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Capital Budgeting

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MODULE 9

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.

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

Capital budgeting defined

1. The long-term planning process for making and financing investments that affect a

companys financial results over a number of years is referred to as

A. capital budgeting

C. master budgeting

B. strategic planning

D. long-range planning

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

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.

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.

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.

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.

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

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Capital Budgeting

D. low and time horizons that are too short

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.

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

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.

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

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 projects 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

projects life, it is ignored in computing the amount of the investment required for

the project.

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

31.In connection with a capital budgeting project, an investment in working capital is

normally recovered

A. at the end of the projects life

B. in the first year of the projects life

C. evenly through the projects life

D. when the company goes out of businessA

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.

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Capital Budgeting

B. Decrease the cost of the investment and decrease cash flows at the end of the

projects 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

projects life.

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.

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.

Cash inflow

66.Which of the following is not a typical cash inflow in capital investment decisions?

A. Incremental revenues

C. Salvage value

B. Cost reductions

D. Additional 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

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.

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.

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

assets life.

D. choice of depreciation method has no impact on the capital investment decision.

70.The tax consequences should be considered under which circumstances when making

capital investment decisions?

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Capital Budgeting

B. Disposal of an asset

C. Depreciation

D. All of the above

Loan financing

43.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

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 projects life.

D. ignore the loan

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.

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

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

34.The technique most concerned with liquidity is

A. Payback method.

B. Net present value technique.

C. Internal rate of return.

D. book rate of return.

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

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.

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Capital Budgeting

33.Which of the

A. It ignores

B. It ignores

C. It ignores

D. It ignores

cash flows because it uses net income.

profitability.

the present values of cash flows.

the pattern of cash flows beyond the payback period.

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

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

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

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.

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.

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

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

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.

D. will never be greater than 1.0.

Internal rate of return

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Capital Budgeting

assumes cash flows are reinvested at the projects rate of return?

A. payback period

C. internal rate of return

B. net present value

D. none of the above

62.The rate of interest that produces a zero net present value when a projects 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

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 companys 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

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

Relationships among NPV, PI & IRR

24.If a companys required rate of return is 12 percent and in using the profitability index

method, a projects index is greater than 1.0, this indicates that the projects 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.

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.

B. equal to the cost of borrowed capital.

C. equal to zero.

D. lower than the companys cutoff rate return.

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 companys cutoff rate for

payback will not meet the companys criterion for IRR.

D. none of the above.

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

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.

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Capital Budgeting

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.

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

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

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.

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

26.All

A.

B.

C.

other things being equal, as cost of capital increases

more capital projects will probably be acceptable.

fewer capital projects will probably be acceptable.

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.

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.

Decision rules independent projects

68.What type of decision involves deciding if an investment meets a predetermined

standard?

A. Investment decisions

C. Management decisions

B. Screening 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 companys cost of capital was low.

D. projects return will always exceed the companys cost of capital.

Net present value

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Capital Budgeting

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

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

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.

NPV & IRR

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.

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 companys profit.

C. if accepted, can also lead to the acceptance of a competing project.

D. require all managers to consider.

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.

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.

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Capital Budgeting

17.A thorough evaluation of how well a projects 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

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 firms capital

investments.

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

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:

A. P252,555

C. P187,592

B. P112,555

D. P327,592

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 4year 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

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Capital Budgeting

salvage value is recognized in computing depreciation expense and no salvage value is

expected at the end of the life of the equipment. The companys 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

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

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

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 equipment90,000

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%.

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 average accounting rate of return on its investment?

A. 7.28 years

C. 9.05 years

B. 5.55 years

D. 4.75 years

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Capital Budgeting

viii

ix

with the expectation that P40,000 per year could be saved in after-tax cash operating

costs if the equipment were acquired. The equipments estimated useful life is 10

years, with no salvage value, and would be depreciated by the straight-line method.

Show Companys 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 assets use

is:

A. 20.0 percent

C. 10.0 percent

B. 10.5 percent

D. 40.0 percent

. 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%

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 years 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

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 years 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

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

Payback Period

xiii

. 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

C. 6 years

B. 7 years

D. 5 years

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

237

Capital Budgeting

xv

Discount

Discounte

Cumulative

Year

Cash Flow

Factor

d Cash

Cash Flows

(10%)

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

xvi

replace its existing cheese cutter. Information on the existing machine and the

replacement machine follow:

Cost of the new machine

P400,000

Net annual savings in operating costs

90,000

Salvage value now of the old machine

60,000

Salvage value of the old machine in 8 years

0

Salvage value of the new machine in 8 years

50,000

Estimated life of the new machine

8 years

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

xvii

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

xviii

xix

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 Companys tax rate is 40

percent.

The payback period for the advertising program is

A. 4.6 years

C. 3.0 years

B. 1.9 years

D. 2.5 years

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

238

Capital Budgeting

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

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

5,000

16,000

useful life

Annual operating costs

44,000

32,000

Accumulated

55,300

depreciation

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)

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 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

xxii

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 projects 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)

xxiii

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 Companys tax rate is 40

percent.

The present value of 1 at 10 percent, end of each period:

239

Capital Budgeting

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)

xxiv

xxv

. 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

. 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

xxvi

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

companys discount rate is 20%.

The net present value for the project is:

A. P 454,620.

C. P(561,553)

B. P (79,303).

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 years 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:

240

Capital Budgeting

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

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

New

Machine

Machine

Original cost of machine at

P80,000

P120,000

acquisition

Remaining useful life as of

6 years

6 years

12/31/06

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, 2006

P40,000

P120,000

December 31, 2012

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 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.

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

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

241

Capital Budgeting

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?

A. 1.011

C. 1.022

B. 1.034

D. 1.044

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. Diamonds 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

Diamonds expected IRR on its investment in this machine is

A. 3.25%

C. 16.00%

B. 12.00%

D. 15.30%

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

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. Forests expected

rate of return is 10%. Information on present value and future amount factors is as

follows:

PERIOD

1

2

3

4

5

Present value of P1 at 10%

.909 .826 .751 .683 .621

Present value of an annuity of .909 1.73 2.48 3.17 3.79

P1 at 10%

6

7

0

1

Future amount of P1 at 10%

1.10 1.21 1.33 1.46 1.61

0

0

1

4

1

Future amount of an annuity 1.00 2.10 3.31 4.64 6.10

of P1 at 10%

0

0

1

5

How much will the machine cost?

A. P 32,220

B. P 62,100

C. P 75,820

D. P122,100

xxxv

.

Paper Products Company is considering a new product that will sell for P100 and has

242

Capital Budgeting

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 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

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 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

C. P114,154

B. P147,487

D. P 88,492

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

xxxix

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

xl

. The following data pertain to Julian Corp. whose management is planning to purchase a

243

Capital Budgeting

unit of equipment.

1. Economic life of equipment 8 years.

2. Disposal value after 8 years Zero.

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 of Bayan Muna 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

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 companys

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 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

before-tax 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

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

xliv

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 companys 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

244

Capital Budgeting

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

12,000

15,200

inflow

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%

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 2s?

A. 9%

C. 11%

B. 10%

D. 12%

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

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

xlviii

245

Capital Budgeting

A. 3.0 years

B. 4.5 years

xlix

C. 5.0 years

D. 6.0 years

A. P276,510

C. P331,510

B. P299,743

D. P253,277

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

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

A. P2,400,000

C. P 900,000

B. P3,000,000

D. P1,500,000

lii

A. P2,786,100

C. P1,028,900

B. P 928,500

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

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 companys 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:

Year

1

2

3

4

5

liv

lv

P100,000

40,000

20,000

10,000

10,000

P180,000

120,000

100,000

90,000

90,000

A. 18 percent

C. 58 percent

B. 6 percent

D. 10 percent

A. Positive P 36,400

C. Negative P 99,600

B. Positive P 55,200

D. Negative P126,800

lvi

A. 0.88

C. 1.14

246

Capital Budgeting

B. 1.45

lvii

D. 0.70

A. 4 years

C. 20 years

B. 5 years

D. 3 years

Use the following information for questions 67 - 70

Pillo Company is considering two capital investment proposals.

Estimates regarding each project are provided below:

Project MA

P2000,000

10,000

50,000

5 years

-0-

Initial investment

Annual net income

Net annual cash inflow

Estimated useful life

Salvage value

Project PA

P300,000

21,000

71,000

6 years

-0-

Present Value of an Annuity of 1

Period

5

6

lviii

lix

lx

9%

3.890

4.486

10%

3.791

4.355

11%

3.696

4.231

12%

3.605

4.111

A. 20 years

C. 5 years

B. 10 years

D. 4 years

A. P309,204

C. P 50,000

B. P 91,456

D. P 9,205

A. 5%

C. 25%

B. 10%

D. 50%

lxi

A. 10%

C. 12%

B. 11%

D. none of these

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

A. P1,875

C. P8,875

B. P7,000

D. P10,000

lxiii

A. P 1,875

C. P 8,875

B. P 7,000

D. P10,000

lxiv

lxv

. Payback amounts to

A. 5.0 years

B. 5.6 years

C. 6.0 years

D. 6.6 years

247

Capital Budgeting

A. P 756

B. P1,005

lxvi

C. P1,756

D. P2,005

A. 8.0%

C. 9.0%

B. 8.5%

D. 9.5%

Questions 46 rough 51 are based on the following:

Homes Pizzas, Inc., operates pizza shops in several cities. One of the companys 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 Homes Pizzas has an

opportunity to lease the vacated space for P18,000 per year under a 15-year lease.

Homes 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. Homes 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, Homes 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.

Homes 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:

Rent- video games

Salaries

Utilities

Insurance and other

Shop

P18,000

--54,000

13,200

7,800

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.

lxvii

A. P 90,000

C. P100,200

B. P108,000

D. P201,000

248

Capital Budgeting

lxviii

lxix

lxx

.

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

A. P48,650

C. P45,000

B. P47,840

D. P32,500.

A. P21,021

C. P68,375

B. P70,103

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)

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

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:

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. Fixed expenses associated with the new shelving products would be (per year):

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:

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.

249

Capital Budgeting

(In all the following questions, please ignore income tax effect)

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

lxxiv

lxxv

.

The annual savings in cost if Machine B is purchased is

A. P56,250

C. P38,250

B. P43,250

D. P21,750

A. 12.5 percent

C. 25.0 percent

B. 20.0 percent

D. 18.0 percent

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

A. 3.0 years

C. 5.0 years

B. 4.5 years

D. 7.5 years

lxxviii

A. 4.0 years.

C. 6.1 years.

B. 4.2 years.

D. 5.9 years.

Question Nos. 58 through 63 are based on the following:

Turkey Companys 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 one-third of the fixed

overhead. The balance is for other fixed overhead costs of the factor that require cash

expenditures.

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.

Year

Year

Year

Year

1

2

3

4

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 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:

250

Capital Budgeting

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, Ill 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 purchased, then the old tools will be retained as standby

equipment. Turkey Companys 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

0.89286

Period 2

0.79719

Period 3

0.71178

Period 4

0.63552

PV of annuity of 1, 4 periods

3.03735

lxxix

lxxx

.

The net investment in new tools amounted to:

A. P1,873,300.

C. P2,528,500.

B. P2,515,000.

D. P2,546.500.

. 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

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

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.

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.

lxxxiv

straight-line method is

A. P 33,830.

C. P112,767.

B. P 56,610.

D. P147,731.

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

251

Capital Budgeting

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 companys 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 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.

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 Franzens 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 Franzens current manufacturing cost, which is presented below.

Direct materials

Direct labor

Variable overhead

Fixed overhead:

Supervision

Facilities

General

Total unit cost

P10

8

6

P2

5

4

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.

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

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.

lxxxv

. The initial net cash outflows if the company decides to continue making the waste

containers is:

A. P 956,600

C. P 978,900

B. P 975,500

D. P1,455,613

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

lxxxvii

252

Capital Budgeting

A. P308,920

B. P313,500

C. P307,826

D. P321,303

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

A. P3,039,662 (defective)

C. P2,083,062

B. P2,730,742

D. P2,718,359

xc

A. P2,036,603

C. P2,996,603

B. P3,039,662

D. P2,993,203 (defective)

ANSWER EXPLANATIONS

253

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

iii

iv

10. Answer: B

vi

160,000

80,000

8,000

88,000

72,000

Answer: D

ATCF = Net investment Payback period

ATCF

(840,000 3.326)

252,555

Net income

(252,555 140,000)

112,555

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.

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.

727,28021,600,0001,200,000400,000330,56031,200,0001,200,000

-04 800,0001,200,000(400,000) (273,200)5

400,0001,200,000(800,000) (496,720)Total present value of difference in depreciation287,920Tax Rate40%Present value

of net advantage115,168

. Answer: B

SYDSLDifferencePresent Value1

150,00090,00060,00053,5682

120,00090,00030,00023,9163

90,00090,000-04

60,00090,000(30,000)(19,066)5

30,00090,000(60,000)(34,046)Total of present values of

depreciation24,372Tax rate40%Present value of net advantage 9,749SYD 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.

.

Answer: D

Annual cost savings

Less depreciation

Annual income

Simple Rate of Return:

(432,000 12)

54,000 432,000

90,000

36,000

54,000

12.5 %

vii

viii

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%

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

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 assets life.

Answer: A

(ATCF Depreciation) Initial investment = Accounting Rate of Return

Let X = Initial investment

(66,000 0.10X) X = 0.12

66,000 - .10X = .12X

.22X = 66,000

X = 300,000

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

42,000

35,000

77,000

xiii

. Answer: B

Payback period = Initial amount of investment Annual after-tax cash flows

P35,000 P5,000 = 7 years

xiv

xv

xvi

Answer: B

Net investment

Divide by CFAT (10,000 x 0.7) (50,000 8 x 0.3)

Payback period

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

(450,000) 254,520

2 + (22,020 105,140)

Answer: D

Cost of the new machine

Salvage value of old machine at period zero

Net investment (Outflows)

Divide by cash flow after tax

Payback period

50,000

8,875

5.6 years

(195,480)

173,460

( 22,020)

2.21 years

400,000

60,000

340,000

90,000

3.78 years

xvii

. Answer: B

Cash InflowUnrecovered OutflowOutflows(4,500,000)First year900,000(3,600,000)Second year1,200,000(2,400,000)Third

year1,500,000( 900,000)Fourth year 900,0000

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 straight-line method.

xviii

xix

Answer: C

Cash inflowsInvestmentPeriod 0(99,300)Period 1 (75,000 25,000) x .6 30,000(69,300)Period 2 ( 30,000 x 1.10)

33,000(36,300)Period 3 (33,000 x 1.10) 36,300 -0-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)

Answer: C

Before-tax cash flow = 40,000 + 35,000

Payback period: 300,000 75,000

xx

xxi

. Answer: C

Computation of Cash Flow After-tax

CFBT

100,000 x 0.7

Depreciation tax shield

62,500 x 0.3

CFAT

Computation of Net Present Value:

75,000

4 years

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

70,000

18,750

88,750

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

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)

257,120 x 3.7908

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.

xxiii

xxiv

xxv

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.

Answer: B

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

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

300,000

80,000

12,800

(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

xxvi

Answer: B

PV of annual cash receipts

PV of salvage value

PV of return of working capital

Cost of new equipment and timbers

P60,000

P30,000

P52,500

P189,250

14,186

203,436

175,000

P 28,436

1,200,000 x 2.58872

650,000 x 0.48225

1,000,000 x 0.48225

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)

Working capital

PV of cost of construction of road

Negative net present value

xxvii

400,000 x .5787

(1,000,000)

( 231,480)

(79,303)

Answer: B

PeriodNominal Cash SavingsPV FactorPresent Value132,000 0.8779028,070.08232,000 x 1.0533,600

0.7694725,854.19332,000 x 1.05235,280 0.6749723,812.94432,000 x 1.05337,044

0.5920821,933.01Total99,670.22Investment80,000.00NPV19,670.22Note that all the annual cash inflows are adjusted

by one period.

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

P497,435

( 2,873)

P494,562

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

P361,100

( 8,209)

80,000

P432,891

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)

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

3.57057

3.69079

83,180.84

297,000

1.034

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 RateNet Present Value0.141,197IRR00.16-708

(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).

xxxii

. Answer: B

The payback period that corresponds to the projects 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

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

xxxv

xxxvi

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

193,535

500,000

693,535

17,338

416,121 300,000

116,121/0.60

193,535 + 500,000

693,535 (100 - 60)

Answer: B

Contribution margin (per No. 23)

Divide by sales volume

Contribution margin per unit

Add variable cost per unit

Selling price per unit

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

Answer: C

Annual after-tax cash flow

Depreciation

Net income

Income before tax

Depreciation

Cash savings before tax:

500,000/5.6502

500,000/10

38,492/0.6

64,154 + 50,000

600,000

480,000

1,730,294

1,500,000

230,294

63,885

106,475

5.32

94.68

88,492

50,000

38,492

64,154

50,000

114,154

xxxviii

. Answer: A

The amount of annual cash flows can be solved by equation:

NPV = PV of annual CF Investment

1,750 = 2.4771CF 2.4018CF

1,750 = 0.1753CF

CF = 9,980

xxxix

xl

xli

xlii

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)

Answer: B

Present value of annual cash flows at IRR

Investment

Difference

Annual increase in cash flows

(81,000 x 4.639)

81,000 x 4.344

23,895/4.344

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

120,000

4,626

115,374

18,776

375,759

351,864

23,895

5,501

50,000

33,608

16,392

23,022

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

xliii

xliv

Answer: B

Cost of equipment

Less PV of tangible benefits

PV of annual intangible benefits

Amount of annual intangible benefits

100,000 x 5.01877

248,123/5.01877

750,000

501,877

248,123

49,440

. 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

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 XProject YPV of after-tax cash flows

(12,000 1.1264)6

455

455

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 1Machine 2PV 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) 90,909.10Net difference 50,000.00( 50,000.00)Difference in investment( 50,000.00)

50,000.00NPV

NIL

NIL

xlvii

. Answer: C

15% Discount Rate

Machine 1Machine 2PV of Difference in ATCF Year 1 155,000 x 0.86957 134,783.35(134,783.35) Year 2 110,000 x

0.75614( 83,175.40) 83,175.40Net difference

51,607.95( 51,607.95)Difference in investment( 50,000.00)

50,000.00NPV

1,607.95( 1,607.95)

At 15 percent discount rate, Machine 1 is more acceptable.

8% Discount Rate

Machine 1Machine 2PV of Difference in ATCF Year 1 155,000 x 0.92593 143,519.15(143,519.15) Year 2 110,000 x

0.85734( 94,307.40) 94,307.40Net difference 49,211.75( 49,211.75)Difference in investment( 50,000.00)

50,000.00NPV (

788.25)

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

950,000

24,200

800

975,000

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

Capital investment

Net present value

Answer: A

Average investment:

Annual depreciation:

Annual net income:

Average annual Rate of Return:

(52 x 5)

(P800 P10 P40)

(260 x P750)

(975,000 195,000)

(195,000 x 6.418)

(55,000 x 0.42241)

(975,000 + 55,000) 2

(975,000 55,000) 10

195,000 92,000

P103,000 P515,000

260

P750

P195,000

5 years

P1,251,510

23,233

P1,274,743

975,000

P 299,743

515,000

92,000

103,000

20%

li

lii

liii

liv

lv

lvi

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

Answer: C

PV of After-tax Cash Flows

Cost of investment

Net Present Value

(6,000,000 4)

(1,500,000 x 0.4)

(2,400,000 x 2.9287)

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)

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

7,028,900

6,000,000

1,028,900

P351,000

P585,000

39,000

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 of the initial investment, in the determination of accounting rate of return.

Answer: B

Cash FlowPV FactorPV of annual net cash flows:180,0000.909163,620120,0000.826 99,120100,0000.751

75,10090,0000.683 61,47090,0000.621 55,890Total455,200Amount of investment400,000Net Present Value 55,200

. 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.

lvii

. Answer: D

Cash InflowUnrecovered InvestmentPeriod 0 Outflows(400,000)Period 1180,000(220,000)Period 2120,000(100,000)Period

3100,000Zero

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.

lviii

Answer: D

Payback period: Investment Net Annual Cash Inflow

P200,000 P50,000 = 4 years

lix

Answer: D

Present value of Net Cash Inflow (71,000 X 4.355)

Investment

Net Present value

309,205

300,000

9.205

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)

P6,250

P1,875

lxiii

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

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

P51,000

756

51,756

50,000

P 1,756

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)

lxvii

lxviii

lxix

lxx

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

Answer: B

Additional rental income

Additional cash flow, snack bar

Total

Less Cash Fixed Expenses:

Rent

Salaries

Utilities

Insurance, etc.

Annual Cash Inflow

Answer: A

PV of annual cash inflow

PV of salvage value

PV of working capital return

Total

Investment:

Remodeling cost

Working capital

Net Present Value

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)

(7,500 x 0.108)

Answer: B

PV of annual cash inflow (65,000 x 5.575)

PV of salvage value

PV of working capital return

80,000

65,000

602,100

3,240

810

606,150

550,000

7,500

557,500

48,650

362,375

1,296

432

Total

Investment:

Remodeling cost

Working capital

Net Present Value

lxxi

364,103

290,000

4,000

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

294,000

70,103

105,000

13,000

118,000

80,000

38,000

(38,000 x 5,575)

211,850

1,296

432

213,578

294,000

( 80,422)

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

lxxiv

Answer: A

Annual revenues

Variable expenses

Contribution margin

Fixed expenses

Advertising

Salaries

Utilities

Insurance

Annual cash income

Less Depreciation

Annual Income

300,000

60,000

240,000

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

lxxv

. Answer: A

Simple Rate of Return = Net Income Initial Investment

52,500 420,000 = 12.50 %

lxxvi

lxxvii

234000 13 years

38,250 225,000

78,000

16,350

5,400

21,750

56,250

56,250

18,000

38,250

17 %

. Answer: C

Payback period = Initial Investment Annual Cash Inflow

420,000 84,000 = 5 years

lxxviii

lxxix

Answer: B

Savings

Less Depreciation

Annual income

Simple Annual Return

156,000

84,000

31,500

52,500

Answer: A

225,000 56,250 = 4 years

Answer: C

Purchase price of new tools

Add increase in working capital

Total

Deduct Salvage value of the old tools

Net investment

2,500,000

60,000

2,560,000

45,000

2,528,500

lxxx

lxxxi

lxxxii

lxxxiii

lxxxiv

lxxxv

lxxxvi

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

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

Answer: A

PV of annual depreciation

PeriodDepreciationPV FactorPresent ValueYear 1 832,5000.89286743,305.95 2 112,5000.79719886,873.88 3

370,0000.71178263,358.60 4 185,0000.63552117,571.20Total2,011,109.63Tax rate0.30PV of tax benefits from

depreciation603,332.89

Answer: C

After tax salvage value 100,000 x .7

70,000

PV of 1 end of 4 periods

0.63552

PV of after tax salvage value

44,486.4

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

1990072

603,333

44,486

38,131

(2528,500)

147,522

Answer: A

PV of tax benefits, declining - balance

PV of tax benefits, straight-line method 2,500,000 4 x .3 x 3.03735

Net advantage

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

lxxxvii

1,600,000

603,333

569,503

33,830

P926,100

11,000

22,900

960,000

900

2,500

3,400

P956,600

(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

. Answer: A

The present value of the tax shield based on declining-depreciation is:

YearDepreciationTax Shield (40%)PV FactorPV of Tax Shield2007P319,968P127,9870.893P114,2922008 426,720

170,6880.797 136,0382009 142,176 56,8700.712 40,4922010 71,136 28,4550.636 18,098TotalP308,920

lxxxviii

. Answer: C

Purchase Cost

Year

ATCF200750,000 x 27 x 0.6 810,000200850,000 x 27 x 0.6 810,000200952,000 x 27 x 0.6

842,400201055,000 x 27 x 0.6 891,000201155,000 x 27 x 0.6 891,0002006(1,500 x 0.6) (

900) Total

4,243,500

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

CFBTCFATPV FactorPVCFAT2006Initial outflow(P956,600)2007(50,000 x 20) + 45,000

(1,045,000 x 0.6) - (319,968 x 0.4)1,045,000

499,013

0.893

445,6192008(1,045,000 x 0.6) (426,720 x 0.4)456,3120.797363,6812009(52,000 x 20) + 45,000

(1,085,000 x 0.6) (142,176 x 0.4)1,085,000

594.130

0.712

423,0212010(55,000 x 20) + 45,000

(1,145,000 x 0.6) (71,136)1,145,000

658,546

0.636

418,8352011(55,000 x 20) + 45,000

(1,145,000 x 0.6)1,145,000

687,000

0.567

385,447Salvage value (12,000 x 0.6)7,200P2,993,203

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