UNIT-4

Profitability, Alternative investments and Replacements

Introduction:

 Profitability is measure of the amount of profit that can be obtained from a given
situation.

 Profitability is the common denominator for all business activities.

 It is necessary to know how much profit can be obtained before capital is invested in a
project and whether or not it might be more advantageous to invest the capital in another
form of enterprise.

Major goals of an economic analysis:

 Determination and analysis of profits obtainable from the investment of capital

 The choice of the best investment among various alternatives .

 Reasons why capital investments are made:

 1) The purpose is merely to supply a service which cannot possibly yield a monetary
profit.

 Ex: Provision of recreation facilities for free use of employees.

 The design engineer, however, usually deals with investments which are expected to
yield a tangible profit.

 2) Investments may be made for replacing or improving an existing property, for

developing a completely new enterprise.

Bases for evaluating project profitability:

 Total profit alone cannot be used as the deciding profitability factor in determining if an
investment should be made.

 If the goal of a company were merely to maximize profits, any investment would be
accepted which would give a profit, no matter how low the return or how great the cost.

 The rate of return, rather than the total amount of profit, is the important profitability
factor in determining if the investment should be made.

Mathematical Methods for Profitability Evaluation:

  The most commonly used methods for profitability evaluation are

 1. Rate of return on investment

 2. Discounted cash flow based on full-life performance

 3. Net present worth

 4. Capitalized costs

 5. Payout period

RATE OF RETURN ON INVESTMENT :

 Rate of return on investment is ordinarily expressed on an annual percentage basis.

Standard % return = (Yearly profit / Total initial investment) * 100

 Profit is defined as the difference between income and expense.

 Therefore , profit is a function of the quantity of goods or services produced and the
selling price.

 The amount of profit is also affected by the economic efficiency of the operation, and
increased profits can be obtained by use of effective methods which reduce operating
expenses.

 To obtain reliable estimates of investment returns, it is necessary to make accurate

predictions of profits and the required investment.

 To determine the profit, estimates must be made of direct production costs, fixed charges
including depreciation, plant overhead costs, and general expenses.

 Profits may be expressed on a before-tax or after-tax basis, but the conditions should be
indicated.

 Both working capital and fixed capital should be considered in determining the total
investment.

Returns Incorporating Minimum Profits as an Expense:

 It is based on the assumption that it must be possible to obtain a certain minimum profit
from an investment. This minimum profit is included as a fictitious expense along with
the other standard expenses.
  When return on investment is determined in this manner, the result shows the risk
earning rate, and represents the return over and above that necessary to make the capital
expenditure advisable.

 If the return is zero or larger, the investment will be attractive. This method is sometimes
designated as return based on capital recovery with minimum profit.

Rate of returns with avg.investment :

• The normal procedure is to base the percent return on investment on the total initial
investment.

• However, because equipment depreciates during its useful life, it is sometimes

convenient to base the rate of return on the average estimated investment during the life
of the project.

• With this method, the rate of return is determined by dividing the average annual profit
by one-half the initial fixed-capital investment minus the estimated salvage value at the
end of the useful life plus the working-capital investment.

Discounted cash flow rate of return based on discounted cash flow:

It takes into account the time value of money and is based on the amount of the investment that
is unreturned at the end of each year during the estimated life of the project.

A trial-and-error procedure is used to establish a rate of return which can be applied to yearly
cash flow so that the original investment is reduced to salvage and land value plus working-
capital investment during the project life.

 Thus, the rate of return by this method is equivalent to the maximum interest rate
(normally, after taxes) at which money could be borrowed to finance the project under
conditions where the net cash flow to the project over its life would be just sufficient to
pay all principal and interest accumulated on the outstanding principal.

It is also the maximum interest rate (after-tax) at which funds could be borrowed for the
investment and just break even at the end of the service life

Net present worth:

 The net present worth of the project is the difference between the present value of the
annual cash flows and the initial required investment.

 The rate of interest is the minimum acceptable return for the project.

CAPITALIZED COSTS
  The capitalized-cost profitability concept is useful for comparing alternatives which exist
as possible investment choices within a single overall project.

 The alternative giving least capitalized cost would be desirable economic choice.

 Capitalized cost represents the amount of money that must be available initially to
purchase the equipment and simultaneously provide sufficient funds for interest
accumulation to permit perpetual replacement of the equipment.
𝐶 𝐶𝑅 (1+𝑖)𝑛
𝐾 = 𝐶𝑣 + (1+𝑖)𝑅𝑛−1 = + 𝑉𝑠
(1+𝑖)𝑛 −1

Inclusion of Operating Costs in Capitalized-Costs Profitability Evaluation:

 The capitalized-costs concept can be extended to include operating costs by adding an

additional capitalized cost to cover operating costs during the life of the project.

 Each annual operating cost is considered as equivalent to a necessary piece of equipment

that will last one year.

 If annual operating cost is constant and the cost is considered as end of the year cost ,the
capitalized cost of operation is equal to operating cost / i

Payout period or Pay out time :

 It 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 .

 Generally, for this method, original capital investment means only the original,
depreciable, fixed-capital investment, and interest effects are neglected.

Payout period including interest:

it takes the time value of money into consideration .

With this method, an appropriate interest rate is chosen is equal to minimum acceptable rate of
return.

ALTERNATIVE INVESTMENTS

 In industrial operations, it is often possible to produce equivalent products in different

ways. Although the physical results may be approximately the same, the capital required
and the expenses involved can vary considerably depending on the particular method
chosen.

 Similarly, alternative methods involving varying capital and expenses can often be used
to carry out other types of business ventures. It may be necessary, therefore, not only to
decide if a given business venture would be profitable, but also to decide which of several
possible methods would be the most desirable.

The final decision as to the best among alternative investments is simplified if it is recognized
that each dollar of additional investment should yield an adequate rate of return.

In practical situations, there are usually a limited number of choices, and the alternatives must be
compared on the basis of incremental increases in the necessary capital investment.

• A general rule for making comparisons of alternative investments can be stated as

follows:

• The minimum investment which will give the necessary functional results and the
required rate of return should always be accepted unless there is a specific reason for
accepting an alternative investment requiring more initial capital.

• Therefore, when alternatives are available the base plan would be that requiring the
minimum acceptable investment. The alternatives should be compared with the base plan,
and additional capital would not be invested unless an acceptable incremental return is
shown.

• When investment comparisons are made, alternatives requiring more initial capital are
compared only with lower investments which have been found to be acceptable

REPLACEMENTS
  The term “replacement” refers to a special type of alternative in which facilities are
currently in existence and it may be desirable to replace these facilities with different
ones.

 The reasons for making replacements can be divided into two general classes, as follows:

 1. An existing property must be replaced in order to continue operation and meet the
required demands for service or production. Some examples of reasons for this type of
necessary replacement are:

 a. The property is worn out and can give no further useful service.

 b. The property does not have sufficient capacity to meet the demand placed upon it.

 c. Operation of the property is no longer economically feasible because changes in

design or product requirements have caused the property to become obsolete.

2. An existing property is capable of yielding the necessary product or service, but more efficient
equipment or property is available which can operate with lower expenses.

• When the reason for a replacement falls in the first general type, the only alternatives are
to make the necessary changes or else go out of business. Under these conditions, the
final economic analysis is usually reduced to a comparison of alternative investments.

• When the reason for a replacement falls in the second category we need to determine
whether or not a change is advisable.

• The operating expenses with the present equipment must be compared with those that
would exist if the change were made.

• Practical considerations, such as amount of capital available or benefits to be gained by

meeting a competitor’s standards, may also have an important effect on the final decision.