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Cash flow diagram

Cash flow

Cash operating

Revenue expenses

Operation

Operating income

Depreciation

Depletion

Gross profit

Net profit

Income tax

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.

Total profit alone cannot be used as the

deciding profitability factor in determining if

an investment should be made.

The profit goal of a company is to

maximize income above the cost of the

capital which must be invested to generate

the income.

Profitability Evaluation

1. Rate of return on investment

2. Payout period

3. Net present worth

4. Discounted cash flow based on full-life

performance

Rate of return on investment

annual profit

ROI 100%

total capital investment

annual profit

ROI 100%

FC WC

Example 1 Determination of rate of return on

investment-consideration of income-tax effects

fixed-capital investment of $900,000 and $100,000

of working capital. It is estimated that the annual

income will be $800,000 and the annual expenses

including depreciation will be $520,000 before

income taxes. A minimum annual return of 15

percent before income taxes is required before the

investment will be worthwhile. Income taxes

amount to 34 percent of all pre-tax profits.

Example 1 Determination of rate of return on

investment-consideration of income-tax effects

(a) The annual percent return on the total initial

investment before income taxes.

(b) The annual percent return on the total initial

investment after income taxes.

(c) The annual percent return on the total initial

investment before income taxes based on

capital recovery with minimum profit.

(d) The annual percent return on the average

investment before income taxes assuming

straight-line depreciation and zero salvage

value.

Example 1 Determination of rate of return on

investment-consideration of income-tax effects

$520,000 = $280,000.

Annual percent return on the total initial

investment before income taxes =

[280,000/(900,000 + 100,000)].(100) = 28 percent.

($280,000)(0.66) = $184,800.

Annual percent return on the total initial

investment after income taxes =

[184,800/(900,000 + 100,000)].(100) = 18.5

percent.

Example 1 Determination of rate of return on

investment-consideration of income-tax effects

(c) Minimum profit required per year before income taxes =

($900,000 + $100,000).(0.15) = $150,000.

Fictitious expenses based on capital recovery with

minimum profit = $520,000 + $150,000 = $670,000/year.

capital recovery with minimum annual rate of return of 15

percent before income taxes = [($800,000 -

670,000)/(900,000 + 100,000)].(100) = 13 percent.

and zero salvage value = $900,000/2 + $100,000 =

$550,000.

Annual percent return on average investment before

income taxes = (280,000/550,000).(100) = 51 percent.

Payout period

Other equivalent names are payback period, payback time, payoff period,

payoff time, and cash recovery period

Example 2. POT

Use the data in example 1. In addition, it is estimated

that the salvage value at end of service life is $100,000.

Use straight line depreciation. Determine the minimum

pay-out-time without interest charge.

Solution:

Depreciable fixed-capital investment = FC SV

= $900,000 - $100,000 = $800,000

Depreciation = $800,000 / 5 = $160,000

Profit before tax = $800,000 - $520,000 = $280,000

Profit after tax = ($280,000)(0.66) = $184,800

POT before tax = $800,000 / ($280,000 + $160,000) =

1.8 years

POT after tax = $800,000 / ($184,800 + $160,000) = 2.3

years

Net Present Worth (NPW)

continuous interest.

Rate of Return Based on

Discounted Cash Flow

Common names of methods of return calculations

related to the discounted-cash-flow approach are

profitability index, interest rate of return, true rate

of return, and investors rate of return.

method.

NPW calculation uses interest rate set by the company.

IRR is the calculated interest rate that will produce NPW

equal to zero.

Example 3: DCFRR & NPW

Consider the case of a proposed project

for which the following data apply:

Initial fixed-capital investment = $100,000

Working-capital investment = $10,000

Service life = 5 years

Salvage value at end of service life =

$10,000

Example 3: DCFRR & NPW

Year Predicted after-tax cash flow to project

based on total income minus all costs

except depreciation, $

(expressed as end-of-year situation)

0 - 110,000

1 30,000

2 31,000

3 36,000

4 40,000

5 43,000

Example 3: DCFRR & NPW

Determine:

a. Net Present worth if the value of capital to

the company is at an interest rate of 15

percent

b. Discounted-cash-flow rate of return with

discrete interest

c. Discounted-cash-flow rate of return with

continuous interest

a. Computation of net present worth

flow, $ Discount factor: 1 Present value, $

1 i n

0 - 110,000

1 30,000 0.8696 26.100

2 31,000 0.7561 23,400

3 36,000 0.6575 23,300

4 40,000 0.5718 22,900

5 43,000 + 0.4971 31,300

20,000

Total 127,000

b. Computation of discounted-cash-flow rate of return

with discrete interest

Year Estimated cash Trial i = 0.15

flow, $ Discount factor: 1 Present value, $

1 i n

0 - 110,000

1 30,000 0.8696 26.100

2 31,000 0.7561 23,400

3 36,000 0.6575 23,300

4 40,000 0.5718 22,900

5 43,000 + 0.4971 31,300

20,000

127,000

total present value

Ratio

total investment 1,155

b. Computation of discounted-cash-flow rate of return

with discrete interest

Year Estimated cash Trial i = 0.1763

flow, $ Discount factor: 1 Present value, $

1 i n

0 - 110,000

1 30,000 0.8501 24852

2 31,000 0.7227 21273

3 36,000 0.6143 20465

4 40,000 0.5222 18837

5 43,000 +

0.4440 24577

20,000

110005

total present value

Ratio

total investment 1,0000

c. Cash flow for computation of discounted-cash-

flow rate of return with continuous interest

based on total income minus all costs except

depreciation with cash flow occurring

continuously, S (total of

continuous cash flow for year indicated)

1 30,000

2 31,000

3 36,000

4 40,000

5 43,000

c. Computation of discounted-cash-flow rate of return

with continuous interest

cash flow, Discount factor: Present value, $

$

Fb Fa

0 - 110,000

01 30,000 0.8955 26,866

12 31,000 0.7152 22,170

23 36,000 0.5711 20,561

34 40,000 0.4561 18,244

45 43,000 0.3642 15,663

5 + 20,000 0.3248 6,496

Total 110,000

Trial i, to get total PW = 110,000

DCFRR with continuous interest = 22.49%

c. Computation of discounted-cash-flow rate of

return with continuous interest

flows which occur in an instant at a point in time

after the reference point.

flows which occur uniformly over one-year periods

after the reference point. (S is the total cash flow

for the nth year.)

References

Peters, M.S., Timmerhaus, K.D., Plant

Design and Economics for Chemical

Engineers, 4th ed., McGraw Hill, New

York, 1991

Couper, J.R., Process Engineering

Economics, Marcel Dekker, Inc., New

York, 2003

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