FINANCIAL MANAGEMENT

Capital Budgeting

Instructions. Choose the BEST answer for each of the following items.

1. What technique does not use cash flow for capital investment decision?
a. payback b. NPV c. ARR d. IRR
2. Cost of capital is 3%; economic life in years = 4; what is the simple PV factor for year 4?
a. 0.915 b. 0.888 c. 0.455 d. 0.350
3. What is the PV factor of any amount at year zero or zero percent?
a. Zero b. 0.50 c. 1.00
d. An amount that cannot be determined without more information.
4. The net present value method assumes the project’s cash flows are reinvested at the
a. Internal rate of return b. Simple rate of return c. Cost of capital d. Payback period
5. If the IRR on an investment is zero,
a. Its NPV is positive c. Its cash flows
b. It is generally a wise investment d. Its annual cash flows equal its required investment
6. Capital budgeting is concerned with
a. Decision affecting only capital-intensive industries c. Analysis of long-range decisions
b. Analysis of short-range decisions d. Scheduling of office personnel in office buildings
7. The most convenient way to handle proceeds from the disposal of an asset is to
a. Treat it as a cash flow c. Offset the amount against the cash outlay
b. Treat it as a reduction in salvage value d. Add to the investment
8. In deciding whether to replace a machine, which of the following is not a sunk cost?
a. The expected resale price of the existing machine b. The original cost of the existing machine
9. To approximate annual cash inflow, depreciation is
a. Subtracted from net income because it is an expense
b. Added back to net income because it is an inflow of cash
c. c. Subtracted from net income because it is an outflow of cash
d. Added back to net income because it is not an outflow of cash
10. 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.
11. 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 c. be deducted for tax purposes
b. be saved if the project is accepted rather than rejected d. affect net income in the period that they are incurred
12. 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 IRR and NPV
d. evaluate mutually exclusive investment
13. How should the following projects be listed in their order of increasing risk?
a. New venture, replacement, expansion c. Replacement, expansion, new venture
b. Replacement, new venture, expansion d. Expansion, replacement, new venture
14. At what stage of the capital budgeting process would management most likely apply present value techniques?
a. Identification stage b. Search stage c. Selection stage d. Financing stage
15. Assuming that the project has already been evaluated using the following techniques, the evaluation under which
technique is least l likely to be affected by the increase in the estimated residual value of the project?
a. Payback period b. Internal rate of return c. Net present value d. Profitability index

Problems
1. Naga Company is considering the sale of a machine with a book value of P80,000 and 3 years remaining in its useful life.
Straight-line depreciation of P25,000 annually is available. The machine has a current market value of P100,000. What is
the cash flow from selling the machine if the tax rate is 40%?
 a. P80,000 b. P88,000 c. P92,000 d. P100,000
2. A company is considering replacing a machine with one that will save P50,000 per year in cash operating costs and has
P20,000 more depreciation expense per year than the existing machine. The tax rate is 40%. Buying the new machine
will increase annual net cash flows of the company by
a. P38,000 b. P30,000 c. P20,000 d. P12,000

3. A project costing P180,000 will produce the following annual cash benefits and salvage value:
Old equipment New equipment
Revenue P150,000 P180,000
Cash operating costs 70,000 60,000
Annual depreciation 30,000 50,000
Income tax, 46%
What is the incremental annual cash income after taxes?
a. P30,000 b. P30,800 c. P40,000 d. P38,000

4. A company invested in a new machine that will generate revenues of P35,000 annually for seven years. The company will
have annual operating expenses of P7,000 on the new machine. Depreciation expense, included in the operating
expenses, is P4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the
company pay for the new machine?
a. P145,600 b. P161,200 c. P166,400 d. P182,000

5. A corporation is considering purchasing a machine that costs P100,000 and has a P20,000 salvage value. The machine will
provide net annual cash inflows of P25,000 per year and has a six-year life. The corporation uses a discount rate of 10%.
The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the
present value of an annuity for six years is 4.355. What is the net present value of the machine?
a. P(2,405) b. P8,875 c. P20,155 d. P28,875

Questions 6 to 10 are based on the following

Lakewood Company is considering the purchase of a special-purpose bottling machine for P280,000. It is expected to
have a useful life of 7 years with a zero terminal disposal price. The plant manager estimates the following savings in
cash-operating costs:
Year Annual Cash Savings
1 140,000
2 110,000
3 80,000
4 60,000
5 40,000
6 30,000
7 30,000
Lakewood uses a required rate of return of 12% in its capital budgeting decisions. Incremental tax rate is 40%. The
company uses straight line depreciation. The present value of an annuity of 1, at 12% for y years is 4.56376. The details
of the present value at 12% in seven years are:
Year Annual cash savings
1 0.89286
2 0.79719
3 0.71178
4 0.63552
5 0.56743
6 0.50663
7 0.45235
6. The number of years to recover the amount of investment is:
a. 4.83 years b. 3.65 years c. 2.38 years d. 4.0 years

7. What is the amount of after-tax cash flow in year 7? a. P30,000 b. 34,000 c. 36,400 d. 22,000
9. What is the net present value for the investment? a. P4,723 b. 8,559 c. (2,159) d. 0
10. What is the accounting rate of return based on initial investment?
a. 6.43% b. 12.86% c. 20.71% d. 41.42%

Questions 11 to 12 are based on the following:

For new equipment acquisitions, Melba Company has set a payback goal of 3 years and a desired rate of return of 25%
based on initial investment. An equipment to be used in Melba’s Forming department is being evaluated. Data
pertaining to the equipment are as follows:
Cost of equipment P1,800,000
Useful life 10 years
Salvage value at the end of the useful life 0
Melba Corporation is subject to 40% income tax rate. It uses the straight-line method in computing depreciation
11. To meet Melba’s payback goal, the new equipment must generate savings in annual cash operating costs of
a. P600,000 b. P880,000 c. P700,000 d. P420,000

12. The new equipment’s accounting rate of return will

a. be lower than the desired rate of return b. be exactly equal to the desired rate of return
b. Exceed he desired rate of return c. exceed its payback period

13. George Company is planning to acquire a new machine at a total cost of P306,000. The estimated life of the machine is
six years and the estimated salvage value is P6,000. George Company estimates annual cash savings from using the
machine will be P80,000. Assume that the company’s cost of capital is 8% and its income tax rate is 40%. The present
value of 1 for six years is 0.630. The present value of an annuity of 1 in arrears at 8% for six years is 4.623. What are the
annual after tax cash benefits of this investment?
a. 30,000 b. 48,000 c. 54,000 d. 68,000

14. Assuming the same information as in no.13, if the annual after tax cash benefits of this investment were P50,000, what
would the net present value of this investment be?
a. 74,850 negative b. 71,070 negative c. 71,070 positive d. 74,850 positive.
15. Warrick Winery is considering two mutually exclusive projects, Project Red and Project White. The projects have the
following cash flows:
Project Red Project White
Year Cash Flows Cash Flows
0- P1,000 -P1,000
1 100 700
2 200 400
3 600 200
4 800 100
Assume that both projects have a 10 percent WACC.
121. What is the internal rate of return (IRR) of the project that has the
highest NPV?
a. 14.30%
b. 21.83%
c. 18.24%
d. 10.00%