Solution manual management advisory services by agamata chapter 14

The weighted average cost of capital is used as a benchmark in evaluating the acceptability or rejection of proposed investment because it measures the point of expected return where the

CHAPTER 14 CAPITAL BUDGETING

[Problem 1]

Additional tax on savings (P25,000 x 40%) 10,000Net cost of investment for decision analysis P118,000[Problem 2]

Add’l tax on savings from repairs(P400,000 x 40%) 160,000

Net cost of investment for decision analysis P4,759,000[Problem 3]

Add’l tax on savings from repairs (P120,000 x 25%) 30,000Net cost of investment for decision analysis P990,500[Problem 4]

Selling and administrative expenses ( 700,000)

Depreciation expense (P1,200,000  5 yrs) ( 240,000)

Preferred dividends = 12% x P100 = P12 / sh Earnings per share = P75,000 / 50,000 sh = P1.50

equity 11% 3,000,000 1.65% 11,000 000 6.05% 5,000,000 2.75% Common

equity 14% 7,000,000 4.90% 7,000,000 4.90% 9,000,000 6.30% Total P20,000,000 9.55% P20,000,000 11.55% P20,000,000 10.85%

2 Package 1 gives the invest WACOC at 9.55%

[Problem 8]

Before Bonds Retirement After Bonds Retirement

Bonds P 5,000,000 (8% x 60% x 5/10) = 2.4% P4,000,000 (8% x 60% x 4/10) = 1.92% Preferred

equity 1,000,000 (9% x 1/10) = 0.9% 1,000,000 (9% x 1/10) = 0.90% Common

equity 4,000,000 (12.5% x 4/10) = 5% 4,000,000 (12.5% x 4/10) = 5.0% Lease 1,000,000 10% x 60% x 1/10) = 0.60% Totals P10,000,000 8.30% P 10,000,000 8.42%

b The weighted average cost of capital is used as a benchmark in

evaluating the acceptability or rejection of proposed investment because

it measures the point of expected return where the minimum required

return of each class of investor is met by reason of cross-subsidizing

from one class of security to another

[Problem 10]

a WACOC under each alternative

Debt (9% x 50% x 2/6) = 1.5% (12% x 50% x 4/6) = 4.0%Equity {[(P1/P20) + 7%] x 4/6} = 8.0% {[(P0.90/P20) + 12%] x 2/6} = 5.5%

b In alternative B, the amount of debt increases thereby increasing the

debt equity ratio signalling the firm is highly leveraged and more risky for investment This tends to increase the nominal rate of the bonds

c Yes; it is logical for stockholders to expect a higher dividend growth rate under alternative B to compensate the higher rate implied by an increase

in the debt exposure of the firm and to validate the theory that the more debt is used in the financing portfolio, the higher the profitability rate of the firm, thereby, the higher the growth rate

3 Maximum point of expansion for retained earnings:

Net income (P4.50 x 15 million shares) P67,500,000

Common dividends (P67,000,000 x 40%

Retained earnings available for expansion P33,750,000

Common equity = 50% of total capitalization

Maximum point of expansion before common stock

shares are issued = P33,750,000 / 50% = P67.5M

4 The WACOC varies among firms in the industry even if the basic

business risk is similar for all firms in the industry This is true because each firm selects the degree of financial leverage it desires This

financial leverage affects the capital mix structure of a firm that affects

the determination of the weighted average cost of capital

[Problem 12]

1 WACOC before and after bond retirement:

[1] Before Bond Retirement [2] After Bond retirement Capital Amount WACOC Amount WACOC

Lease P1,000,000 (10% x 60% x 1/10) = 0.6% 8% Debentures P5,000,000 8% x 60% x 5/10) = 2.4% 4,000,000 (8% 60% x 4/10) = 1.92% 9% Preferred

stock 1,000,000 (9% x 1/10) = 0.9% 1,000,000 {same} 0.9% Common stock 2,000,000 (13% x 2/10) = 2.6% 2,000,000 {same} 2.6% Retained

earnings 2,000,000 (13% x 2/10) = 2.4% 2,000,000 {same} 2.4%

P10,000,000 8.30% P10,000,000 8.42%

2 The component costs and the weighting used to calculate the WACOC

in a-1 is different in a-2 because P1 M of debentures are replaced by

lease which is more expensive (from 8% to 10% nominal rate) This

brings up the WACOC to 8.42%

3 Market values should be used in calculating the WACOC because COC calculation is used to estimate the current marginal cost of capital for the company The use of market values

a recognizes the current investor attitudes regarding the

company’s risk position and will reflect current rates for capital

b recognizes better the capital proportions the company must consider

in the capital sources decision; and

c ignores the influence of past values which are not relevant to future decision

[Problem 13]

1 The board member’s agreement is incorrect because the facts seem to indicate that Kia Corporation’s capitalization is not in optimum mix (i.e., equilibrium) The issuance of new debt will increase the financial

leverage of the firm, increases the risk, increases the note’s nominal rate,and decreases the earnings multiple While the marginal cost of capital

is a combination of explicit interest cost on the notes and the additional cost of earnings that must occur to compensate the common

stockholders for the decline in the earnings multiple The 14% return in this project should be compared with the new weighted average cost of capital if the issuance of note is undertaken.

2 New level of annual earnings of the earnings multiple declines to 9 =?

1 Present market price per share = 10(P2.70) = P27.00

Required EPS (new) = P27/9 = P3.00

Required earnings before tax

(P3.00 x 10,000,000 shares / 50%) P 60,000,000 Interest expense

[(P10 M x 8%) + (P50M x 10%)] 5,800,000 Required earnings before interest and taxes 65,800,000 Less: Old earnings before interest and taxes

{[(P2.70 x 10,000,000 shares) / 50%] + P800,000} 54,800,000 Additional earnings before interest and taxes P 11,000,000

Additional informational analysis:

If the earnings multiple declines to 9, the additional earnings provided by the new assets to maintain the same market priceper share of P27 shall be:

X = additional earnings(new P/E) (new EPS) = P27

9 ( P2.70 + X) = P27 2.70 + X = P3

X = P0.30[Problem14]

3 Graph of marginal cost of capital (MCC) schedule and investment

opportunities schedule (IOC):

1 EPS and market price per share = ?

a Raise P100,000 by issuing 10-year, 12% bonds

Case 1 Case 2 Case 3

(NI / 10,000 shares)

EPS (old) = P36 / 12 = 3

No of shares = P30,000 / P3 = 10,000 sh

b Raise P100,000 by issuing new column stock

Case 1 Case 2 Case 3

No of shares

(P100,000 / P33.33 + 10,000) 13,000 13,000 13,000

The recommendation shall be based on the following criteria:

Wealth Maximization Profit Maximization

 The proposal chosen  The total sales of the

firm should be higherthan P600,000, since itssales last year wasalready at P600,000 Atthis level and more, the

market price per share ishigher by issuing a newshare of stock Wealthmaximization is astrategic reason ofmanaging a business,hence, at guidesorganization in its long-term decisions, such asfinancing decision

3 No, the financing package chosen would be the same The

higher the level of sales in excess of P600,000, the more

favorable it is on the part of the business!

4 The investment banker would rationalize that issuance of more

debt securities would mean a greater variability in earnings and higher risk of bankruptcy created by the fixed commitment to paydebt interest and principal This would bring restrain by

diminishing the earnings multiple to compensate the increased risk in leverage

ARR (average) = [P60,000 / (P1 million/2)] = 12%

Payback period = P 2 million / P668,000 = 2.99 yrs

3 Payback bailout period = [(P4 4M x 80%) / P668,000] = 4.79 yrs

5 ARR (average) = [(P348,000 / (P4 M + P800,000) / 2] = 14.5%

[Problem 21]

Payback period (P40,000 / P11,000) 3.64 yrs

Less: Cost of investment 600,000

[Problem25]

1.

3 The net advantage of investing in distributing an imported product is

Annual cash inflows:

(P500,000 x 3.889) P 1,944,500

(P400,000 x 3.889) P 1,555,600Salvage value

(P100,000 x 0.456) 45,600

Recovery of working capital

(P200,000 x 0.456) 91,200

(P1,400,000 x 0.456) 638,400Total PV of cash inflows 2,081,300 2,194,000Less: COI

(P1,400,000 + P200,000) 1,600,000

(P200,000 + P1,400,000) 1,600,000

Payback period – Proj X [3 yrs + (P358,000/P1,184,000)] 3.30 yrs.

Payback period – Proj Y [2 yrs + (P8,000/P1,012,500)] 2.01 yrs

* (P234,000 = [(Total cash inflows + SV)  5]

b Using Table 2, the PVF of 3.419 is between 14% and 16%

b.1 Using 16% and 18% discount rates we have:

P800,000 P234,000 *

SV 40,000 0.476 19,040 0.437 17,480Totals P 824,770 P 793,940

b.2 Since the cost of investment of P800,000 is found the present

value of cash inflows (PVCI) of 16% and 18%, then by interpolation, the IRR, could be determined as:

?

6,060 18% 793,940

IRR = 20% + 0.006 x 2% = 20.09%

0.127

Background analysis:

Cash savings before depreciation (P138,600 - P91,300) P47,300

1 Payback period = P160,000/P36380 = 4.40 yrs

2 Payback reciprocal = 1/.P4.40 = 22.73%

3 ARR (original) = P16,380/P160,000 = 10.24%ARR (average) = P16,380/(P160,000/2) = 20.48%

PVF at8%

PV of Tax

1 P3.2M P2.0M P1.2M P(480,000) 0.926

P(444,480)

Total P101,760

[Problem 32]

Tax Expense IBIT Tax (30%) Income Expense Tax Straight Line

Method

(P2,400,000 -

P1,430,000) P970,000 P360,000 P610,000 P183,000 P427,000 P360,000 P787,000 Sum-of-the-

years-digit

method

Year 1 P970,000 640,000 330,000 99,000 231,000 640,000 871,000 Year 2 P970,000 560,000 410,000 123,000 287,000 560,000 847,000 Year 3 P970,000 480,000 490,000 147,000 343,000 480,000 823,000 Year 4 P970,000 400,000 570,000 171,000 399,000 400,000 799,000 Year 5 P970,000 320,000 650,000 195,000 455,000 320,000 775,000 Year 6 P970,000 240,000 730,000 219,000 511,000 240,000 751,000 Year 7 P970,000 160,000 810,000 243,000 567,000 160,000 727,000 Year 8 P970,000 80,000 890,000 267,000 623,000 80,000 703,000

1.a Annual cash inflows after tax:

Alternately, cash inflows after tax may be computed by deducting the

corresponding income tax from the cash flows before tax The tax

expense equals cash flows before tax less depreciation expense

b Net present values, straight-line method and SYD method

Recovery of working capital

(P400,000 x 0.540) 216,000 216,000

Cost of investment(P3M +

P400,000) (3,400,000) (3,400,000)

Net present value P1,403.689 P1,458,328

Advantage of the SYD method P 54,639

2 The tax benefit using SYD method instead of the straight-line method

six years ago

=

= P15.132[Problem 35]

1 PV of cash dividends (20,000 shares x P4 x 3.605) P288,400

PV of stock sales (P500,000 x 115% x 0.567) 326,025

P35,000 Future Value Factor @ 15%, n = 6 P35,000

2.313

Less: cost of investment 500,000

2 PV of interest receipts (P500,000 x 14% x 3.605) P252,350

PV of bond redemption (P500,000 x 150% x 0.567) 425,250

3 The investment in bonds is more advantageous by P63,175 (i.e., P177,600– P114,425) than the investment in stock

Net present value of intangible benefits P 637,900

Less: Cost of investment (P2,700,000 – P70,000) 2,630,000

Salvage value – new (P150,000 x 0.519) 77,850 P2,344,004

Less: Cost of investment (P2,700,000 – P70,000 2,630,000

[Problem 38]

1.

Make Buy Relevant cost to buy / make

Year 1 (50,000 x P22 x 0.893) P 982,300 P 1,294,850 (50,000 x P29 x 0.893) Year 2 (50,000 x P22 x 0.797) 876,700 1,155,650 (50,000 x P29 x 0.797) Year 3 (52,000 x P22 x 0.712) 814,528 1,032,400 (50,000 x P29 x 0.712) Year 4 (55,000 x P22 x 0.636) 769,560 1,014,400 (55,000 x P29 x 0.636) Year 5 (55,000 x P22 x 0.567) 686,070 904,365 (55,000 x P29 x 0.567) Avoidable fixed overhead

(P45,000 x 3.605) 162,225

Salvage value - old asset (1,500)

Salvage value - new (P12,000 x 0.567) (6,804)

Tax savings on depreciation expense

PV of relevant costs - 5 yrs P 3,883,772 P 5,401,685

Net advantage of making in 5 yrs P 1,517,913

2 Some of the non-financial and qualitative factors to be considered

before deciding whether to make or buy a part are:

a Availability of materials from supplier

b Stability of prices of material

c Quality of parts to be supplied

d Dependability of past supplier

e Impact of new technology

[Problem 39]

1 Increase in direct materials [(P4.50 – P3.80) x 80,000] P (56,000)

Decrease in direct labor and variable

2 Regular operating cash inflows

(P363,200 + P299,200 + P235,200 + P171,200 + P107,200)P 1,176,000

Zero, there is no excess of after tax cash inflows over the cost of initial investment because the total cash inflow is even lower than thecost of investment.