CPAR

CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila
MS 8907
MANAGEMENT ADVISORY SERVICES

CAPITAL BUDGETING
CAPITAL BUDGETING – the process of identifying, evaluating, planning, and financing capital
investment projects of an organization.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

1. Capital investment decisions usually require large commitments of resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.
4. Capital investment decisions involve so much risk and uncertainty.

CAPITAL INVESTMENT FACTORS

1. Net investment 2. Net Returns 3. Cost of Capital

 NET INVESTMENT = costs or cash outflows less cash inflows or savings incidental to the acquisition
of the investment projects
Costs or cash outflows:
1. The initial cash outlay covering all expenditures on the project up to the time when it
is ready for use or operation:
Ex. Purchase price of the asset
Incidental project-related costs such as freight, insurance taxes, handling,
installation, test-runs, etc.
2. Working capital requirement to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will be transferred to or utilized
in the operations of the proposed capital investment project.
Savings or cash inflows:
1. Trade-in value of old asset (in case of replacement).
2. Proceeds from sale of old asset to be disposed due to the acquisition of the new project
(less applicable tax, in case there is gain on sale, or add tax savings, in case there is loss
on sale).
3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax.

 NET RETURNS
1. Accounting net income
2. Net cash inflows

 COST OF CAPITAL
Cost of Capital – the cost of using funds; it is also called hurdle rate, required rate of return, cut-off
rate, opportunity cost of capital.
– the weighted average rate of return the company must pay to its long-term
creditors and shareholders for the use of their funds.

Computation of COST OF CAPITAL

Source Capital Cost of Capital
After-tax rate of interest i (1 –
Creditors Long-term debt
TxR)
Stockholders:
Preferred dividends per
share
Preferred Preferred stock
Current market price or
Net issuance price

Common Common stock CAPM or DDM

MS 8907 CAPITAL BUDGETING Page 2 of 18

1. CAPITAL ASSET PRICING MODEL (CAPM)

R = RF + ß(RM – RF)
where: R = rate of return
RF = risk-free rate determined by government securities
ß = beta coefficient of an individual stock which is the correlation
between the volatility (price variation) of the stock market and
the volatility of the price of the individual stock
Example: If the price of an individual stock rises 10% and the
stock market 15%, the beta is 1.5.
RM = market return
(RM – RF) = market risk premium or the amount above risk-free rate
required to induce average investors to enter the market

2. THE DIVIDEND DISCOUNT MODEL (OR DIVIDEND GROWTH MODEL)

D1
a. Cost of Retained Earnings +G
P0
where: P0 = current price
D1 = next dividend
G = growth rate in dividends per share (it is assumed that the
dividend payout ratio, retention rate, and therefore the EPS
growth rate are constant)

D1
b. Cost of New Common Stock = +G
P0 (1 – Flotation Cost)
Flotation Cost = the cost of issuing new securities

COMMONLY USED METHODS OF EVALUATING CAPITAL INVESTMENT PROJECTS

1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

the length of time required by the project
PAYBACK PERIOD = Net cost of initial investment =
Annual net cash inflows to return the initial cost of investment.
Advantages:
1. Payback is simple to compute and easy to understand. There is no need to compute or
consider any interest rate. One just has to answer the question: “How soon will the
investment cost be recovered”?
2. Payback gives information about liquidity of the project.
3. It is a good surrogate for risk. A quick payback period indicates a less risky project.

Disadvantages:
1. Payback does not consider the time value of money. All cash received during the payback
period is assumed to be of equal value in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In other
words, more emphasis is given on return of investment rather than the return on
investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.
MS 8907 CAPITAL BUDGETING Page 3 of 18

BAIL-OUT PERIOD – cash recoveries include not only the operating net cash inflows but also
the estimated salvage value or proceeds from sale at the end of each year
of the life of the project.

ACCOUNTING RATE OF RETURN – also called book value rate of return, financial statement
method, average return on investment and unadjusted rate of return.

Accounting Rate of Return Average annual net income

= Investment
Advantages:
1. The ARR computation closely parallels accounting concepts of income measurement
and investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from the
accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.

Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider the time
value of money.
2. With the computation of income and book value based on the historical cost accounting
data, the effect of inflation is ignored.

METHODS THAT CONSIDER THE TIME VALUE OF MONEY (Discounted Cash Flow Methods)
NET PRESENT VALUE
Present value of cash inflows
– Present value of cash outflows
Net Present Value

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.

Disadvantages:
1. It requires predetermination of the cost of capital or the discount rate to be used.
2. The net present values of different competing projects may not be comparable
because of differences in magnitudes or sizes of the projects.

PROFITABILITY INDEX

Total present value of cash inflows

Profitability Index =
Total present value of cash outflows

DISCOUNTED CASH FLOW RATE OF RETURN – the rate of return which equates the present
value (PV) of cash inflows to PV of cash outflows.

1. Determine the present value factor (PVF) for the discounted cash flow rate of return
(DCFRR) with the use of the following formula:

Net Cost of Investment

PVF for DCFRR = Net cash inflows

2. Using Table 2 (present value annuity table), find on line n (economic life) the PVF obtained
in Step 1. The corresponding rate is the DCFRR.
MS 8907 CAPITAL BUDGETING Page 4 of 18

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes true return of project

Disadvantages:
1. Assumes that the IRR is the re-investment rate.
2. When project includes negative earnings during their economic life, different rates of
return may result.

PAYBACK RECIPROCAL – a reasonable estimate of the discounted cash flows rate of return,
provided that the following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

Net cash inflows

Payback Reciprocal =
Investment
or
1 .
Payback Reciprocal =
Payback period

EXERCISES

COST OF CAPITAL

1. Mark Inc.’s currently outstanding 10% coupon bonds have a yield to maturity of 12% Mark
believes it could issue new bonds at par that would provide a similar yield to maturity. It the
income tax rate is 30%, what is Mark Inc.’s after-tax cost of debt?

2. Alvin Enterprises has a series of 9% coupon bonds outstanding with a P1,000 par value. The bonds
mature in 10 years and currently sell for P952. If new bonds are issued, the issuance cost is
expected to be P12 per bond. Alvin’s marginal tax rate is 30%. What is the marginal after tax cost
of debt for Alvin? (Assume annual interest payments.)
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕+𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝒂𝒎𝒐𝒓𝒕 𝒐𝒓−𝒑𝒓𝒆𝒎𝒊𝒖𝒎 𝒂𝒎𝒐𝒓𝒕
YTM =
(𝒑𝒓𝒐𝒄𝒆𝒆𝒅𝒔 𝒙 𝟔𝟎%)+(𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝒗𝒂𝒍𝒍𝒖𝒆 𝒙 𝟒𝟎%)

3. The Lenart Corporation issued an 8%, 20-year bond 8 years ago. At the time of issue, it sold for
its par (face) value of P1,000. Comparable bonds sell for P1,192 today. The bond pays interest
semiannually.

REQUIRED: a. Compute the approximate yield to maturity. If the tax rate is 30%, what is the
after-tax cost of debt?
b. Compute the current yield.
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕+𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝒂𝒎𝒐𝒓𝒕 𝒐𝒓−𝒑𝒓𝒆𝒎𝒊𝒖𝒎 𝒂𝒎𝒐𝒓𝒕
YTM = (𝒑𝒓𝒐𝒄𝒆𝒆𝒅𝒔 𝒙 𝟔𝟎%)+(𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝒗𝒂𝒍𝒍𝒖𝒆 𝒙 𝟒𝟎%)

𝒊𝒏𝒕 𝒇𝒊𝒓𝒔𝒕 𝒚𝒆𝒂𝒓

Current yield =
𝒏𝒆𝒕 𝑷𝒓𝒊𝒄𝒆

4. Chad Corporation plans to issue some P80 par preferred stock with a 7% dividend. A similar stock
is selling on the market for P85. Winner must pay flotation costs of 3% of the issue price. The
income tax rate is 30%. What is the cost of preferred stock?

Kp = Dividend per share/Net Po

5. The P60 par value preferred stock of Eric Corporation pays an annual dividend of 6%. It has a
required rate of return of 9%.
REQUIRED: Compute the price of the preferred stock. Po = Div/Kp
MS 8907 CAPITAL BUDGETING Page 5 of 18

6. Pao Company currently pays a common stock dividend of P5 per share. The common stock price
is P50. Analysts have forecast the earnings and dividends to grow at an average annual rate of 6
percent for the foreseeable future. The issuance price per share is P2.
Required: 1. What is the cost of retained earnings?
𝐷1
Ke = 𝑃𝑜
+g

2. What is the cost of new equity?

𝐷1
Ke = +g
𝑁𝑒𝑡 𝑃𝑜

7. F Corporation just paid a dividend of P8.00 per share on its stock. The dividends are expected to
grow at a constant rate of 10% per year, indefinitely.

REQUIRED: 1. If investors require a 14% return on F Corporation stocks, what is the current
price?

2. What will the price be in three years?

8. Rue has a beta of 0.9. The current risk free rate is 6% and the market rate is 9%. What is the
cost of equity capital?

R = Rf + β(Rm – Rf)

9. Use the basic equation for the capital asset pricing model (CAPM) to work on each of the following:
a. Find the required rate of return for an asset with a beta of 1.10 when the risk-free rate and
market return are 8% and 10%, respectively. 8% + 1.1(10% - 8%) = 10.2%
b. Find the required rate of return for an asset with a beta of 1.20 when the risk-free rate of
return is 7%, and the market risk premium is 3%. 7% + 1.20(3%) = 10.6%
c. Find the required rate of return for an asset with a beta of 1.20 when the risk-free rate of
return is 7%, and the risk premium is 3%. 7% + 3% = 10%
d. Find the beta for an asset with a required return of 8.6% when the risk-free rate and market
return are 5% and 8%, respectively. 8.6% = 5% + x(8% - 5%)
8.6% = 5% + 3%x
3.6% = 3%x
X = 1.20

10. Xander’s new financing will be in proportion to the market value of its current financing shown
below:
Carrying Amount
Long-term debt P5,000,000
Preferred stock (100,000 shares) 2,000,000
Common stock (400,000 shares) 8,000,000

The firm’s bonds are currently selling at 80% of par, generating a current market yield of 10%,
and the corporation has a 30% tax rate. The preferred stock is currently selling at P22 per share
and pays a 5.5% dividend. The common stock has a current market value of P34.50 and is
expected to pay a P4.83 per share dividend. Dividend growth is expected to be 10% per year, and
flotation costs are negligible.

REQUIRED: What is the firm’s weighted average cost of capital?

Source of Capital Carrying Market Value Proportion of Funds Cost of Weighted

Amount Based on market Value Capital Cost
 MS 8907 CAPITAL BUDGETING Page 6 of 18

11. The Gol Company uses a target capital structure when calculating the cost of capital. The target
structure and the current component costs based on market conditions follow:

Component Mix Cost*

Debt 20% 6%
Preferred stock 10 12
Common stock 70 22
Retained earnings 70 19.8

* The costs of debt, preferred stock, and common stock are already adjusted for taxes and/or
flotation costs.

The firm expects to earn P30 million next year and plans to invest an amount in new capital
projects. It generally pays dividends equal to 40% of earnings. Flotation costs are 10% for
common and preferred stock.

a. What is the initial weighted average cost of capital (WACC), based on the target structure
and current component costs of capital?
b. What is the retained earnings breakpoint?
c. What is the new WACC after the retained earnings breakpoint?
d. Gol can borrow up to P6 million at a net cost of 6% as shown. After that, the net cost of
debt rises by 3%. Where is the second break, i. e., what is the debt breakpoint?
e. What is the new WACC after the increase in the cost of debt?

NET INVESTMENT AND RETURNS

12. NET INVESTMENT. Zalucki Company is planning to purchase a new equipment costing P800,000.
Freight and installation costs is P30,000. Additional gross working capital of P50,000 will be needed to
support operations planned with the new equipment.

The new equipment will be purchased to replace an old unit that was acquired several years ago at a
cost of P300,000, for which an accumulated depreciation of P240,000 has been recorded. This old unit
will be sold for P70,000.

Other assets that are to be retired as a result of the acquisition of the new machine can be salvaged
and sold for P60,000. The loss on the retirement of these other assets is P7,000, which will result into
tax savings of P2,100.

If the new equipment is not purchased, extensive repairs on the old equipment will have to be made
at an estimated cost of P40,000. This repairs expense can be avoided by purchasing the equipment.

REQUIRED:

1. Compute the amount of net investment for decision-making purposes.

2. Assume that instead of selling the old unit to be replaced, the same is traded in for P80,000.
Compute the amount of net investment for decision making purposes.

13. RETURNS. Master Donut plans to buy a donut making machine that will be installed in its new sales
outlet. The machine will cost P240,000, including freight and installation cost of P10,000. It is expected
to have a service life of four years, with no salvage value.

Sales of donut are estimated at 5,000 units per month at a price of P15 per unit. Variable costs are
estimated at P8 per unit, while incremental fixed costs, excluding depreciation at P20,000. The company’s
income tax rate is 30%.

REQUIRED: 1. Determine the expected increase in monthly net income of Master Donut if the
machine is acquired and used in the new sales outlet.

2. Determine the monthly net cash inflows that will be generated by the new machine.
 MS 8907 CAPITAL BUDGETING Page 7 of 18

14. RETURNS. Diskarte Company is planning to install a Solar Generator System in its factory. The system
will cost P1,000,000, with a five year useful life, no salvage value at the end of its useful life.

With the use of solar power, a renewable energy source, the company expects to save P600,000 per year
in electricity costs.

The company pays income tax at the rate of 30% of income before tax.

REQUIRED: Determine the annual net returns (net income and net cash inflows) for the proposed
investment.

15. ALTERNATIVE PRODUCTION PROCESS. Face Shield and Mask Manufacturing, Inc. uses a labor-
intensive production process. It plans to replace its existing equipment with a new, more efficient one.

The existing equipment has a book value of P20,000 and a four-year remaining life. In case it is replaced
with a new one, it can be sold for P15,000. Cash operating costs required by this existing machine is
P80,000 per year.

The new equipment can be acquired for P150,000. Its estimated useful life is four years with no
salvage value at the end of its life. This new machine will require P30,000 in annual cash operating
costs. The tax rate is 30%.

REQUIRED: 1. What is the net investment on the new machine for decision making purposes?

2. What is the annual net cash inflow from the new equipment?

EVALUATION TECHNIQUES

16. PAYBACK AND ACCOUNTING RATE OF RETURN. Franz Creations is considering an investment in a
computer that is capable of producing various images that are useful in the production of commercial
art. The computer would cost P200,000 and have an expected life of eight years. The computer is
expected to generate additional annual net cash receipts (before-tax) of P60,000 per year. The
computer will be depreciated according to the straight-line method and the firm's income tax rate is 30
percent.

REQUIRED: 1. Payback period

2. Accounting rate of return (ARR) based on (a) original investment and (b) average
investment.
3. If the firm’s cost of capital is 15%, is the project acceptable?

17. PAYBACK PERIOD COMPUTATION WITH UNEVEN CASH FLOWS. Hmmmm, Inc., a cologne
producer, is considering the purchase of a special-purpose bottling machine for P400,000. It is
expected to have a useful life of five years with a zero terminal disposal price. The plant manager
estimates that the machine will generate income after tax as follows:

Year Amount
1 P100,000
2 70,000
3 40,000
4 20,000
5 10,000
Total P240,000

Hmmmm, Inc. is using a required rate of return of 12% in its capital budgeting decisions. It pays
income tax at the rate of 30% of income before income tax.

REQUIRED: Compute the payback period.

 MS 8907 CAPITAL BUDGETING Page 8 of 18

18. PAYBACK AND BAILOUT PAYBACK. A Company purchased a new machine on January 1 of this
year for P350,000, 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 expected after-tax cash inflows and the
estimated salvage values for each year during the life of the project are as follows:

Year Net Cash Inflows Salvage Value

1 P140,000 P40,000
2 120,000 30,000
3 100,000 20,000
4 90,000 20,000
5 80,000 10,000

REQUIRED: Compute: (1) payback period

(2) bail-out period

19. NET PRESENT VALUE – UNIFORM CASH FLOWS. Now Company plans to buy a new machine
costing P580,000, excluding freight and installation costs of P70,000. If the new machine is acquired,
the company would have to increase its inventory level by P30,000. The new machine is expected to
have a salvage value of P20,000 at the end of its economic life of 5 years, at which time the company’s
inventory level would be brought back to the original level. The annual after-tax cash inflows from this
machine have been estimated at P150,000. The tax rate is 30%. The company desires a minimum of
10% on invested capital.

REQUIRED: Compute the net present value (NPV).

20. NET PRESENT VALUE WITH UNEVEN CASH FLOWS. Ngayonna Company is evaluating a capital
investment proposal that will require an initial cash investment of P250,000. The project will have a
three-year life. The net after tax cash flows from the project are expected to be P180,000 in the first
year, P120,000 in the second year, and P80,000 in the third year. Salvage value of P10,000 is expected
to be received at the end of the life of the project. The straight-line method will be used to depreciate
the project. Income tax rate is 30%, and the company’s cost of capital is 20%.

REQUIRED: What is the net present value?

21. PROFITABILITY INDEX. Bentong Corporation gathered the following data on two capital investment
opportunities:
1 2
Cost of investment P270,000 P480,000
Present value of cash inflows discounted at 10% 336,140 567,270
Net present value 66,140 87,270
Life of the project 6 years 6 years
Internal rate of return 18% 16%

The company’s required rate of return is 10%; thus, a 10% discount rate has been used in the present
value calculations for the two investment opportunities. Limited funds are available for investment, so
the company cannot accept both projects.

REQUIRED: 1. Using the net present value method, which alternative is more attractive?
2. Using the profitability index method, which alternative is more attractive?

22. INTERNAL RATE OF RETURN. Meemon Drapery Service is investigating the purchase of a new
machine for cleaning drapes. The machine would cost P260,000, including freight and installation cost of
P5,000. Meemon has estimated that the new machine would increase the company’s after-tax net cash
inflows by P80,000 per year. The machine would have a five-year useful life and no salvage value. The
company desires a minimum return of 10% on invested capital.

REQUIRED:
1. Net present value using the company’s desired rate of return.
2. Internal rate of return
 MS 8907 CAPITAL BUDGETING Page 9 of 18

23. DISCOUNTED CASH FLOW RATE OF RETURN WITH UNEVEN CASH FLOWS. Wheeler Company
wants to buy a numerically controlled (NC) machine to be used in producing components for
manufacturers of trenching machines. The outlay required is P100,000. The NC equipment will last five
years with no expected salvage value. The expected after-tax net cash inflows associated with the
project follow:
First year P30,000
Second year 40,000
Third year 50,000
Fourth year 20,000
Fifth year 10,000

REQUIRED: Determine the time-adjusted rate of return.

24. PAYBACK RECIPROCAL. Owu Company is planning to buy an equipment costing P800,000 which
has an estimated life of 20 years and is expected to produce after-tax net cash inflows of P150,000 per
year.

REQUIRED: Estimate the discounted cash flow rate of return without using present value factors.

25. DISCOUNTED PAYBACK. A new machine costing P600,000 with three years useful life, no salvage
value at the end of three years, is expected to bring in the following cash inflows after tax:
First year P310,000
Second year 300,000
Third year 250,000

REQUIRED: If the company’s cost of capital is 10%, what is the discounted payback period?

26. INTANGIBLE BENEFITS (Ignore income taxes in this problem.) Macasero, Inc., is considering
investing in automated equipment with a ten-year useful life. Managers at Macasero have estimated
the cash flows associated with the tangible costs and benefits of automation, but have been unable to
estimate the cash flows associated with the intangible benefits. Using the company's 12% required
rate of return, the net present value of the cash flows associated with just the tangible costs and
benefits is a negative P282,500. How large would the annual net cash inflows from the intangible
benefits have to be to make this a financially acceptable investment?

27. Capital budgeting with uneven cash flows, no income taxes. Theena Cola is considering the
purchase of a special-purpose bottling machine for P23,000. It is expected to have a useful life of four
years with no terminal disposal value. The plant manager estimates the following savings in cash
operating costs:
Year 1 P10,000
2 8,000
3 6,000
4 5,000
Total P29,000

Theena Cola uses a required rate of return of 16% in its capital budgeting decisions. Ignore income
taxes in your analysis. Assume all cash flows occur at year-end except for initial investment amounts.

REQUIRED: Calculate the following for the special-purpose bottling machine:

1. Net present value (P1,830)
2. Payback period 2.83 years
3. Discounted payback period At a 16% rate of return, this project does not save enough to
make it worthwhile using the discounted payback method.
4. Internal rate of return (using the interpolation method) 11.44%
5. Accrual accounting rate of return based on net initial investment (Assume straight-
line depreciation. Use the average annual savings in cash operating costs when
computing the numerator of the accrual accounting rate of return.) 6.52%

28. Miranda Company estimates that it can save P28,000 a year in cash operating costs for the next 10
years if it buys a special-purpose machine at a cost of P110,000. No terminal disposal value is expected.
Miranda Company’s required rate of return is 14%. Assume all cash flows occur at year-end except for
initial investment amounts. Miranda Company uses straight-line depreciation, and pays income tax at
the rate of 30% of taxable income.
 MS 8907 CAPITAL BUDGETING Page 10 of 18

REQUIRED: 1. Determine the net present value of the investment.

2. How would your computations in requirement 1 be affected if the special-purpose
machine had a P10,000 salvage value at the end of 10 years?

29. A company has purchased a new equipment for P108,570. the equipment is expected to last for three
years and to provide cash inflows as follows:
Year 1 P50,000
Year 2 40,000
Year 3 ?

REQUIRED: Assuming that the equipment will yield exactly a 12% rate of return, what is the
expected cash inflows for year three?

30. Montante Company is investigating the purchase of a piece of automated equipment that will save
P120,000 each year in direct labor and inventory carrying costs. This equipment costs P586,880 and is
expected to have a ten year useful life with no salvage value. The company requires a minimum of
20% return on all equipment purchases. Management anticipates that this equipment will provide
intangible benefits such as greater flexibility and higher quality output.

REQUIRED: What peso value per year would the intangible benefits have to have in order to make
the equipment an acceptable investment? P20,000

- end –

SELF TEST:

1. The relevance of a particular cost to a decision is determined by

a. riskiness of the decision. c. amount of the cost.
b. number of decision variables. d. potential effect on the decision.

2. In equipment-replacement decisions, which one of the following does not affect the decision-
making process?
a. Current disposal price of the old equipment.
b. Operating costs of the old equipment.
c. Original fair market value of the old equipment.
d. Cost of the new equipment.

3. The term that refers to costs incurred in the past that are not relevant to a future decision is
a. discretionary cost. c. under-allocated indirect cost.
b. full absorption cost. d. sunk cost.

4. Which one of the following statements concerning cash flow determination for capital budgeting
purposes is not correct?
a. Tax depreciation must be considered because it affects cash payments for taxes.
b. Book depreciation is relevant because it affects net income.
c. Sunk costs are not incremental flows and should not be included.
d. Net working capital changes should be included in cash flow forecasts.

5. A depreciation tax shield is

a. an after-tax cash outflow.
b. a reduction in income taxes.
c. the cash provided by recording depreciation.
d. the cash outflow.

6. New Year Corporation is evaluating a lease that takes effect on March 1, 2021. The company
must make eight equal payments, with the first payment due on March 1, 2021. The concept
most relevant to the evaluation of the lease is
MS 8907 CAPITAL BUDGETING Page 11 of 18

a. the present value of an annuity due. c. the future value of an annuity due.
b. the present value of an ordinary annuity. d. the future value of an ordinary annuity.

7. Three Kings, Inc. has P75,000 in a bank account as of December 31, 2021. If the company
plans on depositing P4,000 in the account at the end of each of the next 3 years (2022, 2023,
and 2024) and all amounts in the account earn 8% per year, what will the account balance be
at December 31, 2024? Ignore the effect of income taxes.

8% Interest Rate Factors

Future Value of an Future Value of an
Period Amount of P1 Ordinary Annuity of P1
1 1.08 1.00
2 1.17 2.08
3 1.26 3.25
4 1.36 4.51

a. P87,000 c. P 96,070
b. P88,000 d. P107,500

8. Valentine Corp. is expanding its plant, which requires an investment of P8 million in new equipment.
Valentine’s sales are expected to increase by P6 million per year as a result of the expansion. Cash
investment in current assets averages 30% of sales, and accounts payable and other current
liabilities are 10% of sales. What is the estimated total cash investment for this expansion?
a. P6.8 million c. P9.2 million
b. P8.6 million d. P9.8 million

9. Birthday Company has P150,000 in a bank account as of December 31, 2021. If the company
plans to deposit P8,000 in the account at the end of each of the next 3 years (2022, 2023, and
2024) and all amounts in the account earn 8% per year, what will the account balance be at
December 31, 2024? Ignore the effect of income taxes.

Use the following 8% interest rate factors for this question:

Future Value Future Value
Period of P1 Annuity of P1
1 1.08 1.00
2 1.17 2.08
3 1.26 3.25
4 1.36 4.51

a. P174,000 c. P192,140
b. P176,000 d. P215,000

10. Of the following decisions, capital budgeting techniques would least likely 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 captain ball by a basketball team.
d. adoption of a new method of allocating non-traceable costs to product lines.

11. Holy Week Company has a payback goal of 3 years on new equipment acquisitions. A new
sorter is being evaluated that costs P450,000 and has a 5-year life. Straight-line depreciation
will be used; no salvage is anticipated. Holy Week 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
a. P 60,000 c. P150,000
b. P100,000 d. P190,000

12. The length of time required to recover the initial cash outlay of a capital project is determined by
using the
a. discounted cash flow method. c. weighted net present value method.
b. payback method. d. net present value method.
MS 8907 CAPITAL BUDGETING Page 12 of 18

13. A characteristic of the payback method (before taxes) is that it

a. incorporates the time value of money.
b. uses accrual accounting inflows in the numerator of the calculation.
c. neglects total project profitability.
d. uses the estimated expected life of the asset in the denominator of the calculation.

14. Which one of the following statements about the payback method of investment analysis is correct?
The payback method
a. does not consider the time value of money.
b. considers cash flows after the payback has been reached.
c. uses discounted cash flow techniques.
d. generally leads to the same decision as other methods for long-term projects.

15. The payback reciprocal can be used to approximate a project’s

a. profitability index.
b. net present value.
c. accounting rate of return if the cash flow pattern is relatively stable.
d. internal rate of return if the cash flow pattern is relatively stable.

16. The bailout payback method

a. incorporates the time value of money.
b. equals the recovery period from normal operations.
c. eliminates the disposal value from the payback calculation.
d. measures the risk if a project is terminated.

17. Bataan Co. is considering the acquisition of a new, more efficient press. The cost of the press
is P360,000, and the press has an estimated life of 6 years with zero salvage value. Bataan
uses straight-line depreciation for both financial reporting and income tax reporting purposes
and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type,
Bataan uses a goal of a 4-year payback period. To meet Bataan’s desired payback period, the
press must produce a minimum annual before-tax operating cash savings of
a. P 90,000 c. P114,000
b. P110,000 d. P150,000

18. When evaluating projects, break-even time is best described as

a. Annual fixed costs ÷ monthly contribution margin
b. Project investment ÷ annual net cash inflows
c. The point where cumulative cash inflows on a project equal total cash outflows.
d. The point at which discounted cumulative cash inflows on a project equal discounted total
cash outflows.

Items 19 to 22 are based on the following information:

In order to increase production capacity, a company is considering replacing an existing
production machine with a new technologically improved machine effective January 1, 2021.
The following information are being considered:
➢ The new machine would be purchased for P160,000 in cash. Shipping, installation, and
testing 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 variable costs and total
fixed costs of P40,000 per year.
➢ The investment 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.
➢ The company uses straight-line depreciation for financial reporting and tax reporting
purposes. The new machine has an estimated useful life of 5 years and zero salvage value.
➢ The company is subject to a 40% corporate income tax rate.
MS 8907 CAPITAL BUDGETING Page 13 of 18

The company uses the net present value method to analyze the investments and will employ the
following factors and rates:
Present Value of Present Value of an Ordinary
Period P1 at 10% Annuity of P1 at 10%
1 0.909 0.909
2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791

19. The company’s net cash outflow in a capital budgeting decision is

a. P190,000 c. P204,525
b. P195,000 d. P225,000

20. The company’s discounted annual depreciation tax shield for the year 2021 is
a. P13,817 c. P20,725
b. P16,762 d. P22,800

21. The acquisition of the new production machine will contribute a discounted net-of-tax
contribution margin of
a. P242,624 c. P363,936
b. P303,280 d. P454,920

22. The overall discounted cash flow impact of the company’s working capital investment for the
new production machine would be
a. P( 7,959) c. P(13,265)
b. P(10,080) d. P(35,000)

23. The net present value (NPV) method of investment project analysis assumes that the project’s
cash flows are reinvested at the
a. computed internal rate of return. c. discount rate used in the NPV calculation.
b. risk-free interest rate. d. firm’s accounting rate of return.

24. Kagitingan Industries is replacing a grinder purchased 5 years ago for P15,000 with a new one
costing P25,000 cash. The original grinder is being depreciated on a straight-line basis over 15
years to a zero salvage value; Kagitingan will sell this old equipment to a third party for P6,000
cash. The new equipment will be depreciated on a straight-line basis over 10 years to a zero
salvage value. Assuming a 40% marginal tax rate, Kagitingan’s net cash investment at the time
of purchase if the old grinder is sold and the new one purchased is
a. P19,000 c. P17,400
b. P15,000 d. P25,000

25. Labor Day, Inc. is considering a 10-year capital investment project with forecasted revenues of
P40,000 per year and forecasted cash operating expenses of P29,000 per year. The initial cost
of the equipment for the project is P23,000 and Labor Day expects to sell the equipment for
P9,000 at the end of the tenth year. The equipment will be depreciated over 7 years. The project
requires a working capital investment of P7,000 at its inception and another P5,000 at the end
of year 5. Assuming a 40% income tax rate, the expected net cash flow from the project in the
tenth year is
a. P32,000 c. P20,000
b. P24,000 d. P11,000

26. The rankings of mutually exclusive investments determined using the internal rate of return method
(IRR) and the net present value method (NPV) may be different when
a. the lives of the multiple projects are equal and the size of the required investments are equal.
b. the required rate of return equals the IRR of each project.
c. the required rate of return is higher than the IRR of each project.
d. multiple projects have unequal lives and the size of the investment for each project is different.

27. The proper discount rate to use in calculating certainty equivalent net present value is the
a. risk-adjusted discount rate. c. risk-free rate.
b. cost of capital. d. cost of equity capital.
MS 8907 CAPITAL BUDGETING Page 14 of 18

28. Independence Corp. has not yet decided on its hurdle rate for use in the evaluation of capital
budgeting projects. This lack of information will prohibit Independence from calculating a
project’s
Accounting Rate Net Present Internal Rate
of Return Value of Return
a. No No No
b. Yes Yes Yes
c. No Yes Yes
d. No Yes No

29. When determining net present value in an inflationary environment, adjustments should be made
to
a. increase the discount rate only.
b. increase the estimated cash inflows and increase the discount rate.
c. increase the estimated cash inflows, but not the discount rate.
d. decrease the estimated cash inflows and increase the discount rate.

30. All of the following items are included in discounted cash flow analysis, except
a. future operating cash savings. c. the future asset depreciation expense.
b. the current asset disposal price. d. the tax effects of future asset depreciation.

31. The capital budgeting model that is ordinarily considered the best model for long-range decision-
making is the
a. payback model. c. unadjusted rate of return model.
b. accounting rate of return model. d. discounted cash flow model.

32. 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
a. raising the hurdle rate necessary to justify the project.
b. lowering the net present value of the project.
c. increasing the present value of the depreciation tax shield.
d. increasing the cash outflows at the initial point of the project.

Items 33 to 35 are based on the following information:

Beauty, Inc. uses a 12% hurdle rate for all capital expenditures and has done the following
analysis for four projects for the upcoming year:
Project A Project B Project C Project D
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%

33. Which project(s) should Beauty, Inc. undertake during the upcoming year assuming it has no
budget restrictions?
a. All of the projects c. Projects B, C, and D
b. Projects A, B, and C d. Projects A, C, and D

34. Which project(s) should Beauty, Inc. undertake during the upcoming year if it has only P600,000
of funds available?
a. Projects A and C c. Projects B and C
b. Projects B, C, and D d. Projects C and D

35. Which project(s) should Beauty, Inc. undertake during the upcoming year if it has only P300,000
of capital funds available?
a. Project A c. Projects C and D
b. Projects B, C, and D d. Project C
MS 8907 CAPITAL BUDGETING Page 15 of 18

36. The net present value (NPV) of a project has been calculated to be P215,000. Which one of the
following changes in assumptions would decrease the NPV?
a. Decrease the estimated effective income tax rate.
b. Decrease the initial investment amount.
c. Extend the project life and associated cash inflows.
d. Increase the discount rate.

37. Beast, Inc. is expanding its manufacturing plant, which requires an investment of P4 million in
new equipment and plant modifications. Beast’s sales are expected to increase by P3 million
per year as a result of the expansion. Cash investment in current assets averages 30% of sales;
accounts payable and other current liabilities are 10% of sales. What is the estimated total
investment for this expansion?
a. P3.4 million c. P4.6 million
b. P4.3 million d. P4.9 million

38. A disadvantage of the net present value method of capital expenditure evaluation is that it
a. is calculated using sensitivity analysis.
b. computes the true interest rate.
c. does not provide the true rate of return on investment.
d. is difficult to apply because it uses a trial-and-error approach.

39. Papa, Inc. has no capital rationing constraint and is analyzing many independent investment
alternatives. Papa should accept all investment proposals
a. if debt financing is available for them.
b. that have positive cash outflows.
c. that provide returns greater than the before-tax cost of debt.
d. that have a positive net present value.

40. A company has a cost of capital of 15% and is considering the acquisition of a new machine
which costs P400,000 and has a useful life of 5 years. The company projects that earnings and
cash flow will increase as follows:
Year Net Earnings After-tax Cash Flow
1 P100,000 P160,000
2 100,000 140,000
3 100,000 100,000
4 100,000 100,000
5 200,000 100,000

15% Interest Rate Factors

Present Present Value of
Period Value of P1 an Annuity of P1
1 0.87 0.87
2 0.76 1.63
3 0.66 2.29
4 0.57 2.86
5 0.50 3.36

The net present value of this investment is

a. negative, P64,000 c. positive, P 18,600
b. negative, P14,000 d. positive, P200,000

41. The net present value of a proposed investment is negative; therefore, the discount rate used must
be
a. greater than the project’s internal rate of return.
b. less than the project’s internal rate of return.
c. greater than the firm’s cost of equity.
d. less than the risk-free rate.

42. A weakness of the internal rate of return (IRR) approach for determining the acceptability of
investments is that it
a. does not consider the time value of money.
b. is not a straightforward decision criterion.
MS 8907 CAPITAL BUDGETING Page 16 of 18

c. implicitly assumes that the firm is able to reinvest project cash flows at the firm’s cost of
capital.
d. implicitly assumes that the firm is able to reinvest project cash flows at the project’s internal
rate of return.

43. The internal rate of return (IRR) is the

a. hurdle rate.
b. rate of interest for which the net present value is greater than 1.0.
c. rate of interest for which the net present value is equal to zero.
d. rate of return generated from the operational cash flows.

44. The profitability index approach to investment analysis

a. fails to consider the timing of project cash flows.
b. considers only the project’s contribution to net income and does not consider cash flow
effects.
c. always yields the same accept/reject decisions for independent projects as the net present
value method.
d. always yields the same accept/reject decisions for mutually exclusive projects as the net
present value method.

Items 45 to 47 are based on the following information:

Meldz Company’s financial staff has been requested to review a proposed investment in new
capital equipment. Applicable financial data is presented below. There will be no salvage value
at the end of the investment’s life and, due to realistic depreciation practices, it is estimated that
the salvage value and net book value are equal at the end of each year. All cash flows are
assumed to take place at the end of each year. For investment proposals, Meldz uses a 12%
after-tax target rate of return.

INVESTMENT PROPOSAL
Purchase Cost Annual Net Annual
Year and Book Value After-tax Cash Flow Net Income
0 P250,000 P 0 P 0
1 168,000 120,000 35,000
2 100,000 108,000 39,000
3 50,000 96,000 43,000
4 18,000 84,000 47,000
5 0 72,000 51,000

DISCOUNTED FACTORS FOR A 12% RATE OF RETURN

Present Value of P1 Received Present Value of an Annuity of P1
Period at the End of Each Period Received at the End of Each Period
1 0.89 0.89
2 0.80 1.69
3 0.71 2.40
4 0.64 3.04
5 0.57 3.61
6 0.51 4.12

45. The accounting rate of return on the average investment proposal is

a. 12.0% c. 28.0%
b. 17.2% d. 34.4%

46. The net present value for the investment proposal is

a. P106,160 c. P356,160
b. P (97,970) d. P 96,560

47. The traditional payback period for the investment proposal is

a. over 5 years c. 1.65 years
b. 2.23 years d. 2.83 years
MS 8907 CAPITAL BUDGETING Page 17 of 18

Items 48 to 52 are based on the following information:

A proposed investment is not expected to have any salvage value at the end of its 5-year life.
For present value purposes, cash flows are assumed to occur at the end of each year. The
company uses a 12% after-tax target rate of return.
Purchase Cost Annual Net Annual
Year and Book Value After-tax Cash Flow Net Income
0 P500,000 P 0 P 0
1 336,000 240,000 70,000
2 200,000 216,000 78,000
3 100,000 192,000 86,000
4 36,000 168,000 94,000
5 0 144,000 102,000

DISCOUNTED FACTORS FOR A 12% RATE OF RETURN

Present Value of P1 Received Present Value of an Annuity of P1
Period at the End of Each Period Received at the End of Each Period
1 0.89 0.89
2 0.80 1.69
3 0.71 2.40
4 0.64 3.04
5 0.57 3.61
6 0.51 4.12

48. The accounting rate of return based on the average investment is

a. 84.9% c. 40.8%
b. 34.4% d. 12.0%

49. The net present value is

a. P304,060 c. P (70,000)
b. P212,320 d. P712,320

50. The traditional payback period is

a. over 5 years c. 1.65 years
b. 2.23 years d. 2.83 years

51. The profitability index is

a. 0.61 c. 0.86
b. 0.42 d. 1.425

52. Which statement about the internal rate of return of the investment is true?
a. The IRR is exactly 12%. c. The IRR is under 12%.
b. The IRR is over 12%. d. No information about the IRR can be
determined

Items 53 to 56 are based on the following information:

CPA Corporation is considering the acquisition of a new machine at a cost of P180,000.
Transporting the machine to CPA’s plant will cost P12,000. Installing the machine will cost an
additional P18,000. It has a 10-year life and is expected to have a salvage value of P10,000.
Furthermore, the machine is expected to produce 4,000 units per year with a selling price of
P500 and combined direct materials and direct labor costs of P450 per unit. Tax regulations
permit machines of this type to be depreciated using the straight-line method over 5 years with
no estimated salvage value. CPA has an income tax rate of 40%.

53. What is the net cash outflow at the beginning of the first year that CPA should use in a capital
budgeting analysis?
a. P(170,000) c. P(192,000)
b. P(180,000) d. P(210,000)

54. What is the net cash flow for the third year that CPA Corporation should use in a capital
budgeting analysis?
MS 8907 CAPITAL BUDGETING Page 18 of 18

a. P136,800 c. P128,400
b. P136,000 d. P107,400

55. What is the net cash flow for the tenth year of the project that CPA should use in a capital
budgeting analysis?
a. P200,000 c. P136,800
b. P158,000 d. P126,000

56. What is the approximate payback period on the new machine?

a. 1.05 years c. 1.33 years
b. 1.54 years d. 2.22 years

57. For capital budgeting purposes, management would select a high hurdle rate of return for certain
projects because management
a. wants to use equity funding exclusively.
b. believes too many proposals are being rejected.
c. believes bank loans are riskier than capital investments.
d. wants to factor risk into its consideration of projects.

58. Sensitivity analysis, if used with capital projects

a. is used extensively when cash flows are known with certainty.
b. measures the change in the discounted cash flows when using the discounted payback
method rather than the net present value method.
c. is a “what-if” technique that asks how a given outcome will change if the original estimates
of the capital budgeting model are changed.
d. is a technique used to rank capital expenditure requests.

1. D 11. D 21. D 31. D 41. A 51. D

2. C 12. B 22. C 32. C 42. D 52. B
3. D 13. C 23. C 33. C 43. C 53. D
4. B 14. A 24. C 34. D 44. C 54. A
5. B 15. D 25. B 35. D 45. D 55. D
6. A 16. D 26. D 36. D 46. A 56. B
7. D 17. B 27. C 37. C 47. B 57. D
8. C 18. D 28. D 38. C 48. B 58. C
9. D 19. D 29. B 39. D 49. B
10. D 20. A 30. C 40. C 50. B

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