Net Cost of Investment: International Business Trade
Net Cost of Investment: International Business Trade
Net Cost of Investment: International Business Trade
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:
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:
1
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.
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:
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:
1
Accounting rate of return [P 5,040 / P 41,000] = 12.29%
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%.
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?
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.
1
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.
1
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.
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
1
- 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.
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.
1
Preferred dividends per share
Preferred Preferred Stock
Current market price or Net issuance price
Common Common Stock Earnings per Share
Market Price per Share
1
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