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Mr. Abraham owns a variety of businesses in the Eastern Visayas region. He owns a bank, a

chain of resort hotels and a music store. He wasn’t born with a silver spoon on his mouth. He

had to claw very hard to get to the peak of success where he is right now. His life story might

be regarded as one of those inspiring rags-to-riches story. He’s got two kids, David and

Solomon, with his wife Sarah. David is currently engaged to Ms. Bathsheba, the keyboardist

of their college band Your-Yeah, while Solomon still remains in search for the perfect “fish”

for him.

The patriarch keeps on advancing in years and he can no longer accommodate with his own

hands the management of all of his businesses. Though he still owns all of them, he gave his

sons the responsibility to manage majority of his businesses except for the bank wherein he

wants his trusted nephew, Matthew Treynlo, to oversee its operations.

Since Automated Teller Machines (ATM) have already become common in the banking

industry, Abe Federal Bank is planning to replace some old teller machines and has decided

to use the Median Machine. Eduardo Babaengtumakbo, the controller, has prepared the

analysis shown on the next page. He has recommended the purchase of the machine based

on the positive net present value shown in the analysis.

The Median Machine has an estimated useful life of five years and an expected residual value

of P35,000. Its purchase price is P385,000. Two existing ATMs, each having a carrying value of

P25,000, can be sold to neighboring bank for a total of P50,000. Annual operating cash

inflows are expected to increase in the following manner:

Year 1 P79,900

Year 2 76,600

Year 3 79,900

Year 4 83,200

Year 5 86,500

The Abe Federal Bank uses straight-line depreciation. The minimum rate of return is 12

percent. Tax rate is 30 percent.

Abe Federal Bank

Capital Investment Analysis

Net Present Value Method

1 85,000 0.909 77,265

2 80,000 0.826 66,080

3 85,000 0.751 63,835

4 90,000 0.683 61,470

5 95,000 0.621 58,995

5(residual value) 35,000 0.621 21,735

Total Present Value 349,380

Initial Investment 385,000

Less: Proceeds from the sale of

existing teller machines 50,000 (335,000)

Net Present Value 14,380

Mr. Abraham owns four resorts hotels in Eastern Visayas the management of which was

given to his youngest son, Solomon, five years ago. Because the Palo operation (Hotel 1) has

been booming from the time Solomon had been appointed as its executive manager, he and

his team has decided to build an addition to the hotel. This addition will increase the hotel’s

capacity by 20%. A construction company has bid to build the addition at a cost of

P30,000,000. The building will have an increased residual value of P3,000,000.

Injun Joe, the controller, has started an analysis of the present value for the project. He has

calculated the annual net cash inflows by subtracting the increase in cash operating expenses

from the increase in cash inflows from room rentals. His partially completed schedule

follows:

1 – 20 (each year) P3,900,000

Capital Investment projects of this type must generate 12 percent minimum rate of return to

qualify for consideration. However, the management is willing to accept a 10 percent

minimum rate of return.

David, the eldest son of Mr. Abraham, has become the executive manager of Kai Sports &

Music just last year. David’s passion for music made him ran away from home about five

years ago. He told his parents that he wanted to look for what’s in store for him out there

since he believed that there’s more to life than just being stuck inside the academic

classrooms and helping his father manage their businesses. However, he came back home

last year learning that following one’s heart can’t always mean that you’ll be trekking on the

right path since the heart could be treacherous. Now, a changed man, David is considering

allocating a limited amount of capital investment fund among four proposals. The amount of

proposed investment, estimated income from operations, and net cash flow for each

proposal are as follows:

Proposal A: P 425,000 1 P 40,000 P 125,000

2 40,000 125,000

3 40,000 125,000

4 15,000 100,000

5 (35,000) 50,000

P 100,000 P 525,000

2 158,000 280,000

3 78,000 200,000

4 28,000 150,000

5 (22,000) 100,000

P 400,000 P 1,010,000

2 45,000 100,000

3 45,000 100,000

4 45,000 100,000

5 35,000 90,000

P 215,000 P 490,000

2 22,000 60,000

3 22,000 60,000

4 2,000 40,000

5 2,000 40,000

P 70,000 P 260,000

The company’s capital rationing policy requires a maximum payback period of three years.

In addition, a minimum average rate of return of 12% is required on all projects. If the

preceding standards are met, the net present value method and present value indexes are

used to rank the remaining proposals.

KEY ISSUES

A. BANK – ATM:

1. Analyze Eduardo Babaengtumakbo’s work and identify the changes needed to

be made in her capital investment analysis, if there’s any.

2. What would be your recommendation to bank management about the

purchase of Median Machine? (see “a”)

3. Using IRR method, what would be your recommendation?

B. RESORT HOTELS:

1. Using net present value analysis, evaluate the proposal and make a

recommendation to management.

2. Explain how your recommendation would change if management were willing

to accept a 10 percent minimum rate of return.

3. Using IRR method, what would be your recommendation on situations “a” and

”b”?

C. MUSIC STORE:

1. Compute the cash payback perod for each of the four proposals.

2. Giving effect to straight-line depreciation on the investments and assuming no

estimated residual value, compute the average rate of return for each of the

four proposals. Round to one decimal place.

3. Using the following format, summarize the results of your computations in

parts (1) and (2). By placing the calculated amounts in the first two columns

on the left and by placing a check mark in the appropriate column to the

right, indicate which proposals should be accepted for further analysis and

which should be rejected.

4. For the proposals accepted for further analysis in part (3), compute the net

present value. Use a rate of 12%. Round to the nearest peso.

5. Compute the present value index for each of the proposals in part (4). Round

to two decimal places.

6. Rank the proposals from most attractive to least attractive, based on net

present values of net cash flows computed in part (4).

7. Rank the proposals from most attractive to least attractive, based on the

present value indexes flows computed in part (5).

8. Based on the analysis, comment on the relative attractiveness of the proposals

ranked in parts (6) and (7).

OVERALL:

A. Assume Mr. Abraham has a total of P20,000,000 available funds, which projects must

be implemented? Please use discounted capital budgeting techniques.

B. Assume Mr. Abraham has a total of P30,000,000 available funds, which projects must

be implemented? Please use discounted capital budgeting techniques.

C. Assume Mr. Abraham has a total of P31,000,000 available funds, which projects must

be implemented? Please use discounted capital budgeting techniques.

D. Assume Mr. Abraham has a total of P33,000,000 available funds, which projects must

be implemented? Please use discounted capital budgeting techniques.

RECOMMENDATIONS

A. BANK – ATM

REQUIREMENT 1

Year Net Cash Present Value Factor Present

Inflows* @ 12% Value

1 76,930 0.893 68,698.49

2 74,620 0.797 59,472.14

3 76,930 0.712 54,774.16

4 79,240 0.636 50,396.64

5 81,550 0.567 46,238.85

5(residual value) 35,000 0.567 19,845

Total 299,425.28

Less: Purchase Price (Median Machine) 385,000

Current Market Value (50,000) 335,000

Net Present Value (35,574.72)

*Compute for the after – tax cash inflow using Compute the depreciation of the Median

indirect method: Machine:

𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒

YEAR 1 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Annual cash inflow 385,000−35,000

before tax 79,000

= 5

TAX DUE: = 70,000

Cash inflow 79,900

Less: Dep’n 70,000

9,900

x 30% 2,970

Annual cash inflow 76, 930

After tax

REQUIREMENT 2

Do not accept the proposed replacement of banking machines.

REQUIREMENT 3

335,000

𝑃𝑉 𝐹𝐴𝐶𝑇𝑂𝑅 = = 3.95

84,854∗

5

INTERPOLATION:

NET CASH PV FACTOR PV CASH PV FACTOR PV - CASH

INFLOWS @ 9% INFLOWS @ 8% INFLOWS

76, 930 0.917 70,544.81 0.926 71,237.18

74,620 0.842 62,830.04 0.857 63,949.34

76,930 0.772 59,389.36 0.794 61,082.42

79,240 0.708 56,101.92 0.735 58,241.40

116,550 0.650 75,757.50 0.681 79,370.55

324,624.23 333,880.89

INVESTMENT COST: 335,000

9,256.66

10, 375.77 𝐼𝑅𝑅 = 10,375.77 = 0.89 x 1%

= 9% - 0.89%

= 8.11% vs 12%

Reject the proposal

B. RESORT HOTELS

REQUIREMENT 1

PV – Salvage Value (3M x 0.104) = 312,000

29,441,100

Investment Cost (30,000,000)

Net Present Value (558, 900)

REQUIREMENT 2

PV – Salvage Value (3M x 0.149) = 447,000

33,651,600

Investment Cost (30,000,000)

Net Present Value 3,651,600

REQUIREMENT 3

11.53% 11.5355% vs 12% reject

11.54% 11.5355% vs 10% accept

C. MUSIC STORE

REQUIREMENT 1

PROPOSAL 1

Net Investment 425,000

Net Cash Flow: YEAR

YEAR 1 (125,000) 1

YEAR 2 (125,000) 1

YEAR 3 (125,000) 1

YEAR 4 (50,000) *(100,000-50,000) 6 mos 50,000

*[200,000 x 12 mos]

[

PROPOSAL 2

Net Investment 610,000

Net Cash Flow: YEAR

YEAR 1 (280,000) 1

YEAR 2 (280,000) 1

YEAR 3 (50,000) *(200,000-150,000) 3 mos 50,000

*[200,000 x 12 mos]

[

PROPOSAL 3

Net Investment 275,000

Net Cash Flow: YEAR

YEAR 1 (100,000) 1

YEAR 2 (100,000) 1

YEAR 3 (75,000) *(100,000-25,000) 9 mos 75,000

*[100,000 x 12 mos]

[

PROPOSAL 4

Net Investment 190,000

Net Cash Flow: YEAR

YEAR 1 (60,000) 1

YEAR 2 (60,000) 1

YEAR 3 (60,000) 1

10,000

YEAR 4 (10,000) *(40,000-30,000) 3 mos *[40,000 x 12 mos]

[

REQUIREMENT 2

Formula:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Year 1 125,000 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =

Year 2 125,000 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Year 3 125,000 425,000−0

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 85,000

Year 4 100,000 5

Year 5 50,000

525,000 105,000−85,000

𝐴𝑅𝑅 = = 𝟒. 𝟕%

÷ 5 425,000

105,000

Year 1 280,000 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =

Year 2 280,000 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒

Year 3 200,000 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Year 4 150,000 610,000−0

Year 5 100,000

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 122,000

5

1,010,000

÷ 5 202,000−122,000

𝐴𝑅𝑅 = = 𝟏𝟑. 𝟏%

202,000 610,000

Year 1 100,000 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =

Year 2 100,000 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Year 3 100,000 275,000−0

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 55,000

Year 4 100,000 5

Year 5 90,000

490,000 98,000−55,000

𝐴𝑅𝑅 = = 𝟏𝟓. 𝟔%

÷ 5 275,000

98,000

Year 1 60,000 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =

Year 2 60,000 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Year 3 60,000 190,000−0

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 38,000

Year 4 40,000 5

Year 5 40,000

260,000 52,000−38,000

𝐴𝑅𝑅 = = 𝟕. 𝟒%

÷ 5 190,000

52,000

REQUIREMENT 3

PROPOSAL Cash P.B. ARR Accept for REJECT

Further Analysis

A 3.5 4.7%

B 2.25 13.1%

C 2.75 15.6%

D 3.25 7.4%

REQUIREMENT 4

Proposal D

Year Net Present

Present Value Factor

Cashflows Value

1 280,000 0.892857 250,000

2 280,000 0.797194 223,214

3 200,000 0.711780 142,356

4 150,000 0.635518 95,323

5 100,000 0.56742 (56,742)

767,640

- 610,000

157,640

Proposal C

Year Net Present

Present Value Factor

Cashflows Value

1 100,000 0.892857 89,286

2 100,000 0.797194 79,719

3 100,000 0.711780 71,178

4 100,000 0.635518 63,552

5 90,000 0.56742 51,068

354,803

- 275,000

79,803

REQUIREMENT 5

Proposal B

610,000

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = = 𝟕𝟗. 𝟒𝟔%

767,640

Proposal C

275,000

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = = 𝟕𝟕. 𝟓𝟏%

354,803

REQUIREMENT 6

PROPOSAL RANK

B 1ST

C 2ND

*based on net present values of net cash flows

REQUIREMENT 7

PROPOSAL RANK

B 1ST

C 2ND

*based on the present value indexes flows

REQUIREMENT 8

The relative attractiveness of both proposals is that, they have the same rank

whether it is based on net present values of net cash flows or based on the present value

indexes flows.

OVERALL RECOMMENDATION

REQUIREMENT A

Implement Proposal 3; investment BCD

Available Funds 20,000,000

Cost of Implemented Projects:

B 610,000

C 275,000

D 190,000

Excess funds 18,925,000

REQUIREMENT B

Implement Proposal 3; investment BCD

Available Funds 30,000,000

Cost of Implemented Projects:

B 610,000

C 275,000

D 190,000

Excess funds 28,925,000

REQUIREMENT C

Implement Proposal 3; investment BCD

Available Funds 31,000,000

Cost of Implemented Projects:

B 610,000

C 275,000

D 190,000

Excess funds 29,925,000

REQUIREMENT D

Implement Proposal 3; investment BCD

Available Funds 33,000,000

Cost of Implemented Projects:

B 610,000

C 275,000

D 190,000

Excess funds 31,925,000

CONCLUSION

Steps in accepting the project:

1. Determine the investment proposals

Proposals:

Continue using the old ATM Machine or purchase a new Median Machine.

Add a new building or not.

Determine which investment shall be accepted.

2. Screening investment proposals

Assess the project that will be appropriate with the capital investment

budget.

3. Assessment of investment proposals

Which project provide greater net cash flow to the entity

Considering the cash inflows

Considering the cash outflows

The risk that it will cause to the entity

Compute for the NPV

4. Prioritizing investment proposals

Rank the project that has the highest to the lowest NPV

5. Decision Making

6. Implementation

Implement the projected proposal during the decision making.

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