METHODS FOR CALCULATING

PROFITABILITY
CH-403 Process Economics and Plant Design
Objective
An economic evaluation of the various design studies
and their cost estimate is to be performed before
selecting the most viable project and approve
investment
Every project evaluated must satisfy a minimum
acceptable rate of return (MARR) for it to be approved.
The MARR depends on the source of funds that are
available for funding the project and the type of
project
The MARR is based on highest rate of earning on safe
investments such as corporate bonds, government
bonds and loans.
Risk and MARR on investment
Investment description Level Of Risk Minimum acceptable
return (mar) (after income
taxes), percent/year
Basis: Safe corporate investment Safe 4-8
opportunities or cost of capital
New capacity with established Low 8-16
corporate market position
New product entering into Medium 16-24
established market, or new
process technology
New product or process in a new High 24-32
application
Everything new, high R&D and Very high 32-48
marketing effort
Methods for Calculating Profitability

Methods that do not consider time value of money

Rate of return on investment (ROI)
Payback Period (PBP)

Net Return

Methods that do consider time value of money

Net Present Worth (NPW)
Discounted cash flow rate (DCFR) of return

It is generally the last two methods that are used in

large companies and first one in small companies.
Return on Investment (ROI)
Ratio of Profit to Investment
Profit is net profit after taxes (Np)
Investment is total capital investment (F)

ROI is expressed as a fraction or percentage (Np/F)

Alternatively, ratio of gross profit to fixed capital

could be used
Net profit and investment could change from year
to year
1 N N
ROI N p , j Fj
N j 1 j b
Return on Investment (ROI)
Usually the capital investment can be evaluated at
project start time.
1 N
ROI N p , j F N p ,avg F
N j 1
Np,avg is the average profit per year over the
evaluation period.
If ROI mar , the project offers acceptable rate of
return
Payback Period (PBP)
It is the length of time necessary for the total
returns to match the capital investment
PBP (V Ax ) A
V is the manufacturing fixed cost and Ax is the non-
manufacturing fixed cost, A is the annual cash flow
Cash flow changes from year to year
N
PBP (V Ax ) A
j 1
j (V Ax ) Aj ,avg

Acceptable PBP is based on mar

Payback Period (PBP)
The fixed capital investment V + Ax = 0.85 F,
assuming working capital is 15% of total capital.
Annual cash flow at acceptable return is
A j ,avg N p ,avg d j ,avg mar F (0.85F / N )
Straight line depreciation is assumed.
Acceptable PBP is
0.85F 0.85
PBPar
mar F 0.85F / N mar 0.85 / N

Actual PBP Acceptable PBP

Net Return
Amount of cash flow over and above the minimum
acceptable rate of return and recover the total capital
investment
Net Return N
Rn N p , j d j rj Fj mar N Fj
N N

j
1

j b
j b

return over investment
return over and above investment and mininum acceptable rate of return
Rn > 0, means cash flow greater than that required to
meet minimum requirement after repaying the
investment
Rn = 0, means project just satisfies minimum
acceptable return and repays investment
Net Present Worth
The net return evaluated with present worth factors
(PWF)

NPW PWFcf , j s j c j d j 1 rj d j PWFv, j Fj
N N

j 1 j b

Appropriate discounting rate is mar in case of discrete

discounting
For continuous compounding/discounting minimum
acceptable nominal rate can be defined as
rma ln 1 mar
If NPW 0, the project is favorable.
Discounted Cash Flow Rate of Return

It is that rate of return of investment in which all

investments and cash flows are discounted.
It is obtained by setting NPW = 0.
If for discounting rate set as ram, NPW comes out as
zero then ram used is DCFR.
NPW and DCFR are always used together to find
whether project is favorable.
Example
Initial fixed capital investment = Rs. 1,00,000/-
Working capital investment = Rs. 10,000/-
Salvage value at end of service life = Rs. 10,000/-
Service life, in years = 5
Annual earnings (not including depreciation) after
taxes for 5 years are Rs. 30,000/-, Rs. 31,000/-, Rs.
36,000/-, Rs. 40,000/-, Rs. 43,000/-
Assume straight line method for depreciation
Depreciation per year = (1,00,000-10,000)/5 = Rs. 18,000/-
Minimum acceptable rate of return (mar) = 15% p.a.
Corporate Cash Flow
Assessment by ROI Method
1 N N
Evaluate ROI N p , j F j
N j 1 j b

If ROI mar, the project offers acceptable rate of return

Years (sj-cj)(1-) dj(1-) Np,j
1 30,000 11,700 18,300
2 31,000 11,700 19,300
3 36,000 11,700 24,300
4 40,000 11,700 28,300
5 43,000 11,700 31,300

Np,avg = (Rs. 121,500/5) = Rs. 24,300/- per year

ROI = Rs. 24,300 / (1,00,000+10,000) = 22.1 % > mar
Assessment by Payback Period
% Fixed capital investment = 1,00,000/1,10,000 =
0.91
Acceptable PBP at mar = 15% is
0.91F
2.74 years
0.15F 0.91F / 5

Based on annual earnings and depreciation, actual

PBP is 1,00,000
2.364 years
24,300 18,000
Actual PBP < Acceptable PBP
Assessment by Net Return
Net Return
N
Rn N p , j d j rj Fj mar N Fj
N N

j
1

j b
j b

return over investment
return over and above investment and mininum acceptable rate of return
In our case,
Rn N p , j mar NF
N

j 1

Net Return = Rs. 121,500 0.15 x 5 x 110,000 =Rs.

39,000/- > 0
Assessment by Net Present Worth
Net Present Worth

NPW PWFcf , j s j c j d j 1 rj d j F
N

j 1

Assume annual earnings is continuous cash flow

and we apply continuous discounting to project
time zero e r 1 rj
e
r
Only salvage is a lump sum at end of service life
e rj
 Assessment by Net Present Worth
The discounting rate is effective nominal rate based on
mar is ram ln 1 mar ln 1 0.15 0.14
Year Np,j dj rj er 1 rj Present
e
r PWF Worth
1 18,300 18,000.00 0.00 1.073 0.870 0.933 33,877.48
2 19,300 18,000.00 0.00 1.073 0.756 0.812 30,270.21
3 24,300 18,000.00 0.00 1.073 0.658 0.706 29,850.33
4 28,300 18,000.00 0.00 1.073 0.572 0.614 28,411.36
5 31,300 18,000.00 10,000.00 1.073 0.497 0.534 31,278.08

NPW = Rs. 1,53,687.47 (1,00,000 + 10,000) = Rs.

43,687.47 > 0
 Discounted Cash Flow Rate (DCFR)
Effective Nominal Rate for which NPW = 0
Initial Fixed Capital Investment 100,000
Working Capital Investment 10,000 Adjust Effective Nominal
Salvage 10,000 rate such that the Net
Service Life (in years) 5
Tax Rate = 0.35 Present Worth is Rs.
Minimum rate of return 0.15 0.00/-
Effective nominal rate 0.14
Continuo
(Profits-
Gross Profits Depreciatio Continuous Cash us
Year depreciation) Recovery PWF Present Worth
after taxes n Flow Factor Discounti
after taxes
ng Factor
1 30,000.00 18,000.00 18,300.00 0.00 1.073 0.870 0.933 Rs. 33,877.48
2 31,000.00 18,000.00 19,300.00 0.00 1.073 0.756 0.812 Rs. 30,270.21
3 36,000.00 18,000.00 24,300.00 0.00 1.073 0.658 0.706 Rs. 29,850.33
4 40,000.00 18,000.00 28,300.00 0.00 1.073 0.572 0.614 Rs. 28,411.36
5 43,000.00 18,000.00 31,300.00 10,000.00 1.073 0.497 0.534 Rs. 31,278.08
24,300.00 Rs. 153,687.47

Net Present Worth Rs. 43,687.47

Effect of Inflation
Inflation is the increase in prices of goods and
services over time (deflation is decrease)
This has to do with productivity, demand and
supply of markets.
Inflation effects the buying power of money.
Inflation in prices of equipment may effect project
estimation and actual expenses.
Cost indexes reflect inflation over time.
Estimation of Inflation
If the inflation rate be e, the price at the end of jth
year pj will be
p j p0 1 e
j

For continuous inflation, define nominal rate of

inflation as re ln 1 e and price will be
p j p0ere j
Suppose a car that costs Rs. 5 lacs is to be bought 5
years from now. How much investment would be
required? If annual interest rate available is at 10%
and rate of inflation is 5%.
 Estimation of Inflation
Cash flow factor is e 1 r
rN

Inflation rate is e re N
Scenario - 1 Scenario - 2 Scenario - 3 Scenario - 4
Rate of Interest 0.1 0.1 0.05
Rate of Inflation 0.05 0 0.05 0.05
Nominal rate of interest 0.09531018 0.09531018 0.048790164
Nominal rate of inflation 0.048790164 0 0.048790164 0.048790164
Investment period 5 5 5 5
Final amount required Rs. 5,00,000.00 Rs. 5,00,000.00 Rs. 5,00,000.00 Rs. 5,00,000.00

Cash Flow factor 6.405506749 6.405506749 5.662648757

Inflation factor 0.783526166 1 0.783526166 0.783526166

Investment required every year Rs. 99,623.78 Rs. 78,057.84 Rs. 1,12,692.98 Rs. 6,38,140.78
Estimation of Inflation
Inflation does not effect fixed capital investment or
the depreciation on that capital, however annual
cash flow is effected.
The annual cash flow is A j s j c j d j 1 d j



N p, j

Effect of inflate at the rate of e is

Aj ,e s j c j 1 1 e d j
j

The sales of product will earn more and cost of

operation will cost more.
Estimation of Inflation
The purchasing power of the cash flow decreases
over the period
The present worth of the cash flow discounted for
inflation is
d j
s j c j 1
A j ,e
Aj ,0
1 e j
1 e j

Ignoring the time value of cash flow, the decrease

in purchasing power is

Aj Aj ,0 d j
d j
1 e j

d j 1 1 e
j

Estimation of Inflation
Suppose, initial fixed capital investment is F and
the straight line method on depreciation is used,
decrease in purchasing power over a period of n
years will be
F
n

1 1 e n

Effect of inflation at the rate of 5% and taxation at
the rate of 35% on an investment for 10 years is

n

1 1 e
n

0.35
10

1 1 0.05 1.35%
10
Start-up costs
Start-up costs are the expenses over and above the
fixed capital investment required in first year of
plant operation
In economic estimates, it is generally accounted for
by taking plant productivity as 50% of rated
capacity in first year.
Alternative Investments
Of multiple options of investments, what is most desirable
with attractive rate of return.
Fixed Capital Net Profit ROI
Investment -1 1,200,000 240,000 20%
Investment-2 2,000,000 300,000 15%
Incremental 800,000 60,000 7.5%
If both investments qualify mar, then an additional investment
of 800,000 is only giving returns at the rate of 7.5% which is
not acceptable.
Rule of thumb: Accept minimum investment with functional
results and acceptable mar first.
Alternative Investments
Four different designs of heat exchangers are
available
Data about investment and savings is given
Total Initial Value of
Design Operating Fixed
Installed heat
No. Cost Charges
Cost savings
1 10,000 100 2,000 4100
2 16,000 100 3,200 6300
3 20,000 100 4,000 7300
4 26,000 100 5,200 8850
Choose design based on profitability.
 Alternative investments
Incremen
Total Initial Value of Net
Design Operating Fixed Yearly ROI tal Incremen Incremen
Installed heat Return
No. Cost Charges Profit Method Investme tal Profit tal ROI
Cost savings Method
nt
1 10,000 100 2,000 4100 2,000 0.20 base design 500
2 16,000 100 3,200 6300 3,000 0.19 6,000 1,000 16.67% 600
3 20,000 100 4,000 7300 3,200 0.16 10,000 1,200 12.00% 200
4 26,000 100 5,200 8850 3,550 0.14 -350

Mar 0.15

Only Design No. Using design no. 1 as Design no. 2 has

1, 2 and 3 ROI > base, design no. 2 gives most profitable
mar best incremental ROI return over and
above mar

Design No. 2 is accepted.

 Alternative Investments
Graphical Method
30000
Point of Tangency
25000
Net Savings, Rs./yr

Slope = 0.25 Maximum net Savings

20000

15000

10000

5000

0
0 10,000 20,000 30,000 40,000 50,000 60,000 70,000
Required Investment, in Rs.
Alternative Investments
Incremental ROI = slope of the tangent.
If acceptable incremental ROI is 25%, then
recommended investment is as shown by the
dashed line.
Any further investment will decrease incremental
ROI, that is the additional savings made is not
worth the additional investment.
Our maximum investment is limited by the
acceptable incremental ROI and not by the
maximum savings.
Replacements
Replacement is necessary when an equipment
becomes obsolete.
The economic evaluation of an equipment involves
Net realizable value is the market value of the
equipment
It is usually lower than the book value (obtained after
depreciation)
Difference is unamortized value (is a loss to the
owner) which is part of required investment.
Example
Original cost of equipment = Rs. 30,000/-
Service life of 10 years with salvage value of Rs. 0/-
Depreciation per year is Rs. 3,000/-
After 5 years, net realizable value is Rs. 6,000/-
Operating cost per year is Rs. 22,000/-
New equipment cost is Rs. 40,000/-
Service life of 10 years with salvage value of Rs. 0/-
Depreciation per year is Rs. 4,000/-
Operating cost per year is Rs. 15,000/-
Should the old equipment be replaced? Acceptable rate of
return on investment is 10%
Example
Total expenses per year on old equipment = Rs.
22000/- + Rs. 3000/- = Rs. 25,000/-
Total expenses per year on new equipment = Rs.
15,000/- + Rs. 4000/- = Rs. 19,000/-
Annual savings = Rs. 6000 /-
Investment required = Rs. 40,000 (cost of new
equipment) Rs. 6000 (sale price of old
equipment) = Rs. 34,000 /-
ROI = Rs. 6000/34,000 = 17.6% > 10 % (investment
is acceptable)
References
Peters, M. S., Timmerhaus, K. and West, R. E., Plant
Design and Economics for Chemical Engineers,
McGraw Hill Education, 5th Edition, 2002.
Couper, J. R., Process Engineering Economics, CRC
Press, 1st Edition, 2003.