PROF ELECTIVE 4 - CAPITAL BUDGETING

EXERCISES
1 NET INVESTMENT FOR DECISION-MAKING
The Bow Company plans to replace a unit of equipment that was acquired three (3) years ago and is now recorded at
a net book value of P 65,000. This equipment can be sold now for P 75,000. Tax rate is 25%

New equipment can be acquired from Bee-Cool Company at a list price of P 200,000. Bee-Cool will frant a 2% discount
if the equipment is paid for within 30 days from acquisition date. Shipping, installation and testing charges to be
paid are estimated at P 24,000

Other assets with a book value of P 22,000 that are to be retired as a result of the acquisition of the new machine can
be salvaged and sold for P 20,000

Additional working capital of P 23,000 will be needed to support operations planned with the new equipment

The annual cash flow after income tax from the operation of the new equipment has been estimated at P 50,000.
The equipment is expected to have a useful life of 5 years with a salvage value of P 4,000 at the end of 5 years

REQUIRED: What is the initial cost of Net Investment for decision-making purposes?

2 WEIGHTED AVERAGE COST OF CAPITAL(WACC)

Bag-You Company wants to determine the weighte average cost of capital that it can use to evaluate capital invest-
ment proposals. The company's capital structure with corresponding market values follows:

8% Term bonds Php 600,000 30%

5% Preference share ( P 100 par) 200,000 10%
Ordinary share (no par, 10,000 shares outstanding) 400,000 20%
Retained earnings 800,000 40%
2,000,000 100%

Additional data:
• Current market price per share • Expected ordinary • Dividend • Corporate
> Preference share, P 50 share dividend growth rate tax rate
> Ordinary share. P 40 Php 2.00 per share 4% 30%

REQUIRED:
A Given an operating income of P 500,000, how much is the earnings per share?
B Determine the Weighted Average Cost of Capital

3 NET RETURNS (INCREASE IN REVENUES)

The management of Star-Luck Cinema plans to install cofee vending machines costing P 200,000 in its movie house.
Annual sales of cofee are estimated at 10,000 cups at a price of P 15 per cup. Variable costs are estimated at P 6
per cup, while incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines are expected
to have a service life of 5 years, with no salvage value. Depreciation will be computed on a straight-line basis.
The company's income tax rate is 20%

REQUIRED: Assuming that the vending machines are installed, determine:

A The increase in annual net income
B The annual cash inflows that will be generated by the project

4 NET RETURNS (COST SAVINGS)

Moon-use Corporation is planning to buy cleaning equipment that can reduce car wash service cost and other cash
expenses by an average of P 70,000 per year. The new cleaning equipment wil cost P 100,000 and will be depreciated
for 5 years on a straight-line basis. No salvage value is expected at the end of the equipment's life. Income tax is
estimated at 30% of income before tax.

REQUIRED: Determine the net cash inflows that will be generated by the project.
 5 PAYBACK PERIOD & ACCOUNTING RATE OF RETURN (WITH EVEN CASH FLOWS)
Green Niche Company considers the replacement of some old equipment. The cost of the new equipment is P 90,000
with a useful life estimate of 8 years, and a salvage value of P 10,000. The annual pre-tax cash savings from the use
of the new equipment is P 40,000. The old equipment has zero market value and is fully depreciated. The company
uses a cost of capital of 25%

REQUIRED: Assuming that the income tax rate is 40%, compute:

A Payback period
B Accounting rate of return on original investment
C Accounting rate of return on average investment

6 PAYBACK PERIOD & ACCOUNTING RATE OF RETURN (WITH UNEVEN CASH FLOWS)
Pole-Land Company has an investment opportunity costing P 90,000 that is expected to yield the following cash flows
over the next five years: (assume a cut-off or hurdle rate of 30%)
Year Amount
1 40,000
2 35,000
3 30,000
4 20,000
5 10,000
135,000

REQUIRED: A Payback period in months B Book rate of return

7 BAIL-OUT PAYBACK PERIOD

A project costing P 180,000 will produce the following annual cash flows and salvage value:
Year Cash flows Salvage value
1 50,000 65,000
2 50,000 50,000
3 50,000 35,000
4 50,000 20,000
200,000 170,000

REQUIRED: Bail-out payback period

CONSIDER TIME VALUE OF MONEY

8 NET PRESENT VALUE (WITH UNIFORM CASH FLOWS)
Buli-Can Company plans to buy a new machine costing P 28,000. The new machine is expected to have a salvage
value of P 4,000 at the end of its economic life of 4 years. The annual cash inflows before income tax from this
machine have been estimated at P 11,000. The tax rate is 20%. The company desires a minimum return of 25% on
invested capital.

REQUIRED: Determine the net present value (Round off to three decimal places)

9 NPV, PROFITABILITY INDEX & INTERNAL RATE OF RETURN (EVEN vs. UNEVEN CASH FLOWS)
Can-Yeah Corporation gathered the following data on two capital investment opportunities:
Project No. 1 Project No. 2
Cost of investment Php 195,200 Php 150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash inflows Php 100,000 Php 100,000 * to decline P 20,000
annually thereafter
REQUIRED: Round-off factors to three decimal places in all cases
Fill in the blanks
 Project No. 1 Project No. 2
Net present value A B

Profitability index C D

E What is project 1's Internal Rate of Return?

a 23% b 27% c 25% d 24%

F What is project 2's Time Adjusted Rate of Return?

a Below 30% b Between 30% and 31% c Between 31% and 32% d Above 32%

10 PAYBACK RECIPROCAL
Live-Biz Company is planning to buy an equipment costing P 640,000 that has an estimated life of 30 years and is
expected to produce after-tax net cash inflows of P 128,000 per year.

REQUIRED: Without using present value factors, what is a reasonable estimate of the IRR?

11 DISCOUNTED & NON-DISCOUNTED CAPITAL BUDGETING TECHNIQUES

Mall-Asia Company is considering buying a new machine, requiring an immediate P 400,000 cash outlay. The new
machine is expected to increase annual net-after-tax receipts by P 160,000 in each of the next five years of its
economic life. No salvage value is expected at the end of 5 years. The company desires a minimum return of
14% on invested capital

REQUIRED: Round off factors to three decimal places in all cases.

A Payback period D Profitability Index
B ARR (based on original investment E Internal rate of return
C Net Present Value

12 RELATIONSHIPS - DISCOUNTED TECHNIQUES

Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful life of ten
(10) years and no salvage value. Round off factors to three decimal places in all cases.

Annual Cost of
PROJECT Cash Flow Investment Capital IRR NPV
1 P 45,000 P 188,640 14% (1) (2)
2 75,000 (3) 12% 18% (4)
3 (5) 300,000 (6) 16% 81,440
4 (7) 450,000 12% (8) 115,000

GUIDE:
A = Initial investment C = Annual net cash inflow E = Present value index
B = Life of the project D = Internal rate of return

13 CAPITAL RATIONING - RANKING PROJECTS

Case-Zone Corporation is considering five different investment opportunities. The company's cost of capital is 12%.
Data on these opportunities under consideration are given below.

Project Investment PV-Cash flow NPV IRR (%) Prof Index

1 35,000 39,325 4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,453 14 1.10
4 10,000 10,854 854 18 1.09
5 9,000 8,749 (251) 11 0.97

REQUIRED: A Rank the projects in descending order of preference according to NPV, IRR and benefit/cost ratio.
 B If only a budget of P 55,000 is available, which projects should be chosen?

WRAP-UP EXERCISES (TRUE OR FALSE; MULTIPLE CHOICE)

1 A project's salvage value, realizable at the end of life of the project, is considered in the computation of the net
investments for decision-making purposes

2 The payback period emphasizes the profitability of a capital project while the accounting rate of return, on the other
hand, emphasizes the project's liquidity

3 The payback period emphasizes the liquidity of a capital project while the accounting rate of return, on the other
hand, emphasizes the project's profitability

4 Annual cash inflows from the capital projects are measured in terms of
a Income after depreciation and taxes c Income before depreciation but after taxes
b Income before depreciation and taxes d Income after depreciation but before taxes

5 When computing the Accounting Rate of Return (ARR), which of the following is used?
a Income after depreciation and taxes c Income before depreciation but after taxes
b Income before depreciation and taxes d Income after depreciation but before taxes

6 The technique that does not se cash flow for capital investment decisions
a Payback b NPV c ARR d IRR

7 Which of the following groups of capital budgeting techniques uses the time value of money?
a Book Rate of Return, Payback and Profitability c IRR, ARR and Profitability Index
b IRR, Payback and NPV d IRR, NPV and Profitability Index

8 Cost of capital is 3%; economic life is years = 4 years; simple PV factor for year for is
a 0.915 b 0.888 c 0.455 d 0.350

9 Discount rate is 11%; economic life in years = 3 years; PV of annuity factor for three years is
a 0.731 b 1.713 c 2.444 d 3.102

10 As the discount rate increases.

a Present value factors increase c Present value factors remain constant
b Present value factors decrease d Is is impossible to tell what happens to the factors

Proof: at 3% At 4% At 5%
Year 1 0.971 0.962 0.952
Year 2 0.943 0.925 0.907
Year 3 0.915 0.889 0.864
Year 4 0.888 0.855 0.823
Year 5 0.863 0.822 0.784

11 The PV factor of any amount at year zero percent is always equal to

a Zero c 1.0
b 0.50 d An amount that cannot be determined without more information

12 The present value of P 50,000 due in five years would be highest if discounted at a rate of
a 0% b 10% c 15% d 20%

13 An investment with a positive NPV also has

a A profitability index of one c A profitability index less than one
b A positive profitability index c A profitability index greater than one
14 A company is considering the purchase of an investment that has a positive NPV based on a discount rate of 12%.
What is the Internal Rate of Return?
a Zero b 12% c Less than 12% d Greater than 12%

15 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

16 The NPV method assumes that the project's cash flows are reinveste at the
a Internal Rate of Return c Cost of Capital
b Simple Rate of Return d Payback period

17 The IRR method assumes that the project's cash flows are reinvested at the
a Required Rate of Return c Simple rate of return
b Internal Rate of Return d Payback period

18 Which one of these methods is a project ranking method rather than a project screening method?
a Net Present Value c Simple Rate of Return
b Profitability Index d Sophisticated Rate of Return

19 If the IRR on an investment is zero,

a Its NPV is positive c It is generally a wise investment
b Its annual cash flows equal its required investment d Its cash flows decrease over its life

20 plus