MANAGEMENT ACCOUNTING (VOLUME II) - Solutions Manual

CHAPTER 20
CAPITAL BUDGETING DECISIONS
I.

Questions
1. A capital investment involves a current commitment of funds with the
expectation of generating a satisfactory return on these funds over a
relatively extended period of time in the future.
2. Cost of capital is the weighted minimum desired average rate that a
company must pay for long-term capital while discounted rate of return is
the maximum rate of interest that could be paid for the capital employed
over the life of an investment without loss on the project.
3. The basic principles in capital budgeting are:
1. Capital investment models are focused on the future cash inflows and
outflows - rather than on net income.
2. Investment proposals should be evaluated according to their
differential effects on the companys cash flows as a whole.
3. Financing costs associated with the project are excluded in the
analysis of incremental cash flows in order to avoid the doublecounting of the cost of money.
4. The concept of the time value of money recognizes that a peso of
present return is worth more than a peso of future return.
5. Choose the investments that will maximize the total net present value
of the projects subject to the capital availability constraint.
4. The major classifications as to purpose are:
1. Replacement projects
- those involving replacements of worn-out assets to avoid
disruption of normal operations, or to improve efficiency.
2. Product or process improvement
- projects that aim to produce additional revenue or to realize cost
savings.
3. Expansion
- projects that enhance long-term returns due to increased profitable
volume.
5. Greater amounts of capital may be used in projects whose combined
returns will exceed any alternate combination of total investment.
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Chapter 20 Capital Budgeting Decisions

6. No. This implies that any equity funds are cost free and this is a
dangerous position because it ignores the opportunity cost or alternative
earnings that could be had from the fund.
7. Yes, if there are alternative earnings foregone by stockholders.
II. Matching Type
1.
2.
3.
4.
5.

A
C
F
B
I

6.
7.
8.
9.
10.

H
D
G
J
E

III. Problems
Problem 1 (Equipment Replacement Sensitivity Analysis)
Requirement 1
Total Present Value
A.

B.

New Situation:
Recurring cash operating costs (P26,500 x 2.69)
Cost of new equipment
Disposal value of old equipment now
Present value of net cash outflows
Present Situation:
Recurring cash operating costs (P45,000 x 2.69)
Disposal value of old equipment four years hence
(P2,600 x 0.516)
Present value of net cash inflows
Difference in favor of replacement

P 71,285
44,000
(5,000)
P110,285
P121,050
(1,342)
P119,708
P 9,423

Requirement 2
Payback period for the new equipment

Requirement 3
Let X = annual cash savings
Let O = net present value
20-2

P44,000 P5,000
P18,500

2.1 years

Capital Budgeting Decisions Chapter 20

X (2.69) + P5,000 - P44,000 - P1,342 = O

2.69X = P40,342
X = P14,997
If the annual cash savings decrease from P18,850 to P14,997 or by P3,503,
the point of indifference will be reached.
Another alternative way to get the same answer would be to divide the net
present value of P9,423 by 2.690.
Problem 2
Annual cash expenses of the manual bookkeeping
machine system, P9,800 x 12
Annual cash expenses of computerized data processing
Annual cash savings before taxes
Annual cash savings (a)
Depreciation
Inflow before tax
Income tax (50%) (b)
Cash inflow after tax (a - b)

Year 1
Year 2
Year 3
Year 3 Salvage
Year 3 Tax loss

Year 1
P64,000
20,000
P44,000
22,000
P42,000

Year 2
P64,000
16,000
P48,000
24,000
P40,000

Year 3
P64,000
12,800
P51,200
25,600
P38,400

After Tax
Cash Inflows
P42,000
40,000
38,400
20,000
15,600*

PV Factor
x 0.909
x 0.826
x 0.750
x 0.750
x 0.750

PV
P 38,178
33,040
28,800
15,000
11,700
P126,718
100,000
P 26,718

Investment (I)
Net present value (NPV)
_________________
*

P117,600
53,600
P 64,000

The P15,600 tax benefit of the loss on the disposal of the computer at the end of
year 3 is computed as follows:
Estimated salvage value
Estimated book value:
Historical cost
Accumulated depreciation
Estimated loss
20-3

P 20,000
P100,000
48,800

51,200
P(31,200)

Chapter 20 Capital Budgeting Decisions

Tax rate
Tax effect of estimated loss

50%
P(15,600)

Since the net present value is positive, the computer should be purchased
replacing the manual bookkeeping system.

Problem 3
Requirement 1
(a) Purchase price of new equipment
Disposal of existing equipment:
Selling price
Book value
Loss on disposal
Tax rate
Tax benefit of loss on disposal
Required investment (I)

P(300,000)
P

0
60,000
P60,000
0.4

(b) Increased cash flows resulting from

change in contribution margin:
Using new equipment [18,000 (P20 - P7)] *
Using existing equipment [11,000 (P20 - P9)]
Increased cash flows
Less: Taxes (0.40 x P113,000)
Increased cash flows after taxes
Depreciation tax shield:
Depreciation on new equipment
(P300,000 5)
P60,000
Depreciation on existing equipment
(P60,000 5)
12,000
Increased depreciation charge P48,000
Tax rate
0.40
Depreciation tax shield
Recurring annual cash flows
_________________
*

24,000
P(276,000)

P234,000
121,000
113,000
45,200
P 67,800

19,200
P 87,000

The new equipment is capable of producing 20,000 units, but ETC Products
can sell only 18,000 units annually.
The sales manager made several errors in his calculations of required
investment and annual cash flows. The errors are as follows:
Required investment:

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Capital Budgeting Decisions Chapter 20

-

The cost of the market research study (P44,000) is a sunk cost because it
was incurred last year and will not change regardless of whether the
investment is made or not.
The loss on the disposal of the existing equipment does not result in an
actual cash cost as shown by the sales manager. The loss on disposal
results in a reduction of taxes, which reduces the cost of the new
equipment.

Annual cash flows:

- The sales manager considered only the depreciation on the new equipment
rather than just the additional depreciation which would result from the
acquisition of the new equipment.
- The sales manager also failed to consider that the depreciation is a noncash
expenditure which provides a tax shield.
- The sales managers use of the discount rate (i.e., cost of capital) was
incorrect. The discount rate should be used to reduce the value of future
cash flows to their current equivalent at time period zero.

Requirement 2
Present value of future cash flows (P87,000 x 3.36)
Required investment (I)
Net present value

P292,320
276,000
P 16,320

Problem 4
Requirement 1: P(507,000)
Requirement 2: P(466,200)
Requirement 3: P(23,400)

IV. Multiple Choice Questions

1.
2.
3.
4.
5.
6.
7.
8.

D
C
B
B
A
C
D
B

11.
12.
13.
14.
15.
16.
17.
18.

D
D
D
C
C
D
D
B

21.
22.
23.
24.
25.
26.
27.
28.
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C
B
C
D
C
C
D
B

31.
32.
33.
34.
35.
36.
37.
38.

D
C
C
D
D
B
B
B

Chapter 20 Capital Budgeting Decisions

9. B
10. A

19. A
20. A

29. D
30. A

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39. D
40. B