Chapter 10

Profitability Analysis
Samir Abu-Eishah
1
Discount Factors
Table 9.1 lists the most frequently used discount factors in this text with
their common names and corresponding formulae.
The key to performing any economic analysis is the ability to evaluate and
compare equivalent investments. In order to understand that the equations
presented in Table 9.1 provide a comparison of alternatives, we suggest
that you replace the equal sign with the words is equivalent to. As an
example, consider the equation given for the value of an annuity, A, needed
to provide a specific present worth, P.
FromTable 9.1, Eq. (9.12) can be expressed as
P is equivalent to [A * f(i,n)]
where
(9.12)
) 1 (
1 ) 1 (
(

+
+
=
n
n
n
i i
i
A P
) ( ) ( P/A, i, n i,n f =
2
3
Table 9.1
Cash Flow Diagrams
Up to this point, we have considered only an investment made at a single
point in time at a known interest rate, and we learned to evaluate the future
value of this investment. More complicated transactions involve several
investments and/or payments of differing amounts made at different times.
An effective way to track these transactions is to utilize a Cash Flow
Diagramor CFD.
Figure 9. 2 is the cash flow diagram, it shows that cash transactions were
made periodically. The values given represent payments made at the end of
the year. Figure 9.2 shows that $1000, $1200, and $1500 were received at
the end of the first, second and third year, respectively.
In the fifth and seventh year, $2000 and $X were paid out. There were no
transactions in the fourth and sixth years.
Each cash flow is represented by a vertical line with length proportional to
the cash value of the transaction. The sign convention uses a downward-
pointing arrow when cash flows outward and an upward-pointing arrow
representing inward cash flows. In order to avoid making mistakes and to
save time, it is recommended that prior to doing any calculations, you
sketch a cash flow diagram.
4
Example 9.4
I borrowed 1000, 1200 and 1500 from a bank (at 8%
p.a. effective interest rate) at the end of years
1, 2, and 3, respectively. At the end of year 5, I make
a payment of 2000, and at the end of year 7, I pay off
the loan in full.
1. Draw CFD for this exchange from my point of view
(producer).
2. Draw a discrete cash flow diagram for the investor.
In addition to the discrete CFD described above, we
can show the same information in a cumulative
CFD. This type of CFD presents the accumulated
cash flow at the end of each period.
5
Example 9.5
The yearly cash flow estimated for a project involving the construction and
operation of a chemical plant producing a new product are provided in the
CFD. Using this information, construct a cumulative CFD.
The numbers shown in the worksheet below were obtained from the discrete
diagram.
6
Example 9.5
End of year
Cash Flow (000 $)
(from discrete CFD)
Cumulative CF (000 $)
(calculated)
0 -500 -500
1 -750 -1250
2 -900 -2150
3 300 -1850
4 400
5 400
6 400
7 400
8 400
9 400
10 400
11 400
12 400
7
10.1 A typical cash flow diagram for a
new project
In this chapter, we will see how to apply
the techniques of economic analysis.
A typical cumulative, after-tax cash flow
diagram for a new project is illustrated in
Figure 10.1.
8
9
Figure 10.1
A typical cash flow diagram for a new
project
In the economic analysis of the project it is
assumed that any new land purchases
required are done at the start of the
project, that is, at time zero.
After the decision has been made to build a
new chemical plant or expand an existing
facility, the construction phase of the project
starts.
Depending on the size and scope of the
project, this construction may take anywhere
from 6 months to 3 years to complete.
10
A typical cash flow diagram for a new
project
In the example shown in Figure 10.1, a typical value of 2
years for the time from project initiation to the start-up of
the plant has been assumed.
Over the 2-year construction phase, there is a major
capital outlay. This represents fixed capital expenditures
for purchasing and installing the equipment and auxiliary
facilities required to run the plant.
At the end of the second year, construction has finished
and the plant is started up. At this point, the additional
expenditure for working capital required to float the first
few months of operations is shown. This is one-time
expense at the start-up of the plant and will be recovered
at the end of the project.
11
A typical cash flow diagram for a new
project
After start-up, the process begins to generate finished
products for sale, and the yearly cash flows become
positive. This is reflected in the positive slope of the
cumulative CFD.
Usually the revenue for the first year after start-up is less
than subsequent years due to teething problems in the
plant.
The cash flows for the early years of operation are larger
than those for later years due to the effect of the
depreciation allowance. The time used for depreciation
in Figure 10.1 is 7 years.
12
A typical cash flow diagram for a new
project
In order to evaluate the profitability of a project, we must assume a
life for the process. This is not usually the working life of the
equipment nor is it the time over which depreciation is allowed. It is
a specific length of time over which the profitability of different
projects are to be compared.
Lives of 10, 12, and 15 years are commonly used for this purpose. It
is necessary to standardise the project life when comparing different
projects. This is because profitability is directly related to project
life, and comparing projects using different lives biases the results.
From Figure 10.1 we can see a steadily rising cumulative cash flow
over the 10 operating years of the process, that is, years 2 through
12.
13
A typical cash flow diagram for a new
project
At the end of the 10 years of operation, that is, at the end
of year 12, we assume that the plant is closed down and
that all the equipment is sold for its salvage value, that
the land is also sold, and that we recover our working
capital. This additional cash flow, received on closing
down the plant, is shown by the upward pointing vertical
line in year 12.
Remember that in reality, the plant will most likely not be
closed down we only assume that it will be in order to
perform our economic analysis. The question that we
must now address is how to evaluate the profitability of a
new project.
14
A typical cash flow diagram for a new
project
Looking at Figure 10.1, we can see that at the end of the
project the cumulative CFD is positive. Does this mean
that the project will be profitable?
The answer to this question depends on whether the
value of the income earned during the time the plant
operated was smaller or greater than the investment
made in the beginning of the project.
Therefore, we must consider the time value of money
when evaluating profitability. In the following sections we
will look at different ways to evaluate project profitability.
15
10.2 Profitability criteria for project
evaluation
There are essentially three bases used for the evaluation of profitability.
They are:
Time
Cash
Interest rate
For each of these bases, we can consider discounted or non-
discounted techniques.
The non-discounted techniques do not take into account the time
value of money and are not recommended for evaluating new, large
projects.
Traditionally, however, non-discounted techniques have been and
are still used to evaluate smaller projects, such as process
improvement schemes.
16
10.2.1 Non-discounted profitability
criteria
The non-discounted profitability criteria are illustrated in
Figure 10.2.
17
Figure 10.2
Time Criterion:
The term used for this criterion is the Payback Period
(PBP), which is defined as follows:
PBP = Time required, after start-up, to recover the fixed
capital investment, FCI
L
, for the project. In other words:
PBP is the time when the Cumulative Cash flow = (Land
Cost + Working Capital) (10.1)
The payback period is shown as a length of time on Figure
10.2. Clearly, the shorter the payback period, the more
profitable the project.
18
Cash Criterion:

(8.2)
Projects with cumulative cash ratios > 1.0 are potentially profitable while those with ratios
< 1.0 cannot be profitable.
The criterion used here is the Cumulative Cash
Position (CCP), which is simply the worth of the
project at the end of its life.
However, it is difficult to compare projects with
dissimilar fixed capital investments and sometimes it is
more useful to use the Cumulative Cash Ratio (CCR)
defined as:
19
(10.2)
Interest rate criterion:
The criterion used here is called the Rate of Return
on Investment (ROROI) and represents the non-
discounted rate at which we make money from our
fixed capital investment. The definition is given as:
The annual net profit in the above definition is an
average over the life of the plant after start-up.
(8.3)
20
(10.3)
A new chemical plant is going to be built and will require the following
investments (all figures are in M$):
Cost of land, L = M$ 10
Total fixed capital, FCI
L
= M$ 150
Fixed capital investment during year 1 = M$ 90
Fixed capital investment during year 2 = M$ 60
Plant start-up at end of year 2
Working capital = 20% of FCI
L
= 0.2 * 150 = 30 at end of year 2
The sales revenues and costs of manufacturing are given below:
Yearly revenue (after start-up), R = M$ 75/year
Cost of manufacturing excluding depreciation allowance (after start-up) = COM
d
=
M$ 30 per year
Taxation rate, t = 45%
Example 10.1
21
Example 10.1
After Tax Cash flow = Net profit + Depreciation
= Revenue Expenses Income tax + Depreciation
= (R - COMd d)*(1-t) + d
Salvage value of plant, S = M$ 10
Depreciation: Use MACRS over 5 years. This method uses a
combination of double declining balance (DDB) method and switches
to a straight-line method (SL) when the SL method yields a greater
depreciation allowance for that year. The SL method is applied to the
remaining depreciable capital over the remaining time allowed for
depreciation.
Assume a project life n = 10 years
Calculate each non-discounted profitability criteria given in this
section for this plant.
Using this data we need to draw cumulative cash flow diagram.
See Table E10.1 and Figure E10.1 for solution
22
Depreciation Methods
n
S FCI
d
L
SL
k

=
(

=

=
=
1
0
2
k j
j
j L
DDB
k
d FCI
n
d
2 / ) 1 (
] ][ 1 [
+
+
=
n n
S FCI k n
d
L soyd
k
23
n
S FCI
d
L
SL
k

=
d
k
SL
= (150-10)/8 = 17.5
(

=

=
=
1
0
2
k j
j
j L
DDB
k
d FCI
n
d
24
25
(R-COM
d
-d
k
)x(1-t)+d
k
Table E10.1
Table E10.1 Non-discounted after-Tax Cash Flows for Example 10.1 (in $10
6
)
End of
Year (k)
Investment d
k
FCI
L
-d
k
R COM (R-COM
d
-
d
k
)x(1-t)+d
k
Cash Flow Cumulative
Cash Flow
0 -10 -- 150 -- -- -10 -10
1 -90 -- 150 -- -- -90 -100
2 -60-30 -- 150 -- -- -90 -190
3 18.75 131.25 75 30 33.1875 33.1875 -156.8125
4 18.75 112.5 75 30 33.1875 33.1875 -123.625
5 18.75 93.75 75 30 33.1875 33.1875 -90.4375
6 18.75 75 75 30 33.1875 33.1875 -57.25
7 18.75 56.25 75 30 33.1875 33.1875 -24.0625
8 18.75 37.5 75 30 33.1875 33.1875 9.125
9 18.75 18.75 75 30 33.1875 33.1875 42.3125
10 18.75 0 75 30 33.1875 33.1875 75.5
11 0 0 75 30 24.75 24.75 100.25
12 40 0 0 85 30 70.25 70.25 170.5
26
27
Figure E10.1
10.2.2 Discounted profitability criteria
The main difference between the non-discounted and
discounted criteria is that for the latter we discount each
of yearly cash flows back to time zero.
We then use the resulting discounted cumulative cash
flow diagram to evaluate profitability.
The three different types of criteria are given below:
1. Discounted Payback Period (DPBP)
2. Net Present Value (NPV) or Present Value Ratio (PVR)
3. Discounted Cash Flow Rate of Return (DCFROR)
28
Time criterion:
The Discounted Payback Period (DPBP) is defined in
a manner similar to the non-discounted version given
above.
DPBP = Time required, after start-up, to recover the
fixed capital investment, FCI
L
, required for the
project, with all cash flows discounted back to time
zero.
The project with the shortest discounted payback
period is the most desirable.
29
Cash Criterion:
The Discounted Cumulative Cash Position, more
commonly known as the Net Present Value (NPV) of
the project, is defined as:
NPV = Cumulative discounted cash position at the end
of the project
Again, the NPV of a project is greatly influenced by the
level of fixed capital investment and a better criterion for
comparison of projects with different investment levels
may be the Present Value Ratio (PVR):

Flows Cash Negative All of Value Present
Flows Cash Positive All of Value Present
PVR =
(8.4)
30
(10.4)
Cash Criterion
A present value ratio of unity for a project represents a
break-even situation. Values greater than unity indicate
profitable processes while those less than unity
represent unprofitable projects.
The discount rate is usually determined by corporate
management and represents the minimum acceptable
rate of return that the company will accept for any new
investment.
Many factors influence the determination of this discount
interest rate, and for our purposes, we will assume that it
is always given.
31
Example 10.2
For the plant described in Example 10.1 determine the
following discounted profitability criteria:
1. Discounted Payback Period (DPBP)
2. Net Present Value (NPV)
3. Present Value Ratio (PVR)
Assume a discount rate of 0.1 (i.e., 10% p.a.)
The procedure used is similar to the one used for the
non-discounted evaluation shown in Example 10.1.
The discounted cash flows replace the actual cash flows. For
the discounted case, we must discount all the cash flows in
Table E10.1 back to the beginning of the project (time = 0).
We do this simply by multiplying each cash flow by the
discount factor P = F/(1+i)
n
, where n is the number of years
after the start of the project.
32
33
Table E10.2
Table E10.2 Discounted after-Tax Cash Flows for Example 10.2 (in $10
6
)
End of
Year (k)
Investment d
k
FCI
L
-d
k
R CO
M
(R-COM
d
-
d
k
)x(1-t)+d
k
Discounted
Cash Flow
Discounted
Cumulative
Cash Flow
0 -10 -- 150 -- --
-10.00 -10.00
1 -90 -- 150 -- --
-81.82 -91.82
2 -90 -- 150 -- --
-74.38 -166.20
3 18.75 131.25 75 30 33.1875
24.93 -141.26
4 18.75 112.5 75 30 33.1875
22.67 -118.60
5 18.75 93.75 75 30 33.1875
20.61 -97.99
6 18.75 75 75 30 33.1875
18.73 -79.26
7 18.75 56.25 75 30 33.1875
17.03 -62.23
8 18.75 37.5 75 30 33.1875
15.48 -46.74
9 18.75 18.75 75 30 33.1875
14.07 -32.67
10 18.75 0 75 30 33.1875
12.80 -19.87
11 0 0 75 30 24.75
8.67 -11.20
12 40 0 0 85 30 70.25
22.38 11.18
34
35
Figure E10.2
36
-10.00
-91.82
-166.20
-141.26
-118.60
-97.99
-79.26
-62.23
-46.74
-32.67
-19.87
-11.20
11.18
-180.00
-160.00
-140.00
-120.00
-100.00
-80.00
-60.00
-40.00
-20.00
0.00
20.00
40.00
0 2 4 6 8 10 12 14
Discounted Cumulative Cash Flow
Comments on Examples 10.1 and 10.2
We can see from examples 10.1 and 10.2 that there are
significant effects of discounting the cash flows to account for
the time value of money. From these results, we can make the
following observations:
1. In terms of the time basis, the payback period increases as the discount
rate increases. In the above examples, it increased fromto years.
2. In terms of the cash basis, replacing the cash flow with the discounted
cash flow decreases the value at the end of the project. In the above
examples, it dropped from to million dollars.
3. In term of the cash ratios, discounting the cash flows gives a lower
ratio. In the above examples, the ratio dropped from to . 40
As the discount rate increases, all of the discounted
profitability criteria will show a reduction in profitability.
37
Interest Rate Criterion:
The Discounted Cash Flow Rate of Return (DCFROR) is
defined to be the interest rate at which all the cash flows must
be discounted in order for the net present value of the project
to be equal to zero. Thus, we may write:
DCFROR = Interest or Discount Rate for which the Net
Present Value of the project is equal to zero
Therefore, the DCFROR represents the highest, after-tax
interest or discount rate at which the project can just break
even.
It is worth noting that for evaluation of the discounted cash
flow rate of return, no interest rate is required since this is
what we calculate.
38
Example 10.3
For the problem presented in Examples 10.1 and
10.2, determine the discounted cash flow rate of return
(DCFROR).
The NPVs for several different discount rates were calculated
and the results are shown in the table below and figure next
page:
Discount rate, i NPV
0.0 170.50
0.10 17.12
0.12 0.77
0.13 -6.32
0.15 -18.66
0.20 -41.22

39
Example 10.3
-100
-50
0
50
100
150
200
0 0.05 0.1 0.15 0.2 0.25
N
P
V
,

M
$
Interest rate, %
40
Example 10.3
Figure 10.3 provides the cumulative discounted cash flow
diagram for Example 10.3 for several discount factors.
Figure 10.3 shows the effect of changing discount factors on
the profitability and shape of the curves. It includes a curve for
the DCFROR found in Example 10.3.
For this case, it can be seen that the NPV for the project is
zero. In Example 10.3, if the acceptable rate of return for the
company were set at 20%, then the project would not be
considered an acceptable investment. This is indicated by a
negative NPV for i = 20 %.
41
42
Figure 10.3
10.3