CASE 1:

1. ABC Company’s average production of valve stems over the past three years has been 80,000 units each year. Expectations
are that this volume will remain constant over the next four years. Cost records indicate that unit product costs for the valve
stem over the last several years have been as follows:
Direct materials P 3.60
Direct labor 3.90
Variable manufacturing overhead 1.50
Fixed manufacturing overhead* 9.00
Unit product cost P18.00
*Depreciation of tools (that must now be replaced) accounts for one-third of the fixed overhead. The balance is for other
fixed overhead costs of the factor that require cash expenditures. If the specialized tools are purchased, they will cost
P2,500,000 and will have a disposal value of P100,000 at the end of their four-year useful life.

ABC Company has a 30% tax rate, and management requires a 12% after-tax return on investment. Straight-line
depreciation would be used for financial reporting purposes, but for the tax purposes, the following variable depreciation
each year will be used.
Year 1 P 832,500
Year 2 1,112,500
Year 3 370,000
Year 4 185,000
The sales representative for the manufacturer of the specialized tools has stated, “The new tools will allow direct labor and
variable overhead to be reduced by P1.60 per unit.” Data from another company using identical tools and experiencing
similar operating conditions, except that annual production generally averages 100,000 units, confirms the direct labor and
variable overhead cost savings. However, the other company indicates that it experienced an increase in raw material cost
due to the higher quality of material that had to be used with the new tools. The other company indicates that its unit product
costs have been as follows:
Direct materials P 4.50
Direct labor 3.00
Variable manufacturing overhead 0.80
Fixed manufacturing overhead 10.80
Unit product cost P19.10

Referring to the figures above, the production manager stated, “These numbers look great until you consider the difference in
volume. Even with the reduction in labor and variable overhead cost, I’ll bet our total unit cost figure would increase to over
P20 with the new tools.”

Although the old tools being used by ABC Company are now fully depreciated, they have a salvage value of P45,000. These
tools will be sold if the new tools are purchased; however if the new tools are not purchased, then the old tools will be
retained as standby equipment. ABC Company’s accounting department has confirmed that total fixed manufacturing
overhead costs, other than depreciation, will not change regardless of the decision made concerning the valve stems.
However, the accounting department has estimated that working capital needs will increase by P60,000 if the new tools are
purchased due to the higher quality of material required in the manufacture of the valve stems.

Required:
P 2,515,000
a. The net investment in new tools amounted to? ____________
Solution:
Purchase price of new tools P 2,500,000
Add: Increase in working capital 60,000
Total 2,560,000
Deduct: Salvage Value of the old tools 45,000
Net investment P 2,515,000
P 33,830
b. The net advantage of the use of declining method of depreciation instead of straight-line method is? ____________
Solution:
PV of tax benefits, declining method P 603,333
PV of tax benefits, straight-line method (2,500,000/4*0.3*3.03735) 569,503
Net advantage P 33,830
c. Should ABC Company purchase the new tools? Justify your answer and include not just quantitative aspect of the
project but also the qualitative aspects as well (20 points, minimum of 30 words for the justification paragraph.)