# 22 answer cumulative cash inflows year project a

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22 ANSWER: Cumulative cash inflows: Year Project A Project B 1 140000 20000 2 220000 60000 3 280000 120000 4 300000 220000 5 320000 400000 PBPA = 2 + (240000-220000) / 60000 = 2 + .3333 = 2.33 years PBPB = 4 + (240000-220000) / 180000 = 4 + .1111 = 4.11 years Decision: Project A is better than project B

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12 23 Advantages and disadvantages of payback Advantages include: • it is simple • it is useful in certain situations: – rapidly changing technology – improving investment conditions • it favours quick return: – helps company growth – minimises risk – maximises liquidity • it uses cash flows, not accounting profit. Disadvantages include: • it ignores returns after the payback period • it ignores the timings of the cash flows • it is subjective – no definitive investment signal • it ignores project profitability. 24 Accounting rate of return (ARR) some time called ROCE A comparison of the profit generated by the investment with the cost of the investment Average annual profits before interest and tax ARR = -------------------------------------------- Initial cost of investment or alternatively: Average annual profits before interest and tax ARR = -------------------------------------------- Average capital investment Initial investment + scrap value Average capital investment = ––––––––––––––––––––––––––– 2
13 25 Accounting rate of return (ARR) some time called ROCE e.g. An investment is expected to yield cash flows of £10,000 annually for the next 5 years The initial cost of the investment is £20,000 Total profit therefore is: £30,000 Annual profit = £30,000 / 5 = £6,000 ARR = 6,000/20,000 x 100 = 30% A worthwhile return? 26 Test your understanding ROCE A project involves the immediate purchase of an item of plant costing \$110,000. It would generate annual cash flows of \$24,400 for five years, starting in Year 1. The plant purchased would have a scrap value of \$10,000 in five years, when the project terminates. Depreciation is on a straight-line basis. Determine the project's ROCE using: (a) initial capital costs (b) average capital investment

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14 27 Test your understanding ROCE Annual cash flows are taken to be profit before depreciation. Average annual depreciation = (\$110,000 – \$10,000) ÷ 5 = \$20,000 Average annual profit = \$24,400 – \$20,000 = \$4,400 Using initial cost: ROCE = Average annual profit ––––––––––––––––– × 100% Initial capital cost \$4,400 = –––––––––––– × 100% \$110,000 = 4% 28 Test your understanding ROCE Using average capital investment: Average annual profits (as before) = \$4,400 Average book value of assets = (Initial capital cost + Final scrap value) ÷ 2 = (\$110,000 + \$10,000) ÷ 2 = \$60,000 ROCE = \$4,400 ÷ \$60,000 × 100% = 7.33%

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16 31 Advantages and disadvantages of ROCE Advantages include: • simplicity • links with other accounting measures. Disadvantages include: • no account is taken of project life • no account is taken of timing of cash flows • it varies depending on accounting policies • it may ignore working capital • it does not measure absolute gain • there is no definitive investment signal.
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