Estimate of Profitability

In a free enterprise system, companies are in

business to make a profit. If profits arent
maintained, a companys growth is stifled because
retained earnings are derived from profits. A part or
all these earnings may be used for new investments
to enhance a companys growth. A company is
continually confronted with investment decisions.
Management has the responsibility of investing in
ventures that are financially attractive by increasing
the earnings, providing attractive rates of return,
and increasing economic value added.
CORPORATE OBJECTIVES
Corporate objectives might include one or several of the
following:
Maximize the return on investment.
Maximize the return on stockholders equity.
Maximize aggregate earnings.
Maximize common stock prices.
Find outlets for a maximum of additional investment at
returns greater than the minimum acceptable rate of
return.
Increase market share.
Increase the economic value added.
Increase earnings per share of stock.
Increase the market value added.
PROJECT CLASSIFICATION
In order to consider the requests for funds, a
company establish a priority or classification
system.
For example, projects may be classified as
follows:
Necessity projects
Product improvement projects
Process improvement projects
Expansion projects
New ventures
Necessity projects are those to meet
environmental, health and safety regulations,
legal requirements or possibly to accomplish
intangible but essential needs. Usually these
projects do not require the calculation of a
return, but an important economic consideration
is the change in the cash flow that will occur
when the project becomes operational. If this
type of project is not funded, operations may be
terminated.
Product improvement projects are those that
require capital to improve the quality of a
product, like clarity, stability, odor, or purity to
meet customer needs. A small product
improvement often yields positive returns and
has small risk.
Process improvement projects are concerned
with the reduction of operating expenses, for
example, improvement in reaction yields,
reduction of utilities, and labor expenses. The risk
associated with these ventures is greater than
product improvement projects but still is
relatively low.
Expansion projects often occur to meet increased
sales demand for a product. These projects may
require the retrofitting of an existing facility with
associated high expenses and/or the building of a
new facility. The risk for this type project is higher
than the previous projects as the sales may not
develop as projected.
New ventures require capital expenditures to
introduce new products to the market. These
might also involve joint ventures or alliances
with another company or companies and are
the riskiest projects.
When joint ventures are involved, there may
be differences in philosophies or operational
modes among the companies involved that
can cause delays in start-ups and a host of
other problems. Therefore, these projects
require a high rate of return initially to
consider funding.

PROFITABILITY MEASURES
Quantitative Measures
Qualitative Measures
Return on Investment
It is the simplest and is used frequently



There are several variations of this method:
The numerator might be net earnings before taxes
and
The denominator could be fixed capital investment
or fixed and working capital.
It has some disadvantages:
The time value of money is ignored.
A basic assumption in this method is that all projects
are similar in nature to each other.
The project will last the estimated life and this is
often not true.
Equal weight is given all income for all years and that
is not always true.
It does not consider timing of cash flows.
It does not consider capital recovery.
Return on Average Investment
The profitability of investments utilizing accounting data and are
based on averaging methods



The fixed capital investment is divided by 2, so that over the
life of the investment, the return is earned against the
average investment.
The justification for this is that at the beginning of a project
the return is earned against the full investment, and at the
end of a project the investment has been fully depreciated
and the capital has been recovered. Therefore, on the average
over the life of the investment, half the fixed capital is
involved.
Payout Period (POP)
The objective of this method is to calculate the amount of time
that will be required to recover the depreciable fixed capital
investment from the accrued cash flow of a project.



There are some disadvantages to using the method, since no
consideration is given to cash flows that occur after the
capital is recovered; therefore, this method cannot be
considered as a true measure of profitability. The method
makes no provision for including land or working capital.
Payout Period with Interest (POPI)
The payout period with interest takes into account the time
value of money.
The net effect of the interest calculation is to increase the
payout time



Net Present Worth (NPW)
Net Present Worth (NPW) is the one most companies use since it has none of
the disadvantages of other methods and treats the time value of money
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.
Net present worth (NPW) = present worth of all cash inflow present
worth of all investment items
Net Present Worth Index (NPWI)
The NPWI method is also known as the profitability
index.
The index is the ratio of the present value of the
after-tax cash inflows to the present value of the
cash outflows or capital items.
An index greater than 1 indicates that a project has
a yield greater than the discount (interest) rate.
When more than one project is considered, that
project with the highest net present worth index is to
be preferred, provided it is greater than 1.
Qualitative Measures
There are instances in which major investment decisions
based upon intangible or qualitative factors oppose the
results of a quantitative study; therefore, both must be
considered.
Employee Morale
Employee Safety
Environmental Constraints
Legal Constraints
Product Liability
Corporate Image
Management Goals
Problem Statement:
Small plastics, Inc. is considering the manufacture of novelty
items for a given market. Land may be purchased adjacent to
their existing operation for $425,000. An estimate of the fixed
capital investment for the proposed operation is $3,600,000. At
start-up, $550,000 will be required as working capital.
It will take 2 years to prepare the land site, purchase and install
the necessary equipment.
At the end of project, the land and working capital are
recovered.
The 5-year MACRS depreciation with half-year convention will
be used and the federal income tax rate is 35%.
Develop a cash flow summary table and a cash position plot for
this project using an electronic spreadsheet.
For this 11-year project, the following income and cash
operating expenses have been estimated
Land
Fixed capital investment
Working capital
Total capital investment
Profitloss statement
Income (I) 3,700
Cash operating expenses (COE) 2,950
Depreciation (D) 360 (half year convention 5 years SLM)
Total operating expenses (TOE =COE +D) 3,310
Operating income (OI =I-COE) 750
Net income before Taxes (NIBT = OI-D) 390
Federal income taxes FIT=0.35 * NIBT 137
Net income after taxes NIAT =NIBT-FIT 253
After-tax cash flow ATCF =NIAT +D 613
Internal Rate of Return
The internal rate of return (IRR) is the interest
rate that will make the present worth of the
cash proceeds expected from an investment
equal to the present worth of the required
cash outlays required by the investment.
Therefore, it is discount rate that results
when the net present worth is equal to zero.
The internal rate of return is also known as the
discounted cash flow rate of return.
In NPW, the discount rate is set by management based upon
certain factors whereas in IRR method, the result is the
interest rate that will produce an NPW of zero.
The overall rate of return calculation starts by discounting the
investment cash flows to the present and the revenues to the
end of the project. An assumed discount rate is used in both
calculations.
The net rate of return (NRR) is defined by the following
equation:
The NPWIRR Controversy
The main limitations of the IRR method are:
Multiple rates for return. Unusual cash flow
forecasts can lead to more than one answer for the
IRR.
Reinvestment rate. Inherent in the IRR calculation is
the assumption that funds received during the
project can immediately be reinvested at the same
interest rate as the IRR. This is not always possible.
The higher the return, the lower the probability that
additional projects are available for reinvestment at
that rate.
Comparison of two are more projects. When comparing
two or more mutually exclusive projects will not
necessarily lead to the correct choice. One has to select
the best from the pair and compare it with another
project, and thus by elimination the best project will be
selected.
Size of the investment. The IRR method cant
differentiate between differences in the size of the
investment.
Timing of cash flows. Because of the uncertainty in
forecasts, the nature of the cash flow and timing, there
is the possibility that the discounted value of the net
cash flows can equal zero at more than one interest
rate. This causes problems in analyzing the meaning of
the results.

The net present worth method is superior to the IRR
method since it has none of the above problems.
As stated earlier, if the NPW is positive, the project
earns more than the interest (discount) rate. If the
NPW is negative, it earns less.
An NPW of zero means the investment produces an
interest rate equal to the one used in the calculation.
A rule of thumb is that the best investment is the one
with the higher or highest NPW.
Problem Statement:
A process to manufacture this new chemical called ETCHIT was
developed. A preliminary estimate of the fixed capital
investment of $7,500,000 was obtained for a 20MM lb/yr plant
capacity. It may be assumed that the fixed capital investment
was purchased and installed uniformly over a 2-year period.
Land valued at $200,000 was charged to the projected
instantaneously two years prior to start-up. Working capital at
15% of the fixed capital investment was charged to the project
instantaneously at time zero. Start-up expenses may be assumed
to be 6% of the fixed capital investment uniformly spread over
the first year of operation. In order to produce the chemical, a
proprietary catalyst was licensed for a one-time charge of
$150,000. For the purpose of this analysis, the cost is charged
instantaneously 1 year prior to start-up.
The marketing
department of
Apex provided
the following
information for
a 10-year
project life.
Cash operating
expenses for the
10-year period
were estimated by
the manufacturing
group to be as
follows:
For operating expense estimation use 7-year straight-line
depreciation, and for cash flow use the 7-year MACRS
depreciation factors.
The companys after-tax cost of capital is 10.2% and the
administration requires at least a 20% after-tax return for
projects of this risk level.
For this proposed project, determine the following:
a. ROI
b. POP
c. Cumulative cash flow analysis
d. PW at 20% continuous interest
e. IRR

Solution:
The Total capital investment in:



ROI =(avg annual net profit after taxes/ total capital investment) x 100
= [($20903000/10)/$9425000]x 100
=22.2%
POP = (fixed capital investment/average annual after tax cash flow)
=[$7500000/($28402000/10)]
=2.6 years
c. Cumulative cash flow analysis is found in above table,
and the cumulative cash plot can be plotted from
that.
d. For the present worth at 20% continuous interest, see Table
When making these calculations, one must be careful in
selecting the correct interest factors. This table is divided into
six sections depending on how the cash flows. Sections A and
B are for compounding instantaneously or uniformly,
respectively. Sections C through F are for discounting. In this
problem, section C is for instantaneous discounting, and
section D is for uniform discounting in each individual year. By
carefully reading the table and analyzing how the cash flows,
the proper factors may be obtained.
This project has a positive net present worth at 20%
continuous interest of $1,670,000, which indicates the project
will earn more than 20%, interest; therefore it exceeds
managements requirement for projects of this risk level.

e. The data for the present worth calculations are found in Table.
The resulting return is found by interpolation to be 23.3%.
Although the NPW is $1,670,000, the POP + interest is greater
than the 3 years required by management. This project
therefore meets one requirement but not both, so it will
probably will be rejected for funding at this time. It is
suggested that the marketing data and the manufacturing
expenses be reviewed to determine if these data are realistic;
if they are to be revised, then another economic analysis
should be performed. Management will have to make the
decision regarding whether another analysis is appropriate at
this time.