CHAPTER 25

PFS: FINANCIAL ASPECT – INVESTMENT COSTS

Project preparation should be geared towards the requirements of financial and economic evaluation.
Financial evaluation should preferably rely on discounting methods and incorporate sensitivity analysis. Projects
should also be evaluated from the aspect of their direct and indirect effects on the national economy.
Determination of Total Investment Costs
Investment Costs are defined as the sum of fixed capital (fixed investment plus pre-production capital
costs) and net working capital, with fixed capital constituting the resources required for constructing and
equipping an investment project, and working capital corresponding to the resources needed to operate
the project totally or partially.
At the pre-investment stage, two mistakes are frequently made:
 Working capital is included either not at all or in insufficient amounts.
 Total investment costs are confused with total assets, which correspond to fixed assets plus pre-
production capital costs plus current asset.
Initial Investment Costs
COST OF PROJECT:
Fixed investment cost
Land P xx
Buildings xx
Equipment xx
Total initial fixed investment P xx
Working capital xx
Pre-production capital expenditures xx
TOTAL INITIAL INVESTMENT COSTS Pxx

a. Fixed investments include Land and site preparation, Buildings and civil works, Plant machinery and
equipment including auxiliary equipment, and Industrial property rights.
b. Pre-operating expenditures - These expenditures which have to be capitalized include
1. Preliminary and capital issue expenditure (e.g. registration and formulation of the company
including legal fees, capital issue expenditures, preparation of prospectus, underwriting
commissions, brokerage, etc.)
2. Expenditures for preparatory studies (e.g. consultant fees for preparing the studies and other
expenses for planning the project).
3. Pre-production expenditure which include salaries, travel expense, training costs incurred during
the pre-production period.
4. Trial runs, start-up and commissioning expenditures.
c. Net Working Capital (covered in Chapter 15)
It indicates the financial means required to operate the project according to its production program.
Net Working Capital = Current Assets minus Current Liabilities
Current Asset comprise:
a. Account Receivable – The size of account receivable is determined by the company’s credit sale
policy and may be computed using the following formula:
𝐀𝐧𝐧𝐮𝐚𝐥 𝐒𝐚𝐥𝐞
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 = 𝐱 𝐂𝐫𝐞𝐝𝐢𝐭 𝐭𝐞𝐫𝐦𝐬 𝐢𝐧 𝐦𝐨𝐧𝐭𝐡𝐬
𝟏𝟐 𝒎𝒐𝒏𝒕𝒉𝒔
 b. Inventories – Working capital requirements are considerably affected by the amount of capital
immobilized in the form of inventories.
1.Production materials – In computing, consideration should be given to the sources and
modes of supplies of materials and finished goods.
If materials are locally available, only limited stocks should be maintained unless
there are special storage problems.
If materials are imported and if import procedures are dilatory, inventories
equivalent to as much as six months consumption may have to be maintained.
2. Spare parts – Levels of spare parts inventories depend on the local availability of supplies,
import procedures and maintenance facilities in the area and on the nature of the plant
itself.
3. Work-in-progress – The valuation is made at the factory costs of work-in-progress.
4. Finished goods – The valuation is made at the factory costs plus administrative overheads.

Steps in the Calculation of Net Working Capital

1. Determine the minimum coverage of days for current assets and liabilities.
Based on the study of industry’s operating characteristics, the following minimum requirement for
current assets and current liabilities were established:
Accounts receivable 30 days
Inventory
Raw material A-local 30 days
Raw material B-local 14 days
Imported raw materials 100 days
Spare parts 180 days
Work-in-progress 9 days at factory cost
Finished goods 15 days at factory cost + administrative cost
Cash on Hand 15 days
Accounts Payable 30 days, for raw materials and utilities
2. Compute the annual production, selling and administrative costs since the values of some
components of current assets are expressed in these terms.
The project planner should do the following:
1. Obtain a good understanding of the types of operations and services needed to achieve
the production objective.
2. Divide the production process into related functions grouped into cost centers.
3. Identify the service cost centers that render the supplementary services necessary to the
smooth running of the plant.
4. Identify the administrative and finance cost centers.
The project team should have an excellent comprehension of the various cost centers required
to organize and operate the projects as well as the cost items accruing there.

The major categories of Operating and Financial costs are:

1. Production Costs – are those directly identified with the finished goods or services or those that
are directly attributable in the process of making goods or services. These cost items should be
estimated by the service cost centers.
a. Direct materials – It will be estimated based on expected level production and required
materials per unit of product and projected unit purchase cost.
b. Direct labor – The manpower estimate should meet these two basic requirements:
  Detailed table for manpower required as well as the calculation of the cost of
manpower.
 Comparison of the required personnel with the available labor force which will
facilitate the assessment of the training requirement.
c. Factory overhead – All costs incurred in the factory that are not direct materials or direct
labor. For examples,
i. Indirect labor such as wages and salaries of manpower and employees not directly
involved in the production
ii. Indirect materials
iii. Indirect expenses which include office supplies, utilities and repair and
maintenance
2. Administrative and selling expenses which should be calculated separately
a. Wages and salaries (including benefits and social security contribution for sales and
administrative personnel)
b. Rent
c. Insurance
d. Sales commissions
e. Taxes
These cost elements should be estimated for the selling and administrative centers such as
management, finance, etc.
3. Depreciation and amortization charges which are included under factory overhead and
selling and administrative costs. These are calculated based on the original value of fixed
investment using such methods as straight line, sum of the years’ digits or other methods
approved by the tax authorities.
4. Financial costs such as interest and financing charges on term loans and other sources of
capital.
3. Determine the coefficient of turnover for the components of current assets and liabilities by dividing
360 days by the number of minimum coverage and divide the total cost data developed in Step 2 by
the respective coefficient of turnover.
𝟑𝟔𝟎 𝐝𝐚𝐲𝐬
𝐂𝐨𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭 𝐨𝐟 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝒏 𝒅𝒂𝒚𝒔 𝒐𝒇 𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒎𝒆𝒏𝒕𝒔
Finally, deduct the current liabilities from the sum of current assets. The required cash-on-hand is
calculated separately.
 CHAPTER 26
PFS: FINANCIAL ASPECT – PROJECT FINANCING AND EVALUATION
The allocation of financial resources to a project constitutes an obvious and basic prerequisite not only for
any investment decision but also for project formulation and pre-investment analysis. A preliminary assessment
of project financing possibilities should already have been made in most cases before a feasibility study is
undertaken.
DETERMINING FUNDS REQUIREMENT AND PROFITABILITY
Financial institutions use projected statements when assessing project proposals. (Covered in Chapter 14)
The following statements may be prepared:
A. Projected Statement of Comprehensive Income
 The statements of comprehensive income from the start-up period to the point where the project is
fully operational will be prepared to estimate the net income or loss the company will generate.
 The statement can also be extended to compute the amount of earnings that can be reinvested in
the business during the projection period.
 If projected operating results look poor, the proponents can reformulate its plans for the duration
of the project.
B. Projected Statement of Financial Position
 The statement of financial position will project both the resources required as well as the sources
of financing that will be availed of to meet the needs of the enterprise.
C. Projected Cash Flow
 The timing of inflow of funds (from financial resources and sales revenue) must also be
synchronized with the outflow of the investment expenditures, production costs and other
expenditures.
 It is necessary to prepare a cash-flow table showing the inflow and outflow of finance. Such a
cash-flow table is of utmost importance in the investment phase of the project. A project analyst
should resist the temptation of pleasing the sponsors of the study by low figures.
 Financing planning for the operation period must ensure that cash inflow form sales revenue will
be adequate to cover production costs and all financial commitments.
Bad financial planning in pre-investment studies will clog the progress of the project either while obtaining
clearance by financial institutions or at an even more crucial stage of project implementation.
POSSIBLE SOURCES OF FINANCING
The general financing pattern for an industrial project is to cover the initial capital investment by equity
and long term loans to varying extents and to meet working capital requirements by additional short and medium-
term loans from local banking sources. (Covered in Chapter 17-19)
Equity Financing
 In certain projects, ordinary equity and preference share capital cover not only the initial capital investment
but also net working capital requirements, for the most part.
 The higher the proportion of equity the less the income from individual share units, as dividends would
have to be distributed among a larger number of units. The higher the proportion of loan finance, the
higher the interest liabilities.
Loan financing
Since it is relatively easy to obtain loans, the process of project financing may well start by identifying
the extent to which loan capital can be secured, together with the interest rate applicable.
 a) Short-term loans
 Short-term loans from commercial banks and local financial institutions are available against
hypothecation, or pledging, of inventories.
 Bank borrowing for working capital can be arranged on a temporary basis without jeopardizing
the overall liquidity of the project. In some cases, working capital needs should even be partly
met out of long-term funds (equity capital and long-term loans) since the largest portion of
working capital is permanently tied in inventories.
 Imported machinery and spares can often be financed on deferred-credit terms. Deferred-
payment terms are available against bank guarantees; this enables such machinery suppliers to
obtain refinancing facilities from financial institutions in their own countries.
b) Long-term loans
 Loan financing is usually available with certain regulations, such as restrictions on the
convertibility of shares, and declaration of dividends.
 Investment may also be financed partly by issues of bonds and debentures.
 An important source of finance is also available at government-to-government level in the case
of many developing countries. This can take the form of general bilateral credit or tied credit.

ECONOMIC EVALUATION
Financial evaluation quantifies the results of marketing, technical, management, taxation and legal phases
and expresses in peso terms the possible profitability of the project. This should preferably rely on discounting
methods and incorporate sensitivity analysis.
Inclusion of projected statement in the financial study assists in the evaluation of the results of the financial
projections as to profitability, liquidity and solvency of the projects and its ability to withstand difficulties.
To measure profitability To measure liquidity
1. Common-size projected financial statements 1. Current ratio
2. Rate of return on investments 2. Acid test ratio
i. Discounted rate of return 3. Payback period
ii. Accounting rate of return 4. Cash break-even
iii. Profitability index To measure financial leverage
3. Cost-Volume-Profit/Break-even Analysis 1. Debt-to-equity ratio
4. Earnings per share 2. Equity to assets ratio
3. Debt service break-even point
4. Times interest earned

Break- Even Analysis

Break-even point (BEP) – the point at which sales revenue equal production costs and expenses.
Prior to calculating the break-even point, the following assumptions should be observed:
1. Production costs are a function of the volume of production or of sales;
2. The volume of production equals the volume of sales;
3. Fixed operating costs are the same for every volume of productions;
4. Variable unit costs vary in proportion to the volume of production, and consequently total production cost
also change in proportion to the volume of production;
5. The unit sale price for a product or product mix are the same for all levels of output over time. The sales
value is therefore a linear function of the unit sale prices and the quantity sold;
6. Data from a normal year of operation should be taken;
7. The level of unit sale prices, variable and fixed operating costs remain constant;
8. A single product is manufacture or, if several similar ones are produced, the mix should be convertible
into a single product;
9. The product mix should remain the same over time.
 Basic CVP Analysis CVP Sensitivity Analysis
Quantity Sold Changes Changes
Unit Sales Price Constant Changes
Total Variable costs and expenses Changes in direct proportion to changes in
Changes
quantity sold
Variable Costs rate Constant Changes
Total Fixed costs and expenses Constant Changes
Fixed Costs rate Changes inversely in relation to the
Changes
changes in quantity sold
Sales Mix Constant Changes
Work in Process None None

𝐅𝐈𝐗𝐄𝐃 𝐂𝐎𝐒𝐓𝐒
Break-even Formula: 𝐁𝐄𝐏 (𝐮𝐧𝐢𝐭𝐬) = 𝑼𝒏𝒊𝒕 𝒔𝒆𝒍𝒍𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆−𝑼𝒏𝒊𝒕 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕𝒔

Illustrative Case: Tyro Products manufactures recreational equipment. One of the company’s products, a
skateboard, sell for P37.50. The skateboards are manufactured in an antiquated plant that relies heavily on the
direct labor workers. Thus, variable costs are high, totalling P22.50 per skateboard.
Over the past year the company sold 40,000 skateboards, woth the following operating results:
Sales (40,000 skateboard) P1,500,000
Less variable expenses 900,000
Contribution margin 600,000
Less fixed expenses 480,000
Net income P120,000
Management is anxious to maintain and perhaps even improve its present level of income from the skateboards.
Required:
1. Compute the contribution margin and the break-even point in the skateboard, and the degree of operating
leverage at last year’s level of sales.
2. The company is considering the construction of a new, automated plant to manufacture the skateboard,
the new plant would slash variable costs by 40%, but it would cause fixed cost to increase 90%. Of the
new plant is built, what would be the company’s new CM ration and the new break-even point in
skateboards?
Analysis:
1.
Contribution margin is the amount used to absorb fixed costs and contribute to profit.

Sales P37.50 100%

Less variable expenses 22.50 60
Contribution margin P15.00 40%
Sales = Variable expenses + Fixed expenses + Profits Alternative Solution:
P37.50x = P22.50x + P480,000 + P0 Fixed expenses ÷ Unit Contribution
P15.00x = P480,000 P480,000 ÷ P15 = 32,000 skateboards
X = P480,000 ÷ P15.00
X = 32,000 skateboards
The degree of leverage would be:
𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐧 𝐦𝐚𝐫𝐠𝐢𝐧 P600,000
𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = = 𝟓. 𝟎
𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 P120,000
 Degree of Leverage measures the effect of a change in sales to the profit of the enterprise. In
this case, the profit would have a percentage change of 5% for every 1% change in sales.
2. The new CM ratio would be:

Sales P37.50 100%

Less variable expenses 13.50 36
Contribution margin P24.00 64%
*P22.50 – (P22.50 x 40%) = P13.50

The new break-even point would be:

Sales = Variable expenses + Fixed expenses + Profits Alternative Solution:
P37.50x = P13.50x + P912,000 + P0 Fixed expenses ÷ Unit Contribution
P24.00x = P912,000 P912,000 ÷ P24 = 38,000 skateboards
X = P912,000 ÷ P24.00
X = 38,000 skateboards
 P480,000 x 1.9 = P912,000

Net Present Value

Net Present Value Method is a method that screens and ranks investment proposals by determining the
difference between present value of the cash inflows and the cash outflows associated with the investment
projects.
Procedure:
1. Find the present value of each cash flow, including both inflows and outflows discounted at the
project’s cost of capital.
2. Sum these discounted cash flows; this sum is defined as the project’s NPV.
Decision Rule:
1. If NPV is positive, the project should be accepted.
2. If NPV is negative, the project should be rejected.
3. If two projects are mutually exclusive, the one with the higher NPV should be chosen, provided its
NPV is positive.

Illustrative Case: Rain Mines Inc., is considering investment in the mining rights to a large tract of land in a
mountainous area. The tract contains a mineral deposit that the company believes might be commercially
attractive to mine and sell. An engineering and cost analysis has been made, and it is expected that the following
cash flows would be associated with opening and operating a mine in the area:
Cost of equipment required P850,000
Net annual cash receipts 230,000*
Working capital required 100,000
Cost of road repairs in three years 60,000
Salvage value of equipment in five years 200,000
 Receipts from sales of ore, less out-of-pocket costs for salaries, utilities, insurance, and so forth.
It is estimated that the mineral deposit would be exhausted after five years of mining, at that point, the working
capital would be released for reinvestment elsewhere. The company’s cost of capital is 14%.
Required (ignore income taxes): Determine the net present value of the proposed mining project. Should the
project be undertaken? Explain.
Analysis:
End of 14% PV of Cash Flows
Relevant Items Amount of Cash Flows
Year(s) Factor
Cost of equipment 0 P(850,000) 1.000 P(850,000)
Working capital required 0 (100,000) 1.000 (100,000)
 Net annual cash receipts 1-5 230,000 3.433 789,590
Cost of road repairs 3 (60,000) 0.675 (40,500)
Salvage value of equipment 5 200,000 0.519 103,800
Working capital released 5 100,000 0.519 51,900
NPV P(45,210)
The project should not be undertaken because it will not earn the minimum desired rate of return of 14%.

Internal Rate of Rate (IRR)

The IRR is the discount rate that will cause the net present value of an investment project to be equal to
zero; thus, the IRR represents the internal yield promised by a project over its useful life. This term is synonymous
with discounted rate of return and time-adjusted rate of return.
Procedure:
1. If the net cash inflow is the same every year, divide the investment in the project by expected net
annual cash inflow.
2. The factor derived in (1) is located in the present value tables to see what rate of return it represents.
3. Interpolate if necessary, to get the exact rate of return.
Decision Rule:
1. If the IRR exceeds or equals the minimum desired rate of return pr the cost pf capital the investment
proposal may be accepted.
2. If the IRR is less than the minimum desired rate of return or the cost of capital, the investment proposal
should be rejected.
3. If two projects are mutually exclusive, the one with the higher IRR should be chosen, provided the
IRR exceeds or equals the cost of capital.

Illustrative Case: Ms. Helen Soriano is the managing partner of the Alabang Consultancy Service, Inc. Ms.
Soriano is trying to determine whether or not the firm should move client files and other items out of a spare room
in the main office and use the room for consultant’s work. She has determined that it would require an investment
of P142,950 for equipment and related costs of getting the room ready for use. Based on receipts being generated
from other rooms in the main office, Ms. Soriano estimates that the new room would generate a net cash inflow
P37,500 per year. The equipment purchased for the room would have a seven-year estimated useful life.
Require (ignore income taxes):
1. Compute the IRR on the equipment for the new room.
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐏𝐫𝐨𝐣𝐞𝐜𝐭 P142,950
𝐅𝐚𝐜𝐭𝐨𝐫 𝐨𝐟 𝐈𝐑𝐑 = = = 𝟑. 𝟖𝟏𝟐
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘 P37,500
From the table for Present Value of an Annuity of P1 in Arrears, reading along the 7-period line, a factor
of 3.812 equals an 18 % rate of return.
Verification of the 18%:
14% Factor Present
Amount of
Relevant Items Year(s) Value of
Cash Flows
Cash Flows
Investment of equipment now P(142,950) 1.000 P(142,950)
Annual cash inflows 1-7 37,500 3.812 142,950
Net present value P -0-
IRR of the project is therefore 18%.

Break-even Time or Discounted Payback Period

Discounted Payback Period is the length of time required for the net revenues of an investment discounted at
the investment’s cost of capital, to cover the cost of the investment. Like the regular payback method, it ignores
cash flows beyond the discounted payback period.
 Procedure:
1. Compute the present value of the cash inflows.
2. Cumulate the present value of the cash inflows until it equals the initial outflow. Determine the number
of years to accomplish such.
Decision Rule:
1. The shorter the discounted payback period, the better. It could be compared with the maximum discounted
payback period set by management. Accept the project if DPP is shorter than the maximum allowable
DPP.

Illustrative Case: Solid Rock Inc. has a cost of capital of 15% and is considering the acquisition of a new machine
which costs P4,000,000 and has a useful life of five years. Solid Rock projects that the after-tax cash flows will
increase as follows:
Year After-tax Cash Flow 15% interest rate factors
Present value of 1
1 P2,000,000 0.87
2 1,500,000 0.76
3 1,000,000 0.66
4 1,000,000 0.57
5 1,000,000 0.50
Required: What is the DPP of the new machine?
Analysis:
1. Determine the present value of the increase in after-tax Cash Flows.
Year Amount PV Factor PV Total
1 P2,000,000 0.87 1,740,000 1,740,000
2 1,500,000 0.76 1,140,000 2,880,000
3 1,000,000 0.66 660,000 3,540,000
4 1,000,000 0.57 570,000 4,110,000
5 1,000,000 0.50 500,000 4,610,000
2. Cumulate the present value of the cash inflows until it equals the initial outflow.
4,000,000−3,540,000
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 3 𝑦𝑟𝑠 + ( 𝑥 1 𝑦𝑟)
570,000
𝑫𝑷𝑷 = 𝟑. 𝟖𝟏 𝒚𝒓𝒔
Payback Period
Payback period is the length of time that it takes for an investment project to recoup its own initial cost
out of the cash receipts that it generates. Bail-out payback period considers the salvage value of the asset as part
of cash inflows.
Procedure:
1. When the net annual cash inflow is the same every year, divide the investment required by the net
annual cash flow.
2. When the net annual cash inflow is not uniform every year, cumulate (add) the annual cash inflow until
it equals the investment required. Determine the length of time required to accomplish such.
Decision Rule:
1. If the payback period is equal, to or shorter than the maximum allowable payback period by the investor,
accept the project.
2. If the payback period is longer than the maximum allowable payback period by the investor, reject the
project.
Illustrative Case: An investment of P150,000 is expected to produce annual cash earnings of P50,000 for
years. Its estimated salvage value is P70,000 at the end of the first year and this is expected to decrease by
P15,000 annually.
Required:
1. What is the payback period?
150,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = = 𝟑 𝒚𝒓𝒔
50,000
2. What is the bail-out payback period?
Year Annual Cash Return Salvage Value
1 P50,000 P70,000
2 50,000 55,000
3 50,000 40,000
4 50,000 25,000
5 50,000 10,000

𝑃150,000 − 𝑃105,000 (𝑎)

𝐵𝑎𝑖𝑙 − 𝑜𝑢𝑡 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = ( 𝑥 1 𝑦𝑟) = 𝟏. 𝟗 𝒚𝒓𝒔
𝑃50,000 (𝑏)
(a) Cash returns during the 1st year ÷ Salvage Value, 2nd year (b) Cash returns during the 2nd year

Simple or Accounting Rate of Return

ARR is the rate of return promised by an investment project when the time value of money is not
considered.
Procedure:
1. Use the formula:
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 𝑙𝑒𝑠𝑠 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛
𝑖𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 𝑎𝑛𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 or − 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐴𝑅𝑅 = 𝐴𝑅𝑅 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Decision Rule:
If ARR is equal to or exceeds the minimum desired rate of return, project proposal may be
accepted. If ARR is less than the minimum desired rate of return, reject the proposal.

Illustrative Case: Mindanao Farms, Inc. hires people on a part-time basis to sort eggs. The cost of this hand-
sorting process is P30,000 per year. The company is investigating the purchase of an egg-sorting machine that
would cost P90,000 and have a 15-year useful life. The machine would have negligible salvage value, and it
would cost P10,000 per year to operate and maintain. The egg-sorting equipment currently being used could be
sold for a scrap value of P2,500.
Required: Compute the simple rate of return on the new egg-sorting machine.
Analysis:
𝑃20,000𝑐𝑜𝑠𝑡 𝑠𝑎𝑣𝑖𝑛𝑔 − 𝑃6,000 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑛 𝑛𝑒𝑤 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡
𝐴𝑅𝑅 = = 𝟏𝟔. 𝟎%
𝑃90,000 − 𝑃2,500
 P30,000 – P10,000 = P20,000 cost savings
 P90,000 ÷ 15 years = P6,000 depreciation

SENSITIVITY ANALYSIS
Sensitivity analysis is frequently used if an improvement is felt to be possible by changing some of the
variables. It should be applied already during the project planning stage, when decisions concerning major inputs
are being taken. With the help of sensitivity analysis, it is easy to identify the most important factors in a project,
such as raw materials, labor and energy, and to determine any possibilities of input substitution.

Illustrative Case: West Cost Chemical Company is considering investing in a project that will require investment
of P468,000. The project’s expected annual cash inflows will amount to P 140,000 for five years.
Requirement 1:
 Because of uncertainty of times and volatility of interest rates, management would like toknow if the
investment should be made if the cost if capital is a) 10%? b) 12%? c) 16%?
Analysis:
NPV Approach:
10% 12% 16%
Present value of the annual cash P530,6001 P505,4002 P457,8003
flows
Less: Investment 468,000 468,000 468,000
Net Present Value P62,800 P37,400 P(27,200)
1 2 3
P140,000 x 3.79 P140,000 x 3.61 P140,000 x 3.27
The investment may be made if the cost of capital is 12% or less but should be rejected if the cost of
capital is 16%.
Calculation of IRR will be as follows:
468,000 = 140,000 x F
F = 3.343
Interpolate between 14% and 16%.
3.43 − 3.343
𝐼𝑅𝑅 = 14% + ( 𝑥 2%)
3.43 − 3.270
0.087
𝐼𝑅𝑅 = 14% + ( 𝑥 2%)
0.16
𝐼𝑅𝑅 = 15.09%
If the cost of capital is 15.09% or less, the investment may be made.

Requirement 2:
Supposing that management projects the annual cash flows as follows:
Worst Case Scenario = P100,000 Best Case Scenario = P150,000
If the cost of capital is 12%, should the investment be made under each scenario?
Analysis:
Worst Case Scenario Best Case Scenario
Present value of the annual cash returns
I (P100,000 x 3.61) P361,000
II (P150,000 x 3.61) P541,500
Less: Investment 468,000 468,000
Net Present Value P(107,000) P73,500
The company should reject the proposed investment if the annual expected cash flows will only amount
to P100,000 under the worst case scenario. In this case, determine the minimum annual cash flows to justify the
investment.
Divide the amount of investment by Present Value of an Annuity of 1, at 12% where n=5.

468,000
= 𝑃129,640
3.61
Therefore, if the investment would generate annual cash flows of at least P129,640, then it should be
pursued because it would earn the minimum desired rate of return of 12%.

Prepared by: JERALDYN P. MARANOC

BSA- 4th YEAR