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page 7
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
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)
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
=.233
page 15
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
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%
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
61.
Solutions:
Net Cost of
Investment
0
(P100,000)
(40,000)
30,000
(P110,000)
170,197
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%
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)
x 3.433
x 0.456
x 0.400
x 0.351
x 0.308
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%
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%).
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.
Solutions:
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
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)
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)
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:
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.