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EXECUTIVE SUMMARY

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

Year Net Cash Inflows Present Value Factor Present Value


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:

Year Net Cash Inflows


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:

INVESTMENT YEAR INCOME FROM OPERATIONS NET CASH FLOW


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

Proposal B: P 610,000 1 P 158,000 P 280,000


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

Proposal C: P275,000 1 P 45,000 P 100,000


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

Proposal D: P 190,000 1 22,000 P 60,000


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∗

* 76, 930 + 74,620 + 76,930 + 79,240 + 81,550 + 35,000 = 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

Reject the proposed additional building.

PV of Cash Inflows (3.9M x 7.469) = 29,129,100


PV – Salvage Value (3M x 0.104) = 312,000
29,441,100
Investment Cost (30,000,000)
Net Present Value (558, 900)

REQUIREMENT 2

Build an additional building to the hotel.

PV of Cash Inflows (3.9M x 8.514) = 33,204,600


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

TRIAL & ERROR:


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]
[

-0- 3 yrs & 6 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]
[

-0- 2 yrs & 3 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]
[

-0- 2 yrs & 9 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]
[

-0- 3 yrs & 3 mos


REQUIREMENT 2

Formula:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

A. Average Net Cash Flow


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

B. Average Net Cash Flow


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

C. Average Net Cash Flow


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

D. Average Net Cash Flow


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

 Choose the project depending on the rank made during Step 4


6. Implementation
 Implement the projected proposal during the decision making.