Capital Budgeting Theories: Basic Concepts

Capital Budgeting
MODULE 9
CAPITAL BUDGETING
THEORIES:
Basic Concepts
Decision Making Process
2. The first step in the decision-making process is to
A. determine and evaluate possible courses of action.
B. identify the problem and assign responsibility.
C. make a decision.
D. review results of the decision.
Strategic planning
39.Strategic planning is the process of deciding on an organization’
A. minor programs and the approximate resources to be devoted to them
B. major programs and the approximate resources to be devoted to them
C. minor programs prior to consideration of resources that might be needed
D. major programs prior to consideration of resources that might be needed
Capital budgeting defined

1. The long-term planning process for making and financing investments that affect a
company’s financial results over a number of years is referred to as
A. capital budgeting C. master budgeting
B. strategic planning D. long-range planning
3. Capital budgeting is the process

A. used in sell or process further decisions.
B. of determining how much capital stock to issue
C. of making capital expenditure decisions
D. of eliminating unprofitable product line
5. A capital investment decision is essentially a decision to:

A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash inflows.
C. exchange current cash flow from operating activities for future cash inflows from
investing activities.
D. exchange current cash inflows for future cash outflows.
Risk & return

6. 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 capital is.
D. higher the discount rate is.
9. 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.
14.How should the following projects be listed in order of increasing risk?

A. New venture, replacement, expansion.
B. Replacement, new venture, expansion.
C. Replacement, expansion, new venture.
D. Expansion, replacement, new venture.
41.Problems associated with justifying investments in high-tech projects often include

discount rates that are too
A. low and time horizons that are too long
B. high and time horizons that are too long
C. high and time horizons that are too short
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Capital Budgeting
D. low and time horizons that are too short
60.In evaluating high-tech projects,

A. only tangible benefits should be considered.
B. only intangible benefits should be considered.
C. both tangible and intangible benefits should be considered.
D. neither tangible nor intangible benefits should be considered.
Types of capital projects

4. A project that when accepted or rejected will not affect the cash flows of another
project.
A. Independent projects C. Mutually exclusive projects
B. Dependent projects D. Both b and c
Capital budgeting process

7. The normal methods of analyzing investments
A. cannot be used by not-for-profit entities.
B. do not apply if the project will not 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.
Investments
Sale of old asset
38.When disposing of an old asset and replacing it with a new one, tax effect on
A. gain on sale of the old asset reduces the basis of the new asset
B. gain on sale of the old asset increases the basis of the new asset
C. loss on sale of the old asset reduces the basis of the new asset
D. b and c
Working capital
18.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.
30.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 the annual
cash flows
D. add it to the investment in fixed assets and add the present value of the recovery to
the present value of the annual cash flows
31.In connection with a capital budgeting project, an investment in working capital is

normally recovered
A. at the end of the project’s life
B. in the first year of the project’s life
C. evenly through the project’s life
D. when the company goes out of businessA
32.XYZ Co. is adopting just-in-time principles. When evaluating an investment 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.
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Capital Budgeting
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.
Relevant cash flows

72.Which of the following represents the biggest challenge in the decision to purchase
new equipment?
A. Estimating employee training for the new project.
B. Estimating cash flows for the future.
C. Estimating transportation costs of the new equipment.
D. Estimating maintenance costs for the new equipment.
51.When a firm has the opportunity to add a project that will utilize factory capacity that is
currently not being used, which costs should be used to determine if the added project
should be undertaken?
A. Opportunity costs C. Net present costs
B. Historical costs D. Incremental costs
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.
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.
Cash inflow
66.Which of the following is not a typical cash inflow in capital investment decisions?
A. Incremental revenues C. Salvage value
B. Cost reductions D. Additional working capital
Out-of-pocket costs
45.Which of the following is a cost that requires a future outlay of cash that is which
relevant for future decision-making?
A. Opportunity cost C. Sunk costs
B. Out-of-pocket cost D. Relevant benefits
Depreciation & Tax

22.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.
21.Relevant cash flows for net present value (NPV) models include all of the following
except
A. outflows to purchase new equipment
B. depreciation expense on the newly acquired piece of equipment
C. reductions in operating cash flows as a result of using the new equipment.
D. cash outflows related to purchasing additional inventories for another retail store.
55.When evaluating depreciation methods, managers who are concerned about capital
investment decisions will:
A. choose straight line 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. choice of depreciation method has no impact on the capital investment decision.
70.The tax consequences should be considered under which circumstances when making
capital investment decisions?
A. Positive net income C. Depreciation
B. Disposal of an asset D. All of the above
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Capital Budgeting
Irrelevant cash flows

Loan financing
43.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
10.If Helena 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
Sunk cost
29.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 book value of the existing machine.
C. The original cost of the existing machine.
D. The depreciated cost of the existing machine.
Accounting rate of return

54.The primary advantages of the average rate of return method are its ease 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
Nondiscounted cash flow method

Payback method
36.There are several capital budgeting decision models that do not use discounted cash
flows. What is the name of the simple technique that calculates the total time it will
take to recover, using cash inflows from operations, the amount of cash invested in a
project?
A. Recovery period C. External rate of return
B. Payback model D. Accounting rate of return
34.The technique most concerned with liquidity is

A. Payback method.
B. Net present value technique.
C. Internal rate of return.
D. book rate of return.
73.Which of the following is a potential use of the payback method?

A. Help managers control the risks of estimating cash flows
B. Help minimize the impact of the investment on liquidity
C. Help control the risk of obsolescence
D. All of the answers are correct
47.The cash payback technique:

A. should be used as a final screening tool.
B. can be the only basis for the capital budgeting decision.
C. is relatively easy to compute and understand.
D. considers the expected profitability of a project.
33.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.
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Capital Budgeting
D. It ignores the pattern of cash flows beyond the payback period.
48.The payback method, as a capital budgeting technique, assumes that all intermediate
cash inflows are reinvested to yield a return equal to:
A. Zero C. The Discount Rate
B. The Time-Adjusted-Rate-of-Return D. The Cost-of-Capital
52.Which of the following capital budgeting methods is the least theoretically correct?
A. payback method C. internal rate of return
B. net present value D. none of the above
Discounted cash flow method

49.Which of the following methods of evaluating capital investment projects incorporates
the time value of money?
A. Payback period, accounting rate of return, and internal rate of return
B. Accounting rate of return, net present value, and internal rate of return
C. Payback period and accounting rate of return
D. Net present value and internal rate of return
Net present value

69.Discounted cash flow analysis is used in which of the following techniques?
A. Net present value C. Cost of capital
B. Payback period D. All of the above
8. The primary capital budgeting method that uses discounted cash flow techniques is the
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method.
20.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 C. contribution approach
B. incremental approach. D. total project approach.
40.The discount rate commonly used in present value calculations is the

A. treasury bill rate
B. weighted average return on assets adjusted for risk
C. risk free rate plus inflation rate
D. shareholders’ expected return on equity
44.Which is true of the net present value method of determining the acceptability of an
investment?
A. The initial cost of the investment is subtracted from the present value of net cash
flows
B. The net cash flows are not adjusted to present value
C. A negative net present value indicates the investment should be undertaken
D. The net present value method requires no subjective judgments
Profitability index
35.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 differing initial
investments.
D. will never be greater than 1.0.
Internal rate of return

56.According to the reinvestment rate assumption, which method of capital budgeting
assumes cash flows are reinvested at the project’s rate of return?
A. payback period C. internal rate of return
B. net present value D. none of the above
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Capital Budgeting
62.The rate of interest that produces a zero net present value when a project’s discounted
cash operating advantage is netted against its discounted net investment is the:
A. Cost of capital C. Cutoff rate
B. Discount rate D. Internal rate of return
57.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
Comprehensive
50.Which of the following methods of evaluating capital investment projects do not use a
percentage as a measurement unit?
A. Payback period and net present value
B. Accounting rate of return and payback period
C. Net present value and internal rate of return
D. Internal rate of return and payback period
Relationships among NPV, PI & IRR

24.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. C. less than 12 percent.
B. greater than 12 percent. D. dependent on the size of the investment.
25.If the present value of the future cash flows for an investment equals the required
investment, the IRR is
A. equal to the cutoff rate.
B. equal to the cost of borrowed capital.
C. equal to zero.
D. lower than the company’s cutoff rate return.
27.The relationship between payback period and IRR is that

A. a payback period of less than one-half the life of a project will yield an IRR lower
than the target rate.
B. the payback period is the present value factor for the IRR.
C. a project whose payback period does not meet the company’s cutoff rate for
payback will not meet the company’s criterion for IRR.
D. none of the above.
67.When comparing NPV and IRR, which is not true?

A. With NPV, the discount rate can be adjusted to take into account increased risk and
the uncertainty of cash flows
B. With IRR, cash flows can be adjusted to account for risk
C. NPV can be used to compare investments of various size or magnitude
D. Both NPV and IRR can be used for screening decisions
Sensitivity analysis
13.In capital budgeting, sensitivity analysis is used
A. to determine whether an investment is profitable.
B. to see how a decision would be affected by changes in variables.
C. to test the relationship of the IRR and NPV.
D. to evaluate mutually exclusive investments.
15.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.
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Capital Budgeting
42.Sensitivity analysis is the study of how the outcome of a decision making process
A. changes as one or more of the assumptions change
B. remains the same even though one or more of the assumptions change
C. changes even though one or more of the assumptions do not change
D. does not change as the assumptions do not change either
64.Sensitivity analysis is:

A. An appropriate response to uncertainty in cash flow projections
B. Useful in measuring the variance of the Fisher rate
C. Typically conducted in the post investment audit
D. Useful to compare projects requiring vastly different levels of initial investment
IRR = 0
58.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.
Change in NPV
59.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
Effectof change in cost of capital

26.Allother 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.
Effect of change in residual value

23.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. C. Net Present Value.
B. Internal Rate of Return. D. Profitability Index.
Decision rules – independent projects

68.What type of decision involves deciding if an investment meets a predetermined
standard?
A. Investment decisions C. Management decisions
B. Screening decisions D. Preference decisions
Payback period
46.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.
Net present value

61.An analysis of a proposal by the net present value method indicated that the present
value of future cash inflows exceeded the amount to be invested. Which of the
following statements best describes the results of this analysis?
A. The proposal is desirable and the rate of return expected from the proposal exceeds
the minimum rate used for the analysis
B. The proposal is desirable and the rate of return expected from the proposal is less
than the minimum rate used for the analysis
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Capital Budgeting
C. The proposal is undesirable and the rate of return expected from the proposal is less
than the minimum rate used for the analysis
D. The proposal is undesirable and the rate of return expected from the proposal
exceeds the minimum rate used for the analysis
63.NPV indicates a project is deemed desirable (acceptable) when the NPV is

A. greater than or equal to zero
B. less than zero
C. greater than or equal to the risk-adjusted cost of capital
D. less than or equal to the risk-adjusted cost of capital
Internal rate of return

12.If Arbitrary Company wants to use IRR to evaluate long-term decisions and to establish
a cutoff rate of return, it must be sure that the 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.
NPV & IRR

19.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.
Decision rule – mutually exclusive projects

71.Mutually exclusive projects are those that:
A. if accepted, preclude the acceptance of competing projects.
B. if accepted, can have a negative effect on the company’s profit.
C. if accepted, can also lead to the acceptance of a competing project.
D. require all managers to consider.
28.In choosing from among mutually exclusive investments the manager should normally
select the one with the highest
A. Net present value. C. Profitability index.
B. Internal rate return. D. Book rate of return.
53.Why do the NPV method and the IRR method sometimes produce 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 rate 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.
Post-audit
16.Post-audit of capital projects
A. is usually conclusive.
B. is done using different evaluation techniques than 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 above.
17.A thorough evaluation of how well a project’s actual performance matches the
projections made when the project was proposed is called a
A. pre-audit. C. sensitivity analysis.
B. post-audit. D. risk analysis.
37.A follow-up evaluation of a capital project is performed to see that investment
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Capital Budgeting
expenditures are proceeding on time and on budget, to compare actual cash flows with
those originally predicted, and to evaluate continuation of the project. This follow-up is
called a
A. postaudit. C. management audit
B. performance evaluation D. project review
65.Companies use post audits to:

A. chastise managers whose project does not exceed projections.
B. prove to managers that they should have accepted projects they previously
rejected.
C. have the managers revise poorly performing projects so the projects will have larger
return in the future.
D. provide feedback that enables managers to improve the accuracy of the projections
of future cash flows, thereby maximizing the quality of the firm’s capital
investments.
PROBLEMS:
Net Investment
i
. Bruell Company is considering to replace its old equipment with a new one. The old
equipment had a net book value of P100,000, 4 remaining useful life 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 C. P 80,000
B. P 72,000 D. P 68,000
Operating Cash Flow

Cash Flow Before tax
ii
. Taal Company is considering the purchase of a machine that 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 1 for 6
periods at 20% is 3.326, and at the end of 6 periods is 0.3349.
The approximate annual cash savings before tax is closest to:
A. P252,555 C. P187,592
B. P112,555 D. P327,592
Increase in Annual Income Tax

iii
. Mayon Company is considering replacing its old machine with 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 C. P40,000
B. P28,000 D. P 4,000
Depreciation & Taxes

iv
. 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
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Capital Budgeting
4 0.6830 8 0.4665
The present value of the net advantage of using SYD method of depreciation with a
five-year life instead of straight-line method of depreciating the equipment is:
A. P 86,224 C. P215,560
B. P115,168 D. P287,893
v
. For P450,000, Maleen Corporation purchased a new machine with an estimated useful
life of five years with no salvage value. The machine is expected to produce cash flow
from operations, net of 40 percent income taxes, as follows:
First year P160,000
Second year 140,000
Third year 180,000
Fourth year 120,000
Fifth year 100,000
Maleen will use the sum-of-the-years-digits’ method to depreciate the new machine as
follows:
First year P150,000
Second year 120,000
Third year 90,000
Fourth year 60,000
Fifth year 30,000
The present value of 1 for 5 periods at 12 percent is 3.60478. The present values of 1
at 12 percent at end of each period are:
End of:
Period 1 0.89280
Period 2 0.79719
Period 3 0.71178
Period 4 0.63552
Period 5 0.56743
Had Maleen used straight-line method of depreciation instead of declining method,
what is the difference in net present value provided by the machine at a discount rate
of 12 percent?
A. Increase of P 9,750 C. Decrease of P24,376
B. Decrease of P 9,750 D. Increase of P24,376
Accounting rate of return

Based on initial investment
vi
. A piece of labor saving equipment that Marubeni Electronics Company could use to
reduce costs in one of its plants in Angeles City has just come onto the market.
Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment90,000
Life of the equipment 12 years
What is the simple rate of return to be provided by the equipment?
A. Between 15% and 18%. C. 20.83%.
B. 25.00%. D. 12.50%.
Based on average investment

vii
. The BIBO Company has made an investment in video and recording equipment that
costs P106,700. The equipment is expected to generate cash inflows of P20,000 per
year. How many years will the equipment have to be used to provide the company
with a 10 percent average accounting rate of return on its investment?
A. 7.28 years C. 9.05 years
B. 5.55 years D. 4.75 years
viii
. Show Company is negotiating to purchase an equipment that would cost P200,000,
with the expectation that P40,000 per year could be saved in after-tax cash operating
costs if the equipment were acquired. The equipment’s estimated useful life is 10
years, with no salvage value, and would be depreciated by the straight-line method.
Show Company’s minimum desired rate of return is 12 percent. The present value of
an annuity of 1 at 12 percent for 10 periods is 5.65. The present value of 1 due in 10
periods, at 12 percent, is 0.322.
The average accrual accounting rate of return (ARR) during the first year of asset’s use
is:
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Capital Budgeting
A. 20.0 percent C. 10.0 percent

B. 10.5 percent D. 40.0 percent
ix
. 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 the tax rate applicable to the company is 30%. What is the average return
on investment (accounting rate of return)?
A. 17.6% C. 10.9%
B. 7.6% D. 12.3%
Net Investment
x
. The Makabayan 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 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 C. P550,000
B. P660,000 D. P792,000
xi
. 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 ten 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 C. P660,000
B. P550,000 D. P792,000
CFAT
xii
. The Hills Company, a calendar company, purchased a new machine for P280,000 on
January 1. Depreciation for tax purposes will be P35,000 annually for eight years. The
accounting (book value) rate of return (ARR) is expected to be 15% on the initial
increase in required investment. On the assumption of a uniform cash inflow, this
investment is expected to provide annual cash flow from operations, net of income
taxes, of
A. P35,000 C. P42,000
B. P40,250 D. P77,000
Payback Period
xiii
. 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 C. 6 years
B. 7 years D. 5 years
xiv
. 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 assuming a
tax rate of 30% and a required rate of return of 8%. Salvage value is ignored in
computing depreciation. The project has a payback period of
xv
. The following incomplete information is provided for an investment decision.
Discount Discounte Cumulative
Year Cash Flow Factor d Cash Cash Flows
(10%) Flows
0 P(450,000) 1.000 P(450,000) P(450,000)
1 280,000 .909 254,520
2 210,000 .826
3 140,000 .751
Using break-even time (BET) analysis, when will the investment be recovered?
237
Capital Budgeting
A. In 2.73 years C. At the end of year 2

B. Longer than three years D. In 2.21 years
xvi
. Orlando 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 0
Salvage value of the new machine in 8 years 50,000
Estimated life of the new machine 8 years
What is the expected payback period for the new machine?
xvii
. For P4,500,000, Siniloan 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 P 900,000
Second year 1,200,000
Third year 1,500,000
Fourth year 900,000
Fifth year 800,000
Siniloan 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?
xviii
. Paz Insurance Company’s management is considering an advertising program that
would require an initial expenditure of P165,500 and bring in additional sales over the
next five years. The cost of advertising is immediately recognized as expense. The
projected additional sales revenue in Year 1 is P75,000, with associated expenses of
P25,000. The additional sales revenue and expenses from the advertising program are
projected to increase by 10 percent each year. Paz Insurance Company’s tax rate is 40
percent.
The payback period for the advertising program is
xix
. The Leisure Company is considering the purchase of electronic pinball machines to
place in amusement houses. The machines would cost a total of P300,000, have an
eight-year useful life, and have a total salvage value of P20,000. Based on experience
with other equipment, the company estimates that annual revenues and expenses
associated with the machines would be as follows:
Revenues form use P200,000
Less operating expenses
Commissions to amusement houses P100,000
Insurance 7,000
Depreciation 35,000
Maintenance 18,000 160,000
Net income P 40,000
Ignoring the effect of income taxes, the payback period for the pinball machines would
be
Net Present Value
238
Capital Budgeting
xx
. It is the start of the year and Agudelo Company plans to replace its old grinding
equipment. The following information are made available by the management:
Old New
Equipment cost P70,000 P120,000
Current salvage value 14,000 -
Salvage value, end of 5,000 16,000
useful life
Annual operating costs 44,000 32,000
Accumulated 55,300 -
depreciation
Estimated useful life 10 years 10 years
The company is not subject to tax and its cost of capital is 12%. What is the present
value of all the relevant cash flows at time zero?
A. (P 54,000) C. (P106,000)
B. (P120,000) D. (P124,700)
xxi
. 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 1
and the annuity of 1, 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 C. P 17,606
B. P 10,050 D. P 20,050
xxii
. Zap Manufacturing has an investment opportunity to embark on a project where yearly
revenues for five years are to be P400,000 and operating costs of P104,800. The
equipment costs P1 million, and straight-line depreciation will be used for book and tax
purposes. No salvage value is expected at the end of the project’s life. The company
has a 40 percent marginal tax rate and a 10 percent cost of capital. The equipment
manufacturer has offered a delayed payment plan of P560,500 per year at the end of
the first and second years. There will be no changes in working capital.
The present value of annuity of 1 for 5 periods is 3.7908 at 10 percent.
The present values of 1 end of each period at 10 percent are:
Period 1 0.9091
Period 2 0.8264
Period 3 0.7513
Period 4 0.6830
Period 5 0.6209
The net present value if the equipment were purchased is
A. P (87,977) C. P 1,922
B. P (25,310) D. P (61,094)
xxiii
. Paz Insurance Company’s management is considering an advertising program that
would require an initial expenditure of P165,500 and bring in additional sales over the
next five years. The cost of advertising is immediately recognized as expense. The
projected additional sales revenue in Year 1 is P75,000, with associated expenses of
P25,000. The additional sales revenue and expenses from the advertising program are
projected to increase by 10 percent each year. Paz Insurance Company’s tax rate is 40
percent.
The present value of 1 at 10 percent, end of each period:
Period Present value of 1
1. 0.90909
2. 0.82645
3. 0.75131
4. 0.68301
5. 0.62092
The net present value of the advertising program would be
A. P 37,064 C. P 29,136
B. P(37,064) D. P(29,136)
xxiv
. Mario Hernandez plans to buy a haymaker. It costs P175,000 and is expected to last for
239
Capital Budgeting
five years. He presently hires 6 workers at P10,000 per month for each of the three
harvesting months each year. The equipment would eliminate the need for two
workers. Hernandez uses straight-line depreciation and projects a salvage value of
P25,000. His tax rate is 25% and opportunity cost of funds is 12.0%. The present value
of 1discounted at 12 percent at the end of 5 periods is 0.56743 and the present value
of an annuity of 1 for 5 periods is 3.60478. Which of the following is true?
A. The present value of cash flows in year 5 is P22,710
B. NPV is P28,436
C. NPV is P15,250
D. NPV is P14,186
xxv
. Tabucol Aggregates, Inc. plans to replace one of its machines with a new efficient one.
The old machine has a net book value of P120,000 with remaining economic life of 4
years. This old machine can be sold for P80,000. If the new machine were acquired,
the cash operating expenses will be reduced from P240,000 to P160,000 for each of the
four years, the expected economic life of the new machine. The new machine will cost
Tabucol a cash payment to the dealer of P300,000. The company is subject to 32
percent tax and for this kind of investment, a marginal cost of capital of 9 percent. The
present value of annuity of 1 and the present value of 1 for 4 periods using 9 percent
are 3.23972 and 0.70843, respectively.
The net present value to be provided by the replacement of the old machine is
A. P28,493 C. P46,794
B. P15,693 D. P59,594
xxvi
. Zambales Mines, Inc. is contemplating the purchase of equipment to exploit a mineral
deposit that is located on land to which the company has mineral rights. An
engineering and cost analysis has been made, and it is expected that the following
cash flows would be associated with opening and operating a mine in the area.
Cost of new equipment and timbers 2,750,000
Working capital required 1,000,000
Net annual cash receipts* 1,200,000
Cost to construct new road in three years 400,000
Salvage value of equipment in 4 years 650,000
*Receipts from sales of ore, less out-of-pocket costs for salaries, utilities, insurance,
etc.
It is estimated that the mineral deposit would be exhausted after four years of mining.
At that point, the working capital would be released for reinvestment elsewhere. The
company’s discount rate is 20%.
The net present value for the project is:
A. P 454,620. C. P(561,553)
B. P (79,303). D. P(204,688).
With inflation
xxvii
. By the end of December 31, 2005, Alay Foundation is considering the purchase of a
copying machine for P80,000. The expected annual cash savings are expected to be
P32,000 in the next four years. At the end of the four years, the machine will be
discarded without any salvage value. All the cash savings are stated in number of
pesos at December 31, 2006. The company expected that the inflation rate is
constantly 5 percent each year. Hence, the first year’s cash inflow was adjusted for 5
percent inflation. For simplicity, all cash inflows are assumed to be at year-end.
The present value at 14 % of 1 for 4 periods is 2.91371. The present value of 1 at end
of each period are:
Period 1 0.87719
Period 2 0.76947
Period 3 0.67497
Period 4 0.59208
Using the nominal rate of return of 14 percent, the net present value for this machine is
A. P12,239 C. P13,419
B. P19,670 D. P27,936
xxviii
. Perpetual Foundation, Inc., a nonprofit organization, has one of its activities, the
production of cookies for its snack food store. Several years ago, Perpetual Foundation,
Inc. purchased a special cookie-cutting machine. As of December 31, 2006, this
machine will have been used for three years. Management is considering the purchase
240
Capital Budgeting
of a newer, more efficient machine. If purchased, the new machine would be acquired
on December 31, 2006. Management expects to sell 300,000 dozen cookies in each of
the next six years. The selling price of the cookies is expected to average P1.15 per
dozen.
Perpetual Foundation, Inc. has two options: continue to operate the old machine, or
sell the old machine and purchase the new machine. No trade-in was offered by the
seller of the new machine. The following information has been assembled to help
management decide which option is more desirable.
Old New
Machine Machine
Original cost of machine at P80,000 P120,000
acquisition
Remaining useful life as of 6 years 6 years
12/31/06
Expected annual cash operating
expenses:
Variable cost per dozen P0.38 P0.29
Total fixed costs P21,000 P 11,000
Estimated cash value of
machines:
December 31, 2006 P40,000 P120,000
December 31, 2012 P 7,000 P 20,000
Assume all operating revenues and expenses occur at the end of the year.
The net advantage in present value of the better alternative is:
A. Retain Old Machine, P61,675.
B. Buy New Machine, P61,675.
C. Retain Old Machine, P16,345.
D. Buy New Machine, P16,345.
Profitability index
xxix
. The Pambansang Kamao Corporation has to replace its completely damaged boiler
machine with a new one. The old machine has a net book value of P100,000 with zero
market value; therefore it will give a tax shield, based on 35% tax rate if replaced, by
P35,000. The company has a 10 percent cost of capital. Understandably, the new
machine, through a uniform decrease in cash operating costs, will give a positive net
present value, because this machine will provide an internal rate of return of 12
percent.
The present values at 10% and 12%, respectively, are:
10% 12%
Annuity of 1, 6 periods 4.35526 4.11141
1 end of 6 periods 0.56447 0.50663
If the machine were to be depreciated using straight-line method for 6 years without
any salvage value, the estimated profitability index is:
A. 1.20
B. 1.06
C. 1.07
D. Cannot be determined from the information
xxx
. The Mejicano Company is planning to purchase a piece of equipment that will reduce
annual cash expenses over its 5-year useful life by equal amounts. The company will
depreciate the equipment using straight-line method of depreciation based on
estimated life of 5 years without any salvage value. The company is subject to 40
percent tax. The marginal cost of capital for this acquisition is 11.055 percent. The
management accountant calculated that the internal rate of return based on the
estimated after-tax cash flows is 12.386 percent and a net present value of P10,000.
The president, however, wants to know the profitability index before he finally decides.
What is the profitability index for this investment?
A. 1.011 C. 1.022
B. 1.034 D. 1.044
Internal Rate of Return

xxxi
. Diamond 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
241
Capital Budgeting
years. Diamond estimates that this machine will yield an annual inflow, net of
depreciation and income taxes, of P120,000. Diamond’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
Diamond’s expected IRR on its investment in this machine is
A. 3.25% C. 16.00%
B. 12.00% D. 15.30%
Required investment
xxxii
. 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 C. P 80,800
B. P 99,360 D. P 64,640
xxxiii
. Katol Company invested in a machine with a useful life of six years and no salvage
value. The machine was depreciated using the straight-line method. It was 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. Assuming that Katol used a time- adjusted
rate of return of 10%, what was the amount of the original investment?
A. P10,640 C. P22,750
B. P29,510 D. P26,130
xxxiv
. The Forest Company is planning to invest in a machine with a useful life of five
years and no salvage value. The machine is expected to produce cash flow from
operations, net of income taxes, of P20,000 in each of the five years. Forest’s expected
rate of return is 10%. Information on present value and future amount factors is as
follows:
PERIOD
1 2 3 4 5
Present value of P1 at 10% .909 .826 .751 .683 .621
Present value of an annuity of .909 1.73 2.48 3.17 3.79
P1 at 10% 6 7 0 1
Future amount of P1 at 10% 1.10 1.21 1.33 1.46 1.61
0 0 1 4 1
Future amount of an annuity 1.00 2.10 3.31 4.64 6.10
of P1 at 10% 0 0 1 5
How much will the machine cost?
A. P 32,220 C. P 75,820
B. P 62,100 D. P122,100
Required unit sales

xxxv
. 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 C. 9,838
B. 28,897 D. 12,338
Required selling price
242
Capital Budgeting
xxxvi
. Bughaw Products Company is considering a new product that will sell for P100 and
has a variable cost of P60. Expected sales volume is 20,000 units. New equipment
costing P1,500,000 with a five-year useful life and no terminal salvage value is needed.
The machine will be depreciated using the straight-line method. The machine has 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.
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 C. P70.00
B. P95.00 D. P90.00
Required CFBT
xxxvii
. Aloha Co. is considering the purchase of a new ocean-going vessel that could
potentially reduce labor costs of its operation by a considerable margin. The new ship
would cost P500,000 and would be fully depreciated by the straight-line method over
10 years. At the end of 10 years, the ship will have no value and will be sunk in some
already polluted harbor. The Aloha Co.’s cost of capital is 12 percent, and its marginal
tax rate is 40 percent. If the ship produces equal annual labor cost savings over its 10-
year life, how much do the annual savings in labor costs need to be to generate a net
present value of P0 on the project?
Use the following PV: annuity of 1, 10 periods at 12% - 5.6502; end of 10th period –
0.32197.
A. P 68,492 C. P114,154
B. P147,487 D. P 88,492
Required CFAT
xxxviii
. Prudu Company has decided to invest in some new equipment. The equipment will
have a three-year life and will produce a uniform series of cash savings. The net
present value of the equipment is P1,750, using a discount rate of 8 percent. The
internal rate of return is 12 percent.
Present values at 8% and 12% respectively:
8%: Annuity – 2.5771; end of 3 periods, 0.7938
12%: Annuity – 2,4018; end of 3 periods, 0.7118
What is the amount of annual cash inflow?
A. P 9,980 C. P23,240
B. P21,342 D. P12,351
xxxix
. An asset is purchased for P120,000. It is expected to provide an additional P28,000
of annual net cash inflows. The asset has a 10-year life and an expected salvage value
of P12,000. The hurdle rate is 10%. The present value of an annuity factor of 10% for
10 years is 6.1446, and the present value of P1, discounted for 10 years at 10% is
0.3855.
Given the data provided, the minimum amount of annual cash inflows that would
provide the 10% time-adjusted return is approximately
A. P18,776 C. P24,400
B. P26,600 D. P22,535
Required Increase in CFAT

xl
. The following data pertain to Julian Corp. whose management is planning to purchase a
unit of equipment.
1. Economic life of equipment – 8 years.
2. Disposal value after 8 years – Zero.
3. Estimated net annual cash inflows for each of the 8 years – P81,000.
4. Time-adjusted internal rate of return – 14%
5. Cost of capital of Bayan Muna – 16%
6. The table of present values of P1 received annually for 8 years has these factors:
at 14% = 4.639, at 16% = 4.344
7. Depreciation is approximately P46,970 annually.
Find the required increase in annual cash inflows in order to have the time-adjusted
rate of return approximately equal the cost of capital.
A. P6,501 C. P4,344
B. P5,501 D. P5,871
243
Capital Budgeting
Required CFAT for a certain year

xli
. 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 flow, net of
income taxes will be P18,000 (present value of P16,074) for the first year and P22,000
(present value of P17,534) for the second year. Assuming that the rate of return is
exactly 12%, the cash flow, net of income taxes, for the third year would be
A. P23,022 C. P10,000
B. P 7,120 D. P16,392
Required salvage value

xlii
. The Caravan Company is contemplating to purchase a machine that costs P800,000.
The machine is expected to last for 5 years with a salvage value of P50,000 at the end
of the fifth year. If the machine were purchased, before-tax annual cash savings on
operating expenses will be realized. Caravan Company will depreciate the machine
using straight-line depreciation for 5 years, with the salvage value considered in the
computation.
The company has a 12 percent cost of capital and is subject to 40 percent tax rate.
The present values using 12 percent are:
Annuity of 1 for 5 periods 3.60478
Present value of 1, end of 5 periods 0.56743
The initial analysis indicated a net present value of P7,003. You believe the estimated
before-tax cash savings are fairly determined but you are in doubt of the expected
salvage value of the machine.
How much is the estimated salvage value required if the investment has to yield an IRR
of 12 percent?
A. P41,800 C. P25,100
B. P24,900 D. P44,600
Required value of intangible benefits

xliii
. Solidum Company is investigating the purchase of a piece of automated equipment
that will save P100,000 each year in direct labor and inventory carrying costs. This
equipment costs P750,000 and is expected to have a 10-year useful life with no
salvage value. The company requires a minimum 15% return on all equipment
purchases. Management anticipates that this equipment will provide intangible benefits
such as greater flexibility and higher quality output.
The PV of annuity of 1, 15% for 10 periods 5.01877
The PV of 1, end 10 period 0.24718
What peso value per year would these intangible benefits have to have in order to
make the equipment an acceptable investment?
A. P248,123 C. P 61,331
B. P 49,440 D. P 55,000
xliv
. Altas, Inc., is considering investing in automated equipment with a ten-year useful
life. Managers at Altas 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 10% discount rate, the
net present value of the cash flows associated with just the tangible costs and
benefits is a negative P184,350. The present value of annuity of 1 at 10 percent for
ten years is 6.145 while the present value of 1 is 0.386. How large would the annual
net cash inflows from the intangible benefits have to be to make this a financially
acceptable investment?
A. P18,435. C. P35,000.
B. P30,000. D. P37,236.
Indifference Point
xlv
. Moon Company uses a 10% discount rate and the total cost approach to capital
budgeting analysis. Both alternatives are Akda Investments which has a marginal cost
of capital of 12 percent is evaluating two mutually exclusive projects (X and Y), which
have the following projections:
PROJECT X PROJECT Y
Investment P48,000 P83,225
After-tax cash 12,000 15,200
244
Capital Budgeting
inflow
Asset life 6 years 10 years
The indifference point for the two projects is
A. 12.64% C. 12.00%
B. 16.01% D. 19.33%
xlvi
. Silky Products is considering two pieces of machinery. The first machine costs P50,000
more than the second machine. During the two-year life of these two alternatives, the
first machine has a P155,000 more cash flow in year one and a P110,000 less cash flow
in year two than the seconds machine. All cash flows occur at year-end. The present
value of 1 at 15 percent end of 1 period and 2 periods are 0.86957 and, 0.75614,
respectively. The present value of 1 at 8 percent end of period 1 is 0.92593, and Period
2 is 0.85734.
At what discount rate would Machine 1 be equally acceptable as machine 2’s?
A. 9% C. 11%
B. 10% D. 12%
Decision Rule – Independent Projects

xlvii
. Sylvia Products is considering two types of machinery. The first machine costs P50,000
more than the second machine. During the two-year life of these two alternatives, the
first machine has a P155,000 more cash flow in year one and a P110,000 less cash flow
in year two than the seconds machine. All cash flows occur at year-end. The present
value of 1 at 15 percent end of 1 period and 2 periods are 0.86957 and, 0.75614,
respectively. The present value of 1 at 8 percent end of period 1 is 0.92593, and Period
2 is 0.85734.
Which machine should be purchased if the relevant discount rates are 15 percent and 8
percent, respectively?
15% Discount 8% Discount
A. Machine 1 Machine 1
B. Machine 2 Machine 2
C. Machine 1 Machine 2
D. Machine 2 Machine 1
Comprehensive
Payback, NPV, ARR
Question Nos. 71 through 73 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 P55,000. Installation costs
and freight charges will be P24,200 and P800, respectively. Newman 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 1 for 10 years at 9% is 6.418 while the present value of 1 for 10
years at 9% is 0.42241
xlviii
. The cash payback period is:
xlix
. The project is expected to generate net present value of:
A. P276,510 C. P331,510
B. P299,743 D. P253,277
l
. What is the accounting rate of return provided by the project?
NPV, CFAT, Maximum lost unit sales

Kabalikat Company has the opportunity to introduce a new product. Kabalikat expects the
product to sell for P75 with variable cost per unit of P50. The annual fixed costs, excluding
245
Capital Budgeting
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.
li
. The amount of annual after-tax cash flows is:
A. P2,400,000 C. P 900,000
B. P3,000,000 D. P1,500,000
lii
. The machine’s net present value is:
A. P2,786,100 C. P1,028,900
B. P 928,500 D. P 150,270
liii
. 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 C. 16,714 units
B. 23,400 units D. 10,029 units
ARR, NPV, PI, Payback

Questions 1 through 4 will be based on the following data:
The management of Arleen Corporation is considering the purchase of a new machine
costing P400,000. The company’s desired rate of return is 10%. The present value of P1 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:
Year Income from Operations Net Cash Flow

1 P100,000 P180,000
2 40,000 120,000
3 20,000 100,000
4 10,000 90,000
5 10,000 90,000
liv
. The average rate of return for this investment is:
A. 18 percent C. 58 percent
B. 6 percent D. 10 percent
lv
. The net present value for this investment is:
A. Positive P 36,400 C. Negative P 99,600
B. Positive P 55,200 D. Negative P126,800
lvi
. The present value index for this investment is:
A. 0.88 C. 1.14
B. 1.45 D. 0.70
lvii
. The cash payback period for this investment is:
Payback, NPV, ARR, IRR

Use the following information for questions 67 - 70
Pillo Company is considering two capital investment proposals.
Estimates regarding each project are provided below:
Project MA Project PA
Initial investment P2000,000 P300,000
Annual net income 10,000 21,000
246
Capital Budgeting
Net annual cash inflow 50,000 71,000

Estimated useful life 5 years 6 years
Salvage value -0- -0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Period 9% 10% 11% 12%

5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111
lviii
. The cash payback period for Project MA is
lix
. The net present value for Project PA is
A. P309,204 C. P 50,000
B. P 91,456 D. P 9,205
lx
. The annual rate of return for Project MA is
A. 5% C. 25%
B. 10% D. 50%
lxi
. The internal rate of return for Project PA is closest to
A. 10% C. 12%
B. 11% D. none of these
Depreciation tax shield, CCFAT, Payback, NPV, IRR

Consider a project that requires cash outflow of P50,000 with a life of eight years and a
salvage value of P2,000. Annual cash inflow amounts to P10,000 assuming a tax rate of
30% and a required rate of return of 8%. Salvage value is ignored in computing
depreciation.
lxii
. Annual depreciation tax shield amounts to
A. P1,875 C. P8,875
B. P7,000 D. P10,000
lxiii
. Annual cash flow after tax amounts to
A. P 1,875 C. P 8,875
B. P 7,000 D. P10,000
lxiv
. Payback amounts to
lxv
. Net present value amounts to
A. P 756 C. P1,756
B. P1,005 D. P2,005
lxvi
. Internal rate of return on this project is approximatel
A. 8.0% C. 9.0%
B. 8.5% D. 9.5%
CFAT, NPV, IRR

Questions 46 rough 51 are based on the following:
Home’s Pizza’s, Inc., operates pizza shops in several cities. One of the company’s most
profitable shops is located adjacent to the large CPA review center in Manila. A small
bakery next to the shop has just gone out of business, and Home’s Pizzas has an
opportunity to lease the vacated space for P18,000 per year under a 15-year lease.
Home’s management is considering two ways in which the available space might be used.
247
Capital Budgeting
Alternative 1. The pizza shop in this location is currently selling 40,000 pizzas per year.
Management is confident that sales could be increased by 75% by taking out the wall
between the pizza shop and the vacant space and expanding the pizza outlet. Costs for
remodeling and for new equipment would be P550,000. Management estimates that 20%
of the new sales would be small pizzas, 50% would be medium pizzas, and 30% would be
large pizzas. Selling prices and costs for ingredients for the three sizes of pizzas follow (per
pizza):
Selling Price Cost of Ingredients

Small P 6.70 P1.30
Medium 8.90 2.40
Large 11.00 3.10
An additional P7,500 of working capital would be needed to carry the larger volume of
business. This working capital would be released at the end of the lease term. The
equipment would have a salvage value of P30,000 in 15 years, when the lease ends.
Alternative 2. Home’s sales manager feels that the company needs to diversify its
operations. He has suggested that an opening be cut in the wall between the pizza shop
and the vacant space and that video games be placed in the space, along with a small
snack bar. Costs for remodeling and for the snack bar facilities would be P290,000. The
games would be leased from a large distributor of such equipment. The distributor has
stated that based on the use of game centers elsewhere, Home’s could expect about
26,000 people to use the center each year and to spend an average of P5 each on the
machines. In addition, it is estimated that the snack bar would provide a net cash inflow of
P15,000 per year. An investment of P4,000 in working capital would be needed. This
working capital investment would be released at the end of the lease term. The snack bar
equipment would have a salvage value of about P12,000 in 15 years.
Home’s management is unsure which alternative to select and has asked you to help in
making the decision. You have gathered the following information relating to added costs
that would be incurred each year under the two alternatives:
Expand the Pizza Install the Game

Shop Center
Rent- building space P18,000 P18,000
Rent- video games --- 30,000
Salaries 54,000 17,000
Utilities 13,200 5,400
Insurance and other 7,800 9,600
The company is currently using a 16 percent minimum acceptable rate of return for its
capital investment. The present value of annuity of 1 at 16 percent for 15 periods is 5.575
and end of 15 periods is 0.108. The company is not liable to pay income taxes.
lxvii
. The incremental expected annual cash inflows from Alternative 1 is:
A. P 90,000 C. P100,200
B. P108,000 D. P201,000
lxviii
. The incremental expected annual cash inflows from Alternative 2 is:
A. P 17,000 C. P 59,600
B. P 65,000 D. P145,000
lxix
. The net present value for Alternative 1 is:
A. P48,650 C. P45,000
B. P47,840 D. P32,500.
lxx
. The net present value for Alternative 2 is:
A. P21,021 C. P68,375
B. P70,103 D. P12,807
lxxi
. Assume that the company decides to accept alternative 2. At the end of the first year,
the company finds that only 21,000 people used the game center during the year (each
person spent P5 on games). Also, the snack bar provided a net cash inflow of only
248
Capital Budgeting
P13,000. In light of this information, what is the net present value for alternative 2?
A. P(80,422) C. P(82,150)
B. P(76,422) D. P(80,854)
lxxii
. The sales manager has suggested that an advertising program be initiated to draw
another 5,000 people into the game center each year. Assuming that another 5,000
people can be attracted into the center and that the snack bar receipts increase to the
level originally estimated, how much can be spent on advertising each year and still
allow the game center to provide a 16% rate of return?
A. P70,103.00 C. P58,953.00
B. P 4,673.53 D. P12,574.53
Net Income, CFBT, ARR, Payback Period

Questions 52 through 56 are based on the following information:
Pinewood Craft Company is considering the purchase of two different items of equipment,
as described below:
Machine A. A compacting machine has just come onto the market that would permit
Pinewood Craft Company to compress sawdust into various shelving products. At present
the sawdust is disposed of as a waste product. The following information is available on
the machine:
a. The machine would cost P420,000 and would have a 10% salvage value at the end
of its 12-year useful life. The company uses straight-line depreciation and considers
salvage value in computing depreciation deductions.
b. The shelving products manufactured from use of the machine would generate
revenues of P300,000 per year. Variable manufacturing costs would be 20% of
sales.
c. Fixed expenses associated with the new shelving products would be (per year):
advertising, P40,000; salaries, P110,000; utilities, P5,200; and insurance, P800.
Machine B. A second machine has come onto the market that would allow Pinewood
Craft Company to automate a sanding process that is now done largely by hand. The
following information is available:
a. The new sanding machine would cost P234,000 and would have no salvage value at
the end of its 13-year useful life. The company would use straight-line depreciation
on the new machine.
b. Several old pieces of sanding equipment that are fully depreciated would be
disposed of at a scrap value of P9,000.
c. The new sanding machine would provide substantial annual savings in cash
operating costs. It would require an operator at an annual salary of P16,350 and
P5,400 in annual maintenance costs. The current, hand-operated sanding
procedure costs the company P78,000 per year in total.
Pinewood Craft Company requires a simple rate of return of 15% on all equipment
purchases. Also, the company will not purchase equipment unless the equipment has a
payback period of 4.0 years or less.
(In all the following questions, please ignore income tax effect)
lxxiii
. The expected income each year from the new shelving products (Machine A) is:
A. P 52,500 C. P 84,000
B. P240,000 D. P 92,500
lxxiv
. The annual savings in cost if Machine B is purchased is
A. P56,250 C. P38,250
B. P43,250 D. P21,750
lxxv
. The simple rate (%) of return for Machine A is:
lxxvi
. The simple rate of return for Machine B is:
249
Capital Budgeting

lxxvii
. The payback period for Machine A is:
lxxviii
. The payback period for Machine B is:
A. 4.0 years. C. 6.1 years.
B. 4.2 years. D. 5.9 years.
Net Investment, CFBT, Tax Benefits, NPV, Depreciation Tax Shield,

Turkey Company’s average production of valve stems over the past three years has been
80,000 units each year. Expectations are that this volume will remain constant over the
next four years. Cost records indicate that unit product costs for the valve stem over the
last several years have been as follows:
Direct materials P 3.60

Direct labor 3.90
Variable manufacturing overhead 1.50
Fixed manufacturing overhead* 9.00
Unit product cost P18.00
*Depreciation of tools (that must now be replaced) accounts for one-third of the fixed
overhead. The balance is for other fixed overhead costs of the factor that require cash
expenditures.
If the specialized tools are purchased, they will cost P2,500,000 and will have a disposal
value of P100,000 at the end of their four-year useful life. Turkey Company has a 30% tax
rate, and management requires a 12% after-tax return on investment. Straight-line
depreciation would be used for financial reporting purposes, but for the tax purposes, the
following variable depreciation each year will be used.
Year 1 P 832,500
Year 2 1,112,500
Year 3 370,000
Year 4 185,000
The sales representative for the manufacturer of the specialized tools has stated, “The
new tools will allow direct labor and variable overhead to be reduced by P1.60 per unit.”
Data from another company using identical tools and experiencing similar operating
conditions, except that annual production generally averages 100,000 units, confirms the
direct labor and variable overhead cost savings. However, the other company indicates
that it experienced an increase in raw material cost due to the higher quality of material
that had to be used with the new tools. The other company indicates that its unit product
costs have been as follows:
Direct materials P 4.50

Direct labor 3.00
Variable manufacturing overhead 0.80
Fixed manufacturing overhead 10.80
Unit product cost P19.10
Referring to the figures above, the production manager stated, “These numbers look great
until you consider the difference in volume. Even with the reduction in labor and variable
overhead cost, I’ll bet our total unit cost figure would increase to over P20 with the new
tools.”
Although the old tools being used by Turkey Company are now fully depreciated, they have
a salvage value of P45,000. These tools will be sold if the new tools are purchased;
however if the new tools are not purchased, then the old tools will be retained as standby
equipment. Turkey Company’s accounting department has confirmed that total fixed
manufacturing overhead costs, other than depreciation, will not change regardless of the
250
Capital Budgeting
decision made concerning the valve stems. However, the accounting department has
estimated that working capital needs will increase by P60,000 if the new tools are
purchased due to the higher quality of material required in the manufacture of the valve
stems.
The present values of 1 at the end of each period using 12 percent are:
Period 1 0.89286
Period 2 0.79719
Period 3 0.71178
Period 4 0.63552
PV of annuity of 1, 4 periods 3.03735
lxxix
. The net investment in new tools amounted to:
A. P1,873,300. C. P2,528,500.
B. P2,515,000. D. P2,546.500.
lxxx
. How much annual cost savings will be generated if the Turkey Company purchases the
new tools?
A. P 128,000 C. P 936,000
B. P 216,000 D. P1,008,000
lxxxi
. The present value of tax benefits expected from the use of the new machine tools
is:
A. P 603,333 C. P1,407,777
B. P 804,444 D. P2,011,111
lxxxii
. The present value of the salvage value of the new tools to be received at the end of
fourth year is
A. P 63,552. C. P 44,486.
B. P 19,065. D. P212,615.
lxxxiii
. Using the minimum acceptable rate of return of 12 percent, the net present value of
the investment in new tools is
A. P108,913. C. P147,073.
B. P127,979. D. P166,139.
lxxxiv
. The net advantage of the use of declining method of depreciation instead of
straight-line method is
A. P 33,830. C. P112,767.
B. P 56,610. D. P147,731.
Net Investment, CFAT, Depreciation tax shield, NPV

Franzen Company manufactures three different models of paper shredders including the
waste container, which serves as the base. While the shredder heads are different for all
three models, the waste container is the same. The number of waste containers that
Franzen will need during the next five years is estimated as follows:
2007 50,000
2008 50,000
2009 52,000
2010 55,000
2011 55,000
The equipment used to manufacture the waste container must be replaced because it is
broken and cannot be repaired. The new equipment would have a purchase price of
P945,000 with terms 2/10, n/30; the company’s policy is to take all purchase discounts.
The freight on the equipment would be P11,000, and installation costs would total
P22,900. The equipment would be purchased in December 2006 and placed into service
on January 1, 2007. It would have a five-year economic life and would have the following
depreciation. The equipment is expected to have a salvage value of P12,000 at the end of
its economic life in 2011. The new equipment would be more efficient than the old
equipment, resulting in a 25 percent reduction in both direct material and variable
overhead. The savings in direct material would result in an additional one-time decrease
in working capital requirements of P2,500, resulting from a reduction in direct material
251
Capital Budgeting
inventories. This working capital reduction would be recognized at the time of equipment
acquisition.
The old equipment is fully depreciated and is not included in the fixed overhead. The old
equipment from the plant can be sold for a salvage amount of P1,500. Rather than
replace the equipment, one of Franzen’s production managers has suggested that the
waste containers be purchased. One supplier has quoted a price of P27 per container.
This price is P8 less than Franzen’s current manufacturing cost, which is presented below.
Direct materials P10

Direct labor 8
Variable overhead 6
Fixed overhead:
Supervision P2
Facilities 5
General 4 11
Total unit cost P35
Franzen uses a plantwide fixed overhead rate in its operations. If the waste containers are
purchase outside, the salary and benfits of one supervisor, included in fixed overhead of
P45,000 would be eliminated. There would be no other changes in the other cash and
noncash items included in fixed overhead except depreciation on the new equipment.
The new equipment will be depreciated according to the following declining amounts:
Year Depreciation
2007 P319,968
2008 426,720
2009 142,176
2010 71,136
2011 0
Franzen is subject to a 40 percent tax rate. Management assumes that all cash flows
occur at the end of the year and uses a 12 percent after-tax discount rate.
lxxxv
. The initial net cash outflows if the company decides to continue making the waste
containers is:
A. P 956,600 C. P 978,900
B. P 975,500 D. P1,455,613
lxxxvi
. The total after-tax cash outflows, excluding the initial cash outflows, if the new
equipment is purchased are:
A. P 956,600 C. P2,918,300
B. P2,887,800 (defective) D. P3,279,000
lxxxvii
. The present value of the total depreciation shield is:
A. P308,920 C. P307,826
B. P313,500 D. P321,303
lxxxviii
. The total relevant after-tax costs to buy the waste containers are:
A. P2,829,240 C. P4,243,500 (defective
B. P3,039,662 D. P7,074,000
lxxxix
. What is the net present value of the purchase alternative?
A. P3,039,662 (defective) C. P2,083,062
B. P2,730,742 D. P2,718,359
xc
. What is the net present value of the make alternative?
A. P2,036,603 C. P2,996,603
B. P3,039,662 D. P2,993,203 (defective)
ANSWER EXPLANATIONS
252
i
. Answer: B
Initial amount of investment 160,000
Less Cash inflow (decrease in outflow) at period 0:
MV of old equipment 80,000
Tax benefits on loss on sales (20,000 x .4) 8,000 88,000
Net investment 72,000
ii
. Answer: D
ATCF = Net investment ÷ Payback period
ATCF (840,000 ÷ 3.326) 252,555
Net income (252,555 – 140,000) 112,555
Before-tax income (112,555 ÷ 0.60) 187,592
Before-tax savings (187,592 + 140,000) 327.592
The computation of after-tax cash flows, given the amount of investment and internal
rate of return or PV of annuity of 1 discounted at IRR is the reverse of the computation
of payback period. Remember that the payback method, though a nondiscounted
technique, is closely related to internal rate of return because the payback period is
exactly the present value of annuity of 1 if they are discounted using the internal rate
of return.
iii
. Answer: A
Annual savings on expenses P50,000
Less: Additional depreciation (40,000 – 25,000) 15,000
Additional taxable income 35,000
Additional tax (35,000 x 40%) P14,000
Additional depreciation can be easily calculated by subtracting the book value of the
old machine from the cost of new machine and then the difference divided by the
useful life (160,000 – 100,000) ÷ 4 = 15,000.
iv
10.Answer: B
YearSYDStraight LineDifferencePresent Value12,000,0001,200,000800,000
727,28021,600,0001,200,000400,000330,56031,200,0001,200,000 -04
800,0001,200,000(400,000) (273,200)5 400,0001,200,000(800,000) (496,720)Total
present value of difference in depreciation287,920Tax Rate40%Present value of net
advantage115,168
v
. Answer: B
SYDSLDifferencePresent Value1 150,00090,00060,00053,5682
120,00090,00030,00023,9163 90,00090,000-04 60,00090,000(30,000)
(19,066)5 30,00090,000(60,000)(34,046)Total of present values of
depreciation24,372Tax rate40%Present value of net advantage 9,749SYD method
provides a higher present value on tax benefits because of less amount of tax during
year 1 & 2. In year 4 and 5, the use of SYD requires higher taxes but their equivalent
present values are lower already.
vi
. Answer: D
Annual cost savings 90,000
Less depreciation (432,000 ÷ 12) 36,000
Annual income 54,000
Simple Rate of Return: 54,000 ÷ 432,000 12.5 %
vii
. Answer: A
The useful life of the project can be calculated by using the computational pattern
for Accounting Rate of Return:
Divide by Depreciation expense
CFAT 20,000
Less: Net income (106,700 x 5%) 14,665 5,335
Average life (in years) 7.28
* 10% ARR based on average investment = 5% ARR based on initial investment
viii
. Answer: B
ARR = Average annual net income ÷ Average Investment
Annual after-tax cash flow 40,000
Less Depreciation 20,000
Net Income 20,000
Divide by Average Investment (200,000 + 180,000)/2190,000
ARR: 10.5%
The problem asked for the average accounting rate of return for the first year of
asset’s life.
ix
. Answer: D
The average (accounting) rate of return is determined by dividing the annual after-tax
net income by the average cost of the investment, (beginning book value + ending
book value)/2.
After tax income (P7,200 - (P7,200 x 30%)) P 5,040
Average investment: (P66,000 + 16,000) ÷ 2 P41,000
Accounting rate of return: P5,040/P41,000) 12.3%
x
. Answer: A
(ATCF – Depreciation) ÷ Initial investment = Accounting Rate of Return
Let X = Initial investment
(66,000 – 0.10X) ÷ X = 0.12
66,000 - .10X = .12X
.22X = 66,000
X = 300,000
xi
. Answer: A
Net Income: = 66,000 - .10X
AAR = NI/ Investment
.12 = (66,000 - .10X) / X
.12X = 66,000 - .10X
.22 X = 66,000
X = 300,000
xii
. Answer: D
Net Income (280,000 x 15%)42,000
Add back depreciation 35,000
ATCF 77,000
xiii
. Answer: B
Payback period = Initial amount of investment ÷ Annual after-tax cash flows
P35,000 ÷ P5,000 = 7 years
xiv
. Answer: B
Divide by CFAT (10,000 x 0.7) ÷ (50,000 ÷ 8 x 0.3) 8,875
Payback period 5.6 years
xv
. Answer: D
Cumulative cash flows end of Year 1 (450,000) – 254,520 (195,480)
Discounted cash flow for Year 2 173,460
Cumulative cash flows, end of Year 2 ( 22,020)
Break-even time 2 + (22,020 ÷ 105,140)2.21 years
xvi
. Answer: D
Cost of the new machine 400,000
Salvage value of old machine at period zero 60,000
Net investment (Outflows) 340,000
Divide by cash flow after tax 90,000
Payback period 3.78 years
xvii
. Answer: B
Cash InflowUnrecovered OutflowOutflows(4,500,000)First year900,000(3,600,000)Second
year1,200,000(2,400,000)Third year1,500,000( 900,000)Fourth year 900,0000
Payback Period: At the end of 4 periods, the initial outflows are fully recovered.
Note to the CPA Candidates: A modified question for this problem is to compute the
Present Value of the net advantage of using sum-of-the-years’ digits of depreciation
instead of straight-line method.
xviii
. Answer: C
Cash inflowsInvestmentPeriod 0(99,300)Period 1 (75,000 – 25,000) x .6
30,000(69,300)Period 2 ( 30,000 x 1.10) 33,000(36,300)Period 3 (33,000 x 1.10)
36,300 -0-At the end of the third year, investment is fully recovered.
The net investment of 99,300 is net of tax benefit, (165,500 x .6)
xix
. Answer: C
Before-tax cash flow = 40,000 + 35,000 75,000
Payback period: 300,000 ÷ 75,000 4 years
xx
. Answer: C
There are two cash flows at time zero: P120,000 outflow and P14,000 inflow.
Net cash outflow (120,000 – 14,000) = 106,000
xxi
. Answer: C
Computation of Cash Flow After-tax
CFBT 100,000 x 0.7 70,000
Depreciation tax shield 62,500 x 0.3 18,750
CFAT 88,750
Computation of Net Present Value:
PV of ATCF: 88,750 x 5.747 510,046
PV of After-tax Salvage Value: 20,000 x 0.70 x 0.54 7,560
Total 517,606
Investment 500,000
Net Present Value 17,606
The problem assumed that the salvage value is ignored in the computation of annual
depreciation so that the annual cash flows will be greater. The problem did not
include among the choices the assumption that salvage value will be deducted from
the cost in computing the amount of annual depreciation.
xxii
. Answer: B
Annual revenues 400,000
Less cash operating costs 104,800
Cash flow before tax 295,200
Less Depreciation (1M ÷ 5) 200,000
Income before tax 95,200
Less income tax (40%) 28,080
Net income 57,120
ATCF 257,120
PV of ATCF, n=5; k=10% 257,120 x 3.7908 974,690
Investment 1,000,000
Negative Net Present Value ( 25,310)
The manner of financing the project is not considered in the analysis of capital
investment. Investment must be separate from financing. It is a normally
committed error in the application of capital budgeting techniques where financing
strategy is considered. The explicit or implicit cost of financing the project is taken
care of the discounting process.
xxiii
. Answer: A
Present value of cash returns: (30,000 x 0.90909)
x 5 periods
136,364
Net present value 37,064
Note: Because the constant growth rate and the discount rate are both 10%, the
present value for each period is constant.
xxiv
. Answer: B
Savings (2 workers, each P10,000 for 3 months)2 x P10,000 x 3 P60,000
Depreciation (175,000 – 25,000) ÷ 5 years P30,000
After-tax cash savings: (60,000 x 0.75) + (30,000 x 0.25)P52,500
Present value of after-tax cash savings (52,500 x 3.60478)P189,250
Present value of Salvage Value (25,000 x 0.56743) 14,186
Total 203,436
Investment 175,000
Net Present Value P 28,436
xxv
. Answer: B
Computation of net investment:
Cash purchase price 300,000
Less: MV of old machine 80,000
Tax shield on loss on sale (40,000 x 0.32)12,800 92,800
Annual cash savings before tax (240,000 – 160,000) 80,000

Additional depreciation (300,000 – 120,000) ÷ 4 45,000
Additional taxable income 35,000
Less Additional tax (35,000 x 0.32) 11,200
Net income 23,800
After-tax cash flow 68,800
Alternative computation for ATCF:
(80,000 x 0.68) + (45,000 x 0.32) 68,800
Present value of ATCF (68,800 x 3.23972) 222,893
Investment 207,200
xxvi
. Answer: B
PV of annual cash receipts 1,200,000 x 2.58872 3,106,463
PV of salvage value 650,000 x 0.48225 313,462
PV of return of working capital 1,000,000 x 0.48225 482,250
Cost of new equipment and timbers (2,750,000)
Working capital (1,000,000)
PV of cost of construction of road 400,000 x .5787 ( 231,480)
Negative net present value (79,303)
xxvii
. Answer: B
PeriodNominal Cash SavingsPV FactorPresent Value132,000
0.8779028,070.08232,000 x 1.0533,600 0.7694725,854.19332,000 x 1.05235,280
0.6749723,812.94432,000 x 1.05337,044
0.5920821,933.01Total99,670.22Investment80,000.00NPV19,670.22Note that all the
annual cash inflows are adjusted by one period.
xxviii
. Answer: B
The solution used total analysis approach in computing present value.
Retain the Old Machine:
Present value of annual cash outlay
CFAT (300,000 x P0.38) + P21,000 = P135,000
PVCFAT (135,000 x 3.6847) P497,435
Present value of salvage value (7,000 x 0.41044) ( 2,873)
Total P494,562
Buy New machine:

Present Value of Annual cash outlay
CFAT (300,000 x P0.29) + P11,000 = P98,000
PVCFAT P98,000 x 3.6847) P361,100
Salvage value of new machine, end of 6 years(P20,000 x 0.41044) ( 8,209)
Investment in new machine (120,000 – 40,000) 80,000
Total P432,891
xxix
. Answer: B
The purpose of profitability index is to compare two projects’ profitability by reducing
the present value per 1 peso of investment. Therefore, the ratio of 4.35526 @ 10% to
4.11141 @ 12% indicated the profitability index.
Profitability index: 4.35526/4.11141 = 1.06
xxx
. Answer: B
PV of annuity of 1 at IRR ∑(1 ÷ 1.12386)5 3.57057
PV of annuity of 1 at MCC ∑(1 ÷ 1.11055)5 3.69079
After-tax cash flows 10,000 ÷ (3.69079 – 3.57057) 83,180.84
Investment: 83,180.84 x 3.57057 297,000
Profitability index (297,000 + 10,000) ÷ 297,000 1.034
A shorter calculation of the Profitability Index can be made by:
3.69079 ÷ 3.57057 = 1.034
xxxi
. Answer: D
In discounting the annual cash inflow by the IRR, the NPV = P0
The net present value of ZERO is 14% and 16%. For better time management, the
candidate is expected not to do detailed calculation of finding out the exact rate.
The use of interpolation indicated that the IRR is 15.3%:
Discount RateNet Present Value0.141,197IRR00.16-708
(0.14 – IRR) ÷ (0.14 – 0.16) = 1,197 ÷ ( 1,197 + 708)
(0.14 – IRR) ÷ -.02 = 1,197 ÷ 1905
(0.14 – IRR) ÷ - .02 = 0.628
(0.14 – IRR) = 0.628 x -0.02
0.14 – IRR = 0. 013
IRR = 0.153 or 15.30%
Note: Since at the IRR, NPV is zero, the answer can only be between 14% & 16%,
since only one of the choices, satisfy the criteria, the answer is (D).
xxxii
. Answer: B
The payback period that corresponds to the project’s internal rate of return of 12
percent is 4.968. Therefore, the amount of investment must equal the product of the
payback period and the net cash flows:
Investment: (4.968 x 20,000) = P99,360
xxxiii
. Answer: D
The amount of investment: the PV of annuity at IRR
4.355 x 6,000 = 26,130
xxxiv
. Answer: C
Present value of cash inflows equals amount of investment at 10% IRR.
P20,000 x 3.791 = P75,820
xxxv
. Answer: A
ATCF: P1,500,000/3.60472 416,121
Depreciation 300,000
Net income: 416,121 – 300,000 116,121
Before-tax income: 116,121/0.60 193,535
Fixed costs 500,000
Contribution margin: 193,535 + 500,000 693,535
Unit sales 693,535 ÷ (100 - 60) 17,338
xxxvi
. Answer: B
Contribution margin (per No. 23) 693,535
Divide by sales volume ÷ 20,000
Contribution margin per unit P34.68
Add variable cost per unit 60.00
Selling price per unit P94.68
Alternative Solution:
Cash inflow before tax based on present price: (20,000 x 40) – 200,000
600,000
After-tax cash inflow (600,000 x 0.6) + (300,000 x 0.4)480,000
Present value of ATCF (480,000 x 3.60478)1,730,294
Investment 1,500,000
Net present value (present price) 230,294
Annual excess ATCF due to excess price (230,294 ÷ 3.60478)63,885
Before-tax excess cash inflow (63,885 ÷ 0.6) 106,475
Excess selling price: 106,475 ÷ 20,000 5.32
Reduced selling price to achieve IRR of 12% (100 – 5.32)94.68
xxxvii
. Answer: C
Annual after-tax cash flow500,000/5.6502 88,492
Depreciation 500,000/10 50,000
Net income 38,492
Income before tax 38,492/0.6 64,154
Depreciation 50,000
Cash savings before tax: 64,154 + 50,000 114,154
xxxviii
. Answer: A
The amount of annual cash flows can be solved by equation:
NPV = PV of annual CF – Investment
1,750 = 2.4771CF – 2.4018CF
1,750 = 0.1753CF
CF = 9,980
xxxix
. Answer: A
Investment 120,000
Less Present value of salvage value (12,000 x 0.3855) 4,626
Present value of Annual Cash Inflows 115,374
Minimum Annual Cash Flows (115,374 ÷ 6.1446) 18,776
xl
. Answer: B
Present value of annual cash flows at IRR (81,000 x 4.639) 375,759
Investment 81,000 x 4.344 351,864
Difference 23,895
Annual increase in cash flows 23,895/4.344 5,501
xli
. Answer: A
Investment (Total of present value @ IRR of 12%) 50,000
Less PV, year 1 & 2 (16,074 + 17,534) 33,608
PV of the 3rd cash flow 16,392
After-tax cash flow, third year 16,392/0.712 23,022
xlii
. Answer: B
The net present value = PV of excess salvage value less PV of decrease in after-tax
cash flow
Let X = the excess salvage value
7,003 = 0.56743X – [3.60478 x (0.2X * 0.4)
7,003 = 0.56743X – 0.2883824X
7,003 = 0.2790476X
X = 25,096
Required salvage value: 50,000 – 25,096 = 24,904
xliii
. Answer: B
Cost of equipment 750,000
Less PV of tangible benefits 100,000 x 5.01877 501,877
PV of annual intangible benefits 248,123
Amount of annual intangible benefits 248,123/5.01877 49,440
xliv
. Answer: B
To be acceptable, the project should yield a net present value of zero. The negative
net present value must be offset by the present value of annual intangible benefits.
Present value of intangible benefits P184,350
PV of annuity of 1 at 10% for 10 years ÷ 6.145
Annual net intangible benefits P30,000
xlv
. Answer: A
The indifference rate (crossover or fisher rate) refers to the rate at which the net
present values of the 2 alternatives are indifferent or equal.
The easier test of the rate is to look for IRR (using trial and error technique) of the
investment difference.
Difference 80,000 – 48,000 35,225
PV inflows ∑(3,200 ÷ 1.1264)6 (12,922)
PV inflows ∑(15,200 ÷ 1.1264)10-6 (22,303)
Difference NIL
Alternative Solution:
Project XProject YPV of after-tax cash flows
∑(12,000 ÷ 1.1264)6
48,455 ∑(15,200 ÷ 1.1264)1083,680Investment48,00083,225Net Present Value
455 455
xlvi
. Answer: B
The determination of the indifference point, which is 10%, for the two projects can be
made through the use of trial and error estimation.
Machine 1Machine 2PV of Difference in ATCF Year 1 155,000 ÷ 1.10
140,909.10(140,909.10) Year 2 (110,000 ÷ 1.10)2( 90,909.10) 90,909.10Net
difference 50,000.00( 50,000.00)Difference in investment( 50,000.00)
50,000.00NPV NIL NIL
xlvii
. Answer: C
15% Discount Rate
Machine 1Machine 2PV of Difference in ATCF Year 1 155,000 x 0.86957
134,783.35(134,783.35) Year 2 110,000 x 0.75614( 83,175.40) 83,175.40Net
50,000.00NPV 1,607.95( 1,607.95)
At 15 percent discount rate, Machine 1 is more acceptable.
8% Discount Rate
Machine 1Machine 2PV of Difference in ATCF Year 1 155,000 x 0.92593
143,519.15(143,519.15) Year 2 110,000 x 0.85734( 94,307.40) 94,307.40Net
50,000.00NPV ( 788.25) 788.25
At 8 percent discount rate, Machine 2 is more acceptable.
xlviii
. Answer: C
Cost of Investment:
Invoice price 950,000
Installation cost 24,200
Freight charge 800
Total investment 975,000
Annual Cash Flow:

Number of procedures: (52 x 5) 260
Contribution margin per procedures: (P800 – P10 – P40) P750
Total annual cash flow: (260 x P750) P195,000
Cash payback period: (975,000 ÷ 195,000) 5 years
xlix
. Answer: B
Present value of cash flow (195,000 x 6.418) P1,251,510
Present value of salvage value (55,000 x 0.42241) 23,233
Total P1,274,743
Capital investment 975,000
Net present value P 299,743
l
. Answer: A
Average investment: (975,000 + 55,000) ÷ 2 515,000
Annual depreciation: (975,000 – 55,000) ÷ 10 92,000
Annual net income: 195,000 – 92,000 103,000
Average annual Rate of Return: P103,000  P515,000 20%
li
. Answer: A
Contribution margin: 300,000 x (75 – 50) 7,500,000
Less Fixed costs 4,500,000
Cash flow before tax 3,000,000
Less: Depreciation (6,000,000 ÷ 4) 1,500,000
Income before tax 1,500,000
Less: Income tax (1,500,000 x 0.4) 600,000
Net income 900,000
Add back: Depreciation 1,500,000
After-tax Cash Flow 2,400,000
lii
. Answer: C
PV of After-tax Cash Flows (2,400,000 x 2.9287) 7,028,900
Cost of investment 6,000,000
Net Present Value 1,028,900
liii
. Answer: A
Annual excess present value (1,028,000 ÷ 2.9287) P351,000
Excess cash before tax (351,000 ÷ 0.6) P585,000
Maximum number of units as decrease (585,000 ÷ 15) 39,000
liv
. Answer: A
Average Annual net income:
(100,000 + 40,000 + 20,000 + 10,000 + 10,000) ÷ 5 = 36,000
Divide by average investment (400,000 ÷ 2) 200,000
Accounting rate of return 18%
Accounting rate of return or unadjusted rate of return computes the profitability of the
project in term of accrual profit. Net profit under accrual method considers
depreciation, a substantial amount that understates the average profit. This
understatement of amount that is used in the computation necessarily requires that
preferably, average investment should be used, instead of the initial investment, in
the determination of accounting rate of return.
lv
. Answer: B
Cash FlowPV FactorPV of annual net cash flows:180,0000.909163,620120,0000.826
99,120100,0000.751 75,10090,0000.683 61,47090,0000.621
55,890Total455,200Amount of investment400,000Net Present Value 55,200
lvi
. Answer: C
Present Value Index (Profitability Index)
Present Value of ATCF ÷ Net Investment(455,200 ÷ 400,000) = 1.14
The present value index computes net present value in terms of P1 investment.
Therefore, the index of 1.14 means the net present value per P1 of investment is
P0.14. This concept makes the present value index better than the net present value
technique because the index indicates which one is the most profitable on a per P1
investment.
lvii
. Answer: D
Cash InflowUnrecovered InvestmentPeriod 0 Outflows(400,000)Period
1180,000(220,000)Period 2120,000(100,000)Period 3100,000Zero
The total outflows are fully recovered by the end of period 3.
The analyst should be careful in computing the payback period when the project has
uneven cash inflows. The common error in handling uneven cash flows is using the
average cash flows instead of reducing the unrecovered outflows.
lviii
. Answer: D
Payback period: Investment ÷ Net Annual Cash Inflow
P200,000 ÷ P50,000 = 4 years
lix
. Answer: D
Present value of Net Cash Inflow (71,000 X 4.355) 309,205
Investment 300,000
Net Present value 9.205
lx
. Answer: B
Average Investment: (200,000 ÷ 2) = 100,000
Accounting Rate of Return = Net Income ÷ Average Investment
(10,000 ÷ 100,000) = 10 percent
lxi
. Answer: B
The payback for PA is 4.225. This is closest to the present value of annuity of 1
discounted at 11 percent for 6 periods which is 4.231.
lxii
. Answer: A
Annual depreciation: (P50,000 ÷ 8) P6,250
Annual tax shield: (P6,250 x 0.3) P1,875
lxiii
. Answer: C
Before-tax cash inflow P10,000
Less depreciation 6,250
Income before tax 3,750
Less income tax (3,750 x 0.3) 1,125
Net income 2,625
After-tax cash inflow P 8,875
A quicker calculation of after tax cash flow can be made by adding the tax shield to
after-tax cash inflow without any tax benefit on depreciation.
(P10,000 × .70) + P1,875 = P8,875
lxiv
. Answer: B
Payback period: (P50,000 ÷ P8,875) = 5.6 years
lxv
. Answer: C
Present value of annual ATCF (P8,875 x 5.747) P51,000
Present value of after-tax salvage value (P1,400 x 0.54) 756
Total 51,756
Investment 50,000
Net present value P 1,756
lxvi
. Answer: C
At the discount rate of 8 percent, there is a net present value of P1,756. Therefore,
the IRR is higher than 8 percent.
Using trial and error approach, the first try should use 9 percent. If the present value
of the inflows exceeds P50,000, then the IRR is lower than 9 percent, otherwise it
should be 9.5 percent.
Using 9.0 percent in discounting the inflows, there is a net present value of P(174);
therefore the IRR is slightly lower than but very close to 9.0 percent.
(P8,875 x 5.535) + (P1,400 x 0.5019) – P50,000 = P(174)
lxvii
. Answer: B
Additional contribution margin:
Small 6,000 x 5.40 32,400
Medium 15,000 x 6.50 97,500
Large 9,000 x 7.90 71,100
Total 201,000
Less Cash Fixed Expenses:
Rent 18,000
Salaries 54,000
Utilities 13,200
Insurance, etc. 7,800 93,000
Annual Cash Inflows 108,000
lxviii
. Answer: B
Additional rental income 130,000
Additional cash flow, snack bar 15,000
Total 145,000
Less Cash Fixed Expenses:
Rent 48,000
Salaries 17,000
Utilities 5,400
Insurance, etc. 9,600 80,000
Annual Cash Inflow 65,000
lxix
. Answer: A
PV of annual cash inflow (108,000 x 5.575) 602,100
PV of salvage value (70,000 x 0.108) 3,240
PV of working capital return (7,500 x 0.108) 810
Total 606,150
Investment:
Remodeling cost 550,000
Working capital 7,500 557,500
lxx
. Answer: B
PV of annual cash inflow (65,000 x 5.575) 362,375
PV of salvage value 1,296
PV of working capital return 432
Total 364,103
Investment:
Remodeling cost 290,000
Working capital 4,000 294,000
lxxi
. Answer: A
Rental income 21,000 x 5 105,000
Additional cash inflow, snack bar 13,000
Total 118,000
Less fixed expenses 80,000
Annual cash inflow 38,000
PV of annual cash inflow (38,000 x 5,575) 211,850

PV of salvage value 1,296
PV of working capital return 432
Total 213,578
Investment 294,000
Negative Net Present Value ( 80,422)
lxxii
. Answer: D
The annual cost of advertising can be easily calculated by dividing the net present
value of alternative 2, at 16% by the present value of annuity of 1.
70,103 ÷ 5,575 = 12,574.53
lxxiii
. Answer: A
Annual revenues 300,000
Variable expenses 60,000
Contribution margin 240,000
Fixed expenses
Advertising 40,000
Salaries 110,000
Utilities 5,200
Insurance 800 156,000
Annual cash income 84,000
Less Depreciation 420,000 x 0.90 ÷ 12 31,500
Annual Income 52,500
lxxiv
. Answer: A
Current operating costs – old machine 78,000
Deduct Operating costs – Machine B
Annual salary of operator 16,350
Annual maintenance cost 5,400 21,750
Annual cash savings 56,250
lxxv
. Answer: A
Simple Rate of Return = Net Income ÷ Initial Investment
52,500 ÷ 420,000 = 12.50 %
lxxvi
. Answer: B
Savings 56,250
Less Depreciation 234000 ÷ 13 years 18,000
Annual income 38,250
Simple Annual Return 38,250 ÷ 225,000 17 %
lxxvii
. Answer: C
Payback period = Initial Investment ÷ Annual Cash Inflow
420,000 ÷ 84,000 = 5 years
lxxviii
. Answer: A
225,000 ÷ 56,250 = 4 years
lxxix
. Answer: C
Purchase price of new tools 2,500,000
Add increase in working capital 60,000
Total 2,560,000
Deduct Salvage value of the old tools 45,000
Net investment 2,528,500
lxxx
. Answer: C
Purchase price of valve stem 80,000 x 20 1,600,000
Cost to make:
Direct materials 80,000 x 4.50 360,000
Direct labor 80,000 x 3.90 312,000
Variable overhead 80,000 x 1.50 120,000
Decrease in directs labor and variable costs 80,000 x 1.60(128,000) 664,000
Cost savings 936,000
lxxxi
. Answer: A
PV of annual depreciation
PeriodDepreciationPV FactorPresent ValueYear 1 832,5000.89286743,305.95 2
112,5000.79719886,873.88 3 370,0000.71178263,358.60 4
185,0000.63552117,571.20Total2,011,109.63Tax rate0.30PV of tax benefits from
depreciation603,332.89
lxxxii
. Answer: C
After tax salvage value 100,000 x .7 70,000
PV of 1 end of 4 periods 0.63552
PV of after – tax salvage value 44,486.4
lxxxiii
. Answer: C
PV of after cash savings 936,000 x .7 x 3.03735 1990072
PV of tax benefits from depreciation 603,333
PV of after tax salvage value 44,486
PV of working capital return 60,000 x 0.63552 38,131
Investment (2528,500)
Net present value 147,522
lxxxiv
. Answer: A
PV of tax benefits, declining - balance 603,333
PV of tax benefits, straight-line method 2,500,000  4 x .3 x 3.03735 569,503
Net advantage 33,830
lxxxv
. Answer: A
Invoice price of new equipment (945,000 x 0.98) P926,100
Freight 11,000
Installation cost 22,900
Total 960,000
Less: Salvage value of old equipment (0.6 x 1,500) 900
Reduction in working capital 2,500 3,400
Net initial outflows P956,600
lxxxvi
. Answer: B
Total variable costs (262,000 units x P20*)P5,240,000
Avoidable fixed costs (P45,000 x 5 years) 225,000
Total 5,465,000
After-tax Cash outflows

Operating expenses (5,465,000 x 0.6) P3,279,000
Depreciation (960,000 x 0.4) ( 384,000)
After-tax salvage value of new equipment (12,000 x 0.60) ( 7,200)
Net outflows P2,887,800
*Variable cost per unit

Direct material (10.00 x 0.75) P 7.50
Direct labor 8.00
Variable overhead (6.00 x 0.75) 4.50
Total P20.00
lxxxvii
. Answer: A
The present value of the tax shield based on declining-depreciation is:
YearDepreciationTax Shield (40%)PV FactorPV of Tax
Shield2007P319,968P127,9870.893P114,2922008 426,720 170,6880.797 136,0382009
142,176 56,8700.712 40,4922010 71,136 28,4550.636 18,098TotalP308,920
lxxxviii
. Answer: C
Purchase Cost
Year ATCF200750,000 x 27 x 0.6 810,000200850,000 x 27 x 0.6
810,000200952,000 x 27 x 0.6 842,400201055,000 x 27 x 0.6 891,000201155,000
x 27 x 0.6 891,0002006(1,500 x 0.6) ( 900) Total 4,243,500
lxxxix
. Answer: A
Present value of after-tax cash flows
2007 (810,000 x 0.893) P 723,330
2008 (810,000 x 0.797) 645,570
2009 (842,400 x 0.712( 599,789
2010 (891,000 x 0.636) 566,676
2011 (891,000 x 0.567) 505,197
Salvage value of old equipment (1,500 x 0.60) (900)
Net present value P3,039,662
xc
. Answer: D
CFBTCFATPV FactorPVCFAT2006Initial outflow(P956,600)2007(50,000 x 20) + 45,000
(1,045,000 x 0.6) - (319,968 x 0.4)1,045,000
499,013
0.893
445,6192008(1,045,000 x 0.6) – (426,720 x 0.4)456,3120.797363,6812009(52,000 x 20)
+ 45,000
(1,085,000 x 0.6) – (142,176 x 0.4)1,085,000
594.130
0.712
423,0212010(55,000 x 20) + 45,000
(1,145,000 x 0.6) – (71,136)1,145,000
658,546
0.636
418,8352011(55,000 x 20) + 45,000
(1,145,000 x 0.6)1,145,000
687,000
0.567
385,447Salvage value (12,000 x 0.6)7,200P2,993,203

Capital Budgeting Theories: Basic Concepts

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Capital Budgeting Theories: Basic Concepts

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Capital Budgeting

Capital budgeting defined

3. Capital budgeting is the process

5. A capital investment decision is essentially a decision to:

Risk & return

9. Cost of capital is the

14.How should the following projects be listed in order of increasing risk?

41.Problems associated with justifying investments in high-tech projects often include

D. low and time horizons that are too short

60.In evaluating high-tech projects,

Types of capital projects

Capital budgeting process

30.The proper treatment of an investment in receivables and inventory is to

31.In connection with a capital budgeting project, an investment in working capital is

C. Decrease the cost of the investment.

Relevant cash flows

Depreciation & Tax

Irrelevant cash flows

Accounting rate of return

Nondiscounted cash flow method

34.The technique most concerned with liquidity is

73.Which of the following is a potential use of the payback method?

47.The cash payback technique:

33.Which of the following is NOT a defect of the payback method?

D. It ignores the pattern of cash flows beyond the payback period.

Discounted cash flow method

Net present value

40.The discount rate commonly used in present value calculations is the

Internal rate of return

Relationships among NPV, PI & IRR

27.The relationship between payback period and IRR is that

67.When comparing NPV and IRR, which is not true?

64.Sensitivity analysis is:

Effectof change in cost of capital

Effect of change in residual value

Decision rules – independent projects

Net present value

63.NPV indicates a project is deemed desirable (acceptable) when the NPV is

Internal rate of return

NPV & IRR

Decision rule – mutually exclusive projects

37.A follow-up evaluation of a capital project is performed to see that investment

65.Companies use post audits to:

Operating Cash Flow

Increase in Annual Income Tax

Depreciation & Taxes

Accounting rate of return

Based on average investment

A. 20.0 percent C. 10.0 percent

A. In 2.73 years C. At the end of year 2

Net Present Value

Internal Rate of Return

Required unit sales

Required selling price

Required Increase in CFAT

Required CFAT for a certain year

Required salvage value

Required value of intangible benefits

Decision Rule – Independent Projects