Management consultancy by cabrera chapter 26 answer

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
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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
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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
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Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation

not dilute the earnings per share of the company. Furthermore, the
company 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 required
18% Present Value of
Investment
Year(s) Net
Cash
Flowscash
Factor
annual
inflow Cash Flows
Now P(1,600,000) 1.000
P(1,600,000)
1-8
500,000 4.078
2,039,000
P1,600,000
P 439,000

P500,000
Yes, the project is acceptable since it 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:
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PFS: Financial Aspect - Project Financing and Evaluation

Chapter 26

26% factor.....................
3.241
3.241
Incremental – Incremental
expenses,
Net
Investment
required
=
True factor.....................
3.200

revenues
including depreciation
income
Net annual
=
28% factor.....................
3.076 cash inflow
Initial investment
Difference......................
0.041
0.165
P1,600,000
P300,000
P500,000
P1,600,000
Internal rate of return = 26% +
x 2%
=

26.5%

4. The formula for the payback period is:
Payback period

=
=

0.041
3.2 years
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 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
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Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation

of return greatly understates the true rate of return, which is 26.5% as
shown in (3) above.
PROBLEM 3 (TIGER COMPUTERS, INC.)
Presentcost
Value,
1. The Net
net annual
savings P(192,400)
is computed as follows:

Factor for 10 Years
4,494
Reduction in labor costs..............................................
Reduction in material costs........................................
Total cost reductions.............................................
Less increased maintenance costs (P4,250 x 12)......
Net annual cost savings........................................
2.

P240,000
96,000
336,000
51,000
P285,000

Using this cost savings figure, and other data provided in the text, the net
present value analysis is:
Amount of
18% Present Value of
Items
Year(s) Cash Flows Factor
Cash Flows
Cost of machine.................... Now
P(900,000) 1.000
P(900,000)
Installation and software....... Now
(650,000) 1.000
(650,000)
Salvage of the old machine.... Now
70,000 1.000

70,000
Annual cost savings.............. 1-10
285,000 4.494
1,280,790
Overhaul required.................
6
(90,000) 0.370
(33,300)
Salvage of the new machine. .
10
210,000 0.191
40,110
Net present value...................
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:

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PFS: Financial Aspect - Project Financing and Evaluation

Chapter 26

Per Unit
P2.50
1.60
P0.90

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

The contribution margin per unit on anything over 30,000 units is:
Per Unit
P2.50
1.75
P0.75

Total remaining fixed costs,
P15,000
Sales
price..................................................................
Unit contribution margin on added units,
Less
P.075variable expenses..............................................

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:
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Chapter 26 PFS: Financial Aspect - Project Financing and Evaluation

50,000 units x P2.50 = P125,000 in total sales.
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

Sales
Less: Cost of Sales (60%)
Gross Profit
Less: Operating Expenses
26-8

Optimistic
P750,000
450,000
P300,000
180,000

PFS: Financial Aspect - Project Financing and Evaluation

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

P 60,000
20,000
P 40,000
16,000
P 24,000

Chapter 26

P120,000
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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