Lecturer Notes TK4001Chemical Process Economic Evaluation

Profitability Analysis

Profitability AnalysisCourse Contents:IntroductionProfitability CriteriaIncremental Economic AnalysisEvaluation of Economic AlternativesIncremental Analysis for Retrofitting FacilitiesProfit Margin Analysis

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Profitability AnalysisCorporate objectives:Maximize the return on investment (ROI).Maximize the return on stakeholders equity.Maximize aggregate earnings.Maximize common stock prices.Finds outlet 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.

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Profitability AnalysisProject classification:Necessity projects.Product improvement projects.Process improvement projects.Expansion projects.New ventures.

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Profitability AnalysisProfitability Evaluation (1)

Essential bases for profitability evaluation:TimeNon-discounted small projectCashInterest RateDiscounted large project

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CriterionNon-discountedDiscountedTimePayback Period (PBP)Discounted Payback Period (DPBP)CashCumulative Cash Position (CCP)Cumulative Cash Ratio (CCR)Net Present Value (NPV)Present Value Ratio (PVR)Interest RateRate of Return on Investment (ROROI)Discounted Cash Flow Rate of Return (DCFROR)

Profitability AnalysisProfitability Evaluation (2)

Non-discounted profitability criteria (1 Time):

Payback period (PBP) time required, after start-up, to recover the FCI for the project. the shorter the PBP, the more profitable the project.

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Profitability AnalysisProfitability Evaluation (3)

Non-discounted profitability criteria (2 Cash):

Cumulative Cash Position (CCP) worth or value of the project at the end of its life.Cumulative Cash Ratio (CCR) CCP normalized by the initial investments.

or

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Profitability AnalysisProfitability Evaluation (4)

Non-discounted profitability criteria (3 Interest Rate):

Rate of Return on Investment represent the non-discounted rate at which the money created from FCI.

note:- Annual net profit an average over the life of the plant after start-up.- FCI = TCI WC Land (S*)*

Profitability AnalysisProfitability Evaluation (5)

Non-discounted profitability criteria (Cash Flow):

Non-discounted Cash Flow Scheme*

Profitability AnalysisProfitability Evaluation (6)

Discounted profitability criteria (1 Time):

Discounted Payback Period (DPBP) time required, after start-up, to recover the fixed capital investment (FCI), required for the project, with all cash flows discounted back to time zero. the project with the shortest DPBP is the most desirable.

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Profitability AnalysisProfitability Evaluation (7)

Discounted profitability criteria (2 Cash):

Net Present Value (NPV) or Net Present Worth (NPW) cumulative discounted cash position at the end of the project. greatly influenced by the level of FCI.Present Value Ratio (PVR) better criterion for comparison of project with different investment level. criterion:- PVR = 1 break-even- PVR > 1 profitable- PVR < 1 unprofitable

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Profitability AnalysisProfitability Evaluation (8)

Discounted profitability criteria (3 Interest Rate):

Discounted Cash Flow Rate of Return (DCFROR) interest or discount rate for which the NPV of the project is equal to zero. represents the highest, after-tax interest or discount rate at which the NPV of project to be equal to zero.Internal Interest Rate usually determined by corporate management. represents the minimum acceptable rate of return that the company will accept for any new investment.*

Profitability AnalysisProfitability Evaluation (9)

Discounted profitability criteria (Cash Flow):

Discounted Cash Flow Scheme*

Profitability AnalysisIncremental Economic Analysis

When comparing project investment, DCFROR tells how efficiently the money is used.The higher DCFROR, the more attractive the individual investment.

When comparing mutually exclusive investment alternatives, choose the alternative with the greatest positive net present value.Four steps algorithm:Step 1: Establish the minimum acceptable ROROI for such projects.Step 2: Calculate the NPV for each project using the interest rate from Step 1.Step 3: Eliminate all projects with negative NPV values.Step 4: Of the remaining projects, select the project with the highest NPV.

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Profitability AnalysisEvaluation of Equipment Analysis (1)

Equipment with the same expected operating lives

When the operating costs and initial investments are different but the equipment lives are the same, then the choice is based on NPV.The choice with the least negative NPV (least negative alternatives) will be the best choice.There is trade off between initial investment and operating cost among the alternatives.Low initial investment high operating costHigh initial investment low operating cost

*Trade off

Profitability AnalysisEvaluation of Equipment Analysis (2)

Equipment with different expected operating lives (1)

Assumption: the expected equipment life is less than the expected working life of the plant there is a replacement of the equipment.General methods:1. Equivalent Capitalized Cost Method (ECC)2. Equivalent Annual Operating Cost Method (EAOC)3. Common Denominator Method (CD)All the methods consider both the capital and operating cost.Minimizing expenses maximizing profits.

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Profitability AnalysisEvaluation of Equipment Analysis (3)

Equipment with different expected operating lives (2)Equivalent Capitalized Cost Method (ECC 1)

Lump both capital cost and yearly operating cost into a single cash fund or equivalent cash amount.This fund provides the amount of cash which needed to:- purchase the equipment initially- replace it at the end of its life- continue replacing it forever.*

Profitability AnalysisEvaluation of Equipment Analysis (4)

Equipment with different expected operating lives (3)Equivalent Capitalized Cost Method (ECC 2)

Scheme

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Profitability AnalysisEvaluation of Equipment Analysis (5)

Equipment with different expected operating lives (4)Equivalent Capitalized Cost Method (ECC 3)

Equations

*Equivalent Capitalized Cost = Capitalized Cost + Capitalized Operating Cost

Profitability AnalysisEvaluation of Equipment Analysis (6)

Equipment with different expected operating lives (5)Equivalent Annual Operating Cost Method (EAOC 1)

Amortized (spread out) the capital cost of the equipment over the operating life to establish yearly cost.*

Profitability AnalysisEvaluation of Equipment Analysis (7)

Equipment with different expected operating lives (6)Equivalent Annual Operating Cost Method (EAOC 2)

Scheme*

Profitability AnalysisEvaluation of Equipment Analysis (8)

Equipment with different expected operating lives (7)Equivalent Annual Operating Cost Method (EAOC 3)

Equations

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Profitability AnalysisEvaluation of Equipment Analysis (9)

Equipment with different expected operating lives (8)Common Denominator Method (CD 1)

Compare equipment with unequal operating lives (n & m; n < m).The comparison is made using the NPV of each alternatives.The alternative with least negative NPV is the best option.*

Profitability AnalysisEvaluation of Equipment Analysis (10)

Equipment with different expected operating lives (9)Common Denominator Method (CD 2)

Scheme*

Profitability AnalysisEvaluation of Equipment Analysis (11)

Equipment with different expected operating lives (10)Common Denominator Method (CD 3)

Equations (note: n < m)For equipment with n operating life:

For equipment with m operating life:*

Profitability AnalysisIncremental Analysis for Retrofitting Facilities (1)Involves the profitability criteria used for analyzing situations where a piece of equipment is added to an existing facility (retrofitting).Methods:1. Non-discounted method small retrofit project2. Discounted method large retrofit projectParameters (must be known):1. Project Cost (capital cost) or PC2. Yearly Savings (yearly cash flow) or YS

note:There must be an option with do nothing action (base case).

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Profitability AnalysisIncremental Analysis for Retrofitting Facilities (2)Non-discounted Method

1. Rate of Return on Incremental Investment (ROROII)

2. Incremental Payback Period (IPBP)

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Profitability AnalysisIncremental Analysis for Retrofitting Facilities (3)Discounted Method

1. Incremental Net Present Value (INPV)

2. Equivalent Annual Operating Cost (EAOC)

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Profitability AnalysisProfit Margin AnalysisTool for the initial screening of process alternatives, useful but limited.Parameters:1. If PMA < 0 not profitable2. If PMA > 0 need further investigation

Equation

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