CHAPTER 20 CAPITAL BUDGETING DECISIONS I. Questions 1.

A capital investment involves a current commitment of funds with the exp ectation of generating a satisfactory return on these funds over a relatively ex tended period of time in the future. 2. Cost of capital is the weighted minimum desired average rate that a comp any must pay for long-term capital while discounted rate of return is the maximu m rate of interest that could be paid for the capital employed over the life of an investment without loss on the project. 3. The basic principles in capital budgeting are: 1. Capital investment models are focused on the future cash inflows and outflows - rather than on net income. 2. Investment proposals should be evaluated according to their differential effe cts on the company's cash flows as a whole. 3. Financing costs associated with the project are excluded in the analysis of i ncremental cash flows in order to avoid the double-counting of the cost of money. 4. The concept of the time value of money recognizes that a peso of present retu rn is worth more than a peso of future return. 5. Choose the investments that will maximize the total net present value of the projects subject to the capital availability constraint. 4. The major classifications as to purpose are: 1. Replacement projects those involving replacements of worn-out assets to avoid disruption of n ormal operations, or to improve efficiency. 2. Product or process improvement projects that aim to produce additional revenue or to realize cost savin gs. 3. Expansion projects that enhance long-term returns due to increased profitable volu me. 5. Greater amounts of capital may be used in projects whose combined return s will exceed any alternate combination of total investment. 6. No. This implies that any equity funds are cost free and this is a dang erous position because it ignores the opportunity cost or alternative earnings t hat could be had from the fund. 7. Yes, if there are alternative earnings foregone by stockholders. II. 10.I 1. 6. 2. 7. 3. 8. 4. 9. 5. AE H C D F G B J III. Matching Type Problems

Problem 1 (Equipment Replacement Sensitivity Analysis) Requirement 1 P121,050Disposal Total A. P 44,000 B. P110,285 New71,285 Present Situation: (5,000) Present Present Recurring Disposal C Situation: ost of Value value new value cash equipment of operating ofnet oldcash equipment costs outflows (P26,500 (P45,000 now years four x 2.69) hence (P2,600 x 0.516) Difference P119,708 P (1,342) 9,423 Present Requirement in favor value ofof 2 replacement net cash inflows Payback period for the new equipment = Requirement 3 Let X = annual cash savings Let O = net present value = 2.1 years

X (2.69) + P5,000 - P44,000 - P1,342 = 2.69X = P40,342 X = P14,997

If the annual cash savings decrease from P18,850 to P14,997 or by P3,503, the po int of indifference will be reached. Another alternative way to get the same answer would be to divide the net presen t value of P9,423 by 2.690. Problem 2 Annual cash expenses of the manual bookkeeping machine system, P9,800 x 12 P117,600 Annual cash expenses of computerized data processing Annual cash savings before taxes P 64,000

53,600

P42,000 Year Annual Depreciation P64,000 Inflow Income P51,200 P48,000 P44,000 Cash P38,400 P40,000 12,800 16,000 20,000 25,600 24,000 22,000 1 tax 2 3 inflow cash(50%) before savings after tax(b) tax (a) (a - b) After Tax Cash Inflows PV Factor PV100,000 P42,000 40,000 33,040 38,400 28,800 20,000 Year 15,000 x 15,600* Investment P126,718 Net P _________________ 38,178 26,718 11,700 present 2 3 1 0.750 0.909 0.826 Salvage Tax (I) loss (NPV) value * The P15,600 tax benefit of the loss on the disposal of the computer at t he end of year 3 is computed as follows: Estimated salvage value P 20,000 Estimated book value: Historical cost P100,000 Accumulated depreciation 48,800 51, 200 Estimated loss P(31,200) Tax rate Tax effect of estimated loss 50% P(15,600)

Since the net present value is positive, the computer should be purchase d replacing the manual bookkeeping system. Problem 3 Requirement 1 (a) Purchase price of new equipment P(300,000) Disposal of existing equipment: Selling price P 0 Book value 60,000 Loss on disposal P60,000 Tax rate Tax benefit of loss on disposal Required investment (I) P(276,000) Increased cash flows resulting from change in contribution margin: Using new equipment [18,000 (P20 - P7)] * Using existing equipment [11,000 (P20 - P9)] Increased cash flows 113,000 Less: Taxes (0.40 x P113,000) Increased cash flows after taxes Depreciation tax shield: Depreciation on new equipment (P300,000 5) P60,000

0.4 24,000

(b)

P234,000 121,000 45,200 P 67,800

Depreciation on existing equipment (P60,000 5) 12,000 Increased depreciation charge P48,000 Tax rate 0.40 Depreciation tax shield 19,200 Recurring annual cash flows P 87,000 _________________ * The new equipment is capable of producing 20,000 units, but ETC Products can sell only 18,000 units annually. The sales manager made several errors in his calculations of required in vestment and annual cash flows. The errors are as follows: Required investment: The cost of the market research study (P44,000) is a sunk cost because i t was incurred last year and will not change regardless of whether the investmen t is made or not. The loss on the disposal of the existing equipment does not result in an actual cash cost as shown by the sales manager. The loss on disposal results i n a reduction of taxes, which reduces the cost of the new equipment. Annual cash flows: The sales manager considered only the depreciation on the new equipment rather than just the additional depreciation which would result from the acquisi tion of the new equipment. The sales manager also failed to consider that the depreciation is a non cash expenditure which provides a tax shield. The sales manager's use of the discount rate (i.e., cost of capital) was i ncorrect. The discount rate should be used to reduce the value of future cash f lows to their current equivalent at time period zero. Requirement 2 Present value of future cash flows (P87,000 x 3.36) Required investment (I) 276,000 Net present value P 16,320 Problem 4 Requirement 1: P(507,000) Requirement 2: P(466,200) Requirement 3: P(23,400) P292,320

IV.

Multiple Choice Questions Capital Budgeting Decisions Chapter 20

40.B 1. 11. 21. 31. 2. 12. 22. 32. 3. 13. 23. 33. 4. 14. 24. 34. 5. 15. 25. 35. 6. 16. 26. 36. 7. 17. 27. 37. 8. 18. 28. 38. 9. 19. 29. 39. 10. 20. 30. AB C D C D A Chapter 20

Capital Budgeting Decisions 20-6 20-5

MANAGEMENT ACCOUNTING (VOLUME II) - Solutions Manual 20-1