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Solutions Manual

CHAPTER 28
BASICS OF CAPITAL BUDGETING
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. Only cash can be spent or reinvested, and since accounting profits do not
necessarily represent all cash, they are of less fundamental importance
than cash flows for investment analysis.
2. Capital budgeting analysis should only include those cash flows that will
be affected by the decision. Sunk costs are unrecoverable and cannot be
changed, so they have no bearing on the capital budgeting decision.
Opportunity costs represent the cash flows the firm gives up by investing
in this project rather than its next best alternative, and externalities are
the cash flows (both positive and negative) to other projects that result
from the firm undertaking this project. These cash flows occur only
because the firm took on the capital budgeting project; therefore, they
must be included in the analysis.
3. When a firm takes on a new capital budgeting project, it typically must
increase its investment in receivables and inventories, over and above the
increase in payables and accruals, thus increasing its net operating
working capital (NOWC). Since this increase must be financed, it is
included as an outflow in Year 0 of the analysis. At the end of the
projects life, inventories are depleted and receivables are collected.
Thus, there is a decrease (or reduction) in NOWC, which represents an
inflow in the final year of the projects life.
4. The costs associated with financing are reflected in the weighted average
cost of capital. To include interest expense in the capital budgeting
analysis would double count the cost of debt financing.
5. Daily cash flows would be theoretically best, but they would be costly to
estimate and probably no more accurate than annual estimates because
we simply cannot forecast accurately at a daily level. Therefore, in most
cases we simply assume that all cash flows occur at the end of the year.
However, for some projects it might be useful to assume that cash flows
occur at mid-year, or even quarterly or monthly. There is no clear
upward or downward bias on NPV since both revenues and costs are
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Chapter 28

Basics of Capital Budgeting

being recognized at the end of the year. Unless revenues and costs are
distributed radically different throughout the year, there should be no
bias.
6. In replacement projects, the benefits are generally cost savings, although
the new machinery may also permit additional output. The data for
replacement analysis are generally easier to obtain than for new products,
but the analysis itself is somewhat more complicated because almost all
of the cash flows are incremental, found by subtracting the new cost
numbers from the old numbers. Similarly, differences in depreciation
and any other factor that affects cash flows must also be determined.
II. Problems
Problem 1
(a)

Equipment purchase
NOWC investment
Initial investment outlay

(P 9,000,000)
(3,000,000)
(P12,000,000)

(b) No, last years P50,000 expenditure is considered a sunk cost and does not
represent an incremental cash flow. Hence, it should not be included in the
analysis.
(c) The potential sale of the building represents an opportunity cost of
conducting the project in that building. Therefore, the possible proceeds
after taxes and commissions must be charged against the project as a cost.
Problem 2
(a) The projected cash flow for the first year is:
Project cash flows: t = 1
Sales revenues
Operating costs
Depreciation
EBIT
Taxes (40%)
EBIT (1 T)
Add back depreciation
Project cash flow = EBIT (1 T) + DEP
28-2

P10,000,000
7,000,000
2,000,000
P 1,000,000
400,000
P 600,000
2,000,000
P 2,600,000

Basics of Capital Budgeting

Chapter 28

Problem 3
Equipments original cost
Depreciation (80%)
Book value

P250 M
200 M
P 50 M

Loss on sale = P5 M P50 M


= P45 M
Tax savings = P45 M (0.4)
= P18 M
After-tax salvage value = P5 M + P18M
= P23 M
Problem 4
Level of working capital for old machine

= P25,000 P5,000
= P20,000

Level of working capital for new machine

= P20,000 P5,000
= P15,000

Incremental investment in net working capital

= P15,000 P20,000
= P5,000

Problem 5
Level of working capital for old machine

= P20,000 P5,000
= P15,000

Level of working capital for new machine

= P30,000 P10,000
= P20,000

Incremental investment in net working capital

= P20,000 P15,000
= P5,000

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Chapter 28

Basics of Capital Budgeting

Problem 6
Investment in net working capital

P1,000,000 + (P750,000 x 0.40)


(P1,000,000 x 0.50)

P800,000

P175,000 + P25,000 + (P50,000


P22,500)

P227,500

(P120,000 P50,000) (0.66) +


(P50,000) (0.34)

P63,200

(P50,000) (0.66) + (P50,000


P22,500)

P60,500

Problems 7 through 9:
Problem 7
Net investment cash flow

Problem 8
Operating cash flow

Problem 9
Disposal cash flow

Problems 10 through 13:

Assume that the equipment has 3-year life for tax


purposes using straight line method. Hence no
depreciation can be claimed in the 4 th and 5th years
of the project.

Problem 10
Net investment in cash flow

P175,000 + (P15,000 x 0.60)

P184,000

(P80,000 P10,000) (0.66) +


(175,000 x 0.3333) (0.34)

P66,033

Problem 11
Operating cash flow (1st year)

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Basics of Capital Budgeting

Chapter 28

Problem 12
Operating cash flow (2nd year)

(P80,000 P10,000) (0.66) +


(175,000 x .3333) (0.34)

P66,033

Problem 13 (Total Cash Flows in the 4th year)


Operating cash flow

(P80,000 P10,000) (0.66)

P46,200

Proceeds for sale (no gains for loss asset


fully depreciated)
Recovery working capital (P15,000 x 0.60)
Project-disposal cash flow
Total cash flow

Problems 14 through 19:

P10,000
9,000
P19,000

P46,200 + P19,000

P65,200

Assume that the equipment has an economic life of 3


years and will be depreciated over that period using
straight line method.

Problem 14
Net investment in cash flow

P2,000,000 + (P250,000 x 0.40)

P2,100,000

(P800,000 P350,000) (0.66) +

Problem 15
Operating cash flow (1st year)

P2,000,000 P1,000,000
3

P512,333

(P800,000 P350,000) (0.66) +


(P215,333)

Problem 16
Operating cash flow (2nd year)

28-5

(0.34)

Chapter 28

Basics of Capital Budgeting

P512,333

(P800,000 P350,000) (0.66) +


(P215,333)

P512,333

P2,000,000 P1,900,000

P100,000. If sold for P100,000, no

Problem 17
Operating cash flow (3rd year)

Problem 18
Book value

gain or loss will occur.


Taxes

(P100,000 P100,000) (0.34)

P0

Problem 19
Project-disposal cash flow (end of 3rd year)
Recovery of net working capital (P250,000 x .40)
Proceeds from sale of equipment
Total

28-6

P100,000
100,000
P200,000

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