Management Accounting Services 2019

BREAK-EVEN ANALYSIS How much is the break-even point in dollars?

$ 200,000
BEP = $275,000 = $ 290,909
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 $400,000
Break-Even Point units =
𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒/ 𝑈𝑛𝑖𝑡−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡/𝑈𝑛𝑖𝑡
How much is the margin of safety?
Margin of Safety = $400,000 - $290,909 = $ 109,091
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
BEP peso = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
Assuming that the fixed costs are expected to remain at
$200,000 for the coming year and the sales price per
or
unit and variable cost per unit are also expected to
= Sales price/units x BEP in units remain constant, how much profit before taxes will be
produced if the company anticipates sales for the
𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
Contribution Margin = coming year rising to 130% of the current year’s level?
𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
Or = Profit + Fixed Costs
Profit = (CM x % increase) – Fixed Costs
𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡+𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
# of units to produce = = ($275,000 x 1..30) - $ 200,000
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
Desired Profit = $ 157,500

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𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 Example:
Operating Leverage =
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 Value Pro produces and sells a single product. Information on
Note: its cost follows:
 HIGH OPERATING LEVERAGE
- a large proportion of the company are fixed Variable Cost
costs. SG&A $2 per unit
- The firm earns a large profit on each Production $4 per unit
incremental sale, but must attain sufficient sales Fixed Cost
volume to cover its substantial fixed costs. SG&A $12,000 per year
- The entity will earn a major profit on sales after Production $15,000 per year
is has paid for its fixed costs.
- Earnings will be more sensitive to changes in Assume Value Pro produced and sold 5,000 units. At this level
sales volume. of activity, it will produce a profit of $18,000. What was
 LOW OPERATING LEVERAGE Value Pro’s sales price per unit?
- a large proportion of the company are variable
costs. Contribution Margin = $18,000 + ($12K + $15K)
- it only incur costs when there is sale. = $ 45,000
- The firm earns smaller profit on each sale, but
does not have to generate much sales volume in Contribution Margin $45,000
order to cover the fixed costs. Variable Cost ($6 x 5,000 units) 30,000
- It is easier to earn a profit at low sales level, but Sales $75,000
it does not earn outsized profits if it can Divided by: produced & sold units 5,000
generate additional sales. Sales Price per Unit $ 15

In the upcoming year, Value Pro estimates that it will produce

Margin of Safety = Actual Sales - Break-Even Point and sell 4,000 units. The variable costs per unit and the total
 It shows the total number of sales in peso that can fixed costs are expected to be the same as in the current
be lost before the company losses its money. year. However, it anticipates a sales price of $16 per unit.
𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠−𝐵𝑟𝑒𝑎𝑘−𝐸𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡
What is the Value Pro’s projected margin of safety for the
Margin of Safety = coming year?
𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
 It expresses the buffer zone in terms of percentage
of sales. $27,0000
BEP peso = $𝟏𝟔−$𝟔 = $𝟒𝟑, 𝟐𝟎𝟎
$𝟏𝟔
𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠−𝐵𝑟𝑒𝑎𝑘−𝐸𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡
Margin of Safety =
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
Contribution Margin = ($16 x 4,000 units) - $43,200
 Measures the profitability buffer zone in units
= $20,800
produced.
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EXAMPLE: Example:
Below is an income statement of Thompson Company: Unique Company manufactures a single product. In the prior
Sales $ 400,000 year, the company had sales of $90,000, variable costs of
Variable Costs (125,000) $50,000, and fixed costs of $30,000. Unique expects its cost
Contribution Margin $ 275,000 structure and sales price per unit to remain the same in the
Fixed Costs (200,000) current year, however total sales are expected to increase by
Profit Before Tax $ 75,000 20%. If the current year projections are realized, net income
should exceed prior year’s net income by:
How much is the degree of operating Leverage?
$ 275,000 Income before Adjustment = ($90K - $50) - $30,000
OL = = 3.67 = $10,000
$ 75,000
 Management Accounting Services 2019

Sales $90,000 Example:

Variable Costs 50,000 Mike is interested in entering the catfish farming business. He
Contribution Margin $40,000 estimates if he enters this business, his fixed costs would be
Add: ($40,000 x 20%) 8,000 $50,000 per year and his variable cost would equal 30% of
Adjusted Contribution Margin $48,000 sales. If each catfish sells for $2, how many catfish would
Less: Fixed Costs 30,000 Mike need to sell to generate a profit that is equal to 10% of
Net Income $18,000 sales?

$18,000−$10,000 Let x = number of units to sell

Increase in Net income = = 𝟖𝟎%
$10,000

X - .30X - $50,000 = .10X

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.70X - .10X = $50,000
Example:
X = $83,333
Electric Corporation manufactures and sells two products: A
and B. The operating results of the company are as follows:
Number of units = $83,333 / 2 = 41,667 units
Product A Product B
Sales in Units 2,000 3,000
Sales Price per unit $10 $5
Variable Cost per unit 7 3

In addition, the company incurred total fixed costs in the

amount of $9,000. How many total Units would the
company have needed to sell to break even?

Sales in units = 3,000/ 2,000 = 1.5, therefore Let B = 1.5A

($10 - $7)A + ($5 - $3)B - $9,000 = $0

$3A + $2(1.5A) - $9,000 = $0
$6A - $9,000 = $0
A = 1,500
B = 1.5(1,500) = 2,250

Total Units = 1,500 + 2,250 = 3,750

It can also be calculated as:

Product A Product B
$9,000 $9,000
BEP = BEP =
$10−7 $5−3
= 3,000 / 2 = 4,500 / 2
= 1,500 = 2,250

If the company would have sold a total of 6,000 units,

consistent with CVP assumption how many of those units
would you expect to be product B?

Sales in units = 3,000/ 2,000 = 1.5, therefore Let B = 1.5A

A + 1.5A = 6,000
2.5A = 6,000
A = 2,400 units
B = (2,400 x 1.5) = 3,600 units

How many units would the company have needed to sell to

produce a profit of $12,000?

Sales in units = 3,000/ 2,000 = 1.5, therefore Let B = 1.5A

($10 - $7)A + ($5 - $3)B - $9,000 = $12,000

$3A + $2(1.5A) - $9,000 = $12,000
$6A - $9,000 = $12,000
$6A = $21,000
A = 3,500 units
B = (3,500 x 1.5) = 5,250 units

Total Units 3,500 + 5,250 = 8,750 units

 Management Accounting Services 2019

CAPITAL BUDGETING Example:

An investment opportunity costing $180,000 is expected to
PAYBACK PERIOD yield net cash flows of $60,000 annually for five years. What
Cash Outflow (P xx) is the IRR if the cutoff rate is 12%?
Annual Cash Flow P xx
IRR is between 19% and 20%
Until we reach the year where we can already recover the Trial and Error:
total cash outflow.
1−(1.19)^−5
PV =$60,000 x
.19
Example:
= $60,000 x 3.05763 = $183,458
An investment opportunity costing $55,000 is expected to
yield net cash flows of $22,000 annually for five years. The 1−(1.20)^−5
payback period of the investment is PV =$60,000 x
.20
= $60,000 x 2.99061 = $179,436
Cash Outflow ($55,000)
Year 1 cash flow $22,000 $22,000 To find the exact IRR, do interpolation:
Year 2 cash flow 22,000 44,000 $180,000 − $183,458 $3,458
= = 0.85
Year 3 cash flow 22,000 66,000 $179,436 − $183,458 $4,022
1−(1.1985)^−5
Since by year 3, the total cash flow is $66,000, we will get the $0 = -$180,000 + ($60,000 x )
.1985
exact period to recover the cash outflow. $0 = -$180,000 + ($60,000 x 3)
$66.000−$55,000
= 0.5 $0 = $0
$22,000

Therefore the payback period is 2.5 years. Therefore the exact IRR is 19.85%

BOOK RATE OF RETURN/ACCOUNTING RATE OF RETURN NET PRESENT VALUE

Step 1: Compute first the Net Initial Investment
ARR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 Cost of New Equipment P xx
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 Add: Increase in Working Capital xx
Less: MV of Old Machine P xx
Example: (Tax Savings)/Tax Liability
Scottao has an investment opportunity costing $300,000 that (MV – BV of OM) x Tax Rate (xx)/xx xx
is expected to yield the following cash flows over the next six Net Investment P xx
years.
Year 1 $ 75,000 Step 2: Compute for the After-Tax Cash Flow
Year 2 90,000 Cash Savings P xx
Year 3 115,000 Less: Depreciation xx
Year 4 130,000 Taxable Income P xx
Year 5 100,000 Multiply by: (100% - TR) x%
Year 6 90,000 Net Income P xx
Addback: Depreciation xx
Find the book rate of return of the investment: ATCF P xx
Average Return: ($600,000/6) $100,000 Multiply: PV factor: x.x
Depreciation: ($300K/6) (50,000) PV of ATCF P xx
Average Income $ 50,000 Add: PV of Salvage Value (if any) xx
PV of Working Capital (if any) xx
Average Investment = $300,000/2 = $150,000 Less: Net Investment xx
Net Present Value P xx
BRR = $50,000 / $150,000 = 33.33%

Example: Example:
An investment opportunity costing $80,000 is expected to An investment opportunity costing $180,000 is expected to
yield net cash flows of $25,000 annually for four years. The yield net cash flows of $60,000 annually for five years. What
cost of capital is 10%. The book rate of return would be is the NPV of the investment at a cutoff rate of 12%?

Annual Net cash Flow $25,000 Cash Flow $ 60,000

Depreciation ($80,000/4) (20,000) 1−(1.12)^−5
Multiply by: 3.605
Average Income $ 5,000 .12
Present Value $216,300
Average Investment = $80,000/2 = $40,000 Less: Investment 180,000
Net Present Value $ 36,300
BRR = $5,000/$40,000 = 12.5%

INTERNAL RATE OF RETURN

$0 = -cash outflow + cash inflow (1+i)-1…+ cash inflow (1+i)-n

You can solve this through trial and error or using

financial calculator.
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Example: WEIGHTED AVERAGE COST OF CAPITAL

Garcia Corporation had the opportunity to introduce a new
𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡
product. Garcia expects the product to sell for $60 and to WACC = 𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦 𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 +
𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦
𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 (1 − 𝑇)
have per-unit variable cost of $40 and annual cash fixed costs
0f $3,000,000. Expected annual sales volume is 250,000 units. Example:
The equipment needed to bring out the new product costs 40% Debt; 60% Equity;
$5,000,000, has a four year life and no salvage value, and kd = 9%; T = 40%; WACC = 9.96%; ks = ?
would be depreciated on a straight-line basis. Garcia’s cost of
capital is 10% and its income tax rate is 40%. How much is 0.0996 =
.60
𝑥 𝑘𝑠 +
.40
𝑥 .09(1 − .40)
the NPV. .40+.60 .40+.60
0.0996 = 0.60ks + (0.40 x 0.054)
0.0996 = 0.60ks + 0.0216
Net Investment = $5,000,000
0.60ks = 0.0996 – 0.0216
0.60ks = 0.078
Revenue [250,000 x ($60-$40)] $5,000,000
Ks = 13%
Less: Fixed Costs 3,000,000
Depreciation ($5M/4) 1,250,000
Therefore the cost of equity (ks) is 13%.
Taxable Income $ 750,000
Multiply by: (100% - 40%) 60%
Example:
Net Income $ 450,000
Assume newly formed Corporation ABC needs to
Addback: Depreciation 1,250,000
raise $1 million in capital so it can buy office buildings and
After-Tax Cash Flow $1,700,000
1−(1.10)^−4 the equipment needed to conduct its business. The
Multiply by: 3.170 company issues and sells 6,000 shares of stock at $100
.10
PV of ATCF $5,389,000 each to raise the first $600,000. Because shareholders
Less: Investment 5,000,000 expect a return of 6% on their investment, the cost of
Net Present Value $ 389,000 equity is 6%.
Corporation ABC then sells 400 bonds for $1,000
each to raise the other $400,000 in capital. The people who
PROFITABILITY INDEX bought those bonds expect a 5% return, so ABC's cost of
debt is 5%.
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠/𝐴𝑇𝐶𝐹 Corporation ABC's total market value is now
PI =
𝑁𝐸𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ($600,000 equity + $400,000 debt) = $1 million and its
corporate tax rate is 35%. What is the WACC?
Example:
Garcia Corporation had the opportunity to introduce a new WACC =
$400𝐾
𝑥 5%(1 − .35) +
$600𝐾
𝑥6%
product. Garcia expects the product to sell for $60 and to $400𝐾+$600𝐾 $400𝐾+$600𝐾
= 0.40 (0.0325) + 0.036
have per-unit variable cost of $40 and annual cash fixed costs
= 4.9%
0f $3,000,000. Expected annual sales volume is 250,000 units.
The equipment needed to bring out the new product costs
DIVIDEND VALUATION MODEL
$5,000,000, has a four year life and no salvage value, and
would be depreciated on a straight-line basis. Garcia’s cost of 𝐷1 𝐷𝑜 (1+𝑔)
capital is 10% and its income tax rate is 40%. How much is Ke = 𝑃𝑜+ g or Ke = 𝑃𝑜
+𝑔
the NPV.
Where:
Net Investment = $5,000,000 Ke = cost of equity
D1 = Dividend to be paid at the end of the year1
Revenue [250,000 x ($60-$40)] $5,000,000 Po = Share Price
Less: Fixed Costs 3,000,000 g = future dividend growth rate
Depreciation ($5M/4) 1,250,000 Do= Dividend Paid
Taxable Income $ 750,000
Multiply by: (100% - 40%) 60% Example:
Net Income $ 450,000 Company X had just paid a dividend of .50cents. The market
Addback: Depreciation 1,250,000 value of its share price is P5, and the dividend growth rate is
After-Tax Cash Flow $1,700,000 10%.
1−(1.10)^−4
Multiply by: 3.170
.10
Since dividend is already paid, we will use D0.
PV of ATCF $5,389,000 .50 (1+.10)
Ke = 𝑃5
+ .10
PI =
$5,389,000
= 1.08 = .11 + .10
$5,000,000
= 21%

Example:
Share price = $50; Expected Dividend = $3.80
Growth Rate = 5% ; cost of equity = ?

$3.80
Ke = $50
+ .05
= 0.076 + 0.05
= 12.6%
 Management Accounting Services 2019

Example: Example:
Let's assume XYZ Company intends to pay a Imagine an investor is contemplating a stock worth $100
$1 dividend per share next year and you expect this to per share today that pays a 3-percent annual dividend. The
increase by 5% per year thereafter. Let's further assume stock has a beta compared to the market of 1.3, which
your required rate of return on XYZ Company stock is means it is riskier than a market portfolio. Also assume
10%. Currently, XYZ Company stock is trading at $10 per that the risk-free rate is 3 percent and this investor
share. Using the formula above, we can calculate that expects the market to rise in value by 8 percent per year.
the intrinsic value of one share of XYZ Company stock is:
Expected Return = 3% + 1.3 (8% - 3%)
𝐷1 $1 = 9.5%
Po = = = $20
(𝐾𝑒−𝑔) .10− .05

XYZ Company stock is worth $20 per share but is trading

at $10; the Gordon Growth Model suggests the stock is
undervalued.

Let's assume that during the next few years XYZ

Company's dividends will increase rapidly and then grow
at a stable rate. Next year's dividend is still expected to be
$1 per share, but dividends will increase annually by 7%,
then 10%, then 12%, and then steadily increase by 5%
after that. By using elements of the stable model, but
analyzing each year of unusual dividend growth
separately, we can calculate the current fair value of XYZ
Company stock.

Given:
D1 = $1; Ke = 10% ; g1 = 7%; g2 = 10%; g3 = 12%;
gn = 5%

Step 1: We calculate the actual dividend for those years:

D1 = $1.00
D2 = $1 + ($1 x 7%) = $1.07
D3 = $1.07 + ($1.07 x 10%) = $1.18
D4 = $1.18 + ($1.18 x 12%) = $1.32

Step 2: Calculate the present value of each dividend

D1 = $1.00 (1.10)-1 = $0.91
D2 = $1.07 (1.10)-2 = $0.88
D3 = $1.18 (1.10)-3 = $0.89
D4 = $1.32 (1.10)-4 = $0.90
D5 = $1.32 (1.05) = $1.39 this is the 5th year dividend

Step 3: Apply the stable- growth Gordon Growth Model

formula to these dividends to determine their value in the 5 th
year.
$1.39
Po = = $27.80
(.10−.05)

Step 4: the present value of these stable growth period

dividends are then calculated.
PV = $27.80 (1.10)-5 = $17.26

Step 5: We then add the present values of future dividends

to arrive at the current intrinsic value.
$0.91 + $0.88 + $0.89 + $0.90 + $17.26 = $20.84

CAPITAL ASSET PRICING MODEL (CAPM)

Expected Return = rf + β (rm - rf)

Where:
rf = risk free rate
β = beta
rm = return on the market

Risk premium = β (rm - rf)

Market Premium = (rm - rf)
If market premium is already given no need to
compute (rm - rf).