Capital Budgeting Part 1 and 2

CAPITAL BUDGETING REVIEW
A. Net Investment for Decision-Making
1. 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. FREYA CORP. is planning to replace an old machine with the following related information:
Book value P300,000
Remaining useful life 5 years
Current market value 150,000
Additional information:
• The replacement machine can be acquired at a list price of P500,000. A 5% cash discount
is available if the said machine is paid within 30 days from acquisition date. Freight and
installation costs is estimated at P75,000.
• Should the company decide not to acquire the new machine, it needs to repair the old one
at a cost of P50,000. Otherwise, additional cost of removing the old unit is estimated at
P10,000.
• Additional gross working capital of P15,000 will be needed to support operation planned
with the new equipment.
• The new machine is estimated to reduce cash operating costs amounting to P150,000 per
year and is to be depreciated using the straight-line method over its useful life of 5 years.
• FREYA is subject to a 30% income tax rate.
REQUIRED:
(1) What is the net initial cost of investment to be used in decision making?
(2) What is the increase in annual net income?
(3) What is the increase in annual net cash flows if the company replaces the machine?
Net Returns - Increase in Revenues

3. 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.
1
Net Returns - Cost Savings

4. 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.
Payback and Rate of Return

5. BANE BUS TERMINAL INC. is planning to install vending machines with a cost of P300,000.
It is estimated that these vending machines will generate annual sales of 20,000 cups with a
price of P10 per cup. Cash variable costs are P4 per cup while cash fixed costs are expected to
be P50,000 per year. The vending machine’s estimated economic life would be 5 years with a
salvage value of P50,000 and depreciated using the straight-line method. BANE is subject to a
35% income tax rate.
REQUIREMENTS:
(a) Determine the payback period;
(b) Determine the accounting rate of return based on original investment;
(c) Determine the accounting rate of return based on the average Investment
6. 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
7. 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
8. 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.
2
Discounted Payback period

9. CHIZ INC. is considering two independent projects. Their related information is as follows:
PROJECT 1 PROJECT 2
Cost of investment 300,000 250,000
Estimated salvage value 30,000 20,000
Useful life 5 years 5 years
Cost savings:
1st Year 100,000 90,000
2nd Year 100,000 90,000
3rd Year 100,000 90,000
4th Year 100,000 90,000
5th Year 100,000 90,000
The income tax rate is 30% and the cut-off rate is 10%.
REQUIREMENT: Determine the discounted payback period of PROJECT 1 and PROJECT 2.
Net Present Value

10. Waira Inc. is planning to acquire a new asset with the following expectations:
Annual expected sales volume 80,000 units for five years

Selling price P15
Unit variable cost 6
Cost of required machinery 550,000
Salvage value 50,000
Annual cash fixed costs 100,000
Increase in receivables 60,000
Increase in inventory 40,000
The increase in working capital will be returned in full at the end of the five years. The tax rate is
30% and cost of capital is 12%.
REQUIREMENT:
1. How much is the project’s NPV?
2. What is the profitability index?
3. Compute ARR.
NPV, IRR, and PI (Even and Uneven Cash flows)

11. Bato 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%
3
Payback Reciprocal
12. Cocomelon 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?
CAPITAL RATIONING
13. Ismael Co. is contemplating four independent projects A, B, C and D. The company’s
desired aftertax opportunity costs is 12% and has P900,000 capital budget for the year. In
assisting the company in its decision making, the following information is provided:
Proposals Net Investment NPV IRR PI

A P400,000 P7,540 12.70% 1.02
B 470,000 59,654 17.60% 1.13
C 380,000 54,666 17.20% 1.14
D 420,000 (15,708) 10.60% 0.96
REQUIREMENT: Which projects should the company choose?
Techniques
14. Buko Co. 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
B) Profitability index
C) ARR (based on original investment)
D) Internal rate of return
E) Net present value

Capital Budgeting Part 1 and 2

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CAPITAL BUDGETING REVIEW

A. Net Investment for Decision-Making

Net Returns - Increase in Revenues

Net Returns - Cost Savings

Payback and Rate of Return

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

REQUIRED: Assuming a hurdle rate of 30%, determine:

Discounted Payback period

Net Present Value

Annual expected sales volume 80,000 units for five years

NPV, IRR, and PI (Even and Uneven Cash flows)

* This amount is to decline by P 20,000 annually thereafter.

REQUIRED: Round-off present value factors to three decimal places.

E) What is project 1’s internal rate of return?

F) What is project 2’s internal rate of return?

Proposals Net Investment NPV IRR PI

REQUIREMENT: Which projects should the company choose?

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

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