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Capital Budgeting Sample Problems

POW has a higher NPV and profitability index, so it is the better investment option based on the information provided.

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Mark Gelo Winchester
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84 views10 pages

Capital Budgeting Sample Problems

POW has a higher NPV and profitability index, so it is the better investment option based on the information provided.

Uploaded by

Mark Gelo Winchester
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Sample Problem:

MNO Company is considering to replace a machine that has the following attributes:

Book value Php400,000


Remaining useful life 4 years
Current market value Php360,000

The replacement machine would cost Php500,000, have a four-year life and save Php53,500 per year in cash
operating costs. Similar with the old machine, it would be depreciated using the straight-line method. The tax rate is
40%. The discount rate of the company is 11%. Compute for the following:

a. Net investment
b. Annual cash flow after taxes
c. Present value of the relevant depreciation tax benefit
Solution:

Cost of the new machine 500,000


Less: Current market value of old machine (360,000)
Loss on sale (net of tax) (16,000)
Net investment 124,000

Annual cash operating cost savings 53,500


year in cash Less: Incremental depreciation (25,000)
thod. The tax rate is
Increase in accounting income before tax 28,500
Less: Tax (40%) (11,400)
Increase in net income after tax 17,100
Add: Incremental depreciation 25,000
Annual cash flow after taxes 42,100

Incremental depreciation 25,000


x Tax rate 40%
Tax shield per year 10,000
Annuity PV factor 3.1024
PV of depreciation tax benefit 31,024
Sample Problem:

PQR Company sells packaged donut mix for home bakers in Manila area. The company could establish a
facility in Malabon that will sell about 200,000 packages annually. To operate the facility, PQR Company
would have to hire a nutrition specialist who will cost Php100,000 annually. Machinery will cost
Php500,000, with a five-year useful life to be depeciated using staight-line method and nil salvage value.
Inventories of Php30,000 need to be maintained. A one-time tax incentive (with no other tax
consequences) worth Php20,000 will be received during the first year of operation. Other data are as
follows:

Selling price per unit Php3.00


Variable cost per unit Php0.80
Annual cash operating costs Php120,000
Tax rate 40%
Cost of capital 16%
Solution:

1. Net investment 3. NPV

Cost of the new machine 500,000 Annual cash flow after t


Add: Increase in working capital (inventory) 30,000 Release of working cap
Net investment 530,000 Tax incentive
PV of cash flows
2. Annual cash flow PV of cash disbursemen
NPV
Selling price 3.00
Less: Variable cost (0.80)
Contribution margin/unit 2.20
Units sold 200,000
Total CM 440,000
Less: Annual cash operating costs (120,000)
Cost of nutrition specialist (100,000)
Depreciation (100,000)
Increase in accounting income before tax 120,000
Less: Tax (40%) (48,000)
Increase in net income after tax 72,000
Add: Depreciation 100,000
Annual cash flow after taxes 172,000

Release of working capital 30,000 Other possible one-tim


(Additonal cash flow at Year 5) -sale of equipment (net
-repairs and maintenan
20,000
Tax incentive
(Additonal cash flow at Year 1)
PV Factor
Annual cash flow after taxes 172,000 3.2743 563,179.60
Release of working capital 30,000 0.4761 14,283.00
Tax incentive 20,000 0.8621 17,242.00
PV of cash flows 594,705
PV of cash disbursement (530,000)
64,705

Other possible one-time cash flows:


-sale of equipment (net of tax effect on gain or loss)
-repairs and maintenance (net tax)
Sample Problem:

STU Company is planning to invest Php500,000 in a 5-year project. The expected annual net cash
inflows after tax is Php125,000. The company's desired rate of return is 10%. Compute for the
internal rate of return.

6% 8% 10%
PV of P1 for 5 periods 0.747 0.681 0.621
PV of an annuity of P1 for 5 periods 4.212 3.993 3.791
Solution:

500,000 = 4 (PV factor)


125,000

Linear interpolation fomula:

IRR = lower rate + ([higher rate - lower rate] x [(PVF of LR - PVF of IRR) / (PVF of HR - PVF or LR)])
= 6% + ([8% - 6%] x [(4.212 - 4) / (4.212 - 3.993)])
= 7.94%

or

IRR = higher rate - (higher rate - lower rate [(PVF of IRR - PVF of HR) / (PVF of HR - PVF or LR)])
= 8% - ([8% - 6%] x [(4 - 3.993) / (4.212 - 3.993)])
= 7.94%
HR - PVF or LR)])

- PVF or LR)])
Sample Problem:

XYZ Company is considering a new popper for one of its portable popcorn stands. The
analysis is narrowed down to BANG or POW as detailed below:

BANG POW
Purchase price 90,000 60,000
Annual cash flows 34,000 24,000
Salvage value in five years 8,000 5000
Useful life 5 years 5 years

XYZ Company uses a 16% cost of capital.


Solution:

BANG
PV Factor
Annual cash flow after taxes 34,000 3.2743 111,326.20
Salvage value 8,000 0.4761 3,808.80
PV of cash flows 115,135.00
PV of cash disbursement (90,000.00)
NPV 25,135.00

Profitability Index 1.2793

POW
PV Factor
Annual cash flow after taxes 24,000 3.2743 78,583.20
Salvage value 5,000 0.4761 2,380.50
PV of cash flows 80,963.70
PV of cash disbursement (60,000.00)
NPV 20,963.70

Profitability Index 1.3494

If there is only a budget of Php120,000 for the investment, which machine should it invest?
Answer: POW

Notes:
-If criteria is magnitude of returns, use NPV.
-If criteria is profitability and project size is not comparable, use profitability index.

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