MANAGEMENT CONSULTANCY - Solutions Manual
CHAPTER 26 PFS: FINANCIAL ASPECT - PROJECT FINANCING AND EVALUATION I.
Questions 1. Refe Referr to page page 519 519 2. Refe Referr to to pag pages es 519 519 to 521 521 3. Refe Referr to page page 527 527 4. The most most commo commonly nly used used comme commercia rciall profitabili profitability ty centers centers in evaluatin evaluating g proposed business ventures ventures are: 1. Brea Breakk-ev even en anal analy ysis sis 2. Net Net Pre Prese sen nt val value ue 3. Inte Intern rnal al Rate Rate of of Ret Retur urn n 4. Break-ev Break-even en Time Time or Disco Discount unted ed Payback Payback Period Period 5. Pay Paybac back Pe Perio riod 6. Acco Accoun unti ting ng Rate Rate of of Return Return 7. Sens Sensit itiv ivit ity y anal analy ysis sis 5. The possibl possiblee sourc sources es of of financ financing ing are: 1. Promo Promoter terss and and thei theirr assoc associat iates es 2. Indiv Individ idual ual inve invest stors ors 3. Corp Corpor orat atee inve invest stor orss 4. Engine Engineeri ering ng or managem management ent consul consultanc tancy y firms preparing preparing some some studies for the project 5. Suppl Supplier ierss of mach machin inery ery / raw materi materials als 6. Customers 7. Finan Financia ciall inst institu itutio tions ns 6. The finan financia ciall assistan assistance ce from from the sources sources enume enumerat rated ed in No. 5 may be provided provided through through any of the follow following ing forms: 1. Ordi Ordina nary ry shar shares es 2. Pref Prefer eren encce shar shares es 3. Loans Loans (sho (shortrt-ter term m and lon longg-ter term) m) 4. Purchase Purchase on deferre deferred d paymen paymentt plan plan or on on credit credit 5. Sale of of receiv receivable abless to finance finance compan companies ies 26-1
Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation
6. Lease of land, building and equipment 7. The sound financial practices to be followed in determining the source of financing to be availed of are: 1. Short-term financing should be utilized for short-term assets; long-term financing should be used for long-term assets 2. Foreign currency financing should be used for foreign currency costs or for foreign currency-earnings projects 8. Assumptions are expressed statements about the possible future behavior of certain factors or variables affecting a project which serve as the premises for projecting the financial results. 9. The assumptions that are usually made in a financial study relate to a) Quantity of goods to be sold, selling price b) Production capacity and requirements c) Operating expenses d) Sources of capital e) Inventory level f) Price level changes/foreign exchange rate 10. The following tests and ratios may be useful in the analysis of the financial projects: A. Measures of Solvency 1. Current ratio 2. Cash break-even point 3. Payback period B. Measures of Leverage 1. Debt ratio 2. Equity ratio 3. Debt to Equity ratio 4. Debt service break-even point 5. Times interest earned C. Measure of profitability 1. Cost/Benefit rate 2. Net present value 3. Discounted rate of return 4. Accounting rate of return II. Problems 26-2
PFS: Financial Aspect - Project Financing and Evaluation
Chapter 26
PROBLEM 1 (MAMARIL BROTHERS, INC.)
(1)
A. Net Income after taxes: Income before interest and income taxes Less: Interest expense Alt. I (P15M x 10%) Alt. II (P5M x 8%) Income before income taxes Less: Income taxes (10%) Income after taxes B. Total Assets: Total assets, 12/31/2005 Add (Deduct) Additional Investment Assets provided by profitable operations Total assets, 12/31/2006 C. Rate of Return on Total Assets: Alternative I Alternative II Alternative III
ALT. I Borrow P15M at 10% Interest
ALT. II Issue P15M Common Stock
ALT. III Pay P1M Borrow P5M at 8%; Issue C/S for the balance
P6,000,000
P6,000,000
P6,000,000
1,500,000 400,000 P4,500,000 1,800,000 P2,700,000
P6,000,000 2,400,000 P3,600,000
P5,600,000 2,240,000 P3,360,000
P13,125,000
P13,125,000
P13,125,000
15,000,000
15,000,000
14,000,000
2,700,000 P30,825,000
3,600,000 P31,725,000
3,360,000 P30,485,000
8.76% 10.35% 11.02%
(2) Earnings per Share: Alternative I = P2,700,000 / 2,500,000 shares = Alternative II = P3,600,000 / 3,500,000 shares = Alternative III = P3,360,000 / 3,100,000 shares =
P1.08. P1.03. P1.08.
(3) Based on the above computations, it would seem that Alternative III, that is, pay P1,000,000 immediately, borrow P5,000,000 at 8% interest and issue 600,000 shares of stock, is the best. This alternative would not dilute the earnings per share of the company. Furthermore, the company 26-3
Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation
will not be too highly levered, thereby minimizing the risk involved in the new issuance.
PROBLEM 2 (MAHARLIKA COMPANY)
1. The net annual cash inflow can be computed by deducting the cash expenses from sales: Sales........................................................ Less variable expenses............................ Contribution margin................................ Less advertising, salaries and other fixed out-of-pocket costs.......... Net annual cash inflow............................
P3,000,000 1,800,000 1,200,000 700,000 P 500,000
Or it can be computed by adding depreciation back to net income: Net income..................................................... Add: Noncash deduction for depreciation...... Net annual cash inflow..................................
P300,000 200,000 P500,000
2. The net present value can be computed as follows: Items Cost of new equipment. .. .. . Net annual cash inflow... ... Net present value................
Amount of 18% Present Value of Year(s) Cash Flows Factor Cash Flows Investment required Now Net P(1,600,000) 1.000 annual cash inflow P(1,600,000) 1-8 500,000 4.078 2,039,000 P 439,000
P1,600,000 Yes, the project is acceptable since it has a positive net present value. P500,000 3. The formula for computing the factor of the internal rate of return is: Factor of the internal rate of return =
=
3.200
Looking at the Table of the Present Value of an Annuity of P1 in Arrears and scanning along the 8-period line, we find that a factor of 3.200 represents a rate of return somewhere between 26% and 28%. To find the rate we are after, we must interpolate as follows:
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PFS: Financial Aspect - Project Financing and Evaluation
Chapter 26
26% factor..................... 3.241 3.241 True factor.................... 3.200 Incremental IncrementalInvestment expenses, required Net – 28% factor..................... 3.076 = income revenues including Net depreciation annual cash inflow = Difference...................... 0.041 0.165 Initial investment
P1,600,000 P300,000 P500,000 Internal rate of return = 26% + P1,600,000 =
x 2%
26.5%
4. The formula for the payback period is: Payback period
=
=
=
3.2 years 0.041 0.165by the payback method. No, the project is not acceptable when measured The 3.2 years payback period is longer than the maximum 2 ½ years set by the company.
5. The formula for the simple rate of return is: Simple rate of return
=
=
18.75%
Yes, the project is acceptable when measured by the simple rate of return. The 18.75% return promised by the project is greater than the company’s 18% cost of capital. Notice, however, that the simple rate of return greatly understates the true rate of return, which is 26.5% as shown in (3) above. 26-5
Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation
PROBLEM 3 (TIGER COMPUTERS, INC.)
1. The net annual cost savings is computed as follows: Net Present Value, P(192,400) Reduction in labor costs............................................. Reduction Factor in formaterial 10 Years costs......................................... 4,494 Total cost reductions............................................ Less increased maintenance costs (P4,250 x 12)......... Net annual cost savings........................................
P240,000 96,000 336,000 51,000 P285,000
2. Using this cost savings figure, and other data provided in the text, the net present value analysis is: Items Year(s) Cost of m achine...................... Now Installation and software........ Now Salvage of the old machine.... Now Annual cost savings............... 1-10 Overhaul required.................. 6 Salvage of the new machine... 10 Net present value....................
Amount of Cash Flows P(900,000) (650,000) 70,000 285,000 (90,000) 210,000
18% Present Value of Factor Cash Flows 1.000 P(900,000) 1.000 (650,000) 1.000 70,000 4.494 1,280,790 0.370 (33,300) 0.191 40,110 P(192,400)
No, the etching machine should not be purchased. It has a negative net present value at an 18 percent discount rate. 3. The peso value per year that would be required for the intangible benefits would be: =
P42,813
Thus, if management believes that the intangible benefits are worth at least P42,813 per year to the company, then the new etching machine should be purchased.
PROBLEM 4 (NOVA, INC.)
1. The contribution margin per unit on the first 30,000 units is:
Sales price................................................................ 26-6
Per Unit P2.50
PFS: Financial Aspect - Project Financing and Evaluation
Less variable expenses.............................................. Contribution margin ................................................................................. ................................................................................. P.0
Chapter 26
1.60 P0.90
The contribution margin per unit on anything over 30,000 units is: Per Unit P2.50 1.75 P0.75
Sales Totalprice................................................................ remaining fixed costs, P15,000 Less variable expenses.............................................. Unit contribution margin on added units, P.075 Contribution margin ................................................................................. ................................................................................. P.0
Thus, for the first 30,000 units sold, the total amount of contribution margin generated would be: 30,000 units x P0.90 = P27,000 Since the fixed costs on the first 30,000 units total P40,000, the P27,000 contribution margin above is not enough to permit the company to break even. Therefore, in order to break even, more than 30,000 units will have to be sold. The fixed costs that will have to be covered by the additional sales are: Fixed costs on the first 30,000 units.............................. P40,000 Less contribution margin from the first 30,000 units..... 27,000 Remaining uncovered fixed costs.................................. 13,000 Add monthly rental cost of the additional space needed to produce more than 30,000 units.............. 2,000 Total fixed costs to be covered by remaining sales........ P15,000 The additional sales of units required to cover these fixed costs would be: =
20,000 units
Therefore, a total of 50,000 units (30,000 + 20,000) must be sold in order for the company to break even. This number of units would equal total sales of: 50,000 units x P2.50 = P125,000 in total sales. 26-7
Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation
2.
Desired profit, Unit contribution margin,
P10,500 P0.60
=
12,000 units
Thus, the company must sell 12,000 units above the break-even point in order to earn a profit of P9,000 each month. These units, added to the 50,000 units required to break even, would equal total sales of 62,000 units each month to reach to target profit figure. 3. If a bonus of P0.15 per unit is paid for each unit sold in excess of the break-even point, then the contribution margin on these units would drop from P0.75 to only P0.60 per unit. The desired monthly profit would be: 25% x (P40,000 + P2,000) = P10,500
Desired profit, Unit contribution margin Thus,
P9,000 P0.75 = 17,500 units
Therefore, the company must sell 17,500 units above the break-even point in order to earn a profit of P10,500 each month. These units, added to the 50,000 units required to break even, would equal total sales of 67,500 units each month.
PROBLEM 5 (BILLY MADISON) Projected Income Statement
Pessimistic P600,000 360,000 P240,000 180,000 P 60,000
Sales Less: Cost of Sales (60%) Gross Profit Less: Operating Expenses Operating Income 26-8
Optimistic P750,000 450,000 P300,000 180,000 P120,000
PFS: Financial Aspect - Project Financing and Evaluation
Less: Interest Expense Net Income before taxes Less: Income taxes (40%) Net income
20,000 P 40,000 16,000 P 24,000
Chapter 26
20,000 P100,000 40,000 P 60,000
(1) Mr. Madison should make the investment if he could be assured that the sales would amount to more than P600,000. (2) Rate of Return on Assets a. at P600,000 level of sales = 24,000 / 500,000 = .048 or 4.8% b. at P750,000 level of sales = 60,000 / 500,000 = .12 or 12% (3) Other factors he should consider are: a) Other investment opportunities b) Degree of risk c) Personal satisfaction of having business of his own d) Opportunity cost if he does not go into business. (Income he would otherwise earn if he devotes his time to other ventures.)
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