College of Accounting Education

3F, Business & Engineering Building

Matina, Davao City
Phone No.: (082)300-5456 Local 137

MAS 1: CAPITAL BUDGETING Jade D. Solaña, CPA, MBA

Management Advisory Services August 30, 2022

Review Questions

True or False

1. Capital budgeting decisions usually involve large investments and often have a significant impact
on a company's future profitability.
2. The capital budgeting committee ultimately approves the capital expenditure budget for the year.
3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs
into the capital budgeting decision tools.
4. The cash payback technique is a quick way to calculate a project's net present value.
5. The cash payback period is computed by dividing the cost of the capital investment by the annual
cash inflow.
6. The cash payback method is frequently used as a screening tool but it does not take into
consideration the profitability of a project.
7. The cost of capital is a weighted average of the rates paid on borrowed funds, as well as on funds
provided by investors in the company's stock.
8. Using the net present value method, a net present value of zero indicates that the project would
not be acceptable.
9. The net present value method can only be used in capital budgeting if the expected cash flows
from a project are an equal amount each year.
10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate projects
that could be financially beneficial to the company.
11. To avoid accepting projects that actually should be rejected, a company should ignore intangible
benefits in calculating net present value.
12. One way of incorporating intangible benefits into the capital budgeting decision is to project
conservative estimates of the value of the intangible benefits and include them in the NPV
calculation.
13. The profitability index is calculated by dividing the total cash flows by the initial investment.
14. The profitability index allows comparison of the relative desirability of projects that require
differing initial investments.
15. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among
potential returns.
16. A well-run organization should perform an evaluation, called a post-audit, of its investment
projects before their completion.
17. Post-audits create an incentive for managers to make accurate estimates, since managers know
that their results will be evaluated.
18. A post-audit is an evaluation of how well a project's actual performance matches the projections
made when the project was proposed.
19. The internal rate of return method is, like the NPV method, a discounted cash flow technique.
20. The interest yield of a project is a rate that will cause the present value of the proposed capital
expenditure to equal the present value of the expected annual cash inflows.
21. Using the internal rate of return method, a project is rejected when the rate of return is greater
than or equal to the required rate of return.
22. Using the annual rate of return method, a project is acceptable if its rate of return is greater than
management's minimum rate of return.
23. The annual rate of return method requires dividing a project's annual cash inflows by the
economic life of the project.
24. A major advantage of the annual rate of return method is that it considers the time value of
money.
25. An advantage of the annual rate of return method is that it relies on accrual accounting numbers
rather than actual cash flows.

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Multiple Choice

1. Which of the following groups of capital budgeting techniques uses the time value of money?
a. Book rate of return, payback, and profitability index.
b. IRR, payback, and NPV.
c. IRR, NPV, and profitability index.
d. IRR, book rate of return, and profitability index.

2. Discounted cash flow techniques for analyzing capital budgeting decisions are NOT normally applied
to projects
a. requiring no investment after the first year of life.
b. having useful lives shorter than one year.
c. that are essential to the business.
d. involving replacement of existing assets.

3. The profitability index

a. does not use present values of cash flows.
b. is generally preferable to any other approach for evaluating mutually exclusive investment
alternatives.
c. produces the same ranking of investment alternatives as does the IRR criterion.
d. is a discounted cash flow method.

4. Companies using MACRS for tax purposes and straight-line depreciation for financial reporting
purposes usually find that the relationship between the tax basis and book value of their assets
is
a. the tax basis is lower than book value.
b. the tax basis is higher than book value.
c. the tax basis is the same as book value.
d. none of the above.

5. A company that wants to use MACRS for tax purposes must

a. request permission from the IRS.
b. acquire new assets at or near the middle of the year.
c. ignore salvage value in calculating depreciation.
d. do none of the above.

6. The government could encourage increases in investment by

a. increasing tax rates.
b. lengthening the MACRS periods.
c. letting a company expense fixed assets in the year acquired instead of through annual depreciation
charges.
d. taking actions that would increase interest rates.

7. In choosing from among mutually exclusive investments the manager should normally select the one
with the highest
a. NPV.
b. IRR.
c. profitability index.
d. book rate of return.

8. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
a. The expected resale price of the existing machine.
b. The book value of the existing machine.
c. The original cost of the existing machine.
d. The depreciated cost of the existing machine.

9. Not-for-profit entities
a. cannot use capital budgeting techniques because profitability is irrelevant to them.
b. cannot use discounted cash flow techniques because the time value of money is irrelevant to
them.
c. might have serious problems in quantifying the benefits expected from an investment.
d. should use the IRR method to make investment decisions.

10. A major difference between an investment in working capital and one in depreciable assets is that

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 a. an investment in working capital is never returned, while most depreciable assets have some
residual value.
b. an investment in working capital is returned in full at the end of a project's life, while an
investment in depreciable assets has no residual value.
c. an investment in working capital is not tax-deductible when made, nor taxable when returned,
while an investment in depreciable assets does allow tax deductions.
d. because an investment in working capital is usually returned in full at the end of the project's life,
it is ignored in computing the amount of the investment required for the project.

11. The proper treatment of an investment in receivables and inventory is to

a. ignore it.
b. add it to the required investment in fixed assets.
c. add it to the required investment in fixed assets and subtract it from the annual cash flows.
d. add it to the investment in fixed assets and add the present value of the recovery to the present
value of the annual cash flows.

12. If a company uses a five-year MACRS period to depreciate assets instead of a 10-year life with
straight-line depreciation,
a. the NPV of the investment is higher.
b. the IRR of the investment is lower.
c. there is no difference in either NPV or IRR.
d. total cash flows over the useful life would be lower.

13. The NPV and IRR methods give

a. the same decision (accept or reject) for any single investment.
b. the same choice from among mutually exclusive investments.
c. different rankings of projects with unequal lives.
d. the same rankings of projects with different required investments.

14. An investment with a positive NPV also has

a. a positive profitability index.
b. a profitability index of one.
c. a profitability index less than one.
d. a profitability index greater than one.

15. Classifying an asset in a MACRS life category is based on

a. useful life estimated by the company.
b. asset depreciation range (ADR) guidelines.
c. the cost of the asset.
d. any of the above factors.

16. Which of the following makes investments more desirable than they had been?
a. An increase in the income tax rate.
b. An increase in interest rates.
c. An increase in the number of years over which assets must be depreciated.
d. None of the above.

17. Which of the following statements is true?

a. All revenue is taxed.
b. All expenses are tax-deductible.
c. Some revenues and expenses have no tax effects.
d. Income taxes are based solely on revenues and expenses.

18. The profitability index is the ratio of

a. total cash inflows to the cost of the investment.
b. the present value of cash inflows to the cost of the investment.
c. the NPV of the investment to the cost of the investment.
d. the IRR to the company's cost of capital.

19. With respect to income taxes, the principal advantage of MACRS over straight-line depreciation is
that
a. total taxes will be lower under MACRS.
b. taxes will be constant from year to year under MACRS.
c. taxes will be lower in the earlier years under MACRS.

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 d. taxes will decline in future years under MACRS.

20. If the profitability index is less than one,

a. the IRR is less than cost of capital.
b. the IRR is the same as cost of capital.
c. the IRR is greater than cost of capital.
d. none of the above is true.

21. Which of the following combinations is possible?

Profitability Index NPV IRR
------------------- -------- -------------------------
a. greater than 1 positive equals cost of capital
b. greater than 1 negative less than cost of capital
c. less than 1 negative less than cost of capital
d. less than 1 positive less than cost of capital

22. Which of the following combinations is NOT possible?

Profitability Index NPV IRR
------------------- -------- --------------------------
a. greater than 1 positive more than cost of capital
b. equals 1 zero equals cost of capital
c. less than 1 negative less than cost of capital
d. less than 1 positive less than cost of capital

23. In capital budgeting, sensitivity analysis is used

a. to determine whether an investment is profitable.
b. to see how a decision would be affected by changes in variables.
c. to test the relationship of the IRR and NPV.
d. to evaluate mutually exclusive investments.

24. A unique feature of the analysis of a replacement decision is that

a. the analysis considers total rather than differential costs.
b. the amount used as the cost of the investment is not likely to equal the price to be paid for the
new asset.
c. the time value of money is ignored.
d. such decisions seldom involve cash flows.

25. Because of idle capacity, a company is considering two assets for sale. They are identical in all
respects except that asset A has a higher tax basis than asset B. Only one need be sold now and
the market price is the same for both assets. Which of the following is true?
a. The cash flow is greater from selling asset A.
b. The cash flow is greater from selling asset B.
c. The cash flow is the same no matter which one is sold.
d. It is not possible to determine how the cash flows from sales of the assets will differ.

26. If the tax law were changed so that owners of apartment buildings had to depreciate them over 50
years instead of the current 31.5 years,
a. rents would rise.
b. rents would fall because annual depreciation charges would fall.
c. rents would stay about the same.
d. more people would invest in apartment buildings.

27. Which statement could express the results of a sensitivity analysis of an investment decision?
a. The NPV of the project is P50,000.
b. A 5% decline in volume will make the project unprofitable.
c. This project ranks third out of the five available.
d. This project does not meet the cutoff rate of return.

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28. XYZ Co. is adopting just-in-time principles. When evaluating an investment project that would
reduce inventory, how should XYZ treat the reduction?
a. Ignore it.
b. Decrease the cost of the investment and decrease cash flows at the end of the project's life.
c. Decrease the cost of the investment.
d. Decrease the cost of the investment and increase the cash flow at the end of the project's life.

29. Which of the following combinations of capital budgeting techniques includes only discounted cash
flow techniques?
a. Book rate of return, payback, and profitability index.
b. NPV, IRR, and profitability index.
c. IRR, payback, and NPV.
d. Profitability index, NPV, and payback.

30. An investment whose profitability index is 1.00

a. has an IRR equal to the prevailing interest rate.
b. returns to the company only the cash outlay for the investment.
c. has a payback period equal to its useful life.
d. has an NPV of zero.

31. In connection with a capital budgeting project, an investment in working capital is normally
recovered
a. at the end of the project's life.
b. in the first year of the project's life.
c. evenly through the project's life.
d. when the company goes out of business.

32. For investments that have only costs (no revenues or cost savings), an appropriate decision rule is to
accept the project that has the
a. longest payback period.
b. lowest present value of cash outflows.
c. higher present value of future cash outflows.
d. lowest internal rate of return.

33. The cash inflow from the return of an investment in working capital is
a. adjusted for taxes due.
b. discounted to present value.
c. ignored if any depreciable assets also involved in the project have no expected residual value.
d. not real.

34. NPV is appropriate to use to analyze which decision relating to a joint-products company?
a. Whether or not to sell facilities now used for additional processing of one of the joint products.
b. Whether or not to acquire facilities needed for additional processing of one of the joint products.
c. Whether or not to sell facilities now used to operate the joint process.
d. All of the above.

35. If X Co. expects to get a one-year bank loan to help cover the initial financing of capital project Q, the
analysis of Q should
a. offset the loan against any investment in inventory or receivables required by the project.
b. show the loan as an increase in the investment.
c. show the loan as a cash outflow in the second year of the project's life.
d. ignore the loan.

36. A project that has a negative NPV

a. has a payback period longer than its life.
b. has a negative profitability index.
c. must be rejected.
d. doesn't necessarily fit any of the above descriptions.

37. A company evaluates a project using straight-line depreciation over its 10-year estimated useful life
and then reevaluates it using a 7-year MACRS class life. The second analysis will show
a. a lower IRR for the project.
b. the same NPV and IRR for the project.
c. a higher NPV for the project.

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 d. lower total cash flows over the 10 years.

38. Assuming that a project has already been evaluated using the following techniques, the evaluation
under which technique is least likely to be affected by an increase in the estimated residual value of the
project?
a. Payback period.
b. IRR.
c. NPV.
d. PI.

39. Qualitative factors can influence managers to

a. accept an investment project having negative NPV.
b. reject an investment project having an IRR greater than the company's cutoff rate.
c. raise the "ranking" of an investment project.
d. take any of the above courses of action.

40. The replacement decision is

a. an example of a decision among mutually exclusive alternatives.
b. best arrived at by using the total-project rather than the differential approach.
c. devoid of qualitative issues.
d. none of the above.

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Capital Budgeting – is the process of planning and controlling investments for long-term projects and
programs

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

1. Capital investment decisions usually require large commitments of resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.
4. Capital investment decisions involve so much risk and uncertainty.

TYPES OF CAPITAL INVESTMENT PROJECTS

1. Replacement
2. Improvement
3. Expansion

CAPITAL INVESTMENT FACTORS

1. Net Investment
2. Cost of Capital
3. Net Returns

NET INVESTMENT

Net investment is computed by deducting SAVINGS or CASH INFLOWS from COSTS or CASH OUTFLOWS.

Total Cash Outflows is the sum of the following:

• The initial cash outlay covering all expenditures on the project up to the time when it is ready for
use or operation (PURCHASE PRICE OF THE ASSET, INCIDENTAL PROJECT-RELATED COSTS LIKE
FREIGHT, INSURANCE, TAXES, HANDLING, INSTALLATION, TEST RUNS, ETC.)
• Working capital requirement to operate the project at the desired level.
• Market value of an existing, currently idle asset which will be transferred or utilized in the
operations of the proposed capital investment project.

Total Cash Inflows or Savings consist of the following:

• Trade-in value of old asset (in case of replacement)
• Proceeds from sale of old asset to be disposed due to the acquisition of the new project (LESS
APPLICABLE TAX in case of GAIN ON SALE, or ADD TAX SAVINGS in case there is LOSS ON SALE)
• Avoidable cost of immediate repairs on old asset to be replaced, net of tax.

Ex.

The management of Beefit Fitness and Wellness Hub is planning to replace an old slimming machine which
was acquired 5 years ago at a cost of P30,000. The old machine has been depreciated to its salvage value
of P4,000. Beefit has found a buyer who is willing to purchase the old slimming machine for P6,000. The
new machine will cost P50,000. Incidental costs of installation, freight and insurance will have to be
incurred at a total cost of P10,000. Should the company decide to retain the old slimming machine (and
forget about buying the new one) the same must be upgraded and subjected to major repairs. The
estimated cost of this repairs expense (which is tax deductible) amounts to P8,000. The income tax rate
is 35%. What is the net cost of investment in the new machine for decision making purposes?

Purchase price of new machine 50,000

Incidental costs of installation, freight and insurance 10,000
Total Cost/Cash Outflow 60,000

Less: Savings or Cash Inflows

Proceeds from sale of old machine 6,000
Less: Tax on gain on sale (6,000 - 4,000) x 35% 700 5,300
Avoidable cost of repairs on old machine 8,000
Less: Applicable tax of 35% 2,800 5,200 10,500
Net Cost of Investment 49,500

NET RETURNS
1. Accounting Net income from the new machine
2. Net cash inflows from the project

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 Sales 150,000
COS 50,000
GP 100,000
Opex (ex. Depr.) 30,000
Dep’n Exp 5,000
OI 65,000
Tax (10%) 6,500
NI 58,500 (ANIAT)

Sales 150,000
COS 50,000
GP 100000
Opex 30,000
OI 70,000
Tax 6,500
ACIAT 63,500

Ni 58,500
Dep’n Exp 5,000
ACIAT 63,500

Capital investment decisions should be evaluated carefully and thoroughly for the following reasons:
a. Once made, capital budgeting decisions tend to be relatively inflexible because the commitments
extend well into the future.
b. Without proper timing, additional capacity generated by the acquisition of capital assets may not
coincide with changes in demand for output, resulting in capacity excess or shortage.
c. A capital budget usually involves substantial expenditures. The sources of these funds are critical.

The costs that are considered in capital budgeting analysis include:

a. Avoidable cost – cost that may be eliminated by ceasing an activity or by improving efficiency
b. Common cost – cost that is shared by all options and is not clearly allocable to any one of them.
c. Weighted-average cost of capital – weighted average of the interest cost of debt (net of tax) and
the implicit cost of equity capital to be invested in long-term assets. It represents a required
minimum return of a new investment to prevent dilution of owner’s interests.
d. Deferrable or postponable cost – cost that may be shifted to the future with little or no effect on
current operation.
e. Fixed cost – cost that does not vary with the level of activity within the relevant range
f. Imputed cost – cost that does not entail a specified peso outlay formally recognized by the
accounting system, but it is nevertheless relevant to establishing the economic reality analyzed in
the decision-making process.
g. Incremental cost – it is the difference in cost resulting from selecting one option instead of
another
h. Opportunity cost – it is the benefit forgone by not selecting the best alternative use of scarce
resources
i. Relevant cost – future differential cost that vary with the action
j. Sunk cost – cost that cannot be avoided because an expenditure or an irrevocable decision to
incur the cost has been made
k. Taxes – tax consequences of an investment.

STAGES IN CAPITAL BUDGETING

The stages in the capital budgeting process include the following:

1. Identification and definition of projects and programs.

- This involves the determination of the kinds of capital investments that are needed to attain the
entity’s objectives. Defining the projects and programs determines and limits their extent and
facilitates cost, revenue, and cash flow estimation. This stage is the most difficult.

2. Search for potential investments

- This involves a preliminary evaluation by representatives from each function in the entity’s value
chain

3. Information-acquisition stage

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 - This involves the gathering and evaluation of quantitative as well as qualitative considerations.
The evaluation process involves projection of costs and benefits, technological developments,
demands, competitors’ actions, government regulation and economic conditions

4. Selection
- This step entails choosing projects and programs on the basis of relative costs and benefits. The
results of applying financial decision tools should be considered in light of judgments about
nonfinancial factors

5. Financing
- The financing of projects and programs may be obtained from the entity’s own internal cash flows,
issuance of equity securities, or incurrence of debt

6. Implementation and monitoring

- This entails consideration of whether they are proceeding as scheduled and are within the
budgetary projections. This step also involves determining whether previously unforeseen
problems or opportunities have arisen and what changes in plans are appropriate

The following are steps in the ranking procedure:

1. Determine the asset cost or net investment

a. The net investment is the net outlay, or gross cash requirement, minus cash recovered from the
trade or sale of existing assets, with any necessary adjustments for applicable tax consequences.
Cash outflows in subsequent periods must also be considered
b. The investment required also includes funds to provide for increases in working capital, for
example, the additional receivables and inventories resulting from the acquisition of a new
manufacturing plant. This investment in working capital is treated as an initial cost of the
investment (a cash outflow) that will recovered at the end of the project (i.e., the salvage value is
equal to the initial cost).

2. Calculate estimated cash flows, period by period, using the acquired assets.
1. Reliable estimates of cost savings or revenues are necessary
2. Net cash flow is the economic benefit or cost, period by period, resulting from the investment
3. Economic life is the time period over which the benefits of the investment proposal are expected
to be obtained, as distinguished from the physical or technical life of the asset involved
4. Depreciable life is the period used for accounting and tax purposes over which cost is to be
systematically and rationally allocated. It is based upon permissible or standard guidelines and
may have no particular relevance to economic life.
i. Relate the cash-flow benefits to their cost by using one of several methods to evaluate
the advantage of purchasing the asset.
ii. Rank the investments.

Techniques that may be applied in evaluating capital investment proposals

1. Discounted cash flow approaches

1. Discounted or Internal Rate of Return
• An interest rate computed approach, such that the net present value of the investment is
zero. Hence the present value of the expected cash outflows equals the present value of the
expected cash inflows.
• If the cash inflows are uniform and there is no salvage value, the DRR can be found by looking
up the present value factor derived from the following equation in the annuity table for N
years which is the life of the investment:

Annual Cash Inflow X Present Value Factor = Investment

• If the cash inflows are uneven, the process of calculating the rate is based on the “trial and
error” method. Various rates will be tried the correct one is found. The correct rate is that in
which the present value of the cash inflows is equal to the present value of the investment
(cash outflows)

Time Adjusted Rate of Return

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 - Also known as the adjusted rate of return, internal rate of return (IRR), discounted rate of return
or discounted cash flow rate of return (DCFRR)

Even Cash Inflows

PVFLR – PVFDCFRR
DCFRR = LR + (HR - LR) x
PVFLR – PVFHR

Uneven Cash Inflows

NPVLR – 0
DCFRR = LR + (HR - LR) x
NPVLR – NPVHR

2. Net Present Value

• This is the difference between the present value of the estimated net cash inflows and the
present value of the net cash outflows.

3. Excess Present Value or Profitability Index

• This is the ratio of the present value of the future net cash inflows to the present value of the
initial net investment.

This is computed as follows:

PV Index = Present Value of Cash Inflows/Present Value of Cash Outflows

2. Non-discounted Cash Flow Approaches

a. Payback Period
• This is the number of years required to complete the return of the original investment. It is
computed as follows:

Payback Period = Investment/Annual Cash Inflows

b. Accounting Rate of Return (ARR)

• This is the increase in accounting net income divided by the required investment. This is
computed as follows:

ARR = Average Cash Inflow – Depreciation/Investment

General guidelines that may be used in the DCF approach

a. The NPV and IRR criteria always lead to the same accept/reject decision for independent projects.

b. In mutually exclusive projects, there may be a conflict in project choice between the NPV and IRR
methods. Conflicts can occur because of difference in project costs and/or cash flow timing.

c. The cause of conflicts in project ranking lies also in differing reinvestment rate assumptions
• NPV method implicitly assumes that the project cash flows are reinvested at the project’s cost
of capital
• IRR method implicitly assumes that the project cash flows are reinvested at the projects IRR

d. The assumption of reinvestment at the “cost of capital” which is also the opportunity cost of the
project cash flows is considered the more correct and realistic assumption. Thus, the NPV decision
rule is considered more superior than the IRR decision rule.

PRACTICE PROBLEMS

1. Savanna Company is considering two capital investment proposals. Relevant data on each project are
as follows:
Project Red Project Blue
Capital investment P400,000 P560,000
Annual net income 50,000 80,000

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 Estimated useful life 8 years 8 years

Depreciation is computed by the straight-line method with no salvage value. Savanna requires an 8% rate
of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and the present value
of an annuity of 1 for 8 periods is 5.747.

a. Compute the cash payback period for each project.

b. Compute the net present value for each project.
c. Compute the annual rate of return for each project.
d. Which project should Savanna select?

2. Yappy Company is considering a capital investment of P320,000 in additional equipment. The new
equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is
computed by the straight-line method. During the life of the investment, annual net income and cash
inflows are expected to be P25,000 and P65,000, respectively. Yappy requires a 10% return on all
new investments.
Present Value of an Annuity of 1
Period 8% 9% 10% 11% 12% 15%
8 5.747 5.535 5.335 5.146 4.968 4.487

Compute each of the following:

1. Cash payback period.
2. Net present value.
3. Profitability index.
4 Internal rate of return.
5. Annual rate of return.

3. Shilling Corp. is thinking about opening a baseball camp in Florida. In order to start the camp, the
company would need to purchase land, build five baseball fields, and a dormitory-type sleeping and
dining facility to house 100 players. Each year the camp would be run for 10 sessions of 1 week each.
The company would hire college baseball players as coaches. The camp attendees would be baseball
players age 12-18. Property values in Florida have enjoyed a steady increase in value. It is expected
that after using the facility for 20 years, Shilling can sell the property for more than it was originally
purchased for. The following amounts have been estimated:
Cost of land P 600,000
Cost to build dorm and dining facility 2,100,000
Annual cash inflows assuming 100 players and 10 weeks 2,520,000
Annual cash outflows 2,260,000
Estimated useful life 20 years
Salvage value 3,900,000
Discount rate 10%
Present value of an annuity of 1 8.514
Present value of 1 .149

(a) Calculate the net present value of the project.

(b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers attend
each week, revenues will be P2,085,000 and expenses will be P1,865,000. What is the net
present value using these alternative estimates? Discuss your findings.
(c) Assuming the original facts, what is the net present value if the project is actually riskier than
first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12% is
.104 and the present value of an annuity of 1 is 7.469.

4. Simon Company is considering a P5.4 million asset investment that has a four-year service life and a
P400,000 salvage value. The investment is expected to produce annual savings in cash operating
costs of P860,000 and will require a P250,000 overhaul in year 3, which is fully-deductible for tax
purposes. Simon uses the net-present-value method to analyze investments. Asset investments are
depreciated by the straight-line method, ignoring salvage values in related computations.

Required:
a. Ignoring income taxes, determine the (pre-discounted) cash-flow amounts that would be used in
a net-present-value analysis for:
1) the asset acquisition,
2) annual savings in cash operating costs,

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 3) annual straight-line depreciation,
4) the overhaul in year 3, and
5) disposal of the asset in year 4.
Note cash outflows in parentheses.
b. Repeat requirement "A," assuming the company is subject to a 30% income tax rate.

5. Ivory Corporation is reviewing an investment proposal that has an initial cost of P52,500. An
estimate of the investment's end-of-year book value, the yearly after-tax net cash inflows, and the
yearly net income are presented in the schedule below. The investment's salvage value at the end of
each year is equal to book value, and there will be no salvage value at the end of the investment's
life.

Initial Cost Yearly After- Yearly

and Tax Net Net
Year Book Value Cash Inflows Income
1 P35,000 P20,000 P 2,500
2 21,000 17,500 3,500
3 10,500 15,000 4,500
4 3,500 12,500 5,500
5 ---- 10,000 6,500
P75,000 P22,500

Ivory uses a 14% after-tax target rate of return for new investment proposals.

Required:
a. Calculate the project's payback period.
b. Calculate the accounting rate of return on the initial investment.
c. Calculate the proposal's net present value. Round to the nearest peso.

6. Becker Billing Systems, Inc., has an antiquated high-capacity printer that needs to be upgraded. The
system either can be overhauled or replaced with a new system. The following data have been
gathered concerning these two alternatives:

Overhaul Purchase New

Present System System
Purchase cost when new ................. P300,000 P400,000
Accumulated depreciation .............. P220,000 —
Overhaul costs needed now ............ P250,000 —
Annual cash operating costs ............ P120,000 P90,000
Salvage value now ........................... P90,000 —
Salvage value in ten years ............... P30,000 P80,000
Working capital required ................. — P50,000

The company uses a 10% discount rate and the total-cost approach to capital budgeting analysis. The
working capital required under the new system would be released for use elsewhere at the conclusion
of the project. Both alternatives are expected to have a useful life of ten years.

a. The net present value of the overhaul alternative (rounded to the nearest hundred pesos) is:
b. The net present value of the new system alternative (rounded to the nearest hundred pesos)
is:

7. Almendarez Corporation is considering the purchase of a machine that would cost P320,000 and
would last for 7 years. At the end of 7 years, the machine would have a salvage value of P51,000. By
reducing labor and other operating costs, the machine would provide annual cost savings of P72,000.
The company requires a minimum pretax return of 18% on all investment projects.

a. The present value of the annual cost savings of P72,000 is closest to:
b. The net present value of the proposed project is closest to:

8. Heap 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?

9. The Able Company is considering buying a new donut maker. This machine will replace an old donut

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 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:

10. Para 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)?

11. Dunn 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
_______________.

12. Rusk Company is considering replacing a machine that has the following characteristics.

Book value P200,000

Remaining useful life 4 years
Annual straight-line depreciation P ???
Current market value P160,000

The replacement machine would cost P300,000, have a four-year life, and save P37,500 per year in
cash operating costs. It would be depreciated using the straight-line method. The tax rate is 40%.

a. Find the net investment required to replace the existing machine.

b. Compute the increase in annual income taxes if the company replaces the machine.
c. Compute the increase in annual net cash flows if the company replaces the machine.

13. Zmolek Company is considering the purchase of a machine costing P700,000 with a useful life of 10
years. Annual cash cost savings are expected to be P200,000. Zmolek's income tax rate is 40% and
its cost of capital is 12%. Zmolek expects to use straight-line depreciation for tax purposes.

a. Compute the expected increase in annual net cash flow for this project.
b. Compute the profitability index for the project.

14. Racine Co. has the opportunity to introduce a new product. Racine expects the project to sell for
P200 and to have per-unit variable costs of P130 and annual cash fixed costs of P6,000,000.
Expected annual sales volume is 125,000 units. The equipment needed to bring out the new
product costs P7,200,000, has a four-year life and no salvage value, and would be depreciated on a
straight-line basis. Working capital of P500,000 would be necessary to support the increased sales.
Racine's cost of capital is 12% and its income tax rate is 40%.

a. Compute the NPV of this opportunity.

b. Compute the profitability index of this opportunity.

15. Pepin Company is considering replacing a machine that has the following characteristics.

Book value P100,000

Remaining useful life 5 years
Annual straight-line depreciation P ???
Current market value P 60,000

The replacement machine would cost P150,000, have a five-year life, and save P50,000 per year in
cash operating costs. It would be depreciated using the straight-line method. The tax rate is 40%.

a. Find the net investment required to replace the existing machine.

b. Compute the increase in annual income taxes if the company replaces the machine.

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c. Compute the increase in annual net cash flows if the company replaces the machine.

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