Capital Budgeting

page 7

28. Anilao Corporation is considering investing in a project that will

cost P144,200 and have no salvage value at the end of its 5-year
life. It is estimated that the project will generate annual cash
inflows of P40,000 each year. The company requires a 10% rate of
return.
a. What is the payback reciprocal of this investment?
b. What is the internal rate of return of this investment?
c. What is the profitability index of this investment?
d. How long is the discounted payback period of this investment?
29. Lancaster Manufacturing Company is considering replacing a machine
that has the following attributes:
Book value
P 400,000
Remaining useful life
4 years
Current market value
P 360,000
The replacement machine would cost P500,000, have a four-year life,
and save P53,500 per year in cash operating costs. Similar with the
old machine, it would be depreciated using the straight-line method.
The tax rate is 40%. The discount rate used by the company is 11%.
a. How much is the net investment to replace the old machine?
b. How much is the expected annual cash flow after taxes?
c. How much is the present value of the relevant depreciation tax
benefit?
34. Vito Cruz Corporation is in the process of evaluating an investment
proposal names Project A. Project A has no salvage value, an annual
net income after tax of P60,000, useful life of 10 years, and
internal rate of return of 12%. (Note: Present value factor should
be rounded off to 4 decimal places).
a. How much is the required net investment?
b. What is the accounting rate of return based on original
investment?
c. What is the accounting rate of return based on average
investment?
35. Ghost Rider Corporation is contemplating to investment on a certain
project that require an initial investment in equipment of P90,000
and an investment in working capital of P10,000. Salvage value at
the end of the useful life is expected to be P10,000. The project is
expected to produce sales revenues of P120,000 for three years.
Variable cost ratio is 60%. The assets are depreciated using
straight-line depreciation. The corporate tax rate is 30% and the
cost of capital is 15%.
a. How much is the net present value of this investment? Should
the project be accepted?
b. Assuming cost of capital is reduced to 12%, what is the net
present value of the investment?
c. Assuming that salvage value should not be deducted for tax
purposes, how much is the cash flow after tax in year 3?
36. Harrison Company is studying a project that would have an eight-year
life and would require a P300,000 investment in equipment which has
no salvage value. The project would provide net operating income
each year as follows for the life of the project:
Sales
P
Less: Cash variable expenses
_______
Contribution margin (30% of sales)
P
Less fixed expenses
Fixed cash expenses
P150,000
Depreciation expenses
_______? ______
Net operating income before tax
P
Tax expense
_______
Net operating income after tax
P
=======

Capital Budgeting
page 8
Based on the assessment of the management accountant, the payback
period of this investment is 5 years and that the annual tax benefit
on depreciation is P11,250.
a. How much is the expected cash variable expenses to achieve the
required payback period?
b. What is the exact internal rate of return?
37. Polyester Manufacturing Company is evaluating a new processor to
prepare personalized items for the foreseeable future for 200,000
clients per year. The personalized item is currently prepared on a
3-year old machine that could be used for another five years. The
machine is now worth P85,000 which is equal to its net book value,
or it will have a P15,000 salvage value in five years. The new
machine will have a useful life of five years, cost P275,000 and
have a P25,000 salvage value. Comparative cash operating expenses
are as follows:
Old Machine
New Machine
Variable cost
P2 per client
P1.70 per client
Fixed cost
P 100,000
P80,000
Assume straight line depreciation, a 40% tax rate and a 14% cost of
capital.
a. How much is the net present value of retaining the old machine?
b. How much is the net present value of acquiring the new machine?
c. How much is the increase in net present value assuming the
company decided to acquire the new machine? Should the company
acquire the new machine?
38. You are engaged as the management accountant of R. Mama Pawnshop.
Currently,
management
is
contemplating
on
three
different
investments: A, B, and C. Information on three investment projects
are as follows:
Project
Investment Required
Net Present Value
A
P170,000
P32,775
B
120,000
23,670
C
70,000
14,602
a. Assuming there is no capital restriction, what is the maximum NPV
the company can obtain?
b. Assuming a capital restriction of P200,000, what is the maximum
NPV the company can obtain?
c. Assuming that the company can only invest in one project and using
profitability index as the screening tool, what is the maximum NPV
the company can obtain?
39. Katniss, Inc., a non-taxable entity, is considering a project that
would have a ten-year life and would require a P1M investment in
equipment. At the end of ten years, the project would terminate and
the equipment would have no salvage value. The project would
provide net income each year as follows:
Sales
P
?
Less: Variable expenses
?
Contribution margin (30% of sales)
?
Less fixed expenses (including depreciation)
400,000
Net income before tax
?
All of the above items, except for depreciation of P100,000 a year,
represent cash flows. The companys required rate or return is 12%.
The present value factor of ordinary annuity of P1 at 12% for 10
years is 5.6502
a. In order to have a net present value of P695,060, how much
should the company sell annually?
b. Due to recent developments in the tax code, Katniss Inc. became
subject to a 30% corporate income tax. Assuming sales of
P3,000,000 without changes in other variables, how long is the
payback period?
Capital Budgeting
page 9

40. Tayuman, Inc. is planning to spend P244,000 for a new machine, to be

depreciated on the straight-line basis over 10 years with no
salvage value. The relate cash flow from operations, net of income
taxes, is expected to be P30,000 a year for each of the first 6
years and P32,000 for each of the next 4 years. Tayuman, Inc. has
also estimated the salvage value of the new machine at the end of
year 1 to be P169,000. Salvage value will decline by P10,000 each
year thereafter.
a. How long is the payback period?
b. How long is the bailout payback period?
41. The Mohr Company is considering a new popper for one of its portable
caramel popcorn stands. The analysis is narrowed to the Bang or
Pow. Information on the two devices is:
Bang
Pow
Purchase price
P 90,000
P 60,000
Annual cash inflows
34,000
24,000
Salvage value in 5 years
8,000
6,000
Useful life
5 years
5 years
Either device will do the job equally as well, Mohr uses a 16
percent cost of capital. Ignore taxes.
Required: (Sch-11-10)
1. Which machine has the higher NPV? Is this proper basis for
making this investment decision?
2. Using the profitability index, which machine is more attractive?
3. If Mohr has P180,000 to invest in popping machines, what should
it do? Why?
42. (11-13) The LaLonde Company is considering new word processing
equipment that can reduce personnel costs by an estimated P60,000 a
year. The new equipment is also expected to generate annual
intangible customer service benefits of P70,000. The new equipment
will cost P400,000 and will be depreciated on a straight-line basis
for tax purposes. The asset will have no residual value at the end
of ten years, the estimated life of the equipment. Income tax is
estimated at 40 percent.
1. Determine the annual net cash inflow from the proposed
investment.
2. Will the investment earn an 18 percent after-tax rate of
return?
3. Comment on the NPV.
43. (11-14) Katie Williams, owner of a self-storage business, has just
received an offer that is worth P600,000 after taxes for the
storage buildings. She is interested in another investment
opportunity that can probably yield an annual discounted return of
15 percent after taxes. The storage business is expected to
continue to yield an annual cash inflow, before taxes, of P170,000
for a period of 15 years. The book value of the storage buildings
is P660,000, and straight-line depreciation is used for tax
purposes. Zero salvage value is predicted. A 40 percent tax rate
applies. Should the offer to sell the storage business be accepted?
Explain.
44. (11-18) Litowich Co. purchased a new machine for P50,000 to expand
capacity. Sales are expected to increase by 20 percent. The only
additional fixed expense is the depreciation on the new machine
(straight-line over five years with no salvage value). The income
statement for the past year is:
Sales
P 300,000
Variable expenses
(180,000)
Fixed expenses
(100,000)
Net income before taxes
P
20,000
Taxes (40%)
(8,000)
Net income after taxes
P 12,000
1. What is the expected annual aftertax cash inflow from the new
machine?
2. Find the NPV using a hurdle rate of 15 percent and the payback
period.
Capital Budgeting
page 10

45. (11-34) Ghafari Brothers Company makes office equipment, such as

tables, desks, computer equipment consoles, and work tables. The
sales manager is trying to decide whether to expand the relatively
new computer equipment console product line. The average console
will sell for P300 and has a variable cost of P140 per unit. Volume
is expected to be 4,000 units per year for five years. To make the
desks, the firm will have to buy additional machinery that will
cost 900,000, has a 5-year life, and has a P100,000 salvage value
net of taxes. Straight-line depreciation is used, and salvage value
is ignored in depreciation calculations. Additional fixed cash
operating costs will be P200,000 per year. Ghafari has a 40 percent
tax rate, and its cost of capital is 16 percent.
1. Using NPV, determine whether the computer console line should
be expanded.
2. Compute the payback period.
3. Determine the approximate IRR that the firm expects to earn on
the investment. Ignore salvage value.
46. The following data concern in investment project:
Investment in equipmentP 16,000
Net annual cash inflowsP 3,600
Working capital requiredP 4,500
Salvage value of the equipmentP 2,000
Life of the project 12 years
Discount rate 14%
The working capital will be released for use elsewhere at the
conclusion of the project. Ignore income taxes. The net present
value of the project is:
47. Dodd Company owns a specialty truck with the following attributes:
Book valueP 55,000
Current market value 40,000
Expected salvage value (after 5-year
remaining useful life)
0
Annual depreciation expense, straight-line
method 11,000
Annual cash operating costs 18,000
The firms cost of capital is 14 percent, and a 40 percent tax rate
is applicable to all taxation items. The firm plans to replace the
truck with one costing P80,000 and having an expected salvage value
net of taxes of P5,000, annual cash operating costs of P3,000, and a
useful life of five years. Straight-line depreciation of P16,000 per
year would be taken on the new truck. Additionally, because the new
truck is more dependable, the firm could reduce its repair parts
inventory
by
P15,000.
Ignore
salvage
values
in
computing
depreciation.
Required: Determine the new truck should be brought. Use whatever
capital investment methods you believe will best present the facts
to Dodds management.
48. The Sawyer Company has P80,000 to invest and is considering two
different projects, X and Y. The following data are available on the
projects:
Project X
Project Y
Cost of equipment needed now
P 80,000
Working capital investment needed now
P 80,000
Annual cash operating inflows
23,000
18,000
Salvage value of equipment in 5 years
6,000
Both projects will have a useful life of 5 years; at the end of 5
years, the working capital investment will be released for use
elsewhere. Sawyers required rate of return is 12%.
1. The net present value of project X is:
2. The net present value of project Y is:
3. Which of the following statements is/are correct?
I. Project X is acceptable according to the net present
value method.
II. Project Y is acceptable according to the net present value
method.
III. Project Y has a time-adjusted rate of return which is
greater than 12%.
Capital Budgeting
page 11

49. The Lakers Company is interested in buying piece of equipment that

it needs. The following data have been assembled concerning this
equipment:
Cost of required equipment
P 250,000
Working capital required
P 100,000
Annual operating cash inflows
80,000
Cash repair at the end of 4 years
40,000
Salvage value at the end of 6 years
90,000
This equipment is expected to have a useful life of 6 years. At the
end of the sixth year the working capital would be released for
other investments. The companys cost of capital is 10%. Use the net
present value method to answer the following questions.
a. The present value of the initial outlay for working capital for
this investment is:
b. The present value of all future operating cash inflows is:
c. The present value of the net cash flows (all cash inflows less
all cash outflows) occurring during year 4 is:
d. The present value of the net cash flows (all cash inflows less
all cash outflows) occurring during year 6 is:
50. The Yates Company purchased a piece of equipment which is expected
to have a useful life of 7 years with no salvage value at the end of
the 7-year period. This equipment is expected to generate a cash
inflow of P32,000 each year of its useful life. If this investment
has a time-adjusted rate of return of 14%, then the initial cost of
the equipment is __________
51.

Duke University has a small shuttle bus that is in poor mechanical condition. The
bus can be either overhauled now or replaced with a new shuttle bus. The following
data have been gathered concerning these two alternatives:

Present Bus
New Bus
Purchase cost new
P 32,000
P 40,000
Remaining book value
21,000
Major repair needed now
9,000
Annual cash operating costs
12,000
8,000
Salvage value now
10,000
Salvage value seven years from now
2,000
5,000
The university could continue to use the present bus for the next
seven years. If the new bus is purchased, it will be used for the
next seven years and then traded in for another bus. The university
uses a discount rate of 12% and the total cost approach to net
present value analysis in evaluating its investment decisions.

Required:
1. If the new bus is purchased, the present value of the annual
cash operating costs associated with this alternative.
2. If the new bus is purchased, the present value of all cash
flows that occur now.
3. If the present bus is repaired, the present value of the annual
cash operating costs associated with this alternative.
4. If the present bus is repaired, the present value of all cash
flows that occur now.
5. If the present bus is repaired, the present value of the
salvage received on sale of the bus seven years from now.
52. The NNC Company is pondering the purchase of a machine which will
generate cash inflows of P30,000 each year for the next 9 years. The
machine will have no salvage value at the end of its 9-year useful
life. The companys cost of capital is 16%. Consider the following
two statements:
I.
This investment is acceptable under the time-adjusted rate
of return method.
II.
This investment is not acceptable under the net present
value method.
Required:
1. If the purchase price of this machine is P129,090, which of the
above statements is (are) correct?
2. If the purchase price of this machine is P148,380, which of the
above statements is (are) correct?
Capital Budgeting
page 12

53.

(11-15) Three projects are being evaluated. All have the same
initial investments and expected life. Data from the projects are:
Net Present Value
Accounting
(Using 16%)
Payback
Rate of Return
Project A
P22,000
2.8 years
18%
Project B
23,000
2.7
16
Project C
21,000
2.6
17
a. If present value and profitability are important, rank the
projects.
b. If we want the project that will make us look best in accrual
accounting reports, rank the projects.
c. If avoiding risk and getting our cash investment back quickly
are key factors, rank the projects.

The following projects have been evaluated using four capital budgeting
techniques.

54. (11-23)

Project A
P 3,440

Project B
P 8,550

Project C
P 300

Project D
P(2,000)

Net present value (Using

14%)
Internal rate of return
18%
16%
20%
12%
Payback period
3 Years
2 Years
4 Years
5 Years
Accounting rate of return
25%
18%
22%
20%
a. Based only on the information provided, rank the projects for
each of the capital investment methods shown.
b. What additional information is needed to make better rankings?
Discuss what might cause the difference in the rankings.
55.

Maibelle Industries is contemplating four projects: Project D,

Project E, Project F, and Project G. The capital costs for the
initiation of each mutually-exclusive project and its estimated
after-tax opportunity cost is 12 percent, and the company has a
capital budget for the year of P450,000. Idle funds cannot be
reinvested at greater than 12 percent.
Project D Project E Project F Project G
Initial cost
P 200,000 P 235,000 P 190,000 P 210,000
Annual cash flows
Year 1
P56,500
P90,000
P45,000
P40,000
Year 2
56,500
85,000
55,000
50,000
Year 3
56,500
75,000
65,000
60,000
Year 4
56,500
55,000
70,000
65,000
Year 5
56,500
50,000
75,000
75,000
Net present value
P 3,770
P 29,827
P 27,333
(P 7,854)
IRR
12.7%
17.6%
17.2%
10.6%
Excess
present
1.02
1.13
1.14
0.96
value index
During this year, Maibelle will choose:
a. Projects D, E, and F
c. Projects E and F
b. Projects D, E, F and G.
d. Projects D and F.

56. Telephone Corp. is contemplating four projects: L, M, N, and O. The

capital costs for the initiation of each mutually-exclusive project
and its estimated after-tax, net cash flows are listed below. The
companys desired after-tax opportunity costs is 12%. It has
P900,000 capital budget for the year. Idle funds cannot be
reinvested at greater than 12%.
In Thousand Pesos
L
M
N
O
Initial cost
400
470
380
420
Annual cash flows
Year 1
113
180
90
80
2
113
170
110
100
3
113
150
130
120
4
113
110
140
130
5
113
100
150
150
Net present value
Internal rate of return
Excess
present
value
index

P 7,540
12.7%
1.02

P 59, 654
17.6%
1.13

P 54,666
17.2%
1.14

P( 15,708)
10.6%
0.96

Capital Budgeting
The company will choose:
a. Projects M, N, and O.
b. Projects M, and N.

page 13
c. Projects L and N.
d. Projects L and M.

57. (11-38) Mazzeo Industries has designated a $1.2 million for capital
investment expenditures during the upcoming year. Its cost of
capital is 14 percent. Any unused funds will earn the cost of
capital rate. The following investment opportunities along with
their required investment and estimated net present values have
been identified:
Project

Net
NPV
Project
Net
NPV
Investment
Investment
A
P200,000
P22,000
F
P250,000 P30,000
B
275,000
21,000
G
100,000
7,000
C
150,000
6,000
H
200,000
18,000
D
190,000 (19,000)
I
210,000
4,000
E
500,000
40,000
J
250,000
35,000
1. Rank the projects using the profitability index. Considering
the limit on funds available, which projects should be
accepted?
2. Using the NPV, which projects should be accepted, considering
the limit on funds available?
3. If the available investment funds are reduced to only
P1,000,000:
a. Does the list of accepted projects change from Part 2?
b. What is the opportunity cost of the eliminated P200,000?
58. (12-22) Data relating to the three possible investments are as
follows:
X
Y
Z
Cost
P34,000
P25,000
P75,000
Annual cash savings
8,111
7,458
14,011
Useful life - years
10
5
20
1. Ignore
taxes,
rank
the
investment
according
to
their
desirability using the payback period, IRR, NPV with a discount
rate of 12 percent, and the profitability index.
2. Comment on the impact that the unequal lives have on the
rankings.
3. Comment on the impact that the unequal investments have on the
rankings.
59. (11-29) Fill in the blanks for the following independent cases. The
investments have a life of ten years and no salvage value. Ignore
taxes.
Internal
Annual Cash
Cost of
Rate
Net Present
Inflow
Investment Capital of Return
Value
Case 1. P
45,000 P 188,640
14%
?
P
?_
Case 2. P
80,000
p
_
12%
18%
P
?_
Case 3. P
?_ P 300,000
?
16%
P
81,440
Case 4. P
?_ P 450,000
12%
?
P
115,000
Case 5.
P
100,000 P
?
?
14%
P (38,300)
_
60. (11-22) For these projects, provide the missing values:
Internal Rate of Return

Project
Project
Project
Project
Project
Project

1
2
3
4
5
6

Initial
Investment
P118,932
?
68,000
84,750
?
11,925

Life of
the
Project
6 years
5 years
15 years
? years
? years
20 years

Annual
Net
Cash
Inflow
P34,000
12,000
?
15,000
20,000
?

Percentage
? %
? %
16 %
12 %
20 %
8 %

Present
Value
Factor
(Table 2)
?
3,605
?
?
2,991
?

Capital Budgeting

page 14

Advantages and Disadvantages of the Evaluation Techniques.

The following lists present several advantages and disadvantages of the

four evaluation techniques that have been discussed.
THE PAYBACK (OR PAYOUT) PERIOD METHOD
Advantages
1. It is simple to compute and easy to understand.
2. It may be used to select those investments yielding a quick return
of cash, thus placing an emphasis on liquidity.
3. It permits a company to determine the length of time required to
recapture its original investment, thus offering a possible
indicator of the degree of risk of each investment. Such an
indicator is especially useful when the danger of obsolescence is
great.
4. It is a widely used method that is certainly an improvement over a
hunch, rule of thumb, or intuitive method.
DISADVANTAGES
1. It ignores the time value of money.
2. It ignores cash flows which may occur beyond the payback period.
3. It fails to consider salvage value which may exist after the
payback period.
4. It gives more emphasis on liquidity rather than on profitability.
THE Accounting Rate of RETURN (ON INVESTMENT METHOD)
Advantages
1. It facilitates expenditure follow-up due to more readily available
data from accounting records.
2. It considers income over the entire life of the project.
3. The ARR computation closely parallels accounting concepts of
income measurement and investment returns.
4. It indicates the projects profitability
Disadvantages
1. It ignores the time value of money. Two projects might have the
same average return, yet vary considerably in the pattern of flow
of cash. In such a case, the recognition of the time value of
money would point to the desirability of the alternative having
greater cash flow in the earlier periods.
2. Inflations effect is expected to be included in cash flow
estimates. But a calculation of net income based on historical
cost depreciation and the expression of net income as a return on
an investment, which is also stated at historical cost, may be
quite misleading.
3. The average return on the original investment technique is
inapplicable if any of the investment is made after the beginning
of the project.
4. Presumes uniform flows of income over the projects life.
5. Includes depreciation expense and other accounting accruals in the
calculation of project income losing the purity of cash flows.
THE PRESENT VALUE METHOD
Advantages
1. It considers the time value of money.
2. It considers cash flow over the entire life of the project.
Disadvantages
1. Some argue that this method is too difficult to compute and to
understand.
2. Management must determine a discount rate to be used. However, a wellinformed management should already be aware of its cost of capital that
should represent the benchmark for discount rate purposes.
3. If projects being compared involve different peso amounts of investment,
the project with more profitable dollars, as computed by the present
value method, may not be the better project if it also requires a larger
investment. For example, a net present value of P1,000 on an investment
of P100,000 is not as economically wise as a net present value of P900 on
an investment of P10,000, provided that the P90,000 difference in
investments can be used to realize a net present value index should be
used rather than the net present value dollar figure. This index places
all competing projects on a comparable basis for the purpose of ranking
them. For Diamond Corporation, the computation is:

Net present value index =

Capital Budgeting

Net present value

.= P22,176
Required investment
P 95,000

=.233

page 15

This index simplifies finding the optimum solution for competing

projects when the total budget for capital outlays is fixed
arbitrarily, because it is possible to rank by percentages rather
than absolute pesos.
4. It may be misleading when dealing with alternative projects or
limited funds under the condition of unequal lives, in that the
alternative with the higher net present value may involve longer
economic life to the point that it would be less desirable than an
alternative having a shorter life.
THE DISCOUNTED CASH FLOW RATE OF RETURN
Advantages
1. It considers the time value of money.
2. It considers cash flow over the entire life of the project.
3. The percentage figure may have more meaning for management than
the net present value or net present value index.
4. The percentage figure allows a generally sound, uniform ranking
of projects which require different initial cash outlays and
have unequal lives.
Disadvantages
1. Some argue that this method is too difficult to compute and to
understand.
2. It implies that cash flow is reinvested at the rate earned by
the investment, whereas the present value method implies that
cash flow is reinvested at the rate of discount. It is argued
that the latter assumption is more reasonable.
Cost of Capital
The cost of capital is also called by such other names as cut-off rate,
minimum or lowest desired rate, minimum acceptable rate, target rate
standard rate, hurdle rate.
The cost of capital is the cost of using funds. When a business uses
funds to finance a project, such funds may come from various sources
like bonds, notes payable, common stocks, preferred stock, or even from
earnings retained in the business. When the company floats bonds or
obtains debt to finance a project, it is obliged to pay interest; when
it issues stocks, it has to pay dividends. Even when the company uses
the earnings retained in the business, there is an interest cost
implicit in the utilization of the companys own resources. These
dividends and interests that the company must incur or pay for using
funds to finance a project represent the cost of capital.
When financing can be traced directly to a specific source, the cost of
capital (which is expressed as a certain rate) can easily be determined
as follows:
1. Cost of Debt/Bonds:
Interest rate (1 corporate tax rate)
2. Cost of Preference Shares:
Dividends per share
------------------------------------------Market value per share of Preference Shares
3. Cost of Ordinary Shares (common stock):
a. Book value based (this is used when dividend growth
rate is not given)
Earnings per Share (after tax and preferred dividends)
-----------------------------------------------------Current Market Price of the Ordinary Shares
b. Stock price-based:
Cash Dividends per Share
-------------------------- + Dividend Growth Rate
Current Market Price
of the Ordinary Shares
4. Cost of Retained Earnings
a. Same as ordinary equity
b. In exceptional cases, if marginal tax rate is given:
Earnings per Share (after tax and preferred dividends)
less (1 Marginal Tax brackets of the shareholders)
-----------------------------------------------------Current Market Price of the Ordinary Shares
Capital Budgeting
page 16

Problems Weighted Average Cost of Capital:

1. The capital structure is shown below:
Bonds payable
Preferred stock, 8%, P100 par value
Common stock, 100,000 shares
Retained earnings

Amount
% of Total
P 500,000
50%
100,000
10%
300,000
30%
100,000
10%
P1,000,000
100%

Other data:
Net Income before tax
Less: Tax (35%)
Net Income
Less: Preferred dividends (P100,000
x 8%
Balance to Common stock
Divided by: No. of common shares
Earnings per share

P200,000
__70,000
P130,000
__8,000
P122,000
100,000
P
1.22

Current Market Price:

Common stock, P5
Preferred stock, P160
Compute the:
A. Individual cost of capital
B. Weighted average cost of capital.
2. The capital structure is shown below:
Source
6% Bank loan
5% Preference shares
Ordinary shares
Retained earnings

Amount
300,000
100,000
200,000
400,000
P1,000,000
P

Additional data:
Current market price per share:
Preference shares, P62.50
Ordinary shares, P40
Dividend per share:
Preference shares, P5
Ordinary shares, P2
Dividend growth rate, P4%
Corporate tax rate, 32%
Compute the:
A. Individual cost of capital
B. Weighted average cost of capital.

Proportion
30%
10%
20%
40%
100%

3. The capital structure is shown below:

Source
5% Short-term notes
4% Preference shares, P100
Common stock
Retained earnings
Additional data:

Preferred stock
Common Stock

Current
Market
Price
P150
50

Amount
P 3,500,000
1,750,000
12,250,000
17,500,000
P35,000,000
Expected
Earnings per
Share
P3.20

Proportion
10%
5%
35%
50%
100%
Expected
Dividends
per Share
P 4.00
1.60

The average marginal tax rate for the company stockholders is

estimated to be at 25%. Assume that the corporate tax rate is 40%.
Compute the:
A. Individual cost of capital
B. Weighted average cost of capital.

61.

(11-36). The molding department of Rayon, Inc. has been

investigating the acquisition of new equipment costing P100,000.
Cash savings before income taxes from the use of this equipment are
estimated to be P40,000 per year for ten years. At the end of five
years, the new equipment must be overhauled at a cost of P35,000.
The new equipment will have a salvage value after ten years. The
new machine would replace an old machine that would need a P30,000
overhaul now and again in five years, if it is not replaced. The
old machine is fully depreciated but can still function. To remove
the old machine, environmental precautions (mainly an asbestos
problem) will cost the firm P40,000. The rate used in evaluating
investments is 10%.
The income tax rate is 40%. Rayon uses the
straight-line depreciation.
Required:
1. Calculate the NPV. Make a recommendation.
2. If the asbestos will need to be removed within two years
anyway, how does this impact your answer to part 1? Comment.

Solutions:

(1) Net present value:

Year:
Initial investment
Incremental costs
Saved overhaul costs
Cash savings
Minus incremental depreciation
Change in taxable income
Minus taxes (40%)
Change in net income
Plus depreciation
Net cash flows
Sum of PV Year 1 to 10

Net Cost of
Investment
0
(P100,000)
(40,000)
30,000

(P110,000)
170,197

Life of the Project

1 to 4
5
6 to 10

P40,000
(10,000)
P30,000
(12,000)
P18,000
10,000
P28,000

(P35,000)
30,000
40,000
(10,000)
P25,000
(10,000)
P15,000
10,000
P25,000

P40,000
(10,000)
P30,000
(12,000)
P18,000
10,000
P28,000

(10%, 10 years)
NPV

P 60,197

The new equipment should be purchased. The savings from the new machine plus the saved
overhaul costs provide a significantly large net present value at a 10 percent rate of return.
(2) Because the net present value is so large, the decision is not changed. However, important
perspectives can be identified. If the proposal is so favorable, managers might be able to bury
the cost of asbestos removal in this project and "kill two birds with one stone." Thus, the new
equipment is purchased, shows a very strong NPV, and the asbestos problem disappears.
If the project showed a very small NPV, the asbestos removal could be separated from the new
equipment proposal and evaluated separately. This would allow the equipment proposal to
appear to be more favorable and environmental cleanup to be more onerous.
The needed removal in two years means that the old equipment will probably be disrupted
anyway. This might lead to an argument for deferring the whole project for two years. This,
however makes no economic sense.
The sum-of-years'-digits method creates a higher NPV and is therefore more attractive. This
method increases cash inflow early which is a large benefit considering the time value of money.
62. (12-19) Sensitivity Analysis of Future Estimates. Frear Industries
estimated the following figures on a bid for a 10-year government
contract:
Investment in machineryP 800,000
Additional inventory (funds to be released
when contract ends) 100,000
Cost of equipment overhaul at the end of sixth year 120,000
Machinery salvage value at the end of
contract (10 years)
80,000
Annual revenue from the contract 200,000
Cost of capital
14%

Required: Ignoring income taxes, what impacts (amount and

percentage change) will the following mistakes in estimation have
on the NPV of this contract?
1. An understatement of P20,000 in the investment in machinery.
2. an understatement of P20,000 in the inventory needed.
3. An understatement of P30,000 in the cost of the overhaul.
4. An overstatement of P50,000 in the salvage value at the end of
the contract.
5. An overstatement of P4,000 in the annual revenue
from the
contract.
Solutions:

To analyze the impacts of the mistakes in estimation, first solve for the initial NPV:
Net Cost of
Investment
Life of the Project
Year:
10
Investment in machinery
Additional inventory
Annual revenue
P200,000 P200,000
Equipment overhaul
Released inventory
100,000
Machinery salvage
80,000
Total cash flows
P200,000 P380,000
PV factors (14%)
x 0.270
PVs
61,600
P102,600
PV Years 1 to 10
NPV

1-5

(P800,000)
(100,000)
P200,000 P200,000 P200,000 P200,000
(120,000)

(P900,000) P200,000 P 80,000 P200,000 P200,000

x 1.000

x 3.433

x 0.456

x 0.400

x 0.351

x 0.308

(P 900,000) P686,600 P 36,480 P 80,000 P 70,200

P1,037,480
P 137,480

(a) Original NPV

PV of machinery understatement
New NPV
(b) Original NPV
PV of inventory needed
PV of inventory recovery (Yr 10)
New NPV
(c) Original NPV
PV of overhaul understatement
New NPV
(d) Original NPV
PV of salvage overstatement
New NPV
(e) Original NPV
Revenue overstatement
New NPV

P137,480
(20,000)
P117,480
P137,480
(20,000)
5,400
P122,880
P137,480
(13,680)
P123,800
P137,480
(13,500)
P123,980
P137,480
(20,864)
P116,616

(P20,000 x 1.000)
decrease of 14.55%
(P20,000 x 1.000)
(P20,000 x 0.270)
decrease of 10.62%
(P30,000 x 0.456)
decrease of 9.95%
(P50,000 x 0.270)
decrease of 9.82%
(P4,000 x 5.216)
decrease of 15.18%

63. (12-13) Lease versus Purchase. Zalka and Daugthers, an English

publisher, is considering the purchase of a photocopy machine. The
dealer has offered a sale or lease contract. Maintenance and
supplies costs are the same under either arrangement. The cash
purchase price is P45,000. The lease arrangement is monthly
payments of P2,000 for four months. Zalkas annual cost of funds is
approximately 12 percent (or 1% per month). Assume that the machine
will have a technological life of two years. Ignore taxes. What is
the more appealing financial arrangement?
Solution:

Since the lease payments are monthly, the yearly interest rate of 12 percent must be
converted to a monthly rate by dividing by 12 (12% 12 months = 1%).

Cash purchase price

PV of lease payments P2,000 x 21.243)
Net lease advantage

P45,000
42,486
P 2,514

If the lease is a merely a financing alternative provided by the equipment seller, the lease
advantage comes from a lower interest rate imbedded in the lease payments. Since taxes
are ignored, the deductibility of the lease payment, depreciation, and interest can be ignored.
64.

(12-17) Lease Financing. Vehicle can be lease under a 4-year

contract for P16,000 year or purchase with cash for P54,400.
Vehicle B can be leased on a 6-year contract for P15,000 per year
or purchased with cash of P74,900. Assume cash funds at a cost of
10%. The first payment is due today on both vehicles. Ignore taxes.
Required:
1. What is the embedded interest rate in each vehicles contract?
2. If we want both vehicles, which should be purchased or leased?

Solutions:

(1) Embedded interest rates:

PV factor = (Cash price - Initial cash payment) Annual cash payment
Vehicle A: = (P54,400 P16,000) P16,000
= P38,400 P16,000 = 2.400 (corresponds to 12 percent)
Vehicle B: = (P74,900 P15,000) P15,000
= P59,900 P15,000 = 3.993 (corresponds to 8 percent)
(2) Lease or purchase:
Vehicle A: Cash purchase price
PV of lease payments:
Years 1 to 3 (P16,000 x 2.487)
Lease payment due today
Total lease payments
Net purchase advantage
Vehicle B: Cash purchase price
PV of lease payments:
Years 1 to 5 (P15,000 x 3.791)
Lease payment due today
Total lease payments
Net lease advantage

P 54,400
(P39,792)
(16,000)
(P55,792)
P 1,392
P 74,900
(P56,865)
( 15,000)
(P71,865)
P 3,035

If we want the use of both vehicles, we should purchase Vehicle A and lease Vehicle B.
65. (12-16) Lease versus Purchase Alternative. Al Williams in Freeport,
Subic is evaluating two similar machines. Both machines do the same
tasks and generate the same revenues. Cash operating costs, however,
differ and are as follows:
Year
Year
Year
Year
Year
Year

1
2
3
4
5
6

Alternative A
P125,000
100,000
80,000
80,000
60,000
40,000

Alternative B
P 80,000
80,000
120,000
100,000
100,000
100,000

Both alternatives can be leased under a 6-year contract for P50,000

per year or purchased for P200,000. Als long-term funds have a cost
of 14%. Borrowing against his bank line of credit costs him 10%.

Required:
1. Which alterative is the better for operating decision?
2. Which financing alternative is better?
3. What should be done? Explain this decision.

Solution:

(1) Operating decision: The alternative with the lowest PV of operating costs is the better
investment.
Alternative A:
Investment
Year:
0
Operating costs
PV factors
PV at 14%
PV
(P337,265)

1
(P125,000)
x 0.877
(P109,625)

2
(P100,000)
x 0.769
(P76,900)

Life of the Project

3
4
(P80,000)
(P80,000)
x 0.675
x 0.592
(P54,000)
(P47,360)

5
(P60,000)
x 0.519
(P31,140)

6
(P40,000)
x 0.456
(P18,240)

1
(P 80,000)
x 0.877
(P 70,160)

2
(P80,000)
x 0.769
(P61,520)

Life of the Project

3
4
(P120,000) (P100,000)
x 0.675
x 0.592
(P81,000)
(P59,200)

5
(P100,000)
x 0.519
(P51,900)

6
(P100,000)
x 0.456
(P 45,600)

Alternative B:
Investment
Year:
0
Operating costs
PV factors
PV at 14%
PV
(P369,380)

Alternative A is the better operating choice because the PV of the operating costs is
P32,115
(P369,380 P337,265) less than Alternative B.
(2) Financing decision:
Alternatives A and B: The purchase price and lease payments are identical for both
alternatives.
Cash purchase price
P200,000
PV of lease payments (P50,000 x 3.889)
194,450
Net lease advantage
P 5,550
(3) The best decision is to lease Alternative A since it has the lower operating costs (Part
1) and because leasing is better than purchasing for cash (Part 2).
66. Sittin-in-the-Sun Health Spas is evaluating an expansion of its
existing facilities this fall. The proposal calls for a 6-year
building rental contract of P10,000 a year. Equipment purchases and
facility improvements are expected to cost P60,000. Straight-line
depreciation ignoring the half-year convention is used. Other cash
operating expenses are estimated at P25,000 annually. Based on past
experience, the company thinks new revenues should be P50,000
annually. Sittin-in-the-Sun will not expand unless the project
cover its 14% cost of capital. The companys effective tax rate is
40%.
Inflation is a concern. The controller thinks that the revenues and
cash expenses will inflate by 5% per year. Round he discount rate to
the highest rate available.
Required: Using NPV, suggest whether the expansion project should be
adopted.
Solution:

NPV:

Investment

Year:

Life of the Project

1

P50,000

P52,500

P55,125

6
Purchase cost
Revenues:
(Inflation rate, 5%)
P63,814
Cash costs:
(Inflation rate, 5%)
(31,907)
Rental payments
(10,000)

(P60,000)
P57,881 P 60,775

(25,000)

(26,250)

(27,563)

(28,941)

(30,388)

(10,000)

(10,000)

(10,000)

(10,000)

(10,000)

Minus depreciation
($60,000 6)
(10,000) (10,000) (10,000) (10,000) (10,000)
(10,000)
Taxable income
P 5,000 P 6,250 P 7,562 P 8,940 P10,387
P11,907
Minus taxes (40%)
(2,000)
(2,500)
(3,025)
(3,576)
(4,155)
(4,763)
Income after tax
P 3,000 P 3,750 P 4,537 P 5,364 P 6,232
P 7,144
Plus depreciation
10,000
10,000
10,000
10,000
10,000
10,000
Net cash flow
(P60,000) P13,000 P13,750 P14,537 P15,364 P16,232
P17,144
PV factors (14%)
x 1.000
x 0.877
x 0.769
x 0.675
x 0.592
x
0.519 x 0.456
PV
(P60,000) P11,401 P10,574 P 9,813 P 9,096 P 8,424
P 7,818
Total PV
57,126
NPV
(P 2,874)
Since the NPV of the project is negative, it should not be adopted.