ACCA FM Syllabus D. Investment Appraisal - Accounting Rate of Return - Notes ^{4 / 8}

Note:

• Right, first thing you need to remember about this is that this is the ONLY investment appraisal technique which uses profits and not cash in the F9 exam. 

  This is a drawback of the method - as profits can be manipulated

• The second thing to understand is that it has 2 names - ROCE (return on capital employed) and ARR (Accounting rate of return)

Finally - there are 2 methods of calculating it:

1. Simple Method

   This percentage is compared to the target return you would like to get. 

   Clearly it has to be higher than say the interest rate on the loan you used to buy the capital item.

   More correctly it has to be higher than the company’s cost of capital (more of that later)

2. Average Method

   The average investment is the average value it would be in the SFP over the length of the project

   Illustration of 'average investment' 

   Cost 400 Residual Value 100

   Average Investment = 400 + 100 / 2 = 250

Illustration

RCA are considering expanding their business into Canada by buying up a local college over there.
The local college purchase will cost £500,000 and a further £300,000 to make the premises sexy

Cashflow profits (ie not including depreciation) from the college over the next 5 years are expected to be:

The sexiness of the premises will have disappeared by the end of the 5 years and so sadly have a zero resale value. This will make RCA sad and so they expect to sell up in order to buy a funky new college somewhere else. When they sell they hope to get £400,000 for the college

Required
Calculate the ROCE of this investment (using the average investment method)

Solution

Total profits = Cash - Depreciation

Depreciation = Cost - Residual value

So, Total profits = 1,000,000 - (500+300-400) = 600,000
Therefore Average profits = 600,000 / 5 = 120,000

Average Investment = (Cost + RV)/2
= (800+400) / 2 = 600,000

ARR = Average Profits / Average Investment = 120,000 / 600,000 = 0.2 = 20%

Points about ROCE

This is used when company’s are more interested in PROFITABILITY than liquidity

Unlike the other capital budgeting methods that we have discussed, the simple rate of return method does not focus on cash flows. Rather, it focuses on accounting net operating income.

If a cost reduction project is involved, formula / Equation becomes:

(Cost savings − Depreciation on new equipment) / Initial investment*
*The investment should be reduced by any salvage from the sale of old equipment.

So how useful is this method?

The most damaging criticism of the accounting rate of return method is that it does not consider the time value of money. The simple rate of return method considers a dollar received 10 years from now as just as valuable as a dollar received today. Thus, the accounting rate of return method can be misleading if the alternatives being considered have different cash flow patterns.

Additionally, many projects do not have constant incremental revenues and expenses over their useful lives. As a result the simple rate of return will fluctuate from year to year, with the possibility that a project may appear to be desirable in some years and undesirable in other years. In contrast, the net present value method provides a single number that summarised all of the cash flows over the entire useful life of the project.

In summary the benefits are:

1. Fairly simple

2. Understandable percentage figure

Drawbacks

• It disregards the project life and when the cash flows actually come in.

• It focuses on profits not liquidity.

• It uses accounting profits (which can be manipulated) rather than cash.

• There is no mention of the actual gain made (just a percentage figure)