Chapter 2 Flashcards
(12 cards)
What is the ROCE calculation?
Average annual profits before tax and interest divided by Initial Capital Costs times 100
What are the 2 decision criteria for ROCE?
- Compare the ROCE to the target return and if it’s bigger than target, the project should be accepted.
Advantages of ROCE
- Simple to understand.
- Widely used and accepted.
- It considers the whole life of the project.
Disadvantages of ROCE
- Ignores time value of money.
- Is not a measure of absolute probability.
- Does not consider cash flow.
- Uses subjective accounting profits, which include depreciation.
Why’s it more appropriate to evaluate future cash flows rather than accounting profits? (3)
- Profits cannot be spent.
- Profits are subjective.
- Cash is required to pay dividends.
What are the differences between profit and cash flows? (4)
- Asset purchase and depreciation.
- Changes in working capital.
- Deferred taxation.
- Capitalisation of research and development expenditure.
What are relevant costs? And what should we ignore?
- Relevant - Future, Incremental Cash Flows.
- Ignore - Sunk, Committed, Allocated, Apportioned items and Non cash items (depreciation).
What does payback technique consider?
The time a project will take to pay back the money invested in it. It is based on expected cash flows.
What must a company use with the payback technique?
Target payback period
What is the decision criteria for payback technique?
Compare the payback period to the company’s target return time and if the payback for the project is quicker, should accept.
Advantages of Payback
- Simple to calculate.
- Useful in charging conditions.
- Aids growth, minimises risk and maximises liquidity.
- Uses cash flows rather than profits.
Disadvantages of Payback
- Ignores returns after the payback period.
- Ignores timings of the cash flow.
- No definitive investment signal.
- Ignores project profitability.
