Professional Documents
Culture Documents
CHAPTER 28 - Answer
CHAPTER 28 - Answer
CHAPTER 28
I. Questions
1. Only cash can be spent or reinvested, and since accounting profits do not
necessarily represent all cash, they are of less fundamental importance
than cash flows for investment analysis.
2. Capital budgeting analysis should only include those cash flows that will
be affected by the decision. Sunk costs are unrecoverable and cannot be
changed, so they have no bearing on the capital budgeting decision.
Opportunity costs represent the cash flows the firm gives up by investing
in this project rather than its next best alternative, and externalities are
the cash flows (both positive and negative) to other projects that result
from the firm undertaking this project. These cash flows occur only
because the firm took on the capital budgeting project; therefore, they
must be included in the analysis.
3. When a firm takes on a new capital budgeting project, it typically must
increase its investment in receivables and inventories, over and above the
increase in payables and accruals, thus increasing its net operating
working capital (NOWC). Since this increase must be financed, it is
included as an outflow in Year 0 of the analysis. At the end of the
projects life, inventories are depleted and receivables are collected.
Thus, there is a decrease (or reduction) in NOWC, which represents an
inflow in the final year of the projects life.
4. The costs associated with financing are reflected in the weighted average
cost of capital. To include interest expense in the capital budgeting
analysis would double count the cost of debt financing.
5. Daily cash flows would be theoretically best, but they would be costly to
estimate and probably no more accurate than annual estimates because
we simply cannot forecast accurately at a daily level. Therefore, in most
cases we simply assume that all cash flows occur at the end of the year.
However, for some projects it might be useful to assume that cash flows
occur at mid-year, or even quarterly or monthly. There is no clear
upward or downward bias on NPV since both revenues and costs are
being recognized at the end of the year. Unless revenues and costs are
28-1
Chapter 28 Basics of Capital Budgeting
II. Problems
Problem 1
(b) No, last years P50,000 expenditure is considered a sunk cost and does not
represent an incremental cash flow. Hence, it should not be included in the
analysis.
Problem 2
(a) The projected cash flow for the first year is:
28-2
Basics of Capital Budgeting Chapter 28
Problem 3
Problem 4
Problem 5
28-3
Chapter 28 Basics of Capital Budgeting
Problem 6
Investment in net working capital = P1,000,000 + (P750,000 x 0.40)
(P1,000,000 x 0.50)
= P800,000
Problems 7 through 9:
Problem 7
Net investment cash flow = P175,000 + P25,000 + (P50,000
P22,500)
= P227,500
Problem 8
Operating cash flow = (P120,000 P50,000) (0.66) +
(P50,000) (0.34)
= P63,200
Problem 9
Disposal cash flow = (P50,000) (0.66) + (P50,000
P22,500)
= P60,500
Problems 10 through 13: Assume that the equipment has 3-year life for tax
purposes using straight line method. Hence no
depreciation can be claimed in the 4 th and 5th years
of the project.
Problem 10
Net investment in cash flow = P175,000 + (P15,000 x 0.60)
= P184,000
Problem 11
Operating cash flow (1st year) = (P80,000 P10,000) (0.66) +
(175,000 x 0.3333) (0.34)
= P66,033
28-4
Basics of Capital Budgeting Chapter 28
Problem 12
Operating cash flow (2nd year) = (P80,000 P10,000) (0.66) +
(175,000 x .3333) (0.34)
= P66,033
Problems 14 through 19: Assume that the equipment has an economic life of 3
years and will be depreciated over that period using
straight line method.
Problem 14
Net investment in cash flow = P2,000,000 + (P250,000 x 0.40)
= P2,100,000
Problem 15
Operating cash flow (1st year) = (P800,000 P350,000) (0.66) +
P2,000,000 P1,000,000 (0.34)
3
= P512,333
Problem 16
Operating cash flow (2nd year) = (P800,000 P350,000) (0.66) +
(P215,333)
= P512,333
28-5
Chapter 28 Basics of Capital Budgeting
Problem 17
Operating cash flow (3rd year) = (P800,000 P350,000) (0.66) +
(P215,333)
= P512,333
Problem 18
Book value = P2,000,000 P1,900,000
= P100,000. If sold for P100,000, no
gain or loss will occur.
Problem 19
Project-disposal cash flow (end of 3rd year)
28-6