Lecture Note 6


Profitability, Alternative Investments and Replacements

●Profitability: the measure of the amount of profit that can be obtained from a given situation.

●Before investing a capital in a project or enterprise it is necessary to know how much profit can be obtained and whether its advantageous. 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.

●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 the cases of this sort, its extremely important to make a careful analysis of the capital utilization.

●The basic aim of profitability analysis is to give a measure of the attractiveness of the project for comparison to others. It is, therefore, very important to consider the exact purpose of a profitability analysis before the standard reference or base case is chosen.

●If the purpose is merely to present the total profitability of a given project, a simple statement of total profit per year or annual rate of return may be satisfactory.

●If the purpose is to permit comparison of several different projects in which capital might be invested, the method of analysis should be such that all cases are on the same basis so that direct comparison can be made among the appropriate alternatives.

●In reaching the final decision, alternatives should be considered two at a time with an acceptable basis.

●Total profit alone cannot be used as the deciding profitability factor in determining if an investment should be made. In such a case, any investment which would give profit should be accepted without considering
how low the return
how great the cost
Therefore, the profit goal of a company is to maximize income above the cost of the capital which must be invested to generate the income.

Mathematical Methods for Profitability Evaluation

1.Rate of Return on Investment

●In engineering economic studies, rate of return on investment is ordinarily expressed on annual percentage basis. The yearly profit divided by the total initial investment necessary represents the fractional return and this fraction times 100 is the standard percent return on investment.

●Profit is defined as the difference between the income and expense. Therefore, profit is a function of the quantity of goods or services produced and the selling price. The amount of profit is also affected by the economic efficiency of the operation and increased profits can be obtained by use of effective methods which reduce operating expenses.

●To obtain reliable estimates of investment returns, it is necessary to make accurate predictions of profits and the required investment. To determine the profit, estimates must be made of direct production costs, fixed charges including depreciation, plant overhead costs and general expenses. Profits may be expressed on a before-tax or after-tax basis, but the conditions should be indicated. Both working capital and fixed capital should be considered in determining the total investment.

2. Discount Cash Flow

●This method takes into account the time value of money and is based on the amount of the investment that is unreturned at the end of each year during the estimated life of the project.

●A trial and error procedure is used to establish a rate of return which can be applied to yearly cash flow so that the original investment is reduced to zero (or salvage + land + working capital investment) during the project life.

●The rate of return by this method is equivalent to the maximum interest rate at which money could be borrowed to finance the project under conditions where the net cash flow to the project over its life would be just sufficient to pay all principal and interest accumulated on the outstanding principal.

3. Net Present Worth

●In the “discounted cash flow” method the procedure has involved the determination of an index or interest rate which discounts the annual cash flows to a zero present value when properly compared to the initial investment. This index gives the rate of return which includes the profit on the project, payoff of the investment and normal interest on the investment.

●The net present worth substitutes the cost of capital at an interest rate i for the discounted cash flow rate of return.

●The cost of capital can be taken as the average rate of return the company earns on its capital, or it can be designated as the minimum acceptable return for the project.

●The net present worth of the project is then the difference between the present value of the annual cash flows and the initial required investment.

4. Capitalized Costs

●The capitalized cost profitability concept is useful for comparing alternatives which exist as possible investment choices within a single overall project.

●Capitalized cost related to investment represents the amount of money that must be available initially to purchase the equipment and simultaneously provide sufficient funds for interest accumulation to permit perpetual replacement of the equipment. If only one portion of an overall process to accomplish a set objective is involved and operating costs do not vary, then the alternative giving the least capitalized cost would be the desirable economic choice.

5. Payout Period

●Payout period or payout time is defined as the minimum length of time theoretically necessary to recover the original capital investment in the form of cash flow to the project based on total income minus all costs except depreciation.

●Generally for this method, original capital investment means only the original, depreciable, fixed capital investment and interest effects are neglected.

●Another approach to payout takes the value of money into consideration and is designated as payout period including interest. With this method, an appropriate interest rate is chosen representing the minimum acceptable rate of return. The annual cash flows to the project during the estimated life are discounted at the designated interest rate to permit computation of an average annual figure for profit plus depreciation which reflects the time value of money. The time to recover the fixed capital investment plus compounded interest on the capital investment during the estimated life by means of the average annual cash flow is the payout period including interest.

●This method tends to increase the payout period above that found with no interest charge and reflects advantages for projects that earn most of their profits during the early years of the service life.

●Analysis of Advantages and Disadvantages of various Profitability Measures for Comparing Alternatives;
onet present worth and discounted cash flow are the most generally acceptable and are recommended ocapitalized costs have limited utility but can serve to give useful and correct results when applied opayout period does not adequately consider the later years of the project life, does not consider working capital and is generally useful only for rough and preliminary analyses orates of return on original investment and average investment do not include the time value of money, require approximations for estimating average income and can give distorted results because of methods used for depreciation allowances.

●Example: A company has three alternative investments which are being considered. All three investments are for the same type of unit and yield the same service, only one of the investments can be accepted. The risk factors are the same for all cases. Company policies, based on the current economic situation, dictate that a minimum annual return on the original investment of 15 percent after taxes must be predicted for any unnecessary investment with interest on investment not included as a cost. ( investments yielding a 15 percent return after taxes are available) company policies also dictate that, where applicable straight line depreciation is to be used and for the time value of money interpretations end of the year cost and profit analysis is used. Land value and pre-set up costs can be ignored.

Given the following data, determine which investment, if any, should be made by alternative analysis profitability evaluation methods of

1.Rate of return on initial investment
2.Minimum payout period with no interest change
3.Discounted cash flow
4.Net present worth
5.Capitalized costs

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