International Business Trade

Net Cost of Investment

1. Sandy Corporation is planning to buy a new equipment costing P 150,000 to replace an
old one purchased 6 years ago for P 90,000. The old equipment is being depreciated on a
straight line basis over 10 years to a zero salvage value.

The same method and useful life will be used to depreciate the new equipment. Sandy
Corporation pays tax at a rate of 32% of income before tax.

If the old equipment is sold for P 30,000 and the new one is purchased, the net cash
investment at the time of purchase of the new one is?

Solution:

Purchase price of the new equipment P 150,000

Proceeds from sale of old equipment (30,000)
Tax savings due to loss on sale:
Sales Value 30,000
Less: Book value
Acquisition Cost 90,000
Accumulated Depreciation
(P 90,000 / 10) x 6 years 54,000
Book Value 36,000
Loss on Sale 6,000
x Tax rate 32% (1,920)
Net cash investment of the new equipment P 118,080

2. Fermin Printers Inc. is planning to replace its present printing equipment with a more
efficient unit. The new equipment will cost P 400,000 with 5-year useful life, no salvage
value.

The old unit was acquired three years ago for P 500,000. The company uses straight line
basis and the old unit is being depreciated at P 62,500 per year. If the new equipment is
acquired, the old one will be sold for P 100,000. Otherwise, the company will just continue
using is for 5 years.

Cash operating costs are P 100,000 and P 200,000 for the new and old equipments,
respectively. Income tax is at the rate of 32% of income before tax. What is the net cost
of investment?

Solution:

Purchase price of the new equipment P 400,000

Proceeds from sale of old equipment (100,000)
Tax savings due to loss on sale:
Sales Value 100,000
Less: Book value
Acquisition Cost 500,000
Accumulated Depreciation
(62,500 x 3) 187500
Book Value 312,500
Loss on Sale 212,500
x Tax rate 32% (68,000)
Net cash investment of the new equipment P 232,000

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International Business Trade
Accounting rate of return
Accounting rate of return (ARR) measures the probability of a proposed project. It is
sometimes referred to as a unadjusted rate of return, return on investment, return
on assets, simple accounting rate of return, and unadjusted rate of return. It is the
only project evaluation that uses net income to measure the attractiveness of a proposed
investment based on profitability.

Note: the higher the ARR, the better!

Advantages:
1. The ARR computation closely parallels accounting concepts of income measurement and
investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from the
accounting records.
3. This method considers income over the entire life of the project.
4. It indicated the project’s profitability.

Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider the time value
of money.
2. With the computation of income and book value based on the historical cost accounting
data, the effect of inflation is ignored.

Problem 1
The Tarlac Company is considering the production of new product of a new product line
which will require an investment of P 3,000,000, with P 200,000 residual value. The
investment will have a useful life of ten years during which annual cash inflows before
income taxes of P 1,400,000 are expected. The income tax rate is 40%.

Required:
1. Annual net income
2. Accounting rate of return based on original and average investment balances.

Solutions:

Cash flows before taxes 1,400,000

Less: Depreciation Expense
( P 3 million - P 200,000) / 10 years) 280,000
Income before income tax 1,120,000
Less: Tax (40%) 448,000
Net Income 672,000

* Simple ARR (Original) = P 672,000 / P 3 million = 22.45%

* ARR ( Average) = P 672,000 / [(P 3 million + P200,000) / 2]

= P 672,000 / P 1,600,000 = 42.00%

Problem 2
An asset was purchased for P 66,000. The asset is expected to last for 6 years and will have
a salvage value of P 16,000. The company expects the income before tax to be P 7,200 and
the tax rate applicable to the company is 30%. What is the average return on
investment (accounting rate of return)?

Solution:

After tax income [P 7,200 - (P 7,200 x 30%)] = 5,040

Average Investment (P 66,000 + P 16,000) / 2 = 41,000

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 Accounting rate of return [P 5,040 / P 41,000] = 12.29%

International Business Trade

PRACTICE TEST QUESTIONS
PROBLEM 1

Ojie, Inc. provides ho, ready-to-eat meals to construction workers. The company is
considering the purchase of a new truck to replace an old truck now in use in delivering
meals to construction sites. The new truck would cost P 2,000,000.

If the new truck is purchased, the old truck will be sold as is to another company for P
400,000. This old truck was acquired for P 1, 200,000 and has a current book value of P
500,000/

IF the new truck is not purchased, the company will have to continue using the old one,
although extensive repairs would be needed that will cost P 250,000. The repairs cost will be
expensed, for tax purposes, in the year incurred. The income tax rate is 32%.

What is the net cost of investment?

a. P 1,398,000 b. P 2,000,000 c. P 1,350,000 d. P

1,462,000

PROBLEM 2

ACR Company, which operates a school canteen, is planning to buy a doughnut making
machine for P 300,000. The machine is expected to produce 36,000 units of doughnuts per
year which can be sold for P 10 each. Variable Cost to produce and sell the doughnut is P 4
per unit. Incremental fixed costs, exclusive of depreciation, are estimated at P 56,000 per
year. The doughnut making machine will be depreciated on a straight-line basis for 5 years
to a zero salvage value. The company pays income tax at a rate of 32%.

What is the expected annual return (accounting net income) to be earned from
the doughnut making machine?

a. P 108,800 b. P 128,000 c, P 100,000 d. P 68,000

PROBLEM 3

The Super carry, a domestic shipping line, has recently commissioned a new passenger ship,
the SC 20. The new ship can carry up to 2,000 passengers. It was purchased by Super Carry
at a cist P 300 million. Its estimated service life is 10 years, with a salvage value of P 40
million at the end of its service life.

SC 20 is expected to have a 300 voyage days per year with an average of 80% occupancy
rate. The revenue from each passenger is estimated at P 250 per day, while daily variable
cost per passenger is P 100. An annual fixed cost of operating the ship, exclusive of
depreciation, is estimated at P 20 million per year.

Super Carry pays tax at a tax rate of 32% of income before tax.

What is the expected accounting rate of return based on initial investment in SC

20?

a.5.89% b. 13.60% c. 10.40% d.11.78%

What is the expected accounting rate of return based on average investment in

SC 20?

a.5.89% b. 13.60% c. 10.40% d.11.78%

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International Business Trade
COST OF CAPITAL
Sources of Long term Financing
Principal sources of funds
1. External Sources: Debt, Equity, and Hybrid Financing
2. Internal Sources: Operations

A. Debt Financing
Advantages:
1. Basic control of the firm is not shared with the creditor.
2. Cost of debt is limited. Creditors usually do not participate in the superior
earnings of the firm.
3. Interest paid is tax deductible, thereby reducing cost of capital.
4. Substantial flexibility in the financial structure is enhanced by debt through the
inclusion of call provisions in the bond indenture.
5. The financial obligations are clearly specified and of a fixed nature.
6. In time of inflation, debt may be paid back with “cheaper pesos.”
Disadvantages:
1. Since debt requires a fixed charge, there is a risk of not meeting this obligation if
the earnings of the firm fluctuate.
2. Debt adds risk to a firm.
3. Debt usually has a maturity date.
4. Debt is a long-term commitment, a factor that can affect risk profiles.
5. Certain managerial prerogatives are usually given up in the contractual
relationship outlined in the bond’s indenture contract. Example: specific ratios must
be kept above a certain level during the term of the loan.
6. There are clear-cut limits to the amount of debt available to the individual firm.

BASIC TYPES OF BONDS OR LONG-TERM DEBT:

1. Debenture bonds- unsecured loan; these can be issued only by companies with
the best credit ratings.
2. Mortgage Bonds – a pledge of certain assets, such as real property, for a loan.

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3. Income Bonds- pay interest only if the issuing company has earnings; these
bonds are riskier than other bonds.
4. Serial bonds- bonds with staggered maturities.

B. Equity Financing
- Major source is a common stock and retained earnings.
Advantages of Common Stock as source of funds:
1. Common stock does not require does not require a fixed dividend—dividends are
paid from profits when available.
2. There is no fixed maturity date for repayment of the capital.
3. The sale of common stock is frequently more attractive to investors than debt,
because it grows in value with the success of the firm.
Note: The higher the common stock value, the more advantageous equity financing
is over debt financing.

Disadvantages of Common Stock as source of funds:

1. Issuance of common stocks requires higher underwriting costs.
2. Common stock cash dividends are not tax deductible.
3. The average cost of capital may increase above the optimal level when too much
equity is issued.

Retained Earnings
Earnings after deducting interest, taxes, and preferred dividends may be retained
and used to pay common cash dividends or be plowed back into the firm in the form
of additional capital investment through stock dividends.
Advantages:
1. The after-tax opportunity cost is lower than that for newly issued common stock.
2. Financing with retained earnings leaves the present control structure intact.

C. Hybrid Financing
- Sources of funds that possess a combination of features; these include preferred
stock, leasing, and option securities such as warrants and convertibles.

Preferred Stocks

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- A hybrid security because some of its characteristics are similar to those of both
common stocks and bonds. Legally, like the common stock, it represents a part of
ownership or equity in a firm. However, as in bonds, it has only a limited claim on a
firm’s earnings and assets.

Features of Preferred Stock issues

a, Priority to assets and earnings- the claims of preferred stockholders must be
satisfied before the common stockholders receive anything.
b. Preferred stocks always have par value, which is important in determining the
amount due to Preferred Stockholders in case of liquidation and in computing the
preferred dividends.
c. Most preferred stocks provide for cumulative dividends.
d. Some preferred stocks issues are convertible to common stocks.

Advantages of issuing Preferred Stocks

1. Not default risk because non-payment of dividends does not necessarily mean
bankruptcy.
2. Dividends payment is limited to stated amount.
3. No voting rights like common stocks, except in case of financial distress.
4. Call features and provisions of sinking fund may be included, so the firm may
replace the issue if interest rates decline.

Disadvantages of issuing Preferred Stocks:

1. Preferred stocks are not tax deductible; hence, cost for the company is higher
than that of bonds.
2. The cumulative feature of preferred stock makes payment of preferred dividends
almost mandatory.

COST OF CAPITAL
- The cost of using funds; it is also called hurdle rate, required rate of return,
cut-off rate.
- The weighted average rate of return the company must pay to its long-term
creditors and stockholders for the use of their funds.

COMPUTATION OF COST OF CAPITAL

Source Capital Cost of Capital
Creditors Long-term debt After-tax rate interest = I (1-TxR)
Stockholders:    

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 Preferred dividends per share
Preferred Preferred Stock
Current market price or Net issuance price
Common Common Stock Earnings per Share
Market Price per Share

OTHER WAYS OF COMPUTING COST OF CAPITAL

1. Capital Asset Pricing Model (CAPM)

R = Rf + β (Rm – Rf)
Where: R = rate of return (or cost of capital)
Rf = risk-free rate determined by government securities.
β = beta coefficient of an individual stock which is the correlation between
the volatility (price variation) of the stock market and the volatility of the price of
the individual stock.
Example: If the price of an individual stock rises 10% and the stock
market 15%, the beta is 1.5
Rm = Market return
(Rm – Rf) = market risk premium or the amount above risk-free rate required to
induce average investors to enter the market.
β (Rm – Rf) = risk premium
Example:
Assume a beta of 1.5, a market rate of return of approximately 16% and an
expected risk-free rate of 12%, what is the R?
R = Rf + β (Rm – Rf)
= 12% + 1.5(16% - 12%) = 18%

2. The Dividend Growth Model

a. Cost of Retained Earnings = (D1 / P0) + G
Where:
P0 = Current Price
D1 = next Dividend
G = growth rate in dividends per share (it is assumed that the dividend payout
ratio, retention rate, and therefore the EPS growth rate are constant)
Example:

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A company’s dividend is expected to be P 5 while the market price is P60 and the
dividend is expected to grow at a constant rate of 10%, the cost of retained
earnings is:
= (D 1 / P0) + G
= (5/60) + 10% = 18.33

b. Cost of New Common Stock D1

+ G
=
P0 (1 - Flotation Cost)

Flotation Cost = the cost of issuing new shares