The Influence Of Project Profitability On Company Growth

Abstract

The financial structure of a large company is quite complex. We are able, however, to follow the trend of such elements as the annual net cash income I (which is the income after paying all costs, including overhead and taxes), the annual net profit P (which is the annual net cash income minus writeoffs) and the dividend paid out. Other characteristics of a company, such as the average annual earning power i and the market value V, are not readily detectable but are related in some manner to the aforementioned elements. In an attempt to establish mathematical relationships between the various elements a simple model of a company (Figure 1) was studied. This model starts with an investment of $1000 in a project which yields $400 annually for three years. (It is assumed in the model that the incomes are received at the end of each year.) From the definition of earning power, present value income discounted at earning power i equals investment, or Di (1200) 1000, the deferment factor Di is found to be 0.83. Using deferment factor tables, the value of the earning power i of this project is found to be 10 percent. All incomes derived from the first investment are reinvested in projects with the same characteristics as the first (i = 10 percent, three year constant income). The annual cash income first shows an irregular trend but, as shown in the top curve of Figure 2, after some time this trend stabilizes and the growth rate of I becomes constant. For complete reinvestment of cash incomes the following important relation is true:growth rate g earning power i. (1) If, however, as shown in the lower curve of Figure 2, seven percent of I is paid then the reinvestment ratio b is 0.93 and, although the cash income after stabilization obtains a constant growth rate g, this rate is less than the earning power i.