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**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 26-1

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

Issue C/S for the balance P6.500.000 P3.360.000 P5. Total Assets: Total assets.000 P30. INC.000.000 P13. Rate of Return on Total Assets: Alternative I Alternative II Alternative III P13.500.02% (2) Earnings per Share: Alternative I = P2.000 / 3.000 15.000 P2.76% 10.000 C.000 400.360. Net Income after taxes: Income before interest and income taxes Less: Interest expense Alt.240. III Pay P1M Borrow P5M at 8%. I Borrow P15M at 10% Interest A.000.125.08.000.000 2.600.360.000 shares = Alternative II = P3.000 Add (Deduct) Additional Investment 15.000 3.000 P6. II Issue P15M Common Stock ALT.000 1.700.PFS: Financial Aspect . P1.000 B.000 Assets provided by profitable operations 2.600.Project Financing and Evaluation Chapter 26 4.35% 11.) (1) ALT.000 / 3.000 2.800.000 1.500. I (P15M x 10%) Alt. Accounting rate of return II.08.125. P1.400.000 shares = P1.725.000.000 8.000 3.000 / 2. Problems PROBLEM 1 (MAMARIL BROTHERS.000 P3.600.000.485.000 shares = Alternative III = P3. II (P5M x 8%) Income before income taxes Less: Income taxes (10%) Income after taxes ALT.000 P4.500.000.03. 12/31/2005 P13. 26-3 .000.600.100.000 P6.000 P6.700.125.000 P31.000 14.825.700.000 Total assets. 12/31/2006 P30.

... pay P1.. the project is acceptable since it has a positive net present value.... This alternative would not dilute the earnings per share of the company..........000 Year(s) Cash Flows Factor Cash Flows Now 1-8 P(1..... that is..... Furthermore...........000 1.... the company will not be too highly levered..600.......000 immediately..........000 Yes....000..............039........000 4..000 at 8% interest and issue 600...........000 P 439.....000 Investment Net annual cash inflow 2......... thereby minimizing the risk involved in the new issuance..............600....800... it would seem that Alternative III..000 500.......... is the best........000) 1. 200..Project Financing and Evaluation (3) Based on the above computations.. salaries and other fixed out-of-pocket costs.. Less advertising... PROBLEM 2 (MAHARLIKA COMPANY) 1..000 shares of stock..... The net annual cash inflow can be computed by deducting the cash expenses from sales: Sales..200..000) 2.. Contribution margin.... P3....Chapter 26 PFS: Financial Aspect ..required P500......600.......000 Or it can be computed by adding depreciation back to net income: Net income. P300.000 1.......078 P(1...... P1..............000 Add: Noncash deduction for depreciation .........000 Net annual cash inflow ...... borrow P5. Net present value ..000 700.......000 P 500......000.....000......000 18% Present Value of Amount of P500.. Net annual cash inflow .... 3...... The formula for computing the factor of the internal rate of return is: Factor of the internal rate of return = = 26-4 3..200 ................. Net annual cash inflow ...... Less variable expenses... The net present value can be computed as follows: Items Cost of new equipment.

= Arrears Investment required and scanning along the 8-period line.PFS: Financial Aspect .. To represents a rate= return somewhere between 26% andcash inflowfind of Initial investment the rate we are after.....000 P500..000 26% factor .041 Internal rate of return = = 26% + 26.200 revenues including depreciation Net annual 28%.......000 P300....041 0........ The formula for the payback period is: Payback period = 0......5% x 2% 4..... the project is not acceptable when measured by the payback method.. The 3.000 True factor ...165 = = 3.Project Financing and Evaluation Chapter 26 Looking at the Table Incremental – Value of an Annuity of P1 inNet of the Present Incremental expenses... 0.... The formula for the simple rate of return is: Simple rate of return = 26-5 ... 3....2 years No.600..076 28% factor .... 5.........600...241 P1.200 3...165 Difference.. 3...241 3. 0...2 years payback period is longer than the maximum 2 ½ years set by the company..... we find that a factor income of 3..... we must interpolate as follows: P1.....

... Notice....494 shown in (3) above.............000 96.) 1.000 P285... Using this cost savings figure.300) 40.000 1... Net annual cost savings..250 x 12)...370 0. 6 Salvage of the new machine .......... the net present value analysis is: Items Year(s) Cost of machine .... P(192...... however................000) (650.........000 285...........000 4..000 336.75% return promised by the project is greater than the company’s 18% cost of capital......110 P(192..Project Financing and Evaluation = 18. which is 26...400) No. 1-10 Overhaul required..... It has a negative net present value at an 18 percent discount rate....... the project is acceptable when measured by the simple rate of return...................000) (650..000 51.........000 (90......280....191 Present Value of Cash Flows P(900... and other data provided in the text..... INC....790 (33. Now Installation and software..... Now Annual cost savings ..... Less increased maintenance costs (P4... Total cost reductions................ The net annual cost savings is computed as follows: Reduction in labor costs .... the etching machine should not be purchased... The peso value per year that would be required for the intangible benefits would be: = P42...... 10 Net present value .... Reduction in material costs .Chapter 26 PFS: Financial Aspect .... 3..400) return greatly understates the true rate of return.. PROBLEM 3 (TIGER COMPUTERS..... Now Salvage of the old machine.............75% Yes...000 1..000 18% Factor 1.5% as Factor for 10 Years 4....494 0.... that the simple rate of Net Present Value........000) 70.....000) 70...000 1.813 26-6 ................. P240..000 2...000) 210.... Amount of Cash Flows P(900..... The 18........

........50 1...........000 units will have to be sold..000 units ...... The contribution margin per unit on the first 30.......................... P15............................ more than 30.. the total amount of contribution margin generated would be: 30.....000 Since the fixed costs on the first 30........... PROBLEM 4 (NOVA.........000 contribution margin above is not enough to permit the company to break even......................... P15.... Less variable expenses ...000 units.. Contribution margin.. Therefore....75 P0..000 units ....PFS: Financial Aspect ..........000 The additional sales of units required to cover these fixed costs would be: = 26-7 20...813 per year to the company.000 Remaining uncovered fixed costs .... 2................90 = P27............ INC.......... P Per Unit P2. 27...000...............................50 1.. 13.......075 Sales price ......000 units total P40..... in order to break even..000 units is: Total remaining fixed costs..........000 Unit contribution margin on added units.........000 units sold.Project Financing and Evaluation Chapter 26 Thus... if management believes that the intangible benefits are worth at least P42....75 Sales price .......................000 units x P0.............) 1... Contribution margin.............................000 Add monthly rental cost of the additional space needed to produce more than 30....... P...90 The contribution margin per unit on anything over 30... Less variable expenses ........000 Less contribution margin from the first 30..000 Total fixed costs to be covered by remaining sales. The fixed costs that will have to be covered by the additional sales are: Fixed costs on the first 30...............000 units ......... the P27.........60 P0.... for the first 30.......... P Thus. P40.000 units is: Per Unit P2..... then the new etching machine should be purchased.............

= 17.500 Thus.000 in total sales.000 units (30. P10. would equal total sales of 67.000 units x P2.500 units above the break-even point in order to earn a profit of P10. P0.000) = P10.15 per unit is paid for each unit sold in excess of the break-even point.75 The desired monthly profit would be: 25% x (P40.50 = P125.000 unit. Desired profit.000 units required to break even.000 units above the break-even point in order to earn a profit of P9.000) must be sold in order Unit contribution margin. This number of units would equal total sales of: 50.Chapter 26 PFS: Financial Aspect .60 for the company to break even. If a bonus of P0.60 perP9. the company must sell 17.000 + P2.000 each month. would equal total sales of 62.000 + 20. = 12. These units. added to the 50. These units. a total of 50. PROBLEM 5 (BILLY MADISON) 26-8 .500 Therefore. Unit contribution margin P0.500 units each month.500 each month. added to the 50.75 to only P0.000 units Thus.000 units required to break even. then the contribution margin on these units would drop from P0. 3.500 units Therefore.000 units each month to reach to target profit figure. 2. the company must sell 12.Project Financing and Evaluation Desired profit.

000 360.000 P 24.000 P100.000 Sales Less: Cost of Sales (60%) Gross Profit Less: Operating Expenses Operating Income Less: Interest Expense Net Income before taxes Less: Income taxes (40%) Net income (1) Mr.000 Optimistic P750.000 180.000 P 60.Project Financing and Evaluation Chapter 26 Projected Income Statement Pessimistic P600. (Income he would otherwise earn if he devotes his time to other ventures.000 P240.) 26-9 .000 40.000 20.000 180.000 20.000 / 500.000 level of sales = 60.8% b. at P750.000 level of sales = 24.048 or 4. at P600.12 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 P 40.000 450.000 P120.000.000 = .PFS: Financial Aspect .000 P300.000 = .000 P 60.000 / 500.000 16. (2) Rate of Return on Assets a. Madison should make the investment if he could be assured that the sales would amount to more than P600.

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