EXERCISES – CAPITAL BUDGETING 5. Melody Company is considering the sale of a machine with the following characteristics.

Strategic Cost Management

Book value P120,000
True-False Remaining useful life 5 years
1. Payback period is the length of time it will take a company to recoup its outlay for an investment. Annual straight-line depreciation P 24,000
2. Discounted cash flow techniques apply to investments that involve either costs only, or both costs and revenues. Current market value P 70,000
3. Cost of capital is the interest rate that a company expects to pay to finance a particular capital investment project.
4. The higher the cost of capital, the higher the present value of future cash inflows. If the company sells the machine its cash operating expenses will increase by P30,000 per year due to an operating lease. The tax
5. If the IRR on a capital project is positive, its NPV will be positive. rate is 40%.
6. Salvage value is usually ignored in computing the tax depreciation on an investment in depreciable assets.
7. IRR can be computed for even cash flows, but not for uneven cash flows. a. Find the cash flow from selling the machine.
8. If IRR is less than the cost of capital, the NPV will be negative. b. Calculate the increase in annual net cash outflows as a result of selling the machine.
9. IF NPV is negative, IRR is equal to the cost of capital.
10. Payback emphasizes the return of the investment and ignores the return on the investment. 6. Jilly Company is considering replacing a machine that has the following characteristics.
11. The higher the IRR on an investment project, the higher its profitability index.
12. If the payback period of an investment project is shorter than its life, the project's profitability index is greater than 1. Book value P100,000
13. If a company has decided that a certain task must be performed and three machines accomplish that task, the machine with the Remaining useful life 5 years
lowest initial cash outlay should be selected. Annual straight-line depreciation P ???
14. An investment with an IRR greater than cost of capital has a profitability index greater than 1. Current market value P 60,000
15. The only costs and revenues relevant to a replacement decision are those that will change if a replacement is made.
16. Both the incremental and the total-project approaches to analyzing a replacement decision should yield the same decision. The replacement machine would cost P150,000, have a five-year life, and save P50,000 per year in cash operating costs. It
17. Both the IRR and the book rate of return methods of analyzing investments should yield the same decision. would be depreciated using the straight-line method. The tax rate is 40%.
18. If the payback period of an investment is shorter than its life, its profitability index is greater than l.
19. When compared with straight-line depreciation, using MACRS will result in a larger NPV. a. Find the net investment required to replace the existing machine.
20. IRR and book rate of return will usually yield the same value for an investment. 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.
Problems
1. An investment opportunity costing P180,000 is expected to yield net cash flows of P60,000 annually for five years. 7. Jerome Company is considering the purchase of a machine with the following characteristics.
a. Find the NPV of the investment at a cutoff rate of 12%.
b. Find the payback period of the investment. Cost P100,000
c. Find the IRR on the investment. Useful life 10 years
Expected annual cash cost savings P30,000
2. Kirara is considering the purchase of a machine. Data are as follows:
Cost P100,000 Jerome's income tax rate is 40% and its cost of capital is 12%. Jerome expects to use straight-line depreciation for tax purposes.
Useful life 10 years
Annual straight-line depreciation P 10,000 a. Compute the expected increase in annual net cash flow for this project.
Expected annual savings in cash operation costs P 18,000 b. Compute the profitability index for the project.
c. How would the profitability index for this project be affected if Jerome were to use MACRS depreciation for tax purposes
Kirara's cutoff rate is 12% and its tax rate is 40%. and the machine fell into the 7-year MACRS class? (increase decrease not affected.

a. Compute the annual net cash flows for the investment. 8. Jilly Co. has the opportunity to introduce a new product. Jilly expects the product to sell for P60 and to have per-unit variable
b. Compute the NPV of the project. costs of P35 and annual cash fixed costs of P4,000,000. Expected annual sales volume is 275,000 units. The equipment needed
to bring out the new product costs P6,000,000, has a four-year life and no salvage value, and would be depreciated on a
3. Lolong Co. has the opportunity to introduce a new product. Lolong expects the product to sell for P60 and to have per-unit straight-line basis. Jilly's cost of capital is 14% and its income tax rate is 40%.
variable costs of P40 and annual cash fixed costs of P3,000,000. Expected annual sales volume is 250,000 units. The equipment
needed to bring out the new product costs P5,000,000, has a four-year life and no salvage value, and would be depreciated on a a. Compute the annual net cash flows for the investment.
straight-line basis. Lolong's cost of capital is 10% and its income tax rate is 40%. b. Compute the NPV of the project.
c. Suppose that some of the 275,000 units expected to be sold would be to customers who currently buy another of Jilly's
a. Find the increase in annual after-tax cash flows for this opportunity. products, the X-10, which has a P12 per-unit contribution margin. Find the sales of X-10 that can Jilly lose per year and still
b. Find the payback period on this project. have the investment in the new product return at least the 14% cost of capital.
c. Find the NPV for this project. d. Suppose that selling the new product has no complementary effects but that Jilly's production engineers anticipate some
production problems in making the new product and are not confident of the P35 estimate of per-unit variable costs for the
4. Bolera has an investment opportunity costing P300,000 that is expected to yield the following cash flows over the next six years: new product. Find the amount by which Jilly's estimate of per-unit variable cost could be in error and the investment still
Year One P75,000 have a return at least equal to the 14% cost of capital.
Year Two P90,000
Year Three P115,000 9. Jerome is considering the purchase of a machine. Data are as follows:
Year Four P130,000
Year Five P100,000 Cost P240,000
Year Six P90,000 Useful life 10 years
Annual straight-line depreciation P ???
a. Find the payback period of the investment. Expected annual savings in cash operation costs P 80,000
b. Find the book rate of return of the investment. Additional working capital needed P100,000
c. Find the NPV of the investment at a cutoff rate of 10%.
Jerome's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.
c. Compute the profitability index of the project.
10. The Jerome Company has been operating a small lunch counter for the convenience of employees. The counter occupies space
that is not needed for any other business purpose. The lunch counter has been managed by a part-time employee whose annual
salary is P3,000. Yearly operations have consistently shown a loss as follows:

Receipts P20,000
Expenses for food, supplies (in cash) P19,000
Salary 3,000 22,000
Net Loss P(2,000)

A company has offered to sell Jerome Company automatic vending machines for a total cost of P12,000. Sales terms are cash on
delivery. The old equipment has zero disposal value.

The predicted useful life of the equipment is 10 years, with zero scrap value. The equipment will easily serve the same volume
that the lunch counter handled. A catering company will completely service and supply the machines. Prices and variety of food
and drink will be the same as those that prevailed at the lunch counter. The catering company will pay 5 percent of gross
receipts to the Jerome Company and will bear all costs of food, repairs, and so forth. The part-time employee will be discharged.
Thus, Jerome Company’s only cost will be the initial outlay for the machines.

Consider only the two alternatives mentioned.

Required:
a. What is the annual income difference between alternatives?
b. Compute the payback period.
c. Compute:
1. The net present value if relevant cost of capital is 20 percent.
2. Internal rate of return.
d. Management is very uncertain about the prospective revenue from the vending equipment. Suppose that the gross
receipts amounted to P14,000 instead of P20,000. Repeat the computation in part c.1.
e. What would be the minimum amount of annual gross receipts from the vending equipment that would justify making the
investment? Show computations.

11. The Jilly Automobile Corporation is contemplating the acquisition of an automatic car wash. The following information is
relevant:

The cost of the car wash is P160,000

The anticipated revenue from the car wash is P100,000 per annum.
The useful life of the car wash is 10 years.
Annual operating costs are expected to be:
Salaries P30,000
Utilities 9,600
Water usage 4,400
Supplies 6,000
Repairs/maintenance 10,000
The firm uses straight-line depreciation.
The salvage value for the car wash is zero.
The company's cutoff points are as follows:
Payback 3 years
Accounting rate of return 18%
Internal rate of return 18%

Ignore income taxes.

Required:
a. Compute the annual cash inflow.

b. Compute the net present value.

c. Compute internal rate of return.

d. Compute the payback period.

e. Compute the profitability index.

f. Should the car wash be purchased?