ReSA -?

h Retiau Satod

MS-l0:CAPfTAL
BUDGEnilG
CAPITAL INVESTUEJ{T - involves significant commitment of funds to receive a satisfactory retum -- increase
in revenue or reduction in costs -- over an extended period of time.
Example: purchaseof eQuipmentfor expansion,rcplacementof old equipment

GE]{ERAI CHARACTERISTICS OF CTPITAL ITIVESTIIETIT DECISISIS

-. As to C05T usually involves large expenditure of resources,relative to businesssize
As to COMMITMENT usually funds invested are tied up for a long period of time
. As to FLEXIBIUTY usually more'difficult to reverse than short-term decisions
' As to RISK usually involves so much risks and uncertainties due to operutional and
economicchangesover an extended period of time

cAPrrAL
Bt'DGErrnG
- :il:l:,'ffi:il,lJ"lT:l,"TtrTr"H1'J$:1ffi,'J":'il'?i*,i,3
expenditures for assets, the return on which are expected to continue beyond one-
year period. t

CAPITAL BUDGETING PROCESS

Identification ------------€ Evaluation Decision Making

CapitalInve5uTrent :
Decisions
Replacement (Equipment)
Improvement(PtCIducts)
Expanslon (Facilities) Net Investn'€/nts ilet ReAJms . Costs of Capltal
Addltion(Tecfrnology)
Reduction(Costs)
Non-discountedmethods Discountcd m€thods
Payback period Net prcxnt value
Adt-sntFql*tc* Prp*frAUW hlda(
Accounting t*c d retum , Internal rate of rctam
PayW rrlr;ftur.e, Prexnt value pybe,c*

CAPI?AL IT{I,:3TI'IET{T FrcTOilS

tet tnvofrncntr (Ior ffion-nrlf,ihq putpoxlr,)
. CosF fess savrhgs tncidentaf to the acquigition'of th€ capttal investment proje{ts
. Caishoutflows less csfi inflows inciderital tq the acguisition of the capital imipstrnent projects

Costs or cash effg!,vs

1. Purchase price Of the asset, nef of rclad cash d*ount
2, Incidental prolect-rclcted expenses such as frclght, insurance, handling, installatibn, test-runs, etc.
CONDISERALSOTHE FOLLOWIflIG, if any:
r Additio{ra{'worklqg capital needed to srryport the operation of the project at the desired level.
r Ma*et value of existing idf,eassets to be used in the operation of the proposed capital project.
' Training cost, /tet of relatd tax

Savings or Cash ifflows

Proceeds from sale of old asset disposed, net of telaftd tax
CON$IDERALSOTHE FOLLOWING,if any: (
. Trade-in value of old asset
. Avoidabld cost of immediate repairs on the old asset to be replaced, net of related tax

Net Returns
. ACCRUALBASIS: Accountingnet income (after tax)

' CASHBASIS: Net cash inflows

g DIRECTMETHOD
Net cash inflows = Cash inflows - Cash outflows
g INDIRECTMETHOD
Net cashinflows= Net income(aftertax) + noncashexpenses(e.9.,depreciation
expense)

Page1 of8 pages

ReSA - 74c ReocenSci4al o{ 4czaa''ttaaaT I MS-l0
C A PITAL B UDG E T T NG

THE COSTS OF CAPITAL

' T he' c os t s o f c a p i ta l ' u $ e d rn c a p i ta l b udgeti ng i s tl re V /ei ghted A verage C osts of C api tal (W ACC) .
'
These are specific costs of using lorrg-term funcls, obtainecl frcnvtlre clifferent sources: borrowed
( debt ) and in v e s te d { e q u i ty ) c a p i ta l .
SOURCES cosrs
Debt Interest ratt: {afl-ertax)
Preferred Stock (Pfi) Dividend yield
. C o mmo n Sto c k (C !l ) D i vi dend yi cl d pl us grov/th rare
R e ta i n e d F a rn i n g s (R E ) D i vi dend yrel clpl us grow th rate
The after-tax cost c,f rjebt is compt.rtedlrasecJonl yield r;rte (1 -.tax rate)
-
r Dividend yieid = dividend per share -:-prrc:c".6rcrshare
r-*^"-*"-- -"-'
i Cost of CS arrl RE = * -!Ip*q_q!edqaqh 1]-ry-i{.9.1d
pg1 .5ti.ar_e
-r t-lividendgrowth rate
I
l{"erkStpt lgepg,iloryq!_rt -st1ar_q
. ; The dividend growth rate is assumcd to be consfant uver tirne.
z I n c o mp u ti n g c o s t o f C S & P 5, the rnarket pri cc shoul d be net of fl otati on costs (e. 9. ,
und e rw ri ti n g fe e s )" .
, In computing the cost r:f RE, flotation co:its should be ignored
r Alternativeiy, the cost of equity capital rrray be cornpr-rtccltrased on Capital Asset Pricing
M o d e l { C A PM)
r Re fe r to p a g e 4 o f M SQ - l C j for detai l ed di scussronson C A P M and the D i vi dend Growt h
Model.
Other terms used to denOte tlrr: wc:rghtcdaverilge cost c'f rapital (WACC.):
F Minimum requirerl rate of r*turn
/ Minimum acceptahle rate af ret'Lrrrt I
.
r
Cut-off rate
7'arget t'ate
" bYV
brrrorl,.A
l F-l ..- !i I
L'l
ii I1
, Desired rate af return 'I
ir'\ 't
t \1
t
F Standard rate 3**,P'L&tH I
'r l-lurdlerate (plu19p4], \

CAPITALBUDGETING
TEqHNIQUES
. Non-discountedmethods- rnethodsthat do r,ot consrderthe trme value of money
1. Paybackperiod methocl
2. Bail-outpaybackmethod
3. Accountrngrate of return rletlrod
4. Paybackreciprocalmetrrocl

. method - rnethodsthat considerthc tinrn rralueof rnon*y

Disccrunted
l. Net preient value method
2; Profitabilityindex method
3. Internal rate of return methocl
4. Presentvalue paytlackmethod

HON-DISCOUHTEDTECHIIIQUES:METHODS
THAI-IGNORf:I1MFVi\LUEOF MONEY

I Net inltial cost.o{ lnvestmcnt i

ii Payback Period =
av'aG^ rEr_:.,u- Annual net aftcr tai iaitr infltLws l
'""'\"''':':'-1-L:':Y
'
Advantages,
1. Paybackis simpleto computean<Jeasyto understand,
Z. Paybackgives informationabout the liquirlityof the projeci.
3. lt is a good surrogatefor risk. A quick or sbr:rtpaybar:kperiod indicatesa les:;risky project.

Disadvantages:
the tirne value r-rfrnoney.All cash receivedcluringthe paybackperiod
1. Paybackqfoesrrot gcrrsicler
is assumedto be of equalvalueof in analyzingthe project.
2. It gives more emphasison liquidil,yrather than on profitabilityof the project.In other words,
more emphasisis giverron return of investmeritrafher t"hanthe return crninvestmenr.
' 3. It does not considerthe salvac;evalue of the project .
4. It ignorescashflowsthat rnayoccurafter the paybackperiod{shori-sighted)

Bail-out Payback Feriod a modifieclpaybackperiod methocJwhereirrcash recoveriesinclude ihe

estimatedsalvagevalueat thelerrdof eachyear of the projectlrfe.
ReSA -74o Rerrizrt'Sctio( o{ Aenadarcl?
€
MS.10
CAPITALBUDGETING

Accounting Rate of Reh'rrn(ARR) =

* may be based on original or aveEageinvestment.

Advantages:
1. The ARRclosely parallelsacco,untingconceptsof income m'easurementand investment return.
2. It facilitates re-evaluation of projects due to ready availability of data from the accounting
records.
3. This method considersincome over the entire life of the project.
4. It indicatesand emphasizesthe project's profitability.

Disadvantages:
1. Like traditional payback methods, the ARR method does not considerth€ time value of money.
2. With the comPutdtion of income and book value based on the historical cost accounting data,
the effect of inflation is ignored.

Other terms used to denote the ARR:

Net cash inflows 1

Seac Reclpoca-l =
Investment

Payback reciprocal is a reasonable estimate sf the di*wntu.d cash flow rate of rcntrn (a.k.a. IRIR)
provided that the foflowing conditionsare met:
1. The economic life of the project is at le6st twice the payback period.
2. The net cash inftowb are uniform throughout the life of the project.

DISCOUNTED TEGtlfft([lfS: METHODST*{ATCONSIDERT}lE TIME VALU€ OF,}TONEY

The tr'rne vakrc of money is an opportuhity cost concept. A peso on hand todiy is worth more tbarr I
peso tb be received tomorow because of intere!'ts a peso could earn by puttiqg it in a savlngs account
or placing it in an investment that earns incornt. ltttfnc value of money is usuatly mdosurcd by uring
, a dixount rafe that is in{plicd to be tk interest brcgpne by receiving funds at a later tirne.

of cash fnflorrs - Present value of cash

I > Cash inflofis include cash infused by the capital investrnent project on a regular basis (e.9.,
annual cash inflow) and cash realizablc it the erd of the capital ilrestment project. (e,g.,
salvage value, return of working capital reguirements)

pffisent vahrt of th cash outflaws.

Advantages
1.. Emphasizescash flows
2. Recognlzesthc tlme value of money
3. Assurnes discount rfie as reinyestment rate

Disadvantages:
1. It requires d€t€rmination of the costs of capital or the discount rate to be used.
2. The net pres€nt values of differcnt competilg projects may not be comparable bicause of
differences in magnitudes or sizes of the projects.

= ffi
rrontruntyrrdrx
NFV
tlPtf Index =

The profitability index method is. designed to prcvide a comtnor basis of ranking alternatives that
require different amounts of investment.

NOTE: Profitability index method is also known as desirability index, pre*nt value index and benefit-
cost ratio.

Page3ofSpages
 CAPITALBUDGETING
.r
rnternar
Rate (rRR)
orReturn -
, '
;;'#Ltffl;:i::ti',,1"iff:l:"*";.:#;I'::ffi#
li,.Jl'i;r,tifi
rate of retum, time-adjusted rate of return or sophisticated rate of
return.

Guidelinesin determininqIRR:
1. Determine the present value factor (PVF)for the internal rate of return (IRR) with the use of,the
followingformula:

Net investment
F/F for IRR =
Net cash inffows
' 2. Usingthe presentvqlueannuifytable,find on line'n' (economiclife) the WF obtainedin No. 1.
- The corresponding
rate is the IRR.If the exactrate is not foundon the PVFtable,'interpolation'
processmay'b€necessary.

Advantages:
1. Emphasizescash flows
2, Recognizesthe time value of money
3. Computes true return of project
(
Disadvantages:
1. Assumesthat IRR is tbe re-investment rate.
2. When project.includesnegative earnings during its life, different rates of return may resuft.

EXERCISEro
,i0
I., IIET IT{VESTIIEIITS FOR DEGISIOI{.HAKING
-
{ilr+- Ar,",t'sBag-You Company plans to replace a unit of equipnrcnt with a new,one: :
7
')*K,l it can be sold now at P 75,000. Tax rate is 259o. Wrl W; XJt'l ' ?"at/dr vJ* t'uc'{ti tov
''{w"/ o ThenewunitcanbeacquiredatalistpriceofP2OO,O00. A20,6cishdiscountisavailableifthe
l,i1ng$r
'14r/D. equipment is paid for within 30 days from acquisitiondate. Shipping,instaflationand testing
charges to be paid are estimat€d at P 14,0OO.

'm m0t0' r Otfitr assds with a book value of P 12,000 tttpt are to be retired as a result of the acquisitiod ol
the new machine can be satvagedand sofd for P 10,0O0.,P,wru/..: ,'-" r.::e,'
ts6D . wi[ be ;"d; to support operations ptanned with the
new equrpment.
-.-'-^;# f?N . Thc annuql cash flow from the operation
G'ru-Av Yl ' ..; new equipment
of. the , has been estimated at P 50,000.
use - life of 5 years with- a satvage vatue of p 4,000 at t!9
&llu- I -.L' tL-
rJ The
I ne eqytpgglllgflpgctgd
eoutDmentrs exDected
-L^.:<::i:=:--:::::-' to have a usetul
- 'a
l$cf; "ywFtl'tMulrl-
'l
REQUIRED:
What is the initial cost of net investments for declsion-making purpos6sT l$CffiO

2. WErGI{TGD AvlRAG! COST OF CAPITAT (WACC}

Bee-Coot Company wints to determine the weighted average cost of capital that it can use to evaluate
capitaf invegtment proposal$. The company's cafltal structure with corresponding markd values follows:
80z6Term Bonds P 600,000
5% Prafpt"ed sbck (F 1OO'par) 200,000
Common 610* (no par, 1O,OOO shares ouBtanding) 4OO,OO0
Retalnedearnings
TOTAL

Additional data: t' }g,utA'vy ftxpsru Wffi

1) Curr€nt market price per share: ( IeqTI
1k"t' - *
ffi-- 4{2.crl-
2) Expectedcommon divldptd: P 2 ger share Tt4 (Pro"'l )
-.
3) Dividend growth ratet4Yo N{r-tnrlps 7tQ(('D
4) Corporate tax ratei3} r '
lllEDu ( lot* ,,
REQUIRED: N"?-tt'4 VOU VJ
A) Given ad operating income of P 500,000, how much is the eainings.fer,snrir€U
B) Determine the weighted average cost of capital,

Page4ofSpages
@r'
 ReSA
-74e
Rern*n,Scloo(( Aaautaaq MS-l0
CAPITAL BUDGETING

SOLUTIONGUIDEto Item 2
Operating incorne P 500,ooo
(48,000)
i;Jffifff,s;:"1 P 452,000
- tax (30o/o) _(135,600)
-h-
rts5 =
Income availableto common shares
Number of outstanding shares

Income after tax P 316,400

: preferred dividends (5olo) (10,000) EPS==+:99+q:-
10,000 shares
= P3o.64
Income availableto common shares P 306,400*
SOURCES WEIGHT(%) cosrs
Eonds. 7>^'l ' 8 ' t , (l' r) . 5 L'/. t.6( 7,
Preferred stock lo'l ' b /, /lNJ 1S t.oI . t '/,
common stock & Retained Earnihos l to l ' dl4o+41' q./. ?.4./.
weighted Average cost of capital ( t 88' /-

3. nET RETURfnt (TNCREASE rN REVENAES)

Star-Luek Cinema plans to install coffee vending machines costing P 200,000. Annual sal€s of cofiee
are estimated to be 1b,000 cups at P 15 per cup. variable .orti 5rr at p 6 pcr cup, white
incrementatfixed cash costs, excluding depreciation, at P 20,000 per year."rtiinat"o
The.machines ar€ expicted to
have a servic€ life of 5 years, with no salvage value. Depreciation will be computed on a straight-line basts.
The company's income tax rate is 30o/o.
r
Determine the fotlowing: ( 'l t
- * .REQUIRED; v ' WU^*,f,' 1tlt ,.r
I lOil-r A) The irrcreasein annual net income.
fut$:i B) The annual cash inflows that will ,be generated by the project.. , r

4. NET RETURNSrCOSr SAVTNGS)

Moon-Use CorporaUon is planning to buy a high-tech machine that can reduce cash expenses by an
average of P 70,000 per year. The new machine wilf cost P 10O,0OOand will be depreciatedfior 5 years on
'Inisrne
a straight-line basis. No salvage value is expected at the end of the machine's life. tax rate is 2}o/o
of income.
REQIJIRED:
Determine the net cash inflows that witf be generttirl by the proJect. (rCt;_

5. PAYBACK PERIOO a ARR (WnH AlEN USH FLOWS)

Green-Niche Company considers thc reflacerncrt of some old cquipment. The cost of tha r*v
equi$rnent is P 90,O00, with a useful life estimate of 8 years and a safvage value of P 10,OOO. The annual
pre-tax cash savings from ttrc use of the ncw equipment is P 40,OOO. The old equlpmeni has zero market
value and ts fully depreci*ted. The company uses a cost of capital of 250,6.

fu (ur,,+*le*f qacn
''{'!

REQUIR.ED:
Assuming tha^tthe intome tax rate is 4ogo, compute:
'i'U
A) Paybackperiod W ,. , _ \
e! nciounting rate of r*u$ri on originat investmcnt i ,Sl*rl, ,h. I ' Not Ca-{rftur+ li* eff'
C) Accoonting rate of return on average investm€nt (l.tlt\) t Ct t
1l1* Iluarr'* tl$. .
6. PAYBAGI(PCIIOD l tr|t (wrTH uFtEvEN
CeSr/FLOU/,5.) -M* c&alL)
fu;h;t
Pole-LandCompanyhas an investrnentopportunity costing P 90,O0d*ftiat"is expected to yield the
folftrwihgcashf,owsover the next ftve years:(assri.;#^:te rate of 3o%)
fir,n,D
/,,\Y5
n
t '33;333 ,i:i[;)
'--:.--- L{y r'
.,?od, z/ ' 3 30,000 \*' u,'
A 1- 4 ZO,OOO .-(?c'v\',
f s lo.oqg i t (N) a,l,"t i
P:rEoaa -l-
REeuIRED: nr-'
A) Paybackperiodinmonths B) B-ookrateofretum ,',:r:fd +tl,h.
,------4n, lls u * ' - --, . , ri
,. - (lp g .
\-"t-'-' )
7. eDIt..our pAyBAcK pERr/dbf"6. r '" t'11",' .i
-T A projectcostingP ,180,000
will producethe followingannualcashflowsand saYvage valui:'-,. -
t-
{- Year Cashflows Salvaoevalue
{tt t l't l'l r
1 r/P 50,000 + P 65,000 :
2 vP 50,000
(*Tei'i4'
i- P 50,000= , r1.gtv)!
3 ,,iP50,000 + l,P35,000"-
p z0,ooo'.
tl
4 P 50,000 l i'i;rt^i'
REQUIRED:
Bail-outpaybackperiod. {4{*t'
 ReSA - ?h Ranaa*Sch4ot( Auaaaanq 1ntA
cAprTALBUDGETTNG nrr t\i , Wq 6f &1,h,
q\- i

pREsENrvALuE(wrrH
0$t- ;. ilEr cAsHFLows,
'JNTF,RM
Vrlr-
\ Bull-CanCompanyplans to buy a new rnachinecostingP 28,000. The new machineis expectedto have
a salvbge value of P 4,000 at the end of its economictife Jf 4 years. The annual cash inflows before income
tax from this machine are estimated at P 11,000.
.The tax rate is 209o. The company desires a r-ninimunr
{::;--
return of 25o/oon invested capital.'Cf U d'g|lal
{
REQUIRED: r/nr
Determine the net present value. (Round-offfactors to three decimal places) N i'l 7 n
|/
-
SOLUTIONGUIDEto Item 8
DT
| -L^ |
cash inflows before tax
| - Depreciation _---_
-, . \ t^ I
Lq'rr"'"--iii",'ii7i
Earnings before tax
llifl)'/
r\ r -T a x (Z o o / o ) I' t tl --o
Earningsafter tax
H,** ifll , O
+ Depreciation
Cash inflows after tax
(Present)
PV factor Year 1 Yeat..a .Year3 Year4 1{hJ

tfP\t, FROFTTABTLITY rf{DEX e tRR (NEN vs. UNEVEN CASH.FLOWS)

Cah:YeahCorporationgatheredthe followingdata on two capitalinv€stmentopportunities:

costofinvestrnent ffi##
' Costof capitat tO% 10o/o
Expectedusefullife 3 yeafs
fl t trttf
3 years
Net cashintTows p lot,600 p 1oo,O00*
* Thisarnouhtis to de'cllneby p 20,00Oannuaftythersfter.
REQUIft,ED:Round-offfactoruto three decimalplacesin all cases.
/. 9*?
iltrv
Fill-inthe blanks. It
IL

IIIPV: A) B) tPt( € .41"/

P. Index: C) D)
E) What is projcct l's internal rate of returfi?
a. 23o/s .( zs"to
b. 27o/o d. 24Va
n What is project 2's fime-adjustedrate of return? lfl1;,Df? = lqi&"v
a. Below3O9o c. Between 3lolo and 32o/o
/ E. Be$teen30% and 31olo d. Above 32olo

10. PAYBICT RECIpftOCTt

Live-Biz Company is plaaning to buy an equipment costing P 640,000 with an estimated life of 30 years
4/r=F?,r.
::ffi;Tdtoproduceafter-taxnetcashinnowsorP128'0oo*'lffrn
!*l*.:b,F:
Witffiut usir$ valuefactors,
BrEs€nt FPR = Cn'l'*rcK "
estimatethe IRR. Yt "
l' - *t ' ,t
11. CApITAL EUDGETIT|G TECHTTTQUES *',;un /
Mall-Asia Company is considering buylng a'new machine, requiring an immediate F 400,000 cash
outlay. Tig,new machine is expected to i4creaseannual net after-tax cash receipts by p 160,000 in each of
the next five years'bf.its ecgrffinri,ctife. No salvage value is expected at the end or 5 years.- The company
desiresa minimum return ofl14o/oton investedcapital.
\,/
REQUIRED: Round*offfactors titnru" decimal places in att cases. fuu ttt ll4oq
' A) Paybackperiod ,"r5qvt- ,t D) profitabitity index l,rl- 6lrr{.
B) ARR(basedon originatinvestment)/0/' E) Internal rate of return '-t''
'alue
C) Net present value t r ( f, rt0n\
Nqw
 Scntd o{zluaarry
ReSA - 74eRernau, MS.{0
CAPITAL BUDGETING

Answersto item.11:
A) Paybackperiod: 400,000 + 160,000 = 2.5 Vc?rl
B) Accountingrate of return (based on original investments): 80,000 + 400,000 = 2A9/o
C) Net presentvalue: 160,000(3.433) - 400,000 = P 149,28O
D) Profitability index: 549,280 + 400,OOO= 1",37tlmes
E) Internal rate of return: 28.659o (appioximation through trial and error or interpolation)

12. RELATToNSHIPS - DISCoUNTEDTECHNrauEs( )41{- P1\>

Fill in the blanks for each of the following independentcases. In alf cases, the investrnent has a useful
tife of ten (tf) years and no salvage value. Roundoff factors to three decimal places.
ProJect Annual Cash Flow Investment Cost of Capital IRR

2
7

3
P45 ,000.
P 75,000
G) Q'JoV\
P 188,640
(3) 1V-]@
P 300,000
p 4so;ooo
1.4o,h
t2o/o
( e ) ln %
G) 7Dtla
18%
t60,/0
ftiw
P 81,,440
ol4ref4

4 Ui-W@- I2o/o (8) l1 qbq P 115,000

13.CApITALRATtOlrliG - nnnXrNGPROTcCTS
Case-Zone Corporation is considering ftve different investm€nt opportunities. The company's cost of
capital is l2o/o.
Proiect Inve*nent PV - C4sh Flaw NPV IRR (a/6) P. Index
L P 35,OOO P 39,325 P 4,325 16 L.L2
2 2A,OOO 22,930 2,930 15 1.15
3 25,000 27,453 2,543 14 1.10.
4 10,000 10,854 E54 18 1.09
5 9,000 8,749 (251) 11 4.97
REQUIRED:
A) Rankthe Brojectsin descendingorder of preferenceaccordingto NPV,tRRand benefiVcoetratio.
8) If only a budget qf P 55,0OOis available,which prqj€cts should be chosen?
SOLUTIOI{GUIDE to-Item 13
Project Nn/ fir P. Index
I 1 L
2 zns ,',
3 3ru tl ,
4 4th 1
5 5tn J I

WRAP-|P $(ERCISES (TRUEor FALSE:MULTIFLE-CHOI9E)

Tr. A pqect's salvage valu€, r€alizable at the end of life of the project, is considered in the computation of
the net inyestments for decision-making purposes.
f Z. The payback period emphasizes the profitability of a calital project while the accounting rate of return,
on the other'hand, emphasizes the project's liquidity. (U/a\au'l)
6
3. Annuaf cash inflows from the capital projects are measured in'terms of
a. Income after depreciation and taxes
b. Incorne bcfse'r*reciation and taxes
..{ lncome before deprcciation but after taxes
' d. Incofie after depreciation but before taxes
4. ,tVh-enggmputingfor the accounting ratq of return (ARR), which of the folloWing is used?
' .E Income after dcpreciatlon aM taxes
' b., Income before deprcciation and taxes
C. Income before @reciation but'after toxes
,d.. Irrcome after depreciation but before taxes
5. The t'tchnique that does not use cash flow for capital investment decisions.
a.''Payback ARR
b. Nry -ca
d. IRR
Which of the folfbwing groups of capital bqdgetingtechniques uses the tirne value of money?
3, BSok rate of reiturn, payback and profltability index
b", IRR,,paybackand NPV
f IRR, ARRand profitability index
K IRR; NPVand profitability index

P age T o f B p a g e s
ReSA -7ie ktrat Sclnt og4unrtaraf MS.l0
CAPITALBUDGETING

7. Cost of capital i.s3o/o;economiclife in years = 4'years; sirnple PV factor for year 4 is

a., '0.915 c. 0.455
0.888 d. 0.350
1E
8. Discount rate is 11olo;econoinictife in years = 3 fears; PV annuity factor for 3 yearsis
a. 0.731
b. 1.713 + 31tl
L As the discount rate increases,'
a. Presentvalue factors increase
,W Present value factors decrease
,' c. Presentvalue fartors remain constant
. . d. It is .impossibteto tell what happensto the factors
10. What is the PV factor of any amount at year zero or zero percent?
a. Zero
b. o.50
.9. 1.0O
- d.
An amilunt that cannot be determined without more information
11. 'fhe preserit value of P 50,000 due in five years would be highest if discountedat a rate of
f V / o > 1 .0 &
b: 1O9o
c, I5o/o
d 2Vo/o

t(
t

NW=o , 7l=| , lR'K-'

12. A capitat project with a positive NPVatso has
' a. A profitability index of one
b. A posltive profitability index
c. A profitability index less than one
/-t: A profitability index greater than one
13. A capital project that has a positive NPV based on a discount rate of \2o/oalso has an IRR of
a. zero
b. LZo/o
c, Lessthan 127o
F GlaeaterJh?n.L?ota
14. Which of the foffowing combinationsis possibte?
Prgfitabilify lrylex Nfll IBB
a. . Greater than 1 Positive Equalscost of capitaD<
b. Greater than 1(-) Negative Less than cost of capital
,{ Less than 1 Negative L,€ssthan cost of capGl
- d. Lessthan 1 Positive Less than cost of capital
15. The net pres€r.rtvalue nrethod assumes that the project's cash flows are.reinvested at the
a. Internal rate of return
b. Simple rate of r€turn
.4 Cost of capital
d. Payback period
16' The inte,nd rttt af ratum ntethod assumes that the project'S cash flows are reinvested at the
a. Requiredrate of return
f' tnternal rate of return
' c. Simpb rate of return
d. Paybackperiod
17. Which one of these methods is a prcject ranking method rather than a project screeningmethod?
a. Net present value
f; 3',SlX'l'ii:T,o:jl,- return
d. Sophisticatedrate of
18. Il'the IRR on an investmentis zero,
a. Its NPVis positive
, b. It is generallya wise investment
' c. Its cash flows decreaseover its life
,{. Its annualcash flows equat its requiredinvestment
 ReSA Review School, Inc* . '..'i
/ 09239r24r2t 0914{38383{I resamderv@tnUnall.orn
a 73s9s7 I Vv7W9 I @1(X391320
MANAGEMENT SERVICES A. Lee

Qrnr-zer: lvl910
CAPFALBUDGHNNG
banks
Sources;CMA/ClA/RPCPA/AlCPAlvarioustest

Capitd iSconemed with

a. DeciCb0effiing only capital-inEnsiveindusfieE.
b. Analysisof sfiortlgnge decisions
c. Anglysg of longrange decigirns
d. Schedulingof office personnelin office buiHingc

Naga Company is considering the sale of a mrchinc rvfifi a book vdue of P 80,000 and 3 ycert
remginingin its usoful life. StraighhlineOepreci*on of P 2i,000 annua$yis avaibbb. The m*tinc
has a cunent mafiet vah.p of P 100,000. What is src cach non ftorn ct$irlg the mrd*nc if fic trx rab
is4}Yo? tuDOm
a. p 90,000 c. p 92,996 lrv * { gaD)
fn *art:t
b. P 88,000 d. P l(X),o(n

3. A cornpany i$ aortridering replacing a nractrincwlUr otre that uill crw P 5O,OO0por yeq in cldt
operding costs and has P 20,0W more depteciatbn cxprr|c€ p6r y03r than tht exiling rnacfiinr. Thc
Buyingthe new machinewill inctsasc annualnd wh tlowr of thc wflErny by-
hx rab is 4O0,6.
a. P 38,000 c. P 2O,0OO 't. le-W
Pgt{
b. P 3o;(p0 d. P 12,m0 {lP6a") a1!Y:

4. nffr a bookvatueof p 15,00o

otdequiprnent wittberupl"d bynew.quprffi, .:ffi *
of P 50,0@, exdueird d fntght chargned P 2,Om. Ihc miltd vehc of thc o'frtcquiptncnt F P1l,qn.
R.pdf 6ots of P 2,m qr b erckled if trc rw qtlpmor* b acqufutt. Alat#n a br r* of 3C*.
\Mrat is the initiel (net) invesfrnentof the proi€cf, llgec t aafi
a. P 33,800 s. P 30.700 l.e*.t ' l' l,9
b. P 38,300 d. p tr2,000
----
I\ lbTr )
sLuT[of.l h 4,fi ' t c3L0
Co€ilc + 2,000= P 52,(X)0
(C*h outtb*r):5O,OOO
Savingo(edt infbrvr): 11,0(n+O.35(15,000
Xdnxsl
+ 2,000(l - 0.35)= P 1317@
- 11;000)
JiP*u, 2>=-
5. Thc moct co*wbn't Eylbf*db procscls fiom th. dryoctl of an olt! sct is6
C a. Tt€d il r e carh flow c. Offtct the amo.mtagnin$tthe cslh outlay
b. True il a a reduclbn fi dvqr v*tc d. Add b the inv+ctnent

6. Leg*pi Cmpery * ffiuridc.frlg r4ncfig a rnaddrp wist e book valn of P 400,000, a remaining
usdrl [ro of S ycac, ail{ mmC tFrbH-|fnc d.plr#on of P 8O,0O0.Thc existing rn*hine has a
cunent msfatrnhrC'6f P &,0S. Thl repbemalt rnadrine wouH c6t P 550,(X)0,have a $year life,
and gave P 75,0(repGf y{r in wh op€ratingcosts. lf thc rcflmmcnt machhe would be depreciated
using.the smi$ltslina rmGbd md tfic trx r$c is {0t6, ufift woufd be sto net investmeil requiredto
replacefrtG.rfiEnglmfrlilt?
a. P 90,0m
b. P 150,000,
c. P 330,000
d. P.560,00 ;
ffiw
f45oc.!
gd1w
=::5:'
7. In decirlingwhltftcr b rtpho a macftine,whbh of 0rc bfloudngb ltOT a sunk gsf/
a., Thc expsctedrc!.b prbe of theexbting macfiine
b. The bodt value of the exFfing macfiine
c. The or{;inal cct of the oxistirg machine
d. The depreciatedcost of the existingmachine

q. lil computingthe amountof initialinvestmentbr decisbn-making,tiaxeswouldbe relewnt for all of the

foflowing,except:
a. Avoidablerepairsof old asset
b Profiton saleof old assetreplacedby a new one
c. Increasein rrrcrkingcapitalri4uited tb supportnew capitalinvestment
d. Loss on vwite-offof other assets disposedbecausecif new capital investment

Page1 of 14 pages
 ReSA -74e Ra'iar,, Sc444ta{ Acaruula'u1
MSo-'16
BUDGETING
CAPITAL ;
..
g. SorsogonCompanyis consrdering a P 50,000workingcapitalinvestment'
a projectthat wouldrequire,
initialinvestmentin workingcapital
The companvtlt"*'r"t" i,s 4ay". r"ni t"iit"r budgetinganaiysis,.the
- -;. be:
should
no cash
eashoutflow
c Mrnipt"a by (1-0.40)and shownas a n€t P 30,000
u! ine rate(0.40)andshownas a net P 20,000cashoutflow
b. Muttiptied
c. $hownas a cashoutflowof P 50'000
d. lgnored
in wor{<ingcapitalandone in depreciable assetsis that
10. A majordifferencebetweenan.investment have
C a. Rn investmentin workingcapitaljs never ieturned,while most depreciableassets
someresidualvalue
life, while an
b. An investmentin workingcapitalis returnedin full at the end of a project's
,in vestmentindepreciabte a s s e t s h a s n o re s id u a lv a lu e when
. c. Air investmentin workingcapitalis not tax deductiblewhen made, nor taxable
returned,whilean investmentin depreciable assets does allow tqx deductions
d.
- Becau* an investmentin workingcapitalis usuallyieturnedin full at the end of the
investn€ntrequiredfor the project
Orq"A it is ignoredin computingthl amountof the
:
11. To api:roximate'annualcastl mfiow,depreciationis
D a. ROCeO baek to net incornebecauseit is m inflotttof cash

3 3x:llffilfil l:liffiffi l:HH: it

ll
is
[:l
not
3xffi*"'"*n
an outflowof cash
d Addedbackjo net incorte because
deduction{astyearwas P 50,000and rtstax ratewas 3074The company'stax
12. DaetInc.'s'depreciation
tax shieldfor the yearwas
savingsfromthe depreciation
A a.- P 15,000 c' P 50'000
.', d. P 30'000
b. 'P 35,000
annualcashbenefitsand salvagevalue.
13. A projectcostingp.180,000witlproducethe_fo_llowing
OLQeouipmpnt NEWeouioment
Revenue P 150,000 P 180,000
- Casi operatingcosts 70,000 60,000
Annuatdeprecibtign s,w0 50,000
lncorne tax,460/o 5r& *, f'?ft'r: Vo*\4- '--a-'
4"
What
e . P 30,000
p 30,s00 d. P 38',000
f
'iS a book value of P 200,000ra rernaiftinguseful
14. Nsha0omPanY considering reptacingh machineWift -of
life of 5 years; ind bn:nudst;ignt-finetepreciaton P 40,000.Tle 9lilti19 .rnachinehas a cunent
lifa lnd
marketvatue of 200,000.fhireplac€ment machine-wotddcost P 300,000;harlria S-year
p
luril\D, ;"*€ 1$01400per"-year-in cash qpergtlngcostg, The replacement machirewould be depreciated using
(6oArD
/ rat6 is 40olo.
the straight-linemethodand the tax tL"i let C,r.g
.1.dt" *a;'
,-- "'->
rnacnine? 7A?
replacesffi'6 ''{2N
'P ;'--\ ' flowif thecompany
Whatwoutdbetheincreaserqgg!V{.!et-q3sh :
;. eo.,ooo c' P 76'000
LJ}E
/{LrUu b. P 68,000 ; PPu4,t
d. s4;mo i Coa,\
6ran f.4,.{,
L
--KY.s 15. WhicflStdementdescribeSthe releyanceof depreciationin calculatingcashflows? *' -
n a. Aeppctdiqn'" t"fi*nt gnly when incometaxesexist , , -\
b. Dspr,eciationis alwaybrelevant YofuL
, c., DePreciation E neverrelevant
d. toebreciationis rebvantonlywith discountedCashflow methods
'
16, LigaoGomPanY is analyzinga capitalinvestmentproposalfor a new machineryto producea new
pr[Ouctover the nixt t0'yeirs. nt ihe end of ten years,the machinerymust be disPojf!:f ":'I^:::I"
net bookvaluebut wltha scrapsa{vagevalueof P 20,000.tt will requiresomeP 30,000to rerrlovetne
machinery.The applicable tax rateis 35%.
is:
"end-ofjife"cashflowbasedon the foregoinginformation
The approximate
": ,b. Outftowof P 6,500 ' d. 'Outflowof P 17,000

Page2 of 14 pages
ReSA -?6e Rernaez,
S€laat( Ama*a MSQ-10
,*
CAPITAI-BUDGETING
".- a
C
17. Costofcapblis ,
a. The amountthe companymust paybr its plantassels
K
b. The dividendsa cornpanymustpayon its equitysecurities.
c. The costthe companymust incurto obtainits capitalrss(runoes.
d. Thd cost the company is chargre<lby irwetrnint bankers who handfe the issuanceof
equityor long-termdebtsecurities.

18. Costof capitalis

D a. The interestrate an entity must pay to bonow.rnoney
b. The returnan entity's stockhdldersexpec{on their investnent
c. The rate of retum the entity can'eam ftom inveetingavailabb cash
d. A conceptin manaEerialfineinceincorporatingall of the aborc idcas

19. For a certainproject,the retumthat investorsdemandbr investirqin a ftrm is knownas:

D a. DCF rate of return c. Payback
b. Net presentvalue d. Cost of capital

20. In an investnent in'plant asset,the retum that keeps the ryradctprice of the ftrn stoct(unchangred
is
B a. Net presentvalue c. Adiusbd ratc of rchrrn
b. Cost of capital d. unadiu$tedrate of rdtm

21. Nl of the followingrefierto the discountrdte ucd by a lirm in cqttd htdg€ting, except:
C a. Costofcapthl c. Oppodunfty osts
b. Requiradrateof return d. Hurdlerde '.
22. TabocoCompanyhae5% prcfienedstockurltha parvduc d P 100. Scilingpi@ is P 123.50persharc
andllotation@stsare P 0.50persharc. Tte compar{s tax rat6b 20%.
Whatis the costof prebnedstoc*?
B a. 4.03% c. 4.7o/o
b. 4.A7o/o d. 5%
SOLUtlOtf: Yleld:tlivirbnrlpershrre + mgtct trb p.rtr|l (net)= 5% (100)+ (123.S - O.5O)

23. Pili Companyis attemfling to onrnrb th. cod d lrtlnrl *rd G,(brnal€quity. The compeny't.@nrlul
stock ts curruntlyselHngat P 62.5CIper rhan wtth llotufpn cmt of P 5 pcr slnr!. The next rf,vtlanl Brr
shef€ b P 5.42. Eerningsand dividendsaru expertcd b gfow at a csn$nt fttte of 5%;

WfrgtLftc coot of nwoofnftxrn etock(C/S)and retainedeamiq$s(RyE)?

B 8. C/9: 13.67%;R/E:13.67% c. GIS:13.67%;RIE:14.43%
b. CIS: 14"43%:R/E: 13.67% d. CiS: 14.43%;RlE:14.43%
NOTE:F|dfnion cmt is dcdtc$d fqn mrrkct prioe ln oomptirry cct of @rnrnonand prcbned sbck; it
is ignorudin compdlq cost of rctdnd enrirqn.

24. Thernarket vahred B* Conprry'E conilnon tbd( (book nahrc: P 65M) is estim#d d P 60 M and
the market vakre d ib inbiut bcffilg dobt (booft vahp: P35[t) is eetimdcd d P 40tl. The arorage
bebre tax yic{rf'6nthesc mffise b 15% pcryfir. trtconretax& at 4096. The cornpfly is expectEd
to pay a div{dendd F '10plr rherc cnd the stod( is lding d a price of P 100'pcr shere. The gro\flth
rate of dividendb @pcrbtfto be 2.5% pcr yuer.
vhJ ylcrQv[r( , r
+''/'' lrr
\Mrat is the nleigfrbd everagflrcolt of capital(WACC)of the eo,rnpenyes I wfiole?4 UP , I';',,f-ruu
B a. (Wo
v 11.',|o/o
c. 21.5'lo
d. 25jf
to
/-'- Y.Jl1,li'ir."r
>- '
/rr\.' L"u'f'
25. The weightedayeragecost d capitatapproachto decisionmakhrgis nof direstlyatrectedby the
B a. Valueof 'commonstock
b. CunentbudgeVbrexpansion
c. Cost of debtoutstanding
d. Proposedmix of debt,equity,and existingfundsusedto implementthe project

26. A oompanywith cost of capibl of 15o/oplans to financean investmentwith debt that bears10%interest.
The late it shoulduse to dismunt the cashflows is
B a. l0o/o c. 25o/o
b. 15Yo d. 150%

Page3 of 14 pages
ReSA -74e Rea*ru,ScAad a{ r{ccic4'{t44el MSQ-10
CAPITALBUDGEI'ING
'.-
COST OF CAPITAL: DIVIDEND GROWTH MODEL and CAPITAL ASSET PRICIITG T.IODEL
Accordingto the Dividend Growth Model (also regarded as ,Gordon Model), earnings and dividends are
assumedto'increaseover tlme at a constantErowtn rate (G). The cost of capital is computedbased on the
following:
Ke= -*t- * c
rO
KL.l*e-o:t-slesu$y
"--
The cost oi equity ,representsthe return that equity investors require on their investmefitin thi: firnr.
This is the same KE that may be computed based on the Capital Asset pricing Model,(CApM).Using
the CAPMapproachof corfiputingcost of common eqtLityancl retained earningi, the forrnuta must.be
used basedon the SecurityMarket Line {5ML) apprciach:
K6=KPl*[*"-IF
where:
KE) Expectedrate of return -aT
(KM- Kr(F))Market risk premtutn f/\et\it^{n
, Knr9 Risk-freerate (normall'i basedon t-bill rate)
KM + Market return
' P.) Stock's beta coefficientisensitivity of a stock to market movement)
The CAPM has a sirnple interpretation:.The expected rates of return' demanded by investprs &pend
on two things: (1) compensationfor time value of money (the risk-free rate) ancl (2) risk premium,
which dependson beta and the market risk premium. The fundamentalidea behind the CApM is that
investors expect a reward for both waiting and worrying. The greater the worly, the greater the
expected.return. If you invest in a risk-free T-bill, you just recetve the rate of interest. That's the
reward forrwaiting. When you invest in risky stocks, you can expect an Cxtra return or risk premiurn
for worrying
Dr J. Q!-vid€nd-rn-pelsd-L (E-:reeiled-dj yrde.nd pe r-share].
The dividend to be.used in the cost of capital calculationmust be a prospectiyeone, Assuming the
growth rate (G) is 2oloand the mcistrecentlydeclareddividendis P 2.00 (D6),'theamount of dividendto
be used is P 2.04 {Dr}. This is arriv€d at through the foftowing:p 2.00 (1 + .02).
Dr*Do(1 +G)
The growth rate may also be computedbasedon the followrng
G = Returnon Equity(RoE)x RetentionRatio
UsingDd Pont technique;(Referto MS - 12, page 7, item 5, terter D)
\
Returnon Equity = Returnon Salesx AssetsTurnoverx EquityMultiplier
_, I!!o.ES__. = "_lnqgjle y __Sales . .- AEge!s._
Equity Sales Assets ^ . Equity

Return on Assets (RoA)* = Return on Sales x Assets'Tuf66;; ,i

Returnon Equity = Return on Assetsx Equity Multiplier
. EquityMultiplier= Assets+ Eguity = 1 + Equity Ratio
Returnon Equity = Returnort Assets+ EquityRatio
* This is comparableto RoI cornputation: Return on lnvestrnent (RoI) * Marginx Turnover
Retentionor P&owback Ratio = 100%,- Bividend Payout Ratio
DividendPayout= Dividendsper Share+ EPS= Dividends+ Earnings(Referto MS - t2, p.7, no, 5F)

P-0.?^ \
P-riselt.percC-gJgurrcn!-m-alk-etrricej
The current markat share price must_be computed net al flobtian costs. A flotation cost is simply
defined as the cost of issuingor 'floating' securitiesin the market. This is normally incurred hy issuing
Initial Public Offering (IPO) shares in the exchange market. The costs of selling stock are (l)
underwriter'sspread (2) other direct expenses (3) indirect expenses (4) abnormal returns, and (5)
underpricing.
Rearrangingthe formula, the growth rnoctelequationcould be expressedas foilows:

po= #e_
From the rearrangedformula, one could make the fottowingconclusiohs :
. Fligherexpecteddividends* highercurrent price for stocks.
I Higher reguiredreturn (cost of equity capital) * .lowercurrent price for stocks.
. Highergrowfh rate + higher current price for stocks.
NOTE:The formula "Earningsper Share + Market Priceper Share"to computethe cost 9f common equity is
na langer supportedby modernfinancemodelsand theories.
ReSA * 74e Reodern'Scnad
a{ #anurcraruy
CAPITAI-
BUDGETING
k
pAPfTALqppq.qTlsc-
I Ec-H
NIa.uHs
27. The lengthof timerequiredto recoverthe initialcashoutlayfor a prolectis determined
by usingthe:
B a. Discounted cashflowmethod c. Thenet presentValuemethod
b. The ppybackmethod d. The simplerateof returnmethod

28. Whichof thefollowingmethodsmea$uresthe recoveryperiodof a proposedinvestment?

D rr. Payback c. PV payback
h
Bail-outpayback d. Allofgiven

29. Whichof the fo*lowingis necessaryin orderto calculalethe paybackperiodfor a prgect?

D *: Usefullife c. Net presentvalue
b, Costof capital C,. Annualcashflow

30. lriga Companyis oonsideringa certainprojectwith the followingprojectedcash incomeaftertaxesfor 4

years,the lifeof the project:year1, P 11,000;year2, P 9,000;yeai 3, P 8,000;year4, P 7,000.tf the.
projectrequiresan investment of P 25,000witha salvagevalueof P 5,000,whatis the paybackperiod?
D a. '2.265years 2.526years
b' 2.562years d. 2.625years

31. AlbayInc. recentlyacquireda machineat a coct of P 64,000. lt will be depreciated

on a straight-iine
basisover 8 years,with no salvagevalue. Albay expectsthat this machinewill produceP 18,000
annualnet cashflowbeforeincometax. Assumingan incometax rateof 50%,the appropriate payback
periodon thisinvestment
is: (Hint:computecashflowafrertaxfirst)
B a. 3.6 yedrs c. 7.1years
b. 4.9years d. 12.8years

32. A companyis investigatingthe possibilityof acquiringa machinethat witl cost P 12,000and will have
' annual,depreciationfiortax purposesof P 2,400for 5 years.'The machineis expeetedto resultin cash
savingsfrom operationsof P 4,000per year. lf the tax rate is 50%,what is the paybackperiodfor the
new machine?
B a. 3 years c. 5 years
b. 3.75years d. 6 years

33. An advantageof usingthe paybackmethodis ihat tfr rncthodis:

B a. Precisein estimatesof profitability
b. $impleto compute
c. Not basedon cashflow data
d. lnsensitiveto the life of the projectbeingevaluated

34. BulanCompanyis planningto purchasea new machine. The paybackperiodis estimatedto be 6

yeaffi. The project'safter tax cash flow is estimatedto be P 2,000 yearlyfor the first three yearsand
P3,000yeartyfor the next threeyearsof the paybackperiod Annualdepreciation of P 1,300will be
chargedto incornefor eachof the 6 yearsof the paybaekperiod. The machinewill cost:
A a. P 15;000 c. P 9,000
b. P 12,000 d P 6,000

35. Oas Companyis planningto purchasea newmachinefor P 30,009.The paybackperiodis expectedto

be five years. The new machineis expectedto producecash flowsfrom operations,net of irrcome
taxes,of P 7,000per year in eachof the nextthreeyearsand P 5,500in.thefourthyear. Depreciation
' of P 5,000a yearwill be chargedto incomefor each of the five Vealsof the paybackperiod,

Whatis the amountof cashflowfromoperations, net of incometaxes,thatthe newmachineis expected

to producein the last (fifth)yearof the paybackperiod?
B a. P 1,000 c. P 5,000
b. P 3,500 d P 8,500

36" As a capitalbudgetingtechnklue,the paybackperiodconsidersdepreciatlon

expense(DE) and time
valueof money(TMV)as fiollows:
B a. DE,relevantandTVM,relevant c. DF, irreleyant
and TVM,relevbnt
b. DE, irrelevant
and TVM,irrelevant d, OE,relevantandTVM,irrelevant

37. The paybackmethodassumesthatall cashinflowsare reinvested

to yielda returnequalto
D a The discountrate c. The internalrate of return
b The hurdlerate d. Zero

PageS of 14 pages
ReSA *7Ae Re-rlp*Sc/t*t a/ #cena'ttarry MSq; 19
CAPITAL
BUDGETING s

38. Buhi Company is studying a pro;ect that would have a ten-year life and woultj require a p 800,000
investment in equipment that has no salvage value. The project would provide net operating income
each year as follows for the life of the project:

l:l"rt."rhvariabte
expenses :8lffi
Contributionmargin 400,000
Less:fixedexpenses
Frxedcashexpenses P 200,000
Depreciationexpenses *._A9-O_QQ"_egA,AAg
Netoperatingincome p-j2L0-0-0
Thecompany'srequiredrateof returnis B%.Whatis the paybackpeitoOioittris project?
D a. 3years c 2years
b. 6.67years d 4 years
39. The BaaoGompanyis considering an investment
thathasthe followingdata:
Year
1234 5
lnvestment P8,000 P3,000
Cashinflow P 2,000 2,000 P 5,000 p 4,000 P 4,000
The paybackperiodfor thisinvestment rs
B a. 3.0years- c. 4 0 years
b. 3.5years d, 4.5years
40 A prolectcbsting P 180,000will producethe followingannual cash benefitsand salvage value
c-ag-tr
_!$_o_r:_e_?r re!!'"g-
!gt-e1!9 $elyAgg
1 . P 50,000 P 70,000
2 P 50,000 P 60,000
3 P.50,000 P 50,000
Whatis the bailoutpayback?
B a. 3 years c. 2-4 years
b. 2.6years d 2 years
4't. Sabang Company purchaseda new machinegl,Sruary 1 of this year for P 90,000, with an estimdbcl
useful life of 5 years and a salvage value of P 10,00S. The machine will be depreciated using the
straig-ht-linemethod. The machine is expected to produce cash flow from operations, net of tax, d
P36,000.a year in each of the next 5 years. The new machine's salvagevalue is P 20,000 in years 1
and 2, ard P 15,000in years 3 and 4, What will be the bailoutpayback period,forthis machine?
c a. 1.4years c. 1.9years
b. 2.2 years cl 3 4 years

42. The techniquethat does not use cashflowfor capitalinyestmentdecisions

c a. Payback c. ARR
b. NPV d IRR

43. 'TigaonCo. is consl&ringthe purchaseof a P 100,000machinethat is expectedto reduceoperating

cashexpenses by P 25,000peryear.Thismachine. whrchhasno salvagevalue,hasa usefullifeof 10
yearsandwillbe depreciated on a str5ight-line
basis Thesirnplerateof returnwouldbe:
B a. 1Qo/o c. 25o/o
b. 15ryo d 35o/o

44. $an JoseCompanyis considering of a personalcomputerthat costsP 120;000with an

the acquisition
economiclife of 12 yearsand a terminalsalvagevalueof P 12,000.lt is estlmatedthat the,increase
in'
' net incomebeforetaxesas a resultfromthis investment wiltamountto P 7,000annually lncometaxes
are 35%. The companyusesthe straight-line methodof depreciation.What is the accountingrate of
returnon the averagecost of investment?
C a. 3"79% c 6.809/o
b. 5.83% d. 698%

45.,Lagonoy Inc.purchased a newmachinefor P 60,000on January1. The machineis beingdepreciated

on the sttaight-line
basisoverfive yearswith no salvagevalue,The simplerateof returnis expectedto
be 15oloon the initialinvestmentAssuminga uniformcashflow,this investmentis expectedto provide
, annual'cash flowfromoperations.of:
D a . P7,20 0 | c P12,000
b . P1 3 ,80 0 d p21.000

Page6 of 14pages ffi)

\:-/-y'
ReSA * ?4a Retie* Scl4ncta( r{c.ur*ta"w1 MSQ-10
CAPITALBUDG E T I NG

46. The CamaligCompanyhas rnvestedin a machinethat cost P 70,000,,n* n", a usefullife of seven
years,and that has no salvagevalueat the end of its usefullife.The mqchineis bein$depreciated by
the straight-line
method,basedon its usefullife.lt will havea'paybackperiodof fouryebrs.Giventhese
data,the simplerateof returnon the machineis closestto:
C a. 71% c. 10.7o/o
b. 8.2% d. 39.3%
$OLUTION: Netincome:cashflow- depreciation: (70,000+ 4) - 10,000* 7,500

47, Thepaybackcapitalbudgeting technique considers:

of prpiect
Qa-gltjlgwsover.gdire.Jife Timevatueof rironey
Aa.NoNo
No Yes
c. Yes yes
d. Yes No
48. Whichof thefollowingmethodsis a discounted
cashflowmethodfor evaluatingcapitatinveetment?
C a. Payback c. PV payback
b. Bail-outpayback d. Paybackreciprocal

4eAprorect P2s,71?
costins *,*fj"jlTjJ- arter
taxes:
^qlrul S:l i:ffifll;
1 P 11,000
2 15,000
3 18,000
The company'scost of capitalis 16%. The PV of P 1 for one year at 160/o
is O86'2;for two yearsis
0.743:for threeyearsis 0.641.Whatis thediscounted
(PV)Beybackperiod?
D a. 1.7years c. 2.3years
b. 2 years d. 2.7years

50. Whichof thesecashffowrnethodsof evaluatrng

capitalinvestmentignoresthe timevalueof money?
B a. IRR c. Profitabitity
index
b" ARR d. NPV
51. A p€6orur is worthmorethan a pesoto be rccciwd in the futurebecauseof
C a. lfiflation c. The opportunrtycost of waiting
b, Uncertainty d. Risk

52. Netpresentvalue(NPV)is
C a. The sumof discountedc&shinflows ,;.,
b. The sum of discountedcash ontflows
c. The sum of disoountedcaohinflorusfessthe sum of the discountedcashoutflows
d. The sum sf di$countedcash inflowspfusdiscountedcashoutflows

53. \Nhichcapitalbudgetingmethodassumesthat the funds are reinvestedat the company'scost of

capital?
C a. Payback c. Netpresentvalue
b. Accountingrate of return d. Timeadjustedrate of return
54. You have been consultcdto advise PolanguiCorp. on the prqected acquisihbnof anotherproduction
linecostingP 1 million.The line hasan expoctedusefultifeof five (5) yearswithoutany salvagevalue.
The followingadditbnatinformationwas madeavailable:
Ycar Estimqlgd4mUelQAghlnflow Prgse-nt VatueoJL1
1 P 600,000 0.91
2 300,000 0.76
3 ' 200,000 0.63
4 200,000 0,53
s . , 200.000 04l
roTAL PJ*SSg*ggQ a&z
Assumingthatthe cashflowis to be discounted,
youradviceis
B a, To investdueto netpresentvalueof P 541,280
b. To investdue to net presentvalueof P 94,000
c. To investdueto net advantageof P 500,0CI0
d. To investdue to net presentvalueof P 635,000

Page 7 of 14 pages
ReSA ?4e RearauSl4iol a{ #unaatuctt .r MSQ-10
CAPITAL BUDGETING

55 ln computing the PV of fut0re cash inflows that are uniform, reference will be made to a table that shows
C a. Amountof P1 c. Presentvalueof annuityof P1
b. PVofP 1 d. Futurevalueof annuityof P 1

56. Labo Companypurchaseda machine,which will be depreciatedon the straight-linebasis over an

estimatedudefullife of sevenyearsand no salvagevalue. The machineis expectedto generatecash
. flows from operations,'net of income'taxesof P S0,000in each of the sevenyears. Labo'sexpected
rateof returnis 12o/o.lnformationon pre$entvaluefactorsis as follows:
Presentvalueof P 1 at 12o/o,tor
sevenperiocls:
0.452
. Presentvalueof an ordinaryannuityof P 1 at 12o/o tor7 periods,4 564
Assuming a positivqnetpresentvalueof P 12.7,2l,what is thecostof thenrachine?
C a. P 240,400 c P 352,400
b P 253j20 d. P 377.840

57. An investmentopportunitycostingP 110,000is expectedtro.yield net cashflowsof P 28,000annually

for six years.The NPV of the investmentat'a cutoffrateal 12o/o
woulcjbe (Roundoff PV factorsbased
on threedecimalplaces)
B a . ( P 5 ,10 8 ) c P 110,000
b P 5,10 8 d. P 115,108

58. The effectivenessof the present value method has'Ueen approprrately questtoneclas a capital
expenditureevaluationtechniquebecause:
A a. Predictingfuturecashflows is ofiendifficultand oftenassociatedwith unce'rtainties
b The averagereturnon investmentmethodis moreaccurateand useful
c. The paybackmethodis theoretically morereliable
d. The computationinvolvesdifficultmathematicalapplicationsmost accountantscannot
perform

59. On Janilary1, a companyinvestedin an assetwith a usefullife of 3 years. The company'sexpected

rateof returnis 10o/oThe cashflow and pr"esent
and futurevaluefactorsfor the 3 yearsare as fiollows
)teAI 9aph inflows Prese.nt"valueqLP.l @ 107e E@
1 P 8,000 0,91 1.10
2 P 9,000 0.83 . 1.21
3 P 10,000 075 1.33
All cashinflowsare assumedto occurat year-end.lf the assetgeneratesa positivenet presentvalueof
P2,000,whatwasthe amountof the originalinvestrnent?
A a. P 20,25A c. P 30.991
b. P 22.254 d P 33,991

60. lgnoring taxes, how are the fotlowing used in the calculation of the NPV of a proposed project?
. DbprZdationexpense Sa/vbrievalu€
C a. ' lnclude Include
b. lncfude Exclude
c. Exclude Include
d. Exelr.rde Exclude
61. Guinobatanminagementis considering programthatwouldrequirean inrtialexpenditure
an advertising
of P 165,500and bring in additionalsales over the next five years, The cost of advertisingis
immediatelyrecognized as expense.The projectedadditionalsalesrevenueis year 1 is P 75,000,with
associatedexpensesof P 25,000. The additionalsales revenueand expensesfrom the advertising
programare projectedto increaseby 10 percenteachyear. Guinobatan'stax rate is 40olo.
Thepresentvalueof P 1 at 10%,endof eachperiod:
' Penods o'"oT;;';;'n*"too

t
4
393?i?
0 68301
5 C 62092
Thenet presentvalueof the advertising
programwouldbe approximately
A a. P 37,064 c (P 37,064)
b. P 2 9 .13 6 d (P 2 9 , 1 3 6 )
NOTE: Please refer to page 14 for the soh.ltionand clarification

Page 8 of 14 pages
ReSA *?4& RaraatScka{'al , MSQ-10
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1. :'
CAPITALBUDGETING fc

62 Pilar,Inc.acquireda turningmachinethat has a usefullife of 10 yearswith no salvagevalue. The

incrementalannualnet incomebeforetaxesis P 8,500. Incnmetaxesare 25o/oeachyear. The PV of
an annuityof P-1for 10 yearsat 18%(thecompany's costof capital)is 4 494.Theannualdepreciation
is P 5,000.TheNPVis positiveP 1.119.2.5.
Howmuchis theamountof investment?
C a. P 30,000 c. P 50,000
b. P 40,000 d. P 60.000
63. A decreasein the discountrate:
A a. Willincreasepresentvaluesof futurecashflows
b. ls onewayto compensate for greaterriskin a project
c. Will reducepresentvaluesof futurecashflows
d. R'esponses a and b arebothcorrect

64. The calculationof the net presenlvalue of an investmentprolectrequiresthat the depreciationtax

shield,be includedat:
C a. The amountof the depreciation withno adjustment taxes
b. The amountof the depreciation timesqne minusthe tax rate
c. The amountof the depreciation timesthetax rate
d. Zero,sincedepreciation is notrelevantto the calculatiorr
of net presentvalue
65. For P 450,000,CamarinesCorp.purchaseda new machinewith an estimatedusefullife of five years
with no salvagevalue. The machine,isexpectedto producecash flow from operations,net of 40%
income
taxes'
"- F$3Ii;"r p 160000 year
Fourth p 120,000
Secondyear P 140,000 Fifihyear P 100,000
Thirdyear P 180,000
CamarinesCorp.will usethe sum-of-yearsdigits'
methodto depreciate
the newmachine:
Firstyear P 150,000
$econdyear 120,000
Thirdyear 90,000
Fourthyear 60,000
Fifthyear 30,000
The presentvalueof P 1 for 5 periodsat 12o/o
is 3.60178 The presentvaluesof P 1 at 12o/o
at end of
eachperiodare.
Period PV factor
1 0 89280
2 079719
3 071178
4 0.63552
5 0.56743

HadCamarinesusedthe straight-line
methodof depreciation,
whatis the differencein net presentvalue
provided.
by the machineat a discountrateol 12o/o?
B a. lncreaseof P 9,750 c. Decreaseaf P 24.376
b. Decreaseof P 9,750 d. lncreaseot P 24^376
NOTE; Solutionsand explanationsfor item no. 65 are providedon page 14.

66, A pro;ect requires an investmentof P 40,000 and has a nel present value of F 10,000. The project's
profitability
indexwouldbe;
B a. 0.80 c. 4.4
b. +.25 d. 1.0

67. Consideran investment

withthefollowingcashflows:
Year *ip
----o Cashflows ---*-looo
PV of P 1 at 44o/o
' 31,600)
1 10,000 a.877
2 20,000 0.770
3 10,000 0 675
4 10,000 0.592
SalvageValue: P 5,000
Whatis the profitability
index?
B a- 1. 824 c. 1.482
b. 1. 284 d. 1.842

Page 9 of '14pages
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CAPiTAI.
BUDGHTING "l
68 An investment in a new pieceof equrpment costingP 50,000is expectedto yretcJ
the foltowingover its
S-yearusefullife:Revenues (cash),P 40,000.operating
costs(cash),P 18,000;depreciation,P 10,000.
The presentvalueof P 1 receivedannuaflyfor 5 yearsand discourtted
at the company'scostof capital
is 4"10assuming thataltcashflowsoccurat year-end.The benefiUcostratio(profitability
index)for this
pieceof equipment, ignoringtaxeffect,is
C a 0.984 c, 1 804
b 1.20 0 d 2.200

69 Which of the following methoctsmeasurescash flows and outflowsof a project as if they occurred at a
singlepoint in time?
C a. Paybackand bail-outpayback period c Netpresentvalueandinternalrate of return
b. Accountingand internalrate of return d Returnon originaland averageinvestment
70. The presentvalue and discountedcash flow rate of returnmethodsof evaluatingcapitalexpenditure
proposalsare superiorto the paybackmethodtn thatthey
B a. Areeasierto implement
b. Considerthe timevalueof money
c Requireslessinput
d. Reflectsthe efiectsof depreciation
and incometax
71. Theinternalrateof return(tRR)is the
D a. Hurdlerate
b. Rateof interestat whichthe rtetpresentvatueis greaterthan 1.0
c. Rateof returngeneratedfromthe operational cashflows
d. Rateof interestat whichthe net presentvalueis equalto zero

72. Thediscountratethatequatesthe PV of expectedcashflowswiththe costof investments

is the'
B a. Net presentvalue c. Accounting rateof return
b. lnternalrateof return d Paybackperiocl
73. Under the IRR capital budgretingtechniqde,it is a*trmed that cash flows are reinvestedat the
A a. Company'scost of caprtal c. fnternalrate of return
b. Hurdle rate of return d Discountrate

74. Whichof thefollowingis a basicdifferencebetweenIRRandARRcriteriafor evaluatimginvestments?

D a. IRRemphasizes expenses, ARRemphasiees expenditures
b. IRRemphasizes revenues;ARRernphaskesrecetpts -i..
c. IRRis usedfor internalinvestments; ARRis usedfor externaiinvestrnens
d IRRconcentrates on receipts& payments,ARRconcentrates on revenues& expenses.
75. Virac,lnc. is planningto investP 120,000in a 1O-year prqect. Viracestimates that the ahnuatcash
inflow,net of incometaxes,from.this prqect will be P 20,000 Virac'sdesiredrate for returnon
investments'of thistypeis 10olo.Informationon presehtvaluefactorsis as follows:'
@ 10% @12o/o
Presentvalueof P 1 for 10 periods 0 386 A322
Presentvalueof an annuityof P 1 for 10 periods 6 145 5.650
Virac'sinternalrateof retuinon this investmentis
C a" Lessthan10olo. butmorethan0% c, Lessthan12%,butmorethan10%
b. 10o/o d 12/o

76 BylaCorporation is planningto investP 80,000rna three-yearproject Bula'sexpectedrateof returnrs

presentvalueof P1 at 10%for 1 yearis 0.909,for two yearsis 0.826and forthe threeyears
10"/_o:fhe
is 0.751. The cash flows, net of incometaxes;will be P 30,000for the first year (presentvalue:
P27,27Al.and P 36,000for the secondyear (presentvalue:P 29,736). Assumingthe rite of returnis
exactly10%,whatwill be the netcashflow,netof incometaxes,for thethrrdyear?
D a. P 17,260 c. p 22,904
b. P 22.A00 d. P 30,618

77. LibonCompanyis planningto investin a machinewitha usefullifeof fiveyearsand no salvagevalge

The machineis expectedto producecash flow from operationsof P 20,000in each of the five years.
Libon'srequiredrateof returnis 10%.The maximumpricethat the companywouldpay for the machine
woulcibe:
C . a. P32,220 c. P75.82A
b P 62 ,10 0 d p 122.100
I\-ti\"t-rT--=tll;z]-ry!F:iYry?7 i:.{-.i:;-,:.. i':'i " , ,; .::?i:tryT@fiqr-7.ry''- ::

C API TALBU DG E T I NG l

78. A companyis consideringa capitalinvestment 't is P 20,000.Net cash

for whichthe initialcish ifuflay
net of incometaxes,are predictedto be P 4,000for 10 years. Assumea costof
flowsfromoperations,
Thepresentvalueof an annuityOfP 1 for 10 yearsat variousratesareas follows;
capitalaf 12a/o.
SiqcountRate PV.Factor
'14o/a 5.216
15% 5.018
16% 4.833
17o/a 4.658
internalrateof return?
Whatis thecompany's
A a. 15.1% c. 15.3%
b. 15.2o/o d 15.4o/o

79. lf an investment of P 14,760ns,wis to yieldP 18,000at the end of one year,thenthe internalrateof
.returnfor this investmentto the nearestwholepercentage is:
C a. 14o/o c. 22Ya
b. 18a d. 28%

80. Thepaybackreciprocalcan be usedto approximate a prolect's

D index
a. Profitability
b. Netpresentvalue
c.- Accounting rateof returnif the cashflowpatternis relativelystable
d. lnternalrateof returnif the cashflowpatternis relativelysta.ble

81 lf a companyhascomputedthe profitability indexof an investmentprojectas 1.15,then:

B a, The project'sinternalrateof returnis lessthanthe discountrate '
b. The project'sinternalrateof retumis greaterthanthe discountrate
e. The project'sinternalrateof returnis equaltothe discountrate
d. The relationshipof the rateof returnand the discountrateis impossibleto determinefrom
thedatagiven

82" lf an investmentprojecthasa profitability

indexof 1'.15,the
D a. Proiect'sinternalrateof returnis 15%
b. Projectlscostof capitalis greaterthanits internalrdteof return
c. Project'sinternalrateof returnexceedsits nGttPresentvalue
d. Netpresentvalueof the projectis positive

hurdteratefor all capitalexpenditures.lt hastinedup fourprojects:

83. LaboCo. usesa 12a/o
ln ThousandPesos
-rygf
:P"ffin_q#il-%iq
rnitiarcashoutrkrw
Annualnetcashinflows

Y::il
(ear3
ii8
160
i?3
180
i33
18O
lffi
180
' Year4 B0 130 160 160
Net presentvalue (7,596) 8,552 28,128 29,324
index(%)
Profitsbitity 98% 101a/o 106% 1Q5%
Internalrateof return 11o/o 13Ya 14o/o 15Yo

whichprojects
limitations,
lf thecompanyhasno budgetary shouldbe pursued?
C a. Projects3 and4 c" Proiects2,3 and4
b. Prgect4 d. Allthe fourProjects

84. DelGallegoCompanyis considering proposals,

severalinvestment as shownbelow:

required
Investment ef ooo r rf;ooo solooo raf;ooo
Presentvalueof futurecash inflows . 105,000 120,000 100,000 170,000

Usingthe profitability
index,the rankingwouldbe:
C a. D;B,A,C c. C,D,A,B
b. D,C.A,B d. C,A,D,B

Page11 of 14 pages
ReSA -7A4 Re*u Scki( ol /fun4,4raa&f t MSQ-10
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CAPITAL BUDGETING

85 Sta. ElenaCompiany is consrderingtwo projects,A and I The followinqinformationhas been gathered

on these projects.
ProlectA . Project?
Initialinvestmentneeded P 40,000 P 60,000
Presentvalueof futurecashflows 60.000 85.000
Useful life 4 years 4 ygars
Based on this information,which of the,followingstatementsis (are) true?
A has the higherrankingaccordingto the pr:ofitabilityindexcriterion.
l, Itj*tt
ll ProjectB has the higherrankingaccordfngto the net presentvaluecriterion
C a.'Onlyl c. Both I and ll
b. Only ll d. NeitherI nor ll

86. Milaor Corporationis contemplatingfour prolecis, L, M, N, and O The oapitalcosts for the initiationof
each project and its estimated after-tax,net cash flows are listed betow. The company's desired after-
tax opportunity costs is 12o/o lt has P 900,000 caprtal budget for the year. ldle funds cannot be
reinveste_dat greater than 12o/a.
- ln Thdusand"Pesos
N-----O
L . M---
lnitialcashoutflow 400 4704ZA 380
Annualnetcashinflows:
Yea r1 113 180 90 B0
Ye a r? 113 170 110 100
Yea r3 113 150 130 120 .
Year4 113 110 140 130
Yea r5 113 100 150 1S0
Netpresentvalue P 7,540 P 59,654 P 54,666 (P 15,708)
Profitabiligindex 1,02 113 1.14 0.96
lnternalrateof return 12.7o/o 17.6% 172% 106%
Thecompanywill choose:
B a. Projects,M, N, and O c. ProjectsL and N
b. Pro.lects
M and N d Pro;ectsL and M

87 DonsolCornpany'smarginalcost of nbw capitalis 10% up to P 600,000.lt increasesby 0.5%for the

next P 400,000 and another 0 5olothereafter Several proposed capital projects are under
withprojectedcostand internalrat,esof returnas follows
consideration,
ft# ,,'?ffioo
1ffi,. ,
3
D
Fl33:3ffi i';ZT;
P 350,000 13.5a/s
E F 400:0oo 12 Qo/o
Whatshquldthe company'scapitalbudgetbe?
B a. P65 0 ,000 c P1,500.000
b . P1,05 0 ,000 P1,600,000

rym$E Eesrs
-qepralgsdset
P 1-P 600 , 0 0 0 10Yo
P 601,000- P 1,000,000 10.50/o
AboveP 1.000,000 110,6

Project CumulativeEalancg AB Costs

1') B P 3oo,ooo 14% 1-0"/;
2*) D p 650,000(p 300,000+ p 350,000) 13.5o/o10.5%.
3'o) p 1,050,000(p 650,000+ p 400,000) lzo/o' 1lyo

88. Whichof the followingis a basicdifferencebetweenthe IRR and bookrateof return(ERR)criteriafor

investments
evaluating ?
D a. IRRemphasizes expenses andBRRemphasizes expenditures
b. IRRernphasizes revenues andBRRemphasrzes receipts
c. IRRis usedfor internalinvestments andBRRrsusedforexternalinvestments
d. IRR concentrates on receiptsand expenditures antJBRR concentrates on revenuesand
expenses

Paqe 12 af 14 paees
'Re-SA' - 7;-m:;;fr;'S{fu;; 'T-*xryllBffi(r'jrff

CAPITALBUDGTTING
'.f5,
89. The NPV and lRFimethodsgive
A a. The same decision(i.e.,acceptor reject)fcrr?nysrngleinvestme.nt 1rroject
b. The same choicefrom among rnutuallyexcrr,riveinvestments
c. The same rankingsof projectswith uneqlal lires
d. The same rankingsof projectswith diffeientrecgiredinvestments

90. Qualitative of a preis6lunderwhichof g, 'e followingcor ) ditions?

issuescouldincreasethe acceptability
D a. TheIRRis morethanthecompany's cutoffrate
b. Theprojecthasa positive NpV i
c. The paybackperiodis shorterthanthe industryst6ldardsfor payback
d. All of the alrove

91. lf appliedin capitaibudgeting

evaluation, sensitivityanalysis
B a. ls usedextensively whencashflowsare knownwithc€tairrtv,
b. ls a "whatif' techniquethataskshowa givenoutcomeviil inrngu if theoriginale, itimates
of thecapitalbudgetrng modelarechahgecJ
c. Measures the amountof timeit willtakefor a projectto r,66ys1its initialcapitaloutflou r
d. ls a technique usedto rankvariouscapitalprojects.

Items92 to 95 ard basFdon the fotlowinqrnforqnatrgn

lsarogCompanyhasgatheredthe followingdataon a propos€drr"rv.strrent proiect:
lnvestment required in equipment p 142i00
Annualcash inflows 30,00
Lileof the investment I ye."s,
Requiredrateof return 10,"
92. The paybackperiodfor the inve$tment is closestto
C a. 8.00years c. 4.75years
b. 1.42years d. 0 21 years
93. The sipple rateof returnon theinvestment
is closestto
A a. 8.55% c, 21.05ok
' b. t0.00Yti d 33557o

94 The net presentvalueon this investment

ts closestto
D a. P 300,000 c. P 58,800
b. P76,024 d. P 17,550
95. The internalrateof returnon the investnentis closestto.
A a. 13oA c. 14o/o
b. 15% d. 124/o

96. The relationshipbetweenpaybackperiod:ndtRRis that

B a. A paybackperiodof less than orn-halfthe life of a prolectwill yield an IRRlowerthan the
targetrate
b. The paybackperiodis the presentviluefactorfor the IRR
c. A projectwhose paybackperioddoesnot meetthe company'scutoff rate for oaybacllwill not
meetthe company'scriterionfor IRR
d. Bothmethodsare discounted techniques

97. If the presentvalueof the futurecashflowsfor rn investment

equalstherequiredinvestment.
the IRRi$
A a. Equaltothe cutotfrate
b Equaltothe costof borrowedcapital
c. Equaltozero
d. Low€rthanthe company'scutoffrateof return

indexgreaterthanonefor a prolectinircates
98. A profitability that
A a. Thediscountrateis lessthantheinternalrateof return
b. Therehas beena calculationerror
c. The projectis unattractive
and shouldnot be pusued
d. The companyshouldreevaluate its costof capital

Page 13 of 14 pages
ReS A -1io Re*aea,
S&ool e{ 4cc**ta'ry MSQ-10
C A PI TALBUDG E T I NG

EFFECTon NPV of a CHANGE ih DEPRECIATION i4ETHOD

WRONG
notion 1: Sincedepreciationreducesincome,NpVwitt decrease.
WRONG
notion2: The higherthe depreciation,the towerthe NpVwitt be.

Qepreciationis a non-cash expense. As such, it has no i:ffect on Net Present Value since NpV is a
discountedcash flow.technique;howe.,rer, sincec'lepreciation expensereclucesthe income subjectto tax, the
tax savings (tax shield) of depreciationhas an effect on NPV" Consequently,lrigher depreciationmeans
higher tax savings (effectively a.cash rnflow); therefr:re, the higher the clepreciatian,the higher the Npv witt
be.
Referto page 9, item 65:
The companyis to changefrorn.SYDto straight-linebasisof depreciation:

. Dq2reciatigl__ __*.
Y-e-al glras-ht-[tte] lYD ' -D*1[e;snse -!.q1-Rpte Iaxsa,vings Pv--fa"Etp-rsNPy*effce!
1 P 90,000 P 150,000 (P 60,000) 40% (P 24,000) 0.89280 {p 2t,427.20\
2 P 90,000 P 120,000 (P 30,000) 4ao/o (P 12,000) 0.79tt9 (P 9,566.28)
3 P 90,000 P 90,000 - 400/o . 0 .7r17B
4: P 90,000 P 60,000 P 30,000 4A4/o P 12,000 0.63552 p 7,O26.24
5 P 90,000 P 30,000 F 60,000 4Qo/o P,2-4,000 0.56743 1..13F!8_,_3?..
* Basedon the cost of P 4q0,000 dividedeverrlythroughoutS-yearlife. TOTAL; '(i'S,7qg.gii
Roundedoft answ€r: (P 9,750.0O)

Take note rhat the only effect of depreciition on NPV is the tax savings or-rtof <iepreciationexpense.
Accordingly,computationshall emphasizethe tax savingseffect on NpV.

Since depreciationwill be lower in the early years of ttre prolect life unrJerthe straight-line method (as
opposed to SYD method); then lhe over-all NPV will definitety decreasebased on time value of money, as
representedby the present value factors. Considerthis: lcrwerdepreciationg lower tax savings(shield) t
lower cash inflow I lower NPV.

Alternativesclutionl Basedon above computations,thg differencein depreciationmethotJis multipliedto a

common 409o tax rate to compute the tax shield for each year. This common factr:r (tax bf 40olo)berng
muftipliedevery year makes the calculationsomehow inefficient.We could initially ignore the common tax
factor of 4Ao/oin the disccluntingprocess
and shr:rtenthe cortputationas follows:
Qifferenee PV-Eaelprs NP_V*Pretax-F:tlreEt
(P 60,000) 0.89280 (P 53,568.00)
(P 30,000) 0.797L9 (P 23,915.70)
o.7rL78
P 30,000
p60.000 0.s6743 P 19,0C,5.60
0.63552
i.ax NPV-efrcsi
"_aF-itgii;l8, x 4oo/o = (P 9,748.20)
The same thing could be done to page 8, item 61.

First Etepis to computethe first year after-40o/o-tax

return:
. Bdforetax: P 75,000 .- P 25,000 = P 50,000 A fter tax: P 50,000 x 6A a/o P 30,000
-
Secondstep is to computeyearly discountedcash fiow:
Ysar fft_er:tax8elglnl P_V.fa_e!"fftpV_stcaEhldlo_yy.e
1 P 30i000 0.90909 P 27,272.70
2 P 33,000 0.82645 P 2/,272.85
3 P 36,300 0.75121 P 27,268.92
4 ' P39,930 0.68301 P21,2./7.59
, 5 P 43,923 0.62092 ,. _?.-12-,?/Z.S'-2*_*_.
'
TOI-AL: P 136,359..73
* NOTE:After-tax return is to increaseby l}o/oannuallythereafter.

The investment,'inthe fonn of aclsexpense,is computednet o[ relatedtax: P 165,500(600/o]"'. p 99,300

NPV= 136,359.73- 99,300 = P 37,059.73(with roundrng-bffbrrors) orP 37.,A64(basedon choiceA.).
Alternativesolution:Since the annual increasein returns is 10o/oand the discountrate is also l0o/o,the
effect is somewhatoffsetting.Noticethe last colurnnof the solr-iticn,the investrnentis supposeclto have a
uniformcashflow everyyear; p 27,272.70.Hence,P 27 272.20x 5 years= P 136,364(rounded)is the total
presentvalueof cashinftow.Apparently,choiceA is basedon this: NPV 136,364- 99,300 = P 37,A64.