FM 5 – FINANCIAL MANAGEMENT II TAKE HOME SUMMARY EXERCISE – CHAPTER 5, PART 1

NAME: Dela Torre, Rex Julian O. COURSE & YEAR: BSBA-FM2 DATE: FEB.15 2023

Please answer the following problems, reflecting your computations and final answers, concisely and legibly. (50 points)

A. THEORIES (20 points)

1. Discuss how the effects of current-day hyper-inflation in goods and commodities, and in services and
various industries would impact investment decisions, and modifications to various appraisal methods.
(5 points)

A substantial and ongoing increase in the cost of goods and services, known as hyper-inflation, lowers
consumer purchasing power and raises the risk of economic instability for a nation. Hyperinflation in products and
commodities, as well as in services and different industries, will have a substantial impact on investment choices
when this occurs in the Philippines. The central bank may increase interest rates during a hyperinflation to cut
down on the amount of money in circulation. The bulk of investors will look for alternate investments to safeguard
their portfolios when this happens, which might have a big effect on the Philippine economy.

2. Discuss the advantages and disadvantages of using objective estimates and probabilities, against
subjective ones. How can bias and wrong judgment be minimized? (5 points):

Since they are founded on empirical data and quantifiable information, objective estimates and
probabilities offer the advantage of enabling precise predictions and reasoned decision-making. One drawback is
that it does not fully account for intricate or unknowable elements that could affect the result. The benefit of
subjective estimates is that they allow for individual opinions, convictions, and knowledge that can offer a
broader perspective on a particular situation. On the other hand, the drawback of subjective estimates is that
they can lead to personal biases and are challenging to compare between people or groups. Each estimation
strategy has advantages and disadvantages, and the ideal strategy will depend on the circumstances
surrounding the decision-making process.

3. Discuss the similarities and differences between the shortest-common-period-of-time approach vis-à-vis
the equivalent-annual-annuity approach (5 points):

Financial analysis uses two separate approaches to compare investment options: the equivalent-annual-
annuity approach and the shortest-common-period-of-time approach. They both assess investment possibilities
and determine a single value to represent the options' merit, which is one of their similarities. The equivalent
yearly annuity strategy produces a cash flow quantity, but the shortest common period approach produces a
time period. The equivalent yearly annuity strategy is more complicated and better suited for comparing assets
with the same time horizon, whereas the shortest common period approach is simpler and more appropriate
when comparing investments with different time horizons.

4. What are the ways of treating inflation in relation to the annual cash flows and discount rates? (2 points):

Because it affects the value of future cash flows, inflation is an important consideration in financial
modeling and investment analysis. It is critical to consider both nominal and real cash flows, which are adjusted
for inflation, when calculating the value of cash flows. This approach makes use of nominal cash flows and a real
discount rate. When cash flows are expected to rise in line with inflation, but the discount rate reflects the true
cost of capital, this method is appropriate. This method requires cash flows to be adjusted for inflation using an
inflation index or other inflation adjustment factor. The appropriate method for treating inflation in relation to
annual cash flows and discount rates is determined by the analysis's specific context.
5. Discuss the relevance of risk in evaluating investment proposals and decisions, and give some methods
of dealing with it in the analysis of investment proposals and projects (3 points):

When evaluating investment proposals and making investment decisions, risk is an important factor to
consider. In the context of investments, risk refers to the possibility of financial loss or the failure of an
investment to deliver expected returns. Because investments entail allocating resources in anticipation of future
gains, the level of risk associated with the investment must be considered in order to avoid unexpected losses.
Quantitative and qualitative analysis, which uses statistical tools and models to evaluate the probability of
different outcomes in different data sets, trends, and other factors, is one method of dealing with it in the
analysis.
B. PROBLEMS (30 points)

Plato Pharmaceuticals Ltd has invested £500,000 to date in developing a new type of insect repellent. The
repellent is now ready for production and sale, and the marketing director estimates that the product will sell
150,000 bottles a year over the next five years. The selling price of the insect repellent will be £5 a bottle and
variable costs are estimated to be £3 a bottle. Fixed costs (excluding depreciation) are expected to be £200,000
a year. This figure is made up of £160,000 additional fixed costs and £40,000 fixed costs relating to the existing
business which will be apportioned to the new product.

In order to produce the repellent, machinery and equipment costing £520,000 will have to be purchased
immediately. The estimated residual value of this machinery and equipment in five years’ time is £100,000. The
business calculates depreciation on a straight-line basis.

The business has a cost of capital of 12 per cent. Ignore taxation.

Required:
(a) Calculate the net present value of the product.
(b) Undertake sensitivity analysis to show by how much the following factors would have
to change before the product ceased to be worthwhile:
(i) the discount rate
(ii) the initial outlay on machinery and equipment
(iii) the net operating cash flows
(iv) the residual value of the machinery and equipment.
 (a) Calculation of Net Present Value (NPV):

Step 1: Calculation of Annual Cash Flows

Annual Revenue: 150,000 bottles * £5/bottle = £750,000

Variable Cost: 150,000 bottles * £3/bottle = £450,000

Fixed Costs (excluding depreciation): £200,000 Depreciation = (Initial Cost - Residual Value) / Useful life Depreciation =
(£520,000 - £100,000) / 5 = £84,000

Annual Cash Flow = Revenue - Variable Cost - Fixed Cost - Depreciation Annual Cash Flow = £750,000 - £450,000 -
£200,000 - £84,000 = £16,000

Step 2: Calculation of Present Value Factors

Year 1: PV Factor = 1 / (1 + 12%)1 = 0.893

Year 2: PV Factor = 1 / (1 + 12%)2 = 0.797

Year 3: PV Factor = 1 / (1 + 12%)3 = 0.712

Year 4: PV Factor = 1 / (1 + 12%)4 = 0.636

Year 5: PV Factor = 1 / (1 + 12%)5 = 0.567

Step 3: Calculation of Present Value of Cash Flows

Year 1: PV = £16,000 x 0.893 = £14,188

Year 2: PV = £16,000 x 0.797 = £12,752

Year 3: PV = £16,000 x 0.712 = £11,392

Year 4: PV = £16,000 x 0.636 = £10,176

Year 5: PV = (£16,000 + £100,000) x 0.567 = £63,855

Step 4: Calculation of Net Present Value (NPV)

NPV = Present Value of Cash Flows - Initial Investment NPV = £14,188 + £12,752 + £11,392 + £10,176 + £63,855 -
£520,000 NPV = £32,363

Therefore, the net present value of the product is £32,363.

(b) Sensitivity Analysis:

(i) Discount Rate: The present value of future cash flows drops as the discount rate rises, lowering the NPV in the
process. The project might no longer be worthwhile if the discount rate is higher than the cost of capital. On the other
hand, if the discount rate falls, the NPV will rise. As a result, the discount rate shouldn't be higher than the 12% cost of
capital.

(ii) Initial Outlay on Machinery and Equipment: The NPV will fall and the initial investment would be higher if the
initial expenditure on machines and equipment rises. On the other hand, the NPV will rise if the original investment
in machinery and equipment falls.

(iii) Net Operating Cash Flows: The net operating cash flows and NPV will decline if the anticipated sales volume or
selling price declines. On the other hand, the NPV will rise if the projected sales volume or selling price rises.

(iv) Residual Value of Machinery and Equipment: If the estimated residual value of the machinery and equipment falls,
so will the present value of the cash flow from the sale of the machinery and equipment, and thus the NPV. In contrast,
if the estimated residual value of the machinery and equipment rises, so will the NPV.