CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila
MANAGEMENT ADVISORY SERVICES
CAPITAL BUDGETING

THEORY

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. The “inflation element” refers to the

A. Impact that future price increases will have on the original cost of a capital expenditure.

B. Fact that the real purchasing power of a monetary unit usually increases over time.

C. Future deterioration of the general purchasing power of the monetary unit.

D. Future increases in the general purchasing power of the monetary unit.

3. 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.

4. 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.

5. In capital expenditures decisions, the following are relevant in estimating operating costs except

A. Future costs. B. Cash costs. C. Differential costs. D. Historical costs.

6. Which of the following best identifies the reason for using probabilities in capital budgeting is

A. Different life of projects. C. Uncertainty.

B. Cost of capital. D. Time value of money.

ANWERS:

1. D.

2. C.

3. D.

4. D.

5. D.

6. C.
PROBLEMS

1. Acme is considering the sale of a machine with a book value of $80,000 and 3 years
remaining in its useful life. Straight-line depreciation of $25,000 annually is available. The machine has
a current market value of $100,000. What is the cash flow from selling the machine if the tax rate 40%.

A. $25,000 B. $80,000 C. $92,000 D. $100,000

2. 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

3. Diliman Republic Publishers, Inc. is considering replacing an old press that cost P800, 000 six years ago
with a new one that would cost P2,250,000. Shipping and installation would cost an additional P200,000
. The old press has a book value of P150,000 and could be sold currently for P50,000. The increased
production of the new press would increase inventories by P40,000, accounts receivable by P160,000
and accounts payable by P140,000. Diliman Republic’s net initial investment for analyzing the
acquisition of the new press assuming a 35% income tax rate would be

A. P2,450,000 B. P2,425,000 C. P2,600,000 D. P2,250,000

4. 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

5. Great Value Company is planning to purchase a new machine costing P50,000 with freight
and installation costs amounting to P1,500. The old unit is to be traded-in will be given a
trade-in allowance of P7,500. Other assets that are to be retired as a result of the acquisition
of the new machine can be salvaged and sold for P3,000. The loss on retirement of these
other assets is P1,000 which will reduce income taxes of P400. If the new equipment is not
purchased, repair of the old unit will have to be made at an estimated cost of P4,000. This
cost can be avoided by purchasing the new equipment. Additional gross working capital of
P12,000 will be needed to support operation planned with the new equipment.
The net investment assigned to the new machine for decision analysis is

A. P50,200 B. P52,600 C. P53,600 D. P57,600

6. 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%

7. A company is considering putting up P50,000 in a three-year project. The company’s MSQ-06

expected rate of return is 12%. The present value of P1.00 at 12% for one year is 0.893, for two years is
0.797, and for three years is 0.712. The cash flow, net of income taxes will be P18,000 (present value of
P16,074) for the first year and P22,000 (present value of P17,534) for the second year. Assuming that
the rate of return is exactly 12%, the cash flow, net of income taxes, for the third year would be

A. P7,120 B. P10,000 C. P16,392 D. P23,022

8. Lor Industries is analyzing a capital investment proposal for new machinery to produce a new product
over the next ten years. At the end of the ten years, the machinery must be disposed of with a zero net
book value but with a scrap salvage value of P20,000. It will require some P30,000 to remove the
machinery. The applicable tax rate is 35%. The appropriate “end-of-life” cash flow based on the
foregoing information is

A. Inflow of P30,000. C. Outflow of P10,000.

B. Outflow of P6,500. D. Outflow of P17,000.

9. C Corp. faces a marginal tax rate of 35 percent. One project that is currently under evaluation has a
cash flow in the fourth year of its life that has a present value of $10,000 (after-tax). C Corp. assumes
that all cash flows occur at the end of the year and the company uses 11 percent as its discount rate.
What is the pre-tax amount of the cash flow in year 4? (Round to the nearest dollar.)

A. $15,181 B. $23,356 C. $9,868 D. $43,375

10. 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

11. A project under consideration by the White Corp. would require a working capital investment of
$200,000. The working capital would be liquidated at the end of the project's 10-year life. If White Corp.
has an after-tax cost of capital of 10 percent and a marginal tax rate of 30 percent, what is the present
value of the working capital cash flow expected to be received in year 10?

A. $36,868 B. $77,100 C. $53,970 D. $23,130

12. 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%

13. 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

A. 3.45% B. 2.04% C. 13.8% D. 15.48%

14. 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

15. 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

16. 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 year

17. 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

18. Booker Steel Inc. is considering an investment that would require an initial cash outlay of $400,000
and would have no salvage value. The project would generate annual cash inflows of $75,000. The firm's
discount rate is 8 percent. How many years must the annual cash flows be generated for the project to
generate a net present value of $0?

A. between 5 and 6 years C. between 7 and 8 years

B. between 6 and 7 years D. between 8 and 9 years

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19. 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

ANSWERS:

1. C.
2. B.
3. B.
4. B.
5. A.
6. D.
7. D.
8. B.
9. B.
10. D.
11. B.
12. B.
13. C.
14. C.
15. B.
16. C.
17. A.
18. C.
19. A.