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Dear john
I was practicing opentution practice math number 7 OPERA LTD,here I have a few questions as follows:1.while doing part a why have not we calculated the average rate of return for current year?we calculated it normally and then we compared with the forecasted average rate of return.should not we calculate the average rate of return for current year and then compare it with the average return of the project proposed?i mean why not both are average rate?
2.why did not we include the 2m scrap value while calculating capital employed.should not it be included in the final year as a cash inflow?or it has something to do it with depreciation??pls make my understanding clear on this matter.
3.why did not we calculated the t0?we started from year 1,but should not we been make the initial capital employed at the t0 and then the first addition in the year 1?
4.while calculating the average capital why did not we follow the formula that is initial capital+scrap / 2.?my questions could have been silly but Im really looking forward to have a reply from you to make my understanding clear.
Thanks in advance.To answer your questions:
1 Part (a) specifically defines how it wants you to calculate the average rate of return (average profit divided by average capital employed). Year by year the rate of return will change, but it asks you to base the decision on the average rate of return. The first sentence says that it wants to achieve a return of at least 10%, so if the average rate of return is more than 10% then we will invest (if not, then we will not invest)
(There is no such thing as an average rate of return for the current year – for the current year it would be profit/capital employed, which is not an average – but in this question it is not asked for anyway.)2 We are not calculating the NPV, so cash inflows and outflows are not relevant. The accounting rate of return is a profit measure. We have calculated the average profit by adding up each years profit and dividing by 4.
We have also calculated the capital employed each year (as defined by the question). I must have the wording corrected, but the word ‘fixed’ in the workings, should be ‘non-current assets’ and falls from the initial cost of $14M at the start of the first year, to $5M at the starts of the last year. The fall is due to depreciation and the scrap value has been taken account of when calculating the depreciation.3 I am not quite sure what you mean here. We are only doing the calculation for the new investment that we are considering (so the current assets etc are not relevant). The first years profit is earned from the investment at the start of the first year, the second years profit is earned from the balance sheet value of the asset at the start of the second year, and so on.
4 Usually we do use initial cost + scrap / 2 (and if you had done that here you would have got full marks, even though the answer would be a bit different). What has been done here is actually more accurate.
Dear john
Thank you so much.it is understood clearly.hope we will have more discussions in near future.u are great !!!“4 Usually we do use initial cost + scrap / 2 (and if you had done that here you would have got full marks, even though the answer would be a bit different). What has been done here is actually more accurate.”
Thanks Mr Moffat for highlighting the above. I didnt sleep well last night when I saw a different calculation of average capital employed. Anyway I have a new tool in my toolbox for the exam.
Mr Moffat, Kindly assist on this sentence in the the suggested solution of Opera Ltd:
“Perhaps, most fundamentally, it is bases on accounting profits expressed net of deduction for depreciation provisions, rather than cash flows. This effectively results in double counting for the initial outlay…..” What does the examiner mean by double outlay?
The examiner explains further: “…the capital cost is allowed for twice over, both in the numerator of the ARR calculation and also in the denominator…” This make me more confused. What does it mean to say “…twice over…” Kindly any help with an illustration will be appreciated.
“double counting” and “twice over” mean the same thing.
In this case what the answer means is that first we have included the cost in the denominator, but also, we have included depreciation in the top of the equation (when calculating the profit) and the depreciation is also writing off the cost.
So the cost has been dealt with twice.
Thanks for your response. Every time you something my mind opens up. Thank you.
Basically what i have noticed, to add to your response, “twice over” could mean total depreciation is $12 which is over the half the profit before depreciation of $(17.85/2)=$8.9. As the depreciation costs appears more on top of the the equation, this has the effect depressing the ROCE figure. This is a biased measure….Mr Moffat-Still my mind is struggling but after some days I should be able to get around it.
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