Rivera, Shaira Rehj R.

BSA 4-1

a)
Current Return on Capital Employed = Operating Profit ÷ Capital Employed
P20M ÷ (P75M + P25M) = P20M ÷ P100M = 20%

Analysis of the proposed project:

Project capital requirements are P14M fixed capital plus P0.5M inventories. The annual
depreciation charge (straight line) is: (P14M-2M) ÷ 4 = 3M p.a.

Project profile (PhP in Millions)

Year 1 2 3 4
Sales (P5 x 2M) (P4.5 x 1.8M) (P4 x 1.6M) (P3.5 x 1.6M)
=P10M =P8.1M =P6.4M =P5.6M
OPEX (2M) (1.8M) (1.6M) (1.6M)
Fixed Cost (1.5M) (1.35M) (1.2M) (1.2M)
Depreciation (3M) (3M) (3M) (3M)
Profit P3.5M P1.95M P0.6M P(0.20M)
Capital Employed (start-of-year):
Fixed P14M P11M P8M P5M
Stocks 0.50M 0.50M 0.50M 0.50M
Total P14.5M P11.5M P8.5M P5.5M

Average Rate of Return = Average profit ÷ Average capital employed

P5.85M÷4 P1.46
= = 14.6% ARR
P40.0÷4 P10.0

It shall be noted that if receivables were to be included in the definition of capital employed,
this would reduce the calculated rate of return, while the inclusion of payables would have an
offsetting effect
Rivera, Shaira Rehj R.
BSA 4-1

1.
a.) Current Return on Capital Employed = Operating Profit ÷ Capital Employed
P20M ÷ (P75M + P25M) = P20M ÷ P100M = 20%

Analysis of the proposed project:

Project capital requirements are P14M fixed capital plus P0.5M inventories.
The annual depreciation charge (straight line) is: (P14M-2M) ÷ 4 = 3M p.a.
Year 1 2 3 4
(P4.5 x (P4 x (P3.5 x
Sales (P5 x 2M)
1.8M) 1.6M) 1.6M)
P10M P8.1M P6.4M P5.6M
OPEX (2M) (1.8M) (1.6M) (1.6M)

Fixed Cost (1.5M) (1.35M) (1.2M) (1.2M)

Depreciation (3M) (3M) (3M) (3M)

Profit P3.5M P1.95M P0.6M P(0.20M)

Capital Employed
(start-of-year):

Fixed P14M P11M P8M P5M

Stocks 0.50M 0.50M 0.50M 0.50M
Total P14.5M P11.5M P8.5M P5.5M

Average Rate of Return = Average profit ÷ Average capital employed

14.6% ARR

P5.85M÷4 P1.46M
P40.0M÷4 P10.0
It shall be noted that if receivables were to be included in the definition of capital employed, this would reduce the calculated ra
On the contrary, using the ARR criterion as defined, the proposal has an expected return above the minimum stipulated by Calv
It is therefore concluded, however, that it is unlikely that the senior managers of the Bantayan Division would want to undertak
b.) Three problems with the use of ARR:

· First is, of course,

it ignores the time
value of money.
od is based on
· accounting profits expressed net of deduction for depreciation provisions, rather than cash flows. This effectively results in d
The accounting
rate of return can be
expressed in a variety
of ways and it is
therefore subject to
manipulation. The
ARR is susceptible to
manipulation because
it can be expressed in
a variety of ways.
Although the question
specifies average
profit to average
capital employed,
many other variants
are possible e.g.,
average profit to initial
capital, which would
raise the computed
rate of return. It is also
susceptible to
variation in accounting
policy by the same
firm over time, or as
between different
firms at a point in
time. Different
methods of
depreciation may also
be used. These
different depreciation
methods produces
different profit figures
and hence different
rates of return.

c.) Continued use

provides this
information. Also
many managers are
evaluated on the
overall return of their
divisions on capital
employed. If this is the
case, it is likely that
managers will focus
on the return on
capital employed of
individual projects.
Thus the way that
performance is
measured is likely to
have a profound effect
on the criteria that is
used to appraise
projects. The
continuing use of the
ARR method can by
explained largely by
its utilization of
Statement of Financial
Position and Income
Statement magnitudes
familiar to managers,
namely ‘profit’ and
‘capital employed’. In
addition, the impact of
the project on a
company’s financial
statements can also be
specified. Return on
capital employed is
-2
PV of cost of operating new machines
(£)
Purchase price (£52 000 x 4) 208 000
PV of annual operating costs for 7 years (£1 273 840
Salvage value (4 x £4000 x 0.4523) (7 237)
––––––––
PV of costs over 7-year life 474 603

Equivalent annual cost = PV of costs = £474 603 . = £103 988

annuity 4.564

PV of cost of operating old machine

(£)
Opportunity cost of selling machines (10 x £5000) 50 000
Operating costs (10 x £10 000 x 2.402) 240 200
–––––––
PV of costs over 3-year life 290 200

Equivalent annual cost (£290 200/2.402) = £120 816

The new machines have the lowest equivalent annual cost. Therefore they should be replaced now. This decision is based

The costs of modifying the factory building should be compared with the savings that result from the installation of the ne

PV of modification now 60 000

Less PV of modification in 3 years’ time (£6 42 720
––––––
Relevant cost of modification now 17 280
uld reduce the calculated rate of return, while the inclusion of payables would have an offsetting effect.
nimum stipulated by Calvin Co. It is highly unlikely that the managers of Bantayan Division will propose projects which offer a rate of retu
on would want to undertake the project.
his effectively results in double-counting for the initial outlay i.e., the capital cost is allowed for twice over, both in the numerator of the AR
w. This decision is based on the assumption that no superior or cheaper machines will be available in three years’ time. If oth

the installation of the new machines. Equivalent annual savings from purchasing the new machines are £16 828 (£120 816 – £103 98
(£)
projects which offer a rate of return below the present 20% even where the expected return exceeds the minimum of 10%. To undertake pro
le in three years’ time. If other opportunities are likely to be available in three years’ time then the combination of operating the old

e £16 828 (£120 816 – £103 988) for three years. The PV of these savings is £40 421 (£16 828 x 2.402). It is assumed that if the facto
imum of 10%. To undertake projects with returns in this range will depress the overall divisional return and cast managerial performance in
ombination of operating the old machines and replacing with more efficient or cheaper machines should be considered.

). It is assumed that if the factory is not modified now, it will have to be modified in three years’ time when the current machines reac
d cast managerial performance in a weaker light.
d be considered.

when the current machines reach the end of their life. Assuming the cost of modification will still be £60 000 in three years’ time, the r
0 000 in three years’ time, the relevant cost of the modification is: