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Link Co has been prevented by the competition authorities from buying a competitor, Twist Co, on the basis that
this prevents a monopoly position arising. Link Co has therefore decided to expand existing business operations
instead and as a result the finance director has prepared the following evaluation of a proposed investment project
for the company:
$m
Present value of sales revenue 6,657
Present value of variable costs 2,777
Present value of contribution 3,880
Present value of fixed costs 1,569
Present value of operating cash flow 2,311
Initial capital investment 1,800
Net present value 511
The project life is expected to be four years and the finance director has used a discount rate of 10% in the
evaluation.
The investment project has no scrap value.
The finance director is considering financing the investment project by a new issue of debt.Ques – Using the average investment method and assuming operating cash flows of $729,000 per year, what is
the return on capital employed of the investment project?So for average annual profit should we take 729,000 only as they have clearly mentioned it as a operating flow ?
How have they calculated the average accounting profit?$729,000 is the operating cash flow, not the profit.
The return on capital employed is an accounting measure and uses the average profit per annum.
The profit is the operating cash flow less the average depreciation per year.
I do not know how ‘they’ have calculated the profit because I have not seen their answer, but what they should have done is what I have written above 🙂
they have done:
The total operating cash flow = 4 ? (2,311/3.170) = $2,916,088
The average annual accounting profit = (2,916,088 – 1,800,000)/4 = $279,022
Average investment = 1,800,000/2 = $900,000
ROCE = 100 ? 279,022/900,000 = 31%should we multiple the annuity factor for 4? 3.170 ?
No we should not!!!
The question is asking for the ROCE, not for the present value!!! We only use discount factors when calculating the present values.
The ROCE is the annual accounting profit (which is after depreciation) expressed as a % of the average investment.
The ROCE is the same as the accounting rate of return which I explain in my free lectures on methods of investment appraisal.
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