Activity 29

A. Diane Manufacturing Company is considering investing P 600,000 in new equipment with anestimated
useful life of 10 years and no salvage value. The equipment is expected to produce P 240,000in cash
inflows and P 160,000 in cash outflows annually. The company uses straight-line depreciation,and has
a 30% tax rate. Determine the annual estimated net income and net cash inflow.

Annual Depreciation = 600,000/10 = 60,000

Net Income Net Cash Inflow

Cash Inflows P 240,000 P 240,000
Cash Outflows (160,000) (160,000)
Net Cash Inflows 80,000 80,000
Annual Depreciation (60,000)
Net Income before taxes P 20,000
Tax (6,000) (6,000)
Net Income/Net Cash Inflow P 14,000 P 74,000

B. Zen Manufacturing Company is considering replacing a four-year-old machine with a new, advanced
model. The old machine was purchased for P 60,000, has an estimated useful life of 10 years with no
salvage value, and has annual maintenance costs of P15,000. The new machine would cost P 45,000,
but annual maintenance costs would be only P 6,000. The new machine would have an estimated useful
life of 10 years with no salvage value. Using straight-line depreciation and an assumed 30% tax rate,
compute the additional annual cash inflow if the old machine is replaced.

Change in Annual Cash Expenses: Net Cash Flow

Old Machines P 15,000
New Machine (6,000)
Annual net cash savings before taxes 9,000
x 30% income tax expense (9,000 x 30%) (2,700)
Annual net cash inflow after tax P 6,300
Annual Depreciation:
Old Machines (P60,000/10) 6,000
New Machine (P45,000/10) 4,500
Decrease in Annual Depreciation Expense 1,500
x 30% income tax expense (1,500 x 30%) (450)
Annual net cash inflow after tax P 5,850*

*(6,300 annual net cash inflow + 450 tax increment from depreciation)
C. Given the following annual costs, compute the payback period for the new machine if its initial cost is
P 420,000.
Old machine New machine
Depreciation P 18,000 P 42,000
Labor 72,000 63,000
Repairs 21,000 4,500
Other costs 12,000 3,600
Total P 123,000 P 113,100

Change in Annual Cash Expenses:

Old Machines (72,000+21,000+12,000) P 105,000
New Machine (63,000+4,500+3,600) (71,100)
Annual net cash inflow before tax P 33,900

Payback Period = 420,000/33,900 = 12.39 years or 12 years and 5 months

D. Jefferson Company is considering investing P 33,000 in a new machine. The machine is expected to last
five years and to have a salvage value of P 8,000. Annual before-tax net cash inflow from the machine
is expected to be P 7,000. Calculate the unadjusted rate of return. The income tax rate is 30%.

Net Cash Inflows 7,000

Annual Depreciation (5,000) 1,400
ARR =
Net Income before taxes P 2,000 33,000
Tax ( 600) ARR = 4.24%
Net Income P 1,400

E. Compute the profitability index for each of the following two proposals assuming the desired minimum
rate of return is 20%. Based on the profitability indexes, which proposal is better?
Proposal 1 Proposal 2
Initial cash outlay P 16,000 P 10,300
Net cash inflow (after taxes):
First year 10,000 6,000
Second year 9,000 6,000
Third year 6,000 4,000
Fourth year -0- 2,500

Proposal 1 PV Factor Present Values Proposal 2 PV Factor Present Values

First year 10,000 0.8333 8,333 6,000 0.8333 5,000
Second year 9,000 0.6944 6,250 6,000 0.6944 4,166
Third year 6,000 0.5787 3,472 4,000 0.5787 2,315
Fourth year 2,500 0.4823 1,206
Total 18,055 7,687

1 2
Present value of annual cash flows P 18,055 P 7,687 Based on their
Investment required 16,000 10,300 profitability indexes,
Profitability Index 1.13 0.75
Proposal 1 is better
than Proposal 2.
F. Simone Company is considering the purchase of a new machine costing P 50,000. It is expected to save
P 9,000 cash per year for 10 years, has an estimated useful life of 10 years, and no salvage value.
Management will not make any investment unless at least an 18% rate of return can be earned.
1. Using the net present value method, determine if the proposal is acceptable. Assume all tax effects
are included in these numbers.

Present Value of Cash Inflows:

Annual Cash Flows (9,000 * 4.494) P 40,446
Net Investment (50,000)
Net Present Value P (9,554)

2. Calculate the time-adjusted rate of return.

Investment = Annual Cash Returns (x)

50,000 = 9,000x
x = 5.556

12% - 5.650
0.094
? - 5.556 0.224

13% - 5.426

0.094
Exact IRR = 12% + * 1%
0.224
= 12% + 0.42%
Exact IRR = 12.42%

G. Ross Company is considering three alternative investment proposals. Using the following information,
rank the proposals in order of desirability using the payback period method.
Proposal
A B C
Initial outlay P 360,000 P 360,000 P 360,000
Net cash inflow (after taxes):
First year -0- 90,000 90,000
Second year 180,000 270,000 180,000
Third year 180,000 90,000 270,000
Fourth year 90,000 180,000 450,000
Total Cash Inflow P 450,000 P 630,000 P 990,000
 Proposal A Proposal B
Annual net Investment/ Amount to Annual net Investment/ Amount to
Year Year
cash inflow be recovered cash inflow be recovered
0 —– P 360,000 0 —– P 360,000
1 -0- 360,000 1 90,000 270,000

2 180,000 180,000 2 270,000 0

3 180,000 0

Proposal C
Rank:
Annual net Investment/ Amount to
Year
cash inflow be recovered 1. B – 2 years
0 —– P 360,000
2. C – 2.33 years
3. A – 3 years
1 90,000 270,000
2 180,000 90,000
3 270,000 0
90/270 2.33 years

H. Rank the following investments for Renate Company in order of their desirability using the (a) payback
period method, (b) net present value method, and (c) time-adjusted rate of return method. Management
requires a minimum rate of return of 14%.
Initial Expected after-tax net cash Expected life of proposal
Investment Cash outlay Inflow per year (years)
A P 120,000 P 15,000 8
B 150,000 26,000 20
C 240,000 48,000 10

A B C Rank:
Initial Cash Outlay 120,000 150,000 240,000 1. Inv. C
Cash Inflows 15,000 26,000 48,000 2. Inv. B
Payback (in years) 8 5.77 5 3. Inv. A

A B C
PV of Cash Flows Rank:
15,000 * 4.6389 69,584 1. Inv. B
26,000 * 6.623 172,198 2. Inv. C
48,000 * 5.216 250,368 3. Inv. A
Net Investment 120,000 150,000 240,000
Net Present Value (50,146) 22,198 10,368

A B C
Initial Cash Outlay 120,000 150,000 240,000 Rank:
Cash Inflows 15,000 26,000 48,000 1. Inv. B
PV Factor 8 5.77 5 2. Inv. C
IRR n/a 16.53% 15.10% 3. Inv. A
 Activity 30
A. Hamlet Company is considering the purchase of a new machine that would cost P 300,000 and would
have an estimated useful life of 10 years with no salvage value. The new machine is expected to have
annual before-tax cash inflows of P 100,000 and annual before-tax cash outflows of P 40,000. The
company will depreciate the machine using straight-line depreciation, and the assumed tax rate is 40%.
a. Determine the net after-tax cash inflow for the new machine.
b. Determine the payback period for the new machine.

Annual Depreciation = 300,000/10 = 30,000

Net Income Net Cash Inflow

Cash Inflows P 100,000 P 100,000
Cash Outflows (40,000) (40,000)
Net Cash Inflows 60,000 60,000
Annual Depreciation (30,000)
Net Income before taxes P 30,000
Tax (12,000) (12,000)
Net Income/Net Cash Inflow P 18,000 P 48,000

Payback Period = 300,000/48,000 = 6.25 years or 6 years and 3 months

B. Graham Company currently uses four machines to produce 400,000 units annually. The machines were
bought three years ago for P 50,000 each and have an expected useful life of 10 years with no salvage
value. These machines cost a total of P 30,000 per year to repair and maintain.

The company is considering replacing the four machines with one technologically superior machine
capable of producing 400,000 units annually by itself. The machine would cost P 140,000 and have an
estimated useful life of seven years with no salvage value. Annual repair and maintenance costs are
estimated at P 14,000.

Assuming straight-line depreciation and a 30% tax rate, determine the annual additional after-tax net
cash inflow if the new machine is acquired.

Change in Annual Cash Expenses: Net Cash Flow

Old Machines P 30,000
New Machine (14,000)
Annual net cash savings before taxes 16,000
x 30% income tax expense (9,000 x 30%) (4,800)
Annual net cash inflow after tax P 11,200
Annual Depreciation:
Old Machines (P200,000/10) 20,000
New Machine (P140,000/70) 20,000
Change in Annual Depreciation Expense 0
Annual net cash inflow after tax P 11,200
 Activity 31
Macro Company owns five machines that it uses in its manufacturing operations. Each of the machines
was purchased four years ago at a cost of P 120,000. Each machine has an estimated life of 10 years with
no expected salvage value. A new machine has become available. One new machine has the same
productive capacity as the five old machines combined; it can produce 800,000 units each year. The new
machine will cost P 648,000, is estimated to last six years, and will have a salvage value of P 72,000. A
trade-in allowance of P 24,000 is available for each of the old machines. These are the operating costs per
unit:

Five old Machines New Machines

Repairs P 0.6796 P 0.0856
Depreciation 0.1500 0.2400
Power 0.1890 0.1036
Other operating costs 0.1620 0.0496
Total Costs P 1.1806 P 0.4788

Direction: Ignore income taxes. Show your computations to support your answers.

1. Do you recommend replacing the old machines? Support your answer with computations. Disregard all
factors except those reflected in the data just given.

Initial Cash Outlay P 648,000

Less: Trade-in Allowance (P24,000 *5) 120,000
Net Investment P 528,000

Change in Annual Cash Expenses:

Old Machines (1.0306 * 800,000) P 824,480
New Machine (0.2388 * 800,000) (191,040)
Annual net cash inflow before tax P 633,440

Annual Cash Flows [(633,440 * 6) + P 72,000] P 3,872,640

Net Investment 528,000

Answer: Replace the old machines with the new machine because it will give the company an
additional P 633,440 cash flow for the next six years and the amount of investment will be
recovered.

2. If the old machines were already fully depreciated, would your answer be different? Why?

No. Because ignoring income taxes, there will be no difference in the computation of annual net
cash inflow.

3. Using the net present value method with a discount rate of 20%, present a schedule showing whether
or not the new machine should be acquired.

Present Value of Cash Inflows:

Annual Cash Flows (633,440 * 3.326) 2,106,821
 Salvage Value (72,000 * 0.335) 24,120
Total P 2,130,941
Net Investment (528,000)
Net Present Value P 1,602,941

Activity 32
Span Fruit Company has used a particular canning machine for several years. The machine has a zero-
salvage value. The company is considering buying a technologically improved machine at a cost of P
232,000. The new machine will save P 50,000 per year after taxes in cash operating costs. If the company
decides not to buy the new machine, it can use the old machine for an indefinite time by incurring heavy
repair costs. The new machine would have an estimated useful life of eight years.

Direction: Ignore income taxes. Show your computations to support your answers.

1. Compute the time-adjusted rate of return for the new machine.

Investment = Annual Cash Returns (x)

232,000 = 50,000x
x = 4.64
From the PV OA table, 14% in 8 periods has a factor of 4.64.

2. Management thinks the estimated useful life of the new machine may be more or less than eight years.
Compute the time-adjusted rate of return for the new machine if its useful life is (1) 5 years and (2) 12
years, instead of 8 years.

2% - 4.713
0.073
? - 4.64 0.133

3% - 4.580

0.073
Exact IRR = 2% + * 1%
0.133
= 2% + 0.55%
Exact IRR = 2.55%

18% - 4.793
0.153
? - 4.64 0.182

19% - 4.611
 0.153
Exact IRR = 18% + 0.182 * 1%

= 18% + 0.84%
Exact IRR = 18.84%

3. Suppose the new machine’s useful life is eight years, but the annual after-tax cost savings are only P
45,000. Compute the time-adjusted rate of return.

Investment = Annual Cash Returns (x)

232,000 = 45,000x
x = 5.156

10% - 5.335
0.179
? - 5.156 0.189

11% - 5.146

0.179
Exact IRR = 10% + * 1%
0.189
= 10% + 0.95%
Exact IRR = 10.95%

4. Assume the annual after-tax cost savings from the new machine will be P 35,000 and its useful life will
be 10 years. Compute the time-adjusted rate of return.

Investment = Annual Cash Returns (x)

232,000 = 35,000x
x = 6.629

8% - 6.710
0.081
? - 6.629 0.292

9% - 6.418

0.081
Exact IRR = 8% + * 1%
0.292
= 8% + 0.28%
Exact IRR = 8.28%
 Activity 33

Bail – out Period = 120,000 - 40,000 - 36,000 - 28,000 = 0.5 + 3 years = 3.5 years
32,000