Investment Appraisal

1) A project requires an initial investment of $800,000 and then earns net cash inflows as follow:

Year 1 2 3 4 5 6 7

Cash inflows 100 200 400 400 300 200 150

In addition, at the end of the seven year project the assets initial purchased will be sold for $100,000.

Determine the project’s ROCE using ;
A) INITIAL COST

B) AVERAGE CAPITAL INVESTMENT.

Average annual inflows = 1,750,000/7 = 250,000
Av depr = 800 – 100/ 7 = 100,000
Average CP is 800,000 + 100,000/2 = 450,000

Av profit = 250 – 100 = 150,000
ARR or ROCE = 150,000/ 450,00 * 100% = 33.33%

(2) Acorn Plc is considering purchasing a new machine at a cost of $100,400 that will be operated for 4 years, after which time it will be sold for an estimated $9,600. Acorn uses a straight line policy for depreciation.
Froecast operating profit to be genaerated by the machine are as follows:

Year. $
1. 39,600
2. 19600
3. 22,400
4. 32,400

Select the payback period and the average return on capital employed, calculated as average capital annual profits divided by the average investment.

Answer PP 2.02 YEARS ROCE 47.5%

When calculating for PP, we accounted for depr which was added back to each year’s profit

Depr (110,400 – 9600/4 ) = 252200

Year 1 = 64,800 ( 25,200 + 39,600)
Year 2 = 44,800 ( 25,200 + 19600)
Year 3 = 47,600 ( 25,200 + 32,400)

Cumulative cash flows (45,600) , ( 800) and year 3 positive cash flow of 46,800

PP 2.02 Years.

My question is when calculating ARR , why was depreciation not accounted for in calculating the average annual profit ? Since depr was 25200.

Av. Profit was 39,600 + 19,600 + 22,400+ 32,400/4 = $28,500

Av capital investment = 110,400 + 9600/2 = 60,000

ARR = 28,500/ 60,000 * 100% = 47.5%