Warla 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 materialsP 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. Warla 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 materialsP 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 Warla 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. Warla 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.
The present values of 1 at the end of each period using 12 percent are:
Period 1 0.89286
Period 2 0.79719
Period 3 0.71178
Period 4 0.63552
PV of annuity of 1, 4 periods 3.03735

1. The net investment in new tools amounted to:

2. How much annual cost savings will be generated if the Warla Company purchases the new tools?
3. The present value of tax benefits expected from the use of the new machine tools is:
4. The present value of the salvage value of the new tools to be received at the end of fourth year is
5. Using the minimum acceptable rate of return of 12 percent, the net present value of the investment
in new tools is
6.The net advantage of the use of declining method of depreciation instead of straight-line method is