Problem 3

ETC Products Company manufactures several different products. One of the firm’s principal products
sells for P20 per unit. The sales manager of ETC Products has stated repeatedly that he could sell
more units of this product if they were available. In an attempt to substantiate his claim, the sales
manager conducted a market research study last year at a cost of P44,000 to determine potential
demand for this product. The study indicated that ETC Products could sell 18,000 units of this product
annually for the next five years.
The equipment currently in use has the capacity to produce 11,000 units annually. The variable
production costs are P9 per unit. The equipment has a book value of P60, 000 and a remaining useful
life of five years. The salvage value of the equipment is negligible now and will be zero in five years.
A maximum of 20,000 units could be produced annually on the new machinery which can be
purchased. The new equipment costs P300,000 and has an estimated useful life of five years with no
salvage value at the end of the five years. ETC Product’s production manager has estimated that the
new equipment would provide increased production efficiencies that would reduce the variable
production costs to P7 per unit.
ETC Products Company uses straight-line depreciation on all of its equipment for tax purposes. The
firm is subject to a 40 percent tax rate, and its after-tax cost of capital is 15 percent.
The sales manager felt so strongly about the need for additional capacity that he attempted to
prepare an economic justification for the equipment, although this was not one of his responsibilities.
His analysis, presented on the next page, disappointed him because it did not justify acquiring the
equipment.

Required Investment

Purchase price of new equipment P300,000

Disposal of existing equipment
Loss on Disposal P60,000
Less: Tax benefit (40%) 24,000 36,000
Cost of market research study 44,000
Total Investment P380,000
 Annual Returns
Contribution margin from product
Using the new equipment
[18,000 x (P20 – 7)] P234,000
Using the existing equipment
[11,000 x (P20 – 9)] 121,000
Increase in contribution margin P113,000
Less: Depreciation 60,000
Increase in before-tax income P 53,000
Income tax (40%) 21,200
Increase in income P 31,800
Less: 15% cost of capital on the additional investment
required (0.15 x 380,000) 57,000
Net annual return of proposed investment in new equipment P (25,200)

Required:
1. The controller of ETC Products Company plans to prepare a discounted cash flow analysis for
this investment proposal. The controller has asked you to prepare corrected calculations of:

a) The required investment in the new equipment

Purchase price of new equipment P300,000
Disposal of existing equipment:
Selling price P 0
Book value 60,000
Loss on disposal P60,000
Tax rate 0.4
Tax benefit of loss on disposal 24,000
Required Investment P 276,000
b) The recurring annual cash flows
New Equipment:
Contribution Margin [18,000 (P20 – 7)] P234,000
Less: Depreciation on new equipment (P300,000/5) 60,000
Income before tax 174,000
Less: Income tax ( 174,000 * 40%) 69,600
Net Income P104,400
Add: Depreciation 60,000
Cash Inflow P164,400

Old/Present Equipment:
Contribution Margin [11,000 (P20 – 9)] P121,000
Less: Depreciation on new equipment (P60,000/5) 12,000
Income before tax 109,000
Less: Income tax (109,000 * 40%) 43,600
Net Income P65,400
Add: Depreciation 12,000
Cash Inflow P77,400

Recurring annual cash flows

164,400 – 77,400 = P 87,000

Explain the treatment of each item of your corrected calculations that is treated differently from
the original analysis prepared by the sales manager.
The new equipment is capable of producing 20,000 units, but ETC Product Company
can sell only 18,000 units annually. The sales manager made several errors in his
calculations of required investment and annual cash flows. Concerning the required
investment, the sales manager made two errors: First, the cost of the market research
study ($44,000) is a sunk cost because it was incurred last year and will not change
regardless of whether the investment is made or not.

2. Calculate the net present value of the proposal investment in the new equipment.

Present value of future cash flows (87,000 x 3.35216) P291,637.92

Less: Required Investment 276,000.00
 Net present value P 15,637.92

Problem 4
Notting Hall Hospital needs to expand its facilities and desires to obtain a new building on a piece of
property adjacent to its present location. Two options are available to Notting Hill, as follows:
Option 1: Buy the property, erect the building, and install the fixtures at a total cost of P600,000. This
cost would be paid off in five installments: an immediate payment of P200,000, and a payment of
P100,000 at the end of each of the next four years. The annual cash operating costs associated with
the new facilities are estimated to be P12,000 per year. The new facilities would be occupied for
thirteen years, and would have a total resale value of P300,000 at the end of the 13-year period.
Option 2: A leasing company would buy the property and construct the new facilities for Notting Hill
which would then be leased back to Notting Hill at an annual lease cost of P70,000. The lease period
would run for 13 years, with each payment being due at the BEGINNING of the year. Additionally, the
company would require an immediate P10,000 security deposit, which would be returned to Notting
Hill at the end of the 13-year period. Finally, Notting Hill would have to pay the annual maintenance
cost of the facilities, which is estimated to be P4,000 per year. There would be no resale value at the
end of the 13-year period under this option.
The hospital uses a discount rate of 14% and the total-cost approach to net present value analysis in
evaluating its investment decisions. Ignore income taxes in this problem.

Required:
1. What is the net present value of all cash flows under Option 1 (rounded to the nearest
thousand pesos)?

Present value of installment payment

(100,000 x 2.91371) P(291,371)
Immediate Payment (200,000)
Present value of resale value
(300,000 x 0.18207) 54,621
Present value of operating cost
(12,000 x 5.84236) (70,108)
Net Present Value P (506,858)
(rounded to the nearest thousand) P 507,000
2. What is the net present value of all the annual lease payments of P70,000 under Option 2
(rounded to the nearest hundred pesos)?

Net present value of annual lease payment

(70,000 x 1) P 70,000.00
(70,000 x 5.66029) 396,220.30
Net Present Value P466,220.30
(rounded to the nearest hundred) P466,200

3. What is the present value of all cash flows associated with the maintenance costs under
Option 2 (rounded to the nearest hundred pesos)?

Net present value of annual maintenance cost

(4,000 x 5.84236) P 23,369.44
(rounded to the nearest hundred) P 23,400