MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 26 PFS: FINANCIAL ASPECT - PROJECT FINANCING AND EVALUATION

I. Questions 1. Refer to page 519 2. Refer to pages 519 to 521 3. Refer to page 527 4. The most commonly used commercial profitability centers in evaluating proposed business ventures are: 1. Break-even analysis 2. Net Present value 3. Internal Rate of Return 4. Break-even Time or Discounted Payback Period 5. Payback Period 6. Accounting Rate of Return 7. Sensitivity analysis 5. The possible sources of financing are: 1. Promoters and their associates 2. Individual investors 3. Corporate investors 4. Engineering or management consultancy firms preparing some studies for the project 5. Suppliers of machinery / raw materials 6. Customers 7. Financial institutions 6. The financial assistance from the sources enumerated in No. 5 may be provided through any of the following forms: 1. Ordinary shares 2. Preference shares 3. Loans (short-term and long-term) 4. Purchase on deferred payment plan or on credit 5. Sale of receivables to finance companies 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

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PROBLEM 1 (MAMARIL BROTHERS, INC.) (1)

ALT. I Borrow P15M at 10% Interest 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 P6,000,000 1,500,000 400,000 P4,500,000 1,800,000 P2,700,000 P13,125,000 15,000,000 2,700,000 P30,825,000 8.76% 10.35% 11.02% P6,000,000 2,400,000 P3,600,000 P13,125,000 15,000,000 3,600,000 P31,725,000 P5,600,000 2,240,000 P3,360,000 P13,125,000 14,000,000 3,360,000 P30,485,000 ALT. II Issue P15M Common Stock P6,000,000 ALT. III Pay P1M Borrow P5M at 8%; Issue C/S for the balance P6,000,000

(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.................................. 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 required Cash Flows Investment Factor Now Net annual cash inflow P(1,600,000) P(1,600,000) 1.000 1-8 500,000 4.078 2,039,000 P 439,000

P300,000 200,000 P500,000

P1,600,000 Yes, the project is acceptable since it P500,000 has a positive net present value. 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: 26-4

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26% factor..................... True factor.................... Incremental 28% factor..................... revenues = Difference......................

Initial investment

3.241 3.241 3.200 Incremental expenses, required Investment = Net 3.076 includingNet annual cash inflow depreciation income 0.041 0.165 x 2%

P1,600,000 P300,000 Internal rate of returnP500,000 + = 26% P1,600,000 = 26.5% 4. The formula for the payback period is: Payback period = =

3.2 years 0.041 0.165 No, the project is not acceptable when measured by the payback method. The 3.2 years payback period is longer than the maximum 2 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 companys 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 in material costs......................................... Factor for 10 Years 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 machine...................... 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

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Less variable expenses.............................................. Contribution margin ................................................................................. ................................................................................. P.0

1.60 P0.90

The contribution margin per unit on anything over 30,000 units is: Sales price................................................................ Total remaining fixed costs, P15,000 Less variable expenses.............................................. Unit contribution margin on added units, P.075 Contribution margin ................................................................................. ................................................................................. P.0 Per Unit P2.50 1.75 P0.75

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 Thus, contribution margin

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 Sales Less: Cost of Sales (60%) Gross Profit Less: Operating Expenses Operating Income 26-8 Pessimistic P600,000 360,000 P240,000 180,000 P 60,000 Optimistic P750,000 450,000 P300,000 180,000 P120,000

PFS: Financial Aspect - Project Financing and Evaluation

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Less: Interest Expense Net Income before taxes Less: Income taxes (40%) Net income

20,000 P 40,000 16,000 P 24,000

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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