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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

Equity ratio 3. Debt ratio 2. Net present value 3. Debt to Equity ratio 4.Project Financing and Evaluation 6. 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. Cost/Benefit rate 2. Foreign currency financing should be used for foreign currency costs or for foreign currency-earnings projects 8. The assumptions that are usually made in a financial study relate to a) Quantity of goods to be sold. Measures of Solvency 1. Cash break-even point 3. 9. Accounting rate of return II. Current ratio 2. The following tests and ratios may be useful in the analysis of the financial projects: A. Problems 26-2 . Short-term financing should be utilized for short-term assets. Payback period B.Chapter 26 PFS: Financial Aspect . The sound financial practices to be followed in determining the source of financing to be availed of are: 1. Measures of Leverage 1. Times interest earned C. Lease of land. Measure of profitability 1. 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. building and equipment 7. long-term financing should be used for long-term assets 2. Discounted rate of return 4. Debt service break-even point 5.

600.125.000 P5.100.000.000 P30.000 15.000 P3. Furthermore.000 P13.02% P6.800. Net Income after taxes: Income before interest and income taxes Less: Interest expense Alt.360.000.000 P30.500. borrow P5.000 / 3.600. (3) Based on the above computations.125.000 2.000 P13.600.000 at 8% interest and issue 600.000 2.000 shares = Alternative II = P3. Rate of Return on Total Assets: Alternative I Alternative II Alternative III P6.700.000 (2) Earnings per Share: Alternative I = P2.000 8.000 P3.500.000 P2.000. it would seem that Alternative III.000 ALT.000 immediately.PFS: Financial Aspect .000 1.000 P4.000. II (P5M x 8%) Income before income taxes Less: Income taxes (10%) Income after taxes B.360.600.000 / 3.Project Financing and Evaluation Chapter 26 PROBLEM 1 (MAMARIL BROTHERS. pay P1. I (P15M x 10%) Alt.000 3. II Issue P15M Common Stock P6.35% 11. Total Assets: Total assets.) (1) ALT. that is.000 3.000.76% 10.360.000 ALT.000 400. is the best.825. 12/31/2006 C. This alternative would not dilute the earnings per share of the company.000 2.500.000.000 P31.000 14. the company 26-3 .000 shares of stock.240.08.000.000 15.700.500. III Pay P1M Borrow P5M at 8%.700.000 shares = P1.000 1.000. P1.725.000.000 / 2. INC.125.000 P13. P1.03. Issue C/S for the balance P6.485.000 shares = Alternative III = P3. 12/31/2005 Add (Deduct) Additional Investment Assets provided by profitable operations Total assets.400. I Borrow P15M at 10% Interest A.08.

.000) 1.200 represents a rate of return somewhere between 26% and 28%.....200 Looking at the Table of the Present Value of an Annuity of P1 in Arrears and scanning along the 8-period line............... PROBLEM 2 (MAHARLIKA COMPANY) 1.Chapter 26 PFS: Financial Aspect ....000 4........000 Yes.........................................600.. 2..078 2. Less variable expenses...............000) P(1. Net annual cash inflow....... The formula for computing the factor of the internal rate of return is: Factor of the internal rate of return = = 3......... P3... The net present value can be computed as follows: Items Cost of new equipment...200...000 1-8 500....000 700... Amount of 18% Present Value of Year(s) Cash Flows required Cash Flows Investment Factor Now Net annual cash inflow P(1.000 P300.600........ 3......... Net annual cash inflow............ we must interpolate as follows: 26-4 ..000 200...000 1.000 Or it can be computed by adding depreciation back to net income: Net income.. thereby minimizing the risk involved in the new issuance..000 has a positive net present value.600..000 1... Net annual cash inflow.......Project Financing and Evaluation will not be too highly levered............ Contribution margin.000. To find the rate we are after..........000 P 500... Less advertising............ salaries and other fixed out-of-pocket costs...................000 P1.......................800.. The net annual cash inflow can be computed by deducting the cash expenses from sales: Sales. Add: Noncash deduction for depreciation..............000 P500...000 P 439.....................039.. the project is acceptable since it P500..... we find that a factor of 3. Net present value.

2 years 0.... The formula for the simple rate of return is: Simple rate of return = = 18..200 Incremental expenses.....PFS: Financial Aspect ...2 years payback period is longer than the maximum 2 ½ years set by the company.5% as shown in (3) above... The formula for the payback period is: Payback period = = 3.600...241 3. Initial investment 3........ The 3....076 includingNet annual cash inflow depreciation income 0... that the simple rate of return greatly understates the true rate of return. = 5....600.75% return promised by the project is greater than the company’s 18% cost of capital...000 = 26..... the project is acceptable when measured by the simple rate of return... which is 26..241 3.000 + = 26% P1.....165 x 2% P1. 26-5 .. the project is not acceptable when measured by the payback method...000 Internal rate of returnP500... – revenues = Difference. The 18. however.........5% 4......041 0. True factor..000 P300.. Incremental 28% factor. required Investment = Net 3. Notice...Project Financing and Evaluation Chapter 26 26% factor.........165 No....041 0....75% Yes...

. Net annual cost savings........000 70........ Now Salvage of the old machine..... Less increased maintenance costs (P4..110 P(192...) 1. P(192.494 Total cost reductions..... P240. INC..250 x 12).000) 1.....191 40........ then the new etching machine should be purchased.. 10 Net present value....000 285.........000) 70.....000 units is: Sales price...400) Reduction in labor costs. Now Annual cost savings...........790 0... The net annual cost savings is computed as follows: Net Present Value......................300) 0............ the net present value analysis is: Items Year(s) Cost of machine....370 (33................. Using this cost savings figure..000 18% Present Value of Factor Cash Flows 1.000 (650....... INC..000) (650............ if management believes that the intangible benefits are worth at least P42...813 per year to the company.............50 .813 Thus..400) No.... 3..Project Financing and Evaluation PROBLEM 3 (TIGER COMPUTERS.. the etching machine should not be purchased... The peso value per year that would be required for the intangible benefits would be: = P42.... It has a negative net present value at an 18 percent discount rate............ Amount of Cash Flows P(900.............000 P(900........ 1-10 Overhaul required.. The contribution margin per unit on the first 30.000) 1....................... 26-6 Per Unit P2..) 1..000 51.. PROBLEM 4 (NOVA........... Factor for 10 Years 4.............. Reduction in material costs..........494 1...........000 (90..... and other data provided in the text........Chapter 26 PFS: Financial Aspect ....000 96..000 P285......280.........000) 210..............000 4........ 6 Salvage of the new machine. Now Installation and software.000 336.....000 2........

..........000 units sold...075 Contribution margin .PFS: Financial Aspect ...........................000 units total P40. Total remaining fixed costs.000 in total sales.. This number of units would equal total sales of: 50........................000 Since the fixed costs on the first 30..................... for the first 30..........................000 The additional sales of units required to cover these fixed costs would be: = 20........50 1. 27........ Contribution margin ...90 The contribution margin per unit on anything over 30. Unit contribution margin on added units...50 = P125.. 13......000 Add monthly rental cost of the additional space needed to produce more than 30...75 Thus.............. a total of 50.... P........000 units x P0.............................. the P27........000 units x P2.......... P40................................. ............75 P0..000 Less variable expenses............ The fixed costs that will have to be covered by the additional sales are: Fixed costs on the first 30.......................................... 2... more than 30..........60 P0.000 contribution margin above is not enough to permit the company to break even....000 units is: Sales price.....000 units Therefore............ Therefore................000 Total fixed costs to be covered by remaining sales.000 units............ P..............0 Per Unit P2........................................0 1...000 Remaining uncovered fixed costs........000 units...........Project Financing and Evaluation Chapter 26 Less variable expenses.. P15.000 units will have to be sold..000 Less contribution margin from the first 30..........000 units................ in order to break even........000...000 units (30...... P..000 + 20..... P15.......................... ..................................... the total amount of contribution margin generated would be: 30..000) must be sold in order for the company to break even............ 26-7 .................90 = P27...

Desired profit. the company must sell 17. would equal total sales of 62.000 P120.000 P 60. These units.60 per unit.Chapter 26 PFS: Financial Aspect .000 units each month to reach to target profit figure.000 P240.500 P0. added to the 50.000 360.000 units above the break-even point in order to earn a profit of P9.000 units required to break even.500 units each month.75 = 17.000 P0. then the contribution margin on these units would drop from P0. the company must sell 12.000 . The desired monthly profit would be: 25% x (P40. added to the 50. P10.000 each month. If a bonus of P0. 3.000 Optimistic P750.500 each month.75 to only P0.000) = P10. These units. contribution margin P9. would equal total sales of 67.000 + P2.000 180.000 180.60 = 12.15 per unit is paid for each unit sold in excess of the break-even point. PROBLEM 5 (BILLY MADISON) Projected Income Statement Sales Less: Cost of Sales (60%) Gross Profit Less: Operating Expenses Operating Income 26-8 Pessimistic P600.000 450. Unit contribution margin.000 units required to break even.500 Desired profit.500 units Therefore.Project Financing and Evaluation 2.000 units Thus. Unit Thus.500 units above the break-even point in order to earn a profit of P10.000 P300.

at P600. Madison should make the investment if he could be assured that the sales would amount to more than P600.000 / 500.12 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.000 16. at P750.000 (1) Mr.048 or 4.Project Financing and Evaluation Chapter 26 Less: Interest Expense Net Income before taxes Less: Income taxes (40%) Net income 20. (2) Rate of Return on Assets a.000 20.8% b.000 level of sales = 24.000 P 24.000 = .) 26-9 .000 P100.000.000 P 60. (Income he would otherwise earn if he devotes his time to other ventures.000 P 40.PFS: Financial Aspect .000 40.000 / 500.000 = .000 level of sales = 60.