Question 6.EX.2.1: Calculation of the return on capital employed Carbon plc i...
Calculation of the return on capital employed
Carbon plc is planning to buy a new machine and has found two which meet its needs. Each machine has an expected life of five years. Machine 1 would generate annual cash flows (receipts less payments) of £210,000 and would cost £570,000. Its scrap value at the end of five years would be £70,000. Machine 2 would generate annual cash flows of £510,000 and would cost £1,616,000. The scrap value of this machine at the end of five years would be £301,000. Carbon plc uses the straight-line method of depreciation and has a target return on capital employed of 20 per cent.
Calculate the return on capital employed for both Machine 1 and Machine 2 on an average investment basis and state which machine you would recommend, giving reasons.
\begin{array}{lc}\text { For Machine 2: } & £ \\\text { Total cash flow }=510,000 \times 5= & 2,550,000 \\\text { Total depreciation }=1,616,000-301,000= &\underline{1,315,000} \\\text { Total accounting profit } & \underline{1,235,000} \\\text { Average annual accounting profit }=1,235,000 / 5= & \text{£247,000 per year} \\\text { Average investment }=(1,616,000+301,000) / 2= & £958,500 \\\text { Return on capital employed }=100 \times(247,000 / 958,500)= &25.8 \%\end{array}
Both machines have a return on capital employed greater than the target rate and so are financially acceptable, but as only one machine is to be purchased, the recommendation is that Machine 1 should be chosen, as it has a higher return on capital employed than Machine 2.