AACE International Recommended Practice No.
15R-81
PROFITABILITY METHODS
TCM Framework: 3.3 – Investment Decision Making, 6.1 – Asset Performance
Assessment
This recommended practice was originally published in 1980 and remains unchanged.
This AACE recommended practice was developed based upon a survey of profitability calculation
methods used by representative firms selected from among Fortune magazine's top 500 US corporations.
Fifty-two firms were surveyed, taking the biggest and smallest in each industry group. Twenty-seven
firms (Appendix A) responded. Of those responding:
• All firms use the interest rate of return (IRR).
• Payoff period was more popular than return on investment, but only two firms preferred them to IRR
and net present value (NPV).
• The majority of the firms use this AACE recommended practice.
• Only two companies use other methods, but only in addition to those in this recommended practice.
Copyright 2003 AACE, Inc. AACE International Recommended Practices
AACE International Recommended Practice No. 15R-81
PROFITABILITY METHODS
TCM Framework: 3.3 – Investment Decision Making, 6.1 – Asset Performance
Assessment
November, 1981
INTRODUCTION
AACE suggests the use of the following recommended practices for evaluating investment and estimating
profitability:
• Net Present Value
• Interest Rate of Return.
Additional methods are included in this document because they are widely used. However AACE does
not recommend them for accurate evaluations. They are:
• Return on Original Investment
• Return on Average Investment
• Payoff Period
The choice of a particular method will depend on the individual company and the characteristics of the
project.
DEFINITIONS
a. Net Present Value (NPV) equals the sum, over the venture life, of annual cash flows
discounted to a selected time zero. Annual cash flow is the difference between cash
inflows and cash outflows for the particular year. Cash inflows equal revenues, plus any
salvage values. Cash outflows comprise any capital outlays occurring in that year and all
expenses, including taxes. The discount rate may equal cost of capital, minimum
acceptable rate of return or the average rate that the company earns.
b. Interest Rate of Return equals the discount rate at which NPV becomes zero.
c. Return on Original Investment is the ratio of the original total investment to an average
annual net profit (after taxes), expressed in percent. Total investment includes depreciable
capital, working capital and other non-depreciable investment expenditures. The term
"original" means that only investment laid out during the initial period of the venture is
considered. Net profit of a single mature year may be used instead of averaging over
several years.
d. Return on Average Investment is the ratio of an average outstanding total investment (as
defined in Section c. above) to an average annual net profit (after taxes), expressed in
percent. The term "outstanding" implies averaging annual book values and additional
investment outlays in later years, if applicable.
e. Payoff Period equals the interval between the start of sales and the point at which the
cumulative cash flow (as defined in section a. above) becomes positive.
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Profitability Methods 2 of 9
November, 1981
SAMPLE CALCULATIONS
In order to illustrate the application of the profitability methods, an example of a venture has been
developed on a year-by-year basis in Table 1. Using this illustrative example, sample calculations of the
three profitability indicators are shown in Table 2. Both tables include computational formulas and are
followed by detailed comments.
Annual cash flows including the corresponding discounted and cumulative data are plotted versus time in
the accompanying Cash Flow Chart. The three scales on the X-axis indicate the various time periods
encountered in cash flow analysis. The bottom scale has been chosen so as to show that "time zero" for
discounting purposes does not necessarily coincide with the beginning of venture life.
Table 1—Basic Data for Illustrative Example
Units: Millions of Dollars. For reference numbers in parentheses, see “Comments”
Symbols & Year, n
Variables Equations 1 2 3 4 5 6 7 8 9 10
Capital (1) #1 (mine) C’ - 25 35 - - - 60 - - -
#2 (plant) C” - 15 25 - - - 30 - - -
Land Cost L - 1 - - - - - - - -
Investment Expense (2) X - 8 12 - - - - - - -
Working Capital Increment W - - 10.1 3.2 0.7 2.8 11.2 0.3 2.0 0
Salvage Value (3) S - - - - - - - - - 57.2
Preproduction Expense (4) P 2 1 - - - - - - - -
Start-up Cost (5) U - - - 1 - - - 1 - -
Operating Cost (6) O - - - 31.3 34.7 36.8 39.1 68.0 72.0 76.4
Gen. Adm. & Sel. Expense (7) G - - - 2.2 3.6 3.9 3.9 7.4 7.4 8.1
Depreciation (8) Y - - - 17.7 14.5 11.9 9.7 24.3 19.9 16.2
Revenues (9) R - - - 54 90 97 97 210 210 230
Depletion Allowance (10) A - - - 0.9 9 9.7 9.7 21 21 23
Total Capital K=C’+C”+W+L - 41 70.1 3.2 0.7 2.8 101.2 0.3 2.0 0
Total Expense E=X+P+U+O+G+Y 2 9 12 52.2 52.8 52.6 52.7 100.7 99.3 100.7
DISCUSSION
Net present value and interest rate of return methods have been used for many years.1,2,3 The former is
also called present worth, while the latter is alternatively referred to as discounted cash flow (rate of
return), profitability index, internal rate of return or investor's method.
The recommended methods serve different purposes. The interest rate of return (IRR) is a general
profitability indicator that allows comparison of ventures of various magnitudes and in different areas of
business and technology through expressing results on the same scale, i.e., as a percentage related to
interest rate. If profitability of mutually exclusive alternatives is considered, the IRR should be calculated
on an incremental basis.
IRR has the disadvantage of occasionally leading to multiple or false solutions if a negative cash flow
follows a positive one. Also, IRR does not consider the possibility of more than one discount rate to
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Profitability Methods 3 of 9
November, 1981
reflect variations in interest rate. IRR values of venture components are not additive. Furthermore this
method implies that profits can be reinvested at the same IRR.
Table 2—Sample Calculations
Units: Millions of Dollars (unless indicated otherwise). For reference numbers in parentheses, see “Comments”
Symbols* Year, n
Variables & Equations 1 2 3 4 5 6 7 8 9 10 Total
1. Net Present Value
Taxable Income (1) B = R-E-A 0 0 0 0.9 28.2 34.7 34.6 88.3 89.7 106.3 --
Income Taxes (2) T = tB 0 0 0 0.5 14.1 17.3 17.3 44.2 44.9 53.1 --
Cash Flow (3) F = R-E-T + Y-K+S -2 -46 -76.1 15.9 36.9 36.1 -64.5 89.2 83.7 149.5 --
n-1
Discounted Cash Flow (4) D = F/ (1+d) -2 -40 -57.5 10.4 21.1 18.0 -27.9 33.5 27.4 42.5 --
NPV (5) V= ΣD 25.5
2. Interest Rate of Return (6)
n-1
Discounted Cash Flow (4) D = F/(1+r) -2 -38.3 -52.8 9.2 17.8 14.5 -21.6 24.9 19.4 28.9 --
IRR R (trial & error) 20.0%
3. Return on Original Investment
Net Income (7) N = R-E-T -- -- -- 1.3 23.1 27.1 27.0 65.1 65.8 76.2 285.6
Original Investment I’ = K + X -- 49.0 82.1 -- -- -- -- -- -- -- 131.1
ROI (8) 0 = Nm/I0 20.7%
4. Return on Average Investment
Book Value (9) Cn = Cn-1-Yn-1 -- -- 100.0 82.3 67.8 55.9 136.2 111.9 92.0 75.8 --
Outstanding Investment I = C+L+X+W-S -- 9.0 122.1 85.5 68.5 58.7 147.4 112.2 94.0 18.6 716.0
RAI (10) A = Na/Ia 39.9%
5. Payoff Period
Cash Flow (3) F = R-E-T + Y-K + S -2 -46 -76.1 15.9 36.9 36.1 -64.5 89.2 83.7 149.5 --
Cumul. Cash Flow (11) n -2 -48 -124.1 -108.2 -71.4 -35.2 -99.7 -10.5 73.2 227.7 --
Q= ΣF n
1
POP (12) p (interpolation) 5.13 yrs
* For A,C,E,K,L,R,S,W,X,Y see Table 1
The advantage of net present value (NPV) is that various discount rates can be used for a particular
project. If a single discount rate is used, NPV values of venture components are additive. Once the
discount rate (or set of discount rates) is fixed, the results are consistent and no multiple or false solutions
are possible. However individual companies may use different discount rates, in which case the resulting
NPV values will not be equal and the economic conclusions may differ. Accordingly NPV is not a general
indicator.
Furthermore NPV is expressed as an absolute (dollar) figure rather than as a rate (percentage). This
allows direct comparison of mutually exclusive alternatives but has a disadvantage if two ventures of
different magnitude
are considered. A large NPV might conceal a poor rate of return and an attractive small project might be
ruled out.
Return on original investment (ROI) is also called engineer's method. Alternate names for return on
average investment (RAI) are return on book investment or accountant's method. The terms payout or
payback period or time are also used instead of payoff period (POP) or time. The major disadvantage of
these methods is in that they do not account for the time value of money. Modified RIO, RAI and POP,
described in the reference literature,1,2,4,5 are not considered in this recommended practice document.
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Profitability Methods 4 of 9
November, 1981
These modifications use interest, exclude non-depreciable investment and/or substitute cash flow for
profit or vice versa.
Other problems in the use of ROI, RAI and POP are the treatment of multiple investment outlays, and
averaging of net profit and investment. Some of these problems are touched upon in Table 2. Net profit
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Profitability Methods 5 of 9
November, 1981
averaging may be ambiguous in ROI computations if plant capacity is increased during the venture.
Investment averaging based on depreciable life is a problem if it exceeds venture life or if several lives
apply.
The major advantage of ROI is the ease of calculation, particularly if net profit is based on a mature year
rather than on the arithmetic mean value.
In conclusion, it should be emphasized that profitability methods are devices by which to compare time
streams of cash flows because that is what the investor is interested in. Accordingly, a thorough
profitability analysis should include a cash flow chart such as the one accompanying the illustrative
example.
COMMENTS ON TABLE 1
A mining and metallurgical process has been chosen to demonstrate the use of depletion allowance and
two different tax depreciation lives. However the equations apply equally to any other venture. An
atypically short venture life is assumed to reduce the size of the year-by-year tabulation. Accordingly the
salvage value is relatively high.
The example considers inflation. Costs escalate at the following annual rates:
• Capital 6% after completion of construction
• Operating Cost 5%
• Wages & Salaries 2% in addition to operating cost escalation
• Selling price in cents/lb product is 90 in year 4, 5
97 6, 7
105 8, 9
115 10
The following comments refer to the numbers in parentheses in the table:
1. The term capital is used here for fixed capital including all supporting and allocated investment but
excluding land acquisition cost. In this example, mine capital (#1) denotes the cost of mining and
beneficiation facilities while plant capital (#2) refers to such post-mining processes as smelting or
chemical extraction of metals.
2. Investment expense denotes non-depreciable expenditures associated with the investment, such
as mine development cost in this example (ie, essentially overburden removal).
3. Salvage value includes recovered depreciable and working capital as well as reimbursement for the
sold land in this example.
4. Preproduction expense is the non-depreciable cost which is not part of the investment, such as
R&D cost in this example. The total of $3 million over the first two years may be interpreted as $6
million actually spent while $3 million was saved on taxes at the corporate level.
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Profitability Methods 6 of 9
November, 1981
5. Start-up requires only a few months at the beginning of year 4 and 8 in this example, and its cost is
non-depreciable.
6. Operating (manufacturing) cost excludes depreciation. It is assumed, in this example, that the
mining portion is 2/3 of operating cost.
7. General, administrative and selling cost and other corporate charges.
8. Only tax depreciation is considered in this example. The double declining balance depreciation
schedule is used with a 10- and 14-year life for the mining and postmining, capital, respectively.
9. Revenues denote all reimbursements associated with the venture including, eg, royalties received.
However only sales revenue is considered in this example.
10. Depletion allowance, A, equals a percentage factor, times the market value of the mining product,
or 50% of net income before taxes corresponding to the mining portion of the venture, whichever is
less. As mining cost (Capital #1, mining development and the appropriate portion of operating cost)
amounts to 2/3 of the total in this example, it is assumed that the market value of the beneficiated
ore is 2/3 of the sales revenue. The percentage factor is 15%. Accordingly, A = (0.15)(2/3)R.
COMMENTS ON TABLE 2
1. Taxable income is the basis for income tax calculations.
2. Federal, state and local income taxes. A 50% tax rate, t, is assumed in the example. Tax credit is
not considered.
3. In the cash flow computation, revenues, expenditures and depreciation are assumed to occur at the
end of the year. Salvage value is charged against the last year. Annual cash flows are plotted on
the accompanying chart.
4. In the discounted cash flow (DCF) formulas, d and r are the discount rates, and n is the year
number. In the NPV example, d = 15%. Annual cash flows are discounted to year 1. As
accounting is based on the year's end, "time zero" is the end of year 1 or beginning of year 2, i.e.,
the start of investment outlays. DCF values at 15% discount rate are also plotted on the chart.
5. Summation, Σ, is over the venture life of 10 years. Cumulative DCF values are also plotted on the
chart. The single discount rate makes the NPV calculation comparable with that of IRR. NPV can
be computed at two or more discount rates. E.g., if d = 10 and 15% in year 1 through 3 and 4
through 10, respectively, the annual discounted cash flows for the 10 years are (in $ million) -2, -
41.8, -62.9, 9.2, 17.8, 14.5, -21.6, 24.9, 19.4, 28.9 and NPV = -13.6.
6. Interest rate of return, r is calculated by trial-and-error to make the sum of annual discounted cash
flows, Σ D, equal zero.
7. Net income during earning period.
8. The original total investment is
i
I 0 = ∑ I 'n
n =1
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Profitability Methods 7 of 9
November, 1981
where i is the last year of the initial investment outlay period (3 in this example).
The net income averaging period applicable to the original investment covers years 4 through 7.
However half of the period has lower sales, e.g., due to start-up or market capturing problems.
Accordingly it is more realistic to base averaging on years 6 and 7 only or simply consider the
single net income, Nm, during a mature year, m. The latter technique is used in this example with m
= 6.
Note that ROI is very close to IRR in this example. This happens very often but not always.
9. This is the general book value formula. Because of multiple investment outlays in this example, the
formula has to be modified for certain years as follows to accommodate additional investment and
avoid double counting of capital carried over form a previous year before depreciation starts.
C2 = 0
C3 = C2' + C2" + C3' + C3"
C7 = C6 - Y7 + C7' + C7"
10. Average net income, Na, and average investment, Ia, are defined as follows:
1 v
Na = ∑ Nn
e n= f
where e is earning life, i.e., the number of years involving sales (7 in this example)
1 v
Ia = ∑ In
c n=1
f is the first year of earning life (4 in this example)
v is the last venture year (10 in this example)
c is the applicable investment averaging period. It should equal depreciation life if two or more
capital outlays with different lives are involved. This period may also be set equal to earning life if
the latter is shorter than depreciation life, which is the case in this example (c = e = 7).
Note that RAI is almost twice as high as ROI because both investment outlays and book values are
included in the average investment computation.
11. Cumulative cash flows are also plotted on the Cash Flow Chart.
12. The change from negative to positive cash flow occurs in year 9, ie, after five earning years. The
fraction of the sixth year can be interpolated as follows: 10.5/(10.5 + 73.2) 0.13.
Accordingly, p = 5 + 0.13 = 5.13. POP also can be read from the chart at the intersection of the
broken line with the X axis.
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November, 1981
APPENDIX A -- PROFITABILITY COMPUTATION METHODS USED BY US FIRMS
Results of the 1978 AACE Survey
NPV IRR Return on Invest. Payoff
Firm AACE Modif. AACE AACE AACE Modif. AACE Modif. Other
ROI RAI
AMAX, Inc. 40 20 20 20
AMF, Inc. 33 34 33
Armstrong Rubber 50 50
Brown Group, Inc. 100
Butler Mfg. Co. 100
The Coca-Cola Co. 50 50
The Continental Group 50 50
E.I. duPont de Nemours 50 50
Eastman Kodak Co. 40 40 20
Exxon Corp. 20 40 40
General Dynamics Corp. 100
General Electric Co. 33 34 33
General Motors Corp. 34 33 33
IBM Corp. 20 20 20 10 10 20
International Harvester 40(c) 40 20
Johnson & Johnson 20 20 20 20 20
Mattell, Inc. 40 40 20
McCormic & Co., Inc. 67 33
Memorex Corp. 25 50 25
Miles Laboratories, Inc. 67 33
Mohasco Corp. 17 (c) 17 33 33
Owens Illinois 17 17 (c) 33 33
Pabst Brewing Co. 67 33
The Proctor & Gamble Co. 14 58 28
R.J. Reynolds Industries 25 (c) 50 25
Rockwell International 20 40 40
U.S. Steel Corp. 50 50
-------- -------- -------- -------- -------- -------- -------- -------- --------
Total Points 260 152 1319 177 60 33 546 113 40
Percentages 9% 6% 49% 7% 2% 1% 20% 5% 1%
15% 10% 25%
Survey ranking III I IV II
(a) Each firm has been allowed 100 points. If it indicated preferences, the lower ranking methods have
been allotted approximately one half the number of points allotted to the higher ranking ones.
(b) NPV = net present value, IRR = internal rate of return, ROI = return on original investment, RAI =
return on avg. invest., AACE = as defined by proposed AACE Standard, Modif. = modified.
(c) (c) = Ratio of present values of cash inflows to cash outflows.
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Profitability Methods 9 of 9
November, 1981
REFERENCES
1. Douglas, F. R. and W. H. Kapfer. 1976. Towards an Official AACE Standard of Measure of
Profitability, AACE Transactions. Paper C-7. Morgantown: American Association of Cost
Engineers.
2. Happel, J. and D. Jordan. 1975. Chemical Process Economics, 2nd ed., New York: Marcel
Dekker, Inc.
3. Jelen, F. C. 1970. Cost and Optimization Engineering. New York: McGraw-Hill.
4. Method for Calculating Profitability: D-5.100., Cost Engineers' Notebook. 1975. Morgantown:
American Association of Cost Engineers.
5. Perry, P. R. and C. H. Chilton. 1973. Chemical Engineers' Handbook, 5th ed., New York:
McGraw-Hill.
Copyright 2003 AACE, Inc. AACE International Recommended Practices