VII.

PROFITABILITY

PROFITABILITY
BEFORE CAPITAL IS INVESTED IN A PROJECT, IT IS NECESSARY TO KNOW HOW MUCH PROFIT CAN BE OBTAINED AND WHETHER OR NOT IT MIGHT BE MORE ADVANTAGEOUS TO INVEST THE CAPITAL IN ANOTHER FORM OF ENTERPRICE. THUS, DETERMINATION OF PROFIT IS A MAJOR GOAL OF AN ECONOMIC ANALYSIS. PROFIT CAN BE CALCULATED WITH SOME ASSUMPTIONS ABOUT FUTURE (DEMAND, PRICE, AMOUNT OF PRODUCTION), SO IT IS NOT AN UNFAILING VALUE AND CAN ONLY SERVE AS A GUIDE. PROFIT ALONE CANNOT BE USED FOR DETERMINING IF AN INVESTMENT SHOULD BE MADE. SUPPOSE TWO INVESTMENTS ARE UNDER CONSIDERATION : ONE REQUIRES $100,000 OF CAPITAL AND WILL YIELD A PROFIT OF $10,000/ YEAR; THE OTHER REQUIRES $1 MILLION OF CAPITAL AND WILL YIELD $50,000/ YEAR. THE SECOND GIVES A GREATER YEARLY PROFIT, BUT THE RATE OF RETURN IS ONLY 5% WHILE THE RATE OF RETURN OF THE FIRST IS 10%.

PROFITABILITY
THE MOST COMMONLY USED METHODS FOR PROFITABILITY EVALUATION ARE: 1. RATE OF RETURN 2. PAYOUT PERIOD 3. NET RETURN 4. DISCOUNTED CASH FLOW 5. NET PRESENT WORTH 6. EQUIVALENT ANNUAL COST ANNUAL WORTH EACH OF THESE METHODS HAVE ITS ADVANTAGES AND DISADVANTAGES AND SINCE NO SINGLE METHOD IS BEST FOR ALL SITUATIONS THE ENGINEER SHOULD KNOW THEM ALL AND CHOOSE THE BEST SUITING ONE.

PROFITABILITY
1. RATE OF RETURN ON INVESTMENT THE YEARLY PROFIT DIVIDED BY THE TOTAL INITIAL INVESTMENT (FIXED + WORKING CAPITAL) REPRESENTS THE RETURN ON INVESTMENT. PROFITS AND THEREFORE RATE OF RETURNS MAY BE EXPRESSED ON THE BEFORE-TAX OR AFTER-TAX BASIS AND THIS SHOULD BE INDICATED. ROI = NET PROFIT PER YEAR / TOTAL INVESTMENT RATE OF RETURN MAY BE COMPARED FOR ALTERNATIVE INVESTMENTS, INCLUDING PUTTING THE MONEY IN THE BANK, AND GIVES A FIRST APPROXIMATION OF HOW ATTRACTIVE THE NEW PROJECT MAY BE. IF THE PROFIT VARIES FROM YEAR TO YEAR, AN AVERAGE MAY BE ASSUMED. IN RATE OF RETURN CALCULATION, WE DO NOT CONSIDER THE TIME VALUE OF MONEY.

PROFITABILITY
EXAMPLE : A PROPOSED MANUFACTURING PLANT REQUIRES AN INITIAL FIXED CAPITAL OF $900,000 AND A WORKING CAPITAL OF $100,000. IT IS ESTIMATED THAT ANNUAL INCOME WILL BE $800,000 AND ANNUAL EXPENSES (INCLUDING DEPRECIATION) WILL BE $520,000 BEFORE INCOME TAX. INCOME TAX IS 20%. FIND % RETURN ON INVESTMENT BEFORE AND AFTER TAX. 800,000 520,000 = $280,000 / YEAR PROFIT BEFORE TAX 280,000 / 1,000,000 = 0.28 28% ROI BEFORE TAX (280,000)(0.80) / 1,000,000 = .224 22.4% ROI AFTER TAX

THE MINIMUM ACCEPTABLE RATE OF RETURN (MARR) IS THE RATE SET BY AN ORGANIZATION TO DESIGNATE THE LOWEST LEVEL OF RETURN THAT MAKES AN INVESTMENT ACCEPTABLE. IT IS A DEVICE DESIGNED TO MAKE THE BEST POSSIBLE USE OF MONEY AND APPLIED FOR EVALUATING NEW PROJECTS, COST REDUCTION PROPOSALS, RESEARCH AND DEVELOPMENT PROGRAMS.

PROFITABILITY
2. PAYOUT PERIOD (PAYBACK METHOD) PAYOUT PERIOD OR TIME IS THE MINIMUM LENGTH OF TIME THEORETICALLY NECESSARY TO RECOVER THE ORIGINAL FIXED CAPITAL INVESTMENT IN THE FORM OF CASH FLOW TO THE PROJECT (NET PROFIT + DEPRECIATION). DEPRECIABLE FIXED CAPITAL INVESTMENT

PAYOUT PERIOD =
AV. PROFIT/YEAR + AV. DEPRECIATION/YEAR INTEREST IS NEGLECTED AND ONLY DEPRECIABLE FIXED INVESTMENT IS CONSIDERED. IF TIME VALUE OF MONEY IS ALSO CONSIDERED, THAN WE HAVE PAYOUT PERIOD INCLUDING INTEREST. IN THIS CASE THE ANNUAL CASH FLOWS ARE DISCOUNTED.

PROFITABILITY
EXAMPLE: A COMPANY PLANS AN INVESTMENT OF $300,000 TO MANUFACTURE A NEW PRODUCT. ALLOWABLE DEPRECIATION IS 10 YEARS, ANNUAL NET PROFIT IS $45,000. STRAIGHT- LINE DEPRECIATION WILL BE USED. WHAT IS THE PAYOUT PERIOD a) IF TIME VALUE OF MONEY IS NOT CONSIDERED? b) IF TIME VALUE IS CONSIDERED AND i IS 8%? ANNUAL CASH FLOW = NET PROFIT + DEPRECIATION = 45,000 + 30,000 = 75,000 a) PAYOUT PERIOD = 300,000 / 75,000 = 4 YEARS b) P = R [ {(1 + i)n 1} / i (1 + i)n 300,000 = 75,000 {(1.08)n 1} / 0.08 (1.08)n 4 x 0.08 (1.08)n = (1.08)n 1 0.68(1.08)n = 1 n = log 1.47 / log 1.08 PAYOUT PERIOD n = 5 YEARS

PROFITABILITY
THE PAYOUT PERIOD METHOD IS USED WIDELY TO RATE RELATIVELY SMALL INVESTMENT PROPOSALS IN PRODUCTION DEPARTMENTS. IT MAY LEAD TO INCORRECT CONCLUSIONS SINCE IT DOES NOT RECOGNIZE THE CASH FLOW OCCURING AFTER THE PAYOUT PERIOD. FOR EXAMPLE AN INVESTMENT OF $1000 WITH LIFE OF 1 YEAR AND HAS A NET RETURN OF $1000 WILL YIELD A PAYOUT PERIOD OF 1 YEAR. ANOTHER INVESTMENT OF $1000 PROMISES TO RETURN $250/YEAR DURING ITS ECONOMIC LIFE TEN YEARS. THIS WILL YIELD A PAYOUT PERIOD OF 4 YEARS. IF YOU CONSIDER ONLY PAYOUT PERIODS, YOU SHALL CHOOSE THE FIRST ALTERNATIVE WHICH ACCUALLY EARNS NOTHING.

PROFITABILITY
3. NET RETURN NET RETURN IS THE AMOUNT OF CASH FLOW OVER AND ABOVE THAT REQUIRED TO MEET THE MINIMUM ACCEPTABLE RATE OF RETURN AND RECOVER THE TOTAL CAPITAL INVESTMENT. THIS IS CALCULATED BY SUBTRACTING THE TOTAL AMOUNT EARNED AT THE MINIMUM RATE OF RETURN AND THE TOTAL CAPITAL INVESTMENT FROM THE TOTAL CASH FLOW. IN THIS CALCULATION WE NEGLECT THE TIME VALUE OF MONEY. TOTAL CASH FLOW: TOTAL NET PROFIT + TOTAL DEPRECIATION +SALVAGE VALUE + RECOVERED WORKING CAPITAL INVESTMENT + EARNING OF INVESTMENT: TOTAL CAPITAL INVESTMENT (FIXED + WORKING) + MARR MULTIPLIED BY TOTAL CAPITAL INVESTMENT FOR ALL YEARS

PROFITABILITY
Rn = (NP,j + dj) + S + WC TC (MARR)(N)(TC) j 1 WHERE NP,j IS NET PROFIT, dj IS DEPRECIATION FOR YEAR j, S IS THE SALVAGE VALUE IN CASES WHERE dj + S + WC = TC N Rn = NP,j - (MARR)(N)(TC)
j 1
N

IF WE HAVE AN AVERAGE PROFIT (PAVE), THEN Rn,AVE = PAVE (MARR)(TC)

PROFITABILITY
EXAMPLE: A COMPANY PLANS TO START A NEW PRODUCT WHICH REQUIRES $24 MILLION OF NEW MACHINERY AND $4 MILLION WORKING CAPITAL. ALL FIXED COSTS EXCEPT DEPRECIATION IS $1 MILLION/YEAR, VARIABLE COSTS AT FULL CAPACITY IS $5 MILLION/YEAR. DEPRECIATION IS BY DOUBLE-DECLINING IN 5 YEARS, INCOME TAX IS 35%. THE PRODUCTION RATE AT 100% CAPACITY IS 2 x 106 kg/YEAR. IN THE FIRST YEAR CAPACITY IS USED 50%, IN THE SECOND YEAR 90% AND AFTER THE SECOND YEAR 100%. MARR IS 30%. CALCULATE THE SALES PRICE (p) REQUIRED TO ACHIEVE MARR IN TEN YEARS BY NET RETURN METHOD. USING THE TABLE : PAVE = 1/10 (18.8p 81)(1 - 0.35) 106 = (1.222p 5.265) 106 Rn = 0 = (1.222p) 106 (5.265) 106 (0.30)(28) 106

p = $11.18

PROFITABILITY
YEAR 1 2 3 4 5 6 7 8 9 10 SUM ----------------------------------------------------------------------------------A. PERCENT OF OPERATING TIME 50 90 100 100 100 100 100 100 100 100 B. PRODUCT RATE, 106 kg/yr 1 1.8 2 2 2 2 2 2 2 2 C. ALL VARIABLE COSTS, $ 106/yr 2.5 4.5 5 5 5 5 5 5 5 5 D. ALL FIXED COSTS (EXCEPT DEP.) $ 106/yr 1 1 1 1 1 1 1 1 1 1 E. DEPRECIATION, $ 106/yr 9.6 5.76 3.456 2.592 2.592 0 0 0 0 0 F. TOTAL PRODUCT COST(C+D+E) $ 106/yr 13.1 11.26 9.456 8.592 8.592 6 6 6 6 6

18.8 47 10 24 81

PROFITABILITY
4. NET PRESENT WORTH THE NET PRESENT WORTH OF A PROJECT IS THE DIFFERENCE BETWEEN THE PRESENT VALUE OF THE ANNUAL CASH FLOWS AND THE INITIAL REQUIRED INVESTMENT , OR MORE GENERALLY: P = PRESENT WORTH OF BENEFITS PRESENT WORTH OF COSTS YOU CAN USE PRESENT WORTH TO A. COMPARE ALTERNATIVES (ALLWAYS USING SAME NUMBER OF YEARS AND CONSTANT i); LARGER P IS BETTER B. DECIDE IF A PROJECT IS FEASIBLE OR NOT (TAKING i = MARR); IF P 0, YOUR PROJECT IS EQUAL OR BETTER THAN MARR, IF P < 0, LESS THAN MARR

PROFITABILITY
EXAMPLE : THERE ARE TWO ALTERNATIVE MACHINES YOU CAN BUY TO YOUR FACTORY, A AND B. A COSTS $9000, B COSTS $14,500. THE NET CASH FLOWS ARE: 1.YEAR 2.YEAR 3.YEAR MACHINE A : $ 4,500 4,500 4,500 MACHINE B : $ 6,000 6,000 8,000 FIND PRESENT WORTH IF i = 0.8 AND SALVAGE VALUE IS ZERO PW(A) = (4500) [{(1+0.08)3 - 1} / 0.08 (1+0.08)3] 9000 = $2594 PW(B) = (6000) [{(1+0.08)2 - 1} / 0.08 (1+0.08)2] + 8000 / (1+0.08)3 14,500 = $2550 MACHINE A IS BETTER

PROFITABILITY
EXAMPLE : FIXED CAPITAL INVESTMENT IS $100,000 AND WORKING CAPITAL INVESTMENT IS $10,000, SALVAGE IS $10,000 AT THE END OF 5 YEAR LIFE; FIND PW IF i = 0.15 AND AFTER TAX CASH FLOW AT THE END OF EACH YEAR IS AS FOLLOWS: YEAR 1 2 3 4 5 $ 30,000 31,000 36,000 40,000 43,000 PWINCOME = 30,000 / (1.15) + 31,000 / (1.15)2 + 36,000 / (1.15)3 + 40,000 / (1.15)4 + 43,000 / (1.15)5 + (10,000+10,000) / (1.15)5 = $127,327 NET PRESENT WORTH IS 127,327 110,000 = $17,327

PROFITABILITY
EXAMPLE: A REACTOR TO BE USED FOR OXIDATION OF PARAFFIN VAX TO MAKE FATTY ACIDS IS REQUIRED. TWO ALTERNATIVES ARE SUGGESTED: REACTOR A MADE OF ORDINARY STEEL COSTS $12,000 INSTALLED AND HAS A LIFE OF TWO YEARS WITH A JUNK VALUE OF $200, WHEREAS REACTOR B, MADE OF STEEL BUT GLASS LINED, COSTS $28,000 INSTALLED AND HAS A LIFE OF 6 YEARS WITH A SALVAGE VALUE OF $800 FOR FITTINGS. LABOR AND OTHER OPERATING COSTS FOR BOTH REACTORS ARE THE SAME, BUT REACTOR A IS EXPECTED TO REQUIRE ABOUT $400 FOR MAINTENANCE DURING THE SECOND YEAR, WHEREAS REACTOR B WILL REQUIRE $100 MAINTENANCE DURING THE THIRD YEAR AND $300 DURING THE FIFTH YEAR. IT IS EXPECTED THAT REACTOR B WILL GIVE A SLIGHTLY BETTER YIELD AND A BETTER QUALITY PRODUCT. THE VALUE OF THESE IMPROVEMENTS IS ESTIMATED AT $400 PER YEAR. IF MONEY IS WORTH 10%, WHICH INSTALLATION SHOWS THE LOWER EQUIVALENT CAPITAL REQUIREMENT AT THE PRESENT TIME? PA = 12,000 12,200 / 1.12 12,200 / 1.14 200 / 1.16 = 30,529 PB = 28,000 + 400 / 1.1 + 400 / 1.12 + 300 / 1.13 + 400 / 1.14 + 100 / 1.15 + 1400 / 1.16 = 26,015 REACTOR B HAS LOWER REQUIREMENT

PROFITABILITY
A COMPANY IS CONSIDERING A NEW INVESTMENT WHICH COSTS 12,000,000 TL AS TCI. THE LAND COST IS 2,000,000 TL AND REST OF THE FCI COST IS 8,000,000 TL. THE YEARLY EXPECTED CASH FLOW IS 2,500,000 TL. IF MARR IS 20% AND LIFE OF THE PLANT IS 15 YEARS, IS THIS INVESTMENT FEASIBLE? WC = 12,000,000 10,000,000 = 2,000,000 P = 2,500,000 [ (1.215 1) / .20 (1.215)] + 4,000,000 / 1.215 - 12,000,000 P = - 51,696 TL NOT FEASIBLE

PROFITABILITY
EXAMPLE: IN AN EXISTING PLANT A NEW CHEMICAL WILL BE PRODUCED WITH A RATE OF 100,000kg/YEAR. THE ESTIMATED LIFE OF THIS PROJECT IS 8 YEARS. NECESSARY INVESTMENT IS 800,000 TL WORTH MACHINERY WHICH WILL BE DEPRECIATED BY STRAIGHT- LINE IN 8 YEARS. YEARLY PRODUCTION COST IS ESTIMATED TO BE 1,200,000 TL EXCEPT DEPRECIATION AND WORKING CAPITAL IS 20% OF THE TOTAL YEARLY PRODUCTION COST. IF TAX RATE IS 20%, AND i = 6%, WHAT SHOULD BE THE SELLING PRICE OF THE CHEMICAL IF MANAGEMENT REQUIRES A PRESENT WORTH OF MINIMUM 1,000,000 TL? WC = (1,200,000 + 100,000) .20 = 260,000 P=1,000,000 = -800,000 -260,000 + 260,000/1.068 +(CF) (1.068 -1)/.06(1.068 ) CF (CASH FLOW) = 120,245 = NET PROFIT + DEPRECIATION 120,245 = (100,000p 1,300,000)0.80 + 100,000 p = 13.25 TL

PROFITABILITY
WORK SHEET FOR NET PRESENT WORTH
YEARS 0 1. FIXED CAPITAL INVESTMENT 2. WORKING CAPITAL 3. TOTAL CAPITAL INVESTMENT (1+2) 4.OPERATING RATE (% OF CAPACITY) 5. ANNUAL INCOME (SALES) 6. ANNUAL MANUFACTURING COST 7. DEPRECIATION 8. ANNUAL GENERAL EXPENSES 9. TOTAL PRODUCT COST (6 + 7 + 8) 10. ANNUAL GROSS PROFIT (5 - 9) 11. INCOME TAX 12. ANNUAL NET PROFIT (10 11) 13.ANNUAL OPERATING CASH FLOW (12 + 7) 14.TOTAL ANNUAL CASH FLOW (13 + 3) 1st 2nd 3rd 4th 5th

PROFITABILITY
15.NET PRESENT WORTH ENTER EXPENDITURES AS NEGATIVE, INCOMES AS POSITIVE ASSUME ALL INVESTMENT IS MADE IN YEAR 0 AND PRODUCTION STARTS IN THE BEGINNING OF YEAR 1; WORKING CAPITAL AND SALVAGE VALUE IS RECOVERED AT THE END AND SINCE THEY ARE LUMP-SUM, FINITE CASH FLOW SHOULD BE APPLIED IN ALL CASES. NET PRESENT WORTH (LINE 15) IS CALCULATED BY DECIDING ON r OR i AND USING THE BASIC FORMULAS: a) P = S / ern b) P = S / (1 + i)n

PROFITABILITY
5. DISCOUNTED CASH FLOW RATE OF RETURN BASED ON DISDOUNTED CASH FLOW IS ALSO CALLED PROFITABILITY INDEX, TRUE RATE OF RETURN OR INTERNAL RATE OF RETURN. THIS METHOD TAKES INTO ACCOUNT THE TIME VALUE OF MONEY. 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 ZERO (OR TO SALVAGE AND LAND VALUE PLUS WORKING CAPITAL INVESTMENT) DURING THE PROJECT LIFE. EXAMPLE : FIXED CAPITAL INVESTMENT IS $100,000 AND WORKING CAPITAL INVESTMENT IS $10,000, SALVAGE IS $10,000 AT THE END OF 5 YEAR LIFE; WHAT IS THE INTERNAL RATE OF RETURN IF PREDICTED AFTER-TAX CASH FLOW AT THE END OF EACH YEAR IS AS FOLLOWS: YEAR 1 2 3 4 5 $ 30,000 31,000 36,000 40,000 43,000 S = (30,000)(1+i)4 + (31,000)(1+i)3 + (36,000)(1+i)2 + (40,000)(1+i) + 43,000 = (110,000)(1+i)5 10,000 10,000 BY TRIAL AND ERROR i = 0.207

PROFITABILITY
USE OF CONTINUOUS INTEREST COMPOUNDING : WHEN CONTINUOUS INTEREST IS USED WE SHOULD REPLACE (1 + i)n WITH ern (r IS NOMINAL INTEREST) EXAMPLE : DETERMINE THE DISCOUNTED CASH FLOW RATE OF RETURN (i.e. PROFITABILITY INDEX) FOR THE FOLLOWING PROJECT: ONE YEAR PRIOR TO START - UP, LAND IS PURCHASED FOR $200,000. DURING THE YEAR PRIOR TO START - UP INVESTMENT IS MADE WITH UNIFORM CONTINUOUS SPENDING OF $600,000. A WORKING CAPITAL OF $200,000 IS NEEDED. ESTIMATED LIFE IS 10 YEARS, SALVAGE VALUE IS $100,000. ANNUAL CASH FLOW (NET PROFIT + DEPRECIATION) WILL BE $310,000 AFTER TAX AND IS FLOWING UNIFORMLY. USE CONTINUOUS INTEREST COMPOUNDING AND CONTINUOUS CASH FLOW.

PROFITABILITY
LAND VALUE AT TIME 0 S = Pern = 200,000 er FIXED INVESTMENT AT TIME 0 S = { (ern 1) / r} = 600,000 {(er 1) / r} TOTAL CASH POSITION AT TIME 0 : CP0 = 200,000 er + 600,000 {(er 1) / r} + 200,000 AT THE END OF THE PROJECT WE HAVE SALVAGE + WORKING CAPITAL + LAND WHICH IS $500,000 PWS = 500,000 / e10r PRESENT WORTH OF CASH FLOW : PWC = {(ern 1) / rern} = 310,000 {(e10r 1) / re10r} WE SHOULD FIND THE r WHICH DECREASES THE NET CASH POSITION TO 0 AT THE END OF 10 YEARS : CP0 = PWS + PWC 200,000 er + 600,000 {(er 1) / r} + 200,000 = 500,000 / e10r + 310,000 { (e10r 1) / re10r} BY TRIAL AND ERROR r = 0.26 ; SO PROFITABILITY INDEX IS 26%

PROFITABILITY
6. EQUIVALENT ANNUAL COST ANNUAL WORTH EQUIVALENT ANNUAL COST (EAC) IS CONVERTING ALL COSTS TO AN EQUIVALENT SERIES OF UNIFORM END-OF-YEAR PAYMENTS. IF WE ARE COMPARING INCOMES, WE CONVERT INCOMES SIMILARLY TO OBTAIN EQUIVALENT ANNUAL WORTH (EAW). EXAMPLE: A MACHINE COSTS $1,600, HAS 5 YEARS LIFE. ANNUAL OPERATING COSTS IS $500 PER YEAR AND i = 0.08. WHAT IS EAC a) IF SALVAGE VALUE IS 0 , b) IF SALVAGE VALUE IS $300 ? a) R = P [ i (1 + i)n / {(1 + i)n 1}] = 1,600 [0.08 x 1.085 / (1.085 1)] = 400 EAC = 400 + 500 = $900 b) R = S [ i / {(1 + i)n 1}] = 300 [0.08 /( 1.085 1)] = 51 EAC = 400 51 + 500 = $849

PROFITABILITY
EXAMPLE: EQUIPMENT CAN BE PURCHASED FOR $10,000 AND LAST FOR N YEARS (WITH NO SALVAGE VALUE), OR IT CAN BE LEASED FOR 2,200 A YEAR. IF INTEREST IS 12% PER YEAR, WHAT IS THE MINIMUM N TO JUSTIFY PURCHASING? a) PRESENT WORTH METHOD P = R [ (1 + i)n 1 / i (1 + i)n ] 10,000 = 2,200 [ (1.12)N 1 / .12 (1.12)N ] .545 = (1.12)N 1 / (1.12)N (1.12)N = 2.2 N ln 1.12 = ln 2.2 b) EAC METHOD R = P [ i (1 + i)n / (1 + i)n 1] 2,200 = 10,000 [.12 (1.12)N / (1.12)N 1] N=7

N=7

PROFITABILITY
EXAMPLE: A PACKAGING MACHINE WITH ECONOMIC LIFE OF 10 YEARS COSTS $20,000 WITH 0 SALVAGE VALUE. THIS MACHINE HAS OPERATING AND MAINTENANCE COSTS OF $10 PER HOUR. IT CAN PACKAGE 100 UNITS PER HOUR. THE CURRENT METHOD IS BY HAND LABOR COSTING $12 PER HOUR TO PACKAGE AN AVARAGE OF 100 UNITS IN 1.5 HOURS. HOW MANY PACKAGES SHOULD BE MADE PER YEAR TO JUSTIFY THE PURCHASE OF THIS MACHINE IF i = 6%? R = P { i (1 + i)n / (1 + i)n 1} = 20,000 { 0.06 (1.06)10 / (1.06)10 1} = 2,719 YEARLY COST WITH MACHINE = $2,719 + ($10/HR)(1/100 HR/PACK)(X PACK/YEAR) = 2719 + 0.1X YEARLY COST WITH CURRENT METHOD = ($12/HR)(1.5/100 HR/PACK)(X PACK/YEAR) = 0.18X 2719 + 0.1X = 0.18X X = 33,988 PACKS / YEAR

PROFITABILITY
EXAMPLE: A FURNACE INSTALLATION COSTING $12,000 WITH OPERATING COSTS OF $4,800 PER YEAR AND A 10-YEAR LIFE IS OFFERED BY ONE SUPPLIER; A SECOND ALTERNATIVE GUARANTEES TO PROVIDE THE SAME SERVICE WITH $1,000 A YEAR LOWER OPERATING COSTS AT A COST OF $25,000. SALVAGE VALUE ON BOTH FURNACES IS ESTIMATED AT $1,000. WHAT INCREASE IN SERVICE LIFE WOULD BE REQUIRED FOR THE SECOND PROPOSAL TO WARRANT ITS SELECTION IF i = 8%?

R = P { i (1 + i)n / (1 + i)n 1} AND R = S { i / (1 + i)n 1 } R = 12,000 { 0.08 (1.08)10 / (1.08)10 1} - 1,000 { 0.08 / (1.08)10 1 } = 1,719 1,719 + 4,800 = 25,000 { 0.08 (1.08)n / (1.08)n 1} 1,000 { 0.08 / (1.08)n 1 } + 3800
2719 { (1.08)n 1 } = 25,000 (0.08) (1.08)n 1000 (0.08) (1.08)n = 3.67 n = 16.88

PROFITABILITY
RISK ANALYSIS AND ACCEPTABLE RETURNS: IN INDUSTRIAL OPERATIONS THERE IS ALWAYS A DEGREE OF UNCERTANITY AND CALCULATED RETURN DEPENDS ON SOME ASSUMPTIONS ABOUT THE FUTURE. SO THERE IS ALWAYS A RISK FACTOR. A SIMPLE METHOD IS TO MAKE THE CALCULATIONS FOR WORST, AVERAGE AND BEST CASES. A BETTER METHOD IS TO MAKE RISK ANALYSIS USING PROPER SOFTWARES. YOU SHOULD FIRST DECIDE ON THE RANGE OF VALUES FOR EACH FACTOR (TOTAL INVESTMENT, PLANT LIFE, ANNUAL CASH FLOW) AND THE LIKELIHOOD OF OCCURANCE OF EACH VALUE. COMPUTER THAN CALCULATES THE PROBABILITY OF ALL RETURNS. DUE TO THE UNCERTANITIES, IN AVERAGE 20 30% RETURN BEFORE TAX (NOT CONSIDERING THE EFFECT OF INFLATION) WHICH MEANS 14 20% RETURN AFTER TAX IS REQUIRED FOR INVESTING IN INDUSTRY.