Review Materials on Capital Budgeting

Review Materials – Management Services Capital Budgeting Capital budgeting (or investment appraisal) is the planning process used to determine whether an organisation's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.  Capital Budgeting is a project selection exercise performed by the business enterprise.  Capital budgeting uses the concept of present value to select the projects.  Capital budgeting uses tools such as pay back period, net present value, accounting rate of return, internal rate of return, profitability index to select projects. Payback Period Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use "stipulated payback period", which acts as a standard for screening the project. A. Computation Of Payback Period  When the cash inflows are uniform the formula for payback period is cash outflow divided by annual cash inflow  When the cash inflows are uneven, the cumulative cash inflows are to be arrived at and then the payback period has to be calculated through interpolation. Here payback period is the time when  

cumulative cash inflows are equal to the outflows. The payback period is stated in terms of years. This can be stated in terms of percentage also. This is the payback reciprocal rate. Reciprocal of payback period = [1/payback period] x 100

B. Decision Rules  Select the projects which have payback periods lower than or equivalent to the stipulated payback period.  Arrange these selected projects in increasing order of their respective payback periods.  Select those projects from the top of the list till the capital budget is exhausted.  In the case of two mutually exclusive projects, the one with a lower payback period is accepted, when the respective payback periods are less than or equivalent to the stipulated payback period. Accounting Rate Of Return Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision. Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows. A. Computation Of Accounting Rate Of Return  The accounting rate of return using total investment; or  Sometimes average rate of return is calculated by using the following formula: Net profit after tax Average investment B. Decision Rules • Select the projects whose rates of return are higher than the cut-off rate • Arrange them in the declining order of their rate of return and • Select projects starting from the top of the list till the capital available is exhausted. Net Present Value (Npv) Net present value of an investment/project is the difference between present value of cash inflows and cash outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost of capital. A. Decision Rules • "Capital Rationing" situation  Select projects whose NPV is positive or equivalent to zero.  Arrange in the descending order of NPVs.  Select Projects starting from the list till the capital budget allows. • "No capital Rationing" Situation  Select every project whose NPV >= 0 • Mutually Exclusive Projects Page 1 of 7

 Select the one with a higher NPV. Internal Rate Of Return (Irr) The Internal Rate of Return is also known as the yield method. The IRR of a project/investment is defined as the rate of discount at which the present value of cash inflows and present value of cash outflows are equal. IRR can be restated as the rate of discount, at which the present value of cash flow (inflows and outflows) associated with a project equal zero. A. Decision Rules  "Capital Rationing" Situation  Select those projects whose IRR (r) = k, where k is the cost of capital.  Arrange all the projects in the descending order of their Internal Rate of Return.  Select projects from the top till the capital budget allows.  "No Capital Rationing" Situation  Accept every project whose IRR (r) = k, where k is the cost of capital.  Mutually Exclusive Projects Return  Select the one with higher IRR. Profitability Index (Pi) Profitability ratio is otherwise referred to as Benefit/Cost ratio. This is an extension of the Net Present Value Method. This is a relative valuation index and hence is comparable across different types of projects requiring different quantum of initial investments. Profitability index (PI) is the ratio of present value of cash inflows to the present value of cash outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost of capital. A. Computation Of Profitability Index (Pi)  Profitability index is always expressed on net basis.  Formula for Profitability Index is Present value of cash inflows Present value of cash outflows B. Decision Rule  "Capital Rationing" Situation  Select all projects whose profitability index is greater than or equivalent to 1.  Rank them in the descending order of their profitability indices.  Select projects starting from the top of the list till the capital budget  "No Capital Rationing" Situation  Select every project whose PI >= 1.  Mutually Exclusive Projects  Select the project with higher PI.

MULTIPLE CHOICE (THEORIES & PROBLEMS) 1. Capital budgeting techniques are least likely to be used in evaluating the A. Acquisition of new aircraft by a cargo company. B. Design and implementation of a major advertising program. C. Trade for a star quarterback by a football team. D. Adoption of a new method of allocating non-traceable costs to product lines. 2. Mahlin Movers, Inc. is planning to purchase equipment to make its operations more efficient. This equipment has an estimated useful life of six years. As part of this acquisition, a P150,000 investment in working capital is required. In a discounted cash flow analysis, this investment in working capital should be A. Amortized over the useful life of the equipment. B. Disregarded because no cash is involved. C. Treated as a recurring annual cash flow that is recovered at the end of six years. D. Treated as an immediate cash outflow that is recovered at the end of six years. 3. To approximate annual cash inflow, depreciation is A. Added back to net income because it is an inflow of cash. B. Subtracted from net income because it is an outflow of cash. C. Subtracted from net income because it is an expense. D. Added back to net income because it is not an outflow of cash. 4. An optimal capital budget is determined by the point where the marginal cost of capital is A. Minimized. B. Equal to the average cost of capital. Page 2 of 7

C. Equal to the rate of return on total assets. D. Equal to the marginal rate of return on investment. 5. In capital budgeting decisions, the following items are considered among others: 1. Cash outflow for the investment. 2. Increase in working capital requirements. 3. Profit on sale of old asset 4. Loss on write-off of old asset. For which of the above items would taxes be relevant? A. Items 1 and 3 only. C. All items. B. Items 3 and 4 only. D. Items 1, 3 and 4 only. 6. The following statements refer to the accounting rate of return (ARR) 1. The ARR is based on the accrual basis, not cash basis. 2. The ARR does not consider the time value of money. 3. The profitability of the project is considered. From the above statements, which are considered limitations of the ARR concept? A. Statements 2 and 3 only. C. All the 3 statements. B. Statements 3 and 1 only. D. Statements 1 and 2 only. 7. The payback method assumes that all cash inflows are reinvested to yield a return equal to A. the discount rate. C. the internal rate of return. B. the hurdle rate. D. zero. 8. As a capital budgeting technique, the payback period considers depreciation expenses (DE) and time value of money (TVM) as follows: A. B. C. D. DE relevant irrelevant Irrelevant relevant TVM relevant irrelevant Relevant irrelevant 9. The bailout payback period is A. The payback period used by firms with government insured loans. B. The length of time for payback using cash flows plus the salvage value to recover the original investment C. (a) and (b) D. None of the above. 10. Which of the following methods measures the cash flows and outflows of a project as if they occurred at a single point in time? A. Cash flow based payback period. C. Payback method. B. Capital budgeting. D. Discounted cash flow. 11. The excess present value method is anchored on the theory that the future returns, expressed in terms of present value, must at least be A. Equal to the amount of investment C. More than the amount of investment B. Less than the amount of investment D. Cannot be determined 12. All of the following refer to the discount rate used by a firm in capital budgeting except A. Hurdle rate. C. Opportunity cost. B. Required rate of return. D. Opportunity cost of capital. 13. If a firm identifies (or creates) an investment opportunity with a present value its cost, the value of the firm and the price of its common stock will A. B. C. D. List A Greater than Greater than Equal to Equal to List B Increase Decrease Increase Decrease 14. 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 A. Computes a desired rate of return for capital projects. B. Can be used when there is no constant rate of return required for each year of the project. C. Uses a discount rate that equates the discounted cash inflows with the outflows. D. Uses discounted cash flows whereas the internal rate of return model does not. 15. When using the net present value method for capital budgeting analysis, the required rate of return is called all of the following except the A. Risk-free rate. B. Cost of capital. C. Discount rate. D. Cutoff rate. 16. A project’s net present value, ignoring income tax considerations, is normally affected by the A. Proceeds from the sale of the asset to be replaced. B. Carrying amount of the asset to be replaced by the project. C. Amount of annual depreciation on the asset to be replaced. D. Amount of annual depreciation on fixed assets used directly on the project. 17. How are the following used in the calculation of the internal rate of return of a proposed project? Ignore income tax considerations. A. B. C. D. Residual sales value of project Exclude Include Exclude Include Page 3 of 7

Depreciation expense

Include

Include

Exclude

Exclude

18. Which of the following characteristics represent an advantage of the internal rate of return techniques over the accounting rate of return technique in evaluating a project? I Recognition of the project’s salvage value. II Emphasis on cash flows. III Recognition of the time value of money. A. I only. B. I and II. C. II and III. D. I, II, and III. 19. Polo Co. requires higher rates of return for projects with a life span greater than 5 years. 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? A. B. C. D. Internal Rate of Return Yes No No Yes Net Present Value No Yes No Yes 20. Which of the following combinations is NOT possible? Profitability Index NPV IRR A. Greater than 1 Positive More than cost of capital B. Equals 1 Zero Equals cost of capital C. Less than 1 Negative Less than cost of capital D. Less than 1 Positive Less than cost of capital 21. Hatchet Company is considering replacing a machine with a book value of $400,000, a remaining useful life of 5 years, and annual straight-line depreciation of $80,000. The existing machine has a current market value of $400,000. The replacement machine would cost $550,000, have a 5-year life, and save $75,000 per year in cash operating costs. If the replacement machine would be depreciated using the straight-line method and the tax rate is 40%, what would be the net investment required to replace the existing machine? A. $90,000. B. $150,000 C. $330,000 D. $550,000 22. Key Corp. plans to replace a production machine that was acquired several years ago. Acquisition cost is P450,000 with salvage value of P50,000. The machine being considered is worth P800,000 and the supplier is willing to accept the old machine at a trade-in value of P60,000. Should the company decide not to acquire the new machine, it needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in transaction will not have any implication but the cost to repair is tax-deductible. The effective corporate tax rate is 35% of net income subject to tax. For purposes of capital budgeting, the net investment in the new machine is A. P540,000 B. P610,000 C. P660,000 D. P800,000 23. Hooker Oak Furniture Company is considering the purchase of wood cutting equipment. Data on the equipment are as follows: Original investment $30,000 Net annual cash inflow $12,000 Expected economic life in years 5 Salvage value at the end of five years $3,000 The company uses the straight-line method of depreciation with no mid-year convention. What is the accounting rate of return on original investment rounded off to the nearest percent, assuming no taxes are paid? A. 40.0% B. 20.0% C. 24.0% D. 22.0% 24. Maxwell Company has an opportunity to acquire a new machine to replace one of its present machines. The new machine would cost $90,000, have a 5-year life, and no estimated salvage value. Variable operating costs would be $100,000 per year. The present machine has a book value of $50,000 and a remaining life of 5 years. Its disposal value now is $5,000, but it would be zero after 5 years. Variable operating costs would be $125,000 per year. Ignore income taxes. Considering the 5 years in total, what would be the difference in profit before income taxes by acquiring the new machine as opposed to retaining the present one? A. $10,000 decrease B. $15,000 decrease C. $35,000 increase D. $40,000 increase 25. Lyben Inc. is planning to produce a new product. To do this, it is necessary to acquire a new equipment that will cost the company P100,000. The estimated life of the new equipment is five years with no salvage value. The estimated income and costs based on expected sales of P10,000 units per year are: Sales @ P10.00 per unit P100,000 Costs @ P8.00 per unit 80,000 Net income P 20,000 The accounting rate of return based on initial investment is 20% What will be the accounting rate of return based on initial investment of P100,000 if management decrease its selling price of the new product by 10%? A. 5% B. 10% C. 15% D. 20% 26. MLF Corporation is evaluating the purchase of a 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 Page 4 of 7

A. 3.45%

B. 2.04%

C. 13.8%

D. 15.48%

27. Sweets, Etc., Inc. plans to undertake a capital expenditure requiring P2 million cash outlay. Below are the projected after-tax cash inflow for the five year period covering the useful life. The company’s tax rate is 35%. Year 1 2 3 4 5 P’000 600 700 480 400 400 The founder and president of the candy company believes that the best gauge for capital expenditure 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? A. No, since the payback period is 4 years or 80% of the useful life of the project. B. Yes, since the payback period is 3.55 years or 71% of the useful life of the project. C. No, since the payback period extends beyond the life of the project. D. Yes, since the payback period is 4 years and still shorter than the useful life of the project. 28. APJ, Inc. is planning to purchase a new machine that will take six years to recover the cost. The new machine is expected to produce cash flow from operations, net of income taxes, of P4,500 a year for the first three years of the payback period and P3,500 a year of the last three years of the payback period. Depreciation of P3,000 a year shall be charged to income of the six years of the payback period. How much shall the machine cost? A. P12,000 B. P18,000 C. P24,000 D. P36,000 29. Womark Company purchased a new machine on January 1 of this year for $90,000, with an estimated useful life of 5 years and a salvage value of $10,000. The machine will be depreciated using the straight-line method. The machine is expected to produce cash flow from operations, net of income taxes, of $36,000 a year in each of the next 5 years. The new machine’s salvage value is $20,000 in years 1 and 2, and $15,0000 in years 3 and 4. What will be the bailout period (rounded) for the new machine? A. 1.4 years. B. 2.2 years. C. 1.9 years. D. 3.4 years. 30. It is the start of the year and St. Tropez Co. plans to replace its old sing-along equipment. These information are available: Old New Equipment cost P70,000 P120,000 Current salvage value 10,000 Salvage value, end of useful life 2,000 16,000 Annual operating costs 56,000 38,000 Accumulated depreciation 55,300 Estimated useful life 10 years 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? A. (P54,000) B. (P110,000) C. (P120,000) D. (P124,700) 31. Cramden Armored Car Co. is considering the acquisition of a new armored truck. The truck is expected to cost $300,000. The company's discount rate is 12 percent. The firm has determined that the truck generates a positive net present value of $17,022. However, the firm is uncertain as to whether it has determined a reasonable estimate of the salvage value of the truck. In computing the net present value, the company assumed that the truck would be salvaged at the end of the fifth year for $60,000. What expected salvage value for the truck would cause the investment to generate a net present value of $0? Ignore taxes. A. $30,000 B. $0 C. $55,278 D. $42,978 32. The McNally Co. is considering an investment in a project that generates a profitability index of 1.3. The present value of the cash inflows on the project is $44,000. What is the net present value of this project? A. $10,154 B. $13,200 C. $57,200 D. $33,846 33. The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $50,000. The machine is expected to have zero value at the end of the four-year period. What is the net present value of the investment? Would the company want to purchase the new machine? Income taxes are not considered. A. $119,550; yes B. $69,550; no C. $1,019,550; yes D. $326,750; no 34. Drillers Inc. is evaluating a project to produce a high-tech deep-sea oil exploration device. The investment required is $80 million for a plant with a capacity of 15,000 units a year for 5 years. The device will be sold for a price of $12,000 per unit. Sales are expected to be 12,000 units per year. The variable cost is $7,000 and fixed costs, excluding depreciation, are $25 million per year. Assume Drillers employs straight-line depreciation on all depreciable assets, and assume that they are taxed at a rate of 36%. If the required rate of return is 12%, what is the approximate NPV of the project? A. $17,225,000 B. $21,511,000 C. $26,780,000 D. $56,117,000 35. Smoot Automotive has implemented a new project that has an initial cost, and then generates inflows of $10,000 a year for the next seven (7) years. The project has a payback period of 4.0 years. What is the project's internal rate of return (IRR)? Page 5 of 7

A. 14.79%

B. 16.33%

C. 18.54%

D. 15.61%

36. JJ Corp. is considering the purchase of a new machine that will cost P320,000. It has an estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated 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? Year Present Value of P1 Present Value of an Ordinary Annuity of P1 1 0.862 0.862 2 0.743 1.605 3 0.641 2.246 A. Yes, due to NPV of P6,556. C. Yes, due to NPV of P61,820. B. Yes, due to NPV of P11,684. D. No, due to negative NPV of P1,136 37. A company's marginal cost of new capital (MCC) is 10% up to $600,000. MCC increases .5% for the next $400,000 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 $100,000 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? A. $0 B. $1,050,000 C. $1,500,000 D. $1,600,000 38. The following forecasts have been prepared for a new investment by Oxford Industries of $20 million with an 8-year life: Pessimistic Expected Optimistic Market size 60,000 90,000 140,000 Market share, % 25 30 35 Unit price $750 $800 $875 Unit variable cost $500 $400 $350 Fixed cost, millions $7 $4 $3.5 Assume that Oxford employs straight-line depreciation, and that they are taxed at 35%. Assuming an opportunity cost of capital of 14%, what is the NPV of this project, based on expected outcomes? A. $2,626,415 B. $4,563,505 C. $6,722,109 D. $8,055,722 39. Payback Company is considering the purchase of a copier machine for P42,825. The copier machine will be expected to be economically productive for 4 years. The salvage value at the end of 4 years is negligible. The machine is expected to provide 15% internal rate of return. The company is subject to 40% income tax rate. The present value of an ordinary annuity of 1 for 4 periods is 2.85498. In order to realize the IRR of 15%, how much is the estimated before-tax cash inflow to be provided by the machine? A. P17,860 B. P15,000 C. P25,000 D. P35,700 40. Berry Products is considering two pieces of machinery. The first machine costs P50,000 more than the second machine. During the two-year life of these two alternatives, the first machine has P155,000 more cash flow in year one and a P110,000 less cash flow in year two than the second machine. All cash flows occur at year-end. The present value of 1 at 15% end of 1 period and 2 periods are 0.86957 and 0.75614, respectively. The present value of 1 at 8% end of period 1 is 0.92593 and period 2 is 0.85734. At what discount rate would Machine 1 equally acceptable as machine 2? A. 9% B. 10% C. 11% D. 12% 41. The Zeron Corporation recently purchased a new machine for its factory operations at a cost of $921,250. The investment is expected to generate $250,000 in annual cash flows for a period of six years. The required rate of return is 14%. The old machine has a remaining life of six years. The new machine is expected to have zero value at the end of the six-year period. The disposal value of the old machine at the time of replacement is zero. What is the internal rate of return? A. 15% B. 16% C. 17% D. 18% 42. Five mutually exclusive projects had the following information: A B C D NPV $500 $(200) $200 $1,000 IRR 12% 8% 13% 10% Which project is preferred? A. A C. C B. B D. D Page 6 of 7

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