Capital Budgeting
MODULE 9
Risk & return
6. The higher the risk element in a project, the
A. more attractive the investment is.
B. higher the net present value is.
C. higher the cost of capital is.
D. higher the discount rate is.
CAPITAL BUDGETING
THEORIES:
Basic Concepts
Decision Making Process
2. The first step in the decision-making process is to
A. determine and evaluate possible courses of action.
B. identify the problem and assign responsibility.
C. make a decision.
D. review results of the decision.
9. Cost of capital is the
A. amount the company must pay for its plant assets.
B. dividends a company must pay on its equity securities.
C. cost the company must incur to obtain its capital resources.
D. cost the company is charged by investment bankers who handle the issuance of equity or
long-term debt securities.
Strategic planning
39. Strategic planning is the process of deciding on an organization’
A. minor programs and the approximate resources to be devoted to them
B. major programs and the approximate resources to be devoted to them
C. minor programs prior to consideration of resources that might be needed
D. major programs prior to consideration of resources that might be needed
14. How should the following projects be listed in order of increasing risk?
A. New venture, replacement, expansion.
B. Replacement, new venture, expansion.
C. Replacement, expansion, new venture.
D. Expansion, replacement, new venture.
Capital budgeting defined
1. The long-term planning process for making and financing investments that affect a company’s
financial results over a number of years is referred to as
A. capital budgeting
C. master budgeting
B. strategic planning
D. long-range planning
41. Problems associated with justifying investments in high-tech projects often include discount
rates that are too
A. low and time horizons that are too long
B. high and time horizons that are too long
C. high and time horizons that are too short
D. low and time horizons that are too short
3. Capital budgeting is the process
A. used in sell or process further decisions.
B. of determining how much capital stock to issue
C. of making capital expenditure decisions
D. of eliminating unprofitable product line
60. In evaluating high-tech projects,
A. only tangible benefits should be considered.
B. only intangible benefits should be considered.
C. both tangible and intangible benefits should be considered.
D. neither tangible nor intangible benefits should be considered.
5. A capital investment decision is essentially a decision to:
A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash inflows.
C. exchange current cash flow from operating activities for future cash inflows from investing
activities.
D. exchange current cash inflows for future cash outflows.
Types of capital projects
4. A project that when accepted or rejected will not affect the cash flows of another project.
A. Independent projects
C. Mutually exclusive projects
B. Dependent projects
D. Both b and c
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Capital Budgeting
recovered
A. at the end of the project’s life
B. in the first year of the project’s life
C. evenly through the project’s life
D. when the company goes out of businessA
Capital budgeting process
7. The normal methods of analyzing investments
A. cannot be used by not-for-profit entities.
B. do not apply if the project will not produce revenues.
C. cannot be used if the company plans to finance the project with funds already available
internally.
D. require forecasts of cash flows expected from the project.
32. XYZ Co. is adopting just-in-time principles. When evaluating an investment project that would
reduce inventory, how should XYZ treat the reduction?
A. Ignore it.
B. Decrease the cost of the investment and decrease cash flows at the end of the project’s
life.
C. Decrease the cost of the investment.
D. Decrease the cost of the investment and increase the cash flow at the end of the project’s
life.
Investments
Sale of old asset
38. When disposing of an old asset and replacing it with a new one, tax effect on
A. gain on sale of the old asset reduces the basis of the new asset
B. gain on sale of the old asset increases the basis of the new asset
C. loss on sale of the old asset reduces the basis of the new asset
D. b and c
Relevant cash flows
72. Which of the following represents the biggest challenge in the decision to purchase new
equipment?
A. Estimating employee training for the new project.
B. Estimating cash flows for the future.
C. Estimating transportation costs of the new equipment.
D. Estimating maintenance costs for the new equipment.
Working capital
18. A major difference between an investment in working capital and one in depreciable assets is
that
A. an investment in working capital is never returned, while most depreciable assets have
some residual value.
B. an investment in working capital is returned in full at the end of a project’s life, while an
investment in depreciable assets has no residual value.
C. an investment in working capital is not tax-deductible when made, nor taxable when
returned, while an investment in depreciable assets does allow tax deductions.
D. because an investment in working capital is usually returned in full at the end of the
project’s life, it is ignored in computing the amount of the investment required for the
project.
51. When a firm has the opportunity to add a project that will utilize factory capacity that is
currently not being used, which costs should be used to determine if the added project should
be undertaken?
A. Opportunity costs
C. Net present costs
B. Historical costs
D. Incremental costs
11. The only future costs that are relevant to deciding whether to accept an investment are those
that will
A. be different if the project is accepted rather than rejected.
B. be saved if the project is accepted rather than rejected.
C. be deductible for tax purposes.
D. affect net income in the period that they are incurred.
30. The proper treatment of an investment in receivables and inventory is to
A. ignore it
B. add it to the required investment in fixed assets
C. add it to the required investment in fixed assets and subtract it from the annual cash flows
D. add it to the investment in fixed assets and add the present value of the recovery to the
present value of the annual cash flows
Cash inflow
66. Which of the following is not a typical cash inflow in capital investment decisions?
31. In connection with a capital budgeting project, an investment in working capital is normally
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Capital Budgeting
A. Incremental revenues
B. Cost reductions
C. Salvage value
D. Additional working capital
from all of the following sources except:
A. debt financing
B. cost savings
C. salvage value
D. reduction in the amount of working capital
Out-of-pocket costs
45. Which of the following is a cost that requires a future outlay of cash that is which relevant for
future decision-making?
A. Opportunity cost
C. Sunk costs
B. Out-of-pocket cost
D. Relevant benefits
10. If Helena Company expects to get a one-year bank loan to help cover the initial financing of
one of its capital projects, the analysis of the project should
A. offset the loan against any investment in inventory or receivables required by the project.
B. show the loan as an increase in the investment.
C. show the loan as a cash outflow in the second year of the project’s life.
D. ignore the loan
Depreciation & Tax
22. If there were no income taxes,
A. depreciation would be ignored in capital budgeting.
B. the NPV method would not work.
C. income would be discounted instead of cash flow.
D. all potential investments would be desirable.
Sunk cost
29. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
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.
21. Relevant cash flows for net present value (NPV) models include all of the following except
A. outflows to purchase new equipment
B. depreciation expense on the newly acquired piece of equipment
C. reductions in operating cash flows as a result of using the new equipment.
D. cash outflows related to purchasing additional inventories for another retail store.
Accounting rate of return
54. The primary advantages of the average rate of return method are its ease of computation and
the fact that:
A. It is especially useful to managers whose primary concern is liquidity
B. There is less possibility of loss from changes in economic conditions and obsolescence
when the commitment is short-term
C. It emphasizes the amount of income earned over the life of the proposal
D. Rankings of proposals are necessary
55. When evaluating depreciation methods, managers who are concerned about capital
investment decisions will:
A. choose straight line depreciation so there is minimum impact on the decision.
B. use units of production so more depreciation expense will be allocated to the later years.
C. use accelerated methods to have as much depreciation in the early years of an asset’s
life.
D. choice of depreciation method has no impact on the capital investment decision.
Nondiscounted cash flow method
Payback method
36. There are several capital budgeting decision models that do not use discounted cash flows.
What is the name of the simple technique that calculates the total time it will take to recover,
using cash inflows from operations, the amount of cash invested in a project?
A. Recovery period
C. External rate of return
B. Payback model
D. Accounting rate of return
70. The tax consequences should be considered under which circumstances when making capital
investment decisions?
A. Positive net income
C. Depreciation
B. Disposal of an asset
D. All of the above
Irrelevant cash flows
Loan financing
43. In addition to incremental revenues, cash inflows from capital investments can be generated
34. The technique most concerned with liquidity is
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Capital Budgeting
A.
B.
C.
D.
Payback method.
Net present value technique.
Internal rate of return.
book rate of return.
D. Net present value and internal rate of return
Net present value
69. Discounted cash flow analysis is used in which of the following techniques?
A. Net present value
C. Cost of capital
B. Payback period
D. All of the above
73. Which of the following is a potential use of the payback method?
A. Help managers control the risks of estimating cash flows
B. Help minimize the impact of the investment on liquidity
C. Help control the risk of obsolescence
D. All of the answers are correct
8. The primary capital budgeting method that uses discounted cash flow techniques is the
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method.
47. The cash payback technique:
A. should be used as a final screening tool.
B. can be the only basis for the capital budgeting decision.
C. is relatively easy to compute and understand.
D. considers the expected profitability of a project.
20. The net present value (NPV) model can be used to evaluate and rank two or more proposed
projects. The approach that computes the total impact on cash flows for each option and then
converts these total cash flows to their present values is called the
A. differential approach
C. contribution approach
B. incremental approach.
D. total project approach.
33. Which of the following is NOT a defect of the payback method?
A. It ignores cash flows because it uses net income.
B. It ignores profitability.
C. It ignores the present values of cash flows.
D. It ignores the pattern of cash flows beyond the payback period.
40. The discount rate commonly used in present value calculations is the
A. treasury bill rate
B. weighted average return on assets adjusted for risk
C. risk free rate plus inflation rate
D. shareholders’ expected return on equity
48. The payback method, as a capital budgeting technique, assumes that all intermediate cash
inflows are reinvested to yield a return equal to:
A. Zero
C. The Discount Rate
B. The Time-Adjusted-Rate-of-Return
D. The Cost-of-Capital
52. Which of the following capital budgeting methods is the least theoretically correct?
A. payback method
C. internal rate of return
B. net present value
D. none of the above
44. Which is true of the net present value method of determining the acceptability of an
investment?
A. The initial cost of the investment is subtracted from the present value of net cash flows
B. The net cash flows are not adjusted to present value
C. A negative net present value indicates the investment should be undertaken
D. The net present value method requires no subjective judgments
Discounted cash flow method
49. Which of the following methods of evaluating capital investment projects incorporates the time
value of money?
A. Payback period, accounting rate of return, and internal rate of return
B. Accounting rate of return, net present value, and internal rate of return
C. Payback period and accounting rate of return
Profitability index
35. The profitability index
A. does not take into account the discounted cash flows.
B. Is calculated by dividing total cash flows by the initial investment.
C. allows comparison of the relative desirability of projects that require differing initial
investments.
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Capital Budgeting
D. will never be greater than 1.0.
B. equal to the cost of borrowed capital.
C. equal to zero.
D. lower than the company’s cutoff rate return.
Internal rate of return
56. According to the reinvestment rate assumption, which method of capital budgeting assumes
cash flows are reinvested at the project’s rate of return?
A. payback period
C. internal rate of return
B. net present value
D. none of the above
27. The relationship between payback period and IRR is that
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. none of the above.
62. The rate of interest that produces a zero net present value when a project’s discounted cash
operating advantage is netted against its discounted net investment is the:
A. Cost of capital
C. Cutoff rate
B. Discount rate
D. Internal rate of return
67. When comparing NPV and IRR, which is not true?
A. With NPV, the discount rate can be adjusted to take into account increased risk and the
uncertainty of cash flows
B. With IRR, cash flows can be adjusted to account for risk
C. NPV can be used to compare investments of various size or magnitude
D. Both NPV and IRR can be used for screening decisions
57. A weakness of the internal rate of return method for screening investment projects is that it:
A. Does not consider the time value of money
B. Implicitly assumes that the company is able to reinvest cash flows from the project at
the company’s discount rate
C. Implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return
D. Fails to consider the timing of cash flows
Sensitivity analysis
13. In capital budgeting, sensitivity analysis is used
A. to determine whether an investment is profitable.
B. to see how a decision would be affected by changes in variables.
C. to test the relationship of the IRR and NPV.
D. to evaluate mutually exclusive investments.
Comprehensive
50. Which of the following methods of evaluating capital investment projects do not use a
percentage as a measurement unit?
A. Payback period and net present value
B. Accounting rate of return and payback period
C. Net present value and internal rate of return
D. Internal rate of return and payback period
15. An approach that uses a number of outcome estimates to get a sense of the variability among
potential returns is
A. the discounted cash flow technique.
B. the net present value method.
C. risk analysis.
D. sensitivity analysis.
Relationships among NPV, PI & IRR
24. If a company’s required rate of return is 12 percent and in using the profitability index method,
a project’s index is greater than 1.0, this indicates that the project’s rate of return is
A. equal to 12 percent.
C. less than 12 percent.
B. greater than 12 percent.
D. dependent on the size of the investment.
42. Sensitivity analysis is the study of how the outcome of a decision making process
A. changes as one or more of the assumptions change
B. remains the same even though one or more of the assumptions change
C. changes even though one or more of the assumptions do not change
D. does not change as the assumptions do not change either
25. If the present value of the future cash flows for an investment equals the required investment,
the IRR is
A. equal to the cutoff rate.
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Capital Budgeting
A. Investment decisions
B. Screening decisions
64. Sensitivity analysis is:
A. An appropriate response to uncertainty in cash flow projections
B. Useful in measuring the variance of the Fisher rate
C. Typically conducted in the post investment audit
D. Useful to compare projects requiring vastly different levels of initial investment
C. Management decisions
D. Preference decisions
Payback period
46. If a payback period for a project is greater than its expected useful life, the
A. project will always be profitable.
B. entire initial investment will not be recovered.
C. project would only be acceptable if the company’s cost of capital was low.
D. project’s return will always exceed the company’s cost of capital.
IRR = 0
58. if the internal rate of return on an investment is zero:
A. its NPV is positive.
B. its annual cash flows equal its required investment.
C. it is generally a wise investment.
D. its cash flows decrease over its life.
Net present value
61. An analysis of a proposal by the net present value method indicated that the present value of
future cash inflows exceeded the amount to be invested. Which of the following statements
best describes the results of this analysis?
A. The proposal is desirable and the rate of return expected from the proposal exceeds the
minimum rate used for the analysis
B. The proposal is desirable and the rate of return expected from the proposal is less than
the minimum rate used for the analysis
C. The proposal is undesirable and the rate of return expected from the proposal is less than
the minimum rate used for the analysis
D. The proposal is undesirable and the rate of return expected from the proposal exceeds
the minimum rate used for the analysis
Change in NPV
59. Which of the following would decrease the net present value of a project?
A. A decrease in the income tax rate
B. A decrease in the initial investment
C. An increase in the useful life of the project
D. An increase in the discount rate
Effect of change in cost of capital
26. All other things being equal, as cost of capital increases
A. more capital projects will probably be acceptable.
B. fewer capital projects will probably be acceptable.
C. the number of capital projects that are acceptable will change, but the direction of the
change is not determinable just by knowing the direction of the change in cost of capital.
D. the company will probably want to borrow money rather than issue stock.
63. NPV indicates a project is deemed desirable (acceptable) when the NPV is
A. greater than or equal to zero
B. less than zero
C. greater than or equal to the risk-adjusted cost of capital
D. less than or equal to the risk-adjusted cost of capital
Effect of change in residual value
23. Assuming that a project has already been evaluated using the following techniques, the
evaluation under which technique is least likely to be affected by an increase in the estimated
residual value of the project?
A. Payback Period.
C. Net Present Value.
B. Internal Rate of Return.
D. Profitability Index.
Internal rate of return
12. If Arbitrary Company wants to use IRR to evaluate long-term decisions and to establish a
cutoff rate of return, it must be sure that the cutoff rate is
A. at least equal to its cost of capital.
B. at least equal to the rate used by similar companies.
C. greater than the IRR on projects accepted in the past.
D. greater than the current book rate of return.
Decision rules – independent projects
68. What type of decision involves deciding if an investment meets a predetermined standard?
NPV & IRR
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Capital Budgeting
19. The NPV and IRR methods give
A. the same decision (accept or reject) for any single investment.
B. the same choice from among mutually exclusive investments.
C. different rankings of projects with unequal lives.
D. the same rankings of projects with different required investments.
17. A thorough evaluation of how well a project’s actual performance matches the projections
made when the project was proposed is called a
A. pre-audit.
C. sensitivity analysis.
B. post-audit.
D. risk analysis.
37. A follow-up evaluation of a capital project is performed to see that investment expenditures are
proceeding on time and on budget, to compare actual cash flows with those originally
predicted, and to evaluate continuation of the project. This follow-up is called a
A. postaudit.
C. management audit
B. performance evaluation
D. project review
Decision rule – mutually exclusive projects
71. 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.
65. Companies use post audits to:
A. chastise managers whose project does not exceed projections.
B. prove to managers that they should have accepted projects they previously rejected.
C. have the managers revise poorly performing projects so the projects will have larger
return in the future.
D. provide feedback that enables managers to improve the accuracy of the projections of
future cash flows, thereby maximizing the quality of the firm’s capital investments.
28. In choosing from among mutually exclusive investments the manager should normally select
the one with the highest
A. Net present value.
C. Profitability index.
B. Internal rate return.
D. Book rate of return.
53. Why do the NPV method and the IRR method sometimes produce different rankings of
mutually exclusive investment projects?
A. The NPV method does not assume reinvestment of cash flows while the IRR method
assumes the cash flows will be reinvested at the internal rate of return.
B. The NPV method assumes a reinvestment rate equal to the discount rate while the IRR
method assumes a reinvestment rate equal to the internal rate of return.
C. The IRR method does not assume reinvestment of the cash flows while the NPV assumes
the reinvestment rate is equal to the discount rate.
D. The NPV method assumes a reinvestment rate equal to the bank loan interest rate while
the IRR method assumes a reinvestment rate equal to the discount rate.
PROBLEMS:
Net Investment
i. Bruell Company is considering to replace its old equipment with a new one. The old
equipment had a net book value of P100,000, 4 remaining useful life with P25,000
depreciation each year. The old equipment can be sold at P80,000. The new equipment
costs P160,000, have a 4-year life. Cash savings on operating expenses before 40% taxes
amount to P50,000 per year. What is the amount of investment in the new equipment?
A. P160,000
C. P 80,000
B. P 72,000
D. P 68,000
Post-audit
16. Post-audit of capital projects
A. is usually conclusive.
B. is done using different evaluation techniques than were used in making the original capital
budgeting decision.
C. provides a formal mechanism by which the company can determine whether existing
projects should be supported or terminated.
D. all of the above.
Operating Cash Flow
Cash Flow Before tax
ii. Taal Company is considering the purchase of a machine that promises to reduce operating
costs by equal amounts every year of its 6-year useful life. The machine will cost P840,000
and has no salvage value. The machine has a 20% internal rate of return. Taal Company is
subject to 40% income tax rate. The present value of 1 for 6 periods at 20% is 3.326, and at
the end of 6 periods is 0.3349.
The approximate annual cash savings before tax is closest to:
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Capital Budgeting
A. P252,555
B. P112,555
C. P187,592
D. P327,592
Third year
180,000
Fourth year
120,000
Fifth year
100,000
Maleen will use the sum-of-the-years-digits’ method to depreciate the new machine as follows:
First year
P150,000
Second year
120,000
Third year
90,000
Fourth year
60,000
Fifth year
30,000
The present value of 1 for 5 periods at 12 percent is 3.60478. The present values of 1 at 12
percent at end of each period are:
End of:
Period 1
0.89280
Period 2
0.79719
Period 3
0.71178
Period 4
0.63552
Period 5
0.56743
Had Maleen used straight-line method of depreciation instead of declining method, what is the
difference in net present value provided by the machine at a discount rate of 12 percent?
A. Increase of P 9,750
C. Decrease of P24,376
B. Decrease of P 9,750
D. Increase of P24,376
Increase in Annual Income Tax
iii. Mayon Company is considering replacing its old machine with a new and more efficient one.
The old machine has book value of P100,000, a remaining useful life of 4 years, and annual
straight-line depreciation of P25,000. The existing machine has a current market value of
P80,000. The replacement machine would cost P160,000, have a 4-year life, and will save
P50,000 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 should be the increase in annual
income taxes?
A. P14,000
C. P40,000
B. P28,000
D. P 4,000
Depreciation & Taxes
iv. Prime Consulting, Inc. operates consulting offices in Manila, Olongapo, and Cebu. The firm is
presently considering an investment in a new mainframe computer and communication
software. The computer would cost P6 million and have an expected life of 8 years. For tax
purposes, the computer can be depreciated using either straight-line method or Sum-of-theYears’-Digits (SYD) method over five years. No salvage value is recognized in computing
depreciation expense and no salvage value is expected at the end of the life of the equipment.
The company’s cost of capital is 10 percent and its tax rate is 40 percent.
The present value of annuity of 1 for 5 periods is 3.791 and for 8 periods is 5.335. The
present values of 1 end of each period are:
1
0.9091
5
0.6209
2
0.8264
6
0.5645
3
0.6513
7
0.5132
4
0.6830
8
0.4665
The present value of the net advantage of using SYD method of depreciation with a five-year
life instead of straight-line method of depreciating the equipment is:
A. P 86,224
C. P215,560
B. P115,168
D. P287,893
Accounting rate of return
Based on initial investment
vi. A piece of labor saving equipment that Marubeni Electronics Company could use to reduce
costs in one of its plants in Angeles City has just come onto the market. Relevant data relating
to the equipment follow:
Purchase cost of the equipment
P432,000
Annual cost savings that will be provided by the equipment
90,000
Life of the equipment
12 years
What is the simple rate of return to be provided by the equipment?
A. Between 15% and 18%.
C. 20.83%.
B. 25.00%.
D. 12.50%.
v. For P450,000, Maleen Corporation purchased a new machine with an estimated useful life of
five years with no salvage value. The machine is expected to produce cash flow from
operations, net of 40 percent income taxes, as follows:
First year
P160,000
Second year
140,000
Based on average investment
vii. The BIBO Company has made an investment in video and recording equipment that costs
P106,700. The equipment is expected to generate cash inflows of P20,000 per year. How
many years will the equipment have to be used to provide the company with a 10 percent
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Capital Budgeting
average accounting rate of return on its investment?
A. 7.28 years
C. 9.05 years
B. 5.55 years
D. 4.75 years
B. P550,000
D. P792,000
CFAT
xii. The Hills Company, a calendar company, purchased a new machine for P280,000 on January
1. Depreciation for tax purposes will be P35,000 annually for eight years. The accounting
(book value) rate of return (ARR) is expected to be 15% on the initial increase in required
investment. On the assumption of a uniform cash inflow, this investment is expected to
provide annual cash flow from operations, net of income taxes, of
A. P35,000
C. P42,000
B. P40,250
D. P77,000
viii. Show Company is negotiating to purchase an equipment that would cost P200,000, with the
expectation that P40,000 per year could be saved in after-tax cash operating costs if the
equipment were acquired. The equipment’s estimated useful life is 10 years, with no salvage
value, and would be depreciated by the straight-line method. Show Company’s minimum
desired rate of return is 12 percent. The present value of an annuity of 1 at 12 percent for 10
periods is 5.65. The present value of 1 due in 10 periods, at 12 percent, is 0.322.
The average accrual accounting rate of return (ARR) during the first year of asset’s use is:
A. 20.0 percent
C. 10.0 percent
B. 10.5 percent
D. 40.0 percent
Payback Period
xiii. If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of its tenyear life, and generates annual net cash inflows of P5,000 each year, the cash payback period
is
A. 8 years
C. 6 years
B. 7 years
D. 5 years
ix. An asset was purchased for P66,000. The asset is expected to last for 6 years and will have a
salvage value of P16,000. The company expects the income before tax to be P7,200 and the
tax rate applicable to the company is 30%. What is the average return on investment
(accounting rate of return)?
A. 17.6%
C. 10.9%
B. 7.6%
D. 12.3%
xiv. Consider a project that requires cash outflow of P50,000 with a life of eight years and a
salvage value of P5,000. Annual before-tax cash inflow amounts to P10,000 assuming a tax
rate of 30% and a required rate of return of 8%. Salvage value is ignored in computing
depreciation. The project has a payback period of
A. 5.0 years
C. 6.0 years
B. 5.6 years
D. 6.6 years
Net Investment
x. The Makabayan Company is planning to purchase a new machine which it will depreciate, for
book purposes, on a straight-line basis over a ten-year period with no salvage value and a full
year’s depreciation taken in the year of acquisition. The new machine is expected to produce
cash flows from operations, net of income taxes, of P66,000 a year in each of the next ten
years. The accounting (book value) rate of return on the initial investment is expected to be 12
percent. How much will the new machine cost?
A. P300,000
C. P550,000
B. P660,000
D. P792,000
xv. The following incomplete information is provided for an investment decision.
Discount
Discounted
Cumulative Cash
Year
Cash Flow
Factor (10%)
Cash Flows
Flows
0
P(450,000)
1.000
P(450,000)
P(450,000)
1
280,000
.909
254,520
2
210,000
.826
3
140,000
.751
Using break-even time (BET) analysis, when will the investment be recovered?
A. In 2.73 years
C. At the end of year 2
B. Longer than three years
D. In 2.21 years
xi. The Fields Company is planning to purchase a new machine which it will depreciate, for book
purposes, on a straight-line basis over a ten-year period with no salvage value and a full year’s
depreciation taken in the year of acquisition. The new machine is expected to produce cash
flow from operations, net of income taxes, of P66,000 a year in each of the next ten years.
The accounting (book value) rate of return on the initial investment is expected to be 12%.
How much will the new machine cost?
A. P300,000
C. P660,000
xvi. Orlando Corporation is considering an investment in a new cheese-cutting machine to replace
its existing cheese cutter. Information on the existing machine and the replacement machine
491
Capital Budgeting
follow:
Cost of the new machine
Net annual savings in operating costs
Salvage value now of the old machine
Salvage value of the old machine in 8 years
Salvage value of the new machine in 8 years
Estimated life of the new machine
What is the expected payback period for the new machine?
A. 4.44 years
C. 2.67 years
B. 8.50 years
D. 3.78 years
B. 1.9 years
P400,000
90,000
60,000
0
50,000
8 years
D. 2.5 years
xix. The Leisure Company is considering the purchase of electronic pinball machines to place in
amusement houses. The machines would cost a total of P300,000, have an eight-year useful
life, and have a total salvage value of P20,000. Based on experience with other equipment,
the company estimates that annual revenues and expenses associated with the machines
would be as follows:
Revenues form use
P200,000
Less operating expenses
Commissions to amusement houses
P100,000
Insurance
7,000
Depreciation
35,000
Maintenance
18,000
160,000
Net income
P 40,000
Ignoring the effect of income taxes, the payback period for the pinball machines would be
A. 3.73 years
C. 4.0 years
B. 3.23 years
D. 7.5 years
xvii. For P4,500,000, Siniloan Corporation purchased a new machine with an estimated useful life
of five years with no salvage value at its retirement. The machine is expected to produce cash
flow from operations, net of income taxes, as follows:
First year
P 900,000
Second year
1,200,000
Third year
1,500,000
Fourth year
900,000
Fifth year
800,000
Siniloan will use the sum-of-the-years-digits’ method to depreciate the new machine as
follows:
First year
P1,500,000
Second year
1,200,000
Third year
900,000
Fourth year
600,000
Fifth year
300,000
What is the payback period for the machine?
A. 3 years
C. 5 years
B. 4 years
D. 2 years
Net Present Value
xx. It is the start of the year and Agudelo Company plans to replace its old grinding equipment.
The following information are made available by the management:
Old
New
Equipment cost
P70,000
P120,000
Current salvage value
14,000
Salvage value, end of useful life
5,000
16,000
Annual operating costs
44,000
32,000
Accumulated depreciation
55,300
Estimated useful life
10 years
10 years
The company is not subject to tax and its cost of capital is 12%. What is the present value of
all the relevant cash flows at time zero?
A. (P 54,000)
C. (P106,000)
B. (P120,000)
D. (P124,700)
xviii.Paz Insurance Company’s management is considering an advertising program that would
require an initial expenditure of P165,500 and bring in additional sales over the next five years.
The cost of advertising is immediately recognized as expense. The projected additional sales
revenue in Year 1 is P75,000, with associated expenses of P25,000. The additional sales
revenue and expenses from the advertising program are projected to increase by 10 percent
each year. Paz Insurance Company’s tax rate is 40 percent.
The payback period for the advertising program is
A. 4.6 years
C. 3.0 years
xxi. Consider a project that requires an initial cash outflow of P500,000 with a life of eight years
and a salvage value of P20,000 upon its retirement. Annual cash inflow before tax amounts to
P100,000 and a tax rate of 30 percent will be applicable. The required minimum rate of return
for this type of investment is 8 percent. The present value of 1 and the annuity of 1,
discounted at 8 percent for 8 periods are 0.54 and 5.747, respectively. Salvage value is
492
Capital Budgeting
ignored in computing depreciation. The net present value amounts to
A. P 7,560
C. P 17,606
B. P 10,050
D. P 20,050
xxiv.
Mario Hernandez plans to buy a haymaker. It costs P175,000 and is expected to last for
five years. He presently hires 6 workers at P10,000 per month for each of the three harvesting
months each year. The equipment would eliminate the need for two workers. Hernandez uses
straight-line depreciation and projects a salvage value of P25,000. His tax rate is 25% and
opportunity cost of funds is 12.0%. The present value of 1discounted at 12 percent at the end
of 5 periods is 0.56743 and the present value of an annuity of 1 for 5 periods is 3.60478.
Which of the following is true?
A. The present value of cash flows in year 5 is P22,710
B. NPV is P28,436
C. NPV is P15,250
D. NPV is P14,186
xxii. Zap Manufacturing has an investment opportunity to embark on a project where yearly
revenues for five years are to be P400,000 and operating costs of P104,800. The equipment
costs P1 million, and straight-line depreciation will be used for book and tax purposes. No
salvage value is expected at the end of the project’s life. The company has a 40 percent
marginal tax rate and a 10 percent cost of capital. The equipment manufacturer has offered a
delayed payment plan of P560,500 per year at the end of the first and second years. There will
be no changes in working capital.
The present value of annuity of 1 for 5 periods is 3.7908 at 10 percent.
The present values of 1 end of each period at 10 percent are:
Period 1
0.9091
Period 2
0.8264
Period 3
0.7513
Period 4
0.6830
Period 5
0.6209
The net present value if the equipment were purchased is
A. P (87,977)
C. P 1,922
B. P (25,310)
D. P (61,094)
xxv. Tabucol Aggregates, Inc. plans to replace one of its machines with a new efficient one. The
old machine has a net book value of P120,000 with remaining economic life of 4 years. This
old machine can be sold for P80,000. If the new machine were acquired, the cash operating
expenses will be reduced from P240,000 to P160,000 for each of the four years, the expected
economic life of the new machine. The new machine will cost Tabucol a cash payment to the
dealer of P300,000. The company is subject to 32 percent tax and for this kind of investment,
a marginal cost of capital of 9 percent. The present value of annuity of 1 and the present
value of 1 for 4 periods using 9 percent are 3.23972 and 0.70843, respectively.
The net present value to be provided by the replacement of the old machine is
A. P28,493
C. P46,794
B. P15,693
D. P59,594
xxiii.Paz Insurance Company’s management is considering an advertising program that would
require an initial expenditure of P165,500 and bring in additional sales over the next five years.
The cost of advertising is immediately recognized as expense. The projected additional sales
revenue in Year 1 is P75,000, with associated expenses of P25,000. The additional sales
revenue and expenses from the advertising program are projected to increase by 10 percent
each year. Paz Insurance Company’s tax rate is 40 percent.
The present value of 1 at 10 percent, end of each period:
Period
Present value of 1
1.
0.90909
2.
0.82645
3.
0.75131
4.
0.68301
5.
0.62092
The net present value of the advertising program would be
A. P 37,064
C. P 29,136
B. P(37,064)
D. P(29,136)
xxvi.
Zambales Mines, Inc. is contemplating the purchase of equipment to exploit a mineral
deposit that is located on land to which the company has mineral rights. An engineering and
cost analysis has been made, and it is expected that the following cash flows would be
associated with opening and operating a mine in the area.
Cost of new equipment and timbers
2,750,000
Working capital required
1,000,000
Net annual cash receipts*
1,200,000
Cost to construct new road in three years
400,000
Salvage value of equipment in 4 years
650,000
*Receipts from sales of ore, less out-of-pocket costs for salaries, utilities, insurance, etc.
It is estimated that the mineral deposit would be exhausted after four years of mining. At that
point, the working capital would be released for reinvestment elsewhere. The company’s
discount rate is 20%.
493
Capital Budgeting
The net present value for the project is:
A. P 454,620.
B. P (79,303).
Total fixed costs
P21,000
Estimated cash value of machines:
December 31, 2006
P40,000
December 31, 2012
P 7,000
Assume all operating revenues and expenses occur at the end of the year.
The net advantage in present value of the better alternative is:
A. Retain Old Machine, P61,675.
B. Buy New Machine, P61,675.
C. Retain Old Machine, P16,345.
D. Buy New Machine, P16,345.
C. P(561,553)
D. P(204,688).
With inflation
xxvii. By the end of December 31, 2005, Alay Foundation is considering the purchase of a
copying machine for P80,000. The expected annual cash savings are expected to be
P32,000 in the next four years. At the end of the four years, the machine will be discarded
without any salvage value. All the cash savings are stated in number of pesos at December
31, 2006. The company expected that the inflation rate is constantly 5 percent each year.
Hence, the first year’s cash inflow was adjusted for 5 percent inflation. For simplicity, all cash
inflows are assumed to be at year-end.
The present value at 14 % of 1 for 4 periods is 2.91371. The present value of 1 at end of
each period are:
Period 1
0.87719
Period 2
0.76947
Period 3
0.67497
Period 4
0.59208
Using the nominal rate of return of 14 percent, the net present value for this machine is
A. P12,239
C. P13,419
B. P19,670
D. P27,936
P 11,000
P120,000
P 20,000
Profitability index
xxix.
The Pambansang Kamao Corporation has to replace its completely damaged boiler
machine with a new one. The old machine has a net book value of P100,000 with zero market
value; therefore it will give a tax shield, based on 35% tax rate if replaced, by P35,000. The
company has a 10 percent cost of capital. Understandably, the new machine, through a
uniform decrease in cash operating costs, will give a positive net present value, because this
machine will provide an internal rate of return of 12 percent.
The present values at 10% and 12%, respectively, are:
10%
12%
Annuity of 1, 6 periods
4.35526
4.11141
1 end of 6 periods
0.56447
0.50663
If the machine were to be depreciated using straight-line method for 6 years without any
salvage value, the estimated profitability index is:
A. 1.20
B. 1.06
C. 1.07
D. Cannot be determined from the information
xxviii. Perpetual Foundation, Inc., a nonprofit organization, has one of its activities, the
production of cookies for its snack food store. Several years ago, Perpetual Foundation, Inc.
purchased a special cookie-cutting machine. As of December 31, 2006, this machine will have
been used for three years. Management is considering the purchase of a newer, more
efficient machine. If purchased, the new machine would be acquired on December 31, 2006.
Management expects to sell 300,000 dozen cookies in each of the next six years. The selling
price of the cookies is expected to average P1.15 per dozen.
Perpetual Foundation, Inc. has two options: continue to operate the old machine, or sell the
old machine and purchase the new machine. No trade-in was offered by the seller of the new
machine. The following information has been assembled to help management decide which
option is more desirable.
Old Machine
New Machine
Original cost of machine at acquisition
P80,000
P120,000
Remaining useful life as of 12/31/06
6 years
6 years
Expected annual cash operating expenses:
Variable cost per dozen
P0.38
P0.29
xxx. The Mejicano Company is planning to purchase a piece of equipment that will reduce annual
cash expenses over its 5-year useful life by equal amounts. The company will depreciate the
equipment using straight-line method of depreciation based on estimated life of 5 years
without any salvage value. The company is subject to 40 percent tax. The marginal cost of
capital for this acquisition is 11.055 percent. The management accountant calculated that the
internal rate of return based on the estimated after-tax cash flows is 12.386 percent and a net
present value of P10,000. The president, however, wants to know the profitability index before
he finally decides.
What is the profitability index for this investment?
494
Capital Budgeting
A. 1.011
B. 1.034
C. 1.022
D. 1.044
Information on present value and future amount factors is as follows:
PERIOD
1
2
3
Present value of P1 at 10%
.909
.826
.751
Present value of an annuity of P1 at 10%
.909 1.736 2.487
Future amount of P1 at 10%
1.100 1.210 1.331
Future amount of an annuity of P1 at
1.00 2.100 3.310
10%
Internal Rate of Return
xxxi.
Diamond Company is planning to buy a coin-operated machine costing P400,000. For
book and tax purposes, this machine will be depreciated P80,000 each year for five years.
Diamond estimates that this machine will yield an annual inflow, net of depreciation and
income taxes, of P120,000. Diamond’s desired rate of return on its investments is 12%. At
the following discount rates, the NPVs of the investment in this machine are:
Discount Rate
NPV
12%
+P3,258
14%
+ 1,197
16%
- 708
18%
- 2,474
Diamond’s expected IRR on its investment in this machine is
A. 3.25%
C. 16.00%
B. 12.00%
D. 15.30%
4
.683
3.170
1.464
4.641
5
.621
3.791
1.611
6.105
How much will the machine cost?
A. P 32,220
B. P 62,100
C. P 75,820
D. P122,100
Required unit sales
xxxv. Paper Products Company is considering a new product that will sell for P100 and has a
variable cost of P60. Expected volume is 20,000 units. New equipment costing P1,500,000
and having a five-year useful life and no salvage value is needed, and will be depreciated
using the straight-line method. The machine has fixed cash operating costs of P200,000 per
year. The firm is in the 40 percent tax bracket and has cost of capital of 12 percent. The
present value of 1, end of five periods is 0.56743; present value of annuity of 1 for 5 periods is
3.60478.
How many units per year the firm must sell for the investment to earn 12 percent internal rate
of return?
A. 17,338
C. 9,838
B. 28,897
D. 12,338
Required investment
xxxii. Kipling Company has invested in a project that has an eight-year life. It is expected that
the annual cash inflow from the project will be P20,000. Assuming that the project has a
internal rate of return of 12%, how much was the initial investment in the project if the
present value of annuity of 1 for 8 periods is 4.968 and the present value of 1 is 0.404?
A. P160,000
C. P 80,800
B. P 99,360
D. P 64,640
Required selling price
xxxvi. Bughaw Products Company is considering a new product that will sell for P100 and has a
variable cost of P60. Expected sales volume is 20,000 units. New equipment costing
P1,500,000 with a five-year useful life and no terminal salvage value is needed. The machine
will be depreciated using the straight-line method. The machine has cash operating costs of
P200,000 per year. The firm is in the 40 percent tax bracket and has cost of capital of 12
percent. The present value of 1, end of five periods is 0.56743; present value of annuity of 1
for 5 periods is 3.60478.
Suppose the 20,000 estimated sales volume is sound, but the price is in doubt, what is the
selling price (rounded to nearest peso) needed to earn a 12 percent internal rate of return?
A. P81.00
C. P70.00
B. P95.00
D. P90.00
xxxiii. Katol Company invested in a machine with a useful life of six years and no salvage value.
The machine was depreciated using the straight-line method. It was expected to produce
annual cash inflow from operations, net of income taxes, of P6,000. The present value of an
ordinary annuity of P1 for six periods at 10% is 4.355. The present value of P1 for six periods
at 10% is 0.564. Assuming that Katol used a time- adjusted rate of return of 10%, what was
the amount of the original investment?
A. P10,640
C. P22,750
B. P29,510
D. P26,130
xxxiv. The Forest 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, net of
income taxes, of P20,000 in each of the five years. Forest’s expected rate of return is 10%.
495
Capital Budgeting
Required CFBT
xxxvii. Aloha Co. is considering the purchase of a new ocean-going vessel that could potentially
reduce labor costs of its operation by a considerable margin. The new ship would cost
P500,000 and would be fully depreciated by the straight-line method over 10 years. At the end
of 10 years, the ship will have no value and will be sunk in some already polluted harbor. The
Aloha Co.’s cost of capital is 12 percent, and its marginal tax rate is 40 percent. If the ship
produces equal annual labor cost savings over its 10-year life, how much do the annual
savings in labor costs need to be to generate a net present value of P0 on the project?
Use the following PV: annuity of 1, 10 periods at 12% - 5.6502; end of 10th period – 0.32197.
A. P 68,492
C. P114,154
B. P147,487
D. P 88,492
3.
4.
5.
6.
Estimated net annual cash inflows for each of the 8 years – P81,000.
Time-adjusted internal rate of return – 14%
Cost of capital of Bayan Muna – 16%
The table of present values of P1 received annually for 8 years has these factors: at
14% = 4.639, at 16% = 4.344
7. Depreciation is approximately P46,970 annually.
Find the required increase in annual cash inflows in order to have the time-adjusted rate of
return approximately equal the cost of capital.
A. P6,501
C. P4,344
B. P5,501
D. P5,871
Required CFAT for a certain year
xli. A company is considering putting up P50,000 in a three-year project. The company’s
expected rate of return is 12%. The present value of P1.00 at 12% for one year is 0.893, for
two years is 0.797, and for three years is 0.712. The cash flow, net of income taxes will be
P18,000 (present value of P16,074) for the first year and P22,000 (present value of P17,534)
for the second year. Assuming that the rate of return is exactly 12%, the cash flow, net of
income taxes, for the third year would be
A. P23,022
C. P10,000
B. P 7,120
D. P16,392
Required CFAT
xxxviii. Prudu Company has decided to invest in some new equipment. The equipment will have
a three-year life and will produce a uniform series of cash savings. The net present value of
the equipment is P1,750, using a discount rate of 8 percent. The internal rate of return is 12
percent.
Present values at 8% and 12% respectively:
8%: Annuity – 2.5771; end of 3 periods,
0.7938
12%: Annuity – 2,4018; end of 3 periods,
0.7118
What is the amount of annual cash inflow?
A. P 9,980
C. P23,240
B. P21,342
D. P12,351
Required salvage value
xlii. The Caravan Company is contemplating to purchase a machine that costs P800,000. The
machine is expected to last for 5 years with a salvage value of P50,000 at the end of the fifth
year. If the machine were purchased, before-tax annual cash savings on operating expenses
will be realized. Caravan Company will depreciate the machine using straight-line
depreciation for 5 years, with the salvage value considered in the computation.
The company has a 12 percent cost of capital and is subject to 40 percent tax rate.
The present values using 12 percent are:
Annuity of 1 for 5 periods
3.60478
Present value of 1, end of 5 periods
0.56743
The initial analysis indicated a net present value of P7,003. You believe the estimated beforetax cash savings are fairly determined but you are in doubt of the expected salvage value of
the machine.
How much is the estimated salvage value required if the investment has to yield an IRR of 12
percent?
A. P41,800
C. P25,100
B. P24,900
D. P44,600
xxxix. An asset is purchased for P120,000. It is expected to provide an additional P28,000 of
annual net cash inflows. The asset has a 10-year life and an expected salvage value of
P12,000. The hurdle rate is 10%. The present value of an annuity factor of 10% for 10 years is
6.1446, and the present value of P1, discounted for 10 years at 10% is 0.3855.
Given the data provided, the minimum amount of annual cash inflows that would provide the
10% time-adjusted return is approximately
A. P18,776
C. P24,400
B. P26,600
D. P22,535
Required Increase in CFAT
xl. The following data pertain to Julian Corp. whose management is planning to purchase a unit of
equipment.
1. Economic life of equipment – 8 years.
2. Disposal value after 8 years – Zero.
496
Capital Budgeting
xlvi. Silky Products is considering two pieces of machinery. The first machine costs P50,000 more
than the second machine. During the two-year life of these two alternatives, the first machine
has a P155,000 more cash flow in year one and a P110,000 less cash flow in year two than
the seconds machine. All cash flows occur at year-end. The present value of 1 at 15 percent
end of 1 period and 2 periods are 0.86957 and, 0.75614, respectively. The present value of 1
at 8 percent end of period 1 is 0.92593, and Period 2 is 0.85734.
At what discount rate would Machine 1 be equally acceptable as machine 2’s?
A. 9%
C. 11%
B. 10%
D. 12%
Required value of intangible benefits
xliii. Solidum Company is investigating the purchase of a piece of automated equipment that will
save P100,000 each year in direct labor and inventory carrying costs. This equipment costs
P750,000 and is expected to have a 10-year useful life with no salvage value. The company
requires a minimum 15% return on all equipment purchases. Management anticipates that this
equipment will provide intangible benefits such as greater flexibility and higher quality output.
The PV of annuity of 1, 15% for 10 periods
5.01877
The PV of 1, end 10 period
0.24718
What peso value per year would these intangible benefits have to have in order to make the
equipment an acceptable investment?
A. P248,123
C. P 61,331
B. P 49,440
D. P 55,000
Decision Rule – Independent Projects
xlvii.Sylvia Products is considering two types of machinery. The first machine costs P50,000 more
than the second machine. During the two-year life of these two alternatives, the first machine
has a P155,000 more cash flow in year one and a P110,000 less cash flow in year two than
the seconds machine. All cash flows occur at year-end. The present value of 1 at 15 percent
end of 1 period and 2 periods are 0.86957 and, 0.75614, respectively. The present value of
1 at 8 percent end of period 1 is 0.92593, and Period 2 is 0.85734.
Which machine should be purchased if the relevant discount rates are 15 percent and 8
percent, respectively?
15% Discount
8% Discount
A.
Machine 1
Machine 1
B.
Machine 2
Machine 2
C.
Machine 1
Machine 2
D.
Machine 2
Machine 1
xliv. Altas, Inc., is considering investing in automated equipment with a ten-year useful life.
Managers at Altas have estimated the cash flows associated with the tangible costs and
benefits of automation, but have been unable to estimate the cash flows associated with the
intangible benefits. Using the company’s 10% discount rate, the net present value of the
cash flows associated with just the tangible costs and benefits is a negative P184,350. The
present value of annuity of 1 at 10 percent for ten years is 6.145 while the present value of 1
is 0.386. How large would the annual net cash inflows from the intangible benefits have to
be to make this a financially acceptable investment?
A. P18,435.
C. P35,000.
B. P30,000.
D. P37,236.
Indifference Point
xlv. Moon Company uses a 10% discount rate and the total cost approach to capital budgeting
analysis. Both alternatives are Akda Investments which has a marginal cost of capital of 12
percent is evaluating two mutually exclusive projects (X and Y), which have the following
projections:
PROJECT X
PROJECT Y
Investment
P48,000
P83,225
After-tax cash inflow
12,000
15,200
Asset life
6 years
10 years
The indifference point for the two projects is
A. 12.64%
C. 12.00%
B. 16.01%
D. 19.33%
Comprehensive
Payback, NPV, ARR
Question Nos. 71 through 73 are based on the following:
Cayco Medical Center is considering purchasing an ultrasound machine for P950,000. The
machine has a 10 – year life and an estimated salvage value of P55,000. Installation costs and
freight charges will be P24,200 and P800, respectively. Newman uses straight-line depreciation.
The medical center estimates that the machine will be used five times a week with the average
charges to the patient for ultrasound of P800. There are P10 in medical supplies and P40 of
technician costs for each procedure performed using the machine. The present value of an annuity
of 1 for 10 years at 9% is 6.418 while the present value of 1 for 10 years at 9% is 0.42241
497
Capital Budgeting
xlviii. The cash payback period is:
A. 3.0 years
B. 4.5 years
Questions 1 through 4 will be based on the following data:
The management of Arleen Corporation is considering the purchase of a new machine costing
P400,000. The company’s desired rate of return is 10%. The present value of P1 at compound
interest of 10% for 1 through 5 years are 0.909, 0.826, 0.751, 0.683, and 0.621, respectively, and
the present value of annuity of 1 for 5 periods at 10 percent is 3.79. In addition to the foregoing
information, use the following data in determining the acceptability in this situation:
C. 5.0 years
D. 6.0 years
xlix. The project is expected to generate net present value of:
A. P276,510
C. P331,510
B. P299,743
D. P253,277
l.
Year
1
2
3
4
5
What is the accounting rate of return provided by the project?
A. 20.0 percent
C. 11.2 percent
B. 10.6 percent
D. 38.0 percent
NPV, CFAT, Maximum lost unit sales
Question Nos. 75 through 77 are based on the following:
Kabalikat Company has the opportunity to introduce a new product. Kabalikat expects the product
to sell for P75 with variable cost per unit of P50. The annual fixed costs, excluding the amount of
depreciation is P4,500,000. The company expects to sell 300,000 units. To produce the new
product line, the company needs to purchase a new machine that costs P6,000,000. The new
machine is expected to last for four years with a very negligible salvage value. The company has a
policy of depreciating its machine for both book and tax purposes for four years. The company has
a marginal cost of capital of 13.75 percent and is subject to tax rate of 40 percent.
li.
Net Cash Flow
P180,000
120,000
100,000
90,000
90,000
liv. The average rate of return for this investment is:
A. 18 percent
C. 58 percent
B. 6 percent
D. 10 percent
lv. The net present value for this investment is:
A. Positive P 36,400
B. Positive P 55,200
The amount of annual after-tax cash flows is:
A. P2,400,000
C. P 900,000
B. P3,000,000
D. P1,500,000
lii. The machine’s net present value is:
A. P2,786,100
B. P 928,500
Income from Operations
P100,000
40,000
20,000
10,000
10,000
C. Negative P 99,600
D. Negative P126,800
lvi. The present value index for this investment is:
A. 0.88
C. 1.14
B. 1.45
D. 0.70
lvii. The cash payback period for this investment is:
A. 4 years
C. 20 years
B. 5 years
D. 3 years
C. P1,028,900
D. P 150,270
liii. Assuming that some of the 300,000 units that are expected as sales would be to group of
customers who currently buy K-Z, another product of Kabalikat Company. This Product K-Z
sells for P35 with variable cost of P20. How many units of K-Z can Kabalikat afford to lose
before the purchase of the new machine becomes unattractive?
A. 39,000 units
C. 16,714 units
B. 23,400 units
D. 10,029 units
Payback, NPV, ARR, IRR
Use the following information for questions 67 - 70
Pillo Company is considering two capital investment proposals.
Estimates regarding each project are provided below:
ARR, NPV, PI, Payback
Initial investment
498
Project MA
P2000,000
Project PA
P300,000
Capital Budgeting
Annual net income
Net annual cash inflow
Estimated useful life
Salvage value
10,000
50,000
5 years
-0-
21,000
71,000
6 years
-0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Period
5
6
9%
3.890
4.486
10%
3.791
4.355
lviii. The cash payback period for Project MA is
A. 20 years
B. 10 years
11%
3.696
4.231
12%
3.605
4.111
C. P 50,000
D. P 9,205
lx. The annual rate of return for Project MA is
A. 5%
B. 10%
C. 25%
D. 50%
lxiv. Payback amounts to
A. 5.0 years
B. 5.6 years
C. 6.0 years
D. 6.6 years
lxv. Net present value amounts to
A. P 756
B. P1,005
C. P1,756
D. P2,005
CFAT, NPV, IRR
Questions 46 rough 51 are based on the following:
Home’s Pizza’s, Inc., operates pizza shops in several cities. One of the company’s most profitable
shops is located adjacent to the large CPA review center in Manila. A small bakery next to the shop
has just gone out of business, and Home’s Pizzas has an opportunity to lease the vacated space
for P18,000 per year under a 15-year lease. Home’s management is considering two ways in which
the available space might be used.
Alternative 1. The pizza shop in this location is currently selling 40,000 pizzas per year.
Management is confident that sales could be increased by 75% by taking out the wall between the
pizza shop and the vacant space and expanding the pizza outlet. Costs for remodeling and for new
equipment would be P550,000. Management estimates that 20% of the new sales would be small
pizzas, 50% would be medium pizzas, and 30% would be large pizzas. Selling prices and costs for
ingredients for the three sizes of pizzas follow (per pizza):
lxi. The internal rate of return for Project PA is closest to
A. 10%
C. 12%
B. 11%
D. none of these
Depreciation tax shield, CCFAT, Payback, NPV, IRR
Question Nos. 86 through 90 are based on the following:
Consider a project that requires cash outflow of P50,000 with a life of eight years and a salvage
value of P2,000. Annual cash inflow amounts to P10,000 assuming a tax rate of 30% and a
required rate of return of 8%. Salvage value is ignored in computing depreciation.
lxii. Annual depreciation tax shield amounts to
A. P1,875
B. P7,000
C. P 8,875
D. P10,000
lxvi. Internal rate of return on this project is approximatel
A. 8.0%
C. 9.0%
B. 8.5%
D. 9.5%
C. 5 years
D. 4 years
lix. The net present value for Project PA is
A. P309,204
B. P 91,456
lxiii. Annual cash flow after tax amounts to
A. P 1,875
B. P 7,000
Small
Medium
Large
C. P8,875
D. P10,000
Selling Price
P 6.70
8.90
11.00
Cost of Ingredients
P1.30
2.40
3.10
An additional P7,500 of working capital would be needed to carry the larger volume of business.
499
Capital Budgeting
This working capital would be released at the end of the lease term. The equipment would have a
salvage value of P30,000 in 15 years, when the lease ends.
Alternative 2. Home’s sales manager feels that the company needs to diversify its operations. He
has suggested that an opening be cut in the wall between the pizza shop and the vacant space
and that video games be placed in the space, along with a small snack bar. Costs for remodeling
and for the snack bar facilities would be P290,000. The games would be leased from a large
distributor of such equipment. The distributor has stated that based on the use of game centers
elsewhere, Home’s could expect about 26,000 people to use the center each year and to spend an
average of P5 each on the machines. In addition, it is estimated that the snack bar would provide a
net cash inflow of P15,000 per year. An investment of P4,000 in working capital would be needed.
This working capital investment would be released at the end of the lease term. The snack bar
equipment would have a salvage value of about P12,000 in 15 years.
B. P47,840
lxx. The net present value for Alternative 2 is:
A. P21,021
B. P70,103
Rent- building space
Rent- video games
Salaries
Utilities
Insurance and other
lxxii.The sales manager has suggested that an advertising program be initiated to draw another
5,000 people into the game center each year. Assuming that another 5,000 people can be
attracted into the center and that the snack bar receipts increase to the level originally
estimated, how much can be spent on advertising each year and still allow the game center to
provide a 16% rate of return?
A. P70,103.00
C. P58,953.00
B. P 4,673.53
D. P12,574.53
Install the Game Center
P18,000
30,000
17,000
5,400
9,600
Net Income, CFBT, ARR, Payback Period
Questions 52 through 56 are based on the following information:
Pinewood Craft Company is considering the purchase of two different items of equipment, as
described below:
The company is currently using a 16 percent minimum acceptable rate of return for its capital
investment. The present value of annuity of 1 at 16 percent for 15 periods is 5.575 and end of 15
periods is 0.108. The company is not liable to pay income taxes.
Machine A. A compacting machine has just come onto the market that would permit Pinewood
Craft Company to compress sawdust into various shelving products. At present the sawdust is
disposed of as a waste product. The following information is available on the machine:
lxvii.The incremental expected annual cash inflows from Alternative 1 is:
A. P 90,000
C. P100,200
B. P108,000
D. P201,000
a. The machine would cost P420,000 and would have a 10% salvage value at the end of its
12-year useful life. The company uses straight-line depreciation and considers salvage
value in computing depreciation deductions.
b. The shelving products manufactured from use of the machine would generate revenues of
P300,000 per year. Variable manufacturing costs would be 20% of sales.
c. Fixed expenses associated with the new shelving products would be (per year):
advertising, P40,000; salaries, P110,000; utilities, P5,200; and insurance, P800.
lxviii. The incremental expected annual cash inflows from Alternative 2 is:
A. P 17,000
C. P 59,600
B. P 65,000
D. P145,000
lxix. The net present value for Alternative 1 is:
A. P48,650
C. P68,375
D. P12,807
lxxi. Assume that the company decides to accept alternative 2. At the end of the first year, the
company finds that only 21,000 people used the game center during the year (each person
spent P5 on games). Also, the snack bar provided a net cash inflow of only P13,000. In light of
this information, what is the net present value for alternative 2?
A. P(80,422)
C. P(82,150)
B. P(76,422)
D. P(80,854)
Home’s management is unsure which alternative to select and has asked you to help in making the
decision. You have gathered the following information relating to added costs that would be
incurred each year under the two alternatives:
Expand the Pizza Shop
P18,000
--54,000
13,200
7,800
D. P32,500.
C. P45,000
500
Capital Budgeting
Machine B. A second machine has come onto the market that would allow Pinewood Craft
Company to automate a sanding process that is now done largely by hand. The following
information is available:
lxxviii. The payback period for Machine B is:
A. 4.0 years.
B. 4.2 years.
a. The new sanding machine would cost P234,000 and would have no salvage value at the
end of its 13-year useful life. The company would use straight-line depreciation on the
new machine.
b. Several old pieces of sanding equipment that are fully depreciated would be disposed of
at a scrap value of P9,000.
c. The new sanding machine would provide substantial annual savings in cash operating
costs. It would require an operator at an annual salary of P16,350 and P5,400 in annual
maintenance costs. The current, hand-operated sanding procedure costs the company
P78,000 per year in total.
Net Investment, CFBT, Tax Benefits, NPV, Depreciation Tax Shield,
Question Nos. 58 through 63 are based on the following:
Turkey Company’s average production of valve stems over the past three years has been 80,000
units each year. Expectations are that this volume will remain constant over the next four years.
Cost records indicate that unit product costs for the valve stem over the last several years have
been as follows:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead*
Unit product cost
Pinewood Craft Company requires a simple rate of return of 15% on all equipment purchases.
Also, the company will not purchase equipment unless the equipment has a payback period of 4.0
years or less.
(In all the following questions, please ignore income tax effect)
P 3.60
3.90
1.50
9.00
P18.00
*Depreciation of tools (that must now be replaced) accounts for one-third of the fixed overhead.
The balance is for other fixed overhead costs of the factor that require cash expenditures.
lxxiii. The expected income each year from the new shelving products (Machine A) is:
A. P 52,500
C. P 84,000
B. P240,000
D. P 92,500
If the specialized tools are purchased, they will cost P2,500,000 and will have a disposal value of
P100,000 at the end of their four-year useful life. Turkey Company has a 30% tax rate, and
management requires a 12% after-tax return on investment. Straight-line depreciation would be
used for financial reporting purposes, but for the tax purposes, the following variable depreciation
each year will be used.
lxxiv. The annual savings in cost if Machine B is purchased is
A. P56,250
C. P38,250
B. P43,250
D. P21,750
lxxv.
The simple rate (%) of return for Machine A is:
A. 12.5 percent
C. 25.0 percent
B. 20.0 percent
D. 18.0 percent
Year 1
Year 2
Year 3
Year 4
lxxvi. The simple rate of return for Machine B is:
A. 16.3 percent
C. 25.0 percent
B. 17.0 percent
D. 34.0 percent
lxxvii. The payback period for Machine A is:
A. 3.0 years
B. 4.5 years
C. 6.1 years.
D. 5.9 years.
P 832,500
1,112,500
370,000
185,000
The sales representative for the manufacturer of the specialized tools has stated, “The new tools
will allow direct labor and variable overhead to be reduced by P1.60 per unit.” Data from another
company using identical tools and experiencing similar operating conditions, except that annual
production generally averages 100,000 units, confirms the direct labor and variable overhead cost
savings. However, the other company indicates that it experienced an increase in raw material
C. 5.0 years
D. 7.5 years
501
Capital Budgeting
cost due to the higher quality of material that had to be used with the new tools. The other
company indicates that its unit product costs have been as follows:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Unit product cost
lxxxi. The present value of tax benefits expected from the use of the new machine tools is:
A. P 603,333
C. P1,407,777
B. P 804,444
D. P2,011,111
P 4.50
3.00
0.80
10.80
P19.10
lxxxii. The present value of the salvage value of the new tools to be received at the end of fourth
year is
A. P 63,552.
C. P 44,486.
B. P 19,065.
D. P212,615.
Referring to the figures above, the production manager stated, “These numbers look great until you
consider the difference in volume. Even with the reduction in labor and variable overhead cost, I’ll
bet our total unit cost figure would increase to over P20 with the new tools.”
lxxxiii. Using the minimum acceptable rate of return of 12 percent, the net present value of the
investment in new tools is
A. P108,913.
C. P147,073.
B. P127,979.
D. P166,139.
Although the old tools being used by Turkey Company are now fully depreciated, they have a
salvage value of P45,000. These tools will be sold if the new tools are purchased; however if the
new tools are not purchased, then the old tools will be retained as standby equipment. Turkey
Company’s accounting department has confirmed that total fixed manufacturing overhead costs,
other than depreciation, will not change regardless of the decision made concerning the valve
stems. However, the accounting department has estimated that working capital needs will
increase by P60,000 if the new tools are purchased due to the higher quality of material required in
the manufacture of the valve stems.
The present values of 1 at the end of each period using 12 percent are:
Period 1
Period 2
Period 3
Period 4
PV of annuity of 1, 4 periods
lxxxiv. The net advantage of the use of declining method of depreciation instead of straight-line
method is
A. P 33,830.
C. P112,767.
B. P 56,610.
D. P147,731.
Net Investment, CFAT, Depreciation tax shield, NPV
Question Nos. 77 through 82 are based on the following:
Franzen Company manufactures three different models of paper shredders including the waste
container, which serves as the base. While the shredder heads are different for all three models,
the waste container is the same. The number of waste containers that Franzen will need during
the next five years is estimated as follows:
2007
50,000
2008
50,000
2009
52,000
2010
55,000
2011
55,000
The equipment used to manufacture the waste container must be replaced because it is broken
and cannot be repaired. The new equipment would have a purchase price of P945,000 with terms
2/10, n/30; the company’s policy is to take all purchase discounts. The freight on the equipment
would be P11,000, and installation costs would total P22,900. The equipment would be purchased
in December 2006 and placed into service on January 1, 2007. It would have a five-year economic
life and would have the following depreciation. The equipment is expected to have a salvage value
of P12,000 at the end of its economic life in 2011. The new equipment would be more efficient
0.89286
0.79719
0.71178
0.63552
3.03735
lxxix. The net investment in new tools amounted to:
A. P1,873,300.
C. P2,528,500.
B. P2,515,000.
D. P2,546.500.
lxxx.
How much annual cost savings will be generated if the Turkey Company purchases the
new tools?
A. P 128,000
C. P 936,000
B. P 216,000
D. P1,008,000
502
Capital Budgeting
than the old equipment, resulting in a 25 percent reduction in both direct material and variable
overhead. The savings in direct material would result in an additional one-time decrease in
working capital requirements of P2,500, resulting from a reduction in direct material inventories.
This working capital reduction would be recognized at the time of equipment acquisition.
A. P 956,600
B. P 975,500
lxxxvi. The total after-tax cash outflows, excluding the initial cash outflows, if the new equipment
is purchased are:
A. P 956,600
C. P2,918,300
B. P2,887,800 (defective)
D. P3,279,000
The old equipment is fully depreciated and is not included in the fixed overhead. The old
equipment from the plant can be sold for a salvage amount of P1,500. Rather than replace the
equipment, one of Franzen’s production managers has suggested that the waste containers be
purchased. One supplier has quoted a price of P27 per container. This price is P8 less than
Franzen’s current manufacturing cost, which is presented below.
Direct materials
Direct labor
Variable overhead
Fixed overhead:
Supervision
Facilities
General
Total unit cost
lxxxvii. The present value of the total depreciation shield is:
A. P308,920
C. P307,826
B. P313,500
D. P321,303
P10
8
6
P2
5
4
C. P 978,900
D. P1,455,613
lxxxviii. The total relevant after-tax costs to buy the waste containers are:
A. P2,829,240
C. P4,243,500 (defective
B. P3,039,662
D. P7,074,000
lxxxix. What is the net present value of the purchase alternative?
A. P3,039,662 (defective)
C. P2,083,062
B. P2,730,742
D. P2,718,359
11
P35
Franzen uses a plantwide fixed overhead rate in its operations. If the waste containers are
purchase outside, the salary and benfits of one supervisor, included in fixed overhead of P45,000
would be eliminated. There would be no other changes in the other cash and noncash items
included in fixed overhead except depreciation on the new equipment.
xc. What is the net present value of the make alternative?
A. P2,036,603
C. P2,996,603
B. P3,039,662
D. P2,993,203 (defective)
The new equipment will be depreciated according to the following declining amounts:
Year
Depreciation
2007
P319,968
2008
426,720
2009
142,176
2010
71,136
2011
0
ANSWER EXPLANATIONS
i.
Franzen is subject to a 40 percent tax rate. Management assumes that all cash flows occur at the
end of the year and uses a 12 percent after-tax discount rate.
Answer: B
Initial amount of investment
Less Cash inflow (decrease in outflow) at period 0:
MV of old equipment
Tax benefits on loss on sales (20,000 x .4)
Net investment
ii. Answer: D
ATCF = Net investment ÷ Payback period
ATCF
(840,000 ÷ 3.326)
Net income
(252,555 – 140,000)
lxxxv. The initial net cash outflows if the company decides to continue making the waste
containers is:
503
160,000
80,000
8,000
88,000
72,000
252,555
112,555
Capital Budgeting
Before-tax income
(112,555 ÷ 0.60)
187,592
Before-tax savings
(187,592 + 140,000)
327.592
The computation of after-tax cash flows, given the amount of investment and internal rate of
return or PV of annuity of 1 discounted at IRR is the reverse of the computation of payback
period. Remember that the payback method, though a nondiscounted technique, is closely
related to internal rate of return because the payback period is exactly the present value of
annuity of 1 if they are discounted using the internal rate of return.
SYD method provides a higher present value on tax benefits because of less amount of tax
during year 1 & 2. In year 4 and 5, the use of SYD requires higher taxes but their equivalent
present values are lower already.
vi. Answer: D
Annual cost savings
Less depreciation
Annual income
Simple Rate of Return:
iii. Answer: A
Annual savings on expenses
P50,000
Less: Additional depreciation
(40,000 – 25,000)
15,000
Additional taxable income
35,000
Additional tax
(35,000 x 40%)
P14,000
Additional depreciation can be easily calculated by subtracting the book value of the old
machine from the cost of new machine and then the difference divided by the useful life
(160,000 – 100,000) ÷ 4 = 15,000.
iv10.
Answer: B
Year
SYD
Straight Line
Difference
1
2,000,000
1,200,000
800,000
2
1,600,000
1,200,000
400,000
3
1,200,000
1,200,000
4
800,000
1,200,000
(400,000)
5
400,000
1,200,000
(800,000)
Total present value of difference in depreciation
Tax Rate
Present value of net advantage
Difference
60,000
30,000
(30,000)
(60,000)
54,000 ÷ 432,000
vii. Answer: A
The useful life of the project can be calculated by using the computational pattern for
Accounting Rate of Return:
Net investment
106,700
Divide by Depreciation expense
CFAT
20,000
Less: Net income (106,700 x 5%)
14,665
5,335
Average life (in years)
7.28
* 10% ARR based on average investment = 5% ARR based on initial investment
Present Value
727,280
330,560
0
(273,200)
(496,720)
287,920
40%
115,168
viii. Answer: B
ARR = Average annual net income ÷ Average Investment
Annual after-tax cash flow
40,000
Less Depreciation
20,000
Net Income
20,000
Divide by Average Investment (200,000 + 180,000)/2
190,000
ARR:
10.5%
The problem asked for the average accounting rate of return for the first year of asset’s life.
v. Answer: B
SYD
SL
1 150,000
90,000
2 120,000
90,000
3
90,000
90,000
4
60,000
90,000
5
30,000
90,000
Total of present values of depreciation
Tax rate
Present value of net advantage
(432,000 ÷ 12)
90,000
36,000
54,000
12.5 %
ix. Answer: D
The average (accounting) rate of return is determined by dividing the annual after-tax net
income by the average cost of the investment, (beginning book value + ending book value)/2.
After tax income (P7,200 - (P7,200 x 30%))
P 5,040
Average investment: (P66,000 + 16,000) ÷ 2
P41,000
Accounting rate of return: P5,040/P41,000)
12.3%
Present Value
53,568
23,916
0
(19,066)
(34,046)
24,372
40%
9,749
x. Answer: A
(ATCF – Depreciation) ÷ Initial investment = Accounting Rate of Return
504
Capital Budgeting
Let X = Initial investment
(66,000 – 0.10X) ÷ X = 0.12
66,000 - .10X = .12X
.22X = 66,000
X = 300,000
Divide by cash flow after tax
Payback period
xvii.
Cash Inflow
42,000
35,000
77,000
xiv. Answer: B
Net investment
Divide by CFAT (10,000 x 0.7) ÷ (50,000 ÷ 8 x 0.3)
Payback period
(450,000) – 254,520
2 + (22,020 ÷ 105,140)
xvi. Answer: D
Cost of the new machine
Salvage value of old machine at period zero
Net investment (Outflows)
900,000
1,200,000
1,500,000
900,000
Unrecovered Outflow
(4,500,000)
(3,600,000)
(2,400,000)
( 900,000)
0
Payback Period: At the end of 4 periods, the initial outflows are fully recovered.
Note to the CPA Candidates: A modified question for this problem is to compute the Present
Value of the net advantage of using sum-of-the-years’ digits of depreciation instead of straightline method.
xviii.Answer: C
Cash inflows
Period 0
Period 1 (75,000 – 25,000) x .6
30,000
Period 2 ( 30,000 x 1.10)
33,000
Period 3 (33,000 x 1.10)
36,300
At the end of the third year, investment is fully recovered.
The net investment of 99,300 is net of tax benefit, (165,500 x .6)
xiii. Answer: B
Payback period = Initial amount of investment ÷ Annual after-tax cash flows
P35,000 ÷ P5,000 = 7 years
xv. Answer: D
Cumulative cash flows end of Year 1
Discounted cash flow for Year 2
Cumulative cash flows, end of Year 2
Break-even time
Answer: B
Outflows
First year
Second year
Third year
Fourth year
xi. Answer: A
Net Income: = 66,000 - .10X
AAR = NI/ Investment
.12 = (66,000 - .10X) / X
.12X = 66,000 - .10X
.22 X = 66,000
X = 300,000
xii. Answer: D
Net Income (280,000 x 15%)
Add back depreciation
ATCF
90,000
3.78 years
50,000
8,875
5.6 years
Investment
(99,300)
(69,300)
(36,300)
-0-
xix. Answer: C
Before-tax cash flow = 40,000 + 35,000
Payback period: 300,000 ÷ 75,000
(195,480)
173,460
( 22,020)
2.21 years
75,000
4 years
xx. Answer: C
There are two cash flows at time zero: P120,000 outflow and P14,000 inflow.
Net cash outflow (120,000 – 14,000) = 106,000
xxi. Answer: C
Computation of Cash Flow After-tax
CFBT
100,000 x 0.7
Depreciation tax shield
62,500 x 0.3
CFAT
400,000
60,000
340,000
505
70,000
18,750
88,750
Capital Budgeting
Computation of Net Present Value:
PV of ATCF:
88,750 x 5.747
510,046
PV of After-tax Salvage Value:
20,000 x 0.70 x 0.54
7,560
Total
517,606
Investment
500,000
Net Present Value
17,606
The problem assumed that the salvage value is ignored in the computation of annual
depreciation so that the annual cash flows will be greater. The problem did not include among
the choices the assumption that salvage value will be deducted from the cost in computing the
amount of annual depreciation.
xxii. Answer: B
Annual revenues
Less cash operating costs
Cash flow before tax
Less Depreciation (1M ÷ 5)
Income before tax
Less income tax (40%)
Net income
Add back depreciation
ATCF
PV of ATCF, n=5; k=10%
Investment
Negative Net Present Value
257,120 x 3.7908
Savings (2 workers, each P10,000 for 3 months)
2 x P10,000 x 3
Depreciation
(175,000 – 25,000) ÷ 5 years
After-tax cash savings:
(60,000 x 0.75) + (30,000 x 0.25)
Present value of after-tax cash savings
(52,500 x 3.60478)
Present value of Salvage Value
(25,000 x 0.56743)
Total
Investment
Net Present Value
xxv. Answer: B
Computation of net investment:
Cash purchase price
Less: MV of old machine
Tax shield on loss on sale (40,000 x 0.32)
Net investment
400,000
104,800
295,200
200,000
95,200
28,080
57,120
200,000
257,120
974,690
1,000,000
( 25,310)
xxvi.
xxiii.Answer: A
Present value of cash returns: (30,000 x 0.90909) x 5 periods
136,364
Net investment
99,300
Net present value
37,064
Note: Because the constant growth rate and the discount rate are both 10%, the present
value for each period is constant.
xxiv.
300,000
80,000
12,800
Annual cash savings before tax
(240,000 – 160,000)
Additional depreciation
(300,000 – 120,000) ÷ 4
Additional taxable income
Less Additional tax
(35,000 x 0.32)
Net income
Add back depreciation
After-tax cash flow
Alternative computation for ATCF:
(80,000 x 0.68) + (45,000 x 0.32)
Present value of ATCF
(68,800 x 3.23972)
Investment
Net Present Value
The manner of financing the project is not considered in the analysis of capital investment.
Investment must be separate from financing. It is a normally committed error in the
application of capital budgeting techniques where financing strategy is considered. The
explicit or implicit cost of financing the project is taken care of the discounting process.
Answer: B
506
Answer: B
PV of annual cash receipts
PV of salvage value
PV of return of working capital
Cost of new equipment and timbers
Working capital
PV of cost of construction of road
Negative net present value
1,200,000 x 2.58872
650,000 x 0.48225
1,000,000 x 0.48225
400,000 x .5787
P60,000
P30,000
P52,500
P189,250
14,186
203,436
175,000
P 28,436
92,800
207,200
80,000
45,000
35,000
11,200
23,800
45,000
68,800
68,800
222,893
207,200
15,693
3,106,463
313,462
482,250
(2,750,000)
(1,000,000)
( 231,480)
(79,303)
Capital Budgeting
xxvii.
Answer: B
Period
Nominal Cash Savings
1
32,000
2
32,000 x 1.05
33,600
3
32,000 x 1.052
35,280
4
32,000 x 1.053
37,044
Total
Investment
NPV
Note that all the annual cash inflows are adjusted by one period.
PV Factor
0.87790
0.76947
0.67497
0.59208
xxviii. Answer: B
The solution used total analysis approach in computing present value.
Retain the Old Machine:
Present value of annual cash outlay
CFAT
(300,000 x P0.38) + P21,000 = P135,000
PVCFAT (135,000 x 3.6847)
Present value of salvage value (7,000 x 0.41044)
Total
Buy New machine:
Present Value of Annual cash outlay
CFAT
(300,000 x P0.29) + P11,000 = P98,000
PVCFAT P98,000 x 3.6847)
Salvage value of new machine, end of 6 years(P20,000 x 0.41044)
Investment in new machine (120,000 – 40,000)
Total
Investment:
83,180.84 x 3.57057
Profitability index
(297,000 + 10,000) ÷ 297,000
A shorter calculation of the Profitability Index can be made by:
3.69079 ÷ 3.57057 = 1.034
Present Value
28,070.08
25,854.19
23,812.94
21,933.01
99,670.22
80,000.00
19,670.22
xxxi. Answer: D
In discounting the annual cash inflow by the IRR, the NPV = P0
The net present value of ZERO is 14% and 16%. For better time management, the candidate
is expected not to do detailed calculation of finding out the exact rate.
The use of interpolation indicated that the IRR is 15.3%:
Discount Rate
Net Present Value
0.14
1,197
IRR
0
0.16
-708
(0.14 – IRR) ÷ (0.14 – 0.16) = 1,197 ÷ ( 1,197 + 708)
(0.14 – IRR) ÷ -.02 = 1,197 ÷ 1905
(0.14 – IRR) ÷ - .02 = 0.628
(0.14 – IRR) = 0.628 x -0.02
0.14 – IRR = 0. 013
IRR = 0.153 or 15.30%
Note: Since at the IRR, NPV is zero, the answer can only be between 14% & 16%, since only
one of the choices, satisfy the criteria, the answer is (D).
P497,435
( 2,873)
P494,562
P361,100
( 8,209)
80,000
P432,891
xxxii. Answer: B
The payback period that corresponds to the project’s internal rate of return of 12 percent is
4.968. Therefore, the amount of investment must equal the product of the payback period and
the net cash flows:
Investment: (4.968 x 20,000) = P99,360
xxix.
Answer: B
The purpose of profitability index is to compare two projects’ profitability by reducing the
present value per 1 peso of investment. Therefore, the ratio of 4.35526 @ 10% to 4.11141 @
12% indicated the profitability index.
Profitability index: 4.35526/4.11141 = 1.06
xxx. Answer: B
PV of annuity of 1 at IRR ∑(1 ÷ 1.12386)5
PV of annuity of 1 at MCC ∑(1 ÷ 1.11055)5
After-tax cash flows
10,000 ÷ (3.69079 – 3.57057)
297,000
1.034
xxxiii. Answer: D
The amount of investment: the PV of annuity at IRR
4.355 x 6,000 = 26,130
xxxiv. Answer: C
Present value of cash inflows equals amount of investment at 10% IRR.
P20,000 x 3.791 = P75,820
3.57057
3.69079
83,180.84
507
Capital Budgeting
xxxv.
Answer: A
ATCF:
Depreciation
Net income:
Before-tax income:
Fixed costs
Contribution margin:
Unit sales
P1,500,000/3.60472
416,121 – 300,000
116,121/0.60
193,535 + 500,000
693,535 ÷ (100 - 60)
xxxvi. Answer: B
Contribution margin (per No. 23)
Divide by sales volume
Contribution margin per unit
Add variable cost per unit
Selling price per unit
Answer: C
Annual after-tax cash flow
Depreciation
Net income
Income before tax
Depreciation
Cash savings before tax:
xxxix.
500,000/5.6502
500,000/10
38,492/0.6
64,154 + 50,000
Answer: A
Investment
Less Present value of salvage value
Present value of Annual Cash Inflows
Minimum Annual Cash Flows
(12,000 x 0.3855)
(115,374 ÷ 6.1446)
xl. Answer: B
Present value of annual cash flows at IRR
Investment
Difference
Annual increase in cash flows
693,535
÷ 20,000
P34.68
60.00
P94.68
Alternative Solution:
Cash inflow before tax based on present price: (20,000 x 40) – 200,000
After-tax cash inflow
(600,000 x 0.6) + (300,000 x 0.4)
Present value of ATCF
(480,000 x 3.60478)
Investment
Net present value (present price)
Annual excess ATCF due to excess price (230,294 ÷ 3.60478)
Before-tax excess cash inflow
(63,885 ÷ 0.6)
Excess selling price:
106,475 ÷ 20,000
Reduced selling price to achieve IRR of 12%
(100 – 5.32)
xxxvii.
1,750 = 2.4771CF – 2.4018CF
1,750 = 0.1753CF
CF = 9,980
416,121
300,000
116,121
193,535
500,000
693,535
17,338
(81,000 x 4.639)
81,000 x 4.344
23,895/4.344
xli. Answer: A
Investment (Total of present value @ IRR of 12%)
Less PV, year 1 & 2
(16,074 + 17,534)
PV of the 3rd cash flow
After-tax cash flow, third year
16,392/0.712
600,000
480,000
1,730,294
1,500,000
230,294
63,885
106,475
5.32
94.68
120,000
4,626
115,374
18,776
375,759
351,864
23,895
5,501
50,000
33,608
16,392
23,022
xlii. Answer: B
The net present value = PV of excess salvage value less PV of decrease in after-tax cash
flow
Let X = the excess salvage value
7,003 = 0.56743X – [3.60478 x (0.2X * 0.4)
7,003 = 0.56743X – 0.2883824X
7,003 = 0.2790476X
X = 25,096
Required salvage value: 50,000 – 25,096 = 24,904
88,492
50,000
38,492
64,154
50,000
114,154
xliii. Answer: B
Cost of equipment
Less PV of tangible benefits
PV of annual intangible benefits
Amount of annual intangible benefits
xxxviii. Answer: A
The amount of annual cash flows can be solved by equation:
NPV = PV of annual CF – Investment
508
100,000 x 5.01877
248,123/5.01877
750,000
501,877
248,123
49,440
Capital Budgeting
xliv. Answer: B
To be acceptable, the project should yield a net present value of zero. The negative net
present value must be offset by the present value of annual intangible benefits.
Present value of intangible benefits
P184,350
PV of annuity of 1 at 10% for 10 years
÷ 6.145
Annual net intangible benefits
P30,000
PV of Difference in ATCF
Year 1 155,000 x 0.86957
Year 2 110,000 x 0.75614
Net difference
Difference in investment
NPV
xlv. Answer: A
The indifference rate (crossover or fisher rate) refers to the rate at which the net present
values of the 2 alternatives are indifferent or equal.
The easier test of the rate is to look for IRR (using trial and error technique) of the investment
difference.
Difference 80,000 – 48,000
35,225
PV inflows ∑(3,200 ÷ 1.1264)6
(12,922)
PV inflows ∑(15,200 ÷ 1.1264)10-6
(22,303)
Difference
NIL
Alternative Solution:
Project X
Project Y
PV of after-tax cash flows
∑(12,000 ÷ 1.1264)6
48,455
∑(15,200 ÷ 1.1264)10
83,680
Investment
48,000
83,225
Net Present Value
455
455
Machine 1
Machine 2
134,783.35
( 83,175.40)
51,607.95
( 50,000.00)
1,607.95
(134,783.35)
83,175.40
( 51,607.95)
50,000.00
( 1,607.95)
At 15 percent discount rate, Machine 1 is more acceptable.
8% Discount Rate
PV of Difference in ATCF
Year 1 155,000 x 0.92593
Year 2 110,000 x 0.85734
Net difference
Difference in investment
NPV
Machine 1
Machine 2
143,519.15
( 94,307.40)
49,211.75
( 50,000.00)
(
788.25)
(143,519.15)
94,307.40
( 49,211.75)
50,000.00
788.25
At 8 percent discount rate, Machine 2 is more acceptable.
xlviii. Answer: C
Cost of Investment:
Invoice price
Installation cost
Freight charge
Total investment
xlvi. Answer: B
The determination of the indifference point, which is 10%, for the two projects can be made
through the use of trial and error estimation.
Machine 1
Machine 2
PV of Difference in ATCF
Year 1 155,000 ÷ 1.10
140,909.10
(140,909.10)
Year 2 (110,000 ÷ 1.10)2
( 90,909.10)
90,909.10
Net difference
50,000.00
( 50,000.00)
Difference in investment
( 50,000.00)
50,000.00
NPV
NIL
NIL
950,000
24,200
800
975,000
Annual Cash Flow:
Number of procedures:
Contribution margin per procedures:
Total annual cash flow:
Cash payback period:
xlix. Answer: B
Present value of cash flow
Present value of salvage value
Total
xlvii. Answer: C
15% Discount Rate
509
(52 x 5)
(P800 – P10 – P40)
(260 x P750)
(975,000 ÷ 195,000)
(195,000 x 6.418)
(55,000 x 0.42241)
260
P750
P195,000
5 years
P1,251,510
23,233
P1,274,743
Capital Budgeting
Capital investment
Net present value
975,000
P 299,743
l.
Answer: A
Average investment:
Annual depreciation:
Annual net income:
Average annual Rate of Return:
li.
Answer: A
Contribution margin:
Less Fixed costs
Cash flow before tax
Less: Depreciation
Income before tax
Less: Income tax
Net income
Add back: Depreciation
After-tax Cash Flow
(975,000 + 55,000) ÷ 2
(975,000 – 55,000) ÷ 10
195,000 – 92,000
P103,000  P515,000
300,000 x (75 – 50)
(6,000,000 ÷ 4)
(1,500,000 x 0.4)
lii. Answer: C
PV of After-tax Cash Flows
Cost of investment
Net Present Value
(2,400,000 x 2.9287)
liii. Answer: A
Annual excess present value
Excess cash before tax
Maximum number of units as decrease
(1,028,000 ÷ 2.9287)
(351,000 ÷ 0.6)
(585,000 ÷ 15)
of the initial investment, in the determination of accounting rate of return.
lv. Answer: B
Cash Flow
180,000
120,000
100,000
90,000
90,000
Total
Amount of investment
Net Present Value
515,000
92,000
103,000
20%
7,500,000
4,500,000
3,000,000
1,500,000
1,500,000
600,000
900,000
1,500,000
2,400,000
PV Factor
0.909
0.826
0.751
0.683
0.621
PV of annual net cash flows:
163,620
99,120
75,100
61,470
55,890
455,200
400,000
55,200
lvi. Answer: C
Present Value Index (Profitability Index)
Present Value of ATCF ÷ Net Investment (455,200 ÷ 400,000) = 1.14
The present value index computes net present value in terms of P1 investment. Therefore,
the index of 1.14 means the net present value per P1 of investment is P0.14. This concept
makes the present value index better than the net present value technique because the index
indicates which one is the most profitable on a per P1 investment.
7,028,900
6,000,000
1,028,900
lvii. Answer: D
Cash Inflow
Period 0 Outflows
Period 1
Period 2
Period 3
P351,000
P585,000
39,000
180,000
120,000
100,000
Unrecovered Investment
(400,000)
(220,000)
(100,000)
Zero
The total outflows are fully recovered by the end of period 3.
The analyst should be careful in computing the payback period when the project has uneven
cash inflows. The common error in handling uneven cash flows is using the average cash
flows instead of reducing the unrecovered outflows.
liv. Answer: A
Average Annual net income:
(100,000 + 40,000 + 20,000 + 10,000 + 10,000) ÷ 5 =
36,000
Divide by average investment (400,000 ÷ 2)
200,000
Accounting rate of return
18%
Accounting rate of return or unadjusted rate of return computes the profitability of the project in
term of accrual profit. Net profit under accrual method considers depreciation, a substantial
amount that understates the average profit. This understatement of amount that is used in the
computation necessarily requires that preferably, average investment should be used, instead
lviii. Answer: D
Payback period: Investment ÷ Net Annual Cash Inflow
P200,000 ÷ P50,000 = 4 years
lix. Answer: D
510
Capital Budgeting
Present value of Net Cash Inflow (71,000 X 4.355)
Investment
Net Present value
309,205
300,000
9.205
lxvi. Answer: C
At the discount rate of 8 percent, there is a net present value of P1,756. Therefore, the IRR is
higher than 8 percent.
Using trial and error approach, the first try should use 9 percent. If the present value of the
inflows exceeds P50,000, then the IRR is lower than 9 percent, otherwise it should be 9.5
percent.
Using 9.0 percent in discounting the inflows, there is a net present value of P(174); therefore
the IRR is slightly lower than but very close to 9.0 percent.
(P8,875 x 5.535) + (P1,400 x 0.5019) – P50,000 = P(174)
lx. Answer: B
Average Investment: (200,000 ÷ 2) = 100,000
Accounting Rate of Return = Net Income ÷ Average Investment
(10,000 ÷ 100,000) = 10 percent
lxi. Answer: B
The payback for PA is 4.225. This is closest to the present value of annuity of 1 discounted at
11 percent for 6 periods which is 4.231.
lxii. Answer: A
Annual depreciation: (P50,000 ÷ 8)
Annual tax shield: (P6,250 x 0.3)
lxvii.Answer: B
Additional contribution margin:
Small
6,000 x 5.40
Medium
15,000 x 6.50
Large
9,000 x 7.90
Total
Less Cash Fixed Expenses:
Rent
Salaries
Utilities
Insurance, etc.
Annual Cash Inflows
P6,250
P1,875
lxiii. Answer: C
Before-tax cash inflow
P10,000
Less depreciation
6,250
Income before tax
3,750
Less income tax (3,750 x 0.3)
1,125
Net income
2,625
Add back depreciation
6,250
After-tax cash inflow
P 8,875
A quicker calculation of after tax cash flow can be made by adding the tax shield to after-tax
cash inflow without any tax benefit on depreciation.
(P10,000 × .70) + P1,875 = P8,875
lxviii.
lxiv. Answer: B
Payback period: (P50,000 ÷ P8,875) = 5.6 years
lxv. Answer: C
Present value of annual ATCF (P8,875 x 5.747)
Present value of after-tax salvage value (P1,400 x 0.54)
Total
Investment
Net present value
P51,000
756
51,756
50,000
P 1,756
Answer: B
Additional rental income
Additional cash flow, snack bar
Total
Less Cash Fixed Expenses:
Rent
Salaries
Utilities
Insurance, etc.
Annual Cash Inflow
lxix. Answer: A
PV of annual cash inflow
PV of salvage value
511
32,400
97,500
71,100
201,000
18,000
54,000
13,200
7,800
93,000
108,000
130,000
15,000
145,000
48,000
17,000
5,400
9,600
(108,000 x 5.575)
(70,000 x 0.108)
80,000
65,000
602,100
3,240
Capital Budgeting
PV of working capital return
Total
Investment:
Remodeling cost
Working capital
Net Present Value
(7,500 x 0.108)
550,000
7,500
lxx. Answer: B
PV of annual cash inflow (65,000 x 5.575)
PV of salvage value
PV of working capital return
Total
Investment:
Remodeling cost
Working capital
Net Present Value
lxxi. Answer: A
Rental income
21,000 x 5
Additional cash inflow, snack bar
Total
Less fixed expenses
Annual cash inflow
PV of annual cash inflow
PV of salvage value
PV of working capital return
Total
Investment
Negative Net Present Value
810
606,150
(38,000 x 5,575)
Variable expenses
Contribution margin
Fixed expenses
Advertising
Salaries
Utilities
Insurance
Annual cash income
Less Depreciation
Annual Income
557,500
48,650
362,375
1,296
432
364,103
290,000
4,000
lxxiv.
294,000
70,103
105,000
13,000
118,000
80,000
38,000
Answer: A
Annual revenues
40,000
110,000
5,200
800
420,000 x 0.90 ÷ 12
Answer: A
Current operating costs – old machine
Deduct Operating costs – Machine B
Annual salary of operator
Annual maintenance cost
Annual cash savings
156,000
84,000
31,500
52,500
78,000
16,350
5,400
21,750
56,250
lxxv.
Answer: A
Simple Rate of Return = Net Income ÷ Initial Investment
52,500 ÷ 420,000 = 12.50 %
lxxvi.
211,850
1,296
432
213,578
294,000
( 80,422)
Answer: B
Savings
Less Depreciation
Annual income
Simple Annual Return
234000 ÷ 13 years
38,250 ÷ 225,000
56,250
18,000
38,250
17 %
lxxvii. Answer: C
Payback period = Initial Investment ÷ Annual Cash Inflow
420,000 ÷ 84,000 = 5 years
lxxii.Answer: D
The annual cost of advertising can be easily calculated by dividing the net present value of
alternative 2, at 16% by the present value of annuity of 1.
70,103 ÷ 5,575 = 12,574.53
lxxiii.
60,000
240,000
300,000
512
lxxviii.
Answer: A
225,000 ÷ 56,250 = 4 years
lxxix.
Answer: C
Purchase price of new tools
Add increase in working capital
2,500,000
60,000
Capital Budgeting
Total
Deduct Salvage value of the old tools
Net investment
lxxx.
lxxxi.
lxxxii.
lxxxiii.
lxxxiv.
Answer: C
Purchase price of valve stem 80,000 x 20
Cost to make:
Direct materials
Direct labor
Variable overhead
Decrease in directs labor and variable costs
Cost savings
Answer: A
PV of annual depreciation
Period
Depreciation
Year 1
832,500
2
112,500
3
370,000
4
185,000
Total
Tax rate
PV of tax benefits from depreciation
2,560,000
45,000
2,528,500
PV of tax benefits, declining - balance
PV of tax benefits, straight-line method 2,500,000  4 x .3 x 3.03735
Net advantage
lxxxv.
1,600,000
80,000 x 4.50
80,000 x 3.90
80,000 x 1.50
80,000 x 1.60
360,000
312,000
120,000
(128,000)
664,000
936,000
lxxxvi.
PV Factor
0.89286
0.79719
0.71178
0.63552
Answer: C
After tax salvage value 100,000 x .7
PV of 1 end of 4 periods
PV of after – tax salvage value
Answer: C
PV of after cash savings
936,000 x .7 x 3.03735
PV of tax benefits from depreciation
PV of after tax salvage value
PV of working capital return
60,000 x 0.63552
Investment
Net present value
Present Value
743,305.95
886,873.88
263,358.60
117,571.20
2,011,109.63
0.30
603,332.89
Answer: A
Invoice price of new equipment (945,000 x 0.98)
Freight
Installation cost
Total
Less: Salvage value of old equipment (0.6 x 1,500)
Reduction in working capital
Net initial outflows
Answer: B
Total variable costs
Avoidable fixed costs
Total
After-tax Cash outflows
Operating expenses
Depreciation
After-tax salvage value of new equipment
Net outflows
*Variable cost per unit
Direct material (10.00 x 0.75)
Direct labor
Variable overhead (6.00 x 0.75)
Total
70,000
0.63552
44,486.4
900
2,500
603,333
569,503
33,830
P926,100
11,000
22,900
960,000
3,400
P956,600
(262,000 units x P20*)
(P45,000 x 5 years)
P5,240,000
225,000
5,465,000
(5,465,000 x 0.6)
(960,000 x 0.4)
(12,000 x 0.60)
P3,279,000
( 384,000)
( 7,200)
P2,887,800
P 7.50
8.00
4.50
P20.00
lxxxvii. Answer: A
The present value of the tax shield based on declining-depreciation is:
Year
Depreciation
Tax Shield (40%)
PV Factor PV of Tax Shield
2007
P319,968
P127,987
0.893
P114,292
2008
426,720
170,688
0.797
136,038
2009
142,176
56,870
0.712
40,492
2010
71,136
28,455
0.636
18,098
Total
P308,920
1990072
603,333
44,486
38,131
(2528,500)
147,522
Answer: A
513
Capital Budgeting
lxxxviii. Answer: C
Purchase Cost
Year
2007
2008
2009
2010
2011
2006
Total
ATCF
810,000
810,000
842,400
891,000
891,000
(
900)
4,243,500
50,000 x 27 x 0.6
50,000 x 27 x 0.6
52,000 x 27 x 0.6
55,000 x 27 x 0.6
55,000 x 27 x 0.6
(1,500 x 0.6)
lxxxix. Answer: A
Present value of after-tax cash flows
2007
2008
2009
2010
2011
Salvage value of old equipment
Net present value
(810,000 x 0.893)
(810,000 x 0.797)
(842,400 x 0.712(
(891,000 x 0.636)
(891,000 x 0.567)
(1,500 x 0.60)
P 723,330
645,570
599,789
566,676
505,197
(900)
P3,039,662
xc. Answer: D
CFBT
2006
2007
2008
2009
2010
2011
Initial outflow
(50,000 x 20) + 45,000
(1,045,000 x 0.6) - (319,968 x 0.4)
(1,045,000 x 0.6) – (426,720 x 0.4)
(52,000 x 20) + 45,000
(1,085,000 x 0.6) – (142,176 x 0.4)
(55,000 x 20) + 45,000
(1,145,000 x 0.6) – (71,136)
(55,000 x 20) + 45,000
(1,145,000 x 0.6)
Salvage value (12,000 x 0.6)
1,045,000
1,085,000
1,145,000
1,145,000
CFAT
PV Factor
PVCFAT
(P956,600)
499,013
456,312
0.893
0.797
445,619
363,681
594.130
0.712
423,021
658,546
0.636
418,835
687,000
7,200
0.567
385,447
P2,993,203
514