Solutions Manual

CHAPTER 28

BASICS OF CAPITAL BUDGETING

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

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
project’s 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 project’s 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

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distributed radically different throughout the year, there should be no

bias.
6. In replacement projects, the benefits are generally cost savings, although
the new machinery may also permit additional output. The data for
replacement analysis are generally easier to obtain than for new products,
but the analysis itself is somewhat more complicated because almost all
of the cash flows are incremental, found by subtracting the new cost
numbers from the old numbers. Similarly, differences in depreciation
and any other factor that affects cash flows must also be determined.

II. Problems

Problem 1

(a) Equipment purchase (P 9,000,000)

NOWC investment (3,000,000)
Initial investment outlay (P12,000,000)

(b) No, last year’s 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.

(c) The potential sale of the building represents an opportunity cost of

conducting the project in that building. Therefore, the possible proceeds
after taxes and commissions must be charged against the project as a cost.

Problem 2

(a) The projected cash flow for the first year is:

Project cash flows: t = 1

Sales revenues P10,000,000
Operating costs 7,000,000
Depreciation 2,000,000
EBIT P 1,000,000
Taxes (40%) 400,000
EBIT (1 – T) P 600,000
Add back depreciation 2,000,000
Project cash flow = EBIT (1 – T) + DEP P 2,600,000

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Problem 3

Equipment’s original cost P250 M

Depreciation (80%) 200 M
Book value P 50 M

Loss on sale = P5 M – P50 M

= P45 M

Tax savings = P45 M (0.4)

= P18 M

After-tax salvage value = P5 M + P18M

= P23 M

Problem 4

Level of working capital for old machine = P25,000 – P5,000

= P20,000

Level of working capital for new machine = P20,000 – P5,000

= P15,000

Incremental investment in net working capital = P15,000 – P20,000

= – P5,000

Problem 5

Level of working capital for old machine = P20,000 – P5,000

= P15,000
Level of working capital for new machine = P30,000 – P10,000
= P20,000

Incremental investment in net working capital = P20,000 – P15,000

= P5,000

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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

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Problem 12
Operating cash flow (2nd year) = (P80,000 – P10,000) (0.66) +
(175,000 x .3333) (0.34)
= P66,033

Problem 13 (Total Cash Flows in the 4th year)

Operating cash flow = (P80,000 – P10,000) (0.66)
= P46,200

Proceeds for sale (no gains for loss asset

fully depreciated) P10,000
Recovery working capital (P15,000 x 0.60) 9,000
Project-disposal cash flow P19,000

Total cash flow = P46,200 + P19,000

= P65,200

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

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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.

Taxes = (P100,000 – P100,000) (0.34)

= P0

Problem 19
Project-disposal cash flow (end of 3rd year)

Recovery of net working capital (P250,000 x .40) P100,000

Proceeds from sale of equipment 100,000
Total P200,000

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