It is a relative measure rather than an absolute measure and hence takes no

It is a relative measure rather than an absolute

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It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. It takes no account of the length of the project. Like the payback method, it ignores the time value of money. (8) Advantages It is a quick and simple calculation. It involves the familiar concept of a percentage return. The fact that it gives a relative measure means that ROCE makes it easy to compare two investment options. It looks at the entire project life. Information readily available: all the required data to calculate ROCE is obtainable from the accounting information within the company accounting information system. This would result in time saving and also cost saving in retrieving the data. It can be used to compare mutually exclusively projects: a decision involving mutually exclusive projects can be used based on ROCE ROCE and the comparison of mutually exclusive projects The ROCE method of capital investment appraisal can also be used to compare two or more projects which are mutually exclusive. The project with the highest ROCE would be selected (provided that the expected ROCE is higher than the company's target ROCE). Example
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___________________________________________________________________________________________________________________ Page 13 of 13 IPK COLLEGE 1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG TEL : 012-5203212 / 0125113212 / 04-5512588 Subject: Financial Management (DFM1) Prepared by Susan Lim Email : [email protected] Arrow wants to buy a new item of equipment which will be used to provide a service to customers of the company. Two models of equipment are available, one with a slightly higher capacity and greater reliability than the other. The expected costs and profits of each item are as follows. Equipment item X Equipment item Y Capital cost $80,000 $150,000 Life 5 years 5 years Profits before depreciation $ $ Year 1 50,000 50,000 Year 2 50,000 50,000 Year 3 30,000 60,000 Year 4 20,000 60,000 Year 5 10,000 60,000 Disposal value 0 0 ROCE is measured as the average annual profit after depreciation, divided by the average net book value of the asset. You are required to decide which item of equipment should be selected, if any, if the company's target ROCE is 30%. CHAPTER ROUNDUP Relevant costs of investment appraisal include opportunity costs, working capital costs and wider costs such as infrastructure and human development costs. Non-relevant costs include past costs and committed costs. Relevant benefits from investments include not only increased cash flows, but also savings and better relationships with customers and employees. The payback method of investment appraisal and the ROCE/ARR/ROI methods of investment appraisal are popular appraisal techniques despite their limitations (of which you should be aware). Payback is the amount of time it takes for cash inflows = cash outflows. ROCE= Estimated average/total profits x 100% Estimated average/initial investment
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