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Backpay Co is considering investing $50,000 in a new machine. The machine will have scrap value of $10,000 at the end of its five-year life. It is expected that 20,000 units will be sold each year at a selling price of $3.00 per unit. Variable production costs are expected to be $1.65 per unit, while incremental fixed costs are expected to be $10,000 per year.
Question
2. What is the project’s return on capital employed, based on average investment?The ROCE I calculated is 36.7% because I included the scrap value in year 5’s cash flow, then averaged all cashflows, but that is not the case in the solution. The rest of my calculation is correct but I am a bit confused as to why we shouldn’t treat scrap value as an inflow for year 5, and one more thing to confirm, we only consider investment as an outflow in year 0 for payback period, not for ROCE calculation right. Please let me know. Thanks in advance!
Solution:
The correct answer is 30%.WORKING
Annual cash flow = (20,000 × 1.35) – $10,000 = $17,000
Annual depreciation = (50,000 – 10,000)/5 = $8,000
Annual operating profit = 17,000 – 8,000 = $9,000
Average investment = 1/2 (50,000 + 10,000) = $30,000
ROCE = 9,000/30,000 = 30%
The ROCE is the annual accounting profit (which is after depreciation) expressed as a % of the average investment.
So the average investment is the investment + sales proceeeds from any scrap (or zero scrap value) / 2
The ROCE is the same as the accounting rate of return which John explains in his free lectures on methods of investment appraisal.
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