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CHAPTER 10 Capital Budgeting Decisions

Exercise 1
1. F
2. C
3. H
4. A

5.
6.
7.
8.

B
G
E
D

Exercise 2
a.
The present value is P7,000.
b.
No, an investment of P7,000 will no longer result in P20,000 in 20 years. Due to the lower interest
rates, less interest will be earned over the 20 years, therefore, the initial investment now needs
to be greater than P7,000. PV + interest earned = FV.
Exercise 3
a1.
Present value of the P25,000 at the end of ten years is P9,423 =
P25,000 x 0.3769.
a2.
Present value of the P1,000 semiannual interest payments is P12,462 = P1,000 x 12.4622.
a3.
Present value of the P25,000 bond is P21,885 = (P9,423 + P12,462).
b.
This bond is selling at a discount because the bond is only paying 8% (P2,000 per year / P25,000
face) interest when the market rate is 10%. To achieve the higher yield, the investor pays in
less than face value (discounted), but at maturity the investor receives the full P25,000 face
value.
Exercise 4
a.
Pretax cost
After tax cost
Debt
10%
Common equity
18%
Weighted average cost of capital
b.

WeightWeighted average
(1-tax rate) 6%
70%
18%
30%
9.6%

Rita Corporation may use the cost of capital as a benchmark for accepting or rejecting capital
investment proposals.

Exercise 5
Investment 1
P210,000

Investment 2
P135,000

a.

PV of the initial investment

b.

PV of the annual cash flows


P227,448 = ($60,000 x 3.7908)

c.

Net present value


P17,448 = (P227,448 P210,000)

17,448
16,632
P16,632 = (P151,632 P135,000)

d.

Profitability index
1.083 = (P227,448 / P210,000)

1.083
1.123
1.123 = (P151,632 / P135,000)

e.

The profitability index indicates that Investment 2 is preferred, while the net present value method
does not inherently distinguish between projects with different magnitudes of initial investment.
However, the final choice between these two mutually exclusive alternatives may depend on
qualitative factors that distinguish between the two alternatives or identify other possible uses for the
available funds.

227,448
151,632
P151,632 = (P40,000 x 3.7908)

Exercise 6
a.
Item
20%
Purchase
Services
Salvage

Purchase the Jet


Amount
Yrs
PVat 20%
(820,000)
(747,650)
(40,000)
600,000

Item

Rent the Jet


Amount
Yrs

now

(820,000)

Rent

(250,000)

1-5

1-5
5

(119,624)
241,140
(698,484)

*Depreciation is not a cash flow.

b. Net present value indicates that purchasing the jet is the preferred alternative. However, even though
the net present values differ by P49,166, the additional risk of ownership may sway the company to
choose to rent on a use-by-use basis.

Exercise 7
a.
The net present value is P45,691 when income taxes are taken into account.
Annual cash flow
Depreciation
Taxable income
Tax at 40%
flow
P40,000
P13,000
P27,000
P10,800
After-tax net cash flow

PV factor of an annuity

Net cash
P29,200
Present

value
Initial investment
(P65,000)
Annual cash flows
Net present value
(P45,691)
b.

P29,200

3.7908 (5yrs, 10%)

110,691

Yes, Teddy should consider this purchase because the net present value is positive, which indicates
the purchase meets the companys 10% cost of capital requirement.

Exercise 8
a.
Project A payback period is 4 years.
Project B payback period is 2.33 years = (2 years + P10,000/P30,000)
The payback criterion indicates that Project B is the preferred investment because it has the
shorter payback period.
b.

The advantage of using the payback period criterion is that it gives an indication of the projects risk,
in the sense that the longer the payback period, the longer an organization is exposed to an
unrecovered investment. Drawbacks include that it ignores the time value of money and that it
ignores cash outflows after the initial investment and cash inflows after the payback period.

c.

Project A accounting rate of return is 20% = (*P10,000 average income / **P50,000 average
investment).
Average increase in income is [(10+20+30+40+50) / 5] = P30,000 per year
Depreciation is P100,000 / 5 years = P20,000 per year
* Average income is P10,000 = (Average increase P30,000 Depreciation P20,000)
** Average investment is P50,000 = [(P100,000 initial investment + 0 salvage value) / 2]

Project B accounting rate of return is 20% = (*P10,000 average income / **P50,000 average
investment).
Average increase in income is [(50+40+30+20+10) / 5] = P30,000 per year
Depreciation is P100,000 / 5 years = P20,000 per year
* Average income is P10,000 = (Average increase P30,000 Depreciation P20,000)
** Average investment is P50,000 = [(P100,000 initial investment + 0 salvage value) / 2]
d.

e.

The accounting rate of return criterion indicates both projects are equally attractive.
An advantage of the accounting rate of return is the incorporation of accounting income rather than
cash flows for all periods. Disadvantages include not considering the time value of money and
not explicitly considering the timing of cash flows.
Project B is recommended because it has the shorter payback period.

Exercise 9
a.
5---Present value of cash inflows
at a 10% discount rate
Initial investment
(40,000)
Net present value
(2,024)
b.

Profitability index
-------1------1.18 = 56,727
37,976
48,000

----1----

----2----

----3----

----4----

P56,727
(48,000)

P43,340
(36,000)

P33,614
(27,000)

P52,297
(45,000)

P 8,727

P 7,340

P 6,614

P 7,297P

-------2------1.20 = 43,340

-------3-----1.24 = 33,614

36,000

27,000

-------4------1.16 = 52,2970.95

P37,976

-------5------=

45,000

40,000

c.

Only projects 1 through 4 are acceptable to Davidson Company. Project 5 is not acceptable because
the project does meet the cost of capital requirement of 10%. This is pointed out with the
negative net present value, the profitability index that is below 1, and the 8% internal rate of
return.

d.

1.
2.
3.

e.

Net present value is unable to rank projects with different initial investments.
Profitability ranking from highest to lowest is
Internal rate of return ranking from highest to lowest is

3
4

2
3

1
1

4
2

The profitability index indicates that Investment 3 is preferred, the internal rate of return indicates
that Investment 4 is preferred, while the net present value method does not inherently
distinguish between projects with different magnitudes of investment. However, because the
profitability index is considered superior to the internal rate of return, I would recommend
Investment 3. The final choice may depend on qualitative factors that distinguish the four
alternatives.

Exercise 10
1.
Cash flow
Investment
Working cap.
Cash inflow

Year
0
0
1

Amount
P(100,000 )
P(200,000 )
100,000

Discount factor
1.00
1.00
.8621

Present value
P(100,000 )
(200,000 )
86,210

5
5

Cash inflow
Cash inflow
Cash inflow
Working cap.
Net present value

2
3
4
4

150,000
200,000
200,000
200,000

.7432
.6407
.5523
.5523

111,480
128,140
110,460
110,460
P246,750

2. After the first two years, P250,000 of the original P300,000 investment would be recouped. It would
take one-quarter of the third year (P50,000/P200,000) to recoup the last P50,000. Thus, the payback
period is 2.25 years.
Exercise 11
a.

Cost savings per year


Maintenance per year
Net cash flows per year
Cash
Present value
P30,000
4,300
Net present value of investment

b.

Exercise 12
a.

P5,000
(700 )
P4,300
Discount
1.0000
5.5348

factor
P(30,000.00)
23,799.64
P (6,200.36)

Payback equals P30,000/P4,300 = 6.976 years

Year
Cash flow
1
P150,000
1
32,000
2
57,000
3
5,000
4
28,000
5
16,000
6
3,000
7
15,000
7
70,000
Net present value

Discount factor
1.0000
.9009
.8116
.7312
.6587
.5935
.5346
.4817
.4817

Present value
P(150,000.00 )
28,828.80
46,261.20
3,656.00
18,443.60
9,496.00
1,603.80
7,225.50
33,719.00
P
(766.10 )

b.

Profitability index equals present value of cash flows divided by investment:


P149,233.90/P150,000 = .995

c.

Payback period is 6.11 years, computed as follows:


Year
Cash Flow
Cumulative Cash Flow
1
P32,000
P 32,000
2
57,000
89,000
3
5,000
94,000
4
28,000
122,000
5
16,000
138,000
6
3,000
141,000
7
85,000
226,000

P150,000 P141,000 = P9,000/P85,000 = .11


d.

The project is quantitatively unacceptable because it has a negative NPV, a less-than-one


PI, and a payback period of over six years. However, the NPV and PI are extremely close
to being acceptable. Because the new machine will provide XYZ zero-defect production,
the investment may be desirable if additional qualitative factors are considered such as
improved competitive position, customer satisfaction, goodwill generated, improved
product quality and reliability, and a desire to be in the forefront of manufacturing
capability. XYZ may want to attempt to quantify these benefits and reevaluate the
machines acceptability as an investment.
Test I MULTIPLE CHOICE

1
2
3
4
5
6
7
8
9
10
11
12
13

A
B
B
A
B
A
A
A
A
A
A
A
A

14
15
16
17
18
19
20
21
22
23
24
25
26

A
A
B
A
A
B
A
A
A
A
A
A
D

27
28
29
30
31
32
33
34
35
36
37
38
39

12
13
14
15
16
17
18
19
20
21
22

D
B
A
D
A
D
C
A
B
C
A

23
24
25
26
27
28
29
30
31
32
33

B
A
B
C
A
C
C
B
C
C
B
B
A

40
41
42
43
44
45
46
47
48
49
50

A
D
B
C
D
B
C
B
A
C
C

Test II MULTIPLE CHOICE

1
2
3
4
5
6
7
8
9
10
11

D
A
B
B
A
D
A
A
C
D
B

A
C
B
A
B
D
C
A
C
A
B

34
35
36
37
38
39
40
41
42

D
C
A
C
A
C
A
B
B