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Armcliff Ltd is a division of Shevin plc which requires each of its divisions to achieve a
rate of return on capital employed of at least 10% p.a. For this purpose, capital employed
is defined as fixed capital and investment in stocks. This rate or return is also applied as
a hurdle rate for new investment projects. Divisions have limited borrowing powers and
all capital projects are centrally funded.
The following is an extract from Armcliff’s divisional accounts:
Profit and loss account for the year ended 31 December
(£m)
Turnover 120
Cost of sales (100)
Operating profit 20
Assets employed as at 31 December 1994
(£m) (£m)
Fixed (net): 75
Current assets (inc. stocks £25m) 45
Current liabilities (32) 13
Net capital employed 88
Armcliff’s production engineers wish to invest in a new computer-controlled press. The
equipment cost is £14m. The residual value is expected to be £2m after four years
operation, when the equipment will be shipped to a customer in South America.
The new machine is capable of improving the quality of the existing product and also of
producing a higher volume. The firm’s marketing team is confident of selling the
increased volume by extending the credit period. The expected additional sales are:
Year 1 2 000 000 units
Year 2 1 800 000 units
Year 3 1 600 000 units
Year 4 1 600 000 units
Sales volume is expected to fall over time due to emerging competitive pressures.
Competition will also necessitate a reduction in price by £0.5 each year from the £5 per
unit proposed in the first year. Operating costs are expected to be steady at £1 per unit,
and allocation of overheads (none of which are affected by the new project) by the
central finance department is set at £0.75 per unit.
Higher production levels will require additional investment in stocks of £0.5m, which
would be held at this level until the final stages of operation of the project. Customers at
present settle accounts after 90 days on average.
Required:
(a) Determine whether the proposed capital investment is attractive to Armcliff, using
the average rate of return on capital method, as defined as average profit-to-average
capital employed, ignoring debtors and creditors.
[Note: Ignore taxes]
(b)
(i) Suggest three problems which arise with the use of the average return method for
appraising new investment.
(ii) In view of the problems associated with the ARR method, why do companies
continue to use it in project appraisal?
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