Advanced: Calculation and comparison of ROI and residual income using straight line and annuity methods of depreciation The CP division of R p.l.c. had budgeted a net profit before tax of £3 million per annum over the period of the foreseeable future, based on a net capital employed of £10 million.

Plant replacement anticipated over this period is expected to be approximately equal to the annual depreciation each year. These figures compare well with the organization’s required rate of return of 20% before tax.

CP’s management is currently considering a substantial expansion of its manufacturing capacity to cope with the forecast demands of a new cus¬ tomer. The customer is prepared to offer a five-year contract providing CP with annual sales of £2 million.

In order to meet this contract, a total additional capital outlay of £2 million is envisaged, being £1.5 million of new fixed assets plus £0.5 million work¬ ing capital. A five-year plant life is expected.

Operating costs on the contract are estimated to be £1.35 million per annum, excluding depreci¬ ation.

This is considered to be a low-risk venture as the contract would be firm for five years and the manufacturing processes are well understood within CP.

You are required

(a) to calculate the impact of accepting the contract on the CP divisional Return on Capi¬ tal Employed (ROCE) and Residual Income (RI), indicating whether it would be attractive to CP’s management; (8 marks)

(b) to repeat

(a) using annuity depreciation for the newly acquired plant; (7 marks)

(c) to explain the basis of the calculations in the statements you have produced and discuss the suitability of each method in directing divi¬ sional management toward the achievement of corporate goals. (10 marks)

(Total 25 marks)

CIMA Stage 4-Control and Audit