471719 Profitability and Risk in Conceptual Plant Design:Dealing with Key Financial Parameters Rigorously and Simultaneously

Tuesday, November 15, 2016: 9:27 AM
Carmel II (Hotel Nikko San Francisco)
Duncan A. Mellichamp, UCSB, Santa Barbara, CA

Profitability and Risk in Conceptual Plant Design:

Dealing with Key Financial Parameters Rigorously and Simultaneously

 

Duncan A. Mellichamp

Professor Emeritus

Department of Chemical Engineering

University of California, Santa Barbara, CA USA 93106

e-mail: dmell@engineering.ucsb.edu Phone: 805-569-9858 Fax: 805-893-4731

 

Abstract

Many companies impose a minimum IRR (“hurdle rate”) to justify a “go-forward decision” with a new project, e.g., the IRR must be at least 25% to be deemed profitable enough. Presumably, this hurdle rate is chosen sufficiently higher than the sum of their ongoing Enterprise Rate, ER(the average year-over-year after-tax return on investment to the organization from all continuing operations) plus a “risk cushion” to cover uncertainties that statistically arise, causing loss of profitability or even outright failure of some projects.

Most users of discounted cash flow methods understand that the ER, when used as Discount Rate (DR) in net present value calculations imposes an appropriate “opportunity cost” on a potential project —i.e., foregone return that presumably could be obtained from alternative investment in ongoing internal operations. But few users understand just how problematic IRR is because the calculated value (i.e., Discount Rate) seldom has real physical meaning. Nor can the portion of the DR that is greater than ER be interpreted as “risk compensation.” The key problem is that IRR is defined without parameters, so nothing is strictly associated either with “profit” or with “risk.” Furthermore, IRRis a non-linear function, making any allocation of profit and risk difficult to extrapolate mathematically to different circumstances.In 2013 the author proposed a new index of profitability, NPV%, (NPV, evaluated with DR = ER) normalized by the Total Capital Investment and annualized by the Project Lifetime).* This metric was shown to be linearly related to ROIBT, thus substantially represents “inverse risk” in the same way that Pay-Out Time approximates the length of time a capital investment will be at risk (time to recover the original investment via cash flows). Thus, NPV% can serve as an inverse measure of business risk while its antecedent, NPV, provides a direct estimate of profitability. Further, since NPV% includes at least one more parameter than IRR, it allows for an independent choice of the Discount Rate. Because IRR and NPV% are both directly related to the ROIBT of the proposed project, one can fix ROIBT, calculate NPV% as a function of ER, then use a manifold projection (onto the ROIBT, IRR axis) to establish equivalence.

Several key outcomes are discussed: (1) Company policy ought to be to adjust the hurdle rate to optimize profitability (NPV) and the risk surrogate (inverse of NPV%) while updating IRR [as inferred function of NPV%(ER)] whenever experience with profits (internal Enterprise Rate) changes significantly. (2) A better approach might be to abandon the usual pairing <NPV (with DR = ER), IRR> altogether and adopt <NPV, NPV%> or a related evaluation metric. Ongoing research shows that such a choice can make evaluating project profitability particularly easy, allowing any reasonable optimization strategy to employ 1, 2, or 3 independent variables--e.g., profitability, risk, and/or capital investment--simultaneously.



* Mellichamp, D.A., Computers and Chemical Engineering 48 (2013) 251– 263.


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