CAPITAL BUDGETING – PROBLEMS:

1. Acme is considering the sale of a machine with a book value of P80,000 and 3 years remaining in its useful life. Straight-line depreciation of
P25,000 annually is available. The machine has a current market value of P100,000. What is the cash flow from selling the machine if the tax
rate is 40%?
A. P25,000 B. P80,000 C. P92,000 D. P100,000

Proceeds from sale P 100,000

Additional tax due to gain on sale [(P100,000 – P80,000) x 40%] (8,000)
Net cash inflow P 92,000

2 Hatchet Company is considering replacing a machine with a book value of P400,000, a remaining useful life of 5 years, and annual straight-line
depreciation of P80,000. The existing machine has a current market value of P400,000. The replacement machine would cost P550,000, have a
5-year life, and save P75,000 per year in cash operating costs. If the replacement machine would be depreciated using the straight-line method
and the tax rate is 40%, what would be the net investment required to replace the existing machine?
A. P90,000. B. P150,000 C. P330,000 D. P550,000

Purchase price of new machine P 550,000

Proceeds from sale of old machine (400,000)
Net investment P 150,000

3. Diliman Republic Publishers, Inc. is considering replacing an old press that cost P800,000 six years ago with a new one that would cost
P2,250,000. Shipping and installation would cost an additional P200,000. The old press has a book value of P150,000 and could be sold
currently for P50,000. The increased production of the new press would increase inventories by P40,000, accounts receivable by P160,000 and
accounts payable by P140,000. Diliman Republic’s net initial investment for analyzing the acquisition of the new press assuming a 35% income
tax rate would be
A. P2,450,000 B. P2,425,000 C. P2,600,000 D. P2,250,000

Purchase price of new press P 2,250,000

Shipping and installation 200,000
Proceeds from sale of old press (50,000)
Tax savings due to loss on sale [(50,000 – P150,000) x 35%] (35,000)
Additional working capital (40,000 + 160,000 – 140,000) 60,000
Net investment P 2,425,000

4. Key Corp. plans to replace a production machine that was acquired several years ago. Acquisition cost is P450,000 with salvage value of
P50,000. The machine being considered is worth P800,000 and the supplier is willing to accept the old machine at a trade-in value of P60,000.
Should the company decide not to acquire the new machine, it needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in
transaction will not have any implication but the cost to repair is tax-deductible. The effective corporate tax rate is 35% of net income subject to
tax. For purposes of capital budgeting, the net investment in the new machine is
A. P540,000 B. P610,000 C. P660,000 D. P800,000

Acquisition cost of new machine, net of trade-in value of old machine (P 800,000 – P60,000) P 740,000
Savings from avoided cost of repair, net of tax (P200,000 x 65%) (130,000)
Net investment P 610,000

5. Great Value Company is planning to purchase a new machine costing P50,000 with freight and installation costs amounting to P1,500. The old
unit is to be traded-in will be given a trade-in allowance of P7,500. Other assets that are to be retired as a result of the acquisition of the new
machine can be salvaged and sold for P3,000. The loss on retirement of these other assets is P1,000 which will reduce income taxes of P400. If
the new equipment is not purchased, repair of the old unit will have to be made at an estimated cost of P4,000. This cost can be avoided by
purchasing the new equipment. Additional gross working capital of P12,000 will be needed to support operation planned with the new
equipment.

The net investment assigned to the new machine for decision analysis is
A. P50,200 B. P52,600 C. P53,600 D. P57,600

Purchase price of new machine, net of trade-in value of old machine (P50,000 – P7,500) P 42,500
Freight and installation 1,500
Proceeds from sale of other assets (3,000)
Tax savings due to loss on sale of other assets (400)
Savings from avoided cost of repair, net of tax [P4,000 x (1-40%*)] (2,400)
Additional working capital requirement 12,000
Net investment P 50,200
*tax rate = P400/P1,000 = 40%

6. Hooker Oak Furniture Company is considering the purchase of wood cutting equipment. Data on the equipment are as follows:
Original investment P30,000
Net annual cash inflow P12,000
 Expected economic life in years 5
Salvage value at the end of five years P3,000

The company uses the straight-line method of depreciation with no mid-year convention.

What is the accounting rate of return on original investment rounded off to the nearest percent, assuming no taxes are paid?
A. 40.0% B. 20.0% C. 24.0% D. 22.0%

ARR-orig. = Net income / Original investment

= (P6,600* / P30,000)
= 22%

*Net income:
Net annual cash inflow P 12,000
Depreciation (P30,000 – P3,000) /5 (5,400)
Net income after tax P 6,600

7. A company is considering putting up P50,000 in a three-year project. The company’s expected rate of return is 12%. The present value of
P1.00 at 12% for one year is 0.893, for two years is 0.797, and for three years is 0.712. The cash flow, net of income taxes will be P18,000
(present value of P16,074) for the first year and P22,000 (present value of P17,534) for the second year. Assuming that the rate of return is
exactly 12%, the cash flow, net of income taxes, for the third year would be
A. P7,120 B. P10,000 C. P16,392 D. P23,022

8. Lor Industries is analyzing a capital investment proposal for new machinery to produce a new product over the next ten years. At the end of the
ten years, the machinery must be disposed of with a zero net book value but with a scrap salvage value of P20,000. It will require some
P30,000 to remove the machinery. The applicable tax rate is 35%. The appropriate “end-of-life” cash flow based on the foregoing information
is:
A. Inflow of P30,000. C. Outflow of P10,000.
B. Outflow of P6,500. D. Outflow of P17,000.

Cash flows at the end of useful life:

Proceeds from sale of machinery P 20,000 – inflow
Additional tax due to gain on sale [(P20,000 – 0) x 35%] 7,000 – outflow
Cost of removing the machinery 30,000 – outflow
Tax savings – cost to remove the machine (P30,000 x 35%) 10,500 – inflow
Net outflow P 6,500

9. C Corp. faces a marginal tax rate of 35 percent. One project that is currently under evaluation has a cash flow in the fourth year of its life that
has a present value of P10,000 (after-tax). C Corp. assumes that all cash flows occur at the end of the year and the company uses 11 percent as
its discount rate. What is the pre-tax amount of the cash flow in year 4? (Round to the nearest dollar.)
A. P15,181 B. P23,356 C. P9,868 D. P43,375

10. Maxwell Company has an opportunity to acquire a new machine to replace one of its present machines. The new machine would cost P90,000,
have a 5-year life, and no estimated salvage value. Variable operating costs would be P100,000 per year. The present machine has a book value
of P50,000 and a remaining life of 5 years. Its disposal value now is P5,000, but it would be zero after 5 years. Variable operating costs would
be P125,000 per year. Ignore income taxes. Considering the 5 years in total, what would be the difference in profit before income taxes by
acquiring the new machine as opposed to retaining the present one?
A. P10,000 decrease B. P15,000 decrease C. P35,000 increase D. P40,000 increase

Expenses – new:
Variable operation costs (P100,000 x 5) P 500,000
Depreciation 90,000
Loss on sale of present machine (P50,000 – P5,000) 45,000 P 635,000
Expenses – present:
Variable operation costs (P125,000 x 5) P 625,000
Depreciation 50,000 675,000
Difference (Incremental profit before tax) P 40,000

11. A project under consideration by the White Corp. would require a working capital investment of P200,000. The working capital would be
liquidated at the end of the project's 10-year life. If White Corp. has an after-tax cost of capital of 10 percent and a marginal tax rate of 30
percent, what is the present value of the working capital cash flow expected to be received in year 10?
A. P36,868 B. P77,100 C. P53,970 D. P23,130

Gross cash flow P 200,000

x PV of 1 at 10% after 10 periods 0.3855
PV of working capital returned after 10 years P 77,100
12. Lyben Inc. is planning to produce a new product. To do this, it is necessary to acquire a new equipment that will cost the company P100,000.
The estimated life of the new equipment is five years with no salvage value. The estimated income and costs based on expected sales of
P10,000 units per year are:
Sales @ P10.00 per unit P100,000
Costs @ P8.00 per unit 80,000
Net income P 20,000

The accounting rate of return based on initial investment is 20%

What will be the accounting rate of return based on initial investment of P100,000 if management decrease its selling price of the new product
by 10%?
A. 5% B. 10% C. 15% D. 20%

ARR – orig. = Net income / Original investment

= P10,000 / P100,000
= 10%

*Net income after decrease in SP = P20,000 – (P100,000 x 10%)

= P10,000

13. MLF Corporation is evaluating the purchase of a P500,000 die attach machine. The cash inflows expected from the investment is P145,000 per
year for five years with no equipment salvage value. The cost of capital is 12%. The net present value factor for five (5) years at 12% is 3.6048
and at 14% is 3.4331. The internal rate of return for this investment is
A. 3.45% B. 2.04% C. 13.8% D. 15.48%

14. APJ, Inc. is planning to purchase a new machine that will take six years to recover the cost. The new machine is expected to produce cash flow
from operations, net of income taxes, of P4,500 a year for the first three years of the payback period and P3,500 a year of the last three years of
the payback period. Depreciation of P3,000 a year shall be charged to income of the six years of the payback period. How much shall the
machine cost?
A. P12,000 B. P18,000 C. P24,000 D. P36,000

Net investment = Total cash flows during the payback period

= (P4,500 x 3) + (P3,500 x 3)
= P24,000

15. Sweets, Etc., Inc. plans to undertake a capital expenditure requiring P2 million cash outlay. Below are the projected after-tax cash inflow for the
five-year period covering the useful life. The company’s tax rate is 35%.

Year 1 2 3 4 5
P’000 600 700 480 400 400

The founder and president of the candy company believes that the best gauge for capital expenditure is cash payback period and that the
recovery period should not be more than 75% of the useful life of the project or the asset. Should the company undertake the project?
A. No, since the payback period is 4 years or 80% of the useful life of the project.
B. Yes, since the payback period is 3.55 years or 71% of the useful life of the project.
C. No, since the payback period extends beyond the life of the project.
D. Yes, since the payback period is 4 years and still shorter than the useful life of the project.

PBP:
Net investment P 2,000,000
CF-1 (600,000)
CF-2 (700,000)
CF-3 (480,000)
Unrecovered cost, end of year 3 P 220,000
÷ CF-4 400,000
Portion of Year 4 0.55

PBP = 3.55 years or 71% of asset’s life