EXERCISES – CAPITAL BUDGETING

Strategic Cost Management

True-False
1. Payback period is the length of time it will take a company to recoup its outlay for an
investment.
2. Discounted cash flow techniques apply to investments that involve either costs only, or
both costs and revenues.
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.
5. If the IRR on a capital project is positive, its NPV will be positive.
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.
8. If IRR is less than the cost of capital, the NPV will be negative.
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.
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.
13. If a company has decided that a certain task must be performed and three machines
accomplish that task, the machine with the lowest initial cash outlay should be selected.
14. An investment with an IRR greater than cost of capital has a profitability index greater
than 1.
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.
17. Both the IRR and the book rate of return methods of analyzing investments should yield
the same decision.
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.
20. IRR and book rate of return will usually yield the same value for an investment.
Problems
1. An investment opportunity costing P180,000 is expected to yield net cash flows of P60,000
annually for five years.
a. Find the NPV of the investment at a cutoff rate of 12%.
b. Find the payback period of the investment.
c. Find the IRR on the investment.

2. Kirara is considering the purchase of a machine. Data are as follows:

Cost P100,000
Useful life 10 years
Annual straight-line depreciation P 10,000
Expected annual savings in cash operation costs P 18,000

Kirara'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.

3. Lolong Co. has the opportunity to introduce a new product. Lolong expects the product
to sell for P60 and to have per-unit 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 straight-line basis. Lolong's cost of capital is 10% and its
income tax rate is 40%.

a. Find the increase in annual after-tax cash flows for this opportunity.
b. Find the payback period on this project.
c. Find the NPV for this project.

4. Bolera has an investment opportunity costing P300,000 that is expected to yield the
following cash flows over the next six years:
Year One P75,000
Year Two P90,000
Year Three P115,000
Year Four P130,000
Year Five P100,000
Year Six P90,000

a. Find the payback period of the investment.

b. Find the book rate of return of the investment.
c. Find the NPV of the investment at a cutoff rate of 10%.

5. Melody Company is considering the sale of a machine with the following characteristics.

Book value P120,000

Remaining useful life 5 years
Annual straight-line depreciation P 24,000
Current market value P 70,000

If the company sells the machine its cash operating expenses will increase by P30,000 per
year due to an operating lease. The tax rate is 40%.

a. Find the cash flow from selling the machine.

b. Calculate the increase in annual net cash outflows as a result of selling the machine.
6. Jilly Company is considering replacing a machine that has the following characteristics.

Book value P100,000

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

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

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

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

7. Jerome Company is considering the purchase of a machine with the following

characteristics.

Cost P100,000
Useful life 10 years
Expected annual cash cost savings P30,000

Jerome's income tax rate is 40% and its cost of capital is 12%. Jerome expects to use
straight-line depreciation for tax purposes.

a. Compute the expected increase in annual net cash flow for this project.
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 and the machine fell into the 7-year MACRS
class? (increase decrease not affected.

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 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 straight-line basis. Jilly's cost of capital is 14% and its
income tax rate is 40%.

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

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 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 have the
investment in the new product return at least the 14% cost of capital.
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
new product. Find the amount by which Jilly's estimate of per-unit variable cost could
be in error and the investment still have a return at least equal to the 14% cost of
capital.
9. Jerome is considering the purchase of a machine. Data are as follows:

Cost P240,000
Useful life 10 years
Annual straight-line depreciation P ???
Expected annual savings in cash operation costs P 80,000
Additional working capital needed P100,000

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. he 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?