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# PROBLEM SOLUTIONS

Initial amount of investment 160,000
Less Cash inflow (decrease in outflow) at period 0:
MV of old equipment 80,000
Tax benefits on loss on sales (20,000 x .4) 8,000 88,000
Net investment 72,000

ATCF = Net investment ÷ Payback period
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 taxable income 35,000
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

SYD SL Difference Present Value
1 150,000 90,000 60,000 53,568
2 120,000 90,000 30,000 23,916
3 90,000 90,000 - 0
4 60,000 90,000 (30,000) (19,066)
5 30,000 90,000 (60,000) (34,046)
Total of present values of depreciation 24,372
Tax rate 40%
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.

Annual cost savings 90,000
Less depreciation (432,000 ÷ 12) 36,000
Annual income 54,000
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:
Net investment 106,700
Divide by Depreciation expense
CFAT 20,000
Less: Net income (106,700 x 5%) 14,665 5,335
Average life (in years) 7.28
* 10% ARR based on average investment = 5% ARR based on initial investment

ARR = Average annual net income ÷ Average Investment
Annual after-tax cash flow 40,000
Less Depreciation 20,000
Net Income 20,000
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 asset’s 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.
After tax income (P7,200 - (P7,200 x 30%)) P 5,040
Average investment: (P66,000 + 16,000) ÷ 2 P41,000
Accounting rate of return: P5,040/P41,000) 12.3%

(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

Net Income: = 66,000 - .10X
AAR = NI/ Investment
.12 = (66,000 - .10X) / X
.12X = 66,000 - .10X
.22 X = 66,000
X = 300,000

Net Income (280,000 x 15%) 42,000
Add back depreciation 35,000
ATCF 77,000

Payback period = Initial amount of investment ÷ Annual after-tax cash flows
P35,000 ÷ P5,000 = 7 years

Net investment 50,000
Divide by CFAT (10,000 x 0.7) ÷ (50,000 ÷ 8 x 0.3) 8,875
Payback period 5.6 years

Cumulative cash flows end of Year 1 (450,000) – 254,520 (195,480)
Discounted cash flow for Year 2 173,460
Cumulative cash flows, end of Year 2 ( 22,020)
Break-even time 2 + (22,020 ÷ 105,140) 2.21 years

Cost of the new machine 400,000
Salvage value of old machine at period zero 60,000
Net investment (Outflows) 340,000
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
advantage of using sum-of-the-years’ digits of depreciation instead of straight-line method.

Cash inflows Investment
Period 0 (99,300)
Period 1 (75,000 – 25,000) x .6 30,000 (69,300)
Period 2 ( 30,000 x 1.10) 33,000 (36,300)
Period 3 (33,000 x 1.10) 36,300 -0-
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)

Before-tax cash flow = 40,000 + 35,000 75,000
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

Computation of Cash Flow After-tax
CFBT 100,000 x 0.7 70,000
Depreciation tax shield 62,500 x 0.3 18,750
CFAT 88,750
Computation of Net Present Value:
PV of ATCF: 88,750 x 5.747 510,046
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.

Annual revenues 400,000
Less cash operating costs 104,800
Cash flow before tax 295,200
Less Depreciation (1M ÷ 5) 200,000
Income before tax 95,200
Less income tax (40%) 28,080
Net income 57,120
Add back depreciation 200,000
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.

Present value of cash returns: (30,000 x 0.90909) x 5 periods 136,364
Net investment 99,300
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.

Savings (2 workers, each P10,000 for 3 months) 2 x P10,000 x 3 P60,000
Depreciation (175,000 – 25,000) ÷ 5 years P30,000
After-tax cash savings: (60,000 x 0.75) + (30,000 x 0.25) P52,500
Present value of after-tax cash savings (52,500 x 3.60478) P189,250
Present value of Salvage Value (25,000 x 0.56743) 14,186
Total 203,436
Investment 175,000
Net Present Value P 28,436

Computation of net investment:
Cash purchase price 300,000
Less: MV of old machine 80,000
Tax shield on loss on sale (40,000 x 0.32) 12,800 92,800
Net investment 207,200

## Annual cash savings before tax (240,000 – 160,000) 80,000

Additional depreciation (300,000 – 120,000) ÷ 4 45,000
Additional taxable income 35,000
Less Additional tax (35,000 x 0.32) 11,200
Net income 23,800
Add back depreciation 45,000
After-tax cash flow 68,800
Alternative computation for ATCF:
(80,000 x 0.68) + (45,000 x 0.32) 68,800
Present value of ATCF (68,800 x 3.23972) 222,893
Investment 207,200
Net Present Value 15,693

PV of annual cash receipts 1,200,000 x 2.58872 3,106,463
PV of salvage value 650,000 x 0.48225 313,462
PV of return of working capital 1,000,000 x 0.48225 482,250
Cost of new equipment and timbers (2,750,000)
Working capital (1,000,000)
PV of cost of construction of road 400,000 x .5787 ( 231,480)
Negative net present value (79,303)

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 35,280 0.67497 23,812.94
1.052
4 32,000 x 37,044 0.59208 21,933.01
1.053
Total 99,670.22
Investment 80,000.00
NPV 19,670.22
Note that all the annual cash inflows are adjusted by one period.

The solution used total analysis approach in computing present value.
Retain the Old Machine:
Present value of annual cash outlay
CFAT (300,000 x P0.38) + P21,000 = P135,000
PVCFAT (135,000 x 3.6847) P497,435
Present value of salvage value (7,000 x 0.41044) ( 2,873)
Total P494,562

## Buy New machine:

Present Value of Annual cash outlay
CFAT (300,000 x P0.29) + P11,000 = P98,000
PVCFAT P98,000 x 3.6847) P361,100
Salvage value of new machine, end of 6 years(P20,000 x 0.41044) ( 8,209)
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.
Profitability index: 4.35526/4.11141 = 1.06

PV of annuity of 1 at IRR ∑(1 ÷ 1.12386)5 3.57057
PV of annuity of 1 at MCC ∑(1 ÷ 1.11055)5 3.69079
After-tax cash flows 10,000 ÷ (3.69079 – 3.57057) 83,180.84
Investment: 83,180.84 x 3.57057 297,000
Profitability index (297,000 + 10,000) ÷ 297,000 1.034
A shorter calculation of the Profitability Index can be made by:
3.69079 ÷ 3.57057 = 1.034

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 project’s 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:
Investment: (4.968 x 20,000) = P99,360

The amount of investment: the PV of annuity at IRR
4.355 x 6,000 = 26,130

Present value of cash inflows equals amount of investment at 10% IRR.
P20,000 x 3.791 = P75,820

ATCF: P1,500,000/3.60472 416,121
Depreciation 300,000
Net income: 416,121 – 300,000 116,121
Before-tax income: 116,121/0.60 193,535
Fixed costs 500,000
Contribution margin: 193,535 + 500,000 693,535
Unit sales 693,535 ÷ (100 - 60) 17,338
Contribution margin (per No. 23) 693,535
Divide by sales volume ÷ 20,000
Contribution margin per unit P34.68
Add variable cost per unit 60.00
Selling price per unit P94.68

Alternative Solution:
Cash inflow before tax based on present price: (20,000 x 40) – 200,000600,000
After-tax cash inflow (600,000 x 0.6) + (300,000 x 0.4) 480,000
Present value of ATCF (480,000 x 3.60478) 1,730,294
Investment 1,500,000
Net present value (present price) 230,294
Annual excess ATCF due to excess price (230,294 ÷ 3.60478) 63,885
Before-tax excess cash inflow (63,885 ÷ 0.6) 106,475
Excess selling price: 106,475 ÷ 20,000 5.32
Reduced selling price to achieve IRR of 12% (100 – 5.32) 94.68

Annual after-tax cash flow 500,000/5.6502 88,492
Depreciation 500,000/10 50,000
Net income 38,492
Income before tax 38,492/0.6 64,154
Depreciation 50,000
Cash savings before tax: 64,154 + 50,000 114,154

The amount of annual cash flows can be solved by equation:
NPV = PV of annual CF – Investment
1,750 = 2.4771CF – 2.4018CF
1,750 = 0.1753CF
CF = 9,980

Investment 120,000
Less Present value of salvage value (12,000 x 0.3855) 4,626
Present value of Annual Cash Inflows 115,374
Minimum Annual Cash Flows (115,374 ÷ 6.1446) 18,776

Present value of annual cash flows at IRR (81,000 x 4.639) 375,759
Investment 81,000 x 4.344 351,864
Difference 23,895
Annual increase in cash flows 23,895/4.344 5,501

Investment (Total of present value @ IRR of 12%) 50,000
Less PV, year 1 & 2 (16,074 + 17,534) 33,608
PV of the 3rd cash flow 16,392
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
Let X = the excess salvage value
7,003 = 0.56743X – [3.60478 x (0.2X * 0.4)
7,003 = 0.56743X – 0.2883824X
7,003 = 0.2790476X
X = 25,096
Required salvage value: 50,000 – 25,096 = 24,904

Cost of equipment 750,000
Less PV of tangible benefits 100,000 x 5.01877 501,877
PV of annual intangible benefits 248,123
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.
Present value of intangible benefits P184,350
PV of annuity of 1 at 10% for 10 years ÷ 6.145
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.
Difference 80,000 – 48,000 35,225
PV inflows ∑(3,200 ÷ 1.1264)6 (12,922)
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
Year 1 155,000 ÷ 1.10 140,909.10 (140,909.10)
Year 2 (110,000 ÷ 1.10)2 ( 90,909.10) 90,909.10
Net difference 50,000.00 ( 50,000.00)
Difference in investment ( 50,000.00) 50,000.00
NPV NIL NIL

15% Discount Rate
Machine 1 Machine 2
PV of Difference in ATCF
Year 1 155,000 x 0.86957 134,783.35 (134,783.35)
Year 2 110,000 x 0.75614 ( 83,175.40) 83,175.40
Net difference 51,607.95 ( 51,607.95)
Difference in investment ( 50,000.00) 50,000.00
NPV 1,607.95 ( 1,607.95)

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

8% Discount Rate
Machine 1 Machine 2
PV of Difference in ATCF
Year 1 155,000 x 0.92593 143,519.15 (143,519.15)
Year 2 110,000 x 0.85734 ( 94,307.40) 94,307.40
Net difference 49,211.75 ( 49,211.75)
Difference in investment ( 50,000.00) 50,000.00
NPV ( 788.25) 788.25

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

Cost of Investment:
Invoice price 950,000
Installation cost 24,200
Freight charge 800
Total investment 975,000

## Annual Cash Flow:

Number of procedures: (52 x 5) 260
Contribution margin per procedures: (P800 – P10 – P40) P750
Total annual cash flow: (260 x P750) P195,000
Cash payback period: (975,000 ÷ 195,000) 5 years

Present value of cash flow (195,000 x 6.418) P1,251,510
Present value of salvage value (55,000 x 0.42241) 23,233
Total P1,274,743
Capital investment 975,000
Net present value P 299,743

Average investment: (975,000 + 55,000) ÷ 2 515,000
Annual depreciation: (975,000 – 55,000) ÷ 10 92,000
Annual net income: 195,000 – 92,000 103,000
Average annual Rate of Return: P103,000  P515,000 20%

Contribution margin: 300,000 x (75 – 50) 7,500,000
Less Fixed costs 4,500,000
Cash flow before tax 3,000,000
Less: Depreciation (6,000,000 ÷ 4) 1,500,000
Income before tax 1,500,000
Less: Income tax (1,500,000 x 0.4) 600,000
Net income 900,000
Add back: Depreciation 1,500,000
After-tax Cash Flow 2,400,000

PV of After-tax Cash Flows (2,400,000 x 2.9287) 7,028,900
Cost of investment 6,000,000
Net Present Value 1,028,900

Annual excess present value (1,028,000 ÷ 2.9287) P351,000
Excess cash before tax (351,000 ÷ 0.6) P585,000
Maximum number of units as decrease (585,000 ÷ 15) 39,000

Average Annual net income:
(100,000 + 40,000 + 20,000 + 10,000 + 10,000) ÷ 5 = 36,000
Divide by average investment (400,000 ÷ 2) 200,000
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 400,000
investment
Net Present Value 55,200

Present Value Index (Profitability Index)
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.

Payback period: Investment ÷ Net Annual Cash Inflow
P200,000 ÷ P50,000 = 4 years

Present value of Net Cash Inflow (71,000 X 4.355) 309,205
Investment 300,000
Net Present value 9.205

Average Investment: (200,000 ÷ 2) = 100,000
Accounting Rate of Return = Net Income ÷ Average Investment
(10,000 ÷ 100,000) = 10 percent

Annual depreciation: (P50,000 ÷ 8) P6,250
Annual tax shield: (P6,250 x 0.3) P1,875

Before-tax cash inflow P10,000
Less depreciation 6,250
Income before tax 3,750
Less income tax (3,750 x 0.3) 1,125
Net income 2,625
Add back depreciation 6,250
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.
(P10,000 × .70) + P1,875 = P8,875