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ATCF (840,000 3.326)252,555

Net income (252,555 140,000)112,555
Before-tax income (112,555 0.60) 187,592
Before-tax savings (187,592 + 140,000)327.592
The computation of after-tax cash flows, given the amount of investment and internal rate of return or PV of
annuity of 1 discounted at IRR is the reverse of the computation of payback period. Remember that the
payback method, though a nondiscounted technique, is closely related to internal rate of return because the
payback period is exactly the present value of annuity of 1 if they are discounted using the internal rate of
return.

Annual savings on expenses P50,000

Less: Additional depreciation (40,000 25,000) 15,000

Additional tax (35,000 x 40%) P14,000

Additional depreciation can be easily calculated by subtracting the book value of the old machine from the
cost of new machine and then the difference divided by the useful life (160,000 100,000) 4 = 15,000.

Year SYD Straight Line Difference Present Value

1 2,000,000 1,200,000 800,000 727,280
2 1,600,000 1,200,000 400,000 330,560
3 1,200,000 1,200,000 - 0
4 800,000 1,200,000 (400,000) (273,200)
5 400,000 1,200,000 (800,000) (496,720)
Total present value of difference in depreciation 287,920
Tax Rate 40%
Present value of net advantage 115,168

2 120,000 90,000 30,000 23,916

3 90,000 90,000 - 0

Present value of net advantage 9,749

SYD method provides a higher present value on tax benefits because of less amount of tax during year 1 & 2.
In year 4 and 5, the use of SYD requires higher taxes but their equivalent present values are lower already.

Simple Rate of Return: 54,000 432,000 12.5 %

The useful life of the project can be calculated by using the computational pattern for Accounting Rate of
Return:

CFAT 20,000

ARR = Average annual net income Average Investment

Annual after-tax cash flow 40,000

Divide by Average Investment (200,000 + 180,000)/2 190,000

ARR: 10.5%

The problem asked for the average accounting rate of return for the first year of assets life.

The average (accounting) rate of return is determined by dividing the annual after-tax net income by the
average cost of the investment, (beginning book value + ending book value)/2.

(ATCF Depreciation) Initial investment = Accounting Rate of Return

Let X = Initial investment
(66,000 0.10X) X = 0.12
66,000 - .10X = .12X
.22X = 66,000
X = 300,000

.22 X = 66,000

X = 300,000

ATCF 77,000

Divide by cash flow after tax 90,000

Payback period 3.78 years

Cash Inflow Unrecovered Outflow

Outflows (4,500,000)
First year 900,000 (3,600,000)
Second year 1,200,000 (2,400,000)
Third year 1,500,000 ( 900,000)
Fourth year 900,000 0

Payback Period: At the end of 4 periods, the initial outflows are fully recovered.
Note to the CPA Candidates: A modified question for this problem is to compute the Present Value of the net

Cash inflows Investment

Period 0 (99,300)

At the end of the third year, investment is fully recovered.

The net investment of 99,300 is net of tax benefit, (165,500 x .6)

Payback period: 300,000 75,000 4 years

There are two cash flows at time zero: P120,000 outflow and P14,000 inflow.
Net cash outflow (120,000 14,000) = 106,000

CFAT 88,750

PV of After-tax Salvage Value: 20,000 x 0.70 x 0.54 7,560

Total 517,606

Investment 500,000

Net Present Value 17,606

The problem assumed that the salvage value is ignored in the computation of annual depreciation so that the
annual cash flows will be greater. The problem did not include among the choices the assumption that salvage
value will be deducted from the cost in computing the amount of annual depreciation.

Less Depreciation (1M 5) 200,000

Income before tax 95,200

ATCF 257,120

PV of ATCF, n=5; k=10% 257,120 x 3.7908 974,690

Investment 1,000,000

Negative Net Present Value ( 25,310)

The manner of financing the project is not considered in the analysis of capital investment. Investment must
be separate from financing. It is a normally committed error in the application of capital budgeting
techniques where financing strategy is considered. The explicit or implicit cost of financing the project is
taken care of the discounting process.

Net present value 37,064

Note: Because the constant growth rate and the discount rate are both 10%, the present value for each period
is constant.

Present value of Salvage Value (25,000 x 0.56743) 14,186

Total 203,436

Investment 175,000

Present value of ATCF (68,800 x 3.23972) 222,893

Investment 207,200

Period Nominal Cash Savings PV Factor Present Value

1 32,000 0.87790 28,070.08
2 32,000 x 1.05 33,600 0.76947 25,854.19
3 32,000 x 1.052 35,280 0.67497 23,812.94
4 32,000 x 1.053 37,044 0.59208 21,933.01
Total 99,670.22
Investment 80,000.00
NPV 19,670.22
Note that all the annual cash inflows are adjusted by one period.

Present value of salvage value (7,000 x 0.41044) ( 2,873)

Total P494,562

Present Value of Annual cash outlay
CFAT (300,000 x P0.29) + P11,000 = P98,000

Investment in new machine (120,000 40,000) 80,000

Total P432,891

The purpose of profitability index is to compare two projects profitability by reducing the present value per 1
peso of investment. Therefore, the ratio of 4.35526 @ 10% to 4.11141 @ 12% indicated the profitability index.

In discounting the annual cash inflow by the IRR, the NPV = P0

The net present value of ZERO is 14% and 16%. For better time management, the candidate is expected not
to do detailed calculation of finding out the exact rate.

The use of interpolation indicated that the IRR is 15.3%:

Discount Rate Net Present Value
0.14 1,197
IRR 0
0.16 -708

(0.14 IRR) (0.14 0.16) = 1,197 ( 1,197 + 708)

(0.14 IRR) -.02 = 1,197 1905
(0.14 IRR) - .02 = 0.628
(0.14 IRR) = 0.628 x -0.02
0.14 IRR = 0. 013
IRR = 0.153 or 15.30%
Note: Since at the IRR, NPV is zero, the answer can only be between 14% & 16%, since only one of the choices,
satisfy the criteria, the answer is (D).

The payback period that corresponds to the projects internal rate of return of 12 percent is 4.968. Therefore,
the amount of investment must equal the product of the payback period and the net cash flows:

The amount of investment: the PV of annuity at IRR

4.355 x 6,000 = 26,130

ATCF: P1,500,000/3.60472 416,121

Depreciation 300,000

Selling price per unit P94.68

Alternative Solution:

Cash inflow before tax based on present price: (20,000 x 40) 200,000 600,000

Present value of ATCF (480,000 x 3.60478) 1,730,294

Investment 1,500,000

Income before tax 38,492/0.6 64,154

Depreciation 50,000

1,750 = 2.4771CF 2.4018CF

1,750 = 0.1753CF

CF = 9,980

Investment 120,000

Investment 81,000 x 4.344 351,864

Difference 23,895

After-tax cash flow, third year 16,392/0.712 23,022

The net present value = PV of excess salvage value less PV of decrease in after-tax cash flow

7,003 = 0.56743X 0.2883824X

7,003 = 0.2790476X

X = 25,096

Cost of equipment 750,000

Less PV of tangible benefits 100,000 x 5.01877 501,877

Amount of annual intangible benefits 248,123/5.01877 49,440

To be acceptable, the project should yield a net present value of zero. The negative net present value must be
offset by the present value of annual intangible benefits.

Annual net intangible benefits P30,000

The indifference rate (crossover or fisher rate) refers to the rate at which the net present values of the 2
alternatives are indifferent or equal.

The easier test of the rate is to look for IRR (using trial and error technique) of the investment difference.

PV inflows (15,200 1.1264)10-6 (22,303)

Difference NIL
Alternative Solution:
Project X Project Y
PV of after-tax cash flows
(12,000 1.1264)6 48,455
(15,200 1.1264)10 83,680
Investment 48,000 83,225
Net Present Value 455 455

The determination of the indifference point, which is 10%, for the two projects can be made through the use of
trial and error estimation.
Machine 1 Machine 2

PV of Difference in ATCF

NPV NIL NIL

15% Discount Rate

Machine 1 Machine 2

PV of Difference in ATCF

Year 2 110,000 x 0.75614 ( 83,175.40) 83,175.40

Net difference 51,607.95 ( 51,607.95)

At 15 percent discount rate, Machine 1 is more acceptable.

8% Discount Rate

Machine 1 Machine 2

PV of Difference in ATCF

At 8 percent discount rate, Machine 2 is more acceptable.

Cost of Investment:

Total P1,274,743

Capital investment 975,000

Net present value P 299,743

Annual excess present value (1,028,000 2.9287) P351,000

Excess cash before tax (351,000 0.6) P585,000

Accounting rate of return 18%

Accounting rate of return or unadjusted rate of return computes the profitability of the project in term of
accrual profit. Net profit under accrual method considers depreciation, a substantial amount that understates
the average profit. This understatement of amount that is used in the computation necessarily requires that
preferably, average investment should be used, instead of the initial investment, in the determination of
accounting rate of return.

Cash Flow PV Factor PV of annual net cash flows:
180,000 0.909 163,620
120,000 0.826 99,120
100,000 0.751 75,100
90,000 0.683 61,470
90,000 0.621 55,890
Total 455,200
Amount of investment 400,000
Net Present Value 55,200

Present Value of ATCF Net Investment (455,200 400,000) = 1.14

The present value index computes net present value in terms of P1 investment. Therefore, the index of 1.14
means the net present value per P1 of investment is P0.14. This concept makes the present value index better
than the net present value technique because the index indicates which one is the most profitable on a per P1
investment.

Cash Inflow Unrecovered Investment

Period 0 Outflows (400,000)
Period 1 180,000 (220,000)
Period 2 120,000 (100,000)
Period 3 100,000 Zero

The total outflows are fully recovered by the end of period 3.

The analyst should be careful in computing the payback period when the project has uneven cash inflows. The
common error in handling uneven cash flows is using the average cash flows instead of reducing the
unrecovered outflows.

Present value of Net Cash Inflow (71,000 X 4.355) 309,205

Investment 300,000

(10,000 100,000) = 10 percent

The payback for PA is 4.225. This is closest to the present value of annuity of 1 discounted at 11 percent for 6
periods which is 4.231.

After-tax cash inflow P 8,875

A quicker calculation of after tax cash flow can be made by adding the tax shield to after-tax cash inflow
without any tax benefit on depreciation.

Present value of after-tax salvage value (P1,400 x 0.54) 756

Total 51,756

Investment 50,000

Net present value P 1,756

At the discount rate of 8 percent, there is a net present value of P1,756. Therefore, the IRR is higher than 8
percent.

Using trial and error approach, the first try should use 9 percent. If the present value of the inflows exceeds
P50,000, then the IRR is lower than 9 percent, otherwise it should be 9.5 percent.

Using 9.0 percent in discounting the inflows, there is a net present value of P(174); therefore the IRR is slightly
lower than but very close to 9.0 percent.

Total 201,000

Rent 18,000

Salaries 54,000

Utilities 13,200

Total 145,000

Rent 48,000

Salaries 17,000

Utilities 5,400

PV of annual cash inflow (108,000 x 5.575) 602,100

PV of salvage value (70,000 x 0.108) 3,240
PV of working capital return (7,500 x 0.108) 810
Total 606,150
Investment:
Remodeling cost 550,000
Working capital 7,500 557,500
Net Present Value 48,650

PV of annual cash inflow (65,000 x 5.575) 362,375

PV of salvage value 1,296
PV of working capital return 432
Total 364,103
Investment:
Remodeling cost 290,000
Working capital 4,000 294,000
Net Present Value 70,103

Total 118,000

Annual cash inflow 38,000

PV of annual cash inflow (38,000 x 5,575) 211,850

PV of working capital return 432

Total 213,578

Investment 294,000

Negative Net Present Value ( 80,422)

The annual cost of advertising can be easily calculated by dividing the net present value of alternative 2, at
16% by the present value of annuity of 1.

Fixed expenses

Salaries 110,000

Utilities 5,200

Simple Rate of Return = Net Income Initial Investment

52,500 420,000 = 12.50 %

Savings 56,250
Less Depreciation 234000 13 years 18,000
Annual income 38,250
Simple Annual Return 38,250 225,000 17 %

Payback period = Initial Investment Annual Cash Inflow

420,000 84,000 = 5 years

Total 2,560,000

Cost to make:

Variable overhead 80,000 x 1.50 120,000

Decrease in directs labor and variable costs 80,000 x 1.60 (128,000) 664,000

Cost savings 936,000

PV of annual depreciation

Period Depreciation PV Factor Present Value

Year 1 832,500 0.89286 743,305.95
2 112,500 0.79719 886,873.88
3 370,000 0.71178 263,358.60
4 185,000 0.63552 117,571.20
Total 2,011,109.63
Tax rate 0.30
PV of tax benefits from depreciation 603,332.89

PV of after tax salvage value 44,486

PV of working capital return 60,000 x 0.63552 38,131

Investment (2528,500)
Net present value 147,522

Freight 11,000

Total 960,000

Total 5,465,000

Total P20.00

Year Depreciation Tax Shield (40%) PV Factor PV of Tax Shield

2007 P319,968 P127,987 0.893 P114,292

Total P308,920

Purchase Cost

Year ATCF

Total 4,243,500

CFBT CFAT PV Factor PVCFAT

2006 Initial outflow (P956,600)
2007 (50,000 x 20) + 45,000 1,045,00
(1,045,000 x 0.6) - (319,968 x 0.4) 0 499,013 0.893 445,619
2008 (1,045,000 x 0.6) (426,720 x 0.4) 456,312 0.797 363,681
2009 (52,000 x 20) + 45,000 1,085,00
(1,085,000 x 0.6) (142,176 x 0.4) 0 594.130 0.712 423,021

2010 (55,000 x 20) + 45,000 1,145,00

(1,145,000 x 0.6) (71,136) 0 658,546 0.636 418,835
2011 (55,000 x 20) + 45,000 1,145,00
(1,145,000 x 0.6) 0 687,000 0.567 385,447
Salvage value (12,000 x 0.6) 7,200
P2,993,203