Chap 14 - Capital Budgeting

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MULTIPLE CHOICE - 2 Traditional evaluation models 1. The payback capital budgeting technique considers Income over entire Time value life of project of money No No No Yes Yes Yes Yes No

(aicpa)

1. A ? The one considered by the payback capital budgeting technique.  Payback period measures the length of time over which the cost of investment is recovered. It is determined by dividing the net cost of investment over annual net cash inflows. Payback period does not consider the net income and time value of money, choice-letter “a” is correct. 2. Which one of the following statements about the payback method of investments analysis is correct? The payback method Does not consider the time value of money. Considers cash flows after the payback has been reached. Uses discounted cash flow techniques. Is rarely used in practice. (cma) 2. A ? A correct statement about payback period.  Payback period estimates the stretch of time before the cost of investment is recouped. It is the point in time where the cumulative cash inflows equal cost of investment. Payback period does not consider the time value of money, choiceletter “a” is correct. Choice-letters “b”, “c”, and “d” are incorrect statements regarding payback period. Payback period considers cash flows before and after the payback period; it does not use discounted cash flows techniques; and is popularly used in practice. 3. A machine costing P1,000 produces total cash inflows of P1,400 over 4 years. Determine the payback period given the following cash flows: After-tax Cumulative Year Cash Flows Cash Flows 1 P400 P 400 2 300 700 3 500 1,200 4 200 1,400 2 years. 2.60 years. 3. B

C. 2.86 years. D. 3 years.

(cma)

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The payback period. Payback period is where the cumulative cash flows equal the cost of investment. It is the breakeven time. The cost of investment is P1,000, and by end of second year the cumulative cash is already P700, while the total cash be the end of third year is already P1,200. The payback period is between second year and third year. The get the exact payback period, the fraction in the third year is 0.60 [i.e., (P1,000 – P700) / P500]. Therefore, the payback period is 2.6 years.

4. Nakane Company is planning to purchase a new machine for P500,000. The new machine is expected to produce cash flows from operations, before income taxes, of P135,000 a year in each of the next five years. Depreciation of P100,000 a year will be charged to income for each of the next five years. Assume that the income tax rate is 40%. The payback period would be approximately 2.2 years. C. 3.7 years. 3.4 years. D. 4.1 years. (aicpa) 4. D ? The payback period.  When cash flows are uniform, payback period is computed by dividing cost of investment over net cash inflows. The given cash flows are before taxes. The net cash inflows are still to be calculated as follows: Cash flows before taxes - Depreciation expense Income before income tax - Income tax (40%) Net income + Depreciation expense Net cash inflows

P135,000 100,000 35,000 14,000 21,000 100,000 P121,000

The payback period is 4.1 years (i.e., P500,000/P121,000). 5. An investment project is expected to yield P10,000 in annual revenues, will incur P2,000 in fixed cost per year, and requires an initial inventory of P5,000. Given a cost of goods sold of 60% of sales and ignoring taxes, what is the payback period in years? 2.50 C. 2.00 5.00 D. 1.25 (cia) 5. A ? The payback period.  The cash flows from operations is determined as follows: Sales P10,000 Cost of goods sold (P10,000 x 50%) ( 6,000) Fixed costs ( 2,000) Cash flows from operations P 2,000 The payback period is 2.50 yrs (i.e., P5,000/P2,000).

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6. Sweets, Etc., Inc. plans to undertake a capital expenditure requiring P2 million cash outlay. Below are the projected after-tax cash inflows for the five-year period covering the useful life. The company’s tax rate is 35% Year P000 1 600 2 700 3 480 4 400 5 400 The founder and president of the company believes that the best gauge for capital expenditures is cash payback period and that the recovery period should not be more than 75% of the useful life of the project or the asset. Should the company undertake the project? No, since the payback period is 4 years or 80% of the useful life of the project. Yes, since the payback period is 3.55 years or 71% of the useful life of the project No, since the payback period extends beyond the life of the project. Yes, since the payback period is 4 years and still shorter than the useful life of the project. (rpcpa) 6. B ? The decisions as to whether undertake the project or not using the payback period as criterion.  Payback period (also called as “breakeven time”) indicates the length of time before an investment cost is fully recovered. The problem gives an unequal (irregular) cash inflows after tax. Payback period is then determined by getting the cumulative cash inflows until such time that it equals the net cost of investment (P2 million): Annual net cash Cumulative Inflow, after tax Cash flows P600,000 P 600,000 700,000 1,300,000 480,000 1,780,000 400,000 2,000,000 Payback Period * [(P2,000,000 – P1,780,000) / 400,000)]

Year 1 2 3 4

Payback Period 1.0 1.0 1.0 0.55 * 3.55 years

The remaining P220,000 cash (P2 million - P1,780,000) is expected to come from the cash flows in the 4th year. That is why the fraction of a year after the 3 rd year but before the 4th year is P220,000 divided by P400,000 or 0.55. Hence, the payback period is 3.55 years. 7. Mary Company recently acquired a machine at a cost of P64,000. It will be depreciated on a straight-line basis over eight years with no estimated salvage value. Mary estimates that this machine will produce an annual net cash inflow (before income taxes) of P18,000. Assuming an income tax rate of 35%, what is the approximate payback period on the investment? A. 4.4 years. C. 7.1 years 12.8 years. D. 3.6 years (rpcpa)

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7. A ? The approximate payback period.  Payback period (breakeven time) indicates the length of time before an investment could be recouped. At this period of time, the total cash flows is already equal to the net cost of investment. Let us determine then annual cash inflows, then later, the payback period. Annual cash inflows before tax P18,000 - Depreciation expense (P64,000/8 yrs.) ( 8,000) Income before income tax 10,000 - Tax 3,500 Net income 6,500 + Depreciation expense 8,000 Net cash inflows P14,500 Therefore, payback period is: Payback period = Net cost of investment / Annual cash inflows = P64,000 / P14,500 = 4.4 years 8. Which of the following is necessary in order to calculate the payback period for a project? Useful life. Minimum desired rate of return. Net present value. Annual cash flow. (aicpa) 8. D ? An item necessary in computing the payback period.  Payback period is cost of investment divided by net cash inflows. Hence, choiceletter “d” is correct. Choice-letter “a’ is incorrect because useful life is not needed in the computation of net cash inflows. Choice-letter “b” is incorrect because the concept of minimum desired rate of return is not relevant since payback period speaks of time of return and not rate of return. Choice-letter “c” is incorrect because payback period does not consider the time value of money. 9. Given these data:  Net after tax inflows are: P24,000 for year 1, P30,000 for year 2, P36,000 for year 3, and P30,000 for year 4.  Initial investment outlay is P60,000.  Cost of capital is 18%. Determine the payback period for this investment: 2.5 years. C. 3.00 years. 2.17 years. D. 3.17 years.

(rpcpa)

9. B ? The payback period.  Payback period (or the breakeven time) is the point in time where the cost of investment is equal to the cumulative cash inflows. It indicates on low long should

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an investor wait before his investment is recovered. The shorter the payback period, the better it would be. If the annual cash inflows are even (or uniform, equal), the payback period is net cost investment divided by the annual cash inflows. In this problem, however, the annual cash inflows are uneven or unequal. The payback period is determined as follows: Annual cash Cash to date Payback Year Inflows years 1 P24,000 P24,000 1.0 2 30,000 54,000 1.0 3 36,000 60,000 0.17* Total 2.17 * [(P60,000 – P54,000) / P36,000)]

10. Jasper Company has a payback goal of 3 years on new equipment acquisitions. A new sorter is being evaluated that cost P450,000 and has a 5-year life. Straight-line depreciation will be used; no salvage is anticipated. Jasper is subject to a 40% income tax rate. To meet the company’s payback goal, the sorter must generate reductions in annual cash operating costs of P60,000 C. P150,000 P100,000 D. P190,000 (cma) 10. D ? The amount of reductions in annual cash operating costs.  The cash savings from operations, (or the cash flows before taxes) shall be determined backwards following the normal computations of the net cash inflows, as follows: Cash flows before taxes P190,000 - Depreciation expense 90,000 Income before income taxes (P60,000/60%) 100,000 - Income taxes (P100,000 x 40%) 40,000 Net income 60,000 + Depreciation expense P(450,000 / 5 yrs.) 90,000 Net cash inflows (P450,000/3 yrs.) P150,000 The net cash inflows are computed using the payback period of 3 years. The net income is computed backward by deducting from the net cash inflows the amount of depreciation expense. The income before income taxes is determined by dividing the net income over 60% (i.e., 1 – tax rate). 11. The payback reciprocal is an estimate of the internal rate of return. The Bravo, Inc. is considering the acquisition of a merchandise picking system to improve customer service. Annual cash returns on investment cost of P1.2 million is P220,000. Useful life is estimated at 8 years. The company’s cost of capital is 14% and income tax rate is 35%. Calculate Bravo, Inc.’s payback reciprocal for this investment: 20.5% C. 11.9% 18.3% D. 22.2% (rpcpa)

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11. B ? The payback reciprocal.  Payback reciprocal (PR) is a capital budgeting technique that measures the rate of return on investment, cash-wise. It does not consider the time value of money and is computed as follows: Payback Reciprocal = 1/ Payback period. The PR rate indicates the percentage of annual cash return of the investment made. The higher the PB rate, the better it would be. First, let us compute the payback period then, the payback reciprocal. Payback period is net cost of investment divided by annual cash inflows. The payback period in this problem is 5.45 yrs. (i.e., P1,200,000/P220,000). The payback reciprocal is 18.3% (i.e., 1/5.45). 12. The payback reciprocal can be used to approximate a project’s Net present value. Accounting rate of return if the cash flow pattern is relatively stable. Payback period. Internal rate of return if the cash flow pattern is relatively stable. (cma) 12. D ? The use of payback reciprocal.  Payback reciprocal is determined by dividing 1 over the payback period. It is a measure of liquidity rate of return provided by an investment. With the payback reciprocal, the payback period may be derived, which is the first step needed in computing the internal rate of return (IRR). Therefore, with the payback reciprocal the IRR may be approximated. Hence, choice-letter “d” is correct. Another, it has been shown that the payback reciprocal approximates a project’s IRR especially when cash inflows are relatively stable. Choice-letter “a” is incorrect because net present value needs a discount rate that incorporates business risk and this cannot be derived from the payback reciprocal. Choice-letter “b” is incorrect because accounting rate of return uses net income while payback uses net cash inflows. Choice-letter “c” is incorrect because payback period is a measure of time while payback reciprocal is a measure of rate of return on a cash basis. Payback reciprocal does not approximate but may serve as a basis in precisely computing the payback period. 13. The bailout payback method Incorporates the time value of money. Equals the recovery period from normal operations. Eliminates the disposal value from the payback calculation. Measures the risk if a project is terminated.

(cma)

13. D ? A statement about bailout payback method.  Payback bailout method considers the salvage value as cash inflows of a project in determining the payback period. This means that the project is considered terminated at the end of each year; hence, choice-letter “d” is correct. Payback

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bailout method is applicable when a project is dependent on grants and gratuities of fund providers or dependent on the appropriations made by the government. Choice-letter “a” is incorrect because it does not incorporate the time value of money. Choice-letter “b” is incorrect because it refers to payback period, not payback bailout period. Choice-letter “c” is incorrect because payback bailout method considers the disposal value of the investment. 14. Mark Company purchased a new machine on January 1 of this year for an amount of P90,000, with an estimated useful life of 5 years and a salvage value of P10,000. The machine will be depreciated using the straight-line method. The machine is expected to produce cash flows from operations, net of income taxes, of P36,000 a year in each of the next 5 years. The new machine’s salvage value is P20,000 in years 1 and 2, and P15,000 in years 3 and 4 What will be the bailout period (rounded) for this new machine? 1.4 years. C. 1.9 years. 2.2 years. D. 3.4 years. (aicpa) 14. C ? The bailout period.  The payback bailout period is computed as follows: Net cash Cash to Salvage Payback Period inflows date value Total cash bailout years 01 P36,000 P36,000 P20,000 P56,000 1 02 36,000 72,000 20,000 90,000 0.9 Total 1.9 yrs. The fraction of the payback period in the second year of operations is computed as [(P90,000 – P36,000 – P20,000)/P36,000]. This indicates that the needed cash in the second year amounting to P54,000 (i.e., P90,000 – P36,000) is taken first from the salvage value, then the balance of P34,000 (i.e., P54,000-P20,000) is recovered from the cash generated in the second year. 15. The following statements refer to the accounting rate of return (ARR): 1. The ARR is based on the actual basis, not cash basis. 2. The ARR does not consider the time value of money. 3. The profitability of the project is not considered. From the above statements, which at considered limitations of the ARR concept? Statements 2 and 3 only. C. All the 3 statements . Statements 3 and 1 only. D. Statements 1 and 2 only. (rpcpa) 15. D ? The statement describing limitations of the accounting rate of return (ARR) concept.  ARR uses net income, rather than net cash inflows, in evaluating the desirability of capital expenditures. This is its first limitation if we consider cash inflows as a superior concept of net return than the net income. Second, ARR does not consider the time value of money.

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The third statement could be considered as an advantage of ARR over the other capital budgeting techniques that use cash inflows in their product evaluation because using net income assists the evaluator to determine the profitability of a project. Choice-letter “d” is correct, statements 1 and 2 are considered limitations of the accounting rate of return. A capital budgeting method that provides a rough approximation of an investment’s profitability as measured with net income from the income statement is known as: Average rate of return method. C. Payback period method. Net present value method. D. Internal rate of return method. (rpcpa) 16. A ? A capital budgeting method that provides a rough approximation of an investments profitability as measured with net income.  Choice-letter “a” is correct because accounting rate of return is the only capital expenditure evaluation technique that measures investment proposal based on its profitability. Choice-letters “b”, “c”, and “d” are incorrect because they all measure capital investments projects based on their liquidity (i.e., ability to generate cash inflows). 17. The Hablot Inc. is planning to spend P600,000 for a machine that it will depreciate on a straight-line basis over a ten-year period with no terminal disposal price. The machine will generate cash flow form operations of P120,000 a year. Ignoring income taxes, what is the accounting rate of return on the net initial investment? 5% C. 10% 12% D. 15% (rpcpa) 17. C ? The accounting rate of return (ARR) on the net initial investment.  ARR is equal to net income over original investment. The net income is not readily given but the annual cash flows from operations of P120,000 is given. Income tax is ignored. The ARR on original investment is: Annual cash flows P 120,000 Less: Depreciation expense (P600,000 / 10 yrs.) 60,000 Net income 60,000 Divided by Original Investment 600,000 Accounting rate of return 10% 18. The Folk Company is planning to purchase a new machine, which it will depreciate on a straight-line basis over a ten-year period with no salvage value and a full year’s depreciation in the year of acquisition. The new machine is expected to produce cash flow from operations, net of income taxes, of P66,000 a year in each of the next ten years. The accounting (book value) rate of return on the initial investment is expected to be 12%. How much will the new machine cost? P300,000 C. P660,000 P550,000 D. P792,000 (aicpa) 18. A

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The cost of the new machine. The cost of the new machine may be derived using the accounting rate of return (ARR) of 12%. Since, ARR is net income over cost of investment, then, cost of investment is net income over ARR, as follows: If : x = cost of investment . 10x = Depreciation expense Then, Net income = .12x And, Net income = 66,000 - .10x Therefore, .12x = 66,000 - .10x x = 66,000/.22 = P300,000

19. The method that divides a project’s annual after tax net income by the average investment cost to measure the estimated performance of a capital investment is the Internal rate of return method. Accounting rate of the return method. Payback method. Net present value (NPV) method. (cma) 19. B ? The method that divides net income by the average investment.  Accounting rate of return (ARR) is the only project evaluation method that uses net income (i.e., profitability) to measure the attractiveness of an investment. The ARR on average investment equals net income over average investment. The ARR on original investment is net income over original investment. Choice-letters “a”, “c”, and “d” are incorrect because all of these methods use net cash inflows in measuring a project’s attractiveness, desirability and acceptability. Discounted cash flows model – general concepts 20. Which of the following methods measures the cash inflows and outflows of a project as if they occurred at a single point in time? Cash flow based payback method. Capital budgeting. Payback method. Discounted cash flow. (rpcpa) 20. D ? A method that measures cash inflows and outflows of a project as if they occurred at a single point in time.  Discounted cash flow method considers the time value of money. It measures the equivalent values of cash inflows and outflows as if they occurred at a single point in time. The amount of expected cash inflows is converted at present values before comparing with cost of investment, which is an outflow that occurred at the present time (choice-letter “d” is correct). Choice-letters “a” and “c”, payback period, does not consider the time value of money. Choice-letter “b” capital budgeting is a strategic planning and evaluation technique used to screen off proposed project proposals as to their acceptability and

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priority. The requirement is to identify the specific method of capital budgeting that measures the relation of cash inflows and outflows as if they occurred at a single point in time. 21. The method of project selection which considers the time value of money in a capital budgeting decision is accomplished by computing the a. Accounting rate of return on initial investment. b. Payback period. c. Accounting rate of return on average investment. d. Discounted cash flow. (rpcpa) 21. D ? The capital budgeting project evaluation method which considers the time value of money.  Capital budgeting project evaluation techniques may be classified as to those that do not consider the time value of money (e.g., payback period, accounting rate of return, payback reciprocal, payback bailout method) and those that consider the time value of money or the discounted cash flow method (e.g., net present value, internal rate of return, profitability index, net present value index, present value payback method). Choice-letter “d” is correct because discounted cash flow model considers the time value of money. Choice-letter “a”, “b”, and “c” are incorrect because they do not consider the time value of money. 22. The capital budgeting model that is ordinarily considered the best model for longrange decision making is the Payback model. Accounting rate of return model. Unadjusted rate of return model. Discounted cash flow model. (cma) 22. D ? The capital budgeting model that is considered the best in the long-range decisionmaking.  Long-range decision-making extends over a stretch of many years. This condition suggests to consider in the analysis the time value of money and effects of taxes. These factors are considered in the discounted cash flow model (or, simply, discounted model), where future cash inflows are discounted on their present values and compared with the present value of cash outflows (i.e., cost of investment) to assess the liquidity potential of a proposed project. Choice-letters “a”, “b”, and “c” are incorrect because these methods do not consider the time value of money. All of the following items are included in discounted cash flow analysis except Future operating cash savings. The disposal prices of the current and future assets. C The future assets depreciation.

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D. The tax effects of future assets depreciation.

134 (cma)

23. C ? The item not included in the discounted cash flow analysis.  Discounted cash flow analysis uses net cash inflows in evaluating projects. The depreciation expense, whether past, present, or future, is not considered in the determination of net cash inflows. Choice-letters “a”, “b”, and “d” are incorrect answers because they affect cash flows and are all considered in the computation of net cash inflows. 24. When using one of the discounted cash flow methods to evaluate the desirability of a capital budgeting project, which of the following factors generally is not important? a. The method of financing the project under consideration. b. The impact of the project on income taxes to be paid. c. The timing of cash flows relating to the project. d. The amount of cash flows relating to the project. (rpcpa) 24. A ? The one that is not important in evaluating the desirability of a capital budgeting project using the discounted cash flow method.  In using the discounted cash flow method of evaluating project proposals in capital budgeting, the following factors are important: the cost of investment, amount of cash inflows, and present value factor at a given discount rate and time. Choiceletter “a” is the correct answer because the method of financing the project is not a consideration in the discounted cash flow method. The method of financing affects the determination of cost of capital but not capital budgeting. Choice-letter “b”, “c”, and “d” are all important in the discounted cash flow technique. 25. If income tax considerations are ignored, how is depreciation expense used in the following capital budgeting techniques? Internal rate of return Payback Excluded Excluded Excluded Included Included Excluded Included Included (aicpa) 25. A ? The use of depreciation expense in the internal rate of return and payback techniques in capital budgeting.  The internal rate of return and payback method use net cash inflows in evaluating project investment opportunities. Net cash inflows computation disregards depreciation expense, per se. What is considered is the tax effects of depreciation expense. Hence, depreciation expense is excluded both in the computation of internal rate of return and payback techniques. Choice-letter “a” is correct.

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26. A proposed project has an expected economic life of eight years. In the calculation of the net present value of the proposed project, salvage value would be Excluded from the calculation of the net present value. Included in a cash inflow at the estimated salvage value. Included as a cash inflow at the present value of the estimated salvage value. Included as a cash inflow at the future amount of the estimated salvage value.

(aicpa)

26. C ? The treatment of salvage value in the computation of net present value.  Salvage value is an inflow at the end of the proposed project life, and should be discounted to their present values using the net present value method. Choice-letter “a” is incorrect because salvage value is included, not excluded, in the calculation of net present value. Choice-letters “b” and “d” are incorrect because under the net present value method all future cash inflows should be discounted to their present values, including that of salvage value. 27. It is assumed that cash flows are reinvested at the rate earned by the investment in which of the following capital budgeting techniques? Internal rate of return Net present value Yes Yes Yes No No No No Yes (aicpa) 27. A ? The assumption regarding cash inflows.  Future cash inflows derived from the investment are assumed to be reinvested in the project’s operations and earn interests thereon. This assumption is true to all discounted methods used in capital budgeting. The only difference in this assumption between internal rate of return (IRR) and net present value (NPV) methods is the rate at which the reinvested capital earns its returns. Under the NPV method, the reinvested cash produces returns equal to the discount rate used in computing the net present value. Under the IRR method, the reinvested cash produces returns equal to the internal rate of return. The better assumption is the NPV model. Choice-letter “a” is correct because both the IRR and NPV assume that cash flows are reinvested at the rate earned by the investment. 28. Your company is purchasing a transport equipment as part of its territorial expansion strategy. The technical services department indicated that this equipment needs overhauling in year 4 or year 5 of its useful life. The overhauling cost will be expected during the year the overhauling is done. The Finance Officer insists that the overhauling be done in year 4, not in year 5. The most likely reason is: A. There is lower tax rate in year 5. B. There is higher tax rate in the year 5. C. The time value of money is considered. D. Due to statements A and C above. (rpcpa)

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28. D ? The most likely reason why the Finance Officer insists on doing the equipment overhauling in year 4 instead of year 5.  Choice-letter “d” is correct. The Finance Officer insists on doing the equipment overhauling in year 4 instead of year 5 because probably the tax rate is greater in year 4 than in year 5 and the time value of money is considered. The overhauling cost shall be charged to expense, which will reduce the income subject to tax. A higher tax rate during a lower income before income tax would mean greater tax savings on the part of the company. Considering the time value of money in year 4 compared to year 5, the net benefit in the part of the company would be even greater. 29. Several proposed capital projects, which are economically acceptable, may have to be ranked due to constraints in financial resources. In ranking those projects, the least pertinent is this statement. If the internal rate of return method is used in the capital rationing problem, the higher the rate, the better the project. In selecting the required rate of return, one may either calculate the organization’s cost of capital or use a rate generally acceptable in the industry. A ranking procedure on the basis of quantitative criteria may be established by specifying a minimum desired rate of return, which rate is used in calculating the net present value of each project. If the net present value method is used, the profitability index is calculated to rank the projects. The lower the index, the better the project. rpcpa) 29. D ? The least pertinent statement in ranking capital projects.  Choice-letter “d” is an incorrect statement, and therefore the least pertinent, because in the profitability index calculation, the higher the index, the better the project is. Choice-letter “a” is a pertinent statement, the higher the internal rate of return, the better the project is. Choice-letter “b” is also a pertinent statement because the cost of capital or the rate generally acceptable in the industry serves as the minimum required rate of return for a project to generate and become acceptable. Choiceletter “c” is also a pertinent statement because the minimum required rate of return could be used as the discount rate in determining the net present value of a project. 30. The “inflation element” refers to the Impact that future price increases will have on the original cost of capital expenditure. Fact that the real purchasing power of a monetary unit usually increases over time. Future deterioration of the general purchasing power of the monetary unit. Future increases in the general purchasing power of the monetary unit. (rpcpa) 30. C ? A statement that refers to inflation element.  Inflation element relates to the increases in the value of commodities or deterioration of the general purchasing power of the monetary unit. Choice-letter “c” is correct.

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Choice-letter “a” is incorrect because future price increases are adjustments in prices and not necessarily relate to inflation. Choice-letter “b” is incorrect because real purchasing power of a monetary unit usually decreases, not increases, over time. Choice-letter “d” is incorrect because it refers to the appreciation in the purchasing power of the monetary unit. 31. All of the following refer to the discount rate used by a firm in capital budgeting except Hurdle rate. C. Opportunity cost. Required rate of return. D. Opportunity cost of capital. (rpcpa) 31. C. ? The one that does not refer to the discount rate.  Discount rate may refer to cost of capital, required rate or return, hurdle rate, or minimum rate of return, but not opportunity cost. Opportunity cost, is not a rate, but is a gain or benefit foregone in favor of the chosen alternative. 32. You are the treasurer of Mayaman Corporation. The company is considering a proposed project, which has an expected economic life of seven years. Net present value is the capital budgeting technique the president wants you to use. Salvage value of the project would be. Treated as cash inflow at estimated salvage value. Treated as cash inflow at its present value. Irrelevant cash flow item. Treated as cash inflow at the future value. (rpcpa) 32. B ? The treatment of salvage value in the net present value analysis.  Net present value is a discounted method of evaluating investment proposals. Net present value is the difference between the present value of cash inflows and the cost of investment. There are at least three (3) cash inflows that are considered: one is the cash inflow from regular operations, the remaining two are cash inflows recovered at the end of the project. They are the cash inflows recovered from the salvage value and the working capital. In the net present value model, the salvage value is a future inflow to be adjusted at present values. Choice-letter “d” is correct. 33. Depreciation tax shield is The expense caused by depreciation. The cash provided by recording depreciation. A reduction in income tax. A after-tax cash flow.

(rpcpa)

33. C ? A statement with regard to depreciation tax shield.  Depreciation tax shield refers to the amount of tax savings generated out of recording depreciation expense; choice-letter “c” is correct. Choice-letter “a” is incorrect because tax shield is not an expense but is a savings. Choice-letters “b”

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and “d” are incorrect because there is no cash inflow generated from tax savings but rather a restrain from cash expenditures arising from reduction in tax payments. 34. Sensitivity analysis, if applied in capital budgeting evaluation, Is used extensively when cash flows are known with certainty. Is “what if” techniques that ask how a given outcome will change if the original estimates of the capital budgeting model are changed. Measures the amount of time it will take for a project to recover its initial capital outflow. Is a technique used to rank capital expenditures request. (rpcpa) 34. B ? A description of sensitivity analysis as applied to capital budgeting.  Sensitivity analysis is a simulation technique where predicted outcomes are determined by analyzing the effects of the changes in one or more of the relevant variables affecting the predicted outcome. Choice-letter “b” is the most appropriate answer because sensitivity analysis is a “what if” technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed. Choice-letter “a” is incorrect because sensitivity analysis, just like any other forecasting model is used more extensively when uncertainties abound. Choiceletter “c” is incorrect because it refers to payback period. Choice-letter “d” is incorrect because it refers to a project evaluation technique used to rank investment proposals (such as profitability index, NPV index, IRR, payback period, net present value, etc.). 35. You just passed the CPA licensure examination and took your oath. As you started your practice, Kon Fuse Inc. came you for help in establishing a minimum desired rate of return to be used in the evaluation of a capital project with a five-year life. The following data were provided: Inflation rate for the past 5 years 13% Expected inflation rate for the next 5 years 9% “Risk-free” element 5% “Risk” premium demanded for the project 7% You will advice the client to consider a minimum desired rate of return of 20% C. 16% 21% D. 25% (rpcpa) 35. B ? The minimum desired rate of return to be considered.  The concept of minimum rate of return could either be the cost of capital, the internal rate of return, or desired rate of return. All of them could be referred to as the hurdle rate. The cost of capital is the required rate of return of an investment so not to impair the interests of the common shareholders. The internal rate of return is the minimum rate that a project must earn to breakeven. A discount rate is basically determined as follows: Risk-free rate x%

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Risk-premium rate Basic discount rate at a given level of risk

139

x x

The risk-free rate is the prevailing market rate of securities or investments which gives convincing assurance as to their ability to provide return based on their tract record or because it is supported by the government or by a wide range of financial backup (e.g., treasury bills). The risk-free rate is normally represented by the Treasury bill rate being considered as a risk-free investment. The risk-premium rate measures the level of return that an investor is willing to accept for a given investment after considering an investment business risk. It is the compelling factor that entices the investor to invest in a more risky opportunity with the objective of earning more. The inflation rate is added to the basic discount rate to get the adjusted or final discount rate to be used in analyzing an investment proposal. Specifically, the inflation rate is added to the risk-free rate. In this problem, the discount rate is 21%, computed as follows: Risk-free rate 5% Risk-premium rate 7% Expected inflation rate 9% Minimum desired rate of return 21% 36. The common assumption in capital budgeting analysis that cash inflows occur in lump sums at the end of individuals years during the life of an investment project when in fact they flow more or less continuously during those years Results in understated estimates of NPV. Is done because present value tables for continuous flows cannot be constructed. Will result in inconsistent errors being made on estimating NPV’s such that project cannot be evaluated reliably. Results in higher estimates for the IRR on the investment. (rpcpa) 36. A ? The effect of an assumption in capital budgeting analysis about the timing of cash inflows.  Choice-letter “a” is correct. In capital budgeting cash inflows are commonly assumed to have been received in lump sum at the end of each year wherein in reality cash is received more or less continuously during the year. This assumption result in an understatement of net present value as cash is considered received in a later period, which means lower present value factor applied in the same amount of cash. Choice-letter “b” is incorrect because present value tables may be constructed for continuous flows. Choice-letter “c” is also incorrect because even with assumed timing of cash inflows, projects can be reasonably evaluated with relevance and reliability. Choice-letter “d” is incorrect since an assumption that cash inflows are received at the end of the year reduces the net present value, then the IRR would be reduced as well. 37. You have determined the profitability of a planned project by finding the present value of all cash flows from that project. Which of the following would cause the project to look less appealing, that is, have a lower present value? The discount rate increases.

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The cash flows are extended over a longer period of time. The investment cost decreases without affecting the expected income and life of the project. The cash flows are accelerated and the project life is correspondingly shortened. (rpcpa) 37. A ? A situation that would cause the project look less appealing.  A project will look less appealing if its net present value (NPV) is reduced. The NPV decreases when the present value of cash inflows (PVCI) decreases or the cost of investment is increased. The following causes a decrease in PVCI: (a) an increase in discount rate, or, (b) the same amount of cash is received at a longer period of time. Choice-letter “a” is correct. If the discount rate increases, the present value factor decreases and the PVCI also decreases. Choice-letter “b” will increase the PVCI because cash flows are extended overtime thereby increasing the nominal amount of cash received and its NPV. Choice letters “c” and “d” (decrease in the cost of investment and acceleration of cash flows, respectively) will increase the NPV. 39. Anton Corporation is planning to buy a new machine with the expectation that this investment should earn a discounted rate of return of at least 15%. This machine, which costs P150,000, would yield an estimated net cash flow of P30,000 a year for 10 years, after income taxes. In order to determine the net present value of buying the new machine, Anton should first multiply the P30,000 by what amount of the following factors? 20.304 (Future amount of an ordinary annuity of P1). 5.019 (Present value of an ordinary annuity of P1). 4.046 (Future amount of P1). 0.247 (Present value of P1). (aicpa) 39. B ? The time value factor used in determining the net present value of buying the new machine.  Under the discounted value technique, the cash inflows and cash outflows should be compared at the same point in time, particularly at time zero, at the time the new asset is acquired. To this, future cash inflows should be discounted at their present values. The present values to be used depend on whether future cash inflows are even or uneven. If the cash inflows are even, the present value factor of annuity is to be used for easy (i.e., short-cut) computations. For uneven cash inflows, the present value of single payment should be used. Since the future cash inflows are evenly received at P30,000, then the present value of ordinary annuity is to be used. Hence, choice-letter “b” is correct. Choice-letters “a” and “c” are not correct because the present values should be used, not the future values. Choice-letter “d” is an inferior answer because the cash flows are even, and therefore, for easy computation, the present value factor of annuity should be used in discounting future cash inflows.

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40. Essex Corporation is evaluating a lease that takes effect on March 1, 2006. The Company must make eight equal payments, with the first payment due on March 1, 2006. The concept most relevant to the evaluation of the lease is The present value of an annuity due. The present value of an ordinary annuity. The future value of an annuity due. The future value of an ordinary annuity. (cma) 40. A ? The concept that is most relevant to the evaluation of the lease.  Future lease payments should be discounted at their present values to determine their true worth at the present time. The lease payments should be multiplied by the present value factor of annuity due, since the first payment is made at the start of the lease period. Hence, choice-letter “a” is correct. If the payment is made at the end of each lease year, the present value factor of ordinary annuity should be used; hence, choice-letter “b” is incorrect. Choice-letters “c” and “d” are incorrect because the proper time value to be determined is the present value, not the future value. 41. An actuary has determined that a company should have P90 million accumulated in its pension fund 20 years from now for the fund to be able to meet its obligations. An interest rate of 8% is considered appropriate for all pensions fund calculations. The company wishes to know how much it should contribute to the pension fund at the end of each of the next 20 years. Which set of instructions correctly describes the procedures necessary to compute the annual contribution? Divide P90,000,000 by the factor for present value of an ordinary annuity. Multiply P90,000,000 by the factor for present value of a n ordinary annuity. Divide P90,000,000 by the factor for future value of an ordinary annuity. Multiply P90,000,000 by the factor for future value of an ordinary annuity. (cia) 41. C ? The set of instructions that correctly describes the procedures necessary to compute the annual contribution.  Annual contributions have to be made to establish the P90 million future pension fund balance to meet pension obligations. The annual contributions are to be made every end of the year, therefore an ordinary annuity case. By derivation, we cash say that: If : P90 million = Annual contribution x Future value factor of ordinary annuity Then : Annual contribution = P90 million / Future value factor of ordinary annuity Questions 42 through 44 are based on the following information. Tranx Corporation has agreed to sell some used computer equipment to Rod Santos, one of the company’s employees, for P5,000. Tranx and R. Santos have been discussing alternative financing arrangements for the sale. The information in the opposite column is pertinent to these discussions.

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Present Value of an Ordinary Annuity of P1 Payments 5% 6% 7% 8% 1 0.952 0.943 0.935 0.926 2 1.859 1.833 1.808 1.783 3 2.723 2.673 2.624 2.577 4 3.546 3.465 3.387 3.312 5 4.329 4.212 4.100 3.993 6 5.076 4.917 4.767 4.623 7 5.786 5.582 5.389 5.206 8 6.463 6.210 5.971 5.747 42. Tranx Corporations has offered to accept a P1,000 down payment and set up a note receivable for R. Santos that calls for a P1,000 payment at the end of each of the next 4 years. If Tranx uses a 6% discount rate, the present value of the note receivable would be P2,940 C. P4,212 P4,465 D. P3465 (cma) 42. D ? The present value of the notes receivable.  The notes receivable is equal to four P1,000 payments which should be discounted to its present value. Therefore, the present value of the notes receivable is P3,465 (i.e., P1,000 x 3.465). 43. Rod Santos has agreed to the immediate down payment of P1,000 but would like the note for P4,000 to be payable in full at the end of the fourth year. Because of the increased risk associated with the terms of this note, Tranx Corporation would apply an 8% discount rate. The present value of this note would be P2,940 C. P3,940 P3,312 D. P2,557 (cma) 43. A ? The present value of the note.  The note, with a face value of P4,000, will be received in sum at the end of the fourth year. Therefore, the present value of the note is P2,940 (i.e., P4,000 x 0.7350). The 0.7350 is the present value of single payment at 8%, at the end of fourth year. This value may be computed using your calculator or by deriving it from the present value factor of annuity table at 8% as given in the problem (i.e., 3.312 – 2.577). 44. If Rod Santos borrowed the P5,000 at 8% interest for 4 years from his bank and paid Tranx Corporation the full price of the equipment immediately, Tranx could invest the P5,000 for 3 years at 7%. The future value of this investment (rounded) would be P6,297 C. P6,553 P6,127 D. P6,803 (cma)

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44. B ? The future value of the investment.  The P5,000 investment earns 7% for 3 years. Therefore, the future value of the investment is P6,125 (i.e., P5,000 x 1.225). The 1.225 is the future value factor of annuity for 3 years at 7% rate (i.e., 1.07 x 1.07 x 1.07). Another way to determine the future value of the P5,000 investment at 7% return rate for 3 years is by dividing the P5,000 by the present value factor of 7% at 3 years, computed to be 0.816. This (e.g., 0.816) may be also calculated using your calculator or by getting the difference in the present value factor of annuity at 7% between third year and second year (i.e., 2.624 – 1.808). Therefore, the future value of the investment is P6,127 (i.e., P5,000/0.816). 45. Snow Company plans to invest P2,000 at the end of the next ten years. Assume that Snow will earn interest at an annual rate of 6% compounded annually. The future amount of an ordinary annuity of P1 for 10 periods at 6% is 13.181. The present value of P1 for ten periods at 6% is 0.558. The present value of an ordinary annuity of P1 for ten periods at 6% is 7.360. The investment after the end of ten years would be A. P26,362 C. P14,720 P21,200 D. P27,478 (rpcpa) 45. A ? The amount of investment after ten years.  The future value of investment is the amount of yearly investment times the future value factor annuity. The answer is P26,362 (that is , P2,000 x 13.181). The future value factor of annuity is used because the constant amount of investment made at the end of every year is the same and in an annual series. 46. Girl Casual Wear has P75,000 in a bank account as of December 31, 2005. If the company plans on depositing P4,000 in the account at the end of each of the next 3 years (2006 ,2007, and 2008) and all amounts in the account balance earn 8% per year, what will the account balance be at December 31, 2008? Ignore the effect of income taxes. 8% Interest Rate Factors Future value Future value of Period of P1 an annuity of P1 1 1.08 1.00 2 1.17 2.08 3 1.26 3.25 4 1.36 4.51 P87,000 P88,000

C. P 96,070 D. P107,500

46. D ? The amount of investment balance at December 31, 2008

(cma)

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144

The investment is made in two streams – P75,000 and P4,000. The P75,000 is to be deposited at the beginning of 2006. The P4,000 investment is to be deposited at the end of the next 3 years. The total future value of investments shall be: Single deposit (P75,000 x P1.26) Annuity deposit (P4,000 x 3.25) Future value of investments

P 94,500 13,000 P107,500

Annuity deposit refers to the series of equal deposits to be made in the next 3 years. 47. If a firm identifies (or creates) an investment opportunity with a present value < List A> its cost, the value of the firm and the price of its common stock will . List A List B Greater than Increase Greater than Decrease Equal to Increase Equal to Decrease (cia) 47. A ? The effects of investment opportunity to the present value and price of common stock.  If the present value of an investment opportunity is greater than its cost, meaning, the investment opportunity is attractive or acceptable, profit shall increase and the price of the common stock would increase. Choice-letter “b” is incorrect because it is in contrast with the right answer. Choice-letters “c” and “d” are incorrect because if the present value of investment opportunity is equal to its cost, then the price of the common stock will remain unchanged. 48. The proper discount rate to use in calculating certainty equivalent net present value is the Risk-adjusted discount rate. C. Cost of equity capital Risk-free rate. D. Cost of debt (cma) 48. B ? The proper discount rate to be used in calculating certain equivalent net present value.  The discount rate used in the discounted models is composed of the risk-free rate and the risk-premium rate. The risk-free rate, or certainty rate, represents the rate of return on relatively risk-free investments (e.g., treasury bills). Choice-letter “a” is incorrect because risk-adjusted discount rate incorporates the business risk associated to a given investment opportunity. Choice-letters c” and “d” are incorrect because they refer to cost of funds, which are not used in calculating certainty equivalent rate. 49. A project’s net present value, ignoring income tax considerations, is normally affected by the Proceeds from the sale of the assets to be replaced. Carrying amount of the assets to be replaced by the project. Amount of annual depreciation on the asset to be replaced.

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Amount of annual depreciation on fixed assets used directly on the project.

145 (aicpa)

49. A ? The item that affects the project’s net present value.  Net present value is the difference between present value of cash inflows and cost of investment. Cash inflows may come from incremental sales, savings, or even proceeds from the sale or disposal of old asset. Choice-letter “a” is correct. Choice-letter “b” is incorrect because the carrying amount of the old asset is a sunk cost, not a future cash inflow, and not considered in the net present value computation. Choice-letters “c” and “d” are incorrect because depreciation expense is not considered in the computation of net cash inflows, and is, therefore, disregarded in the net present value computation. Net present value 50. The discount (hurdle) rate of return must be determined in advance for the Internal rate of return method. Net present value method. Payback period method. Time adjusted rate of return method.

(aicpa)

50. B ? The capital budgeting evaluation method affected by the advance determination of the discount (hurdle) rate of return.  The capital budgeting evaluation methods needing a discount rate to be made known in advance are the net present value, profitability index, net present value index, and the discounted payback period. Choice-letter “a” is incorrect because the internal rate of return computes the true discount rate where the present value of cash inflows equals the cost of investment. Internal rate of return does not need a discount rate to be given in advance. Choice-letter “c” is incorrect because payback period does not consider the time value of money. Choice-letter “d” is incorrect because the time-adjusted rate of return is the same as the internal rate of return. 51. The net present value capital budgeting technique can be used when cash flows from period to period are Uniform Uneven No Yes No No Yes No Yes Yes (aicpa) 51. D ? The applicability of net present value model under uniform and uneven cash flows.  Net present value is applicable regardless of cash flows situations – be it even or uneven. If the cash flows are even (uniform), the present value of cash inflows are determined using the present value factor of annuity. When cash flows are uneven,

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the present value of cash inflows are computed using the present value factor of single payment. 52. Velasquez & Company is considering an investment proposal for P10 million yielding a net present value of P450,000. The project has a life of 7 years with salvage value of P200,000. The company uses a discount rate of 12%. Which of the following would decrease the net present value? Extend the project life and associated cash inflows. Increase the discount rate to 15%. Decrease the initial investment amount to P9.0 million. Increase the salvage value. (rpcpa) 52. B ? The one that would decrease the net present value.  Increasing the discount rate to 15% would lower the present value factor, would decrease the present value of cash inflows, and eventually would decrease the net present value of an investment. Choice-letter “b” is correct. Choice-letter “a” is incorrect because extending the project life and associated cash inflows would increase the future cash inflows on top of the regular cash inflows and would therefore increase the net present value of an investment. Choice-letter “c” is also incorrect because decreasing the cost of investment would have an increasing impact on the net present value of the project. Choice-letter “d” is incorrect because increasing the salvage value, other things being the same, would also increase the net present value of the investment. 53. A disadvantage of the net present value method of capital expenditure evaluation is that it A. Is difficult to apply because it uses a trial-and-error approach. B. Does not provide the true rate of return on investment. C. Is calculated using sensitivity analysis. D. Computes the true rate of return. (rpcpa) 53. B ? A disadvantage of the net present value method.  Choice-letter “b” is the correct answer. Net present value method does not provide the true rate of return on investment. This is determined using the internal rate of return. Choice-letter “a” is incorrect because NPV model is not difficult to apply and does not use a trial-and-error approach in its procedure. Choice-letter “c” is incorrect because NPV model is definite in amount after the discount rate is determined. Choice-letter “d” is incorrect because NPV model does not compute the true rate of return. 54. Garfield Company purchased a machine, which will be depreciated on the straightline basis over an estimated useful life of seven years and no salvage value. This machine is expected to generate cash flow from operations, net of income taxes, of P80,000 in each of the seven years. Garfield’s expected rate of return is 12%. Information on present value factors is as follows:

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Present value of P1 at 12% for seven periods 0.452 Present value of an ordinary annuity of P1 at 12% for 7 periods 4.564 Assuming a positive net present value of P12,720, what was the cost of the machine? P240,000 C. P352,400 P253,120 D. P377,840 (aicpa) 54. C ? The cost of the machine given a positive net present value.  Using the net present value method (NPV), the cost of machine is the difference between the present value of cash inflows and positive net present value, as follows: Present value of cash inflows (P80,000 x 4.564) P365,120 - Net present value – positive ( 12,720) Cost of investment P352,400 A positive NPV indicates that the present value of cash inflows is greater than the cost of investment. As such, the positive NPV is deducted from present value of cash inflows to get the cost of investment. Questions 96 and 97 are based on the following data: Apex Corporation is planning to buy production machinery costing P100,000. The machinery’s expected useful life is five years, with no residual value. Apex required a rate of return of 20%, and has calculated the following data pertaining to the purchase and operation of this machinery. Estimated Annual Present value Year Cash Inflow of P1 at 20% 1 P 60,000 .91 2 30,000 .76 3 20,000 .63 4 20,000 .53 5 20,000 .44 Total P150,000 3.27 Assuming that the cash inflow was received evenly during the year. 55. The payback period is 2.50 years 2.75 years

C. 3.00 years D. 5.00 years

(aicpa)

55. A ? The payback period.  The cost of investment is P100,000. At the end of second year, the cumulative cash inflows already hit the P90,000 total (i.e., P60,000 + P30,000). In short, only P10,000 more in cash inflows are needed to be generated in the third year. The fraction of a year in the third year to generate the needed additional P10,000 out of the total third year cash inflows of P20,000 is 0.50 (i.e., P10,000/P20,000). Therefore, the payback period is 2.5 years.

Chapter 14 56. The net present value is P 9,400 P 54,128

Capital Budgeting

C. P 80,000 D. P109,400

148

(aicpa)

56. A ? The net present value (NPV).  The NPV is the difference between the present value of cash inflows and cost of investment, as follows: Estimated Annual Present Value Present Value of Year Cash Inflow of P1 at 20% Cash Inflows 01 P 60,000 .91 P 54,600 02 30,000 .76 22,800 03 20,000 .63 12,600 04 20,000 .53 10,600 05 20,000 .44 8,800 Total 109,400 Less: Cost of investment 100,000 Net present value P 9,400 57. How are the following used in the calculation of the net present value of a proposed project? Ignore income tax considerations. Depreciation Salvage Expense Value Include Include Include Exclude Exclude Include Exclude Exclude (aicpa) 57. C ? The effects of depreciation expense and salvage value in the calculation of net present value.  Net present value (NPV) is the difference between present value of cash inflows and cost of investment. This model uses net cash inflows in assessing the acceptability of an investment opportunity. Depreciation expense is not included in the determination of net cash inflows. However, the salvage value is treated as a cash inflow to be discounted at present value. Hence, choice-letter “c” is correct. 58. The net present value of a proposed project represents the Cash flows less the present value of the cash flows. Cash flows less the original investment. Present value of the cash flows plus the present value of the original investment less the original investment. Present value of the cash flows less the original investment. 58. D ? A representation of the net present value (NPV).

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149

Net present value (NPV) is the difference between present value of cash inflows and the original cost of investment, choice-letter “d” is correct. This model uses net cash inflows in assessing the acceptability of an investment opportunity. It measures the ability of an investment opportunity to provide liquidity more than or less than the cost of investment. Choice-letter “a” is incorrect because it refers to the effects of present value analysis with cash flows. Choice-letter “b” is incorrect because it is a nominal net cash flow calculation without regard to the time value of money. Choice-letter “c” is incorrect because it does not provide a rational treatment of cash flows.

59. It is the start of the year and St. Tropez Company equipment. These information are available: Old Equipment cost P70,000 Current salvage value 10,000 Salvage value, end of useful life 2,000 Annual operating costs 56,000 Accumulated depreciation 55,300 Estimated useful life 10 years

plans to replace its old sing-along New P120,000 16,000 38,000 10 years

The company’s income tax rate is 35% and its cost of capital is 12%. What is the present value of all the relevant cash flows at time zero? (P 54,000) C. (P120,000) (P110,000) D. (P124,000) (rpcpa) 59. B ? The present value of all relevant cash flows at time zero.  The company is considering to replace its old sing-along equipment. The relevant cash flows at present time (i.e., time zero) include the following: Purchase price –new P120,000 Current salvage value – old (10,000) Relevant cash flows (time zero) P110,000 The old equipment has a book value of P14,700 (i.e., P70,000 – P55,300). The disposal of the old equipment will result to a loss of P4,700 (that is, salvage value of P10,000 less the book value of P14,700). This loss of P4,700 gives rise to a tax savings of P1,645 (i.e., P4,700 x 35%). This tax saving is irrelevant in this computation because this tax savings (an inflow) will be realized at the end of the year and not at the present time (time-zero). The book value of the old machine and the loss on disposal of old machine do not affect cash flows, and are also irrelevant in this decision situation. 60 The net present value of a proposed project is negative therefore, the discount rate must be A. Less than the project’ s internal rate or return. B. Less than the risk free rate. C. Greater than the firm’s cost of equity. D. Greater than the project’s internal rate or return. (rpcpa)

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60. D ? The discount rate if the net present value (NPV) of a proposed project is negative.  Net present value is the difference in the present value of cash inflows (PVCI) and the cost of investment. If the NPV is negative, the PVCI is less than the cost of investment. A low PVCI is caused by a low present value factor of annuity brought about by a higher discount rate. Choice-letter “d” is correct because a negative NPV indicates that the internal rate of return (IRR) is less than the discount rate or the discount rate is greater than the IRR. To be accepted, the IRR must be higher than the discount rate. Since the project has negative NPV, then it is not acceptable, and the IRR is lower than the discount rate. (This makes choice-letter “a” incorrect). Choice-letter “b” is incorrect because risk-free rate is only a part of the discount rate. Choice-letter “c” is incorrect because cost of equity (or cost of capital) is normally the same as the discount rate used in capital budgeting techniques The cost of equity is compared with the return on proposed investment to produce meaningful information. 61. You have been consulted to advice CPA Corporation on the projected acquisition of another production line costing P1 million. The line has an expected useful life of 5 years without any salvage value. The company’s hurdle rate is 20% and the following additional information were made available to you. Estimated Annual Present Value of Year Cashflow P1 at 20% 1 P 600,000 0.91 2 300,000 .76 3 200,000 .63 4 200,000 .53 5 200,000 .44 P1,500,000 3.27 Assuming that the cash flow is generated evenly during the year, your advice is To invest due to net present value of P94,000. To invest due to net present value of P541,280. To invest due to net present value of P635,000. To invest due to net advantage of P500,000. (rpcpa) 61. A ? The net present value (NPV) of the project.  The NPV computation is presented below: Annual PV of P1 Year Cash Inflows at 20% Present values 1 P600,000 .91 P P546,000 2 300,000 .76 228,000 3 200,000 .63 126,000 4 200,000 .53 106,000 5 200,000 .44 88,000 Present value of inflows 1,094,000

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Less: Cost of investment Net present value

P

151

1,000,000 94,000

62. J Corporation is considering the purchase of a new machine that will cost P320,000. It has an estimated useful life of 30% in the first year, 40% in the second year, and 30% in the third year. It has a resale value of P20,000 at the end of its economic life. Savings are expected from the use of machine estimated at P170,000 annually. The company has an effective tax rate of 40%. It uses 16% as hurdle rate in evaluating capital projects. Should the company proceed with the P320,000 capital investment? Discount factors at 16% Present value of an Present value of 1 ordinary annuity of P1 Year 1 .862 .862 Year 2 .743 1.605 Year 3 .641 2.246 Yes, due to NPV of P6,556. Yes, due to NPV of P11,684. Yes, due to NPV of P61,820. No, due to negative NPV of P1,136.

(rpcpa)

62. B ? The decision whether the company should proceed with the proposed investment.  The capital budgeting technique used in evaluating the desirability of the proposed investment is the net present value (NPV) as implied in the choice given. The NPV is the difference between the present value of cash inflows and the cost of investment. The annual cash inflows after tax are not given and are initially determined as follows: 1st year 2nd year 3rd year Cash savings before tax P170,000 P170,000 P170,000 Less: Depreciation expense (P300,000 x 30%) ( 90,000) ( 90,000) (P300,000 x 40%) _______ ( 20,000) _______ IBIT 80,000 50,000 80,000 Less: Tax (40%) 32,000 20,000 32,000 Net Income 48,000 30,000 48,000 Add: Depreciation expense 90,000 120,000 90,000 Annual cash inflows P138,000 P150,000 P138,000 The net present value is: Present value of cash inflows: 1st year (P138,000 x 0.862) 2nd year (P150,000 x 0.743) 3rd year (P138,000 x 0.641) Salvage value (P20,000 x 0.641) Less: Cost of investment Net present value

P118,956 111,450 88,458 12,820

P331,684 320,000 P 11,684

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Alternatively, cash flows after tax may be determined as: Cash flows before tax - Tax {[(P170,000 – (P300,000 x 30%)] x 40%} {[(P170,000 – (P300,000 x 40%)] x 40%} Cash flows after tax

1st year P170,000 (32,000)

2nd year P170,000 (32,000)

P138,000

P150,000

3rd year P170,000 (20,000) P138,000

The proposed project may be accepted as its net present value is positive which means that the expected cash inflows is greater than the cash outflows (or cost of investment). 63. Annette Tay has P750,000 in a bank account as of the end of the last year. If she deposits P10,000 in the account at the end of each of the next three years, and all amounts in the account can earn 8% per annum, will she become a millionaire by the end of the said period? (Disregard income tax implications). Below are the factors that may be used: 8% Interest rate factors Future value of Future value on Period P1 annuity of P1 1 1.08 1.00 2 1.17 2.08 3 1.26 3.25 4 1.36 4.51 Yes, with P1,075,000. No, with only P870,000.

C. Yes, with P1,200,000. D. No with only P880,000.

(rpcpa)

63. A ? Determine the future value of investments.  Future value equals cash deposited today multiplied by the future value factor. If the cash deposit is in series (in annuity), then the future value of annuity is to be used. If the deposit is made at the end of the period, there is an ordinary annuity. If the deposit is made at the beginning of the period, there is an annuity due. In this problem, we have ordinary annuity. The future value of investments is computed below: Initial deposit (P750,000 x 1.26) P 945,000 Serial deposits (P40,000 x 3.25) 130,000 Total investments after 3 years P1,075,000 64. The net present value method of investment analysis assumes that the projects cash flows are invested at the Computed internal rate of return. Discounted rate in the NPV calculation. Firm’s average rate of return. Risk free interest rate. (rpcpa) 64. B

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The assumption used by the net present value (NPV) method with regard to cash flows reinvestment analysis. Choice-letter “b” is correct where under the NPV method cash flows are assumed to be reinvested using the discount rate used in the NPV calculations. This separates NPV from the internal rate of return (IRR) where the cash inflows are assumed to be reinvested at the internal rate of return. The NPV method is considered to have the better treatment of cash inflows reinvestment assumption. (Choice-letter “a” is incorrect.) Choice-letter “c”, firm’s average rate of return, is not the discount rate but could be considered as a factor in determining the discount rate. Choice-letter “d” is incorrect because the risk-free interest rate is only one of the two basic factors in computing the discount rate. The other factor in computing the discount rate is the risk-premium rate, which encompasses the business risk of venturing into a given investment.

65. Alang-alang sa Lahat Foundation, Inc., a non stock, nonprofit and tax exempt foundation, invested P1 million is a five-year project at the beginning of the year. The foundation estimates that the annual savings from the project will amount to P325,000. The P1 million asset is depreciable over five (5) years on a straight-line basis. The foundation’s hurdle rate is 12%. To facilitate computations, below are present value factors: 12% 14% 16% Present value of P1 for 5 periods 0.57 0.52 0.48 Present value of an annuity of P1 for 5 period 3.6 3.4 3.3 The net present value of the project is P170,000 C. P182,000 P625,000 D. P450,000

(rpcpa)

65. A ? The net present value of the project.  The annual savings of P325,000 shall be discounted using the present value of ordinary annuity and, then, compute the net present value as follows: Present value of cash inflows (P325,000 x 3.6) - Cost of investment Net present value

P1,170,000 1,000,000 P 170,000

66. McIndon Corporation bought a major equipment which is depreciable over 7 years on a straight line basis without any salvage value. It is estimated that it would generate cash flow from operations, net of income taxes, of P800,000 in each of the seven years. The company’s expected rate of return is 12%. Based on estimates, the project has a net present value of P127,200. What is the cost of the equipment? To facilitate computation, below are present value factors: Present value of P1 and 12% for seven periods is 0.452 Present value of an ordinary annuity of P1 at 12% for seven years is 4.564 P3,651,200 P3,524,000

C. P2,404,000 D. P3,778,400

(rpcpa)

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66. B ? The cost of the equipment.  To compute the cost of investment, the present value of cash inflows (PVCI) is deducted by the cost of investment. Ergo, the cost of investment is PVCI less NPV as shown below: PV of cash inflows (P800,000 x 4.564) Less: Net present value (given) Cost of the equipment

P3,651,200 127,200 P3,524,000

The present value of cash inflows is the annual cash inflows times the present value factor of annuity. Annuity is used because the cash inflows are expected to be received in the next seven years with a constant amount at P800,000. 67. The General Manager of Tela Mills Inc. is considering the purchase of some new machines. The machine would cost P4,000,000 with an economic life of 8 years without any salvage value. Once set up, they would generate P12,500,000 additional revenues but yearly expenses for additional labor and materials would also increase by P11,500,000. Assume the company uses straight-line depreciation for taxes and that the appropriate tax rate is 35%. The required after-tax rate or return is 14%. The following data are an interest rate of 15% and 8 periods: Present value of P1 0.3506 Failure value of P1 2.8526 Present value of annuity of P1 4.6389 Future value of annuity of P1 13.2328 The company should Purchase the machines due to positive NPV of P638,900. Not purchase the machines due to negative NPV of P984,715. Not purchase the machines due to negative NPV of P172,907.50. Be indifferent as the option does not bring about any advantage nor disadvantage. (rpcpa) 67. C ? The decision to make whether to purchase or not to purchase a machine using the NPV method.  The tax rate is 35% and the machine is to be depreciated in 8 years. The incremental annual net cash inflows after-tax is: Revenues P 12,500,000 Materials and labor costs (11,500,000) Depreciation expense (4 million / 8 yrs.) ( 500,000) Income before income tax 500,000 Less: Tax (35%) 175,000 Net income 325,000 Add back: Depreciation expense 500,000 Annual net cash inflows P 825,000 The net present value is: PV of cash inflows (P825,000 x 4.6389)

P 3,827,092.50

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155

4,000,000.00 P ( 172,907.50)

The machine should not be purchased because its net present value is negative. Meaning, its cash inflows are not enough to recover the cost of investment at present values. 68. Junio Assembly Inc. is considering the purchase automatic wirebonder which costs P750,000. It has ten-year life without any salvage value. Junio would save P200,000 in labor cost annually as a result of the use of the new machine. Power cost would however increase by P25,000 annually. The cost of capital is 16%. The present value factor for 10 years at 16% is 4.8332. The present value of the net annual cost savings is: P845,810 C. P745,810 P575,000 D. P966,640 (rpcpa) 69. A ? The present value of the net annual savings.  Present value of savings is equal to amount of savings (or net cash inflows) times the present value factor at a given discount rate. The annual savings is computed below: Operating Income Decrease in labor costs P200,000 Increase in power costs (25,000) Annual cash savings P175,000 Present value of cash savings (P175,000 x 4.8332) P845,810 There is no tax rate given, hence, depreciation expense is not considered anymore in the analysis of cash flows. 69. The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its life to time period zero using the company’s minimum desired rate of return is the Net present value method. C. Payback method. Capital rationing method. D. Accounting rate return method. (cma) 69. A ? The technique that discounts cash flows to time zero.  The discounted cash flow models convert future cash inflows to present values (or at time zero) and compare it with the cost of investment to get the net present value. Choice-letter “a” is correct. Choice-letter “b” is incorrect because capital-rationing method refers to the distribution or allocation of available funds to the best projects, which are ranked according to their ability to produce liquidity or profitability. The methods used to rank acceptable projects are the profitability index and the net present value index. Choice-letters “c” and “d” are incorrect because payback period and accounting rate of return do not consider the time value of money.

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70. The net present value method of capital budgeting assumes that cash flows are reinvested at The risk-free rate. The cost of debt. The internal rate of return. The discount rate used in the analysis.

(cma)

70. D ? The assumption used by net present value with regard to cash flows.  The net cash inflows generated by the project are assumed to be reinvested in the project and earn appropriate return thereof. This is true to all discounted cash flows models. There is, however, a difference between net present value (NPV) method and internal rate of return (IRR) with regard to their assumption on how the cash reinvested to operations earns interest. Under the NPV model, the reinvested cash is expected to earn the same discount rate used in computation. Choice-letter “d” is correct. Under the IRR model, the reinvested cash is expected to earn a rate equal to the internal rate of return. Here lies the big difference. The discount rate used in the NPV computation carries with it a fair return on investment, while the IRR is the breakeven rate. The NPV assumption is better because it factors in a reasonable profit-return in a given business risk. Choice-letter “a” is incorrect because the risk-free rate, or certainty rate, which represents the return of those considered risk-free investment, is only a component of the discount rate, and is not related to internal rate of return. Choice-letter “b” is incorrect because the cost of debt is an isolated cost of financing and is not used in the NPV model. Choice-letter “c” is incorrect because internal rate of return uses the breakeven rate (or true rate) in estimating the earning potential of cash reinvestments. 71. The capital budgeting techniques known as net present value uses: Cash flow over Time value life of project of money No Yes No No Yes No Yes Yes

(aicpa)

71. D ? The items used in net present value (NPV) technique.  The NPV model considers both the time value of money and the cash flows. Choiceletter “d” is correct. Net present value (NPV) is the difference between present value of cash inflows and cost of investment. This model uses net cash inflows in assessing the acceptability of an investment opportunity. 72. A disadvantage of the net present value method of capital expenditure is that it Is calculated using sensitivity analysis. Computes the true interest rate. Does not provide the true rate of return on investment.

Chapter 14 Is difficult to adapt for risk.

Capital Budgeting

157 (cma)

72. C ? A disadvantage of NPV method.  The NPV model considers the time value of money, cash flows, and relative business risk of an investment opportunity. It is easy to use in sensitivity analysis and is easy to adapt for risk. If a business risk is high, the discount is adjusted higher to reflect it in the project evaluation. A disadvantage of NPV is that it does not provide the true rate of return on investment Choice-letter “c” is correct. Choice-letter “a” is incorrect because NPV uses sensitivity analysis. Choiceletter “b” is incorrect because NPV does not compute the true interest rate (or the internal rate of return). Choice-letter “d” is incorrect because NPV model is easy to adapt for risk. 73. An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method Computes a desired rate of return for capital projects. Can be used when there is no constant rate of return required for each year of the projects. Uses a discount rate that equates the discounted cash inflows with the outflows Computes the maximum interest rate that can be used over life of the project to break even. (cma) 73. B ? An advantage of NPV over IRR.  The NPV can be used when there is no constant rate of return required for each year of the projects. This model may be used when cash flows vary from a year to another. And also, NPV may be reasonably applied when business risk varies from year to year. Choice-letters “a”, “c”, and “d” are incorrect because they all relate to internal rate of return. 74. Palafox and Company is considering an investment proposal for P10 million yielding a net present value of P450,000. The project has a life of 7 years with salvage value of P200,000. The company uses a discount rate of 12%. Which of the following would decrease the net present value? Extend the project life and associated cash inflows. Increase the discount rate to 15%. Decrease the initial investment amount to P9.0 million. Increase the salvage value. (rpcpa) 74. B  The item that would decrease the net present value.  Increasing the discount rate to 15% would lower the present value factor, would decrease the present value of cash inflows, and eventually would decrease the net present value of an investment. Choice-letter “b” is correct.

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Choice-letter “a” is incorrect because extending the project life and associated cash inflows would increase the future cash inflows on top of the regular cash inflows and would therefore increase the net present value of an investment. Choice-letter “c” is also incorrect because decreasing the cost of investment would have an increasing impact on the net present value of the project. Choice-letter “d” is incorrect because increasing the salvage value, other things being the same, would also increase the net present value of the an investment. 75. The treasurer of a firm has an opportunity to purchase a secured 15% mortgage with 5 years remaining for P10,000. If the firm purchases the mortgage, it will receive five annual payments of P3,000 each. If the Treasurer wants no less than a 12% return on long-term cash investments, the NPV of the mortgage will be Years: 1 2 3 4 5 Present value of P1 at 12%: .89 .80 .71 .64 .57 Present value of P1 at 15%: .87 .76 .66 .57 .50 P 80. P830.

C. P5,000. D. not enough information.

(cia)

75. B ? The NPV of the mortgage.  The cash inflows of the mortgage is P3,000 for each of the next 5 years. The present value factor of annuity is 3.61 (i.e., .89 + .80 + .71 + .64 +.57). The NPV is determined as follows: Present value of cash inflows (P3,000 x 3.61) P10,830 - Cost of investment 10,000 Net present value P 830 76. Each of three mutually exclusive projects costs P200. Using the table provided, rank the project in descending NPV order. Present Value Interest Factor Projects’ Cash Flow Year 10% A B C 1 .91 P300 P200 P 0 2 .83 200 100 100 3 .75 100 0 100 4 .68 0 100 200 5 .62 0 200 300 A, B, C. B, A, C.

C. C, B, A. D. A, C, B.

(cia)

76. D ? The rank of the projects in descending NPV order.  The projects should be ranked accounting to their NPVs. Net present value is the difference between present value of cash inflows and cost of investment. The present value of cash inflows are computed by multiplying cash inflows with their related present value factors. The NPVs are determined as follows: A B C

Chapter 14

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Present value of cash inflows Year 1 (cash inflows x 0.91) Year 2 (cash inflows x 0.83) Year 3 (cash inflows x 0.75) Year 4 (cash inflows x 0.68) Year 5 (cash inflows x 0.62) Totals - Cost of investment Net present value Rank

P273 166 75 0 0 514 200 P314 (1)

P182 83 0 68 124 457 200 P257 (3)

159

P

0 83 75 136 186 480 200 P280 (2)

Choice-letter “d” is correct. Using the NPV model, the project’s attractiveness and acceptability is ranked as project A, C, and B in descending order. 77. On January 1, Studley Company purchased a new machine for P100,000 to be depreciated over 5 years. It will have no salvage value at the end of 5 years. For book and tax purposes, depreciation will be P20,000 per year. The machine is expected to produce annual cash flow from operations, before income taxes, of P40,000. Assume that Studley uses a discount rate of 12% and that its income tax rate will be 40% for all years. The present value of P1 at 12% for five periods is 0.57, and the present value of an ordinary annuity of P1 at 12% for five periods is 3.61. The NPV of the machine should be P15,520 positive. C. P60,000 positive. P15,520 negative. D. P25,600 negative. (aicpa) 77. A ? The NPV of the machine.  Net present value is the difference between present value of cash inflows and cost of investment. The net cash inflows are determined as follows: Cash flows before taxes P40,000 - Depreciation expense (given) 20,000 Income before income tax 20,000 - Income tax (40%) 8,000 Net income 12,000 + Depreciation expense 20,000 Net cash inflows P32,000 The NPV is now calculated as follows: Present value of cash inflows (P32,000 x 3.61) - Cost of investment Net present value

P115,520 100,000 P 15,520

78. On January 1, a company invested in an asset with a useful life of 3 years. The company’s expected rate of return is 10%. The cash flow and present and future value factors for 3 years are as follows: Cash inflow Present value Future value Year from the Assets of P1 at 10% of P1 at 10% 1 P 8,000 .91 1.10 2 9,000 .83 1.21

Chapter 14 3

Capital Budgeting 10,000

.75

160

1.33

All cash inflows are assumed to occur at year-end. If the asset generates a positive net present value of P2,000, what was the amount of the original investment? P20.250 C. P30,991 P22,250 D. P33,991 (cia) 78. A ? The amount of the original investment.  Following the NPV computations, the cost of investment equals the present value of cash inflows less the positive net present value, as follows: Present value of cash inflows Year 1 (P8,000 x 0.91) P7,280 Year 2 (P9,000 x 0.83) 7,470 Year 3 (P10,000 x 0.75) 7,500 P22,250 - Net present value – positive ( 2,000) Cost of investment P20,250 Internal rate of return 79. MLF Corporation is evaluating the purchase of P500,000 die attach machine. The cash inflows expected from the investment is P145,000 per year for five years with no equipment salvage value. The cost of capital is 12%. The net present value factor for five (5) years at 12% is 3.6048 and at 14% is 3.4331. The internal rate of return for this investment is: 3.45% C. 13,80% 2.04% D. 15.48% (rpcpa) 79. C ? The internal rate of return (IRR).  The IRR is the rate where the present value of cash inflows is equal to the cost of investment. The present value of inflows is annual cash inflows times the present value factor. By using the interpolation method, the IRR is determined as follows: At 12% (P145,000 x 3.6048)

P522,696.00 P22,696.00

2%

Cost of investment

500,000.00

P24,896.50 2,200.50

At 14% (P145,000 x 3.4331)

497,799.50

IRR == 12% + [(P22,696 / P24,896.50) x 2%] = 13.8 %

80. A number of techniques are commonly used in the analysis of capital budgeting decisions. Each method involves the measurement of cash flows, except the: Internal rate of return method. C. Average rate of return method. Payback period method. D. Net present value method. (rpcpa) 80.C ? The capital budgeting technique that does not involve the use of cash flows.  Choice-letter “c” is correct. Average rate of return method (or Accounting rate of return on average investment) is a capital budgeting evaluation technique that

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measures the desirability of capital expenditure proposal using net income as a concept of returns. Internal rate of return, payback period, and net present value methods are evaluation models that use cash inflows in measuring the attractiveness of project investment proposals. Hence, choice-letters “a”, “b”, and “d” are incorrect. 81. Lenders, Inc. is considering an investment that has a positive net present value based on its 16% hurdle rate. The internal rate of return would be More than 16%. C. 16%. Less than 16%. D. Zero. (rpcpa) 81. A ? The internal rate of return (IRR).  At IRR, present value of cash inflows is equal to the cost of investment. Therefore, the net present value is zero, and the profitability index is 1.00. Since the project has a positive net present value at 16%, it means that the present value of cash flows is greater than the cost investment at 16% discount rate. To reduce the net present value and make it zero at IRR, the discount rate must be increased. The higher the discount rate, the lower the present value factor, the lower the present value of cash inflows. Therefore, the IRR is greater than the discount rate of 16%. 82. Kipling Company invested in an eight-year project. It is expected that the amount of cash flows from the project, net of income taxes, will be P20,000. Information on present value factors is as follows: Present value of P1 at 12% for eight periods 0.404 Present value of an ordinary annuity of P1 at 125 for eight months 4.968 Assuming that Kipling based its investment on an internal rate of return of 12%, how much did the project cost? P100,000 C. P80,800 P 99,360 D. P64,640 (aicpa) 82. B ? The project cost based on an internal rate of return of 12%.  Under the internal rate or return (IRR) model, the cost of investment equals the present value of cash inflows. The present value of cash inflows, which is also the cost of the project is P99,360 (i.e., P20,000 x 4.968). 83. Tracy Corporation is planning to invest P80,000 in a three- year project. Tracy’s expected rate of return is 10%. The present value of P1 at 10% for one year is .909, for two years is .826, and for three years is .751. The cash flow, net of income taxes, will be P30,000 for the first year (present value of P27,270) an P36,000 for the second year (present value of P29,736. Assuming the rate of return is exactly 10%, what will the cash flow, net of income taxes, be for the third year? P17,268 C. P22,294 P22,000 D. P30,618 (aicpa)

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83. D ? The amount of net cash flow, net of income taxes, for the third year.  The internal rate of return is 10%, being the exact rate of return. At this rate, total of the present value of cash inflows (i.e., P80,000) equals the cost of investment. The net cash flows in the third year shall be: Present value of cash inflows P80,000 - Present value of cash inflows for Year 1 P( 27,270) Year 2 ( 29,736) Present value of cash inflows in the 3rd year P22,994 Net cash inflows in 3rd year (P22,994/.751)

P30,618.

84. The following data pertain to Sunlight Corporation whose management is planning to purchase automated tanning equipment: 1. Economic life of equipment: 8 years. 2. Disposal value after 8 years: nil. 3. Estimated net annual cash inflows for each of the 8 years: P81,000. 4. Time-adjusted internal rate or return: 14%. 5. Cost of capital of Sunlight Corporation: 16%. 6. The table of present values of P1 received annually for 8 years has these factors: at 14% = 4.639, at 16% = 4.344. 7. Depreciation is approximately P46,970 annually. Find the required increase in annual cash inflows in order to have the time-adjusted rate of return approximately equal the cost of capital. P5,501 C. P4,344 P6,501 D. P5,871 (rpcpa) 84. A ? The required increase in the annual cash inflows in order that the time-adjusted rate of return (TARR) would approximately equal to the cost of capital.  The TARR (or internal rate of return), which is computed at 14%, is less than the cost of capital at 16%, this relationship is unfavorable in order for the project to acceptable, and the TARR must exceed the cost of capital. To increase TARR, the present value of cash inflows (PVCI) or the cost of investment must be reduced. The amount to be reduced is the difference between the present value of cash inflows at TARR and the cost of capital as follows: PV of cash inflows at TARR, 14% (P81,000 x 4.639) P375,759 PV of cash inflows at cost of capital, 16% (P81,000 x 4.344) ( 351,846) Difference in present values for 8 years 23,895 Divided by PV Factor at 16% 4.344 Needed annual increase in cash inflows P 5,501 The procedural computation above is derived as follows: If: PVCI = Annual Cash Inflows x PV Factor PVCI = ACI x PVF Then: ACI = PVCI/PVF

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85.The ranking of mutually exclusive investment determined using the internal rate of return method (IRR) and the net present value method (NPV) may be different when Multiple projects have unequal lives and the size of the investment for each project. The required rate of return equals to the IRR of each project. The lives of the multiple projects are equal and the size of the required investments are equal. The required rate of return is higher than IRR. 85. A ? The instance(s) where the ranking of mutually exclusive projects may be different using the IRR and the NPV methods.  Basically, the decision as to whether to accept or reject a proposed capital investment is similar between internal rate of return (IRR) and net present value (NPV) models except in cases where multiple projects have unequal lives and the size of investment differs. Choice-letter “a” is correct. Choice-letter “b” is incorrect because if the required rate of return equals the IRR, then there would no difference between present value of cash inflows and the cost of investment, and the project is at breakeven. Choice-letter “c” is incorrect because the lives of the projects and the amounts of investment are equal, then, using IRR model and NPV model would arrive at the same decision. Choice-letter “d” is incorrect because if the required rate of return is greater than the IRR, the net present value would be negative, and the project would be rejected. Still, in this case, using the IRR model and the NPV model would arrive at the same decision. 86. The internal rate of return (IRR) is the Rate of return for which the net present value is greater than 1.0. Rate of return for which the net present value is equal to zero. Rate of return generated from the operational cash flows. Hurdle rate.

(rpcpa)

86. B ? The statement describing the internal rate of return (IRR).  Choice-letter “b” is correct. IRR is the rate where the present value of cash inflows equals to the cost of investment. At this point, the net present value is zero, and the probability index is 1.00. Choice-letter “a” is automatically incorrect. Choice-letter “c” is incorrect because the rate of return generated from the operational cash flows is not exclusively used in the IRR model but is used in other capital investment evaluation models. Choice-letter “d” is incorrect because the term “hurdle rate” may refer to required rate of return, cost of capital, minimum rate of return, and sometimes the internal rate of return. 87. A tax-exempt foundation, Sincerely Foundation, Inc. intends to invest P1 million in a five-year project. The foundation estimates that the annual savings from the project will amount to P325,000. The P1 million asset is depreciable over five (5) years of straight-line basis. The foundation’s hurdle is 12% and as a consultant of the foundation, you are asked to determine the internal rate of return and advise if the

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project should be pursued. To facilitate computations, below are the present value factors: Present value of P1 for 5 periods Present value of an annuity of P1 for 5 periods

12% 0.57 3.6

14% 0.52 3.4

Your advice is To proceed due to an estimated IRR of less than 14% but not more than 12%. To proceed due to an estimated IRR of less than 16% but not more than 14%. Not to proceed due to an estimated IRR of less than 12%. To proceed due to an estimated IRR of not more than 16%. (rpcpa) 87. D ? The advice whether to proceed or not to proceed to the project using the IRR as the basis of evaluation.  First, let us determine the IRR, as follows: a. PVFA = P1,000,000 / P325,000 = 3.08 b. Referring to the given present value table, we could find the PVFA of 3.08 to be greater than 14%, where the PVFA at 14% is 3.40. We could say then, that the IRR is greater than 14%, which is also greater than the foundation’s hurdle rate of 12%. Hence, the project is acceptable because its IRR is greater than the hurdle rate. The best answer choice is letter “d”. Choice-letters “a” and “b” are incorrect because the IRR is greater than, not less than, 14%. Choice-letter “c” is incorrect because the project should proceed since its IRR is greater than its hurdle rate. 88. Which of the following statements is false? The net present value (NPV) of a project with cash flows that comes in relatively slowly is more sensitive to changes in the discount rate than is the NPV of a project with cash flows that come in rapidly. Other things held constant, a decrease in the cost of capital (discount rate) will cause an increase in a project’s internal rate of return (IRR). The IRR method can be used in place of the NPV method for all independent projects because the two methods then result in identical decisions. The NPV method is preferred over the IRR method because the NPV method’s reinvestment rate assumption is the correct assumption. (rpcpa) 88. B ? The false statement among the choices given.  Choice-letter “b” is a false statement because the internal rate of return is not affected by a change in the cost of the capital. Internal rate of return is the hurdle rate determined in the capital investment analysis while the cost of capital is the hurdle rate determined in the financing analysis. Choice letter “a” is a true statement because the longer the cash flows period, the more sensitive the cash will be in relation to the discount rate. Choice- letter “c” is correct because in evaluating independent projects the Internal Rate of Return (IRR) and the Net Present Value (NPV) result in the same decision of whether to

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accept or reject a project proposal. If the IRR is higher than the required rate of return (e.g., cost of capital, hurdle rate), the project is acceptable. If the NPV is positive, the project is acceptable. However, the two methods may differ on how the acceptable projects are to be prioritized. Choice – letter “d” is also a true statement. The NPV assumes that cash flows from operations are reinvested to earn the same discount rate used in the NPV calculation. The IRR method assumes that cash flows are reinvested to earn at the internal rate of return. The correct assumption is that of the NPV method because the discount rate includes not only the minimum return but also that of the premium rate related to the investment. Discount rate is equal to the risk-free rate plus risk premium rate (i.e., business risk). 89. You are engaged by the Brod Company to evaluate the introduction of a new product line with an innovative packaging. You computed the net present value (NPV) and internal rate or return (IRR). If your client would reduce the estimate for its sales of the new product and increase the projected cost of capital, what would be the impact of these revisions in the estimates on NPV and IRR? NPV will increase, IRR will increase NPV will decrease, IRR will increase NPV will increase, IRR will decrease NPV will decrease, IRR will decrease (rpcpa) 89. D ? The effect of a reduction in sales and an increase in the cost of capital to net present value (NPV and IRR).  A reduction in sales will decrease the NPV and the IRR, choice-letter “d” is correct. An increase in cost of capital would increase the discount rate used in the NPV calculations. This would mean a lower present value factor (e.g., the higher the discount rate, the lower the PV factor), a lowered present value of cash inflows, and, eventually, a reduced NPV. The IRR computation is based on the amount of future cash inflows and cost of investment. Internal rate of return is the discount rate used when the present value of cash inflows is equal to the cost of investment. This rate is not affected by the company’s cost of capital. However, because of the decrease in sales, the annual cash inflows would likely to decrease and the present value factor of annuity (i.e., payback period) would correspondingly increase to maintain the same present value of cash inflows before the reduction in sales. This increase in PVF Annuity would result to lower internal rate of return. 90. The internal rate of return (IRR) is the Hurdle rate. Rate of interest for which the net present value is positive. Rate of interest for which the net present value is equal to zero. Accounting rate of return. 90. C ? A statement about internal rate of return.

(cma)

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Internal rate of return is the discount rate where the present value of cash inflows is equal to the cost of investment. At this point, the net present value is zero, the profitability index is 1.00, and net present value index is zero. Choice-letter “c” is correct. Choice-letter “a” is incorrect because hurdle rate is a loose term which may refer to minimum rate of return, cost of capital, and sometimes, it refers to the discount rate. Choice-letter “b” is incorrect because at IRR the net present value is zero. Choice-letter “d” is incorrect because accounting rate of return is a measure of profitability while IRR is a measure of liquidity (e.g., cash flows).

91. Scott., Inc. is planning to invest P120,000 in a 10-year project. Scott estimates that the annual cash inflow, net of income taxes, from this project will be P20,000. Scott’s desired rate of return on investments of this type is 10%. Information on present value factors is as follow: At 10% At12% Present value of P1 for ten periods 0.386 0.322 Present value of an annuity of P1 for ten periods 6.145 5.650 Scott’s expected rate of return on this investment is Less than 10%, but more than 0%. 10%. Less than 12%, but more than 10%. 12%.

(aicpa)

91. C ? The expected return on investment.  The expected return on investment, as referred in the problem, is the internal rate of return. It is determined by the following steps: first, get the payback period (or the present value factor of annuity - PVFA); second, proceed to the PVFA table and locate the corresponding rate. If the PVFA factor is not exactly located and is between two discount rates, compute the exact internal rate of return by interpolation (or fraction analysis). Applying the steps, we have: a. PVFA (or payback) = P120,00 /P20,000 = 6.00 b. Using the PVFA table, 6.00 is found between 10% and 12% (final answer) In case you are interested in computing the exact IRR, and by using the interpolation method, the IRR shall be: 10%

6.145

?

6.000

0.145 2%

0.495 0.350

12%

5.650

IRR = 10% + [(0.145/0.495) x 2%] = 10.59% The IRR is less than 12%, but more than 10%.

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92 .Polo Company requires higher rate of return for projects with a life span greater than 5 year. Projects extending beyond 5 years must earn a higher specified rate of return. Which of the following capital budgeting techniques can readily accommodate this requirement? Internal rate of return Net present value Yes No No Yes No No Yes Yes 92. D ? The capital budgeting technique(s) that readily accommodates an adjustment in discount rate.  Choice-letter “d” is correct. Both the internal rate of return and the net present value techniques may incorporate adjustments to risk in their computations. An adjustment in discount rate is readily available to net present value calculation. This is done by simply incorporating the effects of the adjustment to the basic discount rate before adjustment to get the adjusted discount rate and then proceed in determining the net present value. The internal rate of return may also be adjusted to a higher rate as the benchmark for the project acceptability is increased. 93. Which of the following characteristics represent an advantage of the internal rate of return technique over the accounting rate of return technique in evaluating a project? Recognition of the project’s salvage value. Emphasis on cash flows. Recognition of the time value of money. I only. I and II.

C. II and III. D. I, II and III.

(aicpa)

93. C ? A list of advantages of internal rate of return over accounting rate of return.  Internal rate of return uses cash flows (i.e., liquidity) while accounting rate of return uses net income (i.e., profitability) to measure the desirability of investment opportunities. Internal rate of return is a discounted model and therefore considers the time value of money while accounting rate of return is a traditional model and does not consider the time value of money. Internal rate of return considers salvage value in the determination of cash inflows and accounting rate of return also considers salvage value in the computation of net income. Hence, only statements II and III are advantages of IRR over ARR. Choice-letter “c” is correct. 94.Everything else being equal, the internal rate of return (IRR) of an investment project will be lower if The investment cost is lower. Cash inflows are received later in the life of the project.

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Cash inflows are larger. The project has a shorter payback period.

168

(cia)

94. B ? A condition that lowers internal rate of return.  Internal rate of return (IRR) measures the discount rate where the present value of cash inflows (PVCI) is equal to the cost of investment. It is the discount rate where the net present value is zero. To lower the IRR, the cost of investment should be lowered, and the net present value should be reduced. And a way to reduce the net present value is to delay cash inflows at a later date. Another view is that IRR should be greater than the ROI to be acceptable. If the cash inflows are delayed, you have to lower the IRR to increase the corresponding PV Factor and maintain the previous amount of present value of cash inflows that equals the cost of investment. Choice-letter “a” is incorrect because if the investment cost is lowered, the PVCI should also be lowered, and this could be done by increasing the internal rate of return (e.g., the higher the discount rate, the lower the present value factor). Choice-letter “c” is incorrect because when cash inflows are larger, the PVCI will also be larger, and to maintain the same PVCI the discount rate should be brought higher. Choice-letter “d” is incorrect because the project that has a shorter payback period means lower present value factor of annuity, and higher internal rate of return (e.g., the lower the present value factor, the lower the discount rate). 95. A weakness of the internal rate of return (IRR) approach for determining the acceptability of investment is that it: Does not consider the time value of money. Is no longer a straightforward decision criterion. Implicitly assumes that the firm is able to reinvest project cash flows at the firm’s cost of capital. Implicitly assumes that the firm is able to reinvest project cash flows at the project’s internal rate of return. (cma) 95. D ? A weakness of internal rate of return for determining the acceptability of investment.  Internal rate of return (IRR) computes the true rate of return in the sense that the present value of cash inflows is equal to the cost of investment. Additionally, it assumes that the cash inflows reinvested in the operations earn interest at the same internal rate of return. Choice-letter “d” is correct. This assumption in IRR becomes its greatest drawback because an investment is assumed to earn a return that will increase the wealth of the firm. Choice-letter “a” is incorrect because IRR considers the time value of money. Choice-letter “b” is incorrect because IRR is a straightforward criterion where IRR should be greater than the ROI or cost of capital for a project to be acceptable. Choice-letter “c” is incorrect because IRR assumes that cash flows are reinvested to earn at the same true rate of return and not at cost of capital. 96. Universal Corporation is reviewing a capital budgeting decision regarding the acquisition of a capital equipment. Below are the relevant information: Investment P300,000

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Excess PV of net cash inflows Cash-flow tax shield from depreciation

169

200,000 100,000

The company is used to have as benchmark for similar projects an excess present value index of 0.50, that is, the project’s index should be no less than 0.50. Should this project be pursued? No, since the excess present value index is 0.33. Yes, since the excess present value index is 0.67. No, since the excess present value index is less than 0.50. Yes, since the excess present value index is 1.50. (rpcpa) 96. B ? Determine whether the excess present value is less than or more than 0.50 and then decide thereon.  The excess present value index (or net present value index) is 0.67 (i.e., P200,000 / P300,000). Hence the project should be pursued. Choice-letter “b” is correct. 97. L. Celi Company is planning to invest in a 2-year project that is expected to yield cash flows from operations, net of income taxes, of P50,000 in the first year and P80,000 in the second year. Celi requires an internal rate of return of 15%. The present value of P1 for one period at 15% is 0.870 and for two periods at 15% is 0.756. The future value of P1 for one period at 15% is 1.150 and for two periods at 15% is 1.323. The maximum that L.Celi should invest immediately is P 81,670 C. P130,000 P103,980 D. P163,340 (aicpa) 97. B ? The maximum amount that should be invested immediately.  The maximum amount that should be invested in a project should not exceed its present value of cash inflows, determined as follows: Year 1 (P50,000 x 0.870) P 43,500 Year 2 (P80,000 x 0.756) 60,480 Present value of cash inflows P103,980 98.Two projects have an initial outlay of P497, and each has an income lasting 3 years. Project A returns P200 per year for the next 3 years. Project B returns P200 for the first 2 years and P248 for the third year. Present Value – Amount N 8% 10% 12% 14% 1 .9259 .9091 .8929 .8772 2 .8573 .8264 .7972 .7695 3 .7938 .7513 .7118 .6750 The appropriate internal rate of return valuation for Project B is P200(.8772) + P200 (.7695) + P248 (.6750) = P496.74 P200(.8929) + P200 (.7972) + P248 (.7118) = P514.41 P200(9091) + P200 (.8264) + P248 (.7513) = P533.42 P200(.9259) + P200 (.8573) + P248 (.7938) = P553.50

(cia)

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98. A ? The appropriate internal rate of return (IRR).  The IRR is where the PV of cash inflows equals the cost of investment. The cost of investment is P497, therefore, at IRR the PV of cash inflows must also be 497. Choice-letter “a” where the PVCI equals P497, is the right choice, and the IRR is 14%. 99. At a company’s cost of capital (hurdle rate) of 15%, a prospective investment has a positive net present value. Based on this information, it can be concluded that The accounting rate of return is greater than 15%. The internal rate of return is less than 15%. The internal rate of return is greater than 15%. The payback period is shorter than the life of the asset. (cia) 99. C ? A conclusion with regard to a project with a positive net present value.  If a project has a positive net present value, it means that the internal rate of return (IRR) is greater than the discount rate. The project under consideration has an IRR greater than 15% inasmuch as it has a positive net present value. Therefore, choiceletter “c” is correct. A higher IRR indicates a lower present value factor, lower present value of cash inflows, and lower amount of investment, therefore favorable on the part of the business. Viewing it on a different angle, a discount rate lower than the IRR would result to higher present value of cash inflows, positive net present value, and therefore is favorable to a firm. Hence, the lower discount rate, the higher the IRR, the better. Since the project has a positive net present value, it is favorable and therefore, IRR should be higher than the cost of capital. Choice-letter “c” is correct. Choice-letter “a” is incorrect because accounting rate of return is not related to the cost of capital. Choice-letter “b” is incorrect because if the IRR is less that 15%, then the net present value should have been negative. Choice-letter “d” is incorrect because payback period does not affect the net present value of a firm. Profitability index 100.The technique that reflects the time value of money and is calculated by dividing the present value of the future net after-tax cash inflows that have been discounted at the desired cost of capital by the initial cash outlay for an investment is the Net present value method. Capital rationing method. Accounting rate of return method. Profitability index method. (cma) 100. D ? The technique that divides the present value of cash inflows with the cost of investment.  Profitability index measures the relationship of present value of cash inflows divided by the cost of investment. Expectedly, a project should have a profitability index greater than 1.0 to be acceptable. This means, the total of the present value of cash inflows is greater than the cost of investment, and the net present value is positive.

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If the profitability index is lower than 1.0, the present value of cash inflows are less than the cost of investment, and the net present value is negative. Profitability index is more appropriate to use in ranking acceptable projects. The higher the profitability index, the more favored a project is. Choice-letter “d” is correct. Choice-letter “a” is incorrect because net present value is the difference between present value of cash inflows and cost of investment. Choice-letter “b” is incorrect because capital rationing is a process of allocating available investment funds to those that are more prioritized, and profitability index is one of the techniques used in investment priority schedule and fund allocation. Choice-letter “c” is incorrect because accounting rate of return is not concerned with cash flows, but with net income. 101.The profitability index (present value index) Represents the ratio of the discounted net cash outflows to cash inflows. Is the relationship between the net discounted cash inflows minus the discounted cash outflows, divided by the discounted cash outflows. Is calculated by dividing the discounted profits by the cash outflows. Is the ratio of the discounted net cash inflows to discounted by the cash outflows. (cma) 101.D ? A description about profitability index.  Profitability index is measured by dividing present value of cash inflows over the cost of investment. It is not merely used as an accept-reject criterion but is more applied to assess project rankings. Choice-letter “a” is incorrect because the ratio is the reverse of the profitability index calculation. Choice-letter “b” is incorrect because it refers to net present value index. Choice-letter “c” is incorrect because it may be termed as discounted accounting rate of return, which does not exist in financial management literature, and therefore, is not an acceptable answer-choice. 102.Payback period (PP), profitability (present value) index (PI), and simple accounting rate of return (SARR) are some of the capital budgeting techniques. What is the effect of an increase in the cost of capital on these techniques? PP will increase, PI will decrease, and SARR will increase. PP will have no change, PI will decrease, and SARR will have no change. PP will have no change, PI will increase, and SARR will decrease. PP will decrease, PI will have no change, and SARR will have no change. (rpcpa) 102. B ? The effect of an increase in the cost of capital to the payback period (PP), profitability index (PI), and simple accounting rate of return (SARR).  Cost of capital is the cost of using long-term and new funds. In capital budgeting, it is the minimum rate of return that a project must earn so as not to impair the equity of common shareholders. An increase in the cost of capital indicates an adjustment increase in the discount rate. If the discount rate increases, the present value factor

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decreases, and the present value cash inflows will decrease. This will decrease the profitability index (i.e., PI = present value of cash inflows/cost of investment) The payback period and the accounting rate of return are not affected because these methods do not consider the time value of money. Besides, in the ARR, it does not use cash inflows in its analysis but instead uses the concepts of net income. Therefore, choice-letter “b” is correct. 103.Friendly Corporation’s Project Sky has a net investment of P1.2 million. The present value of all future net cash inflows is P2.4 million. The company’s tax rate is 40%. The profitability index is 0.50 C. 0.83 1.20 D. 2.00 (rpcpa) 103.D ? The profitability index.  Profitability index measures the relationship between the present value of cash inflows and the cost of investment. Based on the data given, the profitability index is 2.00 (i.e., P2.4 million / P1.2 million). The tax rate is irrelevant in the computation. 104.SB Company uses a 12% hurdle rate for all capital expenditures. It has lined up four projects and below is the summary thereof. Projects In thousand pesos 1 2 3 4 Initial cash outflow 400 596 496 544 Annual cash inflows: Year 1 130 200 160 190 2 140 270 190 250 3 180 180 180 4 130 160 120 Net present value (7.5) 8.552 28.128 29.324 Probability index 98% 101% 106% 105% Internal rate of return 11% 13% 14% 15% If the company has no budgetary limitations, which projects should be pursued? Project 1. C. Project 2, 3 and 4. Project 3 and 4. D. All the four projects. (rpcpa) 104.C ? The projects to be pursued if the company has no budget limitations.  Since the company has no budget limitations, it may accept all project proposals with positive NPV, or profitability index greater than 1.00, or if the IRR is greater than the hurdle rate (i.e., minimum rate of return). Projects 2, 3, and 4 meet all these requirements, and therefore, choice-letter “c” is correct. 105.Telephone Corporation cost for the initiation of net cash flow are listed 12%. It has P900,000 greater than 12%.

is contemplating four projects: L, M, N, and O. The capital each mutually exclusive project and its estimated after-tax, below. The company’s desired after-tax opportunity costs is capital budget for the year. Idle funds cannot reinvest at

Chapter 14

Capital Budgeting

L 470 Annual cash flows Year 1 Year 2 Year 3 Year 4 Net present value Internal rate of return Excess present value index The company will choose Projects M, N, and O. Projects M and N.

113 113 113 113 113 P7,540 12.7% 1.02

In thousand Pesos M N 380 400 180 170 150 110 100 P59,654 17.6% 1.13

90 110 130 140 150 P54,666 17.2% 1.14

C. Projects L and N. D. Projects L and M.

173

O 420 80 100 120 130 150 P(15,708) 10.6% 0.96

(rpcpa)

105. B ? The projects the company will choose to invest its P900,000 capital budget.  The acceptable projects are L, M, and N, they having positive net present values (NPV). The three (3) projects have a combined investment of P1,250,000 (i.e., P400,000 + P470,000 + P380,000). The available investment amount is only P900,000. Not all the three (3) projects could be possibly financed. The projects must be prioritized. To prioritize the project, the NPV index is to be used; the higher the NPV index, the better. Project N is ranked no. 1 (with highest NPV index) and project M is ranked no. 2; their combined investment total is only P850,000 (i.e., P380,000 + P470,000). 106.A capital budgeting decision model has provided the following information: Proposal A Proposal B Investment P1,000,000 Investment P1,800,000 Profitability index 1.2 Profitability index 2.1 Net present value P 600,000 Net present value P 300,000 The better project is Proposal A because it has the higher net present value. Proposal B because it has the higher profitability index. Proposal B because its profitability index is over 2.0. Proposal A because it has the higher net present value even though its investment base is smaller. (rpcpa) 106. B ? The better project proposal.  Both of the project proposals are acceptable because they have positive net present values. In ranking the projects to allocate the available limited investment, the profitability index should be used to rank projects according to their priority.

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The higher the profitability index, the better. Project B has a higher profitability index than project A, Hence, project B should be prioritized. 107.Information on three (3) investment projects is given below: Project Investment NPV X P150,000 P34,005 C 100,000 22,670 W 60,000 13,602 Rank the projects in terms of preference: 1st W, 2nd C, 3rd X. C. 1st X, 2nd C, 3rd W. st nd rd 1 C, 2 W, 3 X. D. The ranking is the same.

(rpcpa)

107. D ? Rank the projects in terms of preference (capital budgeting).  The net present value (NPV) of each of the projects are given, and they are all positive. It means they are all acceptable therefore; the ranking of the projects should be done using the indices. One of the indices is the profitability index (P.I), which is the “present value of cash inflows divided by the cost of investment”. The higher the index, the better. The PI of each project is: Investment Profitability Rank Project cost NPV PVCI+ Index ** X P150,000 P34,000 P184,000 1.2267 1 C 100,000 22,670 122,670 1.2267 1 W 60,000 13,602 73,602 1.2267 1 ----------------------------+ PVCI = present value of cash inflows ** P.I = PV of cash inflows/ cost of investment The projects have the same profitability index. They are ranked equally. 108.Universal Corporation is reviewing a capital budgeting decision regarding the acquisition of capital equipment. Below are the relevant information: Investment P300,000 PV of net cash inflows 200,000 Cash-flow tax shield from depreciation 100,000 The company is used to have as benchmark for similar projects at an excess present value index of 0.50, that is, the project’s index should be no less than 0.50. Should this project be pursued? No, since the excess present value index is 0.33. Yes, since the excess present value index is 0.67. No, since the excess present value index is less than 0.50. Yes, since the excess present value index is 1.50. 108. C ? To determine whether the project should be pursued using the excess present value index criterion.  The excess present value is hereby construed as the net present value index, which is computed as follows:

Chapter 14 PV of cash inflows - Cost of investment Net present value

Capital Budgeting

175

P 200,000 300,000 P(100,000)

The net present value index should be –0.33 (i.e., -P100,000 / P300,000). Since the NPV index is negative and is lower than the 0.50 criterion, the project should not be pursued. 109.If an investment project has a profitability index of 1.15, the Project’s internal rate of return is 15%. Project’s cost of capital is greater than its internal rate of return. Project’s internal rate of return exceeds its net present value. Net present value of the project is positive.

(cma)

109. D ? The effect if an investment has a profitability index of 1.15.  A 1.15 profitability index indicates that the present value of cash inflows is greater than the cost of investment, and therefore there is a positive net present value. Choice-letters “a”, “b”, and “c” are incorrect because profitability index has no direct relationship with internal rate of return. 110. The profitability index approach to investment analysis Fails to consider the timing of project cash flows. Considers only the project’s contribution to net income and does not consider cash flows effects. Always yields the same accept/ reject decisions for independent projects as the net present value method. Always yields the same accept/reject decisions for mutually exclusive projects as the net present value method. (cma) 110. C ? A statement about profitability index.  Profitability index (PI) yields the same accept/reject decisions for independent projects as the net present value (NPV) method. This is because both are based on the discounted cash flow models and use the same discount rate. Choice-letter “a” is incorrect profitability index is also a discounted cash flow model and considers the time value of money. Choice-letter “b” is incorrect because profitability index considers cash flows and not net income. Choice-letter “d” is incorrect because when projects are mutually exclusive, the PI and NPV may result to different decisions. In mutually exclusive projects, the NPV may result to better ranking decision. For example, a P10 million project may be a better investment than a combination of P7 million project with a higher profitability index and the best alternative use of the remaining P3 million. To illustrate, assume there is an available of P10 million fund for investments and the following mutually-exclusive investment opportunities: Profitability Net present Project Cost Index value Rank A P10 million 1.26 P2.6 million 2

Chapter 14 B C

Capital Budgeting 7 million 3 million

1.30 1.10

2.1 million 0.3 million

176

1 3

Using the profitability index, project B is the first priority up to P7 million only. The remaining P3 million will be used to invest in project C. The combination of these investments will produce a net present value of P2.4 million (i.e., P2.1 million + P0.3 million). Using the net present value model, the better choice is to invest the P10 million to project A and produce a net present value of P2.6 million. 111. The profitability index approach to investment analysis Considers only the project’s contribution to net income and does not consider cash flow effect. Always yield the same accept/ reject decision for mutually-exclusive project as the net present value method. Always yield the same accept/reject decision for independent project as the net present value method. Always yield the same accept/reject decisions for dependent project on the net present value method. (rpcpa) 111. C ? A correct statement regarding profitability index approach to investment analysis.  Choice-letter “c” is correct because the profitability index and net present value always yield the same accept/reject decision for independent projects. Choice-letter “a” is incorrect because profitability index as a measure of project’s desirability considers the net cash inflows (outflows) and not the net income of a proposed project. Choice-letter “b” is incorrect because profitability index may result to different accept/reject decision as compared to net present value method. Choiceletter “d” is incorrect because dependent projects are evaluated not only based on their ability to generate returns but more on their necessity to exist. 112. The capital budgeting technique known as internal rate of return uses: Cash flow over entire life of project - No Time value of money - Yes Cash flow over entire life of project - Yes Time value of money - Yes Cash flow over entire life of project - No Time value of money - No Cash flow over entire life of project - No Time value of money – No

(rpcpa)

112. B ? The variables used in determining the internal rate of return.  The IRR is a breakeven rate where the present value of cash inflows equals the net cost of investment. The present value of cash inflows is equal to cash inflows multiplied by the respective present value factor. In the determination of internal rate of return, the important variables are cash flows, present value factor, and the net cost of investment. Hence, choice-letter “b” is correct.

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NPV index 113.What is the effect of changes in cash flows, investment cost and cash outflows on profitability (present value) index (PI) PI will increase with an increase in cash flows, a decrease in investment costs, or a decrease in cash outflows. PI will increase with an increase in cash inflows, an increase in investment cost, or an increase in cash outflows. PI will decrease with an increase in cash flows, a decrease in investment cost, or a decrease in cash outflows. PI will decrease with an increase in cash outflows, an increase in investment cost, or an increase in cash inflows. (rpcpa) 113.A ? The effect of changes in cash flows, investment cost, and cash outflows on profitability index.  Profitability index (PI) is present value of cash inflows (PVCI) divided by the cost of investment (COI). This relationship is presented below: PI =

PVCI / COI

If PI = 1.0, it means that the proposed project is at breakeven, because PVCI = COI, and the net present value is zero. If PI is greater than 1.0, the project is acceptable because the cash that could be derived from the investment is more than enough to recover the cost of investment and, therefore, would result to a net benefit to the company. If PI is lower than 1.0 the project is not acceptable. To increase PI, the cash inflow must be increased or the cash inflow must be accelerated, the discount rate must be lowered, the cost of investment must be reduced (choice-letter “a” correct). To decrease PI, the cash outflow from investment must decrease, the discount rate must be increased, and the cost of investment is increased. 114.The following data relate to two capital budgeting projects of equal risk: Present Value of Cash Flows Period Project A Project B 0 P(10,000) P(30,000) 1 4,550 13,650 2 4,150 12,450 3 3,750 11,250 Which of the projects will be selected using the profitability-index (PI) approach and the NPV approach? PI NPV Pi NPV B A C. Either A Either B D. B B (cia) 114. B ? The project(s) to be selected using the profitability index (PI) model and the NPV model.  The present value of cash flows are determined and treated as follows:

Chapter 14

Capital Budgeting

Project A PV of cash inflows (PVCI) (P4,550 + P4,150 + P3,750) P12,450 (P13,650 + P12,450 + P11,250) - Cost of investment (COI) 10,000 Net present value P 2,450 Profitability index (PVCI/COI) 1.245

178

Project B P37,350 30,000 P 7,350 1.245

Using the PI model, either of the investment opportunities will give the same rate of return. However, under the NPV model, project B is a better investment because it gives a higher net present value. Other discounted cash flows models 115. Risk to a company is affected by both project variability and how project returns correlate with those of the company’s prevailing business. Overall company risk will be lowest when a project’s returns exhibit Low variability and negative correlation. Low variability and positive correlation. High variability and positive correlation. High variability and no correlation. (cia) 115.A ? The circumstance in which the overall company risk will be lowest.  Business risk relates to uncertainty, unknown outcome of events but known probability of distribution of returns (i.e., known mean and standard deviation). Standard deviation measures the variability (or volatility, changeability) of project outcome, which indicates the spread of deviations (or variations) from expectations, (mean). The wider the standard deviation, the uncertain the outcome is, the greater the risk of the project. The overall risk of a firm is lowered when the variability rate is lowered. Correlation refers to expected outcome of an item in relation to the change in outcome of another. If the relationship of two possible outcomes is direct or positive (e.g.., when one declines, the other declines as well), the business risk increases because of the probability of losing in one condition all of the investments. To reduce business risk, there should be negative correlation among investments, so that a decline in the value of a particular investment would not adversely affect the values of the other investments and that of the overall business portfolio as well (i.e., portfolio management). Hence, the correct answer is letter “a”. Choice-letter “b” is incorrect because a project’s return should exhibit negative correlation to lower the overall business risk. Choice-letters “c” and “d” are incorrect because higher variability means higher business risk. 116.When the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to Divide each cash flows by the payback period. Compute the net present value of each cash flow using firm’s cost of capital.

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Compare the internal rate of return from each cash flow to its risk. Discount each cash flow using a discount rate that reflects the degree of risk. (cma) 116.D ? The procedure for evaluating cash flows when the risks of individual components differ.  Each business project has its own degree of risk. To appropriately evaluate projects that have varying risk, a discount rate that reflects the degree of risk should be used to discount its cash flows. Choice-letter “d” is correct. The higher the risk, the higher the discount rate to be applied, the lower the present value factor, the lower the present value of cash inflows. The lower the risk, the lower the discount rate, and the higher the present value of cash inflows. Choice-letter “a” is incorrect because the payback period does not consider business risk and the time value of money. Choice-letter “b” is incorrect because using the cost of capital, as a discount rate does not consider a business risk appropriately determined for a particular investment opportunity. Choice-letter “c” is incorrect because risk should be incorporated in the computation of internal rate of return and not to be compared with the internal rate of return. 117. Sensitivity analysis, if used with capital projects, Is used extensively when cash flows are known with certainly. Measures the change in the discounted cash flows when using the discounted payback method rather than the net present value method. Is a “what-if” technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed. Is a technique used to rank capital expenditure requests. (cma) 117.C ? A description of sensitivity analysis.  Sensitivity analysis is a mathematical model that predicts possible scenarios or outcomes of events assuming certain conditions are modified, added, altered, or unchanged. It is generally used when there is great existence of uncertainty. Applied to capital budgeting, sensitivity analysis incorporates conditions and changes in business conditions that may contribute to the degree of risk in a particular investment opportunity, and may dramatically alter the outcome of discounted flow analysis. Sensitivity analysis provides possible versions by answering “what-if” techniques that asks how a given outcome will change if the original estimates of the model are changed. Choice-letter “c” is correct. Choice-letter “a” is incorrect because sensitivity analysis is not used when cash flows are known with certainty. Choice-letter “b” is incorrect because sensitivity analysis applies most likely to discounted cash flow models in capital budgeting techniques. Choice-letter “d” is incorrect because sensitivity analysis is not a ranking technique rather it predicts outcomes under varying conditions. 118.When determining net present value in an inflationary environment, adjustments should be made to Increase the discount rate only. Increase the estimated cash inflows and increase the discount rate.

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Decrease the estimated cash inflows and increase the discount rate. Increase the estimated cash inflows and decrease the discount rate.

180

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118.B ? The adjustment to be made in determining net present value in an inflationary environment.  In an inflationary environment, prices are going up and the purchasing power of a unit of measure weakens. These effects should be reflected in the capital budgeting projections with the end-in-view of at least maintaining the present value of cash inflows before the effects of the inflation. This means increasing the discount rate and increasing the nominal value of future cash inflows to compensate the decrease in the present value of cash inflows resulting from an increase in the discount rate. Choice-letter “b” is correct. Choice-letter “a” is incorrect because increasing the discount rate only decreases the present value of cash inflows without any compensating strategy. Choice-letter “’c” has a double decreasing effects because increasing the discount rate and decreasing future cash inflows both diminish the present value of cash inflows. Choice-letter “d” is incorrect because the discount rate should be increased when inflation rate increases. 119.A company’s marginal cost of new capital (MCC) is 10% up to P600,000. MCC Increases .5% for the next P400,000 and another .5% thereafter. Several proposed capital projects are under consideration, with projected cost and internal rates of return (IRR) as follows: Project Cost IRR A P100,000 10.5% B 300.000 14.0 C 450.000 10.8 D 350,000 13.5 E 400,000 12.0 What should the company’s capital budget be? P 0 C. P1,500,000 P1,050,000 D. P1,600,000

(cia)

119.B ? The company’s capital budget.  Investment opportunities should be accepted as long the internal rate of return exceeds the cost of capital, as follows: Cost of Cost of Investment Project IRR MCC Investment to date B 14% 10.0 % P300,000 P 300,000 D 13.5% 10.5% (10% + 0.5%) 350,000 650,000 E 12.0% 11.0% (10.5%+0.5%) 400,000 1,050,000 C 10.8% 11.5% (11.0%+0.5%) rejected because the IRR is less than MCC The maximum investment to be made by the business if P1,050,000, up to where the IRR still exceeds the marginal cost of capital.

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Lease or buy 120.Mr. Al Berbano is contemplating to buy a machine to increase the capacity of his manufacturing operations. He consults you for advise on the alternatives of leasing or buying the equipment. If purchased, the straight line depreciation expense will be P18,700 annually over its life of 5 years. The annual lease payment will amount to P29,000 payable at the end of each of the 5 years. Cost of money is 18%. Tax rate is 35%. There is no salvage value. Present value of P1 received annually for 5 years at 18% is 3.127. Present value of P1 due in 5 years at 18% is .437. What will you recommend and why? Lease the machine because leasing saves P2,817 per year. Lease the machine because leasing saves P4,506 per year. Buy the machine because depreciation saves P16,545 each year. Lease the machine because outlay is less by P58,944. 120.B ? The recommendation whether to lease or buy the machine.  In deciding to lease or buy a machine, the net relevant costs of leasing and buying the machine should be tabulated. The alternative that gives the lower net relevant costs must be followed. In this problem, however, the cash inflows should be converted to their present values (PV), as follows: Leasing Buying Purchase price (P18,700 x 5 yrs.) PV of lease payments (P29,000 x 3.127) PV of tax savings from lease payments (P29,000 x 35% x 3.127) PV of tax savings from depreciation expense (P18,700 x 35% x 3.127)

P90,683 (31,739) _______

P93,500

Net relevant present values Net advantage of leasing – in 5 years (P73,034 – P58,944) Annual savings from leasing (P14,090/3.127)

58,944 P14,090 P 4,506

(20,466) P73,034

The annual depreciation expense is multiplied by the economic life in year to get the purchase price of the new machine (salvage value should be added if there is any). The lease payment should be multiplied by the present value of annuity since the lease payments are expected to be constant and in series (i.e., uninterrupted). Lease payments and depreciation expense are tax-deductible expenses and would therefore reduce income and eventually income tax payments. Tax savings from lease payments and depreciation expense must be converted into their present values. If there is a salvage value, it is treated as an inflow that must be converted to its present value in the alternative of buying. Choice-letter “b” is correct, lease the machine because leasing saves the company P4,506 per year. Miscellaneous 121.If income tax considerations are ignored, how is depreciation handled by the following capital budgeting techniques? Internal Accounting Rate of Return Rate of Return Payback Excluded Included Excluded Included Excluded Included

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Included Included

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(cma)

121.A ? The treatment of depreciation expense in the calculation of internal rate of return, accounting rate of return, and the payback period.  Internal rate of return and payback period use net cash inflows in evaluating the desirability of an investment opportunity. Net cash inflows do not consider depreciation in the computation. What is considered is the tax effects of the depreciation expense. As such, internal rate of return and payback period ignore depreciation expense. Among the capital budgeting techniques of evaluating project proposals, only the accounting rate of return uses net income as a concept of net returns. In the computation of net income, depreciation expense is considered. As such, depreciation expense is included in the calculation of accounting rate of return. Hence, choice-letter “a” is correct. 122.An organization is using capital budgeting techniques to compare two independent projects. It could accept one, both, or neither of the projects. Which of the following statements is true about the use of net present value (NPV) and internal rate of return (IRR) methods for evaluating these two projects? NPV and IRR criteria will always lead to the same accept or reject decisions for two independent projects. If the first project’s IRR is higher than the organization’s cost of capital, the first project will be accepted but the second project will not. If the NPV criterion leads to accepting or rejecting the first project, one cannot predict whether the IRR criterion will lead to accepting or rejecting the first project. If the NPV criterion leads to accepting the first project, the IRR criterion will never lead to accepting the first project. (cia) 122.A ? The true statement about the net present value and the internal rate of return.  The NPV and IRR are both straightforward criteria in deciding to accept or reject a project. If a project yields a positive net present value, it is accepted, otherwise rejected. If a project has an IRR greater than the cost of capital, it is accepted, or else rejected. These methods result to the same accept or reject decisions for two independent projects. Choice-letter “b” is incorrect because the first project IRR may have no effect on the second project’s IRR, hence, the acceptance or rejection of the second project should not be based on the first project’s IRR. Choice-letter “c” is incorrect because IRR is also a straightforward criterion in evaluating the acceptance or rejection of a project. Choice-letter “d” is incorrect because NPV and IRR lead to the same accept/reject decision for independent projects. 123.The rankings of mutually exclusive investments determined using the internal rate of return methods (IRR) and the net person value method (NPV) may be different when

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The lives of the multiple projects are equal and the sizes of the required investments are equal. The required rate of return equals the IRR of each project. The required rate of return is higher than the IRR of each project. Multiple projects have unequal lives and the size of the investments for each project is different. (cma) 123.D ? The conditions where the ranking of mutually exclusive investments may be different using the IRR and NPV.  The basic difference between IRR and NPV rests on their cash reinvestment assumptions. Because of this, the two methods may differ in their decision regarding mutually exclusive projects. Choice-letter “d” is correct. Additionally, IRR may rank small projects better compared with a big project but with longer project life. This situation criticizes the use of IRR model and favors the use of the NPV model. Choice-letter “a” is incorrect because in this situation the IRR and NPV models will result to the same investment decision. Choice-letter “b” is incorrect because if the IRR equals the required rate of return, then the project is at breakeven point and the net present value is zero. Choice-letter “c” is incorrect because if IRR is less than the required rate of return, the project should be rejected since its net present value is negative. 124.Which of the following statements is correct? One key shortcoming of discounted cash flow method is that they ignore the recovery of original investment. Although a cash outlay for non-current assets such as a machine would be considered, in a capital budgeting analysis, a cash outlay for working capital item such as inventory would not be considered. To be acceptable, a project’s time adjusted rate of return cannot be less than the company’s cost of capital If the net present value of an investment is zero, then the project should be rejected since it is not providing any return on the investment. (rpcpa) 124.C ? The correct statement with regard to capital investment evaluation techniques.  The statements relate to capital budgeting. Choice-letter “c” is correct because for the proposed project to be acceptable, the time-adjusted rate of return (or the internal rate of return) must be greater than required rate of return (i.e., cost of capital). At IRR, the cost of investment is the reckoning base, where the lower the cost of investment, the better. At IRR, the present value of cash inflows is equal to the cost of investment. Therefore, if the cost of investment is lower, the needed present value of cash inflows is also lower, which will entail a higher discount rate. Hence, the higher the IRR rate, the better. Choice-letter “a” is incorrect because the discounted cash flow method (i.e., NPV, IRR, profitability index, NPV index, and discounted payback period) aims for the recovery of the cost of investment. Choice-letter “b” is incorrect because working capital is considered in the capital budgeting analysis as an immediate outflow on the date of investment that is expected to be recovered (therefore, a cash inflow) at

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end of the investment. Choice-letter “d” is also incorrect because a zero net present value means that the present value of cash inflows equals the cost of investment. Therefore, the proposed investment is at breakeven. It does not automatically mean that the project is to be rejected because the acceptability of the project may also depend on the necessity of the project in relation to other projects. Questions 128 and 129 are based on the following information. A firm with an 18% cost of capital is considering the following projects (on January 1, 2006): January 1, 2006 December 31, 2010 Cash Outflow Cash Inflow Project Internal (000’s Omitted) (000’s Omitted) Rate of Return Project A P 3,500 P 7,400 16% Project B 4,000 9,950 ? Present value of P1 Due at the End of “N” Periods N 12% 14% 15% 16% 18% 20% 22% 4 .6355 .5921 .5718 .5523 .5158 .482 .4230 5 .5674 .5194 .4972 .4371 .4371 .4019 .3411 6 .5066 .4556 .4323 .4101 .3704 .3349 .2751 125.Using the net-present-value (NPV) method, project A’s net present value is P316,920 C. P(265,460) P 23,140 D. P(316,920)

(cia)

125.C ? The net present value of project A.  Net present value (NPV) is the difference in present value of cash inflows and cost of investment. The NPV of project A is: Present value of cash inflows (P7,400,000 x 0.4371 )P3,234,540 - Cost of investment 3,500,000 Net present value P( 265,460) The cash inflows will be received after 5 years and the discount rate is 18%. 126.Project B’s internal rate of return is closest to 15% C. 18% 16% D. 20%

(cia)

126.D ? Project B’s closest internal rate of return.  Internal rate of return is where the net present value is zero, or the present value of cash inflows equals the cost of investment. Using the present value of single payment, and that all cash flows are received at the end of the project life, the present value factor (PVF) of single payment for internal rate of return shall be 0.4020 (i.e., P4,000/P9,950). Given a 5-year life, the PVF is nearest at 20%.

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127.Amster Corporation has not yet decided on its hurdle rate for use in the evaluation of capital budgeting projects. This lack of information will prohibit Amster from calculating a project’s

Accounting Net Rate of Return Present Value No No Yes Yes No Yes No Yes

Internal Rate of Return No Yes Yes No

(cma)

127.D ? The item that could not be calculated due to the lack of given hurdle rate.  The hurdle rate (or discount rate) is used in computing net present value, profitability index, net present value index, and discounted payback period. Internal rate of return computation does not need a given discount rate because it actually locates for the unknown true rate of return. Accounting rate of return is not a discounted cash flow model, does not consider the time value of money, and does not use a discount rate. Hence, choice-letter “d” is correct. 128.The use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of Raising the hurdle rate necessary to justify the project. Lowering the net present value of the project. Increasing the present value of the depreciation tax shield. Increasing the cash outflows at the initial point of the project. (cma) 128.C ? The effect of using accelerated method instead of straight-line depreciation method in computing the net present value.  The accelerated method of depreciation recognizes greater amount of depreciation expense at the initial years of the asset life. This will reduce net income and accelerate tax savings from depreciation expense. This accelerated cash savings (or cash inflows) would translate to an increased present value of cash inflows. Choice-letter “c” is correct. Choice-letter “a” is incorrect because the choice of depreciation method does not impact the setting of a discount rate. Choice-letter “b” is incorrect because using accelerated depreciation would increase tax savings (or tax shield) and increase present value of cash inflows. Choice-letter “d” is incorrect because the choice of depreciation method does not affect the cost of the investment. 129 If the net present value (NPV) of Project A is known to be higher than the NPV of Project B, it can be concluded that The internal rate of return (IRR) of Project A will definitely be higher than the IRR of Project B. The IRR of Project A will definitely be lower than the IRR of Project B.

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The ranking of IRRs is indeterminate based on the information provided. The payback period for Project A is definitely shorter than the payback period for Project B. (cia) 129.C ? A possible conclusion if the NPV of project A is higher than that of project B.  A higher NPV means that the nominal amount of net present value of project A is greater than the NPV of project B. Due to diversity in the amounts of investment, project lives, and business risk, it does not necessarily follow that a higher NPV means a higher IRR. And the IRRs are not determinable based on the rankings of the NPV. As such, choice-letter “c” is correct. Choice-letters “a” and “b” are incorrect because a higher NPV does not mean a higher IRR, neither does NPV affect the computation of IRR. Choice-letter “d” is incorrect because payback period is not related to the net present value. 130.Net present value (NPV) and internal of return (IRR) differ in that NPV assumes reinvestment of project cash flows at the cost of capital, whereas IRR assumes reinvestments of project cash flows at the internal rate of return. NPV and IRR make the different accept or reject decisions for independent projects. IRR can be used to rank mutually exclusive investments projects, but NPV cannot. NPV is expressed as a percentage, while IRR is expressed as a peso amount.

(cia)

130.A ? The difference between net present value (NPV) and internal rate of return (IRR).  The main difference between NPV and IRR is on their cash reinvestment assumptions. Under the NPV method, cash reinvestments are expected to generate returns at the discount rate used in the NPV determination (e.g., cost of capital), while under the IRR method, cash reinvestments are expected to generate returns at the same internal rate of return. Hence, choice-letter “a” is correct. Choice-letter “b” is incorrect because NPV and IRR result to the same accept/reject decisions for independent projects. Choice-letter “c” is incorrect because NPV may also be used in ranking mutually exclusive projects, even better than using the IRR method. Choice-letter “d” is incorrect because NPV is expressed in peso amount and IRR is expressed in rate. 131.In the capital budgeting, these techniques are applied: payback (PB) method, net present value (NPV) method and time adjusted rate of return (TARR) method. PB method has this in common with NPV and TARR methods: Use of cash flows. Consideration of the time value of money. Use of discounting. Use of accrual method of accounting. (rpcpa) 131.A ? The common factor of PB method with NPV and TARR.  Choice-letter “a” is correct because the payback period (PB), net present value (NPV), and time adjusted rate of return (TARR) use cash flows in the evaluation process. Choice-letter “b” and “c” are incorrect because PB method does not

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consider the time value of money and discounting. Choice-letter “d” is incorrect because PB, NPV, and TARR do not use net income. Questions 135 and 137 are based on the following information. Logg Company is planning to buy a coin-operated machine costing P40,000. For tax purposes, this machine will be depreciated over a five-year period using the straight-line method and no salvage value. Assume that the investment tax credit is not applicable to this purchase. Logg estimates that this machine will yield an annual cash inflow, net of depreciation and income taxes, of P12,000. At the following discount rates, the net present values of the investment is this machine are: Discount Net present rate value 12% + P3,258 14% + 1,197 16% 708 18% - 2,474 Logg’s desired rate of return on its investment is 12%. 132.Logg’s accounting rate of return on its initial investment in this machine is expected to be A. 30% C. 12% 15% D. 10% (aicpa) 132.D ? The accounting rate of return on initial investment.  Accounting rate of return (ARR) on initial investment is determined by dividing net income over the amount of original investment. The depreciation expense is P8,000 (i.e., P40,000/5 yrs.). The net income is derived by deducting from the net cash inflows the depreciation expense and will result to P4,000 (i.e., P12,000 – P8,000). Therefore, the ARR is 10% (i.e., P4,000/P40,000). 133.Log’s expected payback period for its investment in this machine is A. 2.0 years C. 3.3 years 3.0 years D. 5.0 years 133.C ? The expected payback period.  Payback period measures the length of time before the cost of investment is recovered. If the net cash inflows are even, the payback period is computed by dividing cost of investment over net cash inflows, as follows: Payback period = P40,000/P12,000 = 3.3 years 134.Logg’s expected internal rate of return on its investment in this machine is A. 3.3% C. 12.0% 10.0% D. 15.3% (aicpa) 134.D

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The expected internal rate of return (IRR). The IRR is the discount rate where the present value of cash inflows is the same as the cost of investment, and the net present value is zero. At 14%, the net present value is positive P1,197; and at 16%, the net present value is negative P708. The IRR is, therefore, greater than 14% but is less than 16%. The exact IRR is computed as follows: 14% P1,197 1,197 2% ? P 0 1,905 708 16% P( 708) IRR = 14% + [(1,197/1,905) x 2%] = 15.3%

135.On July 1, 2006, James Jacinto signed an agreement to operate a franchise of Fast Foods, Inc., for an initial franchise fee of P60,000. Of this amount, P20,000 was paid when the agreement was signed and the balance is payable in four equal annual payments of P10,000 beginning July 1, 2007. The agreement provides that the down payment is not refundable and no future services are required of the franchisor. Jacinto’s credit rating indicates that he can borrow money at 14% for a loan of this type. Information on present and future value factors is as follows: Present value of P1 at 14% for 4 periods 0.59 Future amount of P1 at 14% for 4 periods 1.69 Present value of an ordinary annuity of P at 14% for 4 periods 2.91 Jacinto should record the acquisition cost of the franchise on July 1, 2006, at A. P43,600 C. P60,000 P49,100 D. P67,600 (aicpa) 135.B ? The acquisition cost of the franchise.  The acquisition cost of the franchise comprises two payments – the P20,000 downpayment and the P10,000 annual payments to be paid in the next 4 years starting the beginning of next year. The total present value of all payments represents the franchise cost, as follows: Down payment P20,000 Annuity payments (P10,000 x 2.91) 29,100 Present value of the franchise P49,100 136.On January 1, 2006, FD Company issued ten-year bonds with a face value of P1,000,000 and a started interest rate of 8% per year payable semiannually July 1 and January 1. The bonds were sold to yield 10%. Present value factors are as follows: Present value of 1 for 10 periods at 10% .386 Present value of 1 for 20 periods at 5% .377 Present value of an annuity of 1 for 10 periods at 10% 6.145 Present value of an annuity of 1 for 20 periods at 5% 12.462 The total issue price of the bonds is

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C. P 980,000 D. P1,000,000

(aicpa)

136.A ? The total issue price of the bonds.  The issue price of the bonds should equal the present value of future payments which comprise the principal payments and the annual interest payments. The interest payments are made semiannually for 10 years, thereby resulting to 20 interest periods. In nominal amount, the interest expense per period is P40,000 (i.e., P1 million x 4%). The effective interest rate shall serve as the discount rate. The present value of these payments are as follows: Present value of principal payment (P1 million x .377) P377,000 Present value of interest payments (P40,000 x 12.462) 498,480 Present value of the bonds P875,480 The present value of the bonds is the benchmark for its issuance price. 137.An office equipment representative has a machine for sale or lease. If you buy the machine, the cost is P7,596. If you lease the machine, you will have to sign a noncancelable lease and make 5 payments of P2,000 each. The first payment will be paid on the first day of the lease. At the time of the last payment you will receive title to the machine. The present value of an ordinary annuity of P1 is as follows: Number of Present value Periods 10% 12% 16% 1 0.909 0.8983 0.862 2 1.736 1.690 1.605 3 2.487 2.402 2.246 4 3.170 3.037 2.798 5 3.791 3.605 3.274 The interest rate implicit in this lease is approximately A. 10% C. Between 10% and 12% 12% D. 16%

(aicpa)

137.D ? The interest rate implicit in the lease.  The implicit interest of the lease (i.e., internal rate of return) is the rate where the present value of lease payments equals the cost of the machine. The annuity payments start from the very first day of the lease (i.e., annuity due). Therefore, only the remaining 4 payments of P2,000 each shall be discounted. To compute for the present value factor of annuity due (PVFA due), the present value factor of ordinary annuity (PVFOA) is deducted by 1, as follows: PVFA due = [(P7,596/P2,000) – 1] = 2.798 Locating the PVFA due in the PVFA table, the number of reference years should be 4 (i.e., 5 – 1). The factor 1 deducted from 5 represents the first payment made at the beginning of the lease period. Going across the table, the 2.798 is found under

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16%. To prove that at 16% the present value of lease payments equal the cost of the machine, we have: The present value of lease payments are determined as follows: Down payment P2,000 Annuity payments (4 payments) (P2,000 x 2.798) 5,596 Present value of lease payments P7,596 Comprehensive problems Questions 138 and 139 are based on the following information. Amaro Hospital, a nonprofit institution not subject to income taxes, is considering the purchase of new equipment costing P20,000, in order to achieve cash savings of P5,000 per year in operating costs. The equipment’s estimated useful life is ten years, with no residual value. Amaro’s cost of capital is 14%. For ten periods of 14%, the present value of P1 is 0.270, while the present value of an ordinary annuity of P1 is 5.216. 138.What factor contained in or developed from the above information should be used in computing the internal rate of return for Amaro’s proposed investment in the new equipment? A. 5.216 C. 1.400 4.000 D. 0.270 (aicpa) 138.B ? The factor to be used in computing the internal rate of return for new equipment.  At internal rate of return, the present value of cash inflows (PVCI) equals the cost of investment (COI). The PVCI is computed by multiplying the net cash inflows (NCI) by the present value factor of annuity (PVFA). By derivation, we cash determine the PVFA as follows: If PVCI = NCI x PVFA Then PVFA = PVCI/NCI And if at internal rate of return PVCI = COI Then PVFA = COI/NCI PVFA = P20,000/P5,000 = 4.000 139.How much is the accounting rate of return based on Amaro’s initial investment in the new equipment? A. 27% C. 15% 25% D. 14% (aicpa) 139.C ? The accounting rate of return (ARR) on initial investment.  Accounting rate of return is determined by dividing net income over the amount of investment. The amount of investment to be used in the computation is the initial (or original) investment. The net income is as follows: Cash savings P5,000

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- Depreciation expense (P20,000/10 yrs.) Net income

191

2,000 P3,000

There is no income tax, so the income before income tax is the same as the net income. The ARR is 15% (i.e., P3,000/P20,000). Questions 140 through 143 are based on the following information. In order to increase production capacity, Rovic Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 2007. The following information is being considered by Gunning Industries: The new machine would be purchased for P160,000 in cash. Shipping and installation would cost an additional P30,000. The new machine is expected to increase annual sales by 20,000 units at a sales price of P40 per unit. Incremental operating costs include P30 per unit in variable cost and total fixed costs of P40,000 per year. The investments in the new machine will require an immediate increase in working capital of P35,000. This cash outflow will be recovered at the end of year 5. Rovic uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value. Rovic is subject to a 40% corporate income tax rate. Rovic uses the net present value method to analyze investments and will employ the following factors and rates: Present Value of an Ordinary Period Present Value of P1 at 10% Annuity of P1 at 10% 1 .909 .909 2 .826 1.736 3 .751 2.487 4 .683 3.170 5 .621 3.791 140.Rovic Industries’ net cash outflow in a capital budgeting decision is P190,000 C. P204,525 P195,000 D. P225.000

(cma)

140.D ? The net cash outflows.  The net cash outflows (or net cost of investment) is composed of the purchase price, other incidental costs to prepare the assets for use, cash inflows from the disposal of old asset, opportunity costs, and effects of taxes. On the data given, the cost of investment is as follows: Purchase price P160,000 Shipping and installation 30,000 Additional working capital 35,000 Cost of the investment P225,000 141.Rovic Industries’ discounted annual depreciation tax shield for the year 2005 is

Chapter 14 P13,817 P16,762

Capital Budgeting C. P20,725 D. P22,800

192

(cma)

141.A ? The discounted annual depreciation tax shield for the year 2007.  The depreciation tax shield refers to tax savings derived from recording depreciation expense. The depreciation tax shield in 2005 is P15,200 [i.e., (P190,000/5 yrs.) x 40%]. And the discounted depreciation tax shield in 2004 is P13,817 (i.e., P15,200 x 0.909). 142.The acquisition of new production machine by Rovic Industries will contribute a discounted net-tax contribution margin of P242,624 C. P363,936 P303,280 D. P454,920 (cma) 142.D ? The discounted net-tax contribution margin.  The unit contribution margin is P10 (i.e., P40 – P30), and the increase in contribution margin from the new machine is P200,000 (i.e., 20,000 units x P10). The after-tax contribution margin is P120,000 (i.e., P200,000 x 60%). The after-tax contribution margin is to be discounted at 10% in 5 years. Finally, the discounted after-tax effect of contribution margin is P454,920 (i.e., P120,000 x 3.791). 143.The overall discounted cash flow impact of Rovic Industry’s working capital investments for the new production machine would be P( 7,959) C. P(13,265) P(10,080) D. P(35,000) (cma) 143.C ? The overall discounted cash flow impact of working capital investments.  The working capital is an outflow at the date of investment and an inflow at the end of the investment life. The net discounted cash flow impact of the working capital flows are: Working capital investment P(35,000) Recovery of working capital (P35,000 x 0.621) 21,735 Net discounted working capital cash flow P(13,265) Questions 144 through 146 are based on the following information. A company that annually reviews its investment opportunities and selects appropriate capital expenditures for the coming year is presented with two projects, called Project A and Project B. Best estimates indicate that the investment outlay for Project A is P30,000 and for Project B is P1 million. The projects are considered to be equally risky. Project A is expected to generate cash inflows of P40,000 at the end of the first 2 years. Project B is expected to generate cash inflows of P700,000 at the end of the first year and P500,000 at the end of the second year. The company has a cost of capital of 8%.

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144. What is the net present value (NPV) of each project when the cost of capital is zero? Project A Project B A. P 30,000 P1,000,000 B. P 50,000 P 200,000 C. P 80,000 P1,200,000 D. P110,000 P2,200,000 (cia) 144.B ? The net present value (NPV) of each project when the cost of capital is zero.  If the cost of capital is zero, the cash flows are expressed on their nominal values, as follows: Project A Project B Cash inflows (P40,000 x 2) P80,000 (P700,000 + P500,000) P1,200,000 - Cost of investment 30,000 1,000,000 Net present value P50,000 P 200,000 The cash inflows are not discounted because the discount rate is zero. 145.The internal rate of return of Project A, to the nearest full percentage point, is 10% C. 25% 15% D. 100% (cia) 145.D ? The internal rate of return (IRR) of project A.  Internal rate of return isf the rate where the net present value is zero. If: IRR ACI COI PVFA NPV

= = = = =

internal rate of return annual cash inflows cost of investment present value of cash inflows net present value

NPV = Σ {[ACI / (1 + IRR)2] - COI} Since NPV = 0, then: 0 = P40,000 / (1 + IRR)1 + P40,000 / (1+ IRR)2 - P30,000 IRR = 100% IRR is when the PVCI = COI: PVCI 40,000 (PVFA) PVFA = 30,000 / 40,000

= COI = 30,000 = 0.75

Questions 146 through 149 are based on the following information. An organization has four investments proposals with the following costs and expected cash inflows: Expected cash Inflows End of End of End of Project Cost Year 1 Year 2 Year 3 A Unknown P10,000 P10,000 P10,000 B P20,000 P 5,000 P10,000 P15,000

Chapter 14 C D

Capital Budgeting P25,000 P30,000

P15,000 P20,000

P10,000 Unknown

194

P 5,000 P20,000

Additional Information

Discount Rate 5% 5% 5% 10% 10% 10% 15% 15% 15%

Present value Present Value of an Annuity Of P1 Due at of P1 per Number of the End of in Periods for n Periods Periods (PVIF) Periods (PVIFA) 1 0.9524 0.9524 2 0.9070 1.8594 3 0.8638 2.7232 1 0.9091 0.9091 2 0.8264 1.7355 3 0.7513 2.4869 1 0.8696 0.8696 2 0.7561 1.6257 3 0.6575 2.2832

146.If Project A has an internal rate of return (IRR) of 15%, it has a cost of P 8,696 C. P24,869 P22,832 D. P27,232 (cia) 146.B ? The project A’s cost if its IRR is 15%.  At IRR, the cost of investment is equal to the present value of cash inflows, determined as follows: Present value of cash inflows (P10,000 x 2.2832) = P22,832 147.If the discount rate is 10%, the net present value (NPV) of Project B is P 4,079 C. P 9,869 P 6,789 D. P39,204 (cia) 147.A ? The NPV of project B using a 10% discount rate.  The NPV is the difference between present value of cash inflows and cost of investment, as follows: PV of cash inflows: Year 1 (P 5,000 x 0.9091) P 4,545.50 Year 2 (P10,000 x 0.8264) 8,264.00 Year 3 (P15,000 x 0.7513) 11,269.50 P24,079 - Cost of investment 20,000 Net present value P 4,079 148.The payback period of Project C is 0 year. C. 2 years.

Chapter 14 1 year.

Capital Budgeting D. 3 years.

195 (cia)

148.C ? The payback period of project C.  Payback period is the point in time where cumulative cash inflows equal the cost of investment. It is the expected period of time before recovery of the cost of investment. For project C, the payback period is 2 years, as follows: Year ACI Cash to date 1 P15,000 P15,000 2 10,000 25,000 = Payback 149.If the discount rate is 5% and the discounted payback period of Project D is exactly 2 years, then the year 2 cash inflow for Project D is P 5,890 C. P12,075 P10,000 D. P14,301 (cia) 149.C ? The year 2 cash inflow for project D if the discounted payback period is exactly 2 years at a discount rate of 5%.  The cost of project D is P30,000. The total of the discounted cash inflows should also be P30,000. Therefore, the net cash inflow in year 2 is: Present value of all cash inflows Present value of cash inflows – year 1 (P20,000 x 0.9524) Present value of cash inflows – year 2

P30,000 ( 19,048) P10,952

Net cash inflows – 2nd year (P10,952/0.9070)

P12,075

Questions 150 through 152 are based on the following information. Capital Investment Inc. uses a 12% hurdle rate for all capital expenditures and has done the following analysis for four project for the upcoming year: Project 1 Project 2 Project 3 Project 4 Initial capital outlay P200,000 P298,000 P248,000 P272,000 Annual net cash inflows Year 1 P 65,000 P100,000 P 80,000 P 95,000 Year 2 70,000 135,000 95,000 125,000 Year 3 80,000 90,000 90,000 90,000 Year 4 40,000 65,000 80,000 60,000 Net present Value ( 3,798) 4,276 14,064 14,662 Profitability index 98% 101% 106% 105% Internal rate of return 11% 13% 14% 15% 150.Which project (s) should Capital Investment Inc. undertake during the upcoming year assuming it has no budget restrictions? All of the projects. C. Projects 2, 3 and 4. Project 1,2, and 3. D. Projects 1, 3 and 4. (cma) 150.C

Chapter 14 ? 

Capital Budgeting

196

The project(s) to be undertaken assuming no budget restrictions. If there is no budget limitation, all projects having positive net present value should be undertaken. The projects with positive net present values are 2, 3, and 4.

151.Which project (s) should Capital Investment Inc. undertake during the upcoming year if it has only P600,000 of funds available? Projects 1 and 3. C. Projects 2 and 3. Projects 2, 3 and 4. D. Projects 3 and 4. (cma) 151.D ? The project(s) to be undertaken if only P600,000 of funds are available.  With the presence of limited funds, the profitability index should be harnessed to rank project priorities, that is, the higher the profitability index, the more prioritized the project is. The priority rank of the projects shall be project 3 (e.g., 106%), project 4 (e.g., 105%), and project 2 (e.g., 101%). Projects 3 and 4 need a total investment of P520,000 (i.e., P248,000 + P272,000). The remaining available investment fund of P80,000 (P600,000 – P520,000) are not enough to finance project 3 investments. Therefore, the limited funds shall be used to finance projects 3 and 4. 152.Which projects (s) should Capital Investment Inc. undertake during the upcoming year if it has only P300,000 of capital funds available Project 1. C. Projects 3 and 4. Project 2,3, and 4. D. Project 3. (cma) 152.D ? The project(s) to be undertaken if only P300,000 of funds are available.  If there are only P300,000 funds available, only project 3 would be financed. Questions 156 through 158 are based on the following information. A company purchased a new machine to stamp the company logo on its products. The cost of the machine was P250,000, and it has an estimated useful life of 5 years with an expected salvage value at the end of its useful life of P50,000. The company uses the straight-line depreciation method. The machine is expected to save P125,000 annually in operating costs. The company’s tax rate is 40%, and it uses a 10% discount rate to evaluate capital expenditures. Present Value of an Year Present value of P1 Ordinary Annuity of P1 1 .909 .909 2 .826 1.735 3 .751 2.486 4 .683 3.169 5 .621 3.790 153.What is the traditional payback period for the new stamping machine? 2.00 years. C. 2.75 years.

Chapter 14 2.63 years.

Capital Budgeting D. 2.94 years.

197 (cia)

153.C ? The traditional payback period for the new stamping machine.  Payback period is determined by dividing cost of investment over annual cash inflows. The annual cash inflows and payback period are calculated as follows: Cash savings before depreciation expense P125,000 - Depreciation expense (P200,000/5 yrs.) 40,000 Income before income tax 85,000 - Income tax (40%) 34,000 Net income 51,000 + Depreciation expense 40,000 Annual cash inflows P 91,000 Payback period (P250,000/P91,000) 2.75 years 154.What is the accounting rate of return based on the average investment in the new stamping machine? 20.4% C. 40.8% 34.0% D. 51.0% (cia) 154.B ? The accounting rate of return (ARR) based on average investment.  Accounting rate of return on average investment is net income divided by average investment. The amount of average investment is original cost plus salvage value, divided by 2. The average investment is measured over the entire life of the asset. The ARR is computed as follows: Net income P 51,000 / Average investment [(P250,000 + P50,000) / 2] 150,000 Accounting rate of return 34% 155.What is the net present value (NPV) of the new stamping machine? P125,940 C. P250,000 P200,000 D. P375,940 (cia) 155.A ? The net present value (NPV) of the new stamping machine.  The NPV is the difference in present value of cash inflows and the cost of investment, as follows: Present value of cash inflows: Regular cash inflows (P91,000 x 3.790) P344,890 Salvage value (P50,000 x 0.621) 31,050 P375,940 - Cost of investment 250,000 Net present value P125,940 Questions 156 through 158 are based on the following information. At the beginning of 2006, Garrison Corporation is considering the replacement of an old machine that is currently being used. The old machine is fully depreciated but can be used by the corporation for an additional 5 years, that is, through 2010. If Garrison decides to

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replace the old machine, Picco Company has offered to purchase it for P60,000 on the replacement date. The old machine would have no salvage value in 2010. If the replacement occurs, a new machine will be acquired from Hillcrest Industries on January 2, 2006. The purchase price of P1 million for the new machine will be paid in cash at the time of replacement. Because of the increased efficiency of the new machine, estimated annual cash savings of P300,000 will be generated through 2010, the end of its expected useful life. The new machine is not expected to have any salvage value at the end of 2010. All operating cash receipts, operating cash expenditures, and applicable tax payments and credits are assumed to occur at the end of the year. Garrison employs the calendar year for reporting purposes. Discount tables for several different interest rates that are to be used in any discounting calculations are given below. Present value of P1.00 Received at End of Period Periods 9% 12% 15% 18% 21% 1 .92 .89 .87 .85 .83 2 .84 .80 .76 .72 .68 3 .77 .71 .65 .61 .56 4 .71 .64 .57 .51 .47 5 .65 .57 .50 .44 .39

Periods 1 2 3 4 5

Present Value of an Annuity of P1.00 Received at the End of Each Period 9% 12% 15% 18% 21% .92 .89 .87 .85 .83 1.76 1.69 1.63 1.57 1.51 2.53 2.40 2.28 2.18 2.07 3.24 3.04 2.85 2.69 2.54 3.89 3.61 3.35 3.13 2.93

For Questions 159 through 161 only, assume that Garrison is not subject to income taxes. 156.If Garrison requires investments to earn a 12% return, the NPV for replacing the old machine with the new machine is P171,000 C. P143,000 P136,400 D. P 83,000 (cma) 156.C ? The NPV for replacing the old machine.  The estimated annual savings of P300,000 is the same amount of net cash inflows because the tax effects are not considered. The cost of the new machine is P940,000, ascertained as follows: Purchase price P1,000,000 Proceeds from sale of old asset ( 60,000) Net cost of investment P 940,000 The NPV is determined as follows: Present value of cash inflows (P300,000 x 3.61) P1,083,000 - Cost of investment 940,000

Chapter 14 Net present value

Capital Budgeting

199 P 143,000

157.The IRR, to the nearest percent, to replace the old machine is 9% C. 17% 15% D. 18%

(cma)

157.D ? The internal rate of return (IRR).  Internal rate of return is the discount rate where the present value of cash inflows equals the cost of investment. Or, where the net present value is zero. To compute the IRR, the present value factor of annuity (PVFA) should be determined as follows: PVFA = P940,000/P300,000 = 3.13 Locating in the PVFA table, at 5 years, the 3.13 is found exactly under the column of 18%. Therefore, the IRR is 18%. 158.The payback period to replace the old machine with the new machine is 1.14 years. C. 3.13 years. 2.78 years. D. 3.33 years. (cma) 158.C ? The payback period.  The payback period is the amount of time spent before the cost of investment is recouped. The payback period is 3.13 years (i.e., P940,000/P300,000). Questions 159 through 162 are based on the following additional information. The assumptions are Garrison requires all investments to earn a 12% after-tax of return to be accepted. Garrison is subject to a marginal income tax rate of 40% on all income and gains (losses). The new machine will have depreciation as follows: Year Depreciation 2004 P 250,000 2005 380,000 2006 370,000 P1,000,000 159.The present value of the depreciation tax shield for 2007 is P182,400 C. P109,440 P121,600 D. P114,304

(cma)

159.B ? The present value of the depreciation tax shield in 2007.  Depreciation tax shield (or saving) is the tax benefit derived from recording depreciation expense. This is computed by multiplying depreciation expense to the marginal tax rate. The discounted depreciation tax savings should be multiplied by

Chapter 14

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200

the present value factor at 12%. The discounted depreciation tax shield in 2007 is determined as follows: Discounted depreciation tax shield (2007)

= P380,000 x 40% x .80 = P121,600

Questions 160 through 162 are based on the information used in question 159. 160.The present value of the after-tax cash flow associated with the salvage of the old machine is P38,640 C. P32,040 P36,000 D. P27,960 (cma) 160.A ? The present value of the after-tax cash flow associated with the salvage value of the old machine.  The salvage value of the old machine has the following present value cash effects: Proceeds from sale of old machine P60,000 Present value of the tax paid for gain on sale of old machine (P60,000 x 40% x 0.89) (21,360) Present value of the after-tax cash flow of salvage value P38,640 161.The present value of the after-tax cash flow savings that arise from the increased efficiency of the new machine throughout its life (calculated before consideration of any depreciation tax shield) is P563,400 C. P433,200 P375,600 D. P649,800 (cma) 161.D ? The present value of the after-tax savings that arise from the increased efficiency of the new machine without consideration of the depreciation tax shield.  The after-tax cash savings without consideration of the depreciation expense is P180,000 (i.e., P300,000 x 60%). The present value of the after-tax cash savings is P649,800 (i.e., P180,000 x 3.61). 162.If the new machine is expected to be sold for P80,000 on December 31, 2010, the present value of the additional after-tax cash flow is P18,240 C. P45,600 P27,360 D. P48,000 (cma) 162.B ? The present value of the additional cash after-tax cash flow if the new machine is expected to be sold for P80,000 on December 31, 2010.  The present value of the additional after-tax cash flows from the sale of the new machine at the end of its life is: Present value of the proceeds from sale (P80,000 x 0.57) P45,600 Present value of the tax paid for gain on sale of old asset (P80,000 x 40% x 0.57) ( 18,240)

Chapter 14

Capital Budgeting

Net present value of the after-tax salvage value

201 P27,360

Questions 163 to 166 are based on the following information: The Apex Company is evaluating a capital budgeting proposal for the current year. The relevant data follow: Present value of an Annuity of P1 Year in Arrears at 15% 1 P0.870 2 1.626 3 2.284 4 2.856 5 3.353 6 3.785 The initial equipment investment would be P30,000. Apex would depreciate the equipment for tax purposes on a straight-line basis over six years with a zero terminal disposal price. The before-tax annual cash inflow arising from this investment is P10,000. The income tax rate is 40%, and income tax is paid the same year as incurred. The after-tax required rate of return is 15%. 163.What is the after-tax accrual accounting rate of return on Apex’s initial equipment investment? A. 10 % C. 26 2/3% 16 2/3 % D. 33 1/3 % 163.A ? The after-tax accrual accounting rate of return (ARR) of initial investment.  ARR is net income divided by the amount of investment. The net income is determined as follows: Cash flows before tax P10,000 - Depreciation expense (P30,000/6 yrs.) 5,000 Income before tax P 5,000 - Tax (40%) 2,000 Net income P 3,000 The ARR on original investment is 10% (i.e., P3,000 / P30,000). 164.What is the after-tax payback period (in years) for Apex’s capital budgeting proposal? A. 5 C. 3 3.75 D. 2 164.B ? The after-tax payback period for capital budgeting purposes.  Payback period is not cost of investment over annual cash flows. In this problem, the annual cash inflows is P8,000 (i.e., P3,000 net income + P5,000 depreciation expense. The payback period is 3.75 years (i.e., P30,000 / P8,000).

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165.What is the net present value of Apex’s capital budgeting proposal? A. P(7,290) C. P 7,850 B. P 280 D. P11,760 165.B ? The net present value (NPV) for capital budgeting purposes.  Net present value is the difference of present value of cash inflows (PVCI) and cost of investment, as follows: PVCI (P8,000 x 3.785) P30,280 - Cost of investment 30,000 Net present value P 280 166.How much would Apex have had to invest five years ago at 15% compounded annually to have P30,000 now? A. P12,960 C. P17,160 P14,910 D. P17,500 166.B ? The amount of investment today to have a value equal to P30,000 after five years at 15% rate of return.  The amount of investment today to earn a future amount of money shall be: FV = PC x FVF PC = FV / FVF where: FV = future value PC = P30,000 / 2.011 FVF = future value factor PC = P14.918 PC = present cash

 done 