Profitability analysis
19CHE405 Process Economics
Amal GS
Profitability
• 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.
• 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.
Profitability standard
• A quantified profitability standard always
serves as a guide for taking decision on
making any investment.
• A profit evaluation is based on a prediction of
future results.
• Many intangible factors, such as future
changes in demand or prices, possibility of
operational failure, or premature
obsolescence, cannot be quantified.
• 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.
Mathematical Methods for Profitability
Evaluation
1. Pay back period
• A. Without interest
• B. With interest
2 Return on investment
• A. Return on Original investment
• B. Return on average investment
3. Net present worth
4. Discounted cash flow rate of return
Pay back or pay out 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.
Pay back or pay out period
• Simple to calculate
• Easy to understand
• Ignore the return beyond the pay back period
• Method does not show how profitable the
investment is.
• Ignore the time value of money
• Project with shorter pay back period is generally
accepted.
• Places too much emphasis on quick return.
• Pay back or pay out period is the time when the
accumulated cash inflow equal the original
investments.
• Payout period in years(no interest) = depreciable
fixed-capital investment/ (avg profit/yr + avg
depreciation/yr)
• The payout period including interest takes into
account, the time value of money also. An
appropriate interest rate is chosen for this
purpose.
• Pay out Period = C/(p +D)
• C= initial investments, normally depreciable
fixed capital investments.
• p = Profit after tax less depreciation
• D = Average annual depreciation.
A project having a cash flow as follows
find the pay back period
Time Cash flow
0 -1000
1 475
2 400
3 330
4 270
5 200
A project having a cash flow as follows
find the pay back period
Time Cash flow Cumulative cash flow
0 -1000 -1000
1 475 -525
2 400 -125
3 330 205
4 270
5 200
Exact pay back period is = 2 + (125/330) = 2.38
2.38 years
Pay out time with interest
• This method allows for a return on the
investments and is subject to many variations.
• The variation considered below applies an
interest charge only on the fixed investment
remaining.
• POP = (C + i)/ (p + D)
• i = interest on capital investment during the
estimated service life.
Find the pay back period with interest
on the investment at 10% per year.
Time Cash flow Investment
for the year
0 -1000
1 475 1000
2 400 625
3 330 287.5
4 270
5 200
Find the pay back period with interest
on the investment at 10% per year.
Time Cash flow Investment Interest Cash flow Cumulative
for the year for after net cash
investme interest flow
nt
0 -1000 -1000 -1000
1 475 1000 100 375 -625
2 400 625 62.5 337.5 -287.5
3 330 287.5 28.75 301.25 13.75
4 270
5 200
Pay out time = 2 +
is =2.95 (287.5/301.25)
years = 2.95
Return on investment (ROI)
• Rate of return on investment is ordinarily
expressed on an 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.
• 1. Return on original investment
• 2. Return on average investment
• ROI =Average net profit/(FCI+WCI)
• RAI =Average net profit/Average investment
• Average investment=Average FCI+WCI
Find the return on original investment
assuming straight line depreciation
Year Cash flow
0 -1000
1 475
2 400
3 330
4 270
5 200
• Asset to be depreciated =1000
• Salvage value =0
• Service life = 5years
• Depreciation for each year=1000/5 =200
Find the return on original investment
assuming straight line depreciation
Year Cash flow Depreciation Net profit
0 -1000
1 475 200 275
2 400 200 200
3 330 200 130
4 270 200 70
5 200 200 0
675
• Cash flow=Net profit +depreciation
• Total profit= 675
• Average profit =675/5=135
• ROI=(135/1000) 100=13.5%
Find the return on average investment
assuming straight line depreciation
Year Cash flow Investment for
each year
0 -1000
1 475 1000
2 400 800
3 330 600
4 270 400
5 200 200
3000
Find the return on average investment
assuming straight line depreciation
Year Cash flow Investment Depreciatio Net profit
for each n
year
0 -1000
1 475 1000 200 275
2 400 800 200 200
3 330 600 200 130
4 270 400 200 70
5 200 200 200 0
3000 675
• RAI= average net profit/average investment
• Average net profit=675/5=135
• Average investment= 3000/5=600
• RAI=135/600=22.5%
Time value of money
• Money yields interest, when saved over a
period of time.
• Two methods which take into account the
time value of money are
• [Link] present value
• 2. Internal rate of return (IRR) or DCFRR
(Discounted cash flow rate of return).
Net present value
• All future cash flows, out flows can be converted
into present value. This method is used to
compare project investment in a quantitative
manner.
• A rate of interest is selected on which the
calculations are based.
• This rate should be the rate which represents the
minimum rate of return on capital acceptable to
the organization.
• If NPV is positive the project is acceptable,
Larger the NPV, better the project.
NPV index(profitability index)
• NPV index = Present value of cash
inflow/Present value of cash out flow
• Advantage of NPV method
• 1. time value of money is taken into
consideration
• 2. entire project life considered
• Disadvantage
• Prediction of interest rate is difficult
NPV Index
• NPVI = (NPV/Investment )x100
• Assume that an investment of Rs 25000/- is under
taken, the cost of capital being 10%. The life of project
is 5 years and in those 5 years, the net cash inflow are
Year Cash inflows (Rs)
1 10000
2 8000
3 6000
4 5000
5 5000
Find the NPV, NPVI
Year Cash inflow Discounting Factor Discounted Present value
1/ (1+i)^n
1 10000 0.9091 9091
2 8000 0.8264 6611
3 6000 0.7513 4507.8
4 5000 0.6830 3415
5 5000 0.6209 3105
Total PV 26729.8
Investments 25000
NPV 1729.8
NPVI 1729.8/25000 = 6.912
If NPV is positive the project is acceptable, Larger the NPV, better the project.
Investment Rs 10000, r=10%,n=4
years, calculate NPV.
year Cash inflow Discounting factor PV of cash inflow
1 1000 0.9091 909
2 2000 0.8264 1653
3 2000 0.7513 1503
4 6000 0.6830 4098
TPV 8163
Investments 10000
NPV -1837
From the negative NPV figures, the project is not acceptable.
Compare the two projects A and B
with following cash flow details, r=10%
and investments is Rs 500 lakhs
Year Discounting Project A Project B
factor Cash flow PV Cash flow PV
1 0.9091 NIL NIL
2 0.8264 100 82.64 150 123.96
3 0.7513 150 112.7 200 150.26
4 0.6830 300 204.9 250 170.75
5 0.6209 300 186.27 250 155.23
Total PV 586.51 600.2
Investments 500 500
NPV 86.51 100.2
Discounted Cash flow return or
Internal rate of return (IRR)
• For NPV calculation, some % of rate of return is
assumed as the discounting factor, which is
generally equal to the cost of capital prevailing
during that period.
• Another approach could be to find out the % rate
of return or the discounting factor for which the
NPV = 0 for the project.
• This rate of return is called Internal rate of return
(IRR) or the discounted rate of return (DCFR).
• IRR is the rate of discount at which the NPV of
the project comes to zero.
• It gives clear picture of the maximum rate at
which funds can be borrowed.
• Discounted rate at NPV = 0 or rate at which cash
inflow equal to outflow.
• If IRR is greater than cost of capital (what you
expect from the project), it is acceptable.
• IRR or DCFR is preferred over NPV as it gives one
figure of the rate of return for each project.
• It also provides an indication of the maximum
rate one can afford to pay for the capital to
finance a particular project.
Interpolating formula for IRR is
IRR = r1 - [NPV1/(NPV2- NPV1)]x (r2- r1)
NPV1 = rate at which NPV is positive and
corresponding rate is r1
NPV2 = rate at which NPV is negative and
corresponding rate is r2.
If difference between NPV1 and NPV2 is
narrower, more accurate value of IRR is
obtained.
• A project requires an investment outlay of Rs
10000 and is likely to generate a net cash
inflow of Rs 5000, 4000, 3000 and 1000
through 1 to 4 years. Find IRR.
Year Cash inflow Discounting PV Discounting PV
factor @ 12% factor @
15%
1 5000 0.8929 4464 0.8696 4348
2 4000 0.7972 3189 0.7561 3024
3 3000 0.7118 2135 0.6575 1973
4 1000 0.6355 636 0.5718 572
TPV 10424 9917
I 10000 10000
NPV 424 -83
• IRR = 0.12 +[ 424/ (424+83)] (0.15-0.12)
• = 0.12 + (424/507)x0.03
• = 0.12 + 0.025 = 0.145 = 14.5%
• Investment Rs 1500, Annual cash flow for
project A & B are given below. Cost of capital
for NPV calculation is 10%. Calculate (1) Pay
back Period (2) Return on original Investment
(3) NPV (4)NPV index and (5) IRR. Which
project do you prefer.
• Project A – 650, 550, 450, 320, 320.
• Project B – 450, 450, 450,450,450.
Project A Project B
Pay back period 2 year 8 months 3 year 4 months
[Link] 30.53% 30%
NPV 300.8 205.9
NPVI 20.05 13.73
IRR 19% 15.7%
Project A is better.
