MS-44L (Capital Budgeting With Risks & Returns)

ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY
CPA Review Batch 44  October 2022 CPA Licensure Examination

MS-44L
MANAGEMENT SERVICES C. LEE  E. ARAÑAS  K. MANUEL
CAPITAL BUDGETING WITH INVESTMENT RISKS & RETURNS

CAPITAL BUDGETING
 CAPITAL INVESTMENT is the long-term commitment of significant funds to meet certain objectives such as
acquiring additional plant assets to expand company operations. Its typical characteristics include:
✓ As to COST: it requires a large sum of money and resources
✓ As to COMMITMENT: it ties up invested funds for a long period of time
✓ As to FLEXIBILITY: it is more difficult to reverse than short-term decisions
✓ As to RISK: it involves so much risks and uncertainties mainly due to estimates and forecasts being
assumed over an extended period of time
 INDEPENDENT capital investment projects (meant for SCREENING decisions) are projects that are evaluated
individually against predetermined corporate standard of acceptability resulting in an accept-or-reject
decision. Common examples: investment in long-term assets such as purchase of property, plant or
equipment, new product development, large-scale advertising campaign.
 MUTUALLY EXCLUSIVE capital investment projects (meant for PREFERENCE decisions) are projects that
require choosing from among alternatives and, once chosen, usually preclude the company from choosing
other competing projects. Common examples: replacement vs. renovation of equipment, lease vs. buy of
facilities, manual bookkeeping vs. computerized system, preventive maintenance vs periodic overhaul.
 CAPITAL BUDGETING is the process of measuring, evaluating, and selecting capital investments.
 Six formal stages of capital budgeting: 1) Identification and definition stage 2) Search stage 3) Information-
acquisition stage – both qualitative and quantitative information is considered 4) Selection stage – choosing projects
after cost-benefit evaluation 5) Financing stage 6) Implementation and Control stage – conduct of post-audit.
 An over-simplified capital budgeting process involves the following steps:
Step 1: Step 2: Step 3:
Identification Evaluation Decision
Nature of Capital Investments FACTORS OF CONSIDERATION

Replacement (Equipment)
Improvement (Products)
Expansion (Facilities) Net Investments Net Returns Costs of Capital
Addition (Technology)
Reduction (Costs)
Capital budgeting, after the selection Non-discounted methods Discounted methods

of the capital investment project, Payback period Net present value (NPV)
typically extends up to the financing, Bail-out payback Profitability index
implementation, monitoring and Accounting rate of return (ARR) Internal rate of return (IRR)
review of the project. Payback reciprocal Discounted payback
 NET INVESTMENTS, primarily computed for decision-making purposes, refer to COSTS (cash outflows) less
SAVINGS (cash inflows) incidental to the acquisition of the capital investment projects.
✓ COSTS (Cash outflows) include:
➢ Purchase price of the asset, net of any related cash discount
➢ Incidental project-related expenses such as freight, insurance, handling, installation, test-runs
➢ Additional working capital needed to support the operation of the project at the desired level.
(NOTE: At the end of the project’s life, additional working capital shall be recaptured as part of the
project’s terminal cash flow, along with any salvage value of the project)
➢ Market value of existing idle assets to be used in the operation of the proposed capital project.
➢ Training cost, net of related tax
✓ SAVINGS (Cash inflows) include:
➢ Proceeds from sale of an old asset disposed or replaced, net of related tax
➢ Trade-in value of the old asset (in case of replacement)
➢ Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax
 NET RETURNS refers to either net income (under accrual basis) or net cash flows (under cash basis), the
latter may be computed under direct or indirect method:
✓ Direct method: Net cash inflows = cash inflows – cash outflows
✓ Indirect method: Net cash inflows = net income + noncash expenses (e.g., depreciation)
 COST of CAPITAL, a.k.a. hurdle rate, minimum required/acceptable rate of return, desired rate, cut-off rate,
standard rate, is used as a discount rate in discounted capital budgeting techniques like NPV and profitability
index. [Cost of Capital is covered in MAS-44K]
 PAYBACK PERIOD measures the length of time required to recover the amount of initial investment.
Net Investment
PAYBACK PERIOD =
Net Cash Inflows
RULE: a project is acceptable if its payback period is shorter than the benchmark period used by management
PROS: simple to compute, easy to understand, useful in evaluating liquidity of the project, a good surrogate
for risk -- a quick or short payback period indicates a less risky project.
CONS: ignores time value of money, ignores salvage value, ignores cash flows after payback period, more
emphasis on return OF investment instead of ROI, maximum payback period may be arbitrary
 BAIL-OUT PAYBACK PERIOD is payback method wherein cash recoveries include not only the annual net cash
inflows but also the estimated salvage value realizable at the end of each year of the project life.
Page 1 of 18 0915-2303213  www.resacpareview.com

ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY
CAPITAL BUDGETING with INVESTMENT RISKS and RETURNS MS-44L
 ACCOUNTING RATE of RETURN, a.k.a. book rate of return, simple rate of return, unadjusted rate of return,
financial statement rate of return, measures the capital project’s profitability from accounting standpoint by
relating the required investment to the future annual net income.
Average Annual Net income
ACCOUNTING RATE of RETURN (ARR) =
Original or Average Investment*
RULE: a project is acceptable if its ARR is higher than the cost of capital.
PROS: emphasize project’s profitability, considers entire life/project results, consistent with FS values
CONS: ignores time value of money, ignores inflationary effects, uses accrual values rather than cash flows
 PAYBACK RECIPROCAL provides a reasonable estimate of the internal rate of return (IRR) provided that the
following two conditions are met:
Condition No. 1: Payback period is at most half of the economic life of the project
Condition No. 2: Net cash inflows are uniform throughout the life of the project.
Net Cash Inflows 1
PAYBACK RECIPROCAL = =
Net Investment Payback period
NOTE: Payback reciprocal is a non-discounted technique used to estimate a discounted technique (IRR).
 NET PRESENT VALUE (NPV) measures the excess of the present value of cash inflows generated by the project
over the amount of initial investment.
NPV = Present Value of Cash Inflows – Present Value of Cash Outflows
✓ CASH INFLOWS include annual net cash inflows infused by the capital investment project and any cash
realizable at the end of the project life (e.g., salvage value, return of working capital requirements).
✓ CASH OUTFLOWS is usually based on the net investment cost required at the inception of the project.
RULE: a project is acceptable if its NPV is positive.
PROS: emphasizes cash flows, considers time value of money, assumes cost of capital as reinvestment rate
CONS: cost of capital is not always available, may be incomparable if projects have different lives or sizes.
 PROFITABILITY INDEX, a.k.a. benefit-cost ratio, desirability index, present value index, expresses the present
value of cash benefits as to an amount per peso of investment in a capital project and is used as a measure
of ranking projects in a descending order of desirability.
Present Value of Cash Inflows
PROFITABILITY INDEX =
Present Value of Cash Outflows
RULE: a project is acceptable if its profitability index is more than 1.0.
 INTERNAL RATE of RETURN (IRR), a.k.a. time-adjusted rate of return, discounted cash flow rate of return,
sophisticated rate of return, break-even cash flow rate or return, is the rate of return that equates the present
value of cash inflows to present value of cash outflows. IRR is the discount rate at which the NPV is zero.
RULE: a project is acceptable if its IRR is higher than the cost of capital.
PROS: emphasizes cash flows, considers time value of money, computes the true return of the project
CONS: difficult to compute for uneven cash flows, requires estimation of cash flows over a long period of
time, assumes IRR as reinvestment rate, may not be meaningful if a project has negative earnings.
NOTE: Determination of a project’s exact IRR usually requires an interpolation process. Alternatively, Trial
and error technique and the payback reciprocal method may also be used to approximate the IRR.
 IRR must be distinguished from CROSSOVER RATE (a.k.a. NPV Point of Indifference, Fisher Rate), which is
the discount rate at which the NPV of two capital investment projects are equal.
 DISCOUNTED PAYBACK, a.k.a. break-even time, is the length of time required to equalize the discounted
cash flows (using the cost of capital as a discount rate) and initial investment of a capital project.
 EQUIVALENT ANNUAL ANNUITY (EAA), a.k.a. annualized NPV, is an NPV-based technique used to compare
capital investment projects with unequal lives.
 CAPITAL RATIONING is, given a constraint on capital budgets, the selection of investment proposals that
would maximize the over-all NPV of the firm. The profitability index, which is considered as a project ranking
method rather than a project screening method, is proven to be more useful than NPV and IRR when the
projects being evaluated involve different investment sizes, earnings pattern and project lives.
 REAL OPTIONS are alternatives or choices that become available over the life of a capital investment. Common
examples include: (1) option to delay, (2) option to expand, (3) option to abandon, (4) option to scale back,
(5) option to vary inputs/output (6) option to enter new market (7) new product option. In capital investment
projects, real options provide management the opportunity to limit possible losses by taking advantage of
future positive events that may improve investment outcomes.
 RISK ANALYSIS in capital budgeting attempts to measure the likelihood of the variability of future returns
from the proposed investment. The following approaches are used to assess risk in capital investments:
✓ RISK-ADJUSTED DISCOUNT RATE is a technique that adjusts the discount rate upward as investment
becomes riskier. By increasing the discount rate, NPV tends to decrease or become negative, thereby
minimizing the chance of accepting undesirable projects.
✓ TIME-ADJUSTED DISCOUNT RATE assumes a higher discount rate in later years of a project’s life due to
uncertainties (e.g., inflation) involved in making projection of cash flows over a long period of time.
✓ SCENARIO ANALYSIS considers multiple possible outcomes or scenarios and associated probabilities to
determine the overall expected outcome based on the weighted average of all possible outcomes.
✓ SENSITIVITY ANALYSIS uses an iterative process that uses forecasts of many NPVs under various “what-
if” assumptions to see how sensitive NPV is to changing conditions.
✓ MONTE CARLO SIMULATION is a sophisticated computer-based analysis that considers uncertainties and
probability distributions for inputs and uses random number inputs to map range of possible outcomes.
✓ DECISION TREE is a probability-based technique used when management needs to decide through a
series of “if-then” scenarios that describe how the firm might react based on future events.

INVESTMENT RISKS & RETURNS
 INVESTMENT RISK, a.k.a. security risk, speculative risk, is possibility that actual investment returns will differ
from expected returns, which could result in either a gain or a loss.
 An investment risk consists of two components: (1) Diversifiable risk (2) Non-diversifiable risk
1) DIVERSIFIABLE risk (a.k.a. UNSYSTEMATIC or controllable risk) represents portion of a security’s risk
that can be controlled through proper diversification. This type of risk is unique to a given security. Default
risk, business risk, liquidity risk normally would fall under this category.
2) NON-DIVERSIFIABLE risk (a.k.a. SYSTEMATIC or non-controllable risk) results from forces outside the
firm’s control and is therefore not unique to a given security. Market risk, political risk, purchasing power
risk, foreign exchange risk normally would fall under this category.
[Various investment risks and corresponding definitions are covered in MAS-44K under Costs of Capital]
 STANDARD DEVIATION (SD), a measure of dispersion of potential returns from average returns, is commonly
used to quantify risk of investment. The higher the SD, the higher the risk of an investment.
 Using SD to compare investment risks is only an absolute measure of dispersion (risk) and does not consider
the dispersion of outcomes in terms of EXPECTED RETURN, which is the weighted average of possible returns
using the probabilities as weights.
 “68-95-99” Normal Rule in Statistics: given a normal probability distribution, 68% of the returns will lie within
 1 SD of the expected return, 95% of all observations will lie within  2 SDs of the expected return and 99%
of all observations will lie within  3 SDs of the expected return.
 SD must be distinguished from STANDARD ERROR of the MEAN (always smaller than SD), which measures
how far a sample mean (e.g., expected return) deviates from the actual mean of a population.
 When comparing investments that have different expected returns, the more appropriate measure of
investment’s relative risk is the COEFFICIENT of VARIATION, a measure of risk per unit of return.
Standard Deviation (ơ)
Coefficient of Variation =
Expected Return (µ)
The higher the coefficient of variation is, the riskier the investment is relative to its expected return.
 An investor may be willing to take additional risks in order to attempt greater returns. The ultimate decision
largely depends on management’s profile and appetite for risks – whether a firm’s management is risk-taker,
risk-neutral or risk-averse.
EXERCISES: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS
1. Net Investment for Decision-Making

Whitney Company plans to replace an old unit of equipment with a new one:
I) The old unit was acquired three years ago; the old unit’s carrying value is now at P 60,000 while it
can be sold for P 70,000. Tax rate is 25%.
II) The new unit can be acquired at a list price of P 400,000. A 10% cash discount is available if the
equipment is paid for within 30 days from acquisition date. Excluded from the list price are shipping
charges of P 15,000, installation charges of P 10,000 and testing charges of P 3,000.
III) Other assets with a book value of P 12,000 that are to be retired as a result of the acquisition of the
new machine can be salvaged and sold for P 10,000.
IV) Additional working capital of P 30,000 will be needed to support operations planned with the new
equipment.
V) The annual cash flow from the use of the new equipment is P 50,000. At the end of its useful life of 5
years, the new equipment must be disposed of with a zero-book value but with an expected salvage
value of P 4,000.
REQUIRED:
A) What is the initial cost of net investments for decision-making purposes?
B) What is the terminal cash flow expected at the end of life of the project?
2. Net Returns - Increase in Revenues

Mariah Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are
estimated to be 10,000 cups to be sold for 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: Determine the following:
A) The increase in annual net income.
B) The annual cash inflows that will be generated by the project.
3. Net Returns - Cost Savings

Celine Company is planning to buy a high-tech machine that can reduce cash expenses by an average of P
80,000 per year. The new machine will 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 machine’s life. Income tax rate is 25%.
REQUIRED:
Determine the net cash inflows that will be generated by the project.

4. Payback Period & ARR (Even Cash Flows)

Lady G Company plans to replace its 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%, determine:

A) Payback period
B) Accounting rate of return on original investment
C) Accounting rate of return on average investment
5. Payback Period & ARR (Uneven Cash Flows)

Katy P Company has an investment opportunity costing P 90,000 that is expected to yield the following cash
flows over the next five years:
Year Amount
1 P 40,000
2 35,000
3 30,000
4 20,000
5 10,000
P 135,000
REQUIRED: Assuming a hurdle rate of 30%, determine:
A) Payback period in months
B) Book rate of return
6. Bail-Out Payback Period

A project costing P 180,000 will produce the following annual cash flows and year-end salvage values:
Year Cash flows Salvage value
1 P 50,000 P 60,000
2 P 50,000 P 55,000
3 P 40,000 P 50,000
4 P 40,000 P 45,000
REQUIRED:
Bail-out payback period.
7. Net Present Value (Even Cash Flows)

Rihanna 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 are estimated at P 11,000. The tax rate is 20%. The company desires a minimum
return of 25% on invested capital.
REQUIRED: Rounding-off present value factors to three decimal places, determine the net present value.
Solution Guide
Year 0 PV factor Year 1 Year 2 Year 3 Year 4

Year 0 ________
Year 1 ________
Year 2 ________
Year 3 ________
Year 4 ________
Year 4 ________
NPV = _________
Cash inflows before tax PV, Cash IN

- Depreciation ____________ 10,000 (_____)
Earnings before tax 4,000 (_____)
- Tax (20%) ____________
Earnings after tax PV, Cash OUT
+ Depreciation ____________ 28,000 (_____)
Cash inflows after tax NPV =

8. NPV, Profitability Index & IRR (Even & Uneven Cash Flows)
Madonna Corporation gathered the following data on two capital investment opportunities:
Project 1 Project 2
Cost of investment P 195,200 P 150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash inflows P 100,000 P 100,000*
* This amount is to decline by P 20,000 annually thereafter.
REQUIRED: Round-off present value factors to three decimal places.
Project 1 Project 2
NPV: A) _____________ B) _____________
P. Index: C) _____________ D) _____________
E) What is project 1’s internal rate of return?
a. 23% c. 25%
b. 27% d. 29%
F) What is project 2’s internal rate of return?
a. Below 30% c. Between 31% and 32%
b. Between 30% and 31% d. Above 32%
9. Capital Budgeting Techniques

Morissette 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 cash 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
10. Equivalent Annual Annuity: Project with Unequal Lives

Project Cost Life Annual Cash Inflow
World P 50,000 10 years P 9,000
Universe P 50,000 15 years P 7,500
REQUIRED: Assuming a cost of capital of 10% (round-off factors to four decimal places):
On the basis of equivalent annual annuity, which project is more attractive?
11. Crossover Rate - NPV Point of Indifference

Olivia Corporation has a weighted average cost of capital of 12% and is evaluating two mutually exclusive
projects (Hollywood and Hallyu), which have the following projections:
Project Hollywood Project Hallyu
Investment P 1,000 P 800
After-tax cash inflow P 400 P 400
Asset life 4 years 3 years
The crossover rate for the two projects is closest to:
a. 20% c. 18%
b. 19% d. 10%
12. Payback Reciprocal
Dua Lipa Company is planning to buy an equipment costing P 640,000 with 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 the best estimate of the IRR?
Answer and solution
Payback period: 640,000 ÷ 128,000 = 5 years Payback reciprocal: 1 ÷ 5 years = 20%
Based on page 2, PAYBACK RECIPROCAL is a reasonable estimate of the internal rate of return (IRR) provided
that the following conditions are met:
 Payback period is at most half of the economic life of the project [i.e., 5 years ≤ (30 ÷ 2)]
 Net cash inflows are uniform throughout the life of the project.
13. 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.
Project Annual Cash Flow Investment Cost of Capital IRR NPV
1 P 45,000 P 188,640 14% (A) _______ (B) ________
2 P 75,000 (C) ________ 12% 18% (D) ________
3 (E) __________ P 300,000 (F) _______ 16% P 81,440
4 (G) __________ P 450,000 12% (H) _______ P 115,000

14. Capital Rationing - Ranking Projects
J-Lo Corporation is considering five investment opportunities. The cost of capital is 12%.
Project Investment PV - Cash Flow NPV IRR (%) P. Index

1 P 35,000 P 39,325 P 4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,543 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 profitability index.
B) If only a budget of P 55,000 is available, which projects should be chosen?
15. Capital Budgeting under Risk: Coefficient of Variation

Rihanna is considering whether to invest in one of two mutually exclusive projects: Project “L” vs. Project “R”.
Depending on the state of the economy, the projects would provide the following cash inflows in each of the
next 5 years. Consider the following probability distribution:
State of Economy Probability Project “L” Project “R”
Recession 30% P 1,000 P 500
Normal 40% P 2,000 P 2,000
Prosperity 30% P 3,000 P 5,000
REQUIRED: Assuming probability distribution is normal when determining confidence interval, determine:
Project “L” Project “R”
Expected Return A) _____________ D) _____________
Standard Deviation (rounded, whole amount) B) _____________ E) _____________
Coefficient of Variation C) _____________ F) _____________
G) Which project is likely to be chosen assuming Rihanna is a conservative, risk-averse type of investor?
WRAP-UP EXERCISES (MULTIPLE-CHOICE)

1. Capital budgeting is the process
a. Used in make-or-buy decision making
b. Of eliminating unprofitable product line
c. Of making capital expenditure decisions
d. Of determining how much capital stock is issued
2. Which of the following is considered in computing the net investment for the decision to replace an old
machine with a new one?
I) Purchase price of the old machine III) Salvage value of the old machine
II) Purchase price of the new machine IV) Salvage value of the new machine
a. I and II c. I and IV
b. II and III d. II and IV
3. Which of the following is not a typical cash inflow in capital investment decisions?
a. Salvage value c. Incremental revenues
b. Cost reductions d. Additional working capital
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. A depreciation tax shield is
a. An after-tax cash outflow c. The expense caused by depreciation
b. A reduction in income taxes d. The cash provided by recording depreciation
6. When computing for 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
7. The payback method measures
a. Cash flows of an investment c. Economic life of an investment
b. Profitability of an investment d. How quickly investment may be recovered
8. The payback period considers (I) income over the entire project life and (II) time value of money.
a. (I) Yes (II) Yes c. (I) No (II) Yes
b. (I) Yes (II) No d. (I) No (II) No
9. Which of the following is a TRUE statement regarding non-discounted capital budgeting techniques?
a. Payback period (liquidity of project); ARR (liquidity of project)
b. Payback period (liquidity of project); ARR (profitability of project)
c. Payback period (profitability of project); ARR (liquidity of project)
d. Payback period (profitability of project); ARR (profitability of project)
10. All of the following capital budgeting analysis techniques use cash flows as the primary basis for the
calculation, except for the:
a. Payback period c. Accounting Rate of Return (ARR)
b. Net Present Value (NPV) d. Internal Rate of Return (IRR)

11. Which of the following groups of capital budgeting techniques considers the time value of money?
a. ARR, IRR and payback period c. ARR, NPV and profitability index
b. IRR, NPV and profitability index d. ARR, IRR and profitability index
12. What is the PV factor of any amount at year zero or zero percent?
a. Zero c. 0.50
b. 1.00 d. 1.50
13. The discount rate (hurdle rate of return) must be determined in advance for the
a. ARR c. Payback period
b. IRR d. Net present value
14. When using the net present value method for capital budgeting analysis, the required rate of return is
called all of the following, EXCEPT
a. Risk-free rate c. Discount rate
b. Cutoff rate d. Cost of capital
15. A capital project with a positive NPV also has
a. A profitability index of one c. A profitability index less than one
b. A positive profitability index d. A profitability index greater than one
16. A capital project that has a positive NPV based on a discount rate of 10% also has an IRR of
a. Zero c. Less than 10%
b. 10% d. Greater than 10%
17. 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
18. The net present value method assumes that the project’s cash flows are reinvested at the
a. Internal rate of return c. Cost of capital
b. Simple rate of return d. Payback period
19. The internal rate of return 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
20. Mutually exclusive projects are those that:
a. If accepted, preclude the acceptance of competing projects
b. If accepted, can have a negative effect on the company’s profit
c. If accepted, can also lead to the acceptance of a competing project
d. Require all managers to consider and make decision on the capital investment project
21. In choosing from among mutually exclusive investments, one must select the one with the highest
a. Net present value c. Book rate of return
b. Profitability index d. Internal rate of return
22. ____ projects do not compete with each other; acceptance of one _____ the others from consideration.
a. Capital; eliminates c. Mutually exclusive; eliminates
b. Independent; does not eliminate d. Replacement; does not eliminate
23. Which capital budgeting method 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
24. Which of the following capital budgeting techniques would allow management to justify investing in a
project that could not be justified currently by using techniques that focus on expected cash flows?
a. Real options c. Internal rate of return
b. Net present value d. Accounting rate of return
25. In the context of capital budgeting, risk refers to
a. The degree of variability of the cash inflows
b. The degree of variability of the initial investment
c. The chance that the net present value will be greater than zero
d. The chance that the internal rate of return will exceed the cost of capital
26. Which of the following is not a technique for considering risks of an investment in capital budgeting?
a. Probability analysis c. Simulation techniques
b. Risk-adjusted discount rate d. Internal rate of return
27. Which of the following expresses the relationship between risk and return?
a. Direct relationship c. Spurious relationship
b. Inverse relationship d. Non-existing relationship
28. The expected return of an investment or a portfolio is measured by the
a. Beta c. Weighted average
b. Variance d. Standard deviation
29. Standard deviation divided by expected return is used to calculate
a. Coefficient of variation c. Coefficient of determination
b. Coefficient of correlation d. Co-variance of a portfolio
30. The expected rate of return for IRON stock is 20%, with a standard deviation of 15%. The expected rate
of return for MAN stock is 10%, with a standard deviation of 9%. The riskier stock is:
a. IRON because its return is higher
b. MAN because its standard deviation is lower
c. IRON because its standard deviation is higher
d. MAN because its coefficient of variation is higher

SELF-TEST QUESTIONS – with suggested answers
(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)
1. Capital budgeting is concerned with
A a. Analysis of long-range decisions
b. Analysis of short-range decisions
c. Scheduling office personnel in office buildings
d. Decisions affecting only capital-intensive industries
2. The stage of the capital budgeting process that has the most risk is
A a. Forecasting cash flow c. Identifying alternative possible projects
b. Evaluating performance and learning d. Raising funds to initially support the project
3. The capital budgeting process contains several stages. At which stage are financial and nonfinancial factors addressed?
D a. Search stage c. Identification and definition stage
b. Selection stage d. Information-acquisition stage
4. At what stage of the capital budgeting process would management most likely apply present value techniques?
B a. Search stage c. Financing stage
b. Selection stage d. Identification stage
5. Of the following decisions, capital budgeting techniques would least likely be used in evaluating the
D a. Acquisition of new aircraft by a cargo company
b. Trade for a star quarterback by a football team
c. Design and implementation of a major advertising program
d. Adoption of a new method of allocating non-traceable costs to product lines
6. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
A 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
7. In equipment-replacement decisions, which one of the following does not affect the decision-making process?
C a. Current disposal price of old equipment c. Original fair market value of the old equipment
b. Operating costs of the old equipment d. Cost of the new equipment
8. Legaspi Company is considering the sale of a machine with a book value of P 80,000 and 3 years remaining in its useful
life. Straight-line depreciation of P 25,000 annually is available. The machine has a current market value of P 100,000.
What is the cash flow from selling the machine if the tax rate is 40%?
C a. P 80,000 c. P 92,000
b. P 88,000 d. P 100,000
9. A company is considering replacing a machine with one that will save P 50,000 per year in cash operating costs and has
P 20,000 more depreciation expense per year than the existing machine. The tax rate is 40%. Buying the new machine
will increase annual net cash flows of the company by
A a. P 38,000 c. P 20,000
b. P 30,000 d. P 12,000
10. Naga Company is considering replacing a machine with a book value of P 400,000, a remaining useful life of 5 years,
and annual straight-line depreciation of P 80,000. The existing machine has a current market value of P 400,000. The
replacement machine would cost P 550,000, have a 5-year life, and save P 75,000 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?
B a. P 90,000 c. P 330,000
b. P 150,000 d. P 550,00
11. Old equipment with a book value of P 15,000 will be replaced by new equipment with a purchase price of P 50,000,
exclusive of freight charges of P 2,000. The market value of the old equipment is P 11,000. Repair costs of P 2,000 can
be avoided if the new equipment is acquired. Assume a tax rate of 35%, what is the net investment of the project?
B a. P 33,800 c. P 39,700
b. P 38,300 d. P 52,000
Costs (Cash outflows): 50,000 + 2,000 = P 52,000
Savings (Cash inflows): 11,000 + 0.35 (15,000 – 11,000) + 2,000 (1 – 0.35) = P 13,700
12. A company is considering a project that requires a P 50,000 working capital investment. The company’s tax rate is 40%.
In a capital budgeting analysis, the initial investment in working capital should be:
C a. Multiplied by (1-0.40) and shown as a net P 30,000 cash outflow
b. Multiplied by the rate (0.40) and shown as a net P 20,000 cash outflow
c. Shown as a cash outflow of P 50,000
d. Ignored
13. Pasacao Company owns a building that originally cost P 400,000 and has a current book value of P 250,000. The building
was financed by a loan that has one payment of P 20,000 outstanding, which must be paid off upon the sale of the
building. Pasacao would like to purchase a new building for P 600,000. If the new building is purchased, the existing
building would be sold for P 380,000. Pasacao Company’s income tax rate is 40%. If the new building is purchased, the
relevant initial cash flows would total
B a. P 272,000 c. P 372,000
b. P 292,000 d. P 392,000
14. In computing the initial investment for decision-making, taxes would be relevant for all of the following, EXCEPT:
C a. Avoidable repairs of old asset
b. Profit on sale of old asset replaced by a new one
c. Increase in working capital required to support new capital investment
d. Loss on write-off of other assets disposed because of new capital investment

15. Which one of these statements concerning cash flow determination for capital budgeting purposes is not correct?
B a. Tax depreciation must be considered because it affects cash payments for taxes.
b. Book depreciation is relevant because it affects net income.
c. Sunk costs are not incremental flows and should not be included.
d. Net working capital changes should be included in cash flow forecasts.
16. Daet is expanding its manufacturing plant, which requires an investment of P 4 million in new equipment and plant
modifications. Daet’s sales are expected to increase by P 3 million per year as a result of the expansion. Cash investment
in current assets averages 30% of sales; accounts payable and other current liabilities are 10% of sales. What is the
estimated total investment for this expansion?
C a. P 3.4 million c. P 4.6 million
b. P 4.3 million d. P 5.2 million
17. Ragay Inc.’s depreciation deduction last year was P 50,000 and its tax rate was 30%. The company’s tax savings from
the depreciation tax shield for the year was
A a. P 15,000 c. P 50,000
b. P 35,000 d. P 30,000
18. A project costing P 180,000 will produce the following annual cash benefits and salvage value:
OLD equipment NEW equipment
Revenue P 150,000 P 180,000
Cash operating costs 70,000 60,000
Annual depreciation 30,000 50,000
Income tax, 46%
What is the incremental annual cash income after taxes?
B a. P 30,000 c. P 40,000
b. P 30,800 d. P 38,000
19. Ligao Company is considering replacing a machine with a book value of P 200,000, a remaining useful life of 5 years,
and annual straight-line depreciation of P 40,000. The existing machine has a current market value of P 200,000. The
replacement machine would cost P 300,000, have a 5-year life, and save P 100,000 per year in cash operating costs.
The replacement machine would be depreciated using the straight-line method and the tax rate is 40%. What would be
the increase in annual net cash flow if the company replaces the machine?
B a. P 60,000 c. P 76,000
b. P 68,000 d. P 84,000
20. Which statement describes the relevance of depreciation in calculating cash flows?
A a. Depreciation is relevant only when income taxes exist
b. Depreciation is always relevant
c. Depreciation is never relevant
d. Depreciation is relevant only with discounted cash flow methods
21. Nabua Company is analyzing a capital investment proposal for a new machinery to produce a new product over the next
10 years. At the end of ten years, the machinery must be disposed of with a zero net book value but with a scrap
salvage value of P 20,000. It will require some P 30,000 to remove the machinery. The applicable tax rate is 35%.
What is the approximate “end-of-life” (terminal) cash flow based on the foregoing information?
B a. Inflow of P 30,000 c. Outflow of P 10,000
b. Outflow of P 6,500 d. Outflow of P 17,000
Items 22 and 23 are based on the following information
Misibis Corporation is considering the acquisition of a new machine. The machine can be purchased for P 90,000; it will
cost P 6,000 to transport to Misibis plant and P 9,000 to install. It is estimated that the machine will last 10 years, and it
is expected to have an estimated salvage value of P 5,000. Over its 10-year life, the machine is expected to produce
2,000 units per year, each with a selling price of P 500 and combined material and labor costs of P 450 per unit. Tax
regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated
salvage value. Misibis has a marginal tax rate of 40%.
22. What is the net cash flow for the third year of the project that Misibis should use in a capital budgeting analysis?
C a. P 64,200 c. P 68,400
b. P 68,000 d. P 79,000
23. What is the net cash flow for the tenth year of the project that Misibis should use in a capital budgeting analysis?
D a. P 100,000 c. P 68,400
b. P 91,000 d. P 63,000
24. Which of the following is irrelevant in projecting the cash flows of the final year of a capital project?
D a. Cash devoted to use in project.
b. Disposal value of equipment purchased specifically for project.
c. Deprecation tax shield generated by equipment purchased specifically for project.
d. Historical cost of equipment disposed of in the project’s first year.
25. The length of time required to recover the initial cash outlay for a project is determined by using the:
B a. Discounted cash flow method c. Net present value method
b. Payback method d. Simple rate of return method
26. An advantage of using the payback method is that the method is:
A a. Simple to compute c. Precise in estimates of profitability
b. Not based on cash flow data d. Insensitive to the life of the project
27. Bulan Company is considering a certain project with the following projected cash income after taxes for 4 years, the life
of the project: year 1, P 11,000; year 2, P 9,000; year 3, P 8,000; year 4, P 7,000. If the project requires an investment
of P 25,000 with a salvage value of P 5,000, what is the payback period?
D a. 2.265 years c. 2.526 years
b. 2.562 years d. 2.625 years

28. Albay, Inc. recently acquired a machine at a cost of P 64,000. It will be depreciated on a straight-line basis over 8 years,
with no salvage value. Albay expects that this machine will produce P 18,000 annual net cash flow before income tax.
Assuming an income tax rate of 50%, the appropriate payback period on this investment is: (Hint: compute cash flow
after tax)
B a. 3.6 years c. 7.1 years
29. A company is planning to buy a machine that costs P 12,000 and has an annual depreciation for tax purposes of P2,400
for 5 years. The machine is expected to result in cash savings from operations of P 4,000 per year. If the tax rate is
50%, then what is the payback period for the new machine?
B a. 3 years c. 5 years
b. 3.75 years d. 6 years
30. Iriga Company is planning to purchase a new machine. The payback period is estimated to be 6 years. The project’s
after-tax cash flow is estimated to be P 2,000 yearly for the first three years and P 3,000 yearly for the next three years
of the payback period. Annual depreciation of P 1,300 will be charged to income for each of the 6 years of the payback
period. The machine will cost:
A a. P 15,000 c. P 9,000
b. P 12,000 d. P 6,000
31. Buhi Company is planning to purchase a new machine for P 30,000. The payback period is expected to be five years.
The new machine is expected to produce cash flows from operations, net of income taxes, of P 7,000 per year in each
of the next three years and P 5,500 in the fourth year. Depreciation of P 5,000 a year will be charged to income for
each of the five years of the payback period. What is the amount of cash flow from operations, net of income taxes,
that the new machine is expected to produce in the last (fifth) year of the payback period?
B a. P 1,000 c. P 5,000
b. P 3,500 d. P 8,500
32. The payback period considers depreciation expense (DE) and time value of money (TMV) as follows:
B a. DE, relevant and TVM, relevant c. DE, irrelevant and TVM, relevant
b. DE, irrelevant and TVM, irrelevant d. DE, relevant and TVM, irrelevant
33. The payback method assumes that all cash inflows are reinvested to yield a return equal to
D a. The discount rate c. The internal rate of return
b. The hurdle rate d. Zero
34. Oas Company is studying a project that has a 10-year life and requires a P 800,000 investment in equipment that has
no salvage value. The project would provide net operating income each year as follows for the life of the project:
Sales P 500,000
Less: cash variable expenses 100,000
Contribution margin 400,000
Less: fixed expenses
Fixed cash expenses P 200,000
Depreciation expenses 80,000 280,000
Net operating income P 120,000
The company’s required rate of return is 8%. What is the payback period for this project?
D a. 3 years c. 2 years
b. 6.67 years d. 4 years
35. Sabang Company purchased a new machine on January 1 of this year for P 90,000, with an estimated useful life of 5
years and a salvage value of P 10,000. The machine will be depreciated using the straight-line method. The machine
is expected to produce cash flow from operations, net of tax, of P 36,000 a year in each of the next 5 years. The new
machine’s salvage value is P 20,000 in years 1 and 2, and P 15,000 in years 3 and 4. What will be the bailout payback
period for this machine?
C a. 1.4 years c. 1.9 years
36. Tigaon Co. is considering the purchase of a P 100,000 machine that is expected to reduce operating cash expenses by
P 25,000 per year. This machine, which has no salvage value, has a useful life of 10 years and will be depreciated on a
straight-line basis. What would be the simple rate of return on original investment?
B a. 10% c. 25%
b. 15% d. 35%
37. San Jose Company is considering the acquisition of a personal computer that costs P 120,000 with an economic life of
12 years and a terminal salvage value of P 12,000. It is estimated that the increase in net income before taxes as a
result from this investment will amount to P 7,000 annually. Income taxes are 35%. The company uses the straight-
line method of depreciation. What is the accounting rate of return on the average cost of investment?
C a. 3.79% c. 6.89%
b. 5.83% d. 6.98%
38. Camalig Inc. purchased a new machine for P 60,000 on January 1. The machine is being depreciated on the straight-line
basis over five years with no salvage value. The simple rate of return is expected to be 15% on the initial investment.
Assuming a uniform cash flow, this investment is expected to provide annual cash flow from operations of:
D a. P 7,200 c. P 12,000
b. P 13,800 d. P 21,000
39. Lagonoy Company has invested in a machine that cost P 70,000, that has a useful life of seven years, and that has no
salvage value at the end of its useful life. If the machine has a payback period of four years, then the simple rate of
return on the machine is closest to:
C a. 7.1% c. 10.7%
b. 8.2% d. 39.3%
Solution: Net income: cash flow – depreciation: (70,000 ÷ 4) – 10,000 = 7,500

40. Which of the following methods is a discounted cash flow method for evaluating capital investment?
C a. Payback c. PV payback
b. Bail-out payback d. Payback reciprocal
41. A project costing P 28,715 will produce the following cash benefits after taxes:
End of year After-tax cash benefits
1 P 11,000
2 15,000
3 18,000
The company’s cost of capital is 16%. The PV of P 1 for one year at 16% is 0.862; for two years is 0.743; for three
years is 0.641. What is the break-even time or discounted (PV) payback period?
D a. 1.7 years c. 2.3 years
b. 2 years d. 2.7 years
42. Which capital budgeting method assumes that the funds are reinvested at the company’s cost of capital?
C a. Payback c. Net present value
b. Accounting rate of return d. Time adjusted rate of return
43. You have been consulted to advise Polangui Corp. on the projected acquisition of another production line costing P 1
million. The line has an expected useful life of five (5) years without any salvage value. The following additional
information was made available:
Year Estimated Annual Cash Inflow Present Value of P 1
1 P 600,000 0.91
2 300,000 0.76
3 200,000 0.63
4 200,000 0.53
5 200,000 . 0.44
TOTAL P 1,500,000 3.27
Assuming that the cash flow is to be discounted, your advice is
B a. To invest due to net present value of P 541,280
b. To invest due to net present value of P 94,000
c. To invest due to net advantage of P 500,000
d. To invest due to net present value of P 635,000
44. Bula Company purchased a machine with an estimated useful life of seven years and no salvage value. The machine is
expected to generate cash flows from operations, net of income taxes of P 80,000 in each of the seven years. Bula’s
expected rate of return is 12%. Information on present value factors is as follows:
Present value of P 1 at 12% for seven periods: 0.452
Present value of an ordinary annuity of P 1 at 12% for 7 periods: 4.564
Assuming a positive net present value of P 12,720, what is the cost of the machine?
C a. P 240,400 c. P 352,400
b. P 253,120 d. P 377,840
45. An investment opportunity costing P 110,000 is expected to yield net cash flows of P 28,000 annually for six years. The
NPV of the investment at a cutoff rate of 12% would be: (Round off PV factors based on three decimal places)
B a. (P 5,108) c. P 110,000
b. P 5,108 d. P 115,108
46. The effectiveness of the present value method has been appropriately questioned as a capital expenditure evaluation
technique because:
A a. Predicting future cash flows is often difficult and often associated with uncertainties
b. The average return on investment method is more accurate and useful
c. The payback method is theoretically more reliable
d. The computation involves difficult mathematical applications most accountants cannot perform
47. On January 1, a company invested in an asset with a useful life of 3 years. The company’s expected rate of return is
10%. The cash flow and present and future value factors for the 3 years are as follows:
Year Cash inflows Present value of P 1 @ 10% Future value of P 1 @ 10%
1 P 8,000 0.91 1.10
2 P 9,000 0.83 1.21
3 P 10,000 0.75 1.33
All cash inflows are assumed to occur at year-end. If the asset generates a positive net present value of P 2,000, what
was the amount of the original investment?
A a. P 20,250 c. P 30,991
b. P 22,250 d. P 33,991
48. Ignoring taxes, how are the following used in the calculation of the NPV of a proposed project?
Depreciation Expense Salvage Value Depreciation Expense Salvage Value
C a. Include Include c. Exclude Include
b. Include Exclude d. Exclude Exclude
49. Pilar acquired a machine that has a useful life of 10 years with no salvage value. The incremental annual net income
before taxes is P 8,500. Income taxes are 25%. The PV of an annuity of P 1 for 10 years at 18% is 4.494. The annual
depreciation is P 5,000. The NPV is positive P 1,119.25. How much is the amount of investment?
C a. P 30,000 c. P 50,000
b. P 40,000 d. P 60,000
50. A decrease in the discount rate:
A a. Will increase present values of future cash flows
b. Is one way to compensate for greater risk in a project
c. Will reduce present values of future cash flows
d. Responses a and b are both correct

51. The calculation of the NPV of an investment project requires that the depreciation tax shield be included at:
C a. The amount of the depreciation with no adjustment taxes
b. The amount of the depreciation times one minus the tax rate
c. The amount of the depreciation times the tax rate
d. Zero, since depreciation is not relevant to the calculation of net present value
52. A disadvantage of the net present value method of capital expenditure evaluation is that it
C a. Computes the true interest rate
b. Is calculated using sensitivity analysis
c. Does not provide the true rate of return on investment
d. Is difficult to apply because it uses a trial-and-error approach
53. A project requires an investment of P 40,000 and has a net present value of P 10,000. The profitability index is:
B a. 0.80 c. 4.0
b. 1.25 d. 1.0
54. Consider an investment with the following cash flows:
Year Cash flows PV of P 1 at 14%
0 (P 31,000) 1.000
1 10,000 0.877
2 20,000 0.770
3 10,000 0.675
4 10,000 0.592
Salvage Value: P 5,000
What is the profitability index?
B a. 1.824 c. 1.482
b. 1.284 d. 1.842
55. An investment in a new piece of equipment costing P 50,000 is expected to yield the following over its 5-year useful life:
Revenues (cash), P 40,000; operating costs (cash), P 18,000; depreciation, P 10,000. The present value of P 1 received
annually for 5 years and discounted at the cost of capital is 4.10 assuming that all cash flows occur at year-end. Ignoring
tax effect, what is the benefit/cost ratio (profitability index) for this piece of equipment?
C a. 0.984 c. 1.804
b. 1.200 d. 2.200
56. Which of these methods measure cash flows and outflows of a project as if they occurred at a single point in time?
C a. Payback and bail-out payback period c. Net present value and internal rate of return
b. Accounting and internal rate of return d. Return on original and average investment
57. The present value and discounted cash flow rate of return methods of evaluating capital expenditure proposals are
superior to the payback method in that they:
C a. Requires less input c. Consider the time value of money
b. Are easier to implement d. Reflects the effects of depreciation and income tax
58. The internal rate of return (IRR) is the
D a. Hurdle rate
b. Rate of interest at which the net present value is greater than 1.0
c. Rate of return generated from the operational cash flows
d. Rate of interest at which the net present value is equal to zero
59. The discount rate that equates the PV of expected cash flows with the cost of investments is the
B a. Net present value c. Accounting rate of return
b. Internal rate of return d. Payback period
60. Which of the following is a basic difference between IRR and ARR criteria for evaluating investments?
D a. IRR emphasizes expenses; ARR emphasizes expenditures
b. IRR emphasizes revenues; ARR emphasizes receipts
c. IRR is used for internal investments; ARR is used for external investments
d. IRR concentrates on receipts & payments; ARR concentrates on revenues & expenses.
61. Virac, Inc. is planning to invest P 120,000 in a 10-year project. Virac estimates that the annual cash inflow, net of income
taxes, from this project will be P 20,000. Virac’s desired rate for return on investments of this type is 10%. Information
on present value factors is as follows:
@ 10% @12%
Present value of P 1 for 10 periods 0.386 0.322
Present value of an annuity of P 1 for 10 periods 6.145 5.650
What is Virac’s internal rate of return on this investment?
C a. Less than 10%, but more than 0% c. Less than 12%, but more than 10%
b. 10% d. 12%
62. Donsol Corporation is planning to invest P 80,000 in a three-year project. Donsol’s expected rate of return is 10%. The
present value of P1 at 10% for 1 year is 0.909, for two years is 0.826 and for the three years is 0.751. The cash flows,
net of income taxes, will be P 30,000 for the first year (present value: P 27,270) and P 36,000 for the second year
(present value: P 29,736). Assuming the rate of return is exactly 10%, what will be the net cash flow, net of income
taxes, for the third year?
D a. P 17,260 c. P 22,904
b. P 22,000 d. P 30,618
63. Libon Company is planning to invest in a machine with a useful life of five years and no salvage value. The machine is
expected to produce cash flow from operations of P 20,000 in each of the five years. Libon’s required rate of return is
10%. What would be the maximum price that the company would pay for the machine?
C a. P 32,220 c. P 75, 820
b. P 62,100 d. P 122,100

64. If an investment of P 14,760 now is to yield P 18,000 at the end of one year, then what is the internal rate of return for
this investment to the nearest whole percentage?
C a. 14% c. 22%
b. 18% d. 28%
65. A company is considering a capital investment for which the initial cash outlay is P 20,000. Net cash flows from
operations, net of income taxes, are predicted to be P 4,000 for 10 years. Assume a cost of capital of 12%. The present
value of an annuity of P 1 for 10 years at various rates are as follows:
Discount Rate PV Factor
14% 5.216
15% 5.018
16% 4.833
17% 4.658
What is the company’s internal rate of return? (choose the best answer)
A a. 15.1% c. 15.3%
b. 15.2% d. 15.4%
66. What is the approximate IRR for a project that costs P 50,000 and provides cash inflows of P 20,000 for 3 years?
A a. 10% c. 22%
b. 12% d. 27%
67. A weakness of the internal rate of return (IRR) approach for determining the acceptability of investments is that it
D a. Does not consider the time value of money.
b. Is not a straightforward decision criterion.
c. Implicitly assumes that the firm is able to reinvest project cash flows at the firms cost of capital.
d. Implicitly assumes that the firm is able to reinvest project cash flows at the projects internal rate of
return.
68. One disadvantage of using internal rate of return (IRR) is that it
B a. Provides a result that cannot be compared to other projects.
b. May not be used when cash flows vary from positive to negative in different years.
c. Is difficult for managers to understand the results of the calculation.
d. Can only use a limited number of years in calculating the result.
69. The payback reciprocal can be used to approximate a project’s
D a. Profitability index
b. Net present value
c. Accounting rate of return if the cash flow pattern is relatively stable
d. Internal rate of return if the cash flow pattern is relatively stable
70. If a company has computed the profitability index of an investment project as 1.15, then:
B a. The project’s internal rate of return is less than the discount rate
b. The project’s internal rate of return is greater than the discount rate
c. The project’s internal rate of return is equal to the discount rate
d. The relationship of rate of return and discount rate is impossible to determine from the data given
71. Del Gallego Company is considering several investment proposals, as shown below:
A B C D
Investment required 90,000 110,000 80,000 140,000
Present value of future cash inflows 105,000 120,000 100,000 170,000
Using the profitability index, what would be the ranking?
C a. D, B, A, C c. C, D, A, B
b. D, C, A, B d. C, A, D, B
72. Libmanan Co. uses a 12% hurdle rate for all capital expenditures. It has lined up four projects:
In Thousand Pesos
Project 1 Project 2 Project 3 Project 4
Initial cash outflow 400 596 496 544
Annual net cash inflows
Year 1 130 200 160 190
Year 2 140 270 190 250
Year 3 160 180 180 180
Year 4 80 130 160 160
Net present value (7,596) 8,552 28,128 29,324
Profitability index (%) 98% 101% 106% 105%
Internal rate of return 11% 13% 14% 15%
If the company has no budgetary limitations, which projects should be pursued?
C a. Projects 3 and 4 c. Projects 2, 3 and 4
b. Project 4 d. All the four projects
73. Sta. Elena Co. is considering two projects, A and B. The following information has been gathered on these projects:
Project A Project B
Initial investment needed P 40,000 P 60,000
Present value of future cash flows 60,000 85,000
Useful life 4 years 4 years
Based on this information, which of the following statements is (are) true?
I. Project A has the higher ranking according to the profitability index criterion.
II. Project B has the higher ranking according to the net present value criterion.
C a. Only I c. Both I and II
b. Only II d. Neither I nor II

74. The NPV and IRR methods give

A a. The same decision (i.e., accept or reject) for any single investment project
b. The same choice from among mutually exclusive investments
c. The same rankings of projects with unequal lives
d. The same rankings of projects with different required investments
75. The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net
present value method (NPV) may be different when
D a. The lives of the multiple projects are equal and the required investment sizes are equal.
b. The required rate of return equals the IRR of each project.
c. The required rate of return is higher than the IRR of each project.
d. Multiple projects have unequal lives and the size of the investment for each project is different.
76. Milaor Corporation is contemplating four projects, L, M, N, and O. The capital costs for the initiation of each project and
its estimated after-tax, net cash flows are listed below. The company’s desired after-tax opportunity costs is 12%. It has
P 900,000 capital budget for the year. Idle funds cannot be reinvested at greater than 12%.
In Thousand Pesos
L M N O
Initial cash outflow 400 470 380 420
Annual net cash inflows:
Year 1 113 180 90 80
Year 2 113 170 110 100
Year 3 113 150 130 120
Year 4 113 110 140 130
Year 5 113 100 150 150
Net present value P 7,540 P 59,654 P 54,666 (P 15,708)
Profitability index 1.02 1.13 1.14 0.96
Internal rate of return 12.7% 17.6% 17.2% 10.6%
The company will choose:
B a. Projects, M, N, and O c. Projects L and N
b. Projects M and N d. Projects L and M
77. In evaluating a capital budget project, the use of the net present value (NPV) model is generally not affected by the
C a. Projected salvage value
b. Initial cost of the project
c. Method of funding the project
d. Amount of added working capital needed for operations during the term of the project
78. A profitability index greater than one for a project indicates that:
A a. The discount rate is less than the internal rate of return
b. There has been a calculation error
c. The project is unattractive and should not be pursued
d. The company should reevaluate its cost of capital
79. Which is a basic difference between the IRR and book rate of return (BRR) criteria for evaluating investments?
D a. IRR emphasizes expenses and BRR emphasizes expenditures
b. IRR emphasizes revenues and BRR emphasizes receipts
c. IRR is used for internal investments and BRR is used for external investments
d. IRR concentrates on receipts and expenditures and BRR concentrates on revenues and expenses
80. If the IRR on an investment is zero,
D a. Its NPV is positive
b. It is generally a wise investment
c. Its cash flows decrease over its life
d. Its annual cash flows equal its required investment
81. The relationship between payback period and IRR is that
B a. A payback period of less than one-half the life of a project will yield an IRR lower than the target rate
b. The payback period is the present value factor for the IRR
c. A project whose payback period does not meet the company’s cutoff rate for payback will not meet the
company’s criterion for IRR
d. Both methods are discounted techniques
82. The internal rate of return on an investment
C a. Usually coincides with the company’s hurdle rate.
b. Disregards discounted cash flows.
c. May produce different rankings from the net present value method on mutually exclusive projects.
d. Would tend to be reduced if a company used an accelerated method of depreciation for tax purposes
rather than the straight-line method.
83. A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximize
shareholders wealth is to invest in all projects having
B a. Present value greater than zero.
b. Net present value greater than zero.
c. Internal rate of return greater than zero.
d. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.
84. A project that when accepted or rejected will not affect the cash flows of another project refers to:
B a. Dependent projects c. Mutually inclusive projects
b. Independent projects d. Mutually exclusive projects

85. Deciding whether or not an investment meets a predetermined company standard is called
B a. Payback decision c. Preference decision
b. Screening decision d. Profitability decision
86. A thorough evaluation of how well a project’s actual performance matches the projections made when the project was
proposed is called a
B a. Pre-audit c. Risk analysis
b. Post-audit d. Sensitivity analysis
87. Which procedure would most likely help managers identify errors in their capital budgeting decisions?
A a. Post-audits c. Value engineering
b. Scenario analysis d. Monte Carlo simulations
88. In capital budgeting, sensitivity analysis is used to:
D a. Evaluate mutually exclusive investments
b. Test the relationship of the IRR and NPV
c. Determine whether an investment is profitable
d. See how decision would be affected by changes in variables
89. How should the following projects be listed in the order of increasing risk?
C a. New venture, replacement, expansion c. Replacement, expansion, new venture
b. Replacement, new venture, expansion d. Expansion, replacement, new venture
90. A company wants to use discounted cash flow techniques when analyzing its capital investment projects. The company
is aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to adjust
for the uncertainty inherent in their estimates is to
C a. Prepare a direct analysis of the probability of outcomes
b. Increase the estimates of the cash flows
c. Adjust the minimum desired rate of return
d. Use accelerated depreciation
91. Assuming that an investment project’s cash flows are not changed but the assumed weighted-average cost of capital is
reduced. What impact would this have on the NPV and IRR of this project?
D a. Both NPV and IRR will increase c. Both NPV and IRR will not change
b. NPV decreases while IRR increases d. NPV increase while IRR will not change
Items 92 to 95 are based on the following information
Isarog Company has gathered the following data on a proposed investment project:
Investment required in equipment P 142,500
Annual cash inflows 30,000
Life of the investment 8 years
Required rate of return 10%
92. The payback period for the investment is closest to:
C a. 8.00 years c. 4.75 years
93. The simple rate of return on the investment is closest to:
A a. 8.55% c. 21.05%
b. 10.00% d. 33.55%
94. The net present value on this investment is closest to:
D a. P 300,000 c. P 58,800
b. P76,024 d. P 17,550
95. The internal rate of return on the investment is closest to:
A a. 13% c. 14%
b. 15% d. 12%
Bee-Cool, Inc. plans to introduce a new product. Returns largely depend on the degree of market acceptance:
Market Acceptance Probability Returns
Very weak 10% 0%
Weak 20% 10%
Moderate 40% 20%
Strong 20% 30%
Very Strong 10% 40%
96. Determine the expected value of the returns.
D a. 4% c. 16%
b. 10% d. 20%
97. Determine the standard deviation of the returns.
B a. 4.5% c. 20.99%
b. 10.95% d. 40%
98. Determine the coefficient of variation of the returns.
D a. 0.12 c. 0.40
b. 0.14 d. 0.55
99. Oragon has a weighted average cost of capital of 12% and is evaluating two mutually exclusive projects (AM and PM):
Project AM Project PM
Investment P 48,000 P 83,225
After-tax cash inflow 12,000 15,200
Asset life 6 years 10 years
What is the indifference point for the two projects?
B a. 12.00% c. 16.01%
b. 12.64% d. 19.33%

100. _________ is the chance of loss or the variability of returns associated with a given asset.
C a. Return c. Risk
b. Value d. Probability
101. The ___________ of an asset is the change in value plus any cash distributions expressed as percentage of the initial
price or amount invested
A a. Return c. Risk
b. Value d. Probability
102. If a person’s required return decreases for an increase in risk, that person is said to be
A a. Risk-seeking. c. Risk-averse.
b. Risk-indifferent. d. Risk-aware.
103. If a person required greater return when risk increases, that person is said to be
C a. Risk-seeking. c. Risk-averse.
104. If a person’s required return does not change when risk increases, that person is said to be
B a. Risk-seeking. c. Risk-averse.
105. Risk aversion is the behavior exhibited by managers who require a greater than proportional _________
B a. Increase in return, for a given decrease in risk.
b. Increase in return, for a given increase in risk.
c. Decrease in return, for a given increase in risk.
d. Decrease in return, for a given decrease in risk.
106. Last year, Sir K bought 100 shares of Swiftie Corporation common stock for P 53 per share. During the year, he received
dividends of P 1.45 per share. The stock is currently selling for P 60 per share. What rate of return did Sir K earn over
the year?
D a. 11.7% c. 14.1%
b. 13.2% d. 15.9%
Solution: [(60 – 53) + 1.45]  53
107. Prime-grade commercial paper will most likely have a higher annual return than an (a)
A a. Treasury bill c. Common stock
b. Preferred stock d. Investment-grade bond
108. An efficient portfolio is one that
B a. Maximizes risk for a given level of return c. Minimizes return for a given level of risk
b. Maximizes return for a given level of risk d. Maximizes return at all risk levels
109. The goal of an efficient portfolio is to
D a. Maximize risk for a given level of return c. Maximize risk in order to maximize profit
b. Maximize risk in order to maximize profit d. Minimize risk for a given level of return
110. Which asset would a risk-averse financial manager prefer?
Initial Investment
Asset A B C D
P 15,000 P 15,000 P 15,000 P 15,000
Annual Rate of Return
Asset A B C D
Pessimistic 8% 5% 3% 11%
Most likely 12% 12% 12% 12%
Optimistic 14% 13% 15% 14%
D a. Asset A c. Asset C
b. Asset B d. Asset D
111. The __________ is the extent of an asset’s risk. It is found by subtracting the pessimistic outcome from the optimistic
outcome.
D a. Return c. Probability distribution
b. Standard deviation d. Range
112. The __________ measures the dispersion around the expected value.
D a. Coefficient of variation c. Mean
b. Chi square d. Standard deviation
113. It is a measure of relative dispersion used in comparing the risk of assets with differing expected returns.
A a. Coefficient of variation c. Mean
b. Chi square d. Standard deviation
114. Given the following expected returns and standard deviations of assets B, M, Q, and D, which asset should the prudent
financial manager select?
Asset Expected Return Standard Deviation
B 10% 5%
M 16% 10%
Q 14% 9%
D 12% 8%
A a. Asset B c. Asset Q
b. Asset M d. Asset D
115. The ________ the coefficient of variation, the __________ the risk.
A a. Lower, lower c. Lower, higher
b. Higher, lower d. More stable, higher

116. The ____________ is a statistical measure of the relationship between series of numbers.
C a. Coefficient of variation c. Correlation
b. Standard deviation d. Probability
117. Perfectly __________ correlated series move exactly together and have a correlation coefficient of ________, while
perfectly __________ correlated series move exactly in opposite directions and have a correlation coefficient of
_________
D a. Negatively, -1, positively, +1 c. Positively, -1, negatively, +1
b. Negatively, +1, positively, -1 d. Positively, +1, negatively, -1
Expected Return (%)

Year Asset A Asset B Asset C
1 6 8 6
2 7 7 7
3 8 6 8
118. The correlation of returns between Asset A and Asset B can be characterized as
B a. Perfectly positively correlated. c. Uncorrelated.
b. Perfectly negatively correlated. d. Cannot be determined.
119. If you were to create a portfolio designed to reduce risk by investing equal proportions in each of two different assets,
which portfolio would you recommend?
A a. Assets A and B c. None of the available combinations
b. Assets A and C d. Cannot be determined
120. The portfolio with a standard deviation of zero
A a. Is comprised of Assets A and B. c. Is not possible.
b. Is comprised of Assets A and C. d. Cannot be determined.
121. Combining two negatively correlated assets to reduce risk is known as
A a. Diversification. c. Liquidation.
b. Valuation. d. Risk aversion.
122. Combining negatively correlated assets having the same expected return results in a portfolio with ________ level of
expected return and _________ level of risk.
C a. A higher, a lower c. The same, a lower
b. The same, a higher d. A lower, a higher
123. Combining positively correlated assets having the same expected return results in a portfolio with ______ level of
expected return and _______ level of risk.
B a. A higher, a lower c. The same, a lower
b. The same, a higher d. A lower, a higher
124. _____________ risk represents the portion of an asset’s risk that can be eliminated by combining assets with less than
perfect positive correlation.
A a. Diversifiable c. Systematic
b. Non-diversifiable d. Non-controllable risk
125. The relevant portion of an asset’s risk attributable to market factors that affect all firms is called
C a. Unsystematic risk c. Systematic risk
b. Diversifiable risk d. Controllable
126. The portion of an asset’s risk that is attributable to firm-specific, random causes is called
A a. Unsystematic risk c. Systematic risk
b. Non-diversifiable risk d. Non-controllable risk
127. Strikes, lawsuits, regulatory actions, and increased competition are all examples of
A a. Diversifiable risk c. Non-controllable risk
b. Non-diversifiable risk d. Systematic risk
128. War, inflation, and the condition of the foreign markets are all examples of
B a. Diversifiable risk c. Controllable risk
b. Non-diversifiable risk d. Unsystematic risk
129. Unsystematic risk is not relevant because
C a. It does not change c. It can be eliminated through diversification
b. It cannot be estimated d. It cannot be eliminated through diversification
130. The beta of the market
C a. Is greater than 1 c. Is 1
b. Is less than 1 d. Cannot be determined
131. A beta coefficient of +1 represents an asset that
A a. Has the same response as the market portfolio.
b. Is more responsive than the market portfolio.
c. Is less responsive than the market portfolio.
d. Is unaffected by market movement.
132. The higher an asset’s beta,
A a. The more responsive it is to changing market returns.
b. The less responsive it is to changing market returns.
c. The higher the expected returns will be in a down market.
d. The lower the expected return will be in an up market.
133. The purpose of adding an asset with a negative or low positive beta is to
B a. Reduce profit c. Increase profit
b. Reduce risk d. Increase risk

You are going to invest P20,000 in a portfolio consisting of assets X, Y, and Z, as follows:
Asset Annual Return Probability Beta Proportion
X 10% 0.50 1.2 0.333
Y 8% 0.25 1.6 0.333
Z 16% 0.25 2.0 0.333
134. What is the expected annual return of this portfolio? (Hint: use probability as weight)
C a. 11.4% c. 11.0%
b. 10.0% d. 11.7%
135. The beta of the portfolio containing assets X, Y, and Z is: (Hint: use proportion as weight)
C a. 1.5 c. 1.6
b. 2.4 d. 2.0
136. The beta of the portfolio indicates this portfolio
A a. Has more risk than the market.
b. Has less risk than the market.
c. Has an undetermined amount of risk compared to the market.
d. Has the same risk as the market.
137. Under the Capital Asset Pricing Model (CAPM), the beta coefficient is a measure of __________ risk and an index of the
degree of movement of an asset’s return in response to a change in the __________.
D a. Diversifiable, prime rate c. Diversifiable, bond index rate
b. Non-diversifiable, T-Bill rate d. Non-diversifiable, market return
138. An increase in non-diversifiable risk
B a. Would cause an increase in the beta and would lower the required return.
b. Would cause an increase in the beta and would increase the required return.
c. Would cause a decrease in the beta and would hence lower the required rate of return.
d. Would have no effect on the beta and would hence cause no changing in the required return.
139. An increase in the T-Bill rate ________ the required rate of return of a common stock.
A a. Increases c. Has no effect on
b. Decreases d. Cannot be determined by
140. As risk aversion increases
C a. A firm’s beta will increase c. Investor’s required rate of return will increase.
b. A firm’s beta will decrease d. Investor’s required rate of return will decrease.
Solutions and Clarifications to Selected Items
13. Cash OUT (Costs): 600,000 + 20,000 = 620,000
Cash IN (Savings): 380,000 - 40% (380,000 – 250,000) = 328,000
18. Cash flow after tax = Net income after tax + Depreciation
OLD Equipment: 54% (150,000 – 100,000) + 30,000 = 57,000
NEW Equipment: 54% (180,000 – 110,000) + 50,000 = 87,800
19. NEW MACHINE OLD MACHINE
Savings (before tax) P 100,000 Depreciation P 40,000
Less: depreciation (60,000) Tax rate X 40%
Income before tax P 40,000 Tax on Depreciation P 16,000
Less: tax (40%) (16,000)
Net income P 24,000 New Machine P 84,000
Add: depreciation 60,000 Old Machine (16,000)
Net cash flows (after tax) P 84,000 Net cash flows P 68,000
NOTE: The tax on ‘lost’ depreciation (P 16,000) is a cash flow deduction since the old machine is to be replaced (i.e., the tax shield on
depreciation of the old machine will be foregone).
Alternative solution: (100,000 – 20,000*) 60% + 20,000* = P 68,000 * Increase in depreciation: 60,000 (new) – 40,000 (old)
37. ARR (based on average investment): 7,000 (1 – 0.35) ÷ (120,000 + 12,000)/2
62. (80,000 – 27,270 – 29,736) ÷ 0.751
96. Expected value: 10% (0) + 20% (10%) + 40% (20%) + 20% (30%) + 10% (40%) = 20%
97. Standard Deviation: Square root of variance = √ 120% = 10.95% (rounded)
(A) (B) (C) (D) (E) (F)
Market Acceptance Returns Expected Value A–B C2 Probability DxE
Very weak 0% 20% -20% 400% 10% 40%
Weak 10% 20% -10% 100% 20% 20%
Moderate 20% 20% 0 0 40% 0
Strong 30% 20% +10% 100% 20% 20%
Very Strong 40% 20% +20% 400% 10% 40% .
Variance: 120%
98. Coefficient of variation: 10.95% ÷ 20%
99. Trial and error: NPV is the same for both projects at @ 12.64%
Project AM: 12,000 (4.038) – 48,000 = P 455 Project PM: 15,200 (5.505) – 83,225 = P 455
Answers and Solutions to Problem No. 9 (Page 5)
A) Payback period: 400,000 ÷ 160,000 = 2.5 years
B) Accounting rate of return (based on original investment): 80,000 ÷ 400,000 = 20%
C) Net present value: 160,000 (3.433) – 400,000 = P 149,280
D) Profitability index: 549,280 ÷ 400,000 = 1.37 times
E) Internal rate of return: 28.65% (approximation through trial and error or interpolation)
Answers to Problem No. 13 (Page 5)
(NOTE: some amounts and percentages are rounded-off)
Project Annual Cash Flow Investment Cost of Capital IRR NPV
1 P 45,000 P 188,640 14% (1) 20% (2) P 46,080
2 P 75,000 (3) P 337,050 12% 18% (4) P 86,700
3 (5) P 62,073 P 300,000 (6) 10% 16% P 81,440
4 (7) P 100,000 P 450,000 12% (8) 18% P 115,000

MS-44L (Capital Budgeting With Risks &amp; Returns)

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MS-44L (Capital Budgeting With Risks &amp; Returns)

Uploaded by

Copyright:

Available Formats

ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

CPA Review Batch 44  October 2022 CPA Licensure Examination

CAPITAL BUDGETING WITH INVESTMENT RISKS & RETURNS

Nature of Capital Investments FACTORS OF CONSIDERATION

Capital budgeting, after the selection Non-discounted methods Discounted methods

Page 1 of 18 0915-2303213  www.resacpareview.com

Page 2 of 18 0915-2303213  www.resacpareview.com

EXERCISES: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS

1. Net Investment for Decision-Making

2. Net Returns - Increase in Revenues

3. Net Returns - Cost Savings

Page 3 of 18 0915-2303213  www.resacpareview.com

4. Payback Period & ARR (Even Cash Flows)

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

5. Payback Period & ARR (Uneven Cash Flows)

6. Bail-Out Payback Period

7. Net Present Value (Even Cash Flows)

Year 0 PV factor Year 1 Year 2 Year 3 Year 4

Cash inflows before tax PV, Cash IN

Page 4 of 18 0915-2303213  www.resacpareview.com

9. Capital Budgeting Techniques

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

10. Equivalent Annual Annuity: Project with Unequal Lives

11. Crossover Rate - NPV Point of Indifference

13. Relationships: Discounted Techniques

Page 5 of 18 0915-2303213  www.resacpareview.com

Project Investment PV - Cash Flow NPV IRR (%) P. Index

15. Capital Budgeting under Risk: Coefficient of Variation

WRAP-UP EXERCISES (MULTIPLE-CHOICE)

Page 6 of 18 0915-2303213  www.resacpareview.com

Page 7 of 18 0915-2303213  www.resacpareview.com

Page 8 of 18 0915-2303213  www.resacpareview.com

Page 9 of 18 0915-2303213  www.resacpareview.com

Page 10 of 18 0915-2303213  www.resacpareview.com

Page 11 of 18 0915-2303213  www.resacpareview.com

Page 12 of 18 0915-2303213  www.resacpareview.com

Page 13 of 18 0915-2303213  www.resacpareview.com

74. The NPV and IRR methods give

Page 14 of 18 0915-2303213  www.resacpareview.com

Page 15 of 18 0915-2303213  www.resacpareview.com

Page 16 of 18 0915-2303213  www.resacpareview.com

Expected Return (%)

Page 17 of 18 0915-2303213  www.resacpareview.com

Page 18 of 18 0915-2303213  www.resacpareview.com

You might also like

MS-44L (Capital Budgeting With Risks & Returns)

MS-44L (Capital Budgeting With Risks & Returns)