ACC 115: Management Science

Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

Lesson title: Net Investment and Net Returns Materials:

Pen and non-scientific calculator
Lesson Objectives: Strategic Cost Management by Cabrera

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At the end of this module, you should be able to:
1. Calculate the net initial investment of a References:

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project. Managerial Accounting by Hilton

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2. Determine the net returns or cash savings on Strategic Cost Management by Hansen
a project. and Mowen

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Productivity Tip:

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Exercise. Doing exercise regularly not only helps in staying healthy but it can also give your body
hormones that it needs to be relaxed, focused, and more productive during the day.
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A. LESSON PREVIEW/REVIEW
1) Introduction
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Managers in all organizations periodically face major decisions that involve cash flows over
several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are
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examples of such decisions. Other examples include decisions involving significant changes in
a production process or adding a new line of products or services to the organization’s activities.
Decisions involving cash inflows and outflows beyond one year are called capital budgeting
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decisions.
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2) Activity 1: What I Know Chart, part 1

Try answering the questions below by writing your ideas under the first column What I Know.
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What I Know Questions: What I Learned (Activity 4)

1. How is additional working capital
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treated in computing net investment?

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2. What is tax shield?

3. What is the difference between net

cash inflow and net income?

B.MAIN LESSON
1) Activity 2: Content Notes
Lesson Objective 1

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 ACC 115: Management Science
Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

Net investment – initial cash outlay that is required to obtain future returns or the net cash outflow to
support a capital investment project.
- costs or cash outflows less cash inflows or savings incidental to the acquisition of the
investment projects

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Costs or cash outflows

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1. The initial cash outlay covering all expenditures on the project up to the time when it is ready for use
or operation:

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Ex. Purchase price of the asset
Incidental project-related costs such as freight, insurance taxes, handling, installation, test-runs, etc.

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2. Working capital requirement to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will be transferred to or utilized in the

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operations of the proposed capital investment project.

Savings or cash inflows

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1 Trade-in value of old asset (in case of replacement).
2. Proceeds from sale of old asset to be disposed due to the acquisition of the new project (less
applicable tax, in case there is gain on sale, or add tax savings, in case there is loss on sale).
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3. Avoidable coat of immediate repairs on old asset to be replaced, net of tax.

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Illustration
The management of Gondo Co. plans to replace a sorting machine that was acquired several years
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ago at a cost P50,000. The machine has been depreciated to its salvage value of P5,000. A new sorter
can be purchased for P60,000. The dealer will grant a trade-in allowance of P6,000 on the old machine.
If a new machine is not purchased, Leonor Company will spend P20,000 to repair the old machine. The
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cost to repair the old machine can be deducted in the first year to compute income tax. Income tax is
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estimated at 40% of the income subject to tax.

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REQUIRED:
a. Compute the net investment in the new machine for decision making purposes.
b. Assume that instead of trading in the old machine, the same is sold for P6,000. Assume also that the
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acquisition of the new machine will require additional investment in working capital of P10,000. What
will be the cost of the new machine for decision making purposes?
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Solution
a. The net investment on the new machine is computed as
Cost 60,000
Less: Trade in allowance 6,000
After tax savings on repairs 12,000
Net investment 42,000
 The purchase price of the old sorting machine is ignored because this is already a sunk cost.
 The old sorting machine’s carrying amount, which is its salvage value, is also ignored because
the old machine is traded and not sold.

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 ACC 115: Management Science
Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

 The savings on the repairs should be after tax because this is supposed to be deductible in
computing the net taxable income. It is computed as follows:
Savings x (1 - Tax rate) = after tax savings on repairs
20,000 x 60% = 12,000

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b. Using the additional information, the net investment on the new machine is computed as

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Cost 60,000
Add: Additional Working Capital Requirement 10,000

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Less: Proceeds from sale of old machine less tax on gain 5,600
After tax savings on repairs 12,000

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Net investment 52,400
 The additional working capital requirement should be added to get the net investment.

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 The effect of applicable tax on the gain on sale of old asset should be absorbed by the proceeds
from sale. In order to get the amount of P5,600, the tax on gain on sale of old asset of P400 was
deducted from the proceeds that was assumed to be P6,000.
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 The P400 tax is computed as
Proceeds from sale of old machine 6,000
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Carrying amount of old machine (5,000)

Gain on sale of old machine 1,000
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x Tax rate 40%

Tax on gain on sale 400
 The after tax savings on repairs is the same with requirement ‘a’.
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Lesson Objective 2
Net Returns
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The net returns may refer to either the net cash inflows or the net income for a proposed project.
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Illustration
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Gwopo Co. is considering an Investment of P2 million in a new product line. Depreciation of P200,000
is to be deducted in each of the net ten years (salvage value is estimated at zero). A selling price of
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P40 per unit is decided upon; unit variable cost is P18, and fixed operating costs, excluding
depreciation are estimated at P400,000 per year. The sales division believes that a sales estimate of
50,000 units per year is realistic. Income tax is estimated at 30% of Income before tax.
REQUIRED: Determine the annual net cash inflows and net income for the proposed investment
project.

Let us first determine the net income and then proceed to annual net cash inflows. We should use the
contribution margin income statement.
50,000 units
Sales (P40 per unit) 2,000,000
Variable cost (P18 per unit) (900,000)
Contribution margin 1,100,000

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 ACC 115: Management Science
Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

Fixed cost (400k + 200k) (600,000)

Net income before tax 500,000
Tax (30%) (150,000)
Net income after tax 350,000

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 The net income would be ₱350,000. The fixed cost is the total of fixed operating cost

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(P400,000) and the annual depreciation (P200,000).

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Using the net income that we have computed, we can determine the net cash inflow by adding the
depreciation back to the net income. Remember that depreciation does not constitute flow of cash so it

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must be added back to determine the net cash inflow.

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Net income after tax 350,000
Add: Depreciation 200,000
Net cash inflow 550,000
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
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We can also compute the net cash inflow by adding the after tax cash inflow and the tax shield from
annual depreciation. Let us apply this using the problem above.
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After tax cash inflow (700,000 x 70%) 490,000

Tax shield from depreciation (200,000 x 30%) 60,000
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Net cash inflow 550,000

 The before tax cash inflow of 700,000 is the net income before tax before deducting the
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depreciation. This is because, again, depreciation does not constitute flow of cash. The before
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tax cash inflow is computed as:

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500,000 net income before tax + 200,000 annual depreciation = 700,000 cash inflow
 The tax shield from depreciation is the reduction of tax because of the depreciation expense.
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This serves as a shield from payment of tax. This is savings that adds to the cash inflow of the
company.
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 The net income can then be computed by deducting the depreciation from the net cash inflow.

Net cash inflow 550,000

less: Depreciation 200,000
Net income after tax 350,000

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 ACC 115: Management Science
Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

2) Activity 3: Skill-building Activities

Puge Co. is considering replacing an old press that cost ₱800,000 six years ago with a new one costing
₱2,250,000. Shipping and installation would cost an additional ₱200,000. The old press has a book
value of ₱150,000 and could be sold currently for ₱50,000. An additional working capital of ₱60,000 is
required to operate the asset. Puge’s net initial investment for analyzing the acquisition of the new

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press assuming a 30% income tax rate would be?

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Check your answers against the Key to Corrections found at the end of this SAS. Be sure to complete
each activity before looking. Write your score on your paper.
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3) Activity 4: What I Know Chart, part 2

Let us see how your knowledge changed by reviewing the questions in the What I Know Chart
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from Activity 1. Write your answers to the questions based on what you now know in the third
column of the chart.

4) Activity 5: Check for Understanding

Kyuti, owner of Cutie Company, was approached by a local dealer in air conditioning units. The
dealer proposed replacing Cutie's old cooling system with a modern, more efficient system. The
cost of the new system was quoted at P100,000, but it would save P20,000 per year in energy
costs. The estimated life of the new system is 10 years, with no salvage value expected. Excited
over the possibility of saving P20,000 per year and having a more reliable unit, Ms. Kyuti requested
an analysis of the project's economic viability. All capital projects are required to earn at least the
firm's cost of capital, which is 10 percent. Income tax rate is 30% of taxable income.

This document is the property of PHINMA EDUCATION 5

 ACC 115: Management Science
Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

REQUIRED: Determine the annual net cash inflows and net returns (net income) for the proposed
project.

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C. LESSON WRAP-UP
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1) Activity 6: Thinking about Learning

Congratulations for finishing this module! Shade the number of this module that you just have finished.
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What part of the topic did you find difficult? ______________________ ________________

_____________________________________________________________________________________________________________

What is your favorite part of the module? ________________________________________________________________

_____________________________________________________________________________________________________________

This document is the property of PHINMA EDUCATION 6

 ACC 115: Management Science
Student Activity Sheet #20

Name: _________________________________________________________ Class number: _______

Section: ____________ Schedule: ________________________________ Date: ________________

KEY TO CORRECTIONS
Skill Building Activity
Cost 2,250,000
Add: Shipping and installation cost 200,000
Additional Working Capital Requirement 60,000

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Less: Proceeds from sale of old press plus tax savings on loss (80,000)

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Net investment 2,430,000

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 The 80,000 proceeds from sale of old press plus tax savings on loss is compute as:
Proceeds from sale of old press 50,000

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Tax savings from loss
((50K proceeds – 150K carrying amount) x 30%) 30,000

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Total 80,000
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Assignment:
Read about non-discounted capital budgeting techniques in your book on pages 425 – 430.
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This document is the property of PHINMA EDUCATION 7