PROBLEM 3

Required 1: a. The required investment in the new equipment

Solution:
Purchase price of new equipment P 300,000
Disposal of existing equipment:
Selling price P 0
Book value 60,000
Loss on disposal P 60,000
x Tax rate (40%) 0.40
Tax benefit of loss on disposal (24,000)
Required investment P 276,000

Required investment:
The cost of the market research study (P44,000) is a sunk cost
because it was incurred last year and will not change regardless
of whether the investment is made or not. The loss on the
disposal of the existing equipment does not result in an actual
cash cost as shown by the sales manager. The loss on disposal
results in a reduction of taxes, which reduces the cost of the new
equipment.

b. The recurring annual cash flows

Solution:
Increased cash flows resulting from change in contribution
margin:
Using new equipment [18,000 (P20 - P7)] * P
234,000
Using existing equipment [11,000 (P20 - P9)] (121,000)
Increased cash flows 113,000
Less: Taxes (0.40 x P113,000) 45,200
Increased cash flows after taxes P 67,800

Depreciation tax shield:

Depreciation on new equipment (P300,000 / 5) P 60,000
Depreciation on existing equipment (P60,000 / 5) (12,000)
Increased depreciation charge P 48,000
x Tax rate (40%) 0.40
Depreciation tax shield 19,200
Recurring annual cash flows P 87,000

Annual cash flows:

The sales manager considered only the depreciation on the new
equipment rather than just the additional depreciation which
would result from the acquisition of the new equipment.
The sales manager also failed to consider that the depreciation is
a noncash expenditure which provides a tax shield.
The sales manager’s use of the discount rate (i.e., cost of capital)
was incorrect. The discount rate should be used to reduce the
value of future cash flows to their current equivalent at time
period zero.
Required 2
Solution:
Present value of future cash flows (P87,000 x 3.36) P
292,320
Required investment
276,000
Net present value P
16,320

Present value of an ordinary annuity of 1 is used (15% for 5

years = 3.36)

PROBLEM 4

Requirement 1: What is the net present value of all cash flows under Option 1 (rounded to the nearest
thousand pesos).

PV of cash inflows:
Resale value (P300,000 × 0.1821) P 54,630.00
PV of cash outflows:
Cost of investment (P100,000 × 2.9137) + P200,000 491,370.00
Annual cash operating costs (P12,000 × 5.8424) 70,108.80 (561,478.80)
P (506,848.80)
Net present value* P (507,000.00)
*Rounded off to nearest thousand pesos

Present value factors:

PV factor of P1 @ 14% for 13 periods 0.1821

PV factor of an ordinary annuity of 1 @ 14% for 4 periods 2.9137

PV factor of an ordinary annuity of 1 @ 14% for 13 periods 5.8424

Requirement 2: What is the net present value of all annual lease payments of P70,000 under Option 2
(rounded to the nearest hundred pesos).

Net present value annual lease payments of

(P70,000 × 6.6603) P 466,200
P70,000*
*Rounded off to nearest hundred pesos

Present value factor:

PV factor of an annuity due of 1 @ 14% for 13 periods 6.6603

Requirement 2: What is the present value of all cash flows associated with maintenance under Option 2
(rounded to the nearest hundred pesos).

Present value of cash flows associated with

(P4,000 × 5.8424) P 23,400
maintenance costs*
*Rounded off to nearest hundred pesos

Present value factors:

PV factor of an ordinary annuity of 1 @ 14% for 13 periods 5.8424

PROBLEM 5

Robert Computers, Inc. is considering the purchase of an

automated etching machine for use in the production of its circuit
boards. The machine would cost P900,000. An additional
P650,000 would be required for installation costs and for
software. Management believes that the automated machine
would provide substantial annual reductions in costs, as shown
below:

Annual Reduction in Costs

Labor costs P240,000
Material costs P96,000

The new machine would require considerable maintenance work

to keep it in proper adjustment. The company’s engineers
estimate that the maintenance costs would increase by P4,250
per month if the machine were purchased. In addition, the
machine would require a P90,000 overhaul at the end of the sixth
year.
The new etching machine would be usable for 10 years, after
which it would be sold for its scrap value of P210,000. It would
replace an old etching machine that can be sold now for its scrap
value of P70,000. Robert Computers, Inc., requires a return of at
least 18% on investments of this type.

REQUIREMENT 1:
Compute the net annual cost savings promised by a new
etching machine.

SOLUTION:

The net annual cost savings is computed as follows:

Reduction in labor costs P240,000
Add: Reduction in material costs 96,000
Total cost reductions 336,000
Less: Increased maintenance costs (P4,250 × 51,000
12)
Net annual cost savings P285,000

REQUIREMENT 2:
Year(s) Amount of 18% Present
Cash Flows Factor Value
of Cash Flows

Cost of the Now P(900,000) 1.000 P (900,000)

machine
Installation Now P(650,000) 1.000 (650,000)
and software
Salvage of Now P70,000 1.000 70,000
the old
machine
Annual cost 1-10 P285,000 4.494 1,280,790
 savings
Overhaul 6 P(90,000) 0.370 (33,300)
required
Salvage of 10 P210,000 0.191 40,110
the new
machine
Net present P
value (192,400)

No, the etching machine should not be purchased. It has a negative net present value at an 18%
discount rate.

REQUIREMENT 3:
The intangible benefits would have to be worth at least P42,813 per year as shown below:

required increase∈net present value P 192,400

= =P 42,813
Factor for 10 years 4.494

Thus, the new etching machine should be purchased if management believes that
the intangible benefits are worth at least P42,813 per year to the company.

Problem 6
Stewart Parcel Service has been offered an eight-year contract to deliver
mail and small parcels between army installations. To accept the contract,
the company would have to purchase several new delivery trucks at a total
cost of P450,000. Other data relating to the contract follow:

Net annual cash receipts (before taxes)

from the contract P108,000
Cost of overhauling the motors
In the trucks in five years P45,000
Salvage value of the trucks at
Termination of the contract P20,000
 If the contract were accepted, several old, fully depreciated trucks would be
sold a total price of P30,000. These funds would be used to help purchase
the new trucks. For tax purposes, the company computes depreciation
deductions assuming zero salvage value and uses straight-line depreciation.
The trucks would be depreciated over eight years. The company requires a
12% after-tax return on all equipment purchases. The tax rate is 30%.

Required: Compute the net present value of this investment opportunity.

Round all peso amounts to the nearest whole peso. Would you recommend
that the contract be accepted?

Solution:
Relevant Year(s Amount of Tax After-Tax Cash 12% Present Value
) Cash Flows Effect Flows (Amount of Cash Factor of Cash Flows
Flows x Tax Effect)
Investment in new trucks Now (P (P 450,000) 1.000 (P 450,000)
450,000)
Salvage from sale of the old Now P 30,000 1- P 21,000 1.000 21,000
trucks 0.30
Net annual cash receipts 1-8 P 108,000 1- P 75,600 4.968 375,581
0.30
Depreciation Deductions 1-8 P 56,250 0.30 P 16,875 4.968 83,835
Overhaul of motors 5 (P 1- (P 31,500) 0.567 (17,861)
45,000) 0.30
Salvage from the new trucks 8 P 20,000 1- P 14,000 0.404 5,656
0.30
Net Present Value P 18,211

Depreciation Deductions
Cost P 450,000
Divide by: Number of 8
Years
Depreciation P 56, 250

Explanation:
As can be seen in the table above, the computations show that the net
present value resulted in the amount of P 18, 211. Since the net present
value is greater than zero, we should accept the contract offered.
Requirement 1:

Computation:

PVFA = Cost of Investment/Annual Cash Inflows

= P142,950/P37,500
= 3.812

In the PV of Ordinary Annuity of 1 table, we can find 3.812, where n=7, at 18%. Hence, the exact
internal rate of return is 18%.

To verify:
Present Value
Present value of annual cash inflows (P37,500 x 3.812) P 142,950
Less: Present value of net investment (P142,950 x 1.000) 142,950
Net Present Value P 0

Requirement 2:

Computation:

PVFA = Cost of Investment/Annual Cash Inflows

Thus:
ACI = Cost of Investment/PVFA
= P142,950/4.288
= P33,337

Requirement 3:

Computation:

PVFA = Cost of Investment/Annual Cash Inflows

= P142,950/P37,500
= 3.812

a. 5-year life of equipment

In the PV of Ordinary Annuity of 1 table, we can find 3.812, where n=5, between 9% and 10%.
Tabulating the PVFA, we have:

Discount rate PVFA

At 9% 3.890
0.078 where: 1% = 0.099
1% ? 3.812 0.099
0.021
At 10% 3.791

IRR = 9% + (1% × 0.078/0.099) = 9.79% or 10%

IRR = 10% - (1% × 0.021/0.099) = 9.79% or 10%

b. 9-year life of equipment

In the PV of Ordinary Annuity of 1 table, we can find 3.812, where n=9, between 20% and 22%.

Tabulating the PVFA, we have:

Discount rate PVFA

At 20% 4.031
0.219 where: 2% = 0.245
2% ? 3.812 0.245
0.026
At 22% 3.786

IRR = 20% + (2% × 0.219/0.245) = 21.79% or 22%

IRR = 22% - (2% × 0.026/0.245) = 21.79% or 22%

To illustrate:

Tw0 (2) years longer.

An increase of 4%.

5-year life of 7-year life of 9-year life of

equipment equipment equipment
10% 18% 22%

Discussion:
Tw0 (2) years shorter.
A decrease of 8%.
 As this illustration shows, a decrease in years has a much greater impact on the rate of return
than an increase in years. This is because of the time value of money; added cash inflows far into the
future do little to enhance the rate of return, but loss of cash inflows in the near term can do much to
reduce it. Therefore, Dr. Blue should be very concerned about any potential decrease in the life of the
equipment, while at the same time realizing that any increase in the life of the equipment will do little to
enhance her rate of return.

Requirement 4:

Computation:

a. The expected annual cash inflow each year is 20% greater than estimated, which is P45,000
(P37,500 x 120%).

PVFA = Cost of Investment/Annual Cash Inflows

= P142,950/P45,000
= 3.177

In the PV of Ordinary Annuity of 1 table, we can find 3.177, where n=7, between 24% and 25%.

Tabulating the PVFA, we have:

Discount rate PVFA

At 24% 3.242
0.065 where: 1% = 0.081
1% ? 3.177 0.081
0.016
At 25% 3.161

IRR = 24% + (1% × 0.065/0.081) = 24.80% or 25%

IRR = 25% - (1% × 0.016/0.081) = 24.80% or 25%

b. The expected annual cash inflow each year is 20% less than estimated, which is P45,000 (P37,500 x
80%).

PVFA = Cost of Investment/Annual Cash Inflows

= P142,950/P30,000
= 4.765

In the PV of Ordinary Annuity of 1 table, we can find 4.765, where n=7, between 10% and 11%.
Tabulating the PVFA, we have:

Discount rate PVFA

At 10% 4.868
0.103 where: 1% = 0.156
1% ? 4.765 0.156
0.053
At 11% 4.712

IRR = 10% + (1% × 0.103/0.156) = 10.66% or 11%

IRR = 11% - (1% × 0.053/0.156) = 10.66% or 11%

To illustrate:

20% increase in cash

inflows. An increase of
7% in IRR.

Annual cash Annual cash

Annual cash
inflows: P37,500 inflows: P45,000
inflows: P30,000
18% 25%
11%

Discussion: 20% decrease in cash

inflows. A decrease of 7%
in IRR.

Unlike changes in time, increases and decreases in cash flows at a given point in time have
basically the same impact on the rate of return, as shown above.

Requirement 5:

Computation:

Present value
Present value of annual cash inflows (P30,000 x 3.605) P 108, 150
Present value of proceeds of sale in equipment (P61,375 x 0.567) 34, 800
Less: Cost of Investment (P142,950 x 1.000) 142, 950
Net present value P 0

Discussion:

Since the cash flows are not even over the five-year period (there is an extra P61,375 cash inflow
from sale of the equipment at the end of the fifth year), some other method must be used to compute
the internal rate of return. Using trial-and-error or more sophisticated methods, it turns out that the
actual internal rate of return will be 12%.

PROBLEM 8

Seattle Amusements Corporation places electronic games and other amusement devices in supermarkets
and similar outlets throughout the country Seattle Amusements is investigating the purchase of a new
electronic game called The Coven. The manufacturer will sell 20 games to Seattle Amusements for a total
price of P180,000. Seattle Amusements has determined the following additional information about the
game:
a. The game would have a five-year useful life and a negligible salvage value. The company uses
straight-line depreciation.
b. The game would replace other games that are unpopular and generating little revenue. These
other games would be sold for a total of P30,000.
c. Seattle Amusements estimates that The Coven would generate annual incremental revenues of
P200,000 (total for all 20 games). Annual incremental out-of-pocket costs would be (in total):;
maintenance, P50,000, and insurance, P10,000. In addition, Seattle Amusements would have to
pay a commission of 40% of total revenues to the supermarkets and other outlets in which the
games were placed.

Requirement 1:
Prepare a contribution format income statement showing the net operating income each year from The
Coven.
Sales revenue P200,000
Less: Commissions (40% × P200,000) 80,000
Contribution margin 120,000
Less: Fixed expenses
Maintenance P50,000
Insurance 10,000
Depreciation 36,000 96,000
Net Operating Income P24,000

Depreciation: P180,000/5 years = P36,000

Requirement 2:
Compute the simple rate of return on The Coven. Will the game be purchased if Seattle Amusements
accepts any project with a simple rate of return greater than 14%?

The initial investment in the simple rate of return calculations is net of the salvage value of the old
equipment as shown below:

Annual incremental net operating income

Simplerate of return=
Initial investment
P 24,000
¿
P 180,000 – P 30,000
P 24,000
¿
P 150,000
= 16%
Yes, the games would be purchased. The return exceeds the 14% threshold set by the company.
Requirement 3:
Compute the payback period on The Coven. If the company accepts any investment with a payback
period of less than three years, will the game be purchased?

Net operating income P24,000

Add: Depreciation P36,000
Net annual cash inflow P60,000

Investment required
Payback Period=
Net Annual Cash Inflow
P 180,000 – P 30,000
¿
P 60,000
P 150,000
¿
P 60,000
= 2.5 years
Yes, the games would be purchased. The payback period is less than the 3 years.