Management Service Solman Chapter 10 14 17Agamata 2019 Solman answer key to solman agamata PDF

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CHAPTER 14CAPITAL BUDGETING[Problem 1] Purchase price P140, Trade-in allowance ( 7,000) Saving from repairs ( 25,000) Additional tax on savings (P25,000 x 40%) 10, Net cost of investment for decision analysis P118,[Problem 2] Purchase price P4,800, Freight and installation 45, Trade-in allowance ( 2...

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CHAPTER 14 CAPITAL BUDGETING

[Problem 1] Purchase price Trade-in allowance Saving from repairs Additional tax on savings (P25,000 x 40%) Net cost of investment for decision analysis

P140,000 ( 7,000) ( 25,000) 10,000 P118,000

[Problem 2] Purchase price P4,800,000 Freight and installation 45,000 Trade-in allowance ( 200,000) Salvage value of other assets 12,000 Tax savings – other assets ( 8,000) Savings from repairs ( 400,000) Add’l tax on savings from repairs (P400,000 x 40%) 160,000 Additional working capital 350,000 Net cost of investment for decision analysis P4,759,000 [Problem 3] Purchase price Freight charge Installation costs Special attachment Add’l working capital Proceeds from sale of old assets Tax savings (P38,000 x 25%) Savings from repairs

P900,000 25,000 22,000 55,000 110,000 ( 22,000) ( 9,500) ( 120,000) Add’l tax on savings from repairs (P120,000 x 25%) 30,000 Net cost of investment for decision analysis P990,500

[Problem 4] Furnishing and equipment Rental deposits Accounts receivable (P9M x 1/3 x 2/3) Inventory Cash Net cost of investment for decision analysis

P 500,000 200,000 2,000 000 400,000 120,000 P5,020,000

[Problem 5] 1. Sales Materials Labor Factory overhead Selling and administrative expenses Depreciation expense (P1,200,000  5 yrs) Income before income tax Tax (30%) Net income Add back: Depreciation expense 2. Annual net cash flows

P6,000,000 ( 800,000) ( 1,200,000) ( 540,000) ( 700,000) ( 240,000) 2,520,000 ( 756,000) 1,764,000 240,000 P2,004,000

[Problem 6]

1.

Weighted Average Cost of Capital (WACOC) = ?

Sources of capital

Market values

Individual Cost of Capital

Capital Mix Fraction

Mortgage bonds

(P300,000 x 105%) = P315,000

(10% x 55%) = 5.5%

Preferred equity

(2000 sh x P96)

=

192,000

(P12 / P96) = 12.5

192 / 1.007

2.38%

Common equity

(50,000 sh x P10)

=

500,000

P1.50 / P10 = 15.0

500 / 1.007

7.45%

Total

315 / 1.007

WACOC

P1,007,000

11.55%

Preferred dividends = 12% x P100 = P12 / sh Earnings per share = P75,000 / 50,000 sh = P1.50

2. Proposed Investment A B C

ROI 7% 10% 14%

WACOC 11.55% 11.55% 11.55%

Advise Reject Reject Accept

Investments are to be accepted if the WACOC is higher than the ROI.

[Problem 7]

1.72%

1.

New WACOC = ? Cost of

Sources of Money Long-term debt Preferred equity Common equity

Package 1

Capital

Amount

WACOC

Amount

6%

P10,000,000

3%

P 2,000 000

11%

3,000,000 1.65%

14%

Total

7,000,000 4.90% P20,000,000

2.

Package 2

9.55%

Package 3

WACOC

11,000 000 7,000, 000

Amount

WACOC

0.60% P 6,000,000

1.80%

6.05%

5,000,000

2.75%

4.90%

9,000,000

P20,000,000 11.55% P20,000,000

6.30% 10.85%

Package 1 gives the invest WACOC at 9.55%.

[Problem 8] Before Bonds Retirement Amount WACOC Bonds Preferred equity Common equity

Amount

After Bonds Retirement WACOC

P 5,000,000 (8% x 60% x 5/10) = 2.4% 1,000,000 (9% x 1/10) 4,000,000 (12.5% x 4/10)

Lease Totals

P10,000,000

P4,000,000 (8% x 60% x 4/10) = 1.92% 1, = 0.9% 000,000 (9% x 1/10) = 0.90% 4, = 5% 000,000 (12.5% x 4/10) = 5.0% 1, 000,000 10% x 60% x 1/10) = 0.60% P 8.30% 10,000,000 8.42%

[Problem 9]

a.

WACOC = ? Funds

Mortgage bonds Common stock Ret earnings Total

Amount P20,000,000 25,000,000 55,000,000

Individual Cost of Capital

WACOC

[(6.5% x 50%) / 95%] 3.42% 0.684% [(P4 x 105%) /P94 + 5%] 9.47 2.3675% 9.47 5.2085%

P100,000,000

8.26%

b. The weighted average cost of capital is used as a benchmark in evaluating the acceptability or rejection of proposed investment because it measures the point of expected return where the minimum required return of each class of investor is met by reason of cross-subsidizing from one class of security to another. [Problem 10] a. WACOC under each alternative

Debt Equity WACOC

b.

Alternative A (9% x 50% x 2/6) = 1.5% {[(P1/P20) + 7%] x 4/6} = 8.0% 9.5%

Alternative B (12% x 50% x 4/6) = 4.0% {[(P0.90/P20) + 12%] x 2/6} = 5.5% 9.5%

In alternative B, the amount of debt increases thereby increasing the debt equity ratio signalling the firm is highly leveraged and more risky for investment. This tends to increase the nominal rate of the bonds.

c. Yes; it is logical for stockholders to expect a higher dividend growth rate under alternative B to compensate the higher rate implied by an increase in the debt exposure of the firm and to validate the theory that the more debt is used in the financing portfolio, the higher the profitability rate of the firm, thereby, the higher the growth rate. [Problem 11] 1. Marginal Cost of Capital for each fund 2. WACOC = ? Capital Mix [b] Sources Rate WACOC Mortgage bonds 15.00% 1.26% Debentures 25.00% 2.175% Preferred stock 10.00% 1.36% Common stock 16.67% 2.11% (P1.80 / P67.50 + 10%)=12.67% Retained earnings 33.33% 4.22% = 12.67% 100.00% 11.125% 3. Maximum point of expansion for retained earnings: Net income (P4.50 x 15 million shares) P67,500,000 Common dividends (P67,000,000 x 40% or P1.80 x 15 million) ( 27,000,000) Preferred stock dividends ( 6,750,000) Retained earnings available for expansion P33,750,000 Common equity = 50% of total capitalization Maximum point of expansion before common stock shares are issued = P33,750,000 / 50% = P67.5M [a] Individual COC (14% x60%) = 8.4% (145% x 60%) = 8.7% (P13.50/ P99.25) = 13.60%

4.

The WACOC varies among firms in the industry even if the basic business risk is similar for all firms in the industry. This is true because each firm selects the degree of financial leverage it desires. This

financial leverage affects the capital mix structure of a firm that affects the determination of the weighted average cost of capital. [Problem 12] 1. WACOC before and after bond retirement: [1] Before Bond Retirement Capital Lease 8% Debentures 9% Preferred stock Common stock Retained earnings

Amount

[2] After Bond retirement

WACOC

Amount WACOC P1,000,000 (10% x 60% x 1/10) = 0.6%

P5,000,000 8% x 60% x 5/10) = 2.4%

4,000,000

(8% 60% x 4/10) = 1.92%

1,000,000

(9% x 1/10) = 0.9%

1,000,000

{same} 0.9%

2,000,000

(13% x 2/10) = 2.6%

2,000,000

{same} 2.6%

2,000,000

(13% x 2/10) = 2.4%

2,000,000

{same} 2.4%

8.30% P10,000,000

8.42%

P10,000,000

2.

The component costs and the weighting used to calculate the WACOC in a-1 is different in a-2 because P1 M of debentures are replaced by lease which is more expensive (from 8% to 10% nominal rate). This brings up the WACOC to 8.42%. 3. Market values should be used in calculating the WACOC because COC calculation is used to estimate the current marginal cost of capital for the company. The use of market values a. recognizes the current investor attitudes regarding the company’s risk position and will reflect current rates for capital. b. recognizes better the capital proportions the company must consider in the capital sources decision; and c. ignores the influence of past values which are not relevant to future decision. [Problem 13] 1. The board member’s agreement is incorrect because the facts seem to indicate that Kia Corporation’s capitalization is not in optimum mix (i.e., equilibrium). The issuance of new debt will increase the financial leverage of the firm, increases the risk, increases the note’s nominal rate, and decreases the earnings multiple. While the marginal cost of capital is a combination of explicit interest cost on the notes and the additional cost of earnings that must occur to compensate the common stockholders for the decline in the earnings multiple. The 14% return in this project should be compared with the new weighted average cost of capital if the issuance of note is undertaken.

2. New level of annual earnings of the earnings multiple declines to 9 =? 1.

Present market price per share = 10(P2.70) = P27.00 Required EPS (new) = P27/9 = P3.00 Required earnings before tax (P3.00 x 10,000,000 shares / 50%) P 60,000,000 Interest expense [(P10 M x 8%) + (P50M x 10%)] 5,800,000 Required earnings before interest and taxes 65,800,000 Less: Old earnings before interest and taxes {[(P2.70 x 10,000,000 shares) / 50%] + P800,000} 54,800,000 Additional earnings before interest and taxes P 11,000,000

Additional informational analysis: If the earnings multiple declines to 9, the additional earnings provided by the new assets to maintain the same market price per share of P27 shall be: X = additional earnings (new P/E) (new EPS) = P27 9 ( P2.70 + X) = P27 2.70 + X = P3 X = P0.30 [Problem14] 1. Breaks = ? Breaks or increases in weighted marginal cost of capital will recur as follows: For Debt = Debt / Debt Ratio = P100,000 / 40% = P250,000 For Equity = Equity / Equity Ratio = P150,000 / 60% = P350,000 2. WACOC = ? a. Before the break (P1 – P250,000 amount of financing) i. Debt = 7% x 40% = 3.2% ii. Equity = 18% x 60% = 10.8% iii. WACOC 14.0% b. After the break (P250,001 – above amount of financing) Debt = 10% x 40% = 4.0% Equity = 22% x 60% = 13.2% WACOC 17.2% 3. Graph of marginal cost of capital (MCC) schedule and investment opportunities schedule (IOC): 26

24 22 20 18 16 14 12 10 8 6 4 2

IRR ( ) MCC (------)

A B

MCC

C

0 100

200 225 300

400 450 500 (new financing, thousands of pesos)

4. Projects are to be accepted as long as the IRR is greater than the MCC. Projects A and B are acceptable; based on the following: Project A B C

IRR 19% 15% 12%

MCC 14% 14% 17.20%

Advise Accept Accept Reject

[Problem15] 1. EPS and market price per share = ? a. Raise P100,000 by issuing 10-year, 12% bonds Case 1 Sales P 400,000 - Costs and operating expenses (90%) 360,000 EBIT 40,000 -Interest charges [P2,000 + (12% x P100,000)] 14,000 IBIT 26,000 - Tax (50%) 13,000 Net Income P 13,000 Earnings per share (NI / 10,000 shares) Price / earnings rates Market price per share

P1.30 10x P13

Case 2 P 600,000 540,000 60,000

Case 3 P 800,000 720,000 80,000

14,000 46,000 23,000 23,000

14,000 66,000 33,000 33,000

P

P2.30 10x P23

P

P3.30 10x P33

EPS (old) = P36 / 12 = No. of shares = P30,000 / P3 = b.

3 10,000 sh

Raise P100,000 by issuing new column stock Sales - Costs and D Exp (90%) EBIT -Interest expense IBIT - Tax (50%) Net Income Earnings per share (NI / 13,000Shares) Price / earnings rates Market price per share No. of shares (P100,000 / P33.33 + 10,000)

Case 1 P 400,000 360,000 40,000 2,000 38,000 19,000 P 19,000

Case 2 P 600,000 540,000 60,000 2,000 58,000 29,000 P 29,000

Case 3 P 800,000 720,000 80,000 2,000 78,000 39,000 P 39,000

P1.46 12x P17.52

P2.23 12x P26.76

P3.00 12x P36

13,000

13,000

13,000

2. Recommended proposal = ? The recommendation shall be based on the following criteria: Wealth Maximization Profit Maximization  Brief desorption of  Wealth maximization is  Profit maximization the criteria primordial among is a short-run strategy shareholders in as much to satisfy the interest as this is the end of shareholders. This maximization objective of business. profit is .best This wealth maximization strategy principle is represented represented by the by the market price per earnings per share. share.  The proposal chosen  The total sales of the firm should be higher than P600,000, since its sales last year was already at P600,000. At this level and more, the market price per share is higher by issuing a new share of stock. Wealth maximization is a

strategic reason of managing a business, hence, at guides organization in its longterm decisions, such as financing decision. 3.

No, the financing package chosen would be the same. The higher the level of sales in excess of P600,000, the more favorable it is on the part of the business!

4.

The investment banker would rationalize that issuance of more debt securities would mean a greater variability in earnings and higher risk of bankruptcy created by the fixed commitment to pay debt interest and principal. This would bring restrain by diminishing the earnings multiple to compensate the increased risk in leverage.

[Problem 16] 1. Sales P600,000 Out-of-pocket costs ( 450,000) Depreciation expense (P500,000/5) ( 100,000) IBIT 50,000 Tax (40%) ( 20,000) Net income 30,000 Depreciation expense 100,000 Annual cash inflows P130,000 Payback period = P500,000 / P130,000 =

3.85 yrs

2. 3. 4.

25.97% 6% 12%

Payback reciprocal ARR (original) ARR (average)

= 1 / 3.85 = P30,000/P500,000 = [P30,000 / (P500,000/2)[

= = =

[Problem 17]

Year 1 2 3 4

Annual Cash Income, Net of Tax P 70,000 90,000 85,000 160,000

Cash to Date P 70,000 160,000 245,000 400,000

Payback Period 1 1 1 0.97

(155,000/160,000)

Total

3.97

yrs.

[Problem 18] Year 1 2 3 4

Net Cash Cash to Inflows Date P300,000 P300,000 400,000 700,000 200,000 900,000 150,000 1,000,000

Salvage Total Value Cash P200,000 P500,000 100,00 800,000 50,000 950,000 20,000 1,000,000

Total

Payback Period 1 1 1 0.53 3.53

[Problem 19] 1. Cash flows before tax Depreciation expense (P1,000,000/ 10) IBIT Tax (40%) Net income 2.

(100,000 - 20,000 150,000 yrs.

P200,000 ( 100,000) 100,000 ( 40,000) P 60,000

ARR (original) = P60,000 / P1 million = ARR (average) = [P60,000 / (P1 million/2)] =

6% 12%

[Problem 20] 1. Sales P4,000,000 Out-of-pocket costs ( 3,100,000) Depreciation expense [(P2M x 80%)/5] ( 320,000) IBIT 580,000 Tax (40%) ( 232,000) Net income 348,000 Add: Depreciation expense 320,000 Annual net cash inflows P 668,000 Payback period = P 2 million / P668,000 = 2.99 yrs. 2. Payback reciprocal = 1 / 2.99 = 33.44% 3. Payback bailout period = [(P4 4M x 80%) / P668,000] = 4.79 yrs. 4. ARR (original) = P348,000 / P4 M = 8.7% 5. ARR (average) = [(P348,000 / (P4 M + P800,000) / 2] = 14.5% [Problem 21] 1. Cash flows before tax - Tax [(P15,000 – P5,000) 40%]

P15,000 4,000

Cash flows after tax Payback period (P40,000 / P11,000) 2.

P11,000 3.64 yrs.

Cash flows after tax P11,000 Less: Depreciation expense 5,000 Net income P 6,000 ARR (original) = P6,000 / P40,000 = 15%

[Problem 22] 1. PVCI: Annual cash inflows (P300,000 x 3.127) P938,100 Salvage value (P20,000 x 0.437) 8,740 P946,840 Less: COI 800,000 Net present value P146,840 2. Profitability index = P946,840 / P800,000 = 1.184 3. NPV index = P146,840 / P800,000 = 0.184 [Problem 23] 1. Year 1 2 3 4 5 SV

2. 3.

Annual Cash PVF at 12% PVCI Inflows P350,000 0.893 P312,550 250,000 0.797 199,250 150,000 0.712 106,800 100,000 0.636 63,600 50,000 0.567 28,350 30,000 0.567 17,010 Total 727,560 Less: Cost of investment 600,000 Net present value P 127,560

Profitability index = (P727,560/P600,000) = 1.21 NPV index = P127,560 / P600,000 = 0.21

[Problem 24]

PVF at Year 14% Proj. 1 Proj. 2 Proj. 3 1 0.877 P2,104,800 P4,823,500 P175,400 2 0.769 1,691,800 1,999,400 461,400 3 0.675 1,215,000 472,500 675,000 4 0.592 651,200 118,400 473,600 SV 0.592 118,400 118,400 47,360 Total PVCI P5,781,200 P7,532,200 P1,832,760 COI P5,000,000 P8,000,000 P1,400,000 Profitability index 1.16 0.94 1.31 The company should make investments on the following projects: Rank 1 Proj. 3 P 1,400,000 Rank 2 Proj. 1 5,000,000 Total investment P 6,400,000

[Problem25] 1.

Annual cash inflows: (P500,000 x 3.889) (P400,000 x 3.889) Salvage value (P100,000 x 0.456) Recovery of working capital (P200,000 x 0.456) (P1,400,000 x 0.456) Total PV of cash inflows Less: COI (P1,400,000 + P200,000) (P200,000 + P1,400,000) Net present value

2. 3.

Profitability index (PVCI / COI)

Produce Wooden Toy

Distribute an Imported Product

P 1,944,500 P

1,555,600

45,600 91,200 638,400 2,194,000

2,081,300 1,600,000 P

481,300

1.30

P

1,600,000 594,000

1.37

The net advantage of investing in distributing an imported product is P112,700 (i.e., P534,000 – P481,300).

{Problem 26] Year 1 2 3 4

Project X Project Y Cash to Cash to PVFC 14% PVCI PVCI Date Date 0.887 P 1,754,000 P 1,754,000 P 3,069,500 P 3,069,500 0.769 1,538,000 3,292,000 1,922,500 4,992,000 0.675 1,350,000 4,642,000 1,012,500 5,000,000 0.592 1,184,000 5,000,000

Payback period – Proj X Payback period – Proj Y

[3 yrs. + (P358,000/P1,184,000)] 3.30 yrs. [2 yrs. + (P8,000/P1,012,500)] 2.01 yrs.

[Problem 27] a. PVF Annuity =

b.

P520,000 = 2.6 P200,000 Using Table 2 (PVFA Table), the IRR is computed as follows: 18%

2.690

?

2.600

0.090 2%

0.102 0.012

20% IRR

=

18%

[Problem 28] a. PVF Annuity =

2.588 +

0.090 x 2% 0.102

P800,000 P234,000 *

= 19.75%

= 3.419

* (P234,000 = [(Total cash inflows + SV)  5] b.

Using Table 2, the PVF of 3.419 is between 14% and 16%

b.1.

Using 16% and 18% discount rates we have: PVCI @ 16%

Year 1 2 3 4 5

Cash Inflows P

350,000 300,000 250,000 150,000 80,000

PVF 0.862 P 0.743 0.641 0.552 0.476

Amount 301,700 222,900 160,250 82,800 38,080

PVCI @ 18% PVF 0.847 P 0.718 0.609 0.516 0.437

Amount 296,450 215,400 152,250 77,400 34,960

SV Totals

b.2.

40,000

0.476

19,040 824,770

P

0.437 P

17,480 793,940

Since the cost of investment of P800,000 is found the present value of cash inflows (PVCI) of 16% and 18%, then by interpolation, the IRR, could be determined as: Discount rate 16%

PVCI P824,770

?

800,000

24,770 2%

30,830 6,060

18% IRR

=

16%

793,940 +

24,770 x 2% 30,830

= 17.61%

[Problem 29] 1. PV of cash dividends (1,400 shares x P20 x 3.791) PV of stock sales (P200,000 x 0.621) PV of the shares of stock Less: Cost of t...