PROFITABILITY

ANALYSIS
Jocelyn G. Corpuz
Objectives

• To solve problems using different methods on the

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calculation of profitability
Introduction
• 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

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existing project.

• The calculation of profitability is generally performed with

methods that do not consider the time value of money and
methods that consider the time value of money
Profitability Analysis
Methods that Do Not Methods that Consider
Consider the Time Value of the Time Value of Money
Money

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• Return on Investment (ROI) • Net Present Worth (NPW)

• Payback Period (PBP) • Discounted Cash Flow Rate of

Return (DCFRR)
Methods that Do For those methods that do not
consider the time value of money, it
Not Consider the is not important what depreciation
schedule is used in the evaluation.
Therefore, straight-line depreciation
Time Value of is often used for convenience.

Money
Return on Investment (ROI)

• simplest measure of the profitability of an investment

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• very simple concept that is easy to understand and apply

• Every project should have an ROI estimate made on it, even

if the profit varies from year to year.
Return on Investment (ROI)

𝑅𝑂𝐼 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠

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𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
= × 100%
𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Return on Investment (ROI)
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

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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…) = $15,000
Return on Investment (ROI)
Solution:
30000 𝑚𝑖/𝑦𝑟 4$
𝐷𝑖𝑒𝑠𝑒𝑙 𝑓𝑢𝑒𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = × ൗ𝑔𝑎𝑙𝑙𝑜𝑛
8 𝑚𝑖/𝑔𝑎𝑙𝑙𝑜𝑛

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= 15000 $/yr
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.
Payback Period

• how rapidly the project will pay for itself or return the
original investment

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Payback Period

𝑡𝑜𝑡𝑎𝑙 𝑝𝑙𝑎𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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𝑃𝐵𝑃 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 (𝐴𝑎𝑣 )
Payback Period
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

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of this project? Period (year) Cash Flow ($)

0 -1000

1 475

2 400

3 330

4 270

5 200
Payback Period
The average annual cash flow is:

475 + 400 + 330 + 270 + 200 $ $

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𝐴𝑎𝑣 = = 335
5 𝑦𝑟𝑠 𝑦𝑟

Hence,
1000 $
𝑃𝐵𝑃 = ≈ 𝟑 𝒚𝒆𝒂𝒓𝒔
$
335
𝑦𝑟
Methods that
These methods account for the
earning power of invested money by
Consider the the discounting techniques. They are
the methods of economic analysis
most often used by large companies.
Time Value of
Money
Net Present Worth

• most companies use it since it has none of the disadvantages

of other methods and treats the time value of money and its

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effect on project profitability properly

• the algebraic sum of the discounted values of the cash flows

each year during the life of a project
Net Present Worth
𝑁

𝑁𝑃𝑊 = ෍ 𝐴𝑛 (1 + 𝑖)−𝑛 −𝐹

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𝑛=1
where:
An = net cash flow at each period n
i = interest or discount rate
F = total fixed cost
Net Present Worth
Example No. 3 – Calculation Using NPW
Using the problem from Example No. 2, calculate for the
NPW of the project at 10%.

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Period (year) Cash Flow ($)

0 -1000

1 475

2 400

3 330

4 270

5 200
Net Present Worth
𝑁𝑃𝑊 =
$475 1 + 0.1 −1 + $400 1 + 0.1 −2 + $330 1 + 0.1 −3

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+ $270 1 + 0.1 −4 + $200 1 + 0.1 −5 − $1000

= $𝟑𝟏𝟖. 𝟗𝟑
Discounted Cash Flow Rate of Return
(DCFRR)
• the return obtained from an investment in which all
investments and cash flows are discounted

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• also known as Internal Rate of Return (IRR)
• determined by setting the NPW equal to zero and solving
for the discount rate that satisfies the resulting relation
• 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
Discounted Cash Flow Rate of Return
(DCFRR)
𝑁

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𝑁𝑃𝑊 = ෍ 𝐴𝑛 (1 + 𝑖)−𝑛 −𝐹 = 0
𝑛=1
Discounted Cash Flow Rate of Return
(DCFRR)
Example No. 4 – Calculation Using DCFRR
Using again the problem from Example No. 2, calculate for the

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DCFRR of the project. Period (year) Cash Flow ($)

0 -1000

1 475

2 400

3 330

4 270

5 200
Discounted Cash Flow Rate of Return
(DCFRR)
Let i = DCFRR = IRR
𝑁𝑃𝑊

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= $475 1 + 𝑖 −1 + $400 1 + 𝑖 −2
+ $330 1 + 𝑖 −3
+ $270 1 + 𝑖 −4 + $200 1 + 𝑖 −5
− $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.

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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.
Example No. 5 – Choosing Between Company A and B
Company A Company B

n, year Cash Flow, $ n, year Cash Flow, $

0 -200,000 0 -200,000

1 45,000 1 35,000

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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
Example No. 5 – Choosing Between Company A and B
For Company A,
NPW:
𝑁𝑃𝑊
$45000 $45000 $45000 $45000 $45000

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

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
Example No. 5 – Choosing Between Company A and B
For Company B,
NPW:
𝑁𝑃𝑊
$35000 $35000 $35000 $35000 $35000 $35000

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= 1 + 2 + 3 + 4 + 5 +
(1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05)6
$35000 $35000 $35000 $35000
+ 7
+ 8
+ 9
+ 10
− $200000 = $70,260.72
(1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05)
DCFRR/IRR (i):
𝑁𝑃𝑊
$35000 $35000 $35000 $35000 $35000 $35000 $35000 $35000
= + + + + + + +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)3 (1 + 𝑖)4 (1 + 𝑖)5 (1 + 𝑖)6 (1 + 𝑖)7 (1 + 𝑖)8
$35000 $35000
+ + − $200000 = 0
(1 + 𝑖)9 (1 + 𝑖)10
Solving for i gives us
𝑖 = 0.12 = 12% = 𝐼𝑅𝑅
Example No. 5 – Choosing Between Company A and B

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

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“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

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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.
Thank
You