ACC 223

Capital Budgeting
PS 3 AK – Problem Solving
Feb. 4, 2021

1. Given the following data:

Cost of equipment.............. P55,750

Annual cash inflows........... P10,000
Internal rate of return......... 16%

The life of the equipment must be:

A) it is impossible to determine from the data given
B) 15 years
C) 12.5 years
D) 5.75 years

Ans:  B
Solution:
The internal rate of return factor is 5.575, or $55,750 ÷ $10,000. In the table for the
Present Value of an Annuity of $1 in Arrears, the factor of 5.575 can be found in the 16%
column in the 15th row; 15 then represents the life of the equipment.
2. Henry Company is considering an investment in a project that will have a two year life.
The project will provide a 10% internal rate of return, and is expected to have a P40,000
cash inflow the first year and a P50,000 cash inflow in the second year. What investment
is required in the project?
A) P74,340
B) P77,660
C) P81,810
D) P90,000

Ans:  B

Solution:

Year(s) Amount 10% Factor PV

st
Cash inflow−1 year.......... 1 40,000 0.909 $36,360
Cash inflow−2nd year.......... 2 50,000 0.826 41,300
Net present value................ $77,660

For the net present value of this project to be zero, the initial investment should be equal
to the present value of the cash inflows, or $77,660.

3. Constancia Beverage Corporation is considering an investment in a capital budgeting

project that has an internal rate of return of 20%. The only cash outflow for this project is
the initial investment. The project is estimated to have an 8 year life and no salvage
value. Cash inflows from this project are expected to be P100,000 per year in each of the
8 years. Constancia's discount rate is 16%. What is the net present value of this project?
A) P5,215
B) P15,464
C) P50,700
D) P55,831

Ans:  C
 Solution:
Internal rate of return factor = Initial investment ÷ Annual inflows
Look up the factor in the table Present Value of an Annuity of $1 in Arrears for 8 periods,
20% column; the factor is 3.837. Substituting into the above equation, 3.837 = Initial
investment ÷ $100,000
Initial investment = $383,700.

Year(s) Amount 16% Factor PV

($383,700
Initial investment............... Now ) 1.000 ($383,700)
Annual net cash receipts.... 1-8 $100,000 4.344 434,400
Net present value................ $ 50,700

4. The Able Company is considering buying a new donut maker. This machine will replace
an old donut maker that still has a useful life of 2 years. The new machine will cost
P2,500 a year to operate, as opposed to the old machine, which costs P2,700 per year to
operate. Also, because of increased capacity, an additional 10,000 donuts a year can be
produced. The company makes a contribution margin of P0.02 per donut. The old
machine can be sold for P5,000 and the new machine costs P25,000. The incremental
annual net cash inflows provided by the new machine would be:
A) P200
B) P400
C) P5,200
D) P5,400

Ans:  B

Solution:

Operating cost savings per year ($2,700 − $2,500)........................ $200

Additional contribution margin provided by the new donut maker
($0.02 × 10,000).......................................................................... 200
Incremental annual net cash inflows provided by new machine.... $400
5. Given the following data:

Initial investment............... P80,000

Annual cash inflow............ ?
Salvage value..................... $0
Net present value................ P13,600
Life of the project............... 6 years
Discount rate...................... 16%

Based on the data given above, the annual cash inflow from the project after the initial
investment is closest to:
A) P50,116
B) P21,710
C) P25,400
D) P38,376

Ans:  C

Solution:

First, set up table:

Year(s) Amount 16% Factor PV
Initial investment............... Now $80,000 1.000 ($80,000)
Annual cash inflows........... 1-6 ? 3.685 ?
Net present value................ $13,600

Second, solve for the present value of the annual cash inflow:
PV of annual cash inflow = $13,600 − (-$80,000) = $93,600
Finally, solve for the annual cash inflow:
Annual cash inflow × 3.685 = $93,600
Annual cash inflow = $25,400
6. Vangie Company invested in a four-year project. Virginia's discount rate is 10%. The
cash inflows from this project are:

Yea
r Cash Inflow
1 $4,000
2 $4,400
3 $4,800
4 $5,200

Assuming a positive net present value of $1,000, the amount of the original investment
was closest to:
A) $2,552
B) $4,552
C) $13,427
D) $17,400

Ans:  C

Solution:

Net present value of cash inflows − Original investment = Net present value of project
Original investment = NPV of cash inflows − NPV of project
= $14,427 − $1,000 = $13,427

Year(s) Amount 10% Factor PV

Year 1 inflow............................... 1 $4,000 0.909 $ 3,636
Year 2 inflow............................... 2 $4,400 0.826 3,634
Year 3 inflow............................... 3 $4,800 0.751 3,605
Year 4 inflow............................... 4 $5,200 0.683 3,552
Net present value of cash inflows $14,427
7. Paragon Corporation is reviewing the following data relating to an energy saving
investment proposal:

Initial investment............... P50,000

Life of the project............... 5 years

Salvage value..................... P10,000

Annual cash savings........... ?

What annual cash savings would be needed in order to satisfy the company's 12%
required rate of return (rounded to the nearest one hundred pesos)?
A) P10,600
B) P11,100
C) P12,300
D) P13,900

Ans:  C
Solution:

Year
s Amount 12% Factor Present Value
($50,000
Total investment................. Now ) 1.000 ($50,000)
Annual cash savings........... 1-5 ? 3.605 ?
Salvage value..................... 5 $10,000 0.567 5,670
Net present value................ $ 0

To solve for the present value of the annual cash savings:

-$50,000 + PV of annual cash savings + $5,670 = $0
PV of annual cash savings = $44,330
To solve for the amount of the annual cash savings:
Amount of annual cash savings × 3.605 = $44,330
Amount of annual cash savings = $12,297, which rounds to $12,300
 9. The Maine Prevention Agency is a non-profit organization that does all of its own
informational printing. The printing press that Maine currently is using needs a P20,000
overhaul. This will extend the useful life of the press by 8 years. As an alternative, Maine
could buy a brand new modern press for P45,000. The new press would also last 8 years.
The annual operating expenses of the old press are P12,000. The annual operating
expenses of the new press will only be P7,000. The old press is not expected to have a
salvage value in 8 years. The new press is expected to have a P6,000 salvage value in 8
years. Maine's discount rate is 14%. The net present value of the decision to buy the new
press instead of overhauling the old press is closest to:
A) P301
B) P(301)
C). P 4,195
D) P(46,089)

Ans:  A

Solution:

Year(s) Amount 14% Factor PV

Initial investment............... Now ($45,000) 1.000 ($45,000)
Annual cost savings
($12,000 − $7,000)......... 1-8 $5,000 4.639 23,195
Salvage value..................... 8 $6,000 0.351 2,106
Net present value of new
press................................ ($19,699)

Cost to overhaul old press................ $20,000

NPV of new press............................. 19,699
NPV of new press vs. old press........ $ 301

10. The Paternos Company is considering a machine that will save P3,000 a year in cash
operating costs each year for the next six years. At the end of six years it would have no
salvage value. If this machine costs P9,060 now, the machine's internal rate of return is
closest to:
A) 18%
B) 20%
C) 22%
D) 24%

Ans:  D

Solution:

Factor of the internal rate of return

= Investment required ÷ Net annual cash inflow = $9,060 ÷ $3,000 = 3.020
The factor of 3.020 for 6 years represents an internal rate of return of 24%.
11. The management of Ella Faye Corporation is considering the purchase of a machine that
would cost P365,695 and would have a useful life of 9 years. The machine would have no
salvage value. The machine would reduce labor and other operating costs by P61,000 per
year. The internal rate of return on the investment in the new machine is closest to:
A) 9%
B) 11%
C) 12%
D) 10%

Ans:  A

Solution:

Factor of the internal rate of return

= Investment required ÷ Net annual cash inflow = $365,695 ÷ $61,000 = 5.995
The factor of 5.995 for 9 years represents an internal rate of return of 9%.

12. Ben Corporation is investigating buying a small used aircraft for the use of its executives.
The aircraft would have a useful life of 9 years. The company uses a discount rate of 10%
in its capital budgeting. The net present value of the investment, excluding the salvage
value of the aircraft, is -P439,527. Management is having difficulty estimating the
salvage value of the aircraft. To the nearest whole dollar how large would the salvage
value of the aircraft have to be to make the investment in the aircraft financially
attractive?
A) P439,527
B) P43,953
C) P4,395,270
D) P1,036,620

Ans:  D

Solution:

Minimum salvage value

= Negative net present value to the offset ÷ Present value factor
= $439,527 ÷ 0.424 = $1,036,613 (answer is slightly off due to rounding)
13. A company is pondering an investment project that has an internal rate of return which is
equal to the company's discount rate. The project profitability index of this investment
project is:
A) 0.0
B) 0.5
C) 1.0
D) 1.5

Ans:  A

14. The management of Sonny Corporation is considering the following three investment
projects:

Project L Project M Project N

Investment required....................... P37,000 P55,000 P82,000

Present value of cash inflows......... P$38,480 P62,150 P90,200

Rank the projects according to the profitability index, from most profitable to least
profitable.
A) M,N,L
B) L,N,M
C) N,L,M
D) N,M,L

Ans:  A

Solution:

Project L Project M Project N

Investment required (a)......................... ($37,000) ($55,000) ($82,000)
Present value of cash inflows...............   38,480   62,150  90,200
Net present value (b)............................. $  1,480 $  7,150 $ 8,200
Project profitability index (b) ÷ (a)....... 0.04 0.13 0.10
Ranked by project profitability index... 3 1 2
15. The management of Lani Corporation is considering a project that would require an
investment of P263,000 and would last for 8 years. The annual net operating income from
the project would be P66,000, which includes depreciation of P31,000. The scrap value
of the project's assets at the end of the project would be P15,000. The payback period of
the project is closest to:
A) 3.8 years
B) 2.6 years
C) 2.7 years
D) 4.0 years

Ans:  C

Solution:
Net annual cash flow = Net operating income + Depreciation
= $66,000 + $31,000 = $97,000
Payback period = Investment required ÷ Net annual cash flow
= $263,000 ÷ $97,000 = 2.7 years

In this case the salvage value plays no part in the payback period since all of the
investment is recovered before the end of the project.
16. Siam Corporation is contemplating purchasing equipment that would increase sales
revenues by P298,000 per year and cash operating expenses by P143,000 per year. The
equipment would cost P712,000 and have a 8 year life with no salvage value. The annual
depreciation would be P89,000. The simple rate of return on the investment is closest to:
A) 9.3%
B) 21.8%
C) 22.1%
D) 12.5%

Ans:  A

Solution:

The simple rate of return is computed as follows:

Cost of machine, net of salvage value (a)........... $712,000

Useful life (b)...................................................... 8 years
Annual depreciation (a) ÷ (b).............................. $89,000

Annual incremental revenue ($298,000 −

$143,000)......................................................... $155,000
Less annual depreciation.....................................     89,000
Annual incremental net operating income.......... $  66,000

Simple rate of return = Annual incremental net operating income ÷ Initial investment =
$66,000 ÷ $712,000 = 9.3%

17. Wanda Corporation uses a discount rate of 14% and has a tax rate of 30%. The
following cash flows occur in the last year of a 10-year equipment selection investment
project:

Cost savings for the year............................ P180,000

Working capital released............................ P120,000

Salvage value from sale of equipment....... P25,000

At the end of the ten years when the equipment is sold, its net book value for tax
purposes is zero. The total after-tax present value of the cash flows above is closest to:
A) $45,765
B) $48,465
C) $61,425
D) $71,145

Ans:  D
Solution:
Tax
Years Amount Effect
Net cash inflow................... 10 $180,000 0.70
Salvage value...................... 10 $25,000 0.70
Working capital released.... 10 $120,000
Net present value................

After-Tax
Cash 14% Present
Flows Factor Value
Net annual cash inflow....... $126,000 0.270 $34,020
Salvage value...................... $17,500 0.270 4,725
Working capital released.... $120,000 0.270 32,400
Net present value................ $71,145
18 A company anticipates a taxable cash receipt of P80,000 in year 3 of a project. The
company's tax rate is 30% and its discount rate is 10%. The present value of this future
cash flow is closest to:
A) P42,056
B) P56,000
C) P24,000
D) P18,032

Ans:  A
Solution:

After-tax cash flow = Before-tax cash flow × (1 − Tax rate)

= $80,000 × (1 − 0.30) = $56,000
Present value factor from Present Value of $1: 0.751
Present value = $56,000 × 0.751 = $42,056

19. A company anticipates a depreciation deduction of $70,000 in year 4 of a project. The

company's tax rate is 30% and its discount rate is 12%. The present value of the
depreciation tax shield resulting from this deduction is closest to:
A) P31,140
B) P49,000
C) P21,000
D) P13,356

Ans:  D

Solution:

Depreciation tax shield = $70,000 × 30% = $21,000

Present value of depreciation shield = $21,000 × 0.636* = $13,356

*Factor from Present Value of $1 table, 12%, 4 years

20. A company needs an increase in working capital of P50,000 in a project that will last
4 years. The company's tax rate is 30% and its discount rate is 14%. The present value of
the release of the working capital at the end of the project is closest to:
A) P15,000
B) P20,723
C) P29,600
D) P35,000

Ans:  C

Solution:
Present value of working capital release = $50,000 × 0.592* = $29,600

*Factor from Present Value of $1 table

21. Dino Construction, Inc., has a large crane that cost P35,000 when purchased ten years
ago. Depreciation taken to date totals P25,000. The crane can be sold now for P6,000.
Assuming a tax rate of 40%, if the crane is sold the total after-tax cash inflow for capital
budgeting purposes will be:
A) P8,400
B) P12,000
C) P7,600
D) P10,000

Ans:  C

Solution:

Sale proceeds....................................................... $ 6,000

Less book value of crane ($35,000 − $25,000).... 10,000
Loss on sale of crane............................................ ($ 4,000)

Cash proceeds from sale...................................... $6,000

Add tax benefit of loss ($4,000 × 0.40)............... 1,600
Total after-tax cash inflow from sale................... $7,600
Shenna Inc. has provided the following data to be used in evaluating a proposed investment
project:

Initial investment............... P280,000

Annual cash receipts.......... $P96,000

Life of the project............... 6 years
Annual cash expenses........ P78,000
Salvage value..................... P28,000

The company's tax rate is 30%. For tax purposes, the entire initial investment will be depreciated
over 5 years without any reduction for salvage value. The company uses a discount rate of 16%.

22. When computing the net present value of the project, what are the annual after-tax cash
receipts?
A) P112,000
B) P137,200
C) P29,400
D) P58,800

Ans:  B
Solution:

Annual after-tax cash receipts = Annual cash receipts × (1 − Tax rate)

= $196,000 × (1 − 0.30) = $137,200
23. When computing the net present value of the project, what are the annual after-tax cash
expenses?
A) P101,400
B) P50,000
C) P54,600
D) P23,400

Ans:  C

Solution:

Annual after-tax cash expenses = Annual cash expenses × (1 − Tax rate)

= $78,000 × (1 − 0.30) = $54,600

24. When computing the net present value of the project, what is the annual amount of
the depreciation tax shield? In other words, by how much does the depreciation deduction
reduce taxes each year in which the depreciation deduction is taken?
A) P16,800
B) P39,200
C) P14,000
D) P32,667

Ans:  A
Solution:

Initial investment........................ $280,000

Life in years................................ 5 years
Annual amount of depreciation... $56,000

Annual amount of depreciation tax shield = $56,000 × 0.30

= $16,800
25. When computing the net present value of the project, what is the after-tax cash flow from
the salvage value in the final year?
A) P28,000
B) P8,400
C) P19,600
D) P0

Ans:  C

Solution:

Gain on sale (asset fully depreciated)..... $28,000

× (1 − Tax rate)....................................... 0.70
After-tax cash flow from salvage value. . $19,600