Peach Co’s latest results are as follows:
| $000 | |
|---|---|
| Profit before interest and taxation | 2,500 |
| Profit before taxation | 2,250 |
| Profit after tax | 1,400 |
| $000 | |
|---|---|
| Equity | 10,000 |
| Non-current liabilities | 2,500 |
What is Peach Co’s return on capital employed (ROCE)?
A. 14%
B. 18%
C. 20%
D. 25%
PV Co, a large stock-exchange-listed company, is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketing trials conducted recently by the company’s research and development division. Product W33 will be manufactured using a fully-automated process which would significantly increase noise levels from PV Co’s factory. The following information relating to this investment proposal has now been prepared:
| Initial investment | $2 million |
|---|---|
| Selling price (current price terms) | $20 per unit |
| Expected selling price inflation | 3% per year |
| Variable operating costs (current price terms) | $8 per unit |
| Fixed operating costs (current price terms) | $170,000 per year |
| Expected operating cost inflation | 4% per year |
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Demand (units) | 60,000 | 70,000 | 120,000 | 45,000 |
It is expected that all units of Product W33 produced will be sold, in line with the company’s policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is expected at the end of four years, when production of Product W33 is planned to end. For investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year and a target return on capital employed of 30% per year. Ignore taxation.
Required:
(a) Calculate the following values for the investment proposal:
(iii) return on capital employed (accounting rate of return) based on average investment. (3 marks)
Which of the following statements is NOT correct?
A. Return on capital employed can be defined as profit before interest and tax divided by the sum of shareholders’ funds and prior charge capital
B. Return on capital employed is the product of net profit margin and net asset turnover
C. Dividend yield can be defined as dividend per share divided by the ex dividend share price
D. Return on equity can be defined as profit before interest and tax divided by shareholders’ funds
| Initial investment | $2 million |
| Selling price (current price terms) | $20 per unit |
| Expected selling price inflation | 3% per year |
| Variable operating costs (current price terms) | $8 per unit |
| Fixed operating costs (current price terms) | $170,000 per year |
| Expected operating cost inflation | 4% per year |
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Demand (units) | 60,000 | 70,000 | 120,000 | 45,000 |
Required:
(a) Calculate the following values for the investment proposal:
(iii) return on capital employed (accounting rate of return) based on average investment. (3 marks)
BQK Co, a house-building company, plans to build 100 houses on a development site over the next four years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of construction. Two types of house will be built, with annual sales of each house expected to be as follows:
| year | 1 | 2 | 3 | 4 |
| number of small houses sold | 15 | 20 | 15 | 5 |
| number of large houses sold | 7 | 8 | 15 | 15 |
Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a long-term personal loan from their bank. Financial information relating to each type of house is as follows:
| small house | large house | |
| selling price | $200000 | $350000 |
| variable cost of construction | $100000 | $200000 |
Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of 3% per year and variable cost of construction inflation of 4·5% per year.
Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These would not relate to any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure cost inflation is expected to be 2% per year.
BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances on the purchase cost of the development site on a straight-line basis over the four years of construction.
BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year. New investments are required by the company to have a before-tax return on capital employed (accounting rate of return) on an average investment basis of 20% per year.
Required:
Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investment on an average investment basis and discuss briefly its financial acceptability.