as “on shot, time bound major activity demanding the commitment of varied skills and resources
to achieve specific goal.”

It includes both setting up of a new unit or substantial expansion of existing units of production.
Characteristics of project:

1. Time activity: which will never be repeated exactly the same manner.
2. Executed in a definite time bound schedule
3. Uses a cross functional relationship because it needs diversified skills and talents from different
professions.
4. Demands the investment and the benefits are spread for number of future periods.

Project feasibility estimation:

Project feasibility is to find out the worthiness of the project in terms of marketing, technical , financial, and
economic indicators so that there is maximum returns and benefit both to the company and society.

Market feasibility: demand, market share

Technical feasibility: process, capacity, location, layout
Financial feasibility: profitability and risk analysis

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Economic feasibility: cost benefit ratio (company and society)

Sensitivity analysis:

Sensitive, the relative magnitude of change in the measure of merit (such as rate of return) caused by one or more
changes in estimated study parameters. It questions whether the original estimates adequately represent the future
conditions that could affect a purpose it if were implemented.

It tells us whether the original estimates adequately represent the future conditions that could affect a proposal if it
were implemented. It involves repeated computations with different cash flow elements and analysis factors to
compare results obtained from these substitutions with results from the original data.

Sensitivity studies: I step: investigating risk

II step: risk analysis

Use of graphs, charts, table: help the decision makers

Tools or techniques for sensitivity analysis: present worth, equivalent annual worth, internal rate of return.

Sensitity analysis is a management accounting tool used by those at the top of organization to analyse scenarios. This
process of gaining insight into likely outocome of events is commonly referred to as a waht if analysis. It is used to
test the effect of critical and non critical variables on the overall profitability of a company. Management incorporate
sensitivity analysis into the capital budgeting process in order to get an idea of the possible relationship that might
exist between certain componenets of the prosed project, contribution, sales, profitability, liquidity and overall
working capital managemnet of an entity.

The main purpose and mission of sensitivity analysis is not to quantify or measure risk but to ascertain the
responsiveness of net present values to variables that are used to calcualte it. Sensitivity analysis is one of the most
widely used risk analysis tools that attempt to measure the extent of change in variables and underlying assiptions that
would bear impact on the bottom line of the cash flow and profitability of a project. The idea of appraising a project
before committing resources to it is to give managers the chance of having a bigger picture of what value the project
would add to th eoverall success of the business.

Advantages of Sensitivity Analysis:

(i). Simplicity: It is simple unlike most concepts in finance and accounting where a level of theory needs to be
appreciated before applying a method.
(ii). Directing management’s efforts: Sensitivity analysis identifies areas that are crucial in the attainment of overall
organizational goal as contained in mission and vision statement of an organization.
(iii). Source of planning information: Through the application of sensitivity analysis information is made available to
management in the form which facilitates the application of professional judgement when discharging their
managerial duties.
(iv). Ease of being automated: Various softwares available makes sensitivity analysis simple and fast.

Disadvantages: (i) Sensitivity analysis is not relative in nature, which considers only the extent of variable change,
but ignorant about the probability of such things to happen.
(ii). It is not solution in the standalone form, provides a basis for further analysis, interpretation and finally decision
making.

INVESTMENT ALTERATNATIVES:

In industrial operations, it is often possible to produce equivalent products in different ways. Although the physical
results may be approximately the same, the capital required and the expenses involved can vary considerably
depending on the particular method chosen. Similarly, alternative methods involving varying capital and expenses can
often be used to carry out other types of business ventures. It may be necessary, therefore, not only to decide if a given
business venture would be profitable, but also to decide which of several possible methods would be the most
desirable.

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The final decision as to the best among alternative investments is simplified if it is recognized that each dollar of
additional investment should yield an adequate rate of return. In practical situations, there are usually a limited number
of choices, and the alternatives must be compared on the basis of incremental increases in the necessary capital
investment.

A general rule for making comparisons of alternative investments can be stated as follows: The minimum investment
which will give the necessary functional results and the required rate of return should always be accepted unless
there is a specific reason for accepting an alternative investment requiring more initial capital.

Problem: Four different heat exchangers have been designed to recover the heat, and all prices, costs, and
savings have been calculated for each of the designs. The results of these calculations are presented in the
following:

The company in charge of the plant demands at least a 10 percent annual return based on the initial investment
for any unnecessary investment. Only one of the four designs can be accepted. Neglecting effects due to income
taxes and the time value of money, which (if any) of the four designs should be recommended?

The first step in the solution of this example problem is to determine the amount of money saved per year for each
design, from which the annual percent return on the initial investment can be determined. The net annual savings
equals the value of heat saved minus the sum of the operating costs and fixed charges; thus,

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Because the indicated percent return for each of the four designs is above the minimum of 10 percent required by the
company, any one of the four designs would be acceptable, and it now becomes necessary to choose one of the four
alternatives.

Problem: Investment comparison for required operation with limited number of choices. A plant is being
designed in which 450,000 lb per 24-h day of a water caustic soda liquor containing 5 percent by weight caustic soda
must be concentrated to 40 percent by weight. A single-effect or multiple-effect evaporator will be used, and a single-
effect evaporator of the required capacity requires an initial investment of $18,000. This same investment is required
for each additional effect. The service life is estimated to be 10 years, and the salvage value of each effect at the end of
the service life is estimated to be $6000. Fixed charges minus depreciation amount to 20 percent yearly, based on the
initial investment. Steam costs $0.60 per 1000 lb, and administration, labor, and miscellaneous costs are $40 per day,
no matter how many evaporator effects are used. Where X is the number of evaporator effects, 0.9X equals the
number of pounds of water evaporated per pound of steam. There are 300 operating days per year. If the minimum
acceptable return on any investment is 15 percent, how many effects should be used?

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When alternatives are available, therefore, the base plan would be that requiring the minimum acceptable investment.
The alternatives should be compared with the base plan, and additional capital would not be invested unless an
acceptable incremental return or some other distinct advantage could be shown.

The system of capital budgeting is employed to evaluate expenditure decisions which involve current
outlays but are likely to produce benefits over a period of time longer than one year. It includes addition,
disposition, modification & replacement of fixed assets.

Problem: Find out the average rate of return from the following data relating to CNC Machine 1 & 2
(Computer Numerical control Machining)

Cost : Rs. 3,00,000 each

Estimated life – 3 years each
Estimated scrap – Rs.60,000 each
Income tax rate - 50%
Additional working capital required- Rs.2,50,000 For each m/c
The estimated cash inflow after taxes for each m/c are as follows:
Year CNC m/c 1 CNC m/c 2
1 1,50,000 2,00,000
2 3,00,000 3,00,000
3 1,50,000 2,50,000
4 - 1,50,000
------------- --------------
6,00,000 9,00,000
------------- --------------
Solution:

The average cash flows after taxes for machine 1: 2, 00,000 or (6,00,000/3)
Machine 2: 2,25,000 or(9,00,000/4)

Average investment: (cost-scrap)/2 +working capital+ scrap

=3,00,000-60,000/2 +2,50,000+60,000
=4,30,000

ARR for machine 1 = average annual profit after taxes/ average investment
= (2,00,000/4,30,000 ) x 100 = 46.5%
ARR for machine 2= (2,25,000/4,30,000) x 100 = 52.32%

Machine 2 will be preferred because its ARR (52.32%) is higher than machine 2 (46.5%)

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