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Hello, dear ACCA tutor and students!
My question of the day is as follows (maybe I will figure out later when I am more or less aware of the topic, but so far I didn’t manage to):
Topic: Investment appraisal.
We are normally given cash flows, initial investment, depreciation, residual value sometimes and we ought to calculate either ROCE (ARR) or NPV.My question: Is RESIDUAL VALUE taken into account when dealing with ROCE and NPV calculation? I mean – do we add RESIDUAL VALUE to the Cash Flows in both methods?
For NPV: when we start our workings we list all our Cash inflows as well as Initial investment AND we add Residual value to the last year cash inflow!
Do we do the same when dealing with ARR (ROCE) or not? and why;)
As far as I know – in ROCE (ARR) when calculating Estimated average annual profit – we add together all cash flows (without residual value) and then deduct depreciation (which involves residual value)
I hope I made some sense by asking this question and I would really appreciate ur help
Best of luck
(If you want me to answer then please in future as in the Ask the ACCA Tutor Forum for F9)
In NPV calculations we bring in the sale value (residual value) because it is a cash flow.
With ARR, you are right in saying that it affects the depreciation and therefore the average annual profit.
We divide this by the average investment and we get this by taking (initial investment + residual value)/2.Hello,
Thanks a lot for responding. OK, I will use the forum u recommended. I just saw some responses from you on this general forum and that’s why I wrote here – sorry about that.
Thank you very muchHi John,
im just going through past questions and saw this question.
“All of our output is currently produced in Europe, but competitive pressures are forcing us to reduce costs and we propose to make a large investment in a manufacturing plant in China. The initial investment would be $8.5m. Costs/savings from the project are forecast as follows:
Year 1 2 3 4 5
Net (costs)/savings ($2m) $2.5m $4m $3.5m $1.5mStem Products will need to raise a bank loan to support the investment at a cost of capital at 10% per annum. Under normal circumstances we would expect to make an accounting rate of return of 15% on our investments, or look for a payback period of about 4 years”.
Required:
Draft an email to the CEO of Stem Products in which you:
(a) State (i) the Accounting Rate of Return and (ii) the payback period for the project.i am not getting this, i know the formula for ARR and have added up all the cost savings and divided it but not getting the correct answer, do you mind to help please…
Thank you
Did you calculate the avg investment correctly? the formula is initial investment+Scrap or Residual Value/2 and for avg profit you have to add them all up and divide them by how many they are!
Good morning john I agree with you but there is no scrap value or disposal in the question! That’s why I am lost
ARR is average profit/initial investment x 100% (you wrote it upside down).
Average profit is (- 2 + 2.5 + 4 + 3.5 + 1.5 – 8.5 (dep’n)) / 5 = 0.20
Average investment is (8.5+0)/2 = 4.25ARR = 0.20/4.25 = 4.71%
(This is a very poor question indeed. I have assumed that the costs/savings are cash costs / cash savings. i.e. before depreciation. If they were after depreciation then the average profit would be 1.9, and the ARR would be 1.9/4.25 = 44.71%. However then it would mess up the payback period because that must be done on cash flows and would be impossible without knowing their depreciation policy.)
Hey john
I think your last explanation was the correct one…. But I don’t understand how you got 1.9????
Ok I think you added the cash savings/ 5, instead off – the investment of 8.5???
Because the answer in the book was just ARR = 45% &
Payback 4years 4 months.
I’m Confused
I have worked out the payback and got the same answer of 4yrs and four months just over the required year.
However I’m puzzled how was I to know the cash savings were AFTER depre???
Well……the question is terribly poor. I know that you are not taking ACCA exams, but thankfully this could not be asked in ACCA!!
For the ARR they have assumed that the costs/savings are the profit/loss figures.
So…the average profit is (-2+2.5+4+3.5+1.5)/5 = 1.9For the payback period they have assumed that the costs/savings are cash flows. So after 4 years the total cash received is (-2+2.5+4+3.5) = 8.
We need to get back 8.5, so we need an extra 0.5. Since the 4th years gives 1.5, it takes 4 + 1/3 years. 1/3 year is 4 months.The reason the question is so dreadful is that they have treated profits and cash as though they are the same. However they are not the same because profits should have depreciation subtracted.
I understand you better regarding them treating the profit as cash…
Could they have asked us to work out npv from what they have given us???
I am doing my degree in accounting but they get these questions from past ACCA and CIMA exams….
They certainly didn’t get this question from any past ACCA exam from the past twenty years!
They could have asked for an NPV because simply saying costs/savings implies that these are cash flows. For this reason, the payback period is fine – it is the ARR where they are wrong about because of depreciation.
Hi there I have a question , why when we calculate investment in ARR, we add the residual value to investment ?
Does it work the same for ROI (Profit /Investment )?
Should we as well add residual value to Investment in ROI or not ?Many thanks
For ARR, we want the average investment over the life. The average investment is (investment investment + residual value) / 2
We do not do the same for ROI or for RI – with these we work on the initial investment only.
Thanks !
One more issue
If we have like profit
For 1,2,3,4 year
While calculating ARR
We are taking average like 1 year +2y+3y+4y and divided by 5
If we calculating roi we need only add 1year+2y+3y+4y without dividing by 5, right ?No – for ROI and RI, in both cases you would divide by 4. (I have no idea where you got 5 from – if there are 4 years you divide by 4; if there are 5 years you divide by 5 🙂 )
Oh sorry I mean 4????
But I was thinking that in ARR we divided by 4 to find average profit, but why we need average for ROI, RI?For the same reasons – we should use the average profit in all cases (if we know it!!).
Anyway, ROI and RI are not relevant for Paper F9!
how do we account for residual value while calculating NPV ,Internal rate of return also payback period
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