Capital Budgeting
CHAPTER 11
CAPITAL BUDGETING
THEORIES:
1.
What does the term capital budgeting mean in the context of
making capital expenditure decisions?
A. The process of choosing assets.
B. The process of allocating the funds among assets.
C. The process of acquiring the funds to finance the business.
D. None of the given choices.
2.
The long-term planning process for making and financing
investments that affects a company’s financial results over a
number of years is referred to as:
A. capital budgeting
B. strategic planning
C. master budgeting
D. long-range planning
3.
Capital budgeting is the process:
A. used in a sell or process further decision.
B. of determining how much capital stock to issue.
C. of making capital expenditure decisions.
D. of eliminating unprofitable product line.
4.
Competing investment projects where accepting one project
eliminates the possibility of taking the remaining projects is
referred to as:
A. Common projects
B. Mutually-exclusive projects
C. Mutually-inclusive projects
D. Independent projects
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Capital Budgeting
5.
A project that when accepted or rejected will not affect the cash
flows of another project refers to:
A. independent projects
B. dependent projects
C. mutually exclusive projects
D. sustaining project
6.
A capital investment decision is essentially a decision to
exchange current:
A. assets for current liabilities.
B. cash outflows for the promise of receiving future cash inflows.
C. cash flows from operating activities for future cash inflows
from investing activities
D. cash inflows for future cash outflows.
7.
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 capitals is.
D. higher the discount rate required is.
8.
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.
9.
Deciding whether or not an investment meets a predetermined
company standard is called a
A. Screening decision
B. Payback decision
C. Profitability decision
D. Preference decision
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Capital Budgeting
10.
The primary capital budgeting method that uses discounted
cash flow technique is the:
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method.
11.
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.
12.
If Troy 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
13.
The only future costs that are relevant to deciding whether to
accept an investment are those that will
A.
B.
C.
D.
14.
be different if the project is accepted rather than rejected.
be saved if the project is accepted rather than rejected.
be deductible for tax purposes.
affect net income in the period that they are incurred.
Arbitrary Company uses IRR to evaluate long-term decisions
and establishes a cutoff rate of return. Such a 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.
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Capital Budgeting
D. greater than the current book rate of return.
15.
In capital budgeting, sensitivity analysis is used to:
A. determine whether an investment is profitable.
B. see how a decision would be affected by changes in variables.
C. test the relationship of the IRR and NPV.
D. evaluate mutually exclusive investments.
16.
How should the following projects be listed in their order of
increasing risk?
A. New venture, replacement, expansion.
B. Replacement, new venture, expansion.
C. Replacement, expansion, new venture.
D. Expansion, replacement, new venture.
17.
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.
18.
Post-audit of capital projects:
A. is usually conclusive.
B. is done using different evaluation techniques than what 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 given choices.
19.
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
B. post-audit
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Capital Budgeting
C. sensitivity analysis
D. risk analysis
20.
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.
21.
Which of the following would not be included as part of the
periodic cash inflows associated with an investment project?
A. Savings for fixed and variable production costs
B. Savings in selling, general, and administrative costs
C. Receipts from sales
D. Opportunity costs of undertaking the project
22.
The periodic cash flows associated with an investment project
include which of the following?
A. Savings in taxes caused by deductibility of depreciation on tax
return
B. Income tax effect of gain (loss) on disposal of existing assets in
an asset replacement decision
C. Purchase of asset and freight cost
D. All of these are periodic cash flows in an investment project
23.
Project Alpha has an expected cash flow of P500,000 at the end
of year 5. Project Bravo has expected cash flows of P100,000 to
be received at the end of each year for the next five years. What
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Capital Budgeting
can be said of the net present value of Project Alpha compared to
Project Bravo?
A. They are the same because both cash flows total P500,000
over the lives of the projects.
B. Project Alpha is preferred because of the largest lump-sum
payment in year 5.
C. Project Bravo is preferred because of the periodic payments
made consistently throughout the years and are made earlier.
D. Both Project Alpha and Project Bravo have the same internal
rate of return and either should be accepted.
24.
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.
25.
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
B. incremental approach
C. contribution approach
D. total project approach
26.
Which statement is most correct concerning depreciation in a
capital budgeting analysis?
A. Depreciation is not a cash flow and does not affect the tax
cash flow.
B. Depreciation is not a cash flow but does affect the tax cash
flow.
C. Depreciation is a cash flow but does not affect the tax cash
flow.
D. Depreciation is a cash flow and does affect the tax cash flow.
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Capital Budgeting
27.
If
A.
B.
C.
D.
there were no income taxes,
depreciation would be ignored in capital budgeting.
the NPV method would not work.
income would be discounted instead of cash flow.
all potential investments would be desirable.
28.
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
B. Internal Rate of Return
C. Net Present Value
D. Profitability Index
29.
Which of the following, when used as the discount rate, equates
the net present value of a series of cash flows to zero?
A. Investment rate of return
B. External rate of return
C. Internal rate of return
D. Breakeven time
30.
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.
B. greater than 12 percent.
C. less than 12 percent.
D. dependent on the size of the investment.
31.
If the present value of the future cash flows for an investment
equals the required investment, the IRR
A. equals the cutoff rate.
B. equals the cost of borrowed capital.
C. equals zero.
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Capital Budgeting
D. Is lower than the company’s cutoff rate return.
32.
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.
33.
Which of the following is true of an investment?
A. The higher the cost of capital, the lower the net present value.
B. The lower the cost of capital, the higher the IRR.
A. The longer the project’s life, the shorter its payback period.
B. The higher the project’s net present value, the shorter its life.
34.
If a project has an internal rate of return of 12 percent and a
positive net present value, which of the following statements is
true regarding the discount rate used for the net present value
computation?
A. The discount rate must have been greater than 12 percent.
B. The discount rate must have been lower than 12 percent.
C. The discount rate must have been equal to 12 percent.
D. The discount rate must
35.
The relationship between payback period and IRR is that
A. have been higher than the IRR.
B. a payback period of less than one-half the life of a project will
yield an IRR lower than the target rate.
C. the payback period is the present value factor for the IRR.
D. a project whose payback period does not meet the company’s
cutoff rate for payback will not meet the company’s criterion
for IRR.
E. none of the given choices.
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Capital Budgeting
36.
In choosing from among mutually exclusive investments, the
manager should normally select the one with the highest:
A. Net present value
B. Internal rate return
C. Profitability index
D. Book rate of return
37.
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
38.
XYZ Co. is adopting just-in-time approach. 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.
39.
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 technique which is most concerned with liquidity is the
A. payback method
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Capital Budgeting
41.
B. net present value technique
C. internal rate of return
D. book rate of return
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 varying initial investments.
D. will never be greater than 1.0.
42.
White Bubbles, Inc. is considering the purchase of an
equipment that costs P200,000. Annual cash savings of P50,000,
with a present value at 15 percent of P189,230, are expected for
the next six years. Given this information, which of the following
statements is true?
A. This investment offers an actual rate of return of 15 percent
B. This investment offers an actual rate of return of less than 15
percent
C. This investment offers an actual rate of return of more than 15
percent
D. This investment offers a negative rate of return
43.
CBN Products, Inc. is considering to invest in one of two
projects. Both projects have a net present value of P25,000;
however Project Alpha requires an initial investment of P700,000
while Project Delta requires an initial investment of P300,000.
Based on this information, which of the following statements is
true?
A. Project Delta will have a higher profitability index
B. Project Alpha will have a higher profitability index
C. Both project will have the same profitability index
D. There is not enough information to determine the profitability
index of either project
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Capital Budgeting
44.
45.
Problems associated with justifying investments in high-tech
projects often include
A. discount rates that are too low and time horizons that are too
long
B. discount rates that are too high and time horizons that are
too long
C. discount rates that are too high and time horizons that are
too short
D. discount rates that are too low and time horizons that are too
short
In addition to incremental revenues, cash inflows from capital
investments can be generated from all of the following sources
except
A. debt financing
B. cost savings
C. salvage value
D. reduction in the amount of working capital
46.
Camel Company, a local company that specializes in home
repairs, is considering replacing its older van with a new and
larger one. The estimated cost of the new van will be P65,0000.
Using a discount rate of 18 percent, the company calculates a net
present value for the new van of P(5,000).
Based on this
information, which of the following statements is true?
A. The actual rate of return on the new van is negative.
B. If the company purchases the van, they are guaranteed a rate
of return of at least 18%.
C. Using a higher discount rate should cause the net present
value to become positive.
D. If the actual cost of the new van ends up being less than
P60,000, the net present value becomes positive.
47.
Diliman Plumbers, Inc. is considering the purchase of a
machine costing approximately P40,000. Using a discount rate of
20 percent, the present value of future cash inflows are calculated
to be P40,000. To yield at least a 20 percent return, the actual
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Capital Budgeting
cost of the machine should not exceed the P40,000 estimated by
more than:
A. P40,000
B. P80,000
C. P 8,000
D. P 0
48.
The appropriate discount rate that the analysts use
computing the present value of future cash flows is comprised
which of the following?
A. An increase in the rate reflecting the inflation expected
occur over the life of the project.
B. A risk factor reflecting the riskiness of the project.
C. A pure rate of interest reflecting the productive capability
the capital asset.
D. All of the given choices are components of the discount rate.
in
of
to
of
49.
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.
50.
The payback method, as a capital budgeting technique, assumes
that all intermediate cash inflows are reinvested to yield a return
equal to:
A. Zero
B. The Time-Adjusted-Rate-of-Return
C. The Discount Rate
D. The Cost-of-Capital
51.
Which of the following capital budgeting methods is the least
theoretically correct?
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Capital Budgeting
A.
B.
C.
D.
payback method
net present value
internal rate of return
none of the given choices
52.
Why do NPV method and the IRR method sometimes give
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.
53.
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 shortterm
C. It emphasizes the amount of income earned over the life of the
proposal
D. Rankings of proposals are necessary
54.
When evaluating depreciation methods, the managers who are
concerned about capital investment decisions most likely
A. choose straight line depreciation so there is minimum impact
on the decision.
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Capital Budgeting
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. Assume that the choice of depreciation method has no impact
on the capital investment decision.
55.
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
56.
If
A.
B.
C.
D.
57.
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
58.
The length of time needed for a long-term project to recapture its
initial investment amount is called the:
A. Discount period
B. Present value
C. Payback period
D. Internal rate of return
the internal rate of return on an investment is zero:
its NPV is positive.
its annual cash flows equal its required investment.
it is generally a wise investment.
its cash flows decrease over its life.
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Capital Budgeting
59.
Which of the following is not a typical cash outflow associated
with a capital investment?
A. Repairs and maintenance needed for purchased equipment.
B. Additional operating costs resulting from the capital
investment.
C. Salvage value received when the newly purchased equipment
is sold.
D. Purchase price of the new equipment.
60.
The internal rate of return method assumes that intermediate
cash flows are immediately reinvested at:
A. The actual rate of return earned by the project.
B. The company’s discount rate.
C. The lower of the company’s discount rate or internal rate of
return.
D. An average of the internal rate of return and the discount rate.
61.
When using the net present value method, the interest rate used
to discount cash flows should not be thought of as the:
A. Hurdle rate
B. Minimum required rate of return
C. Internal rate of return
D. Discount rate
62.
Which of the following statements is false regarding the interest
rate used in net present value calculations?
A. Some companies use their cost of capital as the discount rate.
B. It may be adjusted for uncertainty.
C. It should be equal to the maximum required rate of return
needed to make the investment profitable.
D. It may be higher or lower than the investment’s actual internal
rate of return.
63.
When using the net present value method for a particular
investment decision, if the present value of all cash inflows is
greater than the present value of all cash outflows, then:
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Capital Budgeting
A. The discount rate used was too high.
B. The investment provides an actual rate of return greater than
the discount rate.
C. The investment provides an actual rate of return equal to the
discount rate.
D. The discount rate was too low.
64.
All other things being equal, as cost of capital decreases:
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 the cost of capital.
D. The company will probably want to borrow money rather than
issue stock.
65.
Depreciation charges indirectly affect the after-tax cash flow
because the company
A. Can deduct depreciation expenses on their financial
statements, reducing reported income before tax.
B. Can deduct depreciation expenses on their financial
statements, increasing cash inflows.
C. Can deduct depreciation expenses on their income tax
returns, reducing cash outflow for taxes.
D. Cannot deduct depreciation expenses on their income tax
returns.
66.
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.
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Capital Budgeting
67.
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
68.
The rate that produces a zero net present value when a project’s
discounted cash operating advantage is compared to its
discounted net investment is the:
A. Cost of capital
B. Discount rate
C. Cutoff rate
D. Internal rate of return
69.
NPV indicates that a project is deemed desirable when the net
present value 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. s less than or equal to the risk-adjusted cost of capital
70.
Sensitivity analysis is
A. an appropriate response to uncertainty in cash
projections
B. useful in measuring the variance of the Fisher rate
C. typically conducted in the post investment audit
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flow
Capital Budgeting
D. useful to compare projects requiring vastly different levels of
initial investment
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Capital Budgeting
71.
Which of the following is not a typical cash inflow in capital
investment decisions?
A. Incremental revenues
B. Cost reductions
C. Salvage value
D. Additional working capital
72.
When comparing NPV and IRR, which is incorrect?
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
73.
In which circumstances should the tax consequences be
considered when making capital investment decisions?
A. Positive net income
B. Disposal of an asset
C. Depreciation
D. All of the given choices
74.
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.
75.
Which of the following is a cost that requires a future outlay of
cash that is a relevant one for future decision making?
A. Opportunity cost
B. Relevant benefits
C. Out-of-pocket cost
D. Incremental revenue
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Capital Budgeting
76.
Which of the following capital budgeting methods assumes that
intermediate cash inflows are reinvested at the minimum
acceptable rate of return?
A. Net present value method.
B. Unadjusted rate of return method.
C. Payback method.
D. Internal rate of return method.
77.
If the net present value (NPV) of an investment is zero, then the
internal rate of return (IRR) is:
A. Less than the discount rate.
B. Higher than the discount rate.
C. Equal to the discount rate.
D. Negative.
78.
The calculation of the profitability index (PI) is most helpful for
which type of decisions?
A. Screening
B. Preference
C. Qualitative
D. Short-term
79.
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.
80.
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
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Capital Budgeting
PROBLEMS:
1.
Bravado Company is considering to replace its old equipment
with a new one. The old equipment had a net book value of
P100,000 and 4 remaining useful years 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
B. P 72,000
C. P 80,000
D. P 68,000
2.
Myriad 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 straightline 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
B. P28,000
C. P40,000
D. P 4,000
3.
If an asset costs P35,000 and is expected to have a P5,000
salvage value at the end of its ten-year life, and generates annual
net cash inflows of P5,000 each year, the cash payback period is
A. 8 years
B. 7 years
C. 6 years
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Capital Budgeting
D. 5 years
4.
Umali 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 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
P400,000
90,000
60,000
0
50,000
8 years
What is the expected payback period for the new machine?
A. 4.44 years
B. 8.50 years
C. 2.67 years
D. 3.78 years
5.
For P4,500,000, Siren 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
Second year
Third year
Fourth year
Fifth year
P 900,000
1,200,000
1,500,000
900,000
800,000
Siren will use the sum-of-the-years-digits’ method to depreciate the
new machine as follows:
First year
Second year
P1,500,000
1,200,000
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Capital Budgeting
Third year
Fourth year
Fifth year
900,000
600,000
300,000
What is the payback period for the machine?
A. 3 years
B. 4 years
C. 5 years
D. 2 years
6.
Consider a project that requires cash outflow of P50,000 with a
life of eight years and a salvage value of P5,000. Annual beforetax cash inflow amounts to P10,000. Salvage value is ignored in
computing depreciation.
Assuming a tax rate of 30% and a required rate of return of 8%,
what is the payback period for the project?
A. 5.0 years
B. 5.6 years
C. 6.0 years
D. 6.6 years
7.
Machine Manufacturing Company considers a project that will
require an initial investment of P500,000 and is expected to
generate future cash flows of P200,000 for years 1 through 3 and
P100,000 for years 4 through 7. The project’s payback period is:
A. 2.50 years
B. 3.50 years
C. 1.67 years
D. 3.33 years
8.
Vinson Industries, Inc. requires all its capital investment
projects to have a payback period of 5 years or shorter. Vinson is
currently considering an equipment purchase that has an initial
cost of P900,000. The equipment is expected to have a ten-year
life and a salvage value of P50,000. Assuming cash flows are
229
Capital Budgeting
equal, how much annual cash inflows are necessary in order to
meet the payback period requirement?
A. P180,000
B. P170,000
C. P190,000
D. P 90,000
9.
The Dwight Company plans to invest in a duplicating machine
that costs P120,000. The following are the expected annual cash
inflows that are evenly received each month and the estimated
salvage value at any point of each year.
Year
1
2
3
4
5
Cash Inflows
P40,000
36,000
32,000
28,000
25,000
Salvage Value
P50,000
40,000
28,000
20,000
5,000
What is the bail-out period for this project?
A. 2.50 years
B. 2.43 years
C. 2.57 years
D. 1.83 years
10.
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.
230
Capital Budgeting
Salvage value is ignored in computing depreciation. The net
present value amounts to
A. P 7,560
B. P 10,050
C. P 17,606
D. P 20,050
11.
Vendo 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. Vendo estimates
that this machine will yield an annual inflow, net of depreciation
and income taxes, of P120,000. Vendo’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
12%
14%
16%
18%
NPV
+P3,258
+ 1,197
708
- 2,474
Vendo’s expected IRR on its investment in this machine is
A. 3.25%
B. 12.00%
C. 16.00%
D. 15.30%
12.
Camel Company invests in a machine with a useful life of six
years and no salvage value. The machine will be depreciated
using the straight-line method. It is 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 Camel uses a time-adjusted rate of return of 10%,
how much is the original investment?
231
Capital Budgeting
A.
B.
C.
D.
P10,640
P29,510
P22,750
P26,130
13.
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 flows, net of
income taxes are 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
B. P 7,120
C. P10,000
D. P16,392
14.
The Miracle 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
B. P660,000
C. P550,000
D. P792,000
15.
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
232
Capital Budgeting
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
B. P115,168
C. P215,560
D. P287,893
16.
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
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
Second year
P150,000
120,000
233
Capital Budgeting
Third year
Fourth year
Fifth year
90,000
60,000
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
Period
Period
Period
Period
1
2
3
4
5
0.89280
0.79719
0.71178
0.63552
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
B. Decrease of P 9,750
C. Decrease of P24,376
D. Increase of P24,376
Questions 17 through 20 will be based on the following data:
The management of Queen 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:
234
Capital Budgeting
Year
1
2
3
4
5
Income from
Operations
P100,000
40,000
20,000
10,000
10,000
Net Cash
Flow
P180,000
120,000
100,000
90,000
90,000
17.
The average rate of return for this investment is:
A. 18 percent
B. 6 percent
C. 58 percent
D. 10 percent
18.
The net present value for this investment is:
A. Positive P 36,400
B. Positive P 55,200
C. Negative P 99,600
D. Negative P126,800
19.
The present value index for this investment is:
A. 0.88
B. 1.45
C. 1.14
D. 0.70
20.
The cash payback period for this investment is:
A. 4 years
B. 5 years
C. 20 years
D. 3 years
21.
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
235
Capital Budgeting
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
B. 28,897
C. 9,838
D. 12,338
22.
Refer to the preceding number:
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
B. P95.00
C. P70.00
D. P90.00
23.
Savior Products is considering a purchase of any of 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?
236
Capital Budgeting
A.
B.
C.
D.
15% Discount
Machine 1
Machine 2
Machine 1
Machine 2
8% Discount
Machine 1
Machine 2
Machine 2
Machine 1
237
Capital Budgeting
24.
Refer to the preceding number:
At what discount rate would Machine 1 be equally acceptable as
machine 2’s?
A. 9%
B. 10%
C. 11%
D. 12%
25.
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)
B. P (25,310)
C. P 1,922
D. P (61,094)
26.
Taal Company is considering the purchase of a machine that
promises to reduce operating costs by equal amounts every year
238
Capital Budgeting
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 annuity of 1 for 6 periods at 20% is 3.326, and the
present value at the end of 6 periods is 0.3349.
The approximate annual cash savings before tax is closest to:
A. P252,555
B. P112,555
C. P187,592
D. P327,592
27.
The Premiere 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. 1.07
C. 1.06
D. 0.94
28.
Vivo 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.
239
Capital Budgeting
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. Vivo Insurance Company’s tax
rate is 40 percent.
240
Capital Budgeting
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 payback period for the advertising program is
A. 4.6 years
B. 1.9 years
C. 3.0 years
D. 2.5 years
29.
Refer to question Number 28.
The net present value of the advertising program would be
A. P 37,064
B. P(37,064)
C. P 29,136
D. P(29,136)
30.
The Leisure Company is considering the purchase of electronic
pinball machines to be installed in various 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 upon its
retirement. Based on experience with other equipment, the
company estimates that annual revenues and expenses
associated with the machines would be as follows:
Revenues from use
Less operating expenses
Commissions to amusement houses
Insurance
Depreciation
Maintenance
Net income
241
P200,000
P100,000
7,000
35,000
18,000
160,000
P 40,000
Capital Budgeting
31.
32.
Ignoring the effect of income taxes, the payback period for the
pinball machines would be
A. 3.7 years
B. 3.2 years
C. 4.0 years
D. 7.5 years
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%
B. 7.6%
C. 10.9%
D. 12.3%
It is the start of the year and Agudelo Company plans to replace
its old grinding equipment. The following information is 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)
B. (P120,000)
C. (P106,000)
D. (P124,700)
242
Capital Budgeting
33.
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 10year 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
B. P147,487
C. P114,154
D. P 88,492
34.
Polar Company purchased an asset costing P90,000. Annual
operating cash inflows are expected to be P20,000 each year for
six years. No salvage value is expected at the end of the asset’s
life. The company applies a 16 percent minimum acceptable rate
of return for this kind of investment. The details of the present
values at 16%, six periods are:
Present value of ordinary annuity of 1
Present value of annuity due of 1
3.6847
4.2743
Assuming Polar’s cost of capital is 16 percent, what is the asset’s
net present value? (ignore income taxes).
A. P(16,306)
B. P 30,000
C. P (4,514)
D. P 4,800
35.
Mid-Circle Products, Inc. purchased equipment costing
P100,000. Annual operating cash inflows are expected to be
243
Capital Budgeting
P30,000 each year for five years. At the end of the equipment’s
life, the salvage value is expected to be P6,000. The present value
of cash inflows per 1 at 1 percent, 5 years are:
Present value of 1, end of 5 periods
Present value of ordinary annuity of 1, 5 periods
3.43308
Present value of annuity due of 1, 5 periods
0.51937
3.91371
If Mid-Circle’s cost of capital is 14 percent, what is the asset’s net
present value? (ignore income taxes).
A. P 6,109
B. P20,528
C. P 7,840
D. P23,592
36.
Pale Products Company is considering the purchase of a new
machine. The estimated cost of the machine is P250,000. The
machine is not expected to have a residual value at the end of
four years. The machine is expected to generate annual cash
inflows for the next four years as follows:
Year
1
2
3
4
Annual Cash Inflow
P150,000
P100,000
P 50,000
P 50,000
Pale Products requires a 12 percent return on this investment.
The present value of annuity of 1 at 12 percent for 4 periods is
3.03735. The present values of 1, end of each period, discounted
at 12 percent follow:
Year
1
2
Present Value of 1
0.89286
0.79719
244
Capital Budgeting
3
4
0.71178
0.63552
Assuming that the company uses a discount rate of 12 percent,
what is the expected net present value of the machine (ignore
income taxes)?
A. P 31,013
B. P 15,765
C. P(27,570)
D. P 42,000
37.
Pale Products Company is considering the purchase of a new
machine. The estimated cost of the machine is P300,000. The
machine is not expected to have a residual value at the end of
four years. The machine is expected to generate annual cash
inflows for the next four years as follows:
Year
Annual Cash Inflow
1
P150,000
2
P120,000
3
P 90,000
4
P 50,000
Pale Products has a policy of accepting a project only if it has a
payback period of not longer than 3 years.
What is the expected payback period for this project?
A. 2.93 years
B. 2.33 years
C. 3.00 years
D. 3.60 years
38.
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.
245
Capital Budgeting
3. Estimated net annual cash inflows for each of the 8 years
– P81,000.
4. Time-adjusted internal rate of return – 14%
5. Cost of capital for Julian Corp. – 16%
6. 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
B. P5,501
C. P4,344
D. P5,871
39.
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 of 15% internalrate of 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 is the annual peso value of the intangible benefits in order
to make the equipment an acceptable investment?
A. P248,123
B. P 49,440
C. P 61,331
D. P 55,000
40.
The Mejicano Company is planning to purchase a piece of
equipment that will reduce annual cash expenses over its 5-year
246
Capital Budgeting
useful life by equal amounts. The company will depreciate the
equipment using straight-line method of depreciation based on an
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
calculates, based on the estimated after-tax cash flows, that the
internal-rate of return is 12.386 percent and 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?
A. 1.011
B. 1.034
C. 1.022
D. 1.044
41.
Capital Company requires all capital investment to generate an
internal rate of return of 16 percent.
Capital is currently
considering an investment in a machine that is expected to
generate annual cash inflows of P15,000 for 7 years. The present
value of ordinary annuity of 1, 16 percent for 7 years is 4.03856.
Applying the discounted technique, the amount of investment
should not exceed:
A. P16,800
B. P37,150
C. P60,580
D. P95,500
42.
Pacau, Inc. requires all its capital investments to generate an
internal rate of return of 14 percent. The company is considering
an investment costing P80,000 that is expected to generate equal
annual cash inflows for 5 years. The present value of 1, end of 5
years is 0.51937 and the present value of annuity of 1 is 3.4331
based on 14 percent required rate of return.
247
Capital Budgeting
To meet the 14 percent minimum acceptable rate of return, the
estimated annual cash inflow (ignoring income taxes) is:
A. P 23,303
B. P 51,550
C. P274,648
D. P154,033
43.
Mermaid, Inc. requires all its capital investments to generate an
internal rate of return of 12 percent. The company is considering
an investment costing P150,000 that is expected to generate equal
annual cash inflows of P40,000 for 5 years . The present value of
1, end of 5 years is 0.56743 and the present value of annuity of 1
is 3.60478 based on 12 percent required rate of return.
To meet the 12 percent minimum acceptable rate of return
required by mermaid, the estimated salvage value at the end of 5
years(ignoring income taxes) should be:
A. P10,237
B. P 3,296
C. P 1,611
D. P20,940
44.
Rainbow Company has a project that requires an initial
investment of P100,000 and has the following expected stream of
cash inflows:
Year
1
2
3
Annual Cash Inflow
P80,000
P60,000
P20,000
The present value of annuity of 1 at 12 percent for 3 periods
2.40183 is and the details are:
Year
Annual Cash Inflow
1
0.89286
2
0.79719
248
Capital Budgeting
3
0.71178
Assuming the company adopts the cost of capital of 12 percent as
the discount rate, what is the profitability index for the project?
A. 0.749
B. 1.335
C. 1.600
D. 2.985
45.
Grant Company is considering to invest in an equipment that
costs P70,000.
The equipment would be depreciated over 7 years using straightline method, no salvage value and full year’s depreciation to be
recognized in the first year of the asset’s use. The present value of
annuity of 1, discounted at 14 percent for 7 years is 4.28843, and
the present value of 1 end of 7 years is 0.39963.
If the company has 40 percent tax rate and desires an after-tax
rate of return of 14 percent on investments, the total present
value of the tax shield is:
A. P42,884
B. P27,972
C. P25,731
D. P17,153
46.
Blue Marine 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
Blue Marine 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.
249
Capital Budgeting
The net present value to be provided by the replacement of the old
machine is
A. P28,493
B. P15,693
C. P46,794
D. P59,594
47.
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
B. P26,600
C. P24,400
D. P22,535
48.
Paulina’s Products, Inc. is considering a new piece of equipment
that costs P75,000. The equipment is expected to generate
revenues before-tax cash inflows of P25,000 per year for five
years. The equipment would be depreciated using straight-line
method over its five-year life. Upon retirement, the machine is
expected to have a market value of P8,000.
The company
considers the maximum impact of income taxes in all of its
capital investment decisions. The company has a 35 percent
income tax rate and desires an after-tax rate of return of 12
percent on its investment.
The present value of 1, end of 5 years at 12% is 0.56743 and for
ordinary annuity is 3.60478.
250
Capital Budgeting
The net present value of the equipment is:
A. P 7,042
B. P 4,539
C. P 21,248
D. P 5,453
49.
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
B. P19,670
C. P13,419
D. P27,936
50.
Zambales Mines, Inc. is contemplating the purchase of a piece of
equipment to exploit a mineral deposit that is located on land to
which the company has mineral rights. Based on an engineering
and cost analysis, the following cash flows associated with
opening and operating a mine in the area are expected.
Cost of new equipment and timbers
251
2,750,000
Capital Budgeting
Working capital required
Net annual cash receipts*
Cost to construct new road in three years
Salvage value of equipment in 4 years
1,000,000
1,200,000
400,000
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%.
The net present value for the project is:
A. P 454,620
B. P (79,303)
C. P(561,553)
D. P(204,688)
51.
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
Annual cost savings that will be provided by
the equipment
Life of the equipment
P432,000
90,000
12 years
What is the simple rate of return to be provided by the
equipment?
A. Between 15% and 18%
B. 25.00%
C. 20.83%
D. 12.50%
252
Capital Budgeting
Questions 52 rough 57 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):
Small
Medium
Large
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. 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
253
Capital Budgeting
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.
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
Rent- building space
Rent- video games
Salaries
Utilities
Insurance and other
Install the
Game Center
P18,000
30,000
17,000
5,400
9,600
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.
52.
The incremental annual cash inflows from Alternative 1 is:
A. P 90,000
B. P108,000
C. P100,200
254
Capital Budgeting
D. P201,000
53.
The incremental annual cash inflows from Alternative 2 is:
A. P 17,000
B. P 65,000
C. P 59,600
D. P145,000
54.
The net present value for Alternative 1 is:
A. P48,650
B. P47,840
C. P45,000
D. P32,500
55.
The net present value for Alternative 2 is:
A. P21,021
B. P70,103
C. P68,375
D. P12,807
56.
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)
B. P(76,422)
C. P(82,150)
D. P(80,854)
57.
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
255
Capital Budgeting
each year and still allow the game center to provide a 16% rate of
return?
A. P70,103.00
B. P 4,673.53
C. P58,953.00
D. P12,574.53
Questions 58 through 62 are based on the following information:
Pinewood Craft Company is considering the purchase of two different
items of equipment, as described below:
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:
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. Annual fixed expenses associated with the new shelving products
would be: advertising, P40,000; salaries, P110,000; utilities,
P5,200; and insurance, P800.
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:
256
Capital Budgeting
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.
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)
58.
The expected income each year from the new shelving products
(Machine A) is:
A. P 52,500
B. P240,000
C. P 84,000
D. P 92,500
59.
The annual savings in cost if Machine B is purchased is
A. P56,250
B. P43,250
C. P38,250
D. P21,750
60.
The simple rate (%) of return for Machine A is:
A. 12.5 percent
B. 20.0 percent
C. 25.0 percent
D. 18.0 percent
257
Capital Budgeting
61.
62.
63.
The simple rate of return for Machine B is:
A. 16.3 percent
B. 17.0 percent
C. 25.0 percent
D. 34.0 percent
The payback period for Machine A is:
A. 3.0 years
B. 4.5 years
C. 5.0 years
D. 7.5 years
The payback period for Machine B is:
A. 4.0 years
B. 4.2 years
C. 6.1 years
D. 5.9 years
Question Nos. 64 through 69 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
P 3.60
3.90
1.50
9.00
P18.00
*Depreciation of tools (that must now be replaced) accounts for onethird of the fixed overhead. The balance is for other fixed overhead
costs of the factory that require cash expenditures.
258
Capital Budgeting
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 tax purposes, the following
amounts of variable depreciation will be used.
Year 1
P 832,500
Year 2
1,112,500
Year 3
370,000
Year 4
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 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
P 4.50
3.00
0.80
10.80
P19.10
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.”
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
259
Capital Budgeting
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
260
0.89286
0.79719
0.71178
0.63552
3.03735
Capital Budgeting
64.
The net investment in new tools amounted to:
A. P1,873,300
B. P2,515,000
C. P2,528,500
D. P2,546.500
65.
How much annual cost savings will be generated if the Turkey
Company purchases the new tools?
A. P128,000
B. P216,000
C. P 936,000
D. P1,008,000
66.
The present value of tax benefits expected from the use of the
new machine tools is:
A. P 603,333
B. P 804,444
C. P1,407,777
D. P2,011,111
67.
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
B. P 19,065
C. P 44,486
D. P212,615
68.
Using the minimum acceptable rate of return of 12 percent, the
net present value of the investment in new tools is
A. P108,913
B. P127,979
C. P147,073
D. P166,139
69.
The net advantage of the use of declining method of depreciation
instead of straight-line method is
261
Capital Budgeting
A.
B.
C.
D.
70.
P 33,830
P 56,610
P112,767
P147,731
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
B. P550,000
C. P660,000
D. P792,000
71.
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
B. P40,250
C. P42,000
D. P77,000
Question Nos. 72 through 74 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
262
Capital Budgeting
value of P55,000. Installation costs and freight charges will be P24,200
and P800, respectively. Cayco 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
72.
The cash payback period is:
A.
3.0 years
B.
4.8 years
C.
5.0 years
D.
6.0 years
73.
The project is expected to generate net present value of:
A.
P276,510
B.
P299,743
C.
P331,510
D.
P253,277
74.
What is the accounting rate of return provided by the project?
A. 20.0 percent
B. 10.6 percent
C. 11.2 percent
D. 38.0 percent
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
263
Capital Budgeting
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.
75.
The amount of annual after-tax cash flows is:
A. P2,400,000
B. P3,000,000
C. P 900,000
D. P1,500,000
76.
The machine’s net present value is:
A. P2,786,100
B. P 928,500
C. P1,028,900
D. P 150,270
77.
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
B. 23,400 units
C. 16,714 units
D. 10,029 units
78.
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, 2008, this machine
would 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,
2008. Management expects to sell 300,000 dozen cookies in each
264
Capital Budgeting
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
P80,000
6 years
New
Machine
P120,000
6 years
Original cost of machine at acquisition
Remaining useful life as of 12/31/08
Expected
annual
cash
operating
expenses:
Variable cost per dozen
P0.38
P0.29
Total fixed costs
P21,000 P 11,000
Estimated cash value of machines:
December 31, 2008
P40,000 P120,000
December 31, 2014
P 7,000 P 20,000
Assume all operating revenues and expenses occur at the end of
the year.
The net advantage in present value, using a 16% rate, 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.
79.
Kipling Company has invested in a project that has an eightyear 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?
265
Capital Budgeting
A.
B.
C.
D.
80.
P160,000
P 99,360
P 80,800
P 64,640
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
B. P30,000
C. P35,000
D. P37,236
266
Capital Budgeting
Question Nos. 81 through 85 are based on the following:
Lakewood Company is considering the purchase of a special-purpose
bottling machine for P280,000. It is expected to have a useful life of 7
years with a zero terminal disposal price. The plant manager estimates
the following savings in cash-operating costs:
Year
1
2
3
4
5
6
7
Annual Cash Savings
P140,000
110,000
80,000
60,000
40,000
30,000
30,000
Lakewood uses a required rate of return of 12% in its capital-budgeting
decisions. Incremental tax rate is 40%. The company uses straight-line
depreciation. The present value of annuity of 1, at 12 percent for 7 years
is 4.56376. The details of the present value at 12 percent in 7 years are:
Year
1
2
3
4
5
6
7
81.
A.
B.
C.
D.
Annual Cash Savings
0.89286
0.79719
0.71178
0.63552
0.56743
0.50663
0.45235
The number of years to recover the amount investment is:
4.83 years
3.65 years
2.38 years
4.00 years
267
Capital Budgeting
82.
What is the amount of after-tax cash flow in year 7?
A. P30,000
B. P34,000
C. P36,400
D. P22,000
83.
What is the net present value for this investment?
A. P 4,723
B. P 8,559
C. P (2,159)
D. P 0
84.
What is the accounting rate of return based on initial
investment?
A. 6.43%
B. 12.86%
C. 20.71%
D. 41.42%
85.
What is the net advantage of applying sum-of-the-years’-digits
method instead of using straight-line depreciation?
A. P6,379
B. P8,188
C. P4,154
D. P2,491
268