ventures Ltd presently earns a return on its capital of 18%. it proposes to manufacture and market a new product, mukeme. the manufacture of mukeme will require the purchase of new machine at a cost of k100M and additional working capital of k40M.
sales of mukeme are expected to be k66M per annum. the cost of manufacture will be k25M per annum. selling and distribution cost will amount to k3M per annum, there will be no additional administration expenses.
venture Ltd depreciates its machinary at the rate of 10% on cost each year.
a) calculate the account rate of return expected the mukeme
Financial management?
- Posted:
- 3+ months ago by jeanpaul
- Topics:
- market, capital, news, management, financial, product, return, venture
Details:
Added 3+ months ago:
b) state with reasons whether or not venture ltd should proceed to make a market mukeme
Answers (1)
this question is a bit tricky. i do not use ARR so I am not very familiar with all the details that need to be considered - in this case the tricky bit is the working capital and the time of the project.
So I had to make 3 assumptions:
- the working capital is relevant for the calculation AND it it is consumed by the end of the project (it makes sense to me to consider this as you will need to finance it either from the your own capital or via debt)
- the project lasts 10 years so the machine will be fully depreciated at the end or the project
- the depreciation is not included in the 'manufacturing expense'
- the working capital is needed for the whole project time (not yearly) AND it is included in the manufacturing cost
As such:
1)
ARR = Average profit/Average investment
Average investment = (Book value Y1+Book value Y10)/2 => (100+40 - 0- 0)/2 = 70k
Yearly profit: 66-(25+3+100/10) = 66-38 = 28 =>
ARR = 28/70 = 40%
2)
At 40% ARR this is higher than the current return on capital and then, strictly using ARR the project shoul be accepted. However, the company should be aware that this is an accounting method that does not deal with some real factors of the market (e.g. the cost of capital could be significantly higher under current market conditions) and taking the decision simply on the result of ARR could be wrong. I would suggest using time-value of money amalysis instead.
Even if my ARR is not 100% correct, still if you present the logic of the calculation and the reasoning at 2) you will get a decent mark :)