DETERMINATION OF NET INITIAL INVESTMENT

The management of Maingat company plans to replace a sorting

machine that was acquired several years ago at a cost of P60,000. The
machine has been depreciated to its residual value of P10,000
A new sorter can be purchased for P96,000. The dealer will grant a
trade-in allowance of P16,000 on the old machine. If a new machine is
not purchased, Maingat Company will spend P10,000 to repair the old
machine. Gains and losses on trade-in transactions are not subject to
income taxes. The cost to repair the old machine can be deducted in
computing income taxes. Income taxes are estimated at 40% of the
income subject to tax. Additional working capital required is P50,000.
SOLUTION:

Purchase price of new sorter P96,000

Add: Additional working capital 50,000
Total P146,000
Less: Trade-in allowance on old sorter 16,000
Avoidable repairs cost on old sorter
(net of increase in income taxes of P4,000) 6,000 22,000
Net investment P124,000
DETERMINATION OF ANNUAL CASH RETURNS

Alalay Company is considering the acquisition of a new machine which

will cost P120,000. It has an expected useful life of five years at the of
which its scrap value will be P20,000. The company expects to be able
to generate annual cash flow before taxes of P40,000. Estimated
income tax rate is 30%. What is the annual cash flow after taxes on this
investment?
SOLUTION:

Annual cashflow before taxes P40,000

Less: Depreciation 20,000
Net Income before taxes P20,000
Less: Income taxes (30%) 6,000
Net income after taxes P14,000
Add: Depreciation 20,000
Annual cashflow after taxes P34,000
Computation of Weighted Average Cost of Capital
The following information on Bettina Corporation’s Capital structure is available from the latest financial statement:
SOURCE AMOUNT PROPORTION
6% Bank loan P300,000 30%
5% Preference shares P100,000 10
Ordinary shares P200,000 20
Retained earning P400,000 40
Total P1,000,000 100

Additional data:
Current market price per share
Preference shares P62.50
Ordinary shares P40.00
Dividend per share
Preference shares P5
Ordinary shares P2
Dividend growth rate 4%
Corporate tax rate 32%
SOLUTION:

a. Cost of Debt
= 6% x (1 – 32%)
= 4.08%
b. Cost of Preference shares
= P5/P62.50
= 8%
c. Cost of Ordinary shares
= (P2/P40) + 4%
= 9%
d. Retained Earnings (same as ordinary shares)
Weighted Average Cost of Capital:

(30% x 4.08%) + (10% x 8%) + (20% x 9%) + (40% x 9%)

= 7.4%