Estimate of ProfitabilityIn a free enterprise system, companies are in business to make a profit. If profits aren’t maintained, a company’s 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 company’s 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 OBJECTIVESCorporate objectives might include one or several of the

following:• Maximize the return on investment.• Maximize the return on stockholder’s 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 CLASSIFICATIONIn 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 MeasuresQualitative Measures

Return on InvestmentIt 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 InvestmentThe 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 SafetyEnvironmental Constraints

Legal ConstraintsProduct LiabilityCorporate ImageManagement 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

LandFixed capital investmentWorking capitalTotal capital investmentProfit–loss statementIncome (I) 3,700Cash operating expenses (COE) 2,950Depreciation (D) 360 (half year convention 5 years

SLM)Total operating expenses (TOE =COE +D) 3,310Operating income (OI =I-COE) 750Net income before Taxes (NIBT = OI-D) 390Federal income taxes FIT=0.35 * NIBT 137Net income after taxes NIAT =NIBT-FIT 253After-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 NPW–IRR ControversyThe 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 can’t 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 company’s 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. ROIb. POPc. Cumulative cash flow analysisd. PW at 20% continuous intereste. 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 management’s 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.