Chapter 10 - Profitability Analysis

Profitability

  • A measure of the ability of an investment to generate profit relative to the capital invested

(A) Profitability analysis

  • used to: (1) assess the attractiveness of a project; (2) compare the alternative investment options; (3) guide capital allocation decisions

Profitability standard

  • A quantitative measure that relates profit earned to investment made

  • Key principle: Investments must be evaluated based on their rate of return.

Minimum acceptable rate of return (MAR)

  • The minimum rate of earning that an investment must achieve to be considered acceptable

  • Represents the minimum performance required to justify investing capital

  • Purpose: (1) Serves as a benchmark for decision-making; (2) Ensures that capital is invested only in economically viable projects

  • Decision rule: If rate of return is greater than or equal to MAR, accept the project. If rate of return is lesser than MAR, reject the project.

Cost of capital

  • The cost incurred for using funds obtained from sources such as loans, bonds, or equity

  • Serves as the basis for the minimum acceptable rate of return (MAR)

  • Two sources of capital: (1) Debts; (2) Equity

Rate of return on investment (ROI)

  • Is the ratio of annual profit to the total capital investment

  • Represents the earning power of invested capital, expressed as a percentage

  • Measures how efficiently capital is used to generate profit

Discounted cash flow (DCF)

  • Evaluates profitability by considering the time value of money

  • Uses annual cash flows

  • Applies a rate of return (i) to evaluate investment

  • Provides a more realistic evaluation because it accounts for when cash is received, not just how much is received

Net present worth (NPW)

  • The difference between the present value of the project’s cash inflows and the initial investment required

  • Measures how much value a project adds after recovering the required investment and return

  • If NPW is greater than 0, the actual return is higher than assumed return; therefore, increase i.

  • If NPW is lesser than 0, the actual return is lower than assumed return; therefore, decrease i.

  • If NPW is equal to 0, the assumed rate of return is correct.

Capitalized cost

  • Converts repeating future costs into a single equivalent present value

  • Used for: (1) Equipment requiring periodic replacement; (2) Long-term or continuous operations

  • Can be extended to include annual operating costs over the life of the project

  • Decision rule: Choose the option with the lowest capitalized cost.

Total capitalized cost

  • Represents the full cost of owning and operating a system indefinitely

Payout period

  • The minimum time required to recover the original capital investment from the project’s cash flow

  • Measures how fast investment is recovered based on cash flow = profit + depreciation

  • Decision rule: Accept if payout period is less than the desired recovery time