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. - large sum
of money
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.
- Not irreversible
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

Creditors: Long-term debt After-tax rate of interest
i(1 – Tax Rate)
Stockholders:

Preferred Preferred stock Preferred dividends per share

Current market price or
Net issuance price

Common stock
Common CAPM or DDM

CAPITAL ASSET PRICING MODEL (CAPM)

R = RF + β(RM – RF)

where: R = rate of return

RF = risk-free rate determined by government securities
β = 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

THE DIVIDEND DISCOUNT MODEL (OR DIVIDEND GROWTH MODEL)

 !"
a. Cost of Retained Earnings $%
+G
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)
!"
b. Cost of New Common Stock $% ("'()*+,+,-*. /*0,)
+G
Floatation 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 TINAE VALUE OF MONEY

23, 4*0, *5 -.-,-+) -.630,73., the length of time required by the project
PAYBACK PERIOD = =
8..9+) .3, 4+0: -.5)*;0 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.
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.

863<+=3 +..9+) .3, -.4*73

Accounting Rate of Return = >.630,73.,

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 redetermination 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

?*,+) @<303., 6+)93 *5 4+0: -.5)*;0

Profitability Index =
?*,+) @<303., 6+)93 *5 4+0: *9,5)*;0

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
(DFRR) with the use of the following formula:

23, /*0, *5 >.630,73.,

PVF for DCFRR = 23, /+0: >.5)*;0

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.

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.

23, /+0: >.5)*;0

Payback Reciprocal = >.630,73.,
or

"
Payback Reciprocal = $+AB+4C @3<-*D
SOURCES:
Rodelio Roque CPAR Modules and Reviewer (2016 Ed), Cabrera 2000 Edition
ACC115
EXERCISES/ASSIGNMENT:
CHAP 16

THEORIES:
1. What does the term capital budgeting mean in the context of making capital expenditure
decisions?
A. The process of choosing assets.
B. The process of allocating the funds among assets.
C. The process of acquiring the funds to finance the business.
D. None of the given choices.
2. The long-term planning process for making and financing investments that affects a
company's financial results over a number of years is referred to as:
A. capital budgeting
B. strategic planning
C master budgeting
D. long-range planning
3. Capital budgeting is the process:
A. used in a sell or process further decision.
B. of determining how much capital stock to issue.
C. of making capital expenditure decisions.
D. of eliminating unprofitable product line.
4. Competing investment projects where accepting one project eliminates the
possibility of taking the remaining projects is referred to as:
A. Common projects
B. Mutually-exclusive projects
C. Mutually-inclusive projects
D. Independent projects
5. A project that when accepted or rejected will not affect the cash flows of
another project refers to:
A. independent projects
B. dependent projects
C. mutually exclusive projects
D. sustaining project
6. A capital investment decision is essentially a decision to exchange current.
A. assets for current liabilities.
B. cash outflows for the promise of receiving future cash inflows.
C. cash flows from operating activities for future cash inflows from investing activities
D. cash inflows for future cash outflows.
7. The higher the risk element in a project, the
A. more attractive the investment is.
B. higher the net present value is.
C. higher the cost of capitals is.
D. higher the discount rate required is.
8. The normal methods of analyzing investments
A. cannot be used by not-for-profit entities.
B. do not apply if the project will nor produce revenues.
C. cannot be used if the company plans to finance the project with funds
already available internally.
D. require forecasts of cash flows expected from the project.
9. Deciding whether or not an investment meets a predetermined company standard is
called a
A Screening decision
B. Payback decision
C. Profitability decision
D. Preference decision
10. The primary capital budgeting method that uses discounted cash flow technique is the:
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method
11. Cost of capital is the:
A. amount the company must pay for its plant assets.
B. dividends a company must pay on its equity securities.
C. cost the company must incur to obtain its capital resources.
D. cost the company is charged by investment bankers who handle the issuance of equity or
long-term debt securities.
12. If Troy Company expects to get a one-year bank loan to help cover the initial financing
of one of its capital projects, the analysis of the project should
A. offset the loan against any investment in inventory or receivables required by the project.
B. show the loan as an increase in the investment.
C. show the loan as a cash outflow in the second year of the project’s life.
D. ignore the loan
13. The only future costs that are relevant to deciding whether to accept an investment are
those that will
A. be different if the project is accepted rather than rejected
B. be saved if the project is accepted rather than rejected.
C. be deductible for tax purposes.
D. affect net income in the period that they are incurred.
14. Arbitrary Company uses IRR to evaluate long-term decisions and establishes a
cutoff rate of return. Such a cutoff rate is
A. at least equal to its cost of capital.
B. at least equal to the rate used by similar companies.
C. greater than the IRR on projects accepted in the past.
D. greater than the current book rate of return.
15. In capital budgeting, sensitivity analysis is used to:
A. determine whether an investment is profitable.
B. see how a decision would be affected by changes in variables.
C. test the relationship of the IRR and NPV.
D. evaluate mutually exclusive investments.
16. How should the following projects be listed in their order of increasing risk?
A. New venture, replacement, expansion.
B. Replacement, new venture, expansion,
C. Replacement, expansion, new venture.
D. Expansion, replacement, new venture.
17. An approach that uses a number of outcome estimates to get a sense of the variability
among potential returns is
A. the discounted cash flow technique.
B. the net present value method.
C. risk analysis.
D. sensitivity analysis.
18. Post-audit of capital projects:
A. is usually conclusive.
B. is done using different evaluation techniques than what were used in making the original
capital budgeting decision.
C. provides a formal mechanism by which the company can determine whether existing
projects should be supported or terminated.
D. all of the given choices.
19. A thorough evaluation of how well a project's actual performance marches the
projections made when the project was proposed is called a
A. pre-audit
B. post-audit
C. sensitivity analysis
D. risk analysis
20. A major difference between an investment in working capital and one in depreciable
assets is that
A. an investment in working capital is never returned, while most depreciable assets have
some residual value.
B. an investment in working capital is returned in full at the end of a project’s life, while an
investment in depreciable assets has no residual value.
C. an investment in working capital is not tax-deductible when made, nor taxable when
returned, while an investment in depreciable assets does allow tax deductions.
D. because an investment in working capital is usually returned in full at the end of the
project's life, it is ignored in computing the amount of the investment required for the project.
21. Which of the following would not be included as part of the periodic cash inflows
associated with an investment project?
A. Savings for fixed and variable production costs
B. Savings in selling, general, and administrative costs
C. Receipts from sales
D. Opportunity costs of undertaking the project.
22. The periodic cash flows associated with an investment project include which of
A. Savings in taxes caused by deductibility of depreciation on tax return
B. Income tax effect of gain (loss) on disposal of existing assets in an asset replacement
decision
C. Purchase of asset and freight cost
D. All of these are periodic cash flows in an investment project
23. Project Alpha has an exacted cash flow of P500,000 at the end of year 5 project Bravo
has expected cash flows of P100,000 to be received at the end of each year for the next five
years. What can be said of the net present value of Project Alpha compared to Project
Bravo?
A. They are the same because both cash flows total P500,000 over the lives of the projects.
B. project Alpha is preferred because of the largest lump-sum payment in year.
C. Project Bravo is preferred because of the periodic payments made consistently throughout
the years and are made earlier.
D. Both Project Alpha and Project Bravo have the same internal rate of return and either
should be accepted.
24. The NPV and IRR methods give
A. the same decision (accept or reject) for any single investment.
B. the same choice from among mutually exclusive investments.
C. different rankings of projects with unequal lives.
D. the same rankings of projects with different required investments.
25. The net present value (NPV) model can be used to evaluate and rank two or more
proposed projects. The approach that computes the total impact on cash flows for each
option and then converts these total cash flows to their present values is called the
A. differential approach
B. incremental approach
C. contribution approach
D. total project approach
26. Which statement is most correct concerning depreciation in a capital budgeting
analysis?
A. Depreciation is not a cash flow and does not affect the tax cash flow.
B. Depreciation is not a cash flow but does affect the tax cash flow.
C. Depreciation is a cash flow but does not affect the tax cash flow.
D. Depreciation is a cash flow and does affect the tax cash flow.
27. If there were no income taxes,
A. depreciation would be ignored in capital budgeting.
B. the NPV method would not work.
C. income would be discounted instead of cash flow
D. all potential investments would be desirable.
28. Assuming that a project has already been evaluated using the following techniques, the
evaluation under which technique is least likely to be affected by an increase in the estimated
residual value of the project?
A. Payback Period
B. Internal Rate of Return
C. Net Present Value
D. Profitability Index
29. Which of the following, when used as the discount rate, equates the net present value of
a series of cash flows to zero?
A. Investment rate of return
B. External rate of return
C. Internal rate of return
D. Breakeven time
30. If a company's required rate of return is 12 percent and in using the profitability index
method, a project's index is greater than 1.0, this indicates that the project's rate of return is
A. equal to 12 percent.
B. greater than 12 percent.
C. less than 12 percent.
D. dependent on the size of the investment.
31. If the present value of the future cash flows for an investment equals the required
investment, the IRR
A. equals the cutoff rate.
B. equals the cost of borrowed capital.
C. equals zero.
D. Is lower than the company's cutoff rate return.
32. All other things being equal, as cost of capital increases
A. more capital projects will probably be acceptable.
B. fewer capital projects will probably be acceptable.
C. the number of capital projects that are acceptable will change, but the direction of the
change is not determinable just by knowing the direction of the change in cost of capital.
D. the company will probably want to borrow money rather than issue stock.
33. Which of the following is true of an investment?
A. The higher the cost of capital, the lower the net present value.
B. The lower the cost of capital, the higher the IRR
C. The longer the project's life, the shorter its payback period.
D. The higher the project's net present value, the shorter its life.
34. If a project has an internal fare of return of 12 percent and a positive net present value,
which of the following statements is true regarding the dive net rate used for the net present
value computation?
A. The discount rate must have been greater than 12 percent.
B. The discount rate must have been lower than 12 percent.
C. The discount rate must have been equal to 12 percent.
D. 0
35. The relationship between payback period and IRR is that
A. have been higher than the IRR.
B. a payback period of less than one-half the life of a project will yield an IRR lower than the
target rate.
C. the payback period is the present value factor for the IRR.
D. a project whose payback period does not meet the company's cutoff rate for payback will
not meet the company's criterion for IRR.
E. none of the given choices.
36. In choosing from among mutually exclusive investments, the manager should normally
select the one with the highest:
A. Net present value
B. Internal rate return
C. Profitability index
D. Book rate of return
37. The proper treatment of an investment in receivables and inventory is to
A. ignore it
B. add it to the required investment in fixed assets
C. add it to the required investment in fixed assets and subtract it from annual cash flows
D. add it to the investment in fixed assets and add the present value of recovery to the
present value of the annual cash flows
38. XYZ Co. is adopting just-in-time approach. When evaluating an invest project that
would reduce inventory, how should XYZ treat the reduction?
A. Ignore it.
B. Decrease the cost of the investment and decrease cash flows at the end of the project's
life.
C. Decrease the cost of the investment.
D. Decrease the cost of the investment and increase the cash flow at the end of the project's
life.
39. Which of the following is NOT a defect of the payback method?
A. It ignores cash flows because it uses net income.
B. It ignores profitability.
C. It ignores the present values of cash flows.
D. It ignores the pattern of cash flows beyond the payback period.
40. The technique which is most concerned with liquidity is the
A. payback method
B. net present value technique
C. internal rate of return
D. book rate of return
41. The profitability index
A. does not take into account the discounted cash flows.
B. Is calculated by dividing total cash flows by the initial investment.
C. allows comparison of the relative desirability of projects that require
varying initial investments.
D. will never be greater than 1.0.
42. White Bubbles, Inc. is considering the purchase of an equipment that costs P200,000.
Annual cash savings of P50,000, with a present value at 15 percent of P189,230, are
expected for the next six years. Given this information, which of the following statements is
true?
A. This investment offers an actual rate of return of 15 percent
B. This investment offers an actual rate of return of less than 15 percent
C. This investment offers an actual rate of return of more than 15 percent
D. This investment offers a negative rate of return
43. CB Products, Inc. is considering to invest in one of two projects. Both projects have a net
present value of P25,000; however, Project Alpha requires an initial investment of P700,000
while Project Delta requires an initial investment of P300,000. Based on this information,
which of the following statements is true?
A. Project Delta will have a higher profitability index
B. Project Alpha will have a higher profitability index
C. Both Project will have the same profitability index
D. There is not enough information to determine the profitability index of either project
44. Problems associated with justifying investments in high-tech projects often include
A. discount rates that are too low and time horizons that are too long,
B. discount rates that are too high and time horizons that are too long
C. discount rates that are too high and time horizons that are too short
D. discount rates that are too low and time horizons that are too short
45. In addition to incremental revenues, cash inflows from capital investments can be
generated from all of the following sources except
A. debt financing
B. cost savings
C. salvage value
D. reduction in the amount of working capital
46. Camel Company, a local company that specializes in home repairs, is considering
replacing its older van with a new and larger one. The estimated cost of the new van will be
P65,000. Using a discount rate of 18 percent, the company calculates a net present value
for the new van of P(5,000): Based on this information, which of the following statements is
true?
A. The actual rate of return on the new van is negative.
B. If the company purchases the van, they are guaranteed a rate of return of at least 18%.
C. Using a higher discount rate should cause the net present value to become positive.
D. if the actual cost of the new van ends up being less than P60,000, the net present value
becomes positive.
47. Diliman Plumbers, Inc. is considering the purchase of a machine costing approximately
P40,000, Using a discount rate of 20 percent, the present value of future cash inflows are
calculated to be P40,000. To yield at least a 20 percent return, the actual cost of the
machine should not exceed the P40,000 estimated by more than:
A. P40,000
B. P80,000
C. P 8.000
D. P0
48. The appropriate discount rate that the analysts use in computing the present value of
future cash flows is comprised of which of the following?
A. An increase in the rate reflecting the inflation expected to occur over the life of the
project.
B. A risk factor reflecting the riskiness of the project.
C. A pure rate of interest reflecting the productive capability of the capital asset.
D. All of the given choices are components of the discount rate.
49. If a payback period for a project is greater than its expected useful life, the
A. project will always be profitable.
B. entire initial investment will not be recovered.
C. project would only be acceptable if the company's cost of capital was low.
D. project's return will always exceed the company's cost of capital.
50. The payback method, as a capital budgeting technique, assumes that all intermediate
cash inflows are reinvested to yield a return equal to:
A. Zero
B. The Time-Adjusted-Rate-of-Return
C. The Discount Rate
D. The Cost-of-Capital
51. Which of the following capital budgeting methods is the least theoretically correct?
A. payback method
B. net present value
C. internal rate of return
D. none of the given choices
52. Why do NPV method and the IRR method sometimes give different rankings of mutually
exclusive investment projects?
A. The NPV method does not assume reinvestment of cash flows while the IRR method
assumes the cash flows will be reinvested at the internal rare of return.
B. The NPV method assumes a reinvestment rate equal to the discount rate while the IRR
method assumes a reinvestment rate equal to the internal rate of return.
C. The IRR method does not assume reinvestment of the cash flows while the NPV assumes
the reinvestment rate is equal to the discount rate.
D. The NPV method assumes a reinvestment rate equal to the bank loan interest rate while
the IRR method assumes a reinvestment rate equal to the discount rate.
53. The primary advantages of the average rate of return method are its case of
computation and the fact that:
A. It is especially useful to managers whose primary concern is liquidity.
B. There is less possibility of loss from changes in economic conditions and obsolescence
when the commitment is short-term.
C. It emphasizes the amount of income earned over the life of the proposal.
D. Rankings of proposals are necessary.
54. When evaluating depreciation methods, the managers who are concerned about
A. choose straight lime depreciation so there is minimum impact on the decision.
B. use units of production so more depreciation expense will be allocated to the later years.
C. use accelerated methods to have as much depreciation in the early years of an asset's
life.
D. Assume that the choice of depreciation method has no impact on the capital investment
decision.
55. A weakness of the internal rate of return method for screening investment projects is that
it:
A. does not consider the time value of money
B. implicitly assumes that the company is able to reinvest cash flows from the project at the
company's discount rate
C. implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return
D. fails to consider the timing of cash flows
56. If the internal rate of return on an investment is zero:
A. its NPV is positive.
B. its annual cash flows equal its required investment.
C. it is generally a wise investment.
D. its cash flows decrease over its life.
57. Which of the following would decrease the net present value of a project?
A. A decrease in the income tax rate
B. A decrease in the initial investment
C. An increase in the useful life of the project
D. An increase in the discount rate
58. The length of time needed for a long-term project to recapture its initia investment
amount is called the:
A. Discount period
B. Present value
C. Payback period
D. Internal rate of return
59. Which of the following is not a typical cash outflow associated with a capital investment?
A. Repairs and maintenance needed for purchased equipment.
B. Additional operating costs resulting from the capital investment.
C. Salvage value received when the newly purchased equipment is sold.
D. Purchase price of the new equipment.
60. The internal rate of return method assumes that intermediate cash flows are immediately
reinvested at:
A. The accrual rate of return earned by the project.
B. The company's discount rate.
C. The lower of the company's discount rate or internal rate of return.
D. An average of the internal rate of return and the discount rate.
Problems:

1. Bravado Company is considering to replace its old equipment with a new one. The old
equipment had a net book value of P100,000 and 4 remaining useful years with P25,000
depreciation each year. The old equipment can be sold at P80,000. The new equipment costs
P160,000, have a 4-year life. Cash savings on operating expenses before 40% taxes amount
to P50,000 per year.
What is the amount of investment in the new equipment?
A. P160,000
B P 72,000
C. P 80,000
D. P 68,000
2. Myriad Company is considering replacing its old machine wish a new and more efficient
one. The old machine has book value of P100,000, a remaining useful life of 4 years, and
annual straight-line depreciation of P25,000. The existing machine has a current market value
of P80,000. The replacement machine would cost P160,000, have a 4-year life, and will save
P50,000 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 should be the increase in annual
income taxes?
A. P14,000
B. P28,000
C. P40,000
D. P 4,000
3. If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of its
ten-year life, and generates annual net cash inflows of P5,000 each year, the cash payback
period is
A. 8 years
B. 7 years
C. 6 years
D. 5 years
4. Umali Corporation is considering an investment in a new cheese-cutting machine to replace
its existing cheese cutter. Information on the existing machine and the replacement machine
follow:

Cost of the new machine P400,000

Net annual savings in operating costs 90,000
Salvage value now of the old machine 60,000
Salvage value of the old machine in 8 years 50,000
Salvage value of the new machine in 8 years 0
Estimated life of the new machine 8 years

What is the expected payback period for the new machine?

A. 4.44 years
B. 8.50 years
C. 2.67 years
D. 3.78 years

5. For P4,500,000, Siren Corporation purchased a new machine with an estimated useful life
of five years with no salvage value at its retirement. The machine is expected to produce cash
flow from operations, net of income taxes, as follows:
First year P900,000
Second year 1,200,000
Third year 1,500,000
Fourth year 900,000
Fifth year 800,000

Siren will use the sum-of-the-years-digits' method to depreciate the new machine as follows:
First year P1,500,000
Second year 1,200,000
Third year 900,000
Fourth year 600,000
Fifth year 300,000
What is the payback period for the machine?
A. 3 years
B. 4 years
C. 5 years
D. 2 years
6. Consider a project that requires cash outflow of P50,000 with a life of eight years and a
salvage value of P5,000. Annual before-tax cash inflow amounts to P10,000. Salvage value
is ignored in computing depreciation.
Assuming a tax rate of 30% and a required rate of return of 896, what is the payback period
for the project?
A. 5.0 years
B. 5.6 years
C. 6.0 years
D. 6.6 years
7. Machine Manufacturing Company considers a project that will require an initial investment
of P500,000 and is expected to generate future cash flows of P200,000 for years I through 3
and P100,000 for years 4 through 7. The project's payback period is:
A. 2.50 years
B. 3.50 years
C. 1.67 years
D. 3.33 years
8. Vinson Industries, Inc. requires all its capital investment projects to have a payback period
of 5 years or shorter. Vinson is currently considering an equipment purchase that has an initial
cost of P900,000. The equipment is expected to have a ten-year life and a salvage value of
P50,000. Assuming cash flows are equal, how much annual cash inflows are necessary in
order to meet the payback period requirement?
A. P180,000
B. P170,000
C. P190,000
D. P 90,000
9. The Dwight Company plans to invest in a duplicating machine thar costs P120,000. The
following are the expected annual cash inflows that are evenly received each month and the
estimated salvage value at any point of each year.

Year Cash Inflows Salvage Value

1 P40,000 P50,000
2 36,000 40,000
3 32,000 28,000
4 28,000 20,000
5 25,000 5,000

What is the bail-out period for this project?

A. 2.50 years
B. 2.43 years
C. 2.57 years
D. 1.83 years
10. Consider a project that requires an initial cash outflow of P500,000 with a life of eight
years and a salvage value of P20,000 upon its retirement. Annual cash inflow before tax
amounts to P100,000 and a tax rate of 30 percent will be applicable. The required minimum
rate of return for this type of investment is 8 percent. The present value of i and the annuity of
I, discounted at 8 percent for 8 periods are 0.54 and 5.747, respectively. Salvage value is
ignored in computing depreciation. The net present value amounts to
A. P 7,560
B. P 10,050
C. P 17,606
D. P 20,050
11. Vendo Company is planning to buy a coin-operated machine costing P400,000.
For book and tax purposes, this machine will be depreciated P80,000 each year for five years.
Vendo estimates that this machine will yield an annual inflow, net of depreciation and income
taxes, of P120,000. Vendo's desired rate of return on its investments is 12%. At the following
discount rates, the NPVs of the investment in this machine are:
Discount Rate NPV
12% + P3,258
14% + 1,197
16% - ….708
18% - ….2,474

Vendo's expected IRR on its investment in this machine is

A. 3.25%
B. 12.00%
C. 16.00%
D. 15.30%
12. Camel Company invests in a machine with a useful life of six years and no salvage value.
The machine will be depreciated using the straight-line method. It is expected to produce
annual cash inflow from operations, net of income taxes, of P6,000. The present value of an
ordinary annuity of P1 for six periods at 10% is 4.355. The present value of P1 for six periods
at 10% is 0.564. the original investment?
Assuming char Camel uses a time-adjusted rate of return of 1096, how much is
A. P10,640
B. P29,510
C. P22,750
D. P26,130
13. A company is considering putting up P50,000 in a three-year project. The company's
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 flows, net of income taxes are
P18,000 (present value of P16,074) for the At 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. P23,022
B. P 7,120
C. P10,000
D. P16,392
14. The Miracle Company is planning to purchase a new machine which it will depreciate,
for book purposes, on a straight-line basis over a ren-year period with no salvage value and
a full year's depreciation taken in the year of acquisition. The new machine is expected to
produce cash flows 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 percent. How much will the new machine cost?
A. P300,000
B. P660,000
C P550,000
D. P792,000
15. Prime Consulting, Inc. operates consulting offices in Manila, Olongapo, and Cebu. The
firm is presently considering an investment in a new mainframe computer and communication
software. The computer would cost P6 million and have an expected life of 8 years. For tax
purposes, the computer can be depreciated using either straight-line method or Sum-of-the-
Years'-Digits (SYD) method over five years. No salvage value is recognized in computing.
depreciation expense and no salvage value is expected at the end of the life of the equipment.
The company's cost of capital is 10 percent and its tax rate is 40 percent.

The present value of annuity of 1 for 5 periods is 3.791 and for 8 periods is 5.335. The
present values of 1 end of each period are:
1 0.9091 5 0.6209
2 0.8264 6 0.5645
3 0.6513 7 0.5132
4 0.6830 8 0.4665

The present value of the net advantage of using SYD method of depreciation which a five year
life instead of straight-line method of depreciating the equipment is:
A. P 86,224
B. P115,168
C. P215,560
D. P287,893

Questions 16 through 19 will be based on the following data:

The management of Queen Corporation is considering the purchase of a new machine
casting P400,000. The company's desired rate of return is 10%. The present value of 1
at compound interest of 10% for 1 through 5 years are 0.909. 0.826, 0.751. 0.683, and
0.621, respectively, and the present value of annuity of 1 for 5 periods at 10 percent is
3.79. In addition to the foregoing information, use the following data in determining the
acceptability in this situation:
Income from Net Cash
Year Operations Flow
1 P100,000 P180,000
2 40,000 120,000
3 20,000 100,000
4 10,000 20,000
5 10,000 20,000
16. The average rate of return for this investment is:
A. 18 percent
B. 6 percent
C. 58 percent
D. 10 percent
17. The net present value for this investment is:
A. Positive P 36,400
B. Positive P 55,200
C. Negative P 99,600
D. Negative P126,800
18. The present value index for this investment is:
A. 0.88
B. 1.45
C. 1.14
D. 0.70
19. The cash payback period for this investment is:
A. 4 years
B. 5 years
C. 20 years
D. 3 years
20. Paper Products Company is considering a new product that will sell for P100 and has a
variable cost of P60. Expected volume is 20,000 units. New equipment costing P1,500,000
and having a five-year useful life and no salvage value is needed, and will be depreciated
using the straight-line method. The machine has fixed cash operating costs of P200,000 per
year. The firm is in the 40 percent tax bracket and has cost of capital of 12 percent. The
present value of 1, end of five periods is 0.56743; present value of annuity of 1 for 5 periods
is 3.60478.
How many units per year the firm must sell for the investment to earn 12 percent internal rate
of return?
A. 17,338
B. 28,897
C. 9,838
D. 12,338
21. Refer to the preceding number:
Suppose the 20,000 estimated sales volume is sound, but the price is in doubt, what is the
selling price (rounded to nearest peso) needed to earn a 12 percent internal rate of return?
A. P81.00
B. P95.00
C. P70.00
D. P90.00
22. Taal Company is considering the purchase of a machine thar promises to reduce operating
costs by equal amounts every year of its 6-year useful life. The machine will cost P840,000
and has no salvage value. The machine has a 20%, internal rate of return. Taal Company is
subject to 40% income tax rate. The present value of annuity of 1 for 6 periods at 20% is
3.326, and the present value at the end of 6 periods is 0.3349.
The approximate annual cash savings before tax is closest to:
A. P252,555
B. P112,555
C. P187,592
D. P327,592

23. An asset was purchased for P66,000. The asset is expected to last for 6 years and will
have a salvage value of P16,000. The company expects the income before tax to be P7,200
and he tax rate applicable to the company is 30%. What is the average return on investment
(accounting rate of return)?
A. 17.6%
B. 7.6%
C. 10.9%
D. 12.3%

24. Capital Company requires all capital investment to generate an internal rate of return of
16 percent. Capital is currently considering an investment in machine that is expected to
generate annual cash inflows of P15,000 for 7 years. The present value of ordinary annuity
of 1, 16 percent for 7 years is 4.03856. Applying the discounted technique, the amount of
investment should not exceed:
A. P16,800
B. P37,150
C. P60,580
D. P95,500

25. Pacau, Inc. requires all its capital investments to generate an internal rate of return of 14
percent. The company is considering an investment costing P80,000 that is expected to
generate equal annual cash inflows for 5 years. The present value of 1, end of 5 years is
0.51937 and the present value of annuity of 1 is 3.4331 based on 14 percent required rate
of return. To meet the 14 percent minimum acceptable rate of return, the estimated
annual cash inflow (ignoring income taxes) is:
A. P 23,303
B. P 51,550
C. P274,648
D. P154,033
26. The Fields Company is planning to purchase a new machine which it will depreciate, for
book purposes, on a straight-line basis over a ten-year period with no salvage value and a
full year's depreciation taken 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 ren years. The accounting (book value) rate of return on
the initial investment is expected to be 12%.
How much will the new machine cost?
A. P300,000
B. P550,000
C. P660,000
D. P792,000
27. Kipling Company has invested in a project that has an eight-year life. It is expected that
the annual cash inflow from the project will be P20,000. Assuming that the project has a
internal rate of return of 12%, how much was the initial investment in the project if the present
value of annuity of 1 for 8 periods is 4.968 and the present value of 1 is 0.404?
A. P160,000
B. P 99,360
C. P 80,800
D. P 64,640

Question Nos. 28 through 30 are based on the following:

Kabalikat Company has the opportunity so introduce a new product. Kabalikat experts the
produce to sell for P75 with variable cost per unit of P50. The annual fixed conf excluding the
amount of depreciation is P4,500,000. The company expects to sell 300,000 units. To produce
the new product line, the company needs to purchase a new machine that costs P6,000,000.
The new machine is expected to last for four years with a very negligible salvage value. The
company has a policy of depreciating its machine for both, book and tax purposes for four
years. The company has a marginal cost of capital of 13.75 percent and is subject to tax rate
of 40 percent.

28. The amount of annual after-tax cash flows is:

A. P2,400,000
B. P3,000,000
C. P 900,000
D. P1,500,000
29. The machine's net present value is:
A. P2,786,100
B. P 928,500
C. P1,028,900
D. P 150,270
30. Assuming that some of the 300,000 units that are expected as sales would be to
group of customers who currently buy K-Z, another product of Kabalikat Company. This
Product K-Z sells for P35 with variable cost of P20. How many units of K-Z can Kabalikat
afford to lose before the purchase of the new machine becomes unattractive?
A. 39,000 units
B. 23,400 units
C. 16,714 units
D. 10,029 units

Question Nos. 31 through 33 are based on the following:

Cayco Medical Center is considering purchasing an ultrasound machine for P950,000
The machine has a 10 - year life and an estimated salvage value of P$5,000. Installation
costs and freight changes will be P24,200 and P800, respectively. Cayeo uses straight-line
depreciation. The medical center estimates that the machine will be used five times a week
with the average charges to the patient for ultrasound of P800. There are P10 in medical
supplies and P40 of technician costs for each procedure performed using the machine. The
present value of an annuity of I for 10 years at 9% is 6.418 while the present value of I for 10
years at 9% is 0.42241

31. The cash payback period is:

A. 3.0 years
B. 4.8 years
C. 5.0 years
D. 6.0 years
32. The project is expected to generate net present value of:
A. P276,510
B. P299,743
C. P331,510
D. P253,277
33. What is the accounting rate of return provided by the project?
A. 20.0 percent
B. 10.6 percent
C. 11.2 percent
D. 38.0 percent