CENTER FORACCOUNTANCYREVIEW&TRAINING

ES T A B L I S H E D 2003
2ndFlr.,ManangoBldg., City Road., Centro East, Santiago City, Philippines; Mobile No.: 09108298588

MANAGEMENT ADVISORY SERVICES

Jimmy I. Peru, MBM, MICB, CPA

CAPITAL BUDGETING

Capital Budgeting Project Evaluation Techniques

The process of identifying, evaluating, planning,
and financing capital investments projects of an
organization.
Major Concerns are:
*Net Cost Investment- cash outflow less cash inflow
or saving incidental to the acquisition of the
investment projects
* Traditional Models
-do not consider time value of money
1. Payback Period- this method measures the time
required for a project’s cash inflows to equal the
original investment.
Assumption- the longer it takes to recover the initial
investment, the greater is the projects risk.

Outflows: Year Annual Amount Cumulative Total

T-Tax paid in case of gain and from cost of savings 0 (11,500) (11,500)
O-Other cost paid (incidental to the acquisition) 1 3,300 ( 8,200)
W-Working Capital- Increase 2 3,200 ( 5,000)
A-Asset acquired 3 3,200 ( 1,800)
4 2,900 1,100
Inflows: 5 2,400 3,500
R-Repair Avoided
A-Asset sold 2. Payback Bail Out
T-Tax savings from loss on sale -Similar with payback period, the only
difference is, this method considers salvage value
*Net Returns
-Accounting Income 3. Accounting Rate of Return
-Net Cash Inflows -measures the profitability of a proposed project

*Cost of Capital Simple ARR= Net Income/Investment

-cost of raising funds Average ARR= Net Income/ [ (Investment+SV) /2]

“Characteristics of Debt and Equity” * Discounted Models

-consider time value of money
Debt Preferred Common
Claims Highest Second Last 1. Net Present Value- amount of money contributed
Obligation Required Not Required Not Required to the company
Risk Lowest Moderate Highest Present Value of Cash Inflow xxxx
Ownership NO NO YES Net Investment ( xxx)
Taxable YES NO NO Net Present Value xx

Cost of Debt- Interest 2. Profitability Index- used in ranking projects

Present Value of Cash Inflow
1. Current Yield = Interest/Price 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
Net Investment
2. Current After Tax Yield = Interest/Price*(1-tax)
3. Internal Rate of Return- the rate of return which
equates the present value (PV) of cash inflow to net
3. Yield to Maturity (YTM)
investment
interest + discount amort. −premium amort.
x (1 − 𝑡𝑎𝑥) 4. Payback Reciprocal
(60%xPrice) + (40% Face Value) Annual Cash Flow after Tax 1
𝑃𝑅 = or
Net Investment Payback period
Cost of Preferred Stock
Dividends
5. Discounted Payback Period
(𝑃𝑟𝑖𝑐𝑒 − 𝐹𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡)
-similar with payback period ‘
Cost of Common Equity:
Exercises:
>Constant Growth Model
D1
+ 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 1. Capital budgeting is concerned with
𝑃𝑜 − (1 − 𝐹𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡)
a. Decision affecting only capital-intensive
industries
D1= next year dividend [paid dividend x (1 + GR)
b. Analysis of short-range decision
Po= Current Price
c. Analysis of long-range decision
d. Scheduling of office personnel in office
>CAPM (Capital Asset Pricing Method)
𝑅 = 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 + 𝛽(𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒) buildings

VJ De Leon MS Page 1
2. Corporation has sold P1 00,000,000 of P1,000 par
value, 10% coupon bonds. The bonds were sold at a
premium and the corporation received P1,200 per
bond. If the corporate tax rate is 30%, what is the
after tax cost of these bonds for the first year?
a. 6.00% b. 6.50%
c. 5.83% d. 5.55%
3. The preferred stock of B Corporation pays an
annual dividend of P4.80. It has a required rate of
return of 8%. Compute the price of the preferred
stock?
a. 60 b. 65
c. 58 d. 55
4. C Corporation paid a dividend of P3.00 per share
on its common stocks last year. Over the net 12
months, the dividend is expected to grow at 6%,
which is the constant growth rate (g) for the firm.
The common stock currently sells for P50 per share.
Compute the required rate of return on the common
stock?
a. 12.20% b. 12.50%
c. 12.36% d. 13.00%
D Corporation just paid a dividend of P4.00 per
share on its stock. The dividends are expected to
grow at a constant rate of 7% per year, indefinitely.
5. If investors require a 12% return on D’s
Corporation stocks, what is the current price?
a. 90 b. 95
c. 87.4 d. 85.6
6. What will be the price be in two years?
a. 98 b. 95
c. 97 d. 96
7. Use the basic equation for the capital asset pricing
model (CAPM) to work on each of the following:
a. Find the required rate of return for an asset
with a beta of 0.80 when the risk-free rate of return
is 6%, and the market risk premium is 4%
b. Find the beta for an asset with a required
return of 7.4% when the risk-free rate and market
return are 6% and 8%, respectively
8. A firm’s new financing will be in proportion to the
market value of its current financing shown below:
Carrying Amount
Long Term debt P 7,000,000
Preferred stock (100,000 shares) 1,000,000
Common stock (200,000 shares) 7,000,000
The firms bonds are currently selling at 80% of par,
generating a current market yield of 9%, and the
corporation has a 40% tax rate. The preferred stock
is selling at its par value and pays a 6% dividend.
The common stock has a current market value of
P40 and is expected to pay a P1.20 per share this
year. Dividend growth is expected to be 10% per
year, and flotation costs are negligible. What is the
firm’s weighted average cost of capital?
a. 9.601% b. 9.501%
c. 10.20% d. 9.401%
9. Old equipment with a book value of P 15,000 will
be replaced by new equipment with a purchase price
of P 50,000, exclusive of freight charges of P 2,000.
The market value of the old equipment is P 11,000.
Repair costs of P 2,000 can be avoided if the new
equipment is acquired. Assume a tax rate of 35%.
What is the net investment of the project?
a. P 33,800 b. P 38,300
c. P 39,700 d. P 52,000
VJ De Leon
10. Jack Company is considering replacing a machine
with a book value of P 400,000, a remaining useful
life of 5 years, and annual straight-line depreciation
of P 80,000. The existing machine has a current
market value of P400,000. The replacement machine
would cost P 550,000, have a 5 year life, and save P
75,000 per year in cash operating costs. If the
replacement machine would be depreciated using the
straight-line method and the tax rate is 40%, what
would be the net investment required to replace the
existing machine?
a. P 90,000 b. P 150,000
c. P 330,000 d. P 550,000
11. In deciding whether to replace a machine, which
of the following is not a sunk cost?
a. The expected resale price of the existing
machine
b. The book value of the existing machine
c. The original cost of the existing machine
d. The depreciated cost of the existing machine
12. Jess Inc. recently acquired a machine at a cost of
P 64,000. It will be depreciated on a straight line
basis over 8 years, with no salvage value. Jess
expects that this machine will produce P 18,000
annual net cash flow before income tax. Assuming an
income tax rate of 50%, the appropriate payback
period on this investment is:
a. 3.6 years b. 4.9 years
c. 7.1 years d. 12.8 years
13. Kat Corporation gathered the following data on
the two capital investment opportunities:
Hard Auto Semi Auto
Cost of investment P 800,000 P 1,400,000
Discount rate 14% 14%
Net cash inflows P 365,000 P 590,000
For the coming period, the available fund for capital
investment projects is P 1,600,000 only. Both
machines have 4 year lives and no anticipated
salvage value. The company uses straight line
depreciation and has a 30% income tax rate.
Required:
a. Which alternative has the higher net present
value?
b. Using the profitability index method, which
alternative is more attractive?
14. Alone boy management considering an
advertising program the will require an initial
expenditure of P 165,500 and bring in additional
sales over the next five years. The cost of
advertising is immediately recognized as expense.
The projected additional sales revenue in year 1 is P
75,000, with associated expenses of P 25,000. The
additional sales revenue and expenses from the
advertising program are projected to increase by
10% each year. Alone boy tax rate is 40%.
The present value of P 1 at 10%, end of each period:
Period’s Present value factors
1 0.90909
2 0.82645
3 0.75131
4 0.68301
5 0.62092
The net present value of the advertising program
would be approximately?
a. P 37,064 b. (P 37,064)
c. P 29,136 d. (P 29,136)
MS Page 2
15. The internal rate of return (IRR) is the Hay Naku Co. manufactures copier equipment and
a. Hurdle rate has the opportunity to replace one of its existing
b. Rate of interest at which the net present value machines with a new model. The existing machine
is greater than 1.0 has a net book value of P 120,000 and a market
c. Rate of return generated from the operational value of P 60,000. It has an estimated remaining life
cash flows of four years, at which time it will have no salvage
d. Rate of interest at which the net present value value. The company uses straight line depreciation of
is equal to zero P 30,000 per year on the machine, and its annual
cash operating cost is P 280,000.
16. Ti Nakaw Corporation is planning to invest P
80,000 in a three- year project. Ti Nakaw’s expected The new model costs P500,000 and has a four year
rate of return is 10%. The present value of P1 at estimated life with no salvage value. Its annual cash
10% for 1st year, 2nd year and 3rd year are 0.909, operating cost is estimated at 160,000. The firm will
0.826, and 0.751 respectively. The cash flows, net of use straight line depreciation. The tax rate is 40%
income taxes, will be P 30,000 for the first year and the cost of capital is 12%. The purchase of the
(present value: P 27,270) and P 36,000 for the new, more efficient machine will enable the company
second year (present value: P 29736). Assuming the to reduce its investment in inventory by P 80,000.
rate of return is exactly 10%, what will be the net
cash flow, net of income taxes, for the third year? 23. Determine the investment required to purchase
a. P 17,260 b. P 22,000 the new machine.
c. P 22,904 d. P 30,618 a. 336,000 b. 335,000
c. 334,000 d. 340,000
17. Tsuk Aww, Inc. is planning to invest P 120,000 in
a 10-year project. Tsuk Aww estimates that the 24. Determine the net present value of the
annual cash inflow, net of income taxes, from this investment.
project will bee P 20,000. Tsuk Aww desired rate of a. 1,930 b. ( 1,930 )
return on investments of this type is 10%. c. 1,830 d. ( 1,830 )
Information on present value factors is as follow:
at 10% at 12% 25. Suppose that the new machine has a 10%
PV of P 1 for 10 periods 0.386 0.322 salvage value. The company will consider the salvage
PV of an annuity of value in determining annual depreciation. Determine
P 1 for 10 periods 6.145 5.650 the net present value of the investment.
a. 14,685 b. 15,685
Tsuk Aww’s internal rate of return on this investment c. 13,685 d. 14,000
is?
a. Less than 10%, but more than 8% 26. Suppose that new machine has a 10% salvage
b. 10% value. The company will ignore the salvage value in
c. Less than 12%, but more than 10% determining annual depreciation. The applicable tax
d. 12% rate is 40%. Determine the net present value of the
investment.
Lover boy Company has gathered the following data a. 17,550 b. 17,450
on a proposed investment project: c. 17,150 d. 17,250
Investment required in equipment P 142,500
Annual cash inflow 30,000 27. Mountain view hospital has purchased new lab
Life of investment 8 years equipment for P 134,650. The equipment is expected
Required rate of return 10% to last for three years and to provide cash inflows as
follows:
18. The payback period for the investment is closest
to: Year 1 P 45,000
a. 8.00 years b. 1.42 years Year 2 60,000
c. 4.75 years d. 0.21 years Year 3 ?

19. The simple rate of return on the investment is Assuming that the equipment will yield exactly a
closest to: 16% return, what is the expected cash inflow for
a. 8.55% b. 10.00% year three?
c. 21.05% d. 33.55% a. 75,000 b. 80,000
c. 78,000 d. 85,000
20. The net present value on this investment is
closest to: 28. hei wazzupp duuudsss yeehhh weeehhhhh
a. P 300,000 b. P 58,800 taalllaaagagaga hehheheh yiyiyiyiyi hohohohoho
c. P 76,024 d. P 17,550 natatae akkkoo oo break it down is investigating the
purchase of a piece of automated equipment that will
21. The internal rate of return on the investment is be save P 150,000 each year in direct labor and
closest to: inventory carrying costs. This equipment costs P
a. 13% b. 15% 700,000 and is expected to have a five year useful
c. 14% d. 12% life with no salvage value. The company requires a
minimum of 10% return on all equipment purchases.
22. A new machine costing P 40,000 with three years Management anticipates that this equipment will
useful life, no salvage value at the end of three provide intangible benefits such as greater flexibility
years, is expected to bring in the following cash and higher quality output.
inflows after tax:
What peso value per year would the intangible
First year P 30,000 benefits have to have in order to make the
Second year 25,000 equipment an acceptable investment?
Third year 10,000 a. 184,647.85
If the company’s cost of capital is 20%, what is the b. 160,352.15
discounted payback period? c. 34,647.85
a. 1.86 b. 1.87 d. 43,352.15
c. 1.88 d. 1.80

VJ De Leon MS Page 3