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

**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, *IRR*is 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

*ROI*

*, thus substantially represents “inverse risk” in the same way that*

_{BT}*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*

_{%}*ROI*

*of the proposed project, one can fix*

_{BT}*ROI*

*, calculate*

_{BT}*NPV*

*as a function of*

_{%}*ER*, then use a manifold projection (onto the

*ROI*,

_{BT}*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*.

**Extended Abstract:**File Not Uploaded

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