Manila * Cavite * Laguna * Cebu * Cagayan De Oro * Davao
Since 1977
MANAGEMENT SERVICES
MS 3412 – CAPITAL BUDGETING
LECTURE NOTES
Capital investment decisions are concerned with the
process of planning, setting goals and priorities,
arranging financing, and using certain criteria to select
long-term assets.
Capital budgeting decisions are concerned with two
types of projects: independent projects and mutually
exclusive projects. Independent projects are projects
that, if accepted or rejected, will not affect the cash
flows of another project. Mutually exclusive projects are
projects that, if accepted, preclude the acceptance of
competing projects.
To make a capital investment decision, a manager must
estimate the quantity and timing of cash flows, assess
the risk of the investment, and consider the impact of
the project on the firm’s profits.
Capital Budgeting Techniques
1. Payback Method. The payback period is the time
required for a firm to recover its original investment.
When the cash flows of a project are assumed to be
even, the following formula can be used:
Payback Original Investment
=
Period Annual Cash Flow
Some possible reasons for use of the payback method
include:
• Helping to control the risks associated with the
uncertainty of future cash flows
• Helping to minimize the impact of an investment
on a firm’s liquidity problems
• Helping to control the risk of obsolescence
• Helping to control the effect of the investment on
performance measures
The major deficiencies of the payback method are that
the payback method ignores the time value of money as
well as the performance of the investment beyond the
payback period.
2. Accounting Rate of Return. The accounting rate of
return (ARR) measures the return on a project in
terms of income, as opposed to using the project's
cash flow. The accounting rate of return is
computed by the following formula:
Accounting Rate of Average income
=
Return Investment
To convert annual cash flow for a project to annual net
income, subtract average depreciation from the average
cash flow. Investment can be defined as either original
investment or average investment. The average
investment is found by summing the original investment
and the salvage value and dividing by two.
ARR can be used as a screening measure to ensure that
new investments will not adversely affect net income
and to ensure a favorable effect on net income so that
bonuses can be earned (or increased). The major
deficiency of the accounting rate of return is that it
ignores the time value of money.
3. Net Present Value Method. Net present value (NPV)
is the difference between the present value of the
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TRINIDAD
MAY 2023
future cash inflows and the present value of cash
outflows associated with a project. Present value is
computed using a required rate of return. The
required rate of return is the minimum acceptable
rate of return.
If NPV = 0, this indicates:
The initial investment has been recovered.
Thus, a break-even scenario has been achieved, and we
are indifferent about the project.
If NPV < 0, this indicates:
The initial investment may or may not be recovered.
Thus, the project should be rejected.
The NPV model assumes that all cash flows generated
by a project are immediately reinvested to earn the
required rate of return throughout the life of the project.
4. Internal Rate of Return. The internal rate of return
(IRR) is defined as the interest rate that sets the
present value of a project’s cash inflows equal to
present value of the project’s cost (the point where
NPV = 0).
The decision criteria for IRR is as follows:
• If the IRR > Cost of Capital, the project should
be accepted.
• If the IRR = Cost of Capital, acceptance or
rejection is equal.
• If the IRR < Cost of Capital, the project should
be rejected.
IRR assumes that the cash inflows received from the
project are immediately reinvested to earn a return
equal to the IRR for the remaining life of the project.
NPV VERSUS IRR: MUTUALLY EXCLUSIVE PROJECTS
There are two major differences between the these two
approaches:
NPV assumes cash inflows are reinvested at the required
rate of return, whereas the IRR method assumes that
the inflows are reinvested at the internal rate of return.
NPV measures the profitability of a project in absolute
pesos, whereas the IRR method measures it as a
percentage.
COMPUTING AFTER-TAX CASH FLOWS
1. Adjusting Forecasts for Inflation. The effect
inflation will have on the forecast should also be
described. The cost of capital should reflect a real
rate of return plus an inflationary component, while
future cash flows should be restated to reflect the
expected inflation rate. Since the cost of capital
reflects an inflationary component at the time NPV
analysis is performed, restating future cash flows to
reflect inflation is the key adjustment.
2. Conversion of Gross Cash Flows to After-Tax Cash
Flows. Cash outflows and inflows adjusted for tax
effects are called net cash outflows and inflows. Net
cash flows provide provisions for revenues,
operating expenses, depreciation, and relevant tax
implications.
MS.3412
 STRAIGHT PROBLEMS
PROBLEM NO. 1.
In December 2022, Herald Corporation sold a forklift for
P110,000. The machine was purchased in early 2019 for
P750,000. Since then, P600,000 in depreciation has been
recorded on the forklift. Determine the after-tax cash flow
at the time the forklift was sold. The firm’s tax rate is
30%.
PROBLEM NO. 2.
Lakeview Company is planning to purchase a new machine
for P900.000. The installation of the new machine costs
P80,000. This new machine shall replace an old unit that
was acquired 2 years ago at a cost of P750,000 with an
annual depreciation of P150,000. The old unit can be sold
at P300,000. If the new equipment were not purchased,
extensive repairs on the old machine would have to be
made immediately at a cost of P60,000. The purchase of
the new machine will immediately require P250,000
working capital. The new machine will be depreciated for
3 years with a 10% salvage value. The company is subject
to 40 percent income tax and requires a discount rate of
10 for this type of asset. Compute the net cost of
investment for the new machine.
PROBLEM NO. 3.
Mercado Manufacturing is considering buying an
automated machine that costs P3,000,000. Annual cash
savings are anticipated to be P900,000 for five years.
The company uses straight-line depreciation. The
salvage value at the end of five years is expected to be
P80,000. Assume 8 percent discount rate and 40
percent tax rate.
Requirements: Compute the:
1. accrual accounting rate of return based on the
initial investment
2. payback period and payback reciprocal
3. net present value
4. profitability index
5. breakeven time
6. internal rate of return
PROBLEM NO. 4.
Manila Theater’s board of directors is considering the
replacement of the theater’s lighting system. The old
system requires two people to operate it, but the new
system would require only a single operator. The new
lighting system will cost P129,750 and save the theater
P27,000 annually for the next eight years.
Requirements:
1. Compute the net present value if the minimum
required rate of return is 8 percent.
2. How low could the new lighting system’s annual
savings be and still justify acceptance of the proposal
by the board of directors if the hurdle rate is 8
percent?
PROBLEM NO. 5.
Mountain View Hospital has purchased new lab equipment
for P134,650. The equipment is expected to last for three
years and to provide cash inflows as follows:
Year 1 P45,000
Year 2 60,000
Year 3 ? the opportunity to replace one of its existing machine
Assuming that the equipment will yield exactly a 12%
rate of return, what is the expected cash inflows for
year 3?
PROBLEM NO. 6.
Trent Company has gathered the following data on a
proposed investment project:
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Cost of the investment P1,600,000
Estimated salvage value P100,000
Annual cash inflows P300,000
Life of the project 10 years
Discount rate 10%
Requirements:
1. What is the payback period for the investment?
2. What is the unadjusted rate of return on the
average investment?
PROBLEM NO. 7.
The following lettered exercises are unrelated and
independent from each other:
Case A:
National Company is considering the purchase of a
P600,000 machine, which will be depreciated on the
straight-line method over an 8-year period with no
salvage value for both book and tax purposes. The
machine is expected to generate an annual before-tax
cash inflow of P175,000. The income tax rate is 40%.
Requirements:
1. Determine the payback period.
2. Compute the accounting rate of return on: a)
original investment; b) average investment.
3. Assuming that the company considers the use of 10
years for book depreciation and 8 years for income
tax depreciation, what is the payback period?
Case B:
Philips Company is evaluating a capital budgeting
proposal that will require an initial investment of
P350,000. The project will have a 6-year life. The
after-tax annual cash inflow expected from this
investment is P100,000. The desired rate of return is
11%.
Requirements:
1. What is the payback period?
2. Compute the net present value of the project.
Case C:
Sanyo Corporation purchased a special machine one
year ago at a cost of P200,000. At that time, the
machine was estimated to have a useful life of 8 years
and zero disposal value. The annual cash operating
expenses is approximately P400,000.
A new machine that has just come on the market will do
the same job but with an annual cash operating
expenses of P340,000. This new machine costs
P385,000 and has an estimated life of 7 years with no
expected salvage value. The old machine can be sold for
P120,000. The company’s income tax rate is 40%, and
its cost of capital is 12%.
Compute the net present value to be provided by the
new machine.
Case D:
Sony Company manufactures copier equipment and has
with a new model. The existing machine has a net book
value of P80,000 and a market value of P50,000. It has
an estimated remaining life of four years, at which time
it will have no salvage value. The company uses
straight-line depreciation of P20,000 per year on the
machine, and its annual cash operating costs are
P240,000.
MS.3412
EXCEL PROFESSIONAL SERVICES, INC.
The new model costs P300,000 and has a four-year
estimated life with no salvage value. Its annual cash
operating costs are estimated at P170,000. The firm
will use straight-line depreciation. The tax rate is 40%
and cost of capital is 15%. The purchase of the new
more efficient machine will enable the company to
reduce its investment in inventory by P50,000.
Requirements:
1. Determine the investment required to obtain the
new machine.
2. Determine the present value of the net cash flows
expected from the investment and the NPV of the
investment.
3. Suppose that the new machine has a salvage value
of P30,000. The company will consider the salvage
value in determining annual depreciation.
Determine the NPV of the investment.
4. Suppose that the new machine has a salvage value
of P30,000. The company will ignore the salvage
value in determining annual depreciation and so will
have a gain that will be taxed at 40%. Determine
the NPV of the investment.
Case E:
Luna Company expects to sell 90,000 units annually for
the next four years at P8 each, with variable costs of P3
per unit, and annual cash fixed costs of P250,000. The
product requires machinery costing P300,000 with a
four-year life and no salvage value. The company will
depreciate the machinery using straight-line
depreciation. Additionally, working capital (in form of
receivables and inventory) will increase by P150,000.
This additional working capital will be returned in full at
the end of the four years. The tax rate is 40% and cost
of capital is 10%. What is the net present value of the
investment?
Case F:
MYB Consulting operates consulting offices in Manila,
Cebu, Davao, CDO and other key cities across the
country. The firm is presently considering an investment
in a new mainframe computer and communication
software. The computer would cost P6 million and have
an expected life of 8 years. For tax purposes, the
computer can be depreciated using either straight-line
method or Sum-of-the-Years’-Digits (SYD) method over
five years. No salvage value is recognized in computing
depreciation expense and no salvage value is expected
at the end of the life of the equipment. The company’s
cost of capital is 8 percent and its tax rate is 40 percent.
What is the present value of the net advantage of using
SYD method of depreciation with a five-year life instead
of straight-line method of depreciating the equipment?
Case G:
The manager of Riverside Company is considering the
purchase of a new computer for P100,000. A cost study
indicates that the new computer should save the company
P30,000, measured in real pesos, during each of the next
eight years. The real interest rate is 8 percent and the
inflation rate is 5 percent. The company is exempted from
paying income taxes.
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Requirements:
1. Using cash flows measured in real pesos, compute the
net present value of the proposed computer. Use a
real discount rate equal to the real interest rate.
2. Compute the nominal interest rate.
3. Using cash flows measured in nominal pesos,
compute the net present value of the proposed
computer acquisition. Use a nominal discount rate
equal to the nominal interest rate.
Case H:
Homer Corporation is considering the acquisition of a
new machine that is expected to produce annual savings
in cash operating costs of P30,000 before income taxes.
The machine costs P100,000, has a useful life of five
years, and no salvage value. Homer uses straight-line
depreciation on all assets, is subject to a 30% income
tax rate, and has an after-tax hurdle rate of 8%.
Requirements:
1. Compute the machine's payback period.
2. Compute the machine's accounting rate of return
on the initial investment.
3. Compute the machine's net present value.
Case I:
The owner of Baliuag Confectionary is considering the
purchase of a new semiautomatic candy machine. The
machine will cost P250,000 and last 10 years. The
machine is expected to have no salvage value at the end
of its useful life. The owner projects that the new candy
machine will generate P40,000 after-tax savings each year
during its life (including the depreciation tax shield).
Compute the profitability index on the proposed candy
machine, assuming an after-tax hurdle rate of 12 percent
Case J:
Loyalty Insurance Company’s management is considering
an advertising program that would require an initial
expenditure of P165,500 and bring in additional sales over
the next five years. The projected additional sales revenue
in year 1 is P75,000, with associated expenses of P25,000.
The additional sales revenue and expenses from the
advertising program are projected to increase by 10
percent each year. Loyalty’s tax rate is 40 percent.
Requirements:
1. Compute the payback period for the advertising
program.
2. Calculate the advertising program’s net present value,
assuming an after-tax hurdle rate of 10 percent.
Case K:
Union Bay Plastics is investigating the purchase of a piece
of automated equipment that will save P100,000 each year
in direct labor and inventory carrying costs. This
equipment costs P750,000 and is expected to have a 10-
year useful life with no salvage value. The company
requires a minimum 15% return on all equipment
purchases. Management anticipates that this equipment
will provide intangible benefits such as greater flexibility
and higher quality output.
What peso value per year would these intangible benefits
have to have in order to make the equipment an
acceptable investment?
MS.3412
EXCEL PROFESSIONAL SERVICES, INC.
MULTIPLE CHOICE QUESTIONS
1. Which of the following capital budgeting techniques
does not routinely rely on the assumption that all
cash flows occur at the end of the period?
a. internal rate of return
b. net present value
c. profitability index
d. payback period
2. All other factors equal, a large number is preferred
to a smaller number for all capital project
evaluation measures except
a. net present value.
b. payback period.
c. internal rate of return.
d. profitability index.
3. The net present value method of evaluating
proposed investments
a. measures a project's internal rate of return.
b. discounts cash flows using the internal rate of
return.
c. applies only to mutually exclusive investment
proposals.
d. discounts cash flows at a minimum desired rate
of return.
4. When a profitable corporation sells an asset at a
loss, the after-tax cash flow on the sale will
a. exceed the pre-tax cash flow on the sale.
b. be less than the pre-tax cash flow on the sale.
c. be the same as the pre-tax cash flow on the
sale.
d. increase the corporation's overall tax liability.
5. Your company is purchasing a transport equipment
as part of its territorial expansion strategy. The
technical services department indicated that this
equipment needs overhauling in year 4 or year 5 of
its useful life. The overhauling cost will be
expected during the year the overhauling is done.
The finance officer insists that the overhauling be
done in year 4, not in year 5. The most likely
reason is
a. There is lower tax rate in year 5
b. The time value of money is considered.
c. There is higher tax rate in year 5
d. Due statements A and C above.
6. The following statements refer to the accounting
rate of return (ARR)
1. The ARR is based on the accrual basis, not cash
basis.
2. The ARR does not consider the time value of
money.
3. The profitability of the project is considered.
From the above statements, which are considered
limitations of the ARR concept?
a. Statements 2 and 3 only.
b. All the 3 statements.
c. Statements 3 and 1 only.
d. Statements 1 and 2 only.
7. Several proposed capital projects which are
economically acceptable may have to be ranked due
to constraints in financial resources. In ranking
these projects, which is the least pertinent
statement?
a. If the internal rate of return method is used in the
capital rationing problem, the higher the rate, the
better the project.
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b. In selecting the required rate of return, one may
either calculate the organization’s cost of capital or
use a rate generally acceptable in the industry.
c. A ranking procedure on the basis of quantitative
criteria may be established by specifying a
minimum desired rate of return, which rate is used
in calculating the net present value of each project.
d. If the net present value method is used, the
profitability index is calculated to rank the projects.
The lower the index, the better the project.
8. The net present value (NPV) method of investment
project analysis assumes that the project's cash
flows are reinvested at the
a. Computed internal rate of return
b. Risk-free interest rate
c. Discount rate used in the NPV calculation
d. Firm's accounting rate of return
9. Annual cash inflows from capital projects are
measured in terms of
a. Net income before depreciation but after taxes
b. Net income after depreciation and taxes
c. Net income before depreciation and taxes
d. Net income after depreciation but before taxes
10. Discounted-cash-flow analysis focuses primarily on:
a. the stability of cash flows.
b. the timing of cash flows.
c. the probability of cash flows.
d. the sensitivity of cash flows.
11. 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 c. P53,600
b. P52,600 d. P57,600
12. Cramden Armored Car Co. is considering the
acquisition of a new armored truck. The truck is
expected to cost P300,000. The company's discount
rate is 12 percent. The firm has determined that
the truck generates a positive net present value of
P17,022. However, the firm is uncertain as to
whether it has determined a reasonable estimate of
the salvage value of the truck. In computing the
net present value, the company assumed that the
truck would be salvaged at the end of the fifth year
for P60,000. What expected salvage value for the
truck would cause the investment to generate a net
present value of P0? Ignore taxes.
a. P30,000 c. P55,278
b. P0 d. P42,978
MS.3412
13. The following data pertain to Sunlight Corp., whose
management is planning to purchase an automated
tanning equipment.
1. Economic life of equipment – 8 years.
2. Disposal value after 8 years – nil.
3. Estimated net annual cash inflows for each of the 8
years – P81,000.
4. Time-adjusted internal rate of return – 14%
5. Cost of capital of Sunlight Corp – 16%
6. The table of present values of P1 received annually
for 8 years has these factors: at 14% = 4.639, at
16% = 4.344
7. Depreciation is approximately P46,970 annually.
Find the required increase in annual cash inflows in
order to have the time-adjusted rate of return
approximately equal the cost of capital.
a. P5,501 c. P4,344
b. P6,501 d. P5,871
14. Cramden Armored Car Co. is considering the
acquisition of a new armored truck. The truck is
expected to cost P300,000. The company's discount
rate is 12 percent. The firm has determined that
the truck generates a positive net present value of
P17,022. However, the firm is uncertain as to
whether it has determined a reasonable estimate of
the salvage value of the truck. In computing the
net present value, the company assumed that the
truck would be salvaged at the end of the fifth year
for P65,000. What expected salvage value for the
truck would cause the investment to generate a net
present value of P0? Ignore taxes.
a. P30,000 c. P35,000
b. P55,278 d. P0
15. Knight Motors is considering either leasing or
buying some new equipment. The lease payments
would be P14,500 a year for 3 years. The purchase
price is P52,000. The equipment has a 3-year life
and then is expected to have a resale value of
P12,000. Knight Motors uses straight-line
depreciation, borrows money at 9 percent, and has
a 35 percent tax rate. What is the net advantage to
leasing?
a. -P2,742
b. -P2,212
c. P3,898
d. P3,529
16. Door-to-Door is considering the purchase of a
delivery truck costing P61,000. The truck can be
leased for 3 years at P22,000 per year or it can be
purchased at an interest rate of 8 percent. The
estimated life of the truck is 3 years. The corporate
tax rate is 35 percent. The company does not
expect to owe any taxes for the next several years
due to accumulated net operating losses. The firm
uses straight-line depreciation. What is the net
advantage to leasing?
a. P4,088
b. P4,287
c. P4,304
d. P4,611
17. 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
revenue 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
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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% c. 15%
b. 10% d. 20%
18. 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 internal rate of
return for this investment is
a. 3.45% c. 13.8%
b. 2.04% d. 15.48%
19. 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 c. P24,000
b. P18,000 d. P36,000
20. The McNally Co. is considering an investment in a
project that generates a profitability index of 1.3.
The present value of the cash inflows on the project
is P44,000. What is the net present value of this
project?
a. P10,154 c. P57,200
b. P13,200 d. P33,846
Use the following information for the next three
questions.
Levely Corporation is considering undertaking a capital
project.
The company would have to commit P24,000 of working
capital in addition to an immediate outlay of P160,000
for new equipment. The project is expected to generate
P100,000 of annual income for 10 years. At the end of
that time, the new equipment, which will be depreciated
on a straight-line basis, is expected to have a salvage
value of P10,000.
The existing equipment that would be sold to make
room for the project that has a historical cost of
P220,000 and accumulated depreciation of P208,000. It
has an estimated remaining useful life of 2 years and
the remaining carrying amount is being depreciated on a
straight-line basis. A scrap dealer has agreed to buy it
for P8,000.
The company’s effective tax rate is 40%.
21. The net initial investment required for Levely to
undertake this capital project is
a. P184,000 c. P174,400
b. P176,000 d. P160,000
22. If the project is accepted, Levely’s expected net
cash inflow at the end of the first year is
a. P110,000 c. P60,000
b. P64,000 d. P56,000
23. Levely’s expected total cash inflow in the final year
of the project is
a. P100,400 c. P90,000
b. P96,400 d. P72,400
MS.3412
EXCEL PROFESSIONAL SERVICES, INC.

Use the following information for the next three 24. What are the payback period and accounting rate of
questions. return (based on initial investment) respectively?
Homer Corporation is considering the acquisition of a a. 2.875 years and 12 percent
new machine that is expected to produce annual savings b. 3.125 years and 12 percent
in cash operating costs of P60,000 before income taxes. c. 2.875 years and 32 percent
The machine costs P150,000, has a useful life of five d. 3.125 years and 32 percent
years, and no salvage value. Homer uses straight-line
depreciation on all assets for book purposes and the 25. What is the difference in amount of present value of
sum-of-the-years-digits method for income tax the tax shield in year 3 if the company has to use
purposes. Homer is subject to a 40% income tax rate straight-line method of depreciation instead of the
and has an after-tax hurdle rate of 10%. The present sum-of-the-years-digits method for income tax
value of 1, end of each period using 10% are: The purposes?
present value of 1, end of each period using 10% are: a. P9,016 c. P4,000
Year 1 – 0.909, Year 2 – 0.826, Year 3 – 0.751, Year 4 b. P7,513 d. P0
– 0.683, Year 5 – 0.621; the present value of annuity of
1, at 10% for 5 periods is 3.791.

“Success is neither magical nor mysterious. Success is the natural consequence of consistently applying the basic
fundamentals.” - Anonymous

– end -

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