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CHAPTER 9

CAPITAL BUDGETING DECISIONS


I.

Questions
1.

A hotel may consider buying an item of equipment with a rapid payback rather
than one with a high average rate of return if
a)

Management is risk-averse; that is, it does not want to assume risk of


its money being tied up in an investment for a relatively long period of
time.
b) Management believes that the equipment can be subjected to rapid
obsolescence.
c) The company has obtained a loan to finance the equipment and it wants
to repay the principal right away to avoid financing costs.
2.

The money is worth more now than that same amount of money a year from
now.

3.

If the cash outlay today is P10,000 and the present value of the total cash returns
were P9,500, one should not make the investment because this means that the
investment will not yield the desired return on investment. For the project to be
acceptable, the present value of the returns should at least be equal to the present
value of the investment.

4.

Net Present Value is the excess of the present value of cash inflows generated by
the project over the amount of the initial investment. This is computed as
follows:
Present value of cash inflows computed based
on minimum desired discount rate
Less: Present value of investment
Net Present Value

Pxx
xx
Pxx

Discounted Rate of Return, also known as internal rate of return (IRR) and timeadjusted rate of return, is the rate which equates the present value of the future
cash inflows with the cost of the investment which produces them. It is also the
equivalent maximum rate of interest that could be paid each year for the capital
employed over the life of an investment without loss on the project.
If an independent project is being evaluated, then the NPV and IRR criteria
always lead to the same accept/reject decision.

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Solutions Manual - Managerial Accounting and Finance for Hospitality Operations

For mutually exclusive projects (choosing among acceptable alternative)


especially those that differ in scale (project size) and/or timing, a conflicts of
ranking may arise. That is, the IRR method may favor one alternative over
another while the NPV method may indicate otherwise. If conflicts arise, the
NPV method should be used. The NPV method assumes the cash flows will be
reinvested at the firms cost of capital while the IRR method assumes
reinvestment at the projects IRR. Because reinvestment at the cost of capital is
generally a better (closer to reality) assumption, the NPV is superior to the IRR.
5.

Comparison between the cash flows from operations before and after the
landscaping is done may be made. The purpose of the investment is to make the
resort more attractive to patrons and guests. Hence, when more resources are
generated after the investment is made, it is an indication that the decision has
been beneficial to the company.
Negative NPV would generally indicate that the investment proposal is not
acceptable because the desired rate of return is not attainable. It does not mean
however that the project will be unprofitable. Therefore if the prospective
investor is willing to accept a lower rate of return, then the project may become
acceptable.

II. Practical Exercises and Problems


A. EXERCISES
EXERCISE 1
Requirement (a)
Payback period:
Machine A
P25,800
P5,940

Machine B
=

4.34 yrs.

P24,200
P7,800

3.10 yrs.

Requirement (b)
Yes. Machine B. It is the more preferable investment because the recovery period of
capital is shorter.

Capital Budgeting Decisions

9-3

EXERCISE 2
Repayment schedule:
End of Year
0
1
2
3
4
5

Principal

Payment
Interest

Total

4,500
4,500
4,500
4,500
4,500

2,250
1,800
1,350
900
450

6,750
6,300
5,850
5,400
4,950

Balance
of Principal
22,500
18,000
13,500
9,000
4,500
0

B. PROBLEMS
PROBLEM 1
Relevant Data
Investment required
Cash flows from
operations

Salvage value of furniture


and equipment
Net Present Value

End of
Period
0

Cash In (Out) Flow


Amount
PVf at 13% Present Value
P(205,000)
1.000
P(205,000)

1
2
3
4
5

37,500
43,800
46,300
50,000
60,000

0.885
0.783
0.693
0.613
0.543

33,188
34,295
32,086
30,650
32,580

18,500

0.543

10,046
P(32,155)

The prospective investor should not make the investment because it would not yield
the desired rate of return of 13%. The negative net present value as shown in the
computation indicates that the internal rate of return is lower than 13%.
Through Trial Computations, the IRR can be determined as follows:

0
1
2
3
4
5
5

Trial at 6%
Cash In (Out) Flow
Amount
PVf
PV
(205,000)
1.000
(205,000)
37,500
0.943
35,263
43,800
0.890
38,982
46,300
0.840
38,892
50,000
0.792
39,600
60,000
0.747
44,820
18,500
0.705
13,042
5,599

Trial at 8%
Cash In (Out) Flow
Amount
PVf
PV
(205,000)
1.000
(205,000)
37,500
0.926
34,725
43,800
0.857
37,537
46,300
0.794
36,762
50,000
0.735
36,750
60,000
0.681
40,860
18,500
0.681
12,599
(5,767)

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Solutions Manual - Managerial Accounting and Finance for Hospitality Operations

To get the Internal Rate of Return closest to the exact rate, interpolation may be
applied as follows:
IRR

6% +

5,599 0
5,599 (5,767)

6% +

5,599
11,366

6% + 0.98%

6.98%

x 2%

x 2%

Proof: Using 6.98% as the discount rate, the net present value will be as follows:
End of Year
0
1
2
3
4
5
5

Amount
P(205,000)
37,500
43,800
46,300
50,000
60,000
18,500
Net Present Value

PVf at 13%
1.000
0.935
0.873
0.816
0.763
0.714
0.714

* Rounding off difference


PROBLEM 2
Requirement (a)
Payback Period:
Alternative 1
Year

Annual CF

1
2
3
4
5

4,200
5,800
8,500
11,500
12,000

Cumulative
CF
4,200
10,000
18,500
30,000
42,000

Present Value
P(205,000)
35,063
38,237
37,781
38,150
42,840
13,209
P
280 *

Capital Budgeting Decisions

9-5

Payback Period
=

4 years +

4.42 years

35,000 30,000
12,000

1 year

Alternative 2
Year

Annual CF

1
2
3
4

12,100
9,900
8,900
5,400

Cumulative
CF
12,100
22,000
30,900
36,300

Payback Period
=

3 years +

3.76 years

35,000 30,900
5,400

1 year

Requirement (b)
Net Present Value 10% discount rate
Relevant Data
Investment
Cash Inflows

End of
Year
0

1
2
3
4
5
Net Present Value

Amount
P(35,000
)
4,200
5,800
8,500
11,500
12,000

Alternative 1
PVf
PV
1.000 P(35,000
)
0.909
3,818
0.826
4,791
0.751
6,384
0.683
7,855
0.621
7,452
P (4,700)

Amount
P(35,000
)
12,100
9,900
8,600
5,400
4,000

Alternative 2
PVf
PV
1.000 P(35,000
)
0.909
10,999
0.826
8,177
0.751
6,459
0.683
3,688
0.621
2,484
P (3,193)

No. Both alternatives would not yield the desired rate of return of 10%.