ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

CPA Review Batch 41  May 2021 CPA Licensure Examination  Weeks 16-17
MANAGEMENT ADVISORY SERVICES C.P. Lee  E.S Arañas  K.L. Manuel

MAS-14: CAPITAL BUDGETING WITH INVESTMENT RISKS & RETURNS

CAPITAL BUDGETING
 CAPITAL INVESTMENT is the long-term commitment of significant funds to meet certain objectives such as
acquiring additional plant assets to expand company operations. Its typical characteristics include:
 As to COST: requires a large sum of money and resources
 As to COMMITMENT: ties up invested funds for a long period of time
 As to FLEXIBILITY: more difficult to reverse than short-term decisions
 As to RISK: involves so much risks and uncertainties mainly due to estimates and forecasts being
assumed over an extended period of time
 INDEPENDENT capital investment projects (meant for SCREENING decisions) are projects that are evaluated
individually against predetermined corporate standard of acceptability resulting in an accept-or-reject
decision. Common examples: investment in long-term assets such as purchase of property, plant or
equipment, new product development, large-scale advertising campaign.
 MUTUALLY EXCLUSIVE capital investment projects (meant for PREFERENCE decisions) are projects that
require choosing from among alternatives and, once chosen, usually preclude the company from choosing
other competing projects. Common examples: replacement vs. renovation of equipment, lease vs. buy of
facilities, manual bookkeeping vs. computerized system, preventive maintenance vs periodic overhaul.
 CAPITAL BUDGETING is the process of measuring, evaluating, and selecting capital investments.
 Six formal stages of capital budgeting: 1) Identification and definition stage 2) Search stage 3) Information-
acquisition stage – both qualitative and quantitative information is considered 4) Selection stage – choosing projects
after cost-benefit evaluation 5) Financing stage 6) Implementation and Control stage – conduct of post-audit.
 An over-simplified capital budgeting process involves the following steps:
Step 1: Step 2: Step 3:
Identification Evaluation Decision

Nature of Capital Investments FACTORS OF CONSIDERATION

Replacement (Equipment)
Improvement (Products)
Expansion (Facilities) Net Investments Net Returns Costs of Capital
Addition (Technology)
Reduction (Costs)

Capital budgeting, after the selection Non-discounted methods Discounted methods

of the capital investment project, Payback period Net present value (NPV)
typically extends up to the financing, Bail-out payback Profitability index
implementation, monitoring and Accounting rate of return (ARR) Internal rate of return (IRR)
review of the project. Payback reciprocal Discounted payback
 NET INVESTMENTS, primarily computed for decision-making purposes, refer to COSTS (cash outflows) less
SAVINGS (cash inflows) incidental to the acquisition of the capital investment projects.
 COSTS (Cash outflows) include:
 Purchase price of the asset, net of any related cash discount
 Incidental project-related expenses such as freight, insurance, handling, installation, test-runs
 Additional working capital needed to support the operation of the project at the desired level.
(NOTE: At the end of the project’s life, additional working capital shall be recaptured as part of the
project’s terminal cash flow, along with any salvage value of the project)
 Market value of existing idle assets to be used in the operation of the proposed capital project.
 Training cost, net of related tax
 SAVINGS (Cash inflows) include:
 Proceeds from sale of an old asset disposed, net of related tax
 Trade-in value of the old asset (in case of replacement)
 Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax
 NET RETURNS refers to either net income (under accrual basis) or net cash flows (under cash basis), the
latter may be computed under direct or indirect method:
 Direct method: Net cash inflows = cash inflows – cash outflows
 Indirect method: Net cash inflows = Net income + noncash expenses (e.g., depreciation)
 COST of CAPITAL, a.k.a. hurdle rate, minimum required/acceptable rate of return, desired rate, cut-off rate,
standard rate, is used as a discount rate in discounted capital budgeting techniques like NPV and
profitability index. [Cost of Capital was discussed in MAS-13 during Week 15]
 PAYBACK PERIOD measures the length of time required to recover the amount of initial investment.
Net Investment
PAYBACK PERIOD =
Net Cash Inflows
RULE: the shorter the payback period, the less risky the project and the greater the liquidity
PROS: simple to compute, easy to understand, useful in evaluating liquidity of the project, a good surrogate
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for risk -- a quick or short payback period indicates a less risky project.
CONS: ignores time value of money, ignores salvage value and cash flows after payback period, more
emphasis on return OF investment instead of ROI, maximum payback period may be arbitrary
 BAIL-OUT PAYBACK PERIOD is payback method wherein cash recoveries include not only the annual net
cash inflows but also the estimated salvage value realizable at the end of each year of the project life.
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Weeks 16-17: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS

 ACCOUNTING RATE of RETURN, a.k.a. book rate of return, simple rate of return, unadjusted rate of return,
financial statement rate of return, measures the profitability from accounting standpoint by relating the
required investment to the future annual net income.
Average Annual Net income
ACCOUNTING RATE of RETURN (ARR) =
Original or Average Investment*
RULE: choose the project with higher ARR vs. the cost of capital.
PROS: emphasize project9s profitability, considers entire life and project results, consistent with FS values
CONS: ignores time value of money, ignores inflationary effects, uses accrual values rather than cash flows
 PAYBACK RECIPROCAL provides a reasonable estimate of the internal rate of return (IRR) provided that the
following two conditions are met:
Condition No. 1: Payback period is at most half of the economic life of the project
Condition No. 2: Net cash inflows are uniform throughout the life of the project.
Net Cash Inflows 1
PAYBACK RECIPROCAL = =
Net Investment Payback period
NOTE: Payback reciprocal is a non-discounted technique used to estimate a discounted technique (IRR).
 NET PRESENT VALUE measures the excess of the present value of cash inflows generated by the project
over the amount of initial investment.
Net Present Value (NPV) = Present Value of Cash Inflows – Present Value of Cash Outflows
 CASH INFLOWS include annual net cash inflows infused by the capital investment project and any cash
realizable at the end of the project life (e.g., salvage value, return of working capital requirements).
 CASH OUTFLOWS is usually based on the net investment cost required at the inception of the project.
RULE: choose the project that has positive NPV.
PROS: emphasizes cash flows, considers time value of money, assumes cost of capital as reinvestment rate
CONS: costs of capital is not always available, may be incomparable if projects have different lives or sizes.
 PROFITABILITY INDEX, a.k.a. benefit-cost ratio, desirability index, present value index, expresses the
present value of cash benefits as to an amount per peso of investment in a capital project and is used as a
measure of ranking projects in a descending order of desirability.
Present Value of Cash Inflows
PROFITABILITY INDEX =
Present Value of Cash Outflows
RULE: choose the project that has a profitability index of more than 1.0.
 INTERNAL RATE of RETURN (IRR), a.k.a. time-adjusted rate of return, discounted cash flow rate of return,
sophisticated rate of return, break-even cash flow rate or return, is the rate of return that equates the
present value of cash inflows to present value of cash outflows. IRR is the discount rate at which the net
present value is zero.
RULE: choose the project with higher IRR vs. the cost of capital.
PROS: emphasizes cash flows, considers time value of money, computes the true return of the project
CONS: difficult to compute for uneven cash flows, requires estimation of cash flows over a long period of
time, assumes IRR as reinvestment rate, may not be meaningful if a project has negative earnings.
NOTE: Determination of a project9s exact IRR may require an interpolation process. Trial and error
technique and the payback reciprocal method may also be used to approximate the IRR.
 IRR must be distinguished from CROSSOVER RATE (a.k.a. NPV Point of Indifference, Fisher Rate*), which is
the discount rate at which the NPV of two capital investment projects are equal.
 DISCOUNTED PAYBACK, a.k.a. break-even time, is the length of time required to equalize the discounted
cash flows (using the cost of capital as a discount rate) and initial investment of a capital project.
 EQUIVALENT ANNUAL ANNUITY (EAA), a.k.a. annualized NPV, is a NPV-based technique that is used to
compare capital investment projects with unequal lives.
 CAPITAL RATIONING is, given a constraint on capital budget, the selection of investment proposals that
would maximize the over-all NPV of the firm. The profitability index, which is considered as a project
ranking method rather than a project screening method, is proven to be more useful than NPV and IRR
when the projects being evaluated involve different investment sizes, earnings pattern and project lives.
 REAL OPTIONS are alternatives or choices that become available over the life of a capital investment.
Common examples include: (1) option to delay, (2) option to expand, (3) option to abandon, (4) option to
scale back, (5) option to vary inputs/output (6) option to enter new market (7) new product option. In
capital investment projects, real options provide management the opportunity to limit possible losses by
taking advantage of future positive events that may improve investment outcomes.
 RISK ANALYSIS attempts to measure the likelihood of the variability of future returns from the proposed
investment. The following approaches are used to assess risk in capital investments:
 RISK-ADJUSTED DISCOUNT RATE is a technique that adjusts the discount rate upward as investment
becomes riskier. By increasing the discount rate, the expected flow from the investment must be
relatively larger or a negative NPV will be generated and the proposed investment would be rejected.
 TIME-ADJUSTED DISCOUNT RATE assumes a higher discount rate in later years of a project9s life due to
uncertainties (e.g., inflation) involved in making projection of cash flows over a long period of time.
 SCENARIO ANALYSIS considers multiple possible outcomes or scenarios and associated probabilities to
determine the overall expected outcome based on the weighted average of all possible outcomes.
 SENSITIVITY ANALYSIS uses an iterative process that uses forecasts of many NPVs under various
<what-if= assumptions to see how sensitive NPV is to changing conditions.

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 MONTE CARLO SIMULATION is a sophisticated computer analysis that considers uncertainties and
probability distributions for inputs and uses random number inputs to map range of possible outcomes.
 DECISION TREE is a probability-based technique used when management needs to decide through a
series of <if-then= scenarios that describe how the firm might react based on future events.
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Weeks 16-17: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS

INVESTMENT RISKS & RETURNS

 INVESTMENT RISK, a.k.a. security risk, speculative risk, is possibility that actual investment returns will
differ from expected returns, which could result in either a gain or a loss.
 An investment risk consists of two components: (1) Diversifiable risk (2) Non-diversifiable risk
1) DIVERSIFIABLE risk (a.k.a. UNSYSTEMATIC or controllable risk) represents portion of a security9s risk
that can be controlled through proper diversification. This type of risk is unique to a given security.
Default risk, business risk, liquidity risk normally fall under this category.
2) NON-DIVERSIFIABLE risk (a.k.a. SYSTEMATIC or non-controllable risk) results from forces outside the
firm9s control and is therefore not unique to a given security. Marker risk, political risk, purchasing
power risk, foreign exchange risk normally fall under this category.
[Various investment risks and corresponding definitions are covered in MAS-13 under Costs of Capital]
 STANDARD DEVIATION (SD), a measure of dispersion of potential returns from average returns, is
commonly used to quantify risk of investment. The smaller the SD, the lower the risk of the investment.
 Using SD to compare investment risks is only an absolute measure of dispersion (risk) and does not
consider the dispersion of outcomes in term of EXPECTED RETURN, which is the weighted average of
possible returns using the probabilities as weights.
 <68-95-99= Normal Rule in statistics: given a normal probability distribution, 68% of the returns will lie
within  1 SD of the expected return, 95% of all observations will lie within  2 SDs of the expected return
and 99% of all observations will lie within  3 SDs of the expected return.
 SD must be distinguished from STANDARD ERROR of the MEAN (always smaller than SD), which measures
how far a sample mean (e.g., expected return) deviates from the actual mean of a population.
 When comparing investments that have different expected returns, the more appropriate measure of
investment9s relative risk is the COEFFICIENT of VARIATION, a measure of risk per unit of return.
Standard Deviation (ơ)
Coefficient of Variation =
Expected Return (µ)
The higher the coefficient of variation is, the riskier the investment is relative to its expected return.
 An investor may be willing to take additional risks in order to attempt greater returns. The ultimate decision
largely depends on management9s profile and appetite for risks and returns – whether a firm9s management
is risk-taker, risk-neutral or risk-averse.

EXERCISES: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS

1. Net Investment for Decision-Making

Zilong Company plans to replace an old unit of equipment with a new one:
I) The old unit was acquired three years ago; the old unit9s carrying value is now at P 50,000 while it
can be sold for P 60,000. Tax rate is 25%.
II) The new unit can be acquired at a list price of P 300,000. A 10% cash discount is available if the
equipment is paid for within 30 days from acquisition date. Shipping, installation and testing
charges to be paid are estimated at P 16,000.
III) Other assets with a book value of P 12,000 that are to be retired as a result of the acquisition of the
new machine can be salvaged and sold for P 10,000.
IV) Additional working capital of P 32,000 will be needed to support operations planned with the new
equipment.
V) The annual cash flow from the use of the new equipment is P 50,000. At the end of its useful life of
5 years, the new equipment must be disposed of with a zero book value but with a n expected
salvage value of P 4,000.
REQUIRED:
A) What is the initial cost of net investments for decision-making purposes?
B) What is the terminal cash flow expected at the end of life of the project?

2. Net Returns - Increase in Revenues

Bruno Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are
estimated to be 10,000 cups to be sold for P 15 per cup. Variable costs are estimated at P 6 per cup, while
incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines are expected to
have a service life of 5 years, with no salvage value. Depreciation will be computed on a straight-line basis.
The company9s income tax rate is 20%.
REQUIRED: Determine the following:
A) The increase in annual net income.
B) The annual cash inflows that will be generated by the project.

3. Net Returns - Cost Savings

Gord, Inc. is planning to buy a high-tech machine that can reduce cash expenses by an average of P 70,000
per year. The new machine will cost P 100,000 and will be depreciated for 5 years on a straight-line basis.
No salvage value is expected at the end of the machine9s life. Income tax rate is 30%.

REQUIRED: 0 0
Determine the net cash inflows that will be generated by the project.
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4. Payback Period & ARR (Even Cash Flows)

Nana Company plans to replace its old equipment. The cost of the new equipment is P 90,000, with a
useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash savings from the
use of the new equipment is P 40,000. The old equipment has zero market value and is fully depreciated.
The company uses a cost of capital of 25%.

REQUIRED: Assuming that the income tax rate is 40%, determine:

A) Payback period
B) Accounting rate of return on original investment
C) Accounting rate of return on average investment

5. Payback Period & ARR (Uneven Cash Flows)

Pharsa Company has an investment opportunity costing P 90,000 that is expected to yield the following
cash flows over the next five years:
Year Amount
1 P 40,000
2 35,000
3 30,000
4 20,000
5 10,000
P 135,000
REQUIRED: Assuming a hurdle rate of 30%, determine:
A) Payback period in months
B) Book rate of return

6. Bail-Out Payback Period

A project costing P 180,000 will produce the following annual cash flows and year-end salvage values:
Year Cash flows Salvage value
1 P 50,000 P 60,000
2 P 50,000 P 55,000
3 P 40,000 P 50,000
4 P 40,000 P 45,000
REQUIRED:
Bail-out payback period.

7. Net Present Value (Even Cash Flows)

Hanabi Company plans to buy a new machine costing P 28,000. The new machine is expected to have a
salvage value of P 4,000 at the end of its economic life of 4 years. The annual cash inflows before income
tax from this machine are estimated at P 11,000. The tax rate is 20%. The company desires a minimum
return of 25% on invested capital.
REQUIRED: Rounding-off present value factors to three decimal places, determine the net present value.

Solution Guide

Year 0 PV factor Year 1 Year 2 Year 3 Year 4

Year 0 ________
Year 1 ________
Year 2 ________
Year 3 ________
Year 4 ________
Year 4 ________
NPV = _________

Cash inflows before tax PV, Cash IN

- Depreciation ____________ 10,000 (_____)
Earnings before tax 4,000 (_____)
- Tax (20%) ____________
Earnings after tax PV, Cash OUT
+ Depreciation ____________ 28,000 (_____)
Cash inflows after tax NPV =

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8. NPV, Profitability Index & IRR (Even & Uneven Cash Flows)
Vale Corporation gathered the following data on two capital investment opportunities:
Project 1 Project 2
Cost of investment P 195,200 P 150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash inflows P 100,000 P 100,000*
* This amount is to decline by P 20,000 annually thereafter.
REQUIRED: Round-off present value factors to three decimal places.
Project 1 Project 2
NPV: A) _____________ B) _____________
P. Index: C) _____________ D) _____________
E) What is project 19s internal rate of return?
a. 23% c. 25%
b. 27% d. 29%
F) What is project 29s internal rate of return?
a. Below 30% c. Between 31% and 32%
b. Between 30% and 31% d. Above 32%

9. Capital Budgeting Techniques

Silvanna Company is considering buying a new machine, requiring an immediate P 400,000 cash outlay.
The new machine is expected to increase annual net after-tax cash receipts by P 160,000 in each of the
next five years of its economic life. No salvage value is expected at the end of 5 years. The company
desires a minimum return of 14% on invested capital.

REQUIRED: Round-off factors to three decimal places in all cases.

A) Payback period D) Profitability index
B) ARR (based on original investment) E) Internal rate of return
C) Net present value
10. Equivalent Annual Annuity: Project with Unequal Lives
Project Cost Life Annual Cash Inflow
Guinevere P 50,000 10 years P 9,000
Lancelot P 50,000 15 years P 7,500
REQUIRED: Assuming a cost of capital of 10% (round-off factors to four decimal places):
On the basis of equivalent annual annuity, which project is more attractive?

11. Crossover Rate - NPV Point of Indifference

Mythical Glory Corporation has a weighted average cost of capital of 12% and is evaluating two mutually
exclusive projects (Fighter and Tank), which have the following projections:
Project Fighter Project Tank
Investment P 1,000 P 800
After-tax cash inflow P 400 P 400
Asset life 4 years 3 years
The crossover rate for the two projects is closest to:
a. 20% c. 18%
b. 19% d. 10%
12. Payback Reciprocal
Gatotkaca Company is planning to buy an equipment costing P 640,000 with an estimated life of 30 years
and is expected to produce after-tax net cash inflows of P 128,000 per year.

REQUIRED:
Without using present value factors, what is the best estimate of the IRR?
Answer and solution
Payback period: 640,000 ÷ 128,000 = 5 years Payback reciprocal: 1 ÷ 5 years = 20%
Based on page 2, PAYBACK RECIPROCAL is a reasonable estimate of the internal rate of return (IRR)
provided that the following conditions are met:
 Payback period is at most half of the economic life of the project [i.e., 5 years ≤ (30 ÷ 2)]
 Net cash inflows are uniform throughout the life of the project.

13. Relationships: Discounted Techniques

Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful
life of ten (10) years and no salvage value. Round off factors to three decimal places.
Project Annual Cash Flow Investment Cost of Capital IRR NPV
1 P 45,000 P 188,640 14% (A) _______ (B) ________
2 P 75,000 0
(C) ________ 0
12% 18% (D) ________
3 (E) __________ P 300,000 (F) _______ 16% P 81,440
4 (G) __________ P 450,000 12% (H) _______ P 115,000
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14. Capital Rationing - Ranking Projects

Leslie Corporation is considering five investment opportunities. The cost of capital is 12%.
Project Investment PV - Cash Flow NPV IRR (%) P. Index
1 P 35,000 P 39,325 P 4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,543 14 1.10
4 10,000 10,854 854 18 1.09
5 9,000 8,749 (251) 11 0.97
REQUIRED:
A) Rank the projects in descending order of preference according to NPV, IRR and profitability index.
B) If only a budget of P 55,000 is available, which projects should be chosen?

15. Capital Budgeting under Risk: Coefficient of Variation

ML is considering whether to invest in one of two mutually exclusive projects: Project <MM= vs. Project
<Mage=. Depending on the state of the economy, the projects would provide the following cash inflows in
each of the next 5 years. Consider the following probability distribution:
State of Economy Probability Project <MM= Project <Mage=
Recession 30% P 1,000 P 500
Normal 40% P 2,000 P 2,000
Prosperity 30% P 3,000 P 5,000
REQUIRED: Assuming probability distribution is normal when determining confidence internal, determine:
Project MM Project Mage
Expected Return A) _____________ E) _____________
Standard Deviation (rounded, whole amount) B) _____________ F) _____________
Confidence Interval (with 68% probability) C) _____________ G) _____________
Coefficient of Variation D) _____________ H) _____________
I) Which project is likely to be chosen assuming ML is a conservative, risk-averse type of investor?

WRAP-UP EXERCISES (MULTIPLE-CHOICE)

1. Capital budgeting is the process
a. Used in make-or-buy decision making
b. Of eliminating unprofitable product line
c. Of making capital expenditure decisions
d. Of determining how much capital stock is issued
2. Which of the following is considered in computing the net investment for the decision to replace an old
machine with a new one?
I) Purchase price of the old machine III) Salvage value of the old machine
II) Purchase price of the new machine IV) Salvage value of the new machine
a. I and II c. I and IV
b. II and III d. II and IV
3. Which of the following is not a typical cash inflow in capital investment decisions?
a. Salvage value c. Incremental revenues
b. Cost reductions d. Additional working capital
4. Annual cash inflows from the capital projects are measured in terms of
a. Income after depreciation and taxes c. Income before depreciation but after taxes
b. Income before depreciation and taxes d. Income after depreciation but before taxes
5. A depreciation tax shield is
a. An after-tax cash outflow c. The expense caused by depreciation
b. A reduction in income taxes d. The cash provided by recording depreciation
6. When computing for the accounting rate of return (ARR), which of the following is used?
a. Income after depreciation and taxes c. Income before depreciation but after taxes
b. Income before depreciation and taxes d. Income after depreciation but before taxes
7. The payback method measures
a. Cash flows of an investment c. Economic life of an investment
b. Profitability of an investment d. How quickly investment may be recovered
8. The payback period considers (I) income over the entire project life and (II) time value of money.
a. (I) Yes (II) Yes c. (I) No (II) Yes
b. (I) Yes (II) No d. (I) No (II) No
9. Which of the following is a TRUE statement regarding non-discounted capital budgeting techniques?
a. Payback period (liquidity of project); ARR (liquidity of project)
b. Payback period (liquidity of project); ARR (profitability of project)
c. Payback period (profitability of project); ARR (liquidity of project)
d. Payback period (profitability of project); ARR (profitability of project)
10. All of the following capital budgeting analysis techniques use cash flows as the primary basis for the
calculation, except for the:
a. Payback period 0 0
c. Accounting Rate of Return (ARR)
b. Net Present Value (NPV) d. Internal Rate of Return (IRR)
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11. Which of the following groups of capital budgeting techniques considers the time value of money?
a. ARR, IRR and payback period c. ARR, NPV and profitability index
b. IRR, NPV and profitability index d. ARR, IRR and profitability index
12. Cost of capital is 8%; economic life in years = 4 years; what is the simple PV factor for year 4?
a. 0.095 c. 0.735
b. 0.171 d. 0.794
13. Discount rate is 12%; economic life in years = 3 years; what is the PV annuity factor for 3 years?
a. 0.712 c. 2.402
b. 1.690 d. 3.157
14. What is the PV factor of any amount at year zero or zero percent?
a. Zero c. 0.50
b. 1.00 d. 1.50
15. The discount rate (hurdle rate of return) must be determined in advance for the
a. ARR c. Payback period
b. IRR d. Net present value
16. When using the net present value method for capital budgeting analysis, the required rate of return is
called all of the following, except
a. Risk-free rate c. Discount rate
b. Cutoff rate d. Cost of capital
17. A capital project with a positive NPV also has
a. A profitability index of one c. A profitability index less than one
b. A positive profitability index d. A profitability index greater than one
18. A capital project that has a positive NPV based on a discount rate of 12% also has an IRR of
a. Zero c. Less than 12%
b. 12% d. Greater than 12%
19. Which of the following combinations is possible?
Profitability Index NPV IRR
a. Greater than 1 Positive Equals cost of capital
b. Greater than 1 Negative Less than cost of capital
c. Less than 1 Negative Less than cost of capital
d. Less than 1 Positive Less than cost of capital
20. The net present value method assumes that the project9s cash flows are reinvested at the
a. Internal rate of return c. Cost of capital
b. Simple rate of return d. Payback period
21. The internal rate of return method assumes that the project9s cash flows are reinvested at the
a. Required rate of return c. Simple rate of return
b. Internal rate of return d. Payback period
22. 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 company9s profit
c. If accepted, can also lead to the acceptance of a competing project
d. Require all managers to consider and make decision on the capital investment project
23. In choosing from among mutually exclusive investments, an entity shall normally select the one with
the highest
a. Net present value c. Book rate of return
b. Profitability index d. Internal rate of return
24. Which capital budgeting method is a project-ranking method rather than a project-screening method?
a. Net present value c. Simple rate of return
b. Profitability index d. Sophisticated rate of return
25. Which of the following capital budgeting techniques would allow management to justify investing in a
project that could not be justified currently by using techniques that focus on expected cash flows?
a. Real options c. Internal rate of return
b. Net present value d. Accounting rate of return
26. Which of the following is not a technique for considering risks of an investment in capital budgeting?
a. Probability analysis c. Simulation techniques
b. Risk-adjusted discount rate d. Internal rate of return
27. Which of the following expresses the relationship between risk and return?
a. Direct relationship c. Spurious relationship
b. Inverse relationship d. Non-existing relationship
28. The expected return of an investment or a portfolio is measured by the
a. Beta c. Weighted average
b. Variance d. Standard deviation
29. Standard deviation divided by expected return is used to calculate
a. Coefficient of variation c. Coefficient of determination
b. Coefficient of correlation d. Co-variance of a portfolio
30. The expected rate of return for ABC stock is 20%, with a standard deviation of 15%. The expected rate
of return for XYZ stock is 10%, with a standard deviation of 9%. The riskier stock is:
a. ABC because its return is higher
0
b. XYZ because its standard deviation is lower 0
c. ABC because its standard deviation is higher
d. XYZ because its coefficient of variation is higher
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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-14
Weeks 16-17: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS

SELF-TEST QUESTIONS – with suggested answers

(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)
1. Capital budgeting is concerned with
C a. Decisions affecting only capital intensive industries
b. Analysis of short-range decisions
c. Analysis of long-range decisions
d. Scheduling office personnel in office buildings
2. Of the following decisions, capital budgeting techniques would least likely be used in evaluating the
D a. Acquisition of new aircraft by a cargo company
b. Trade for a star quarterback by a football team
c. Design and implementation of a major advertising program
d. Adoption of a new method of allocating non-traceable costs to product lines
3. The capital budgeting process contains several stages. At which stage are financial and nonfinancial factors addressed?
D a. Search stage c. Identification and definition stage
b. Selection stage d. Information-acquisition stage
4. At what stage of the capital budgeting process would management most likely apply present value techniques?
B a. Search stage c. Financing stage
b. Selection stage d. Identification stage
5. The stage of the capital budgeting process that has the most risk is
A a. Forecasting cash flow c. Identifying alternative possible projects
b. Evaluating performance and learning d. Raising funds to initially support the project
6. In equipment-replacement decisions, which one of the following does not affect the decision-making process?
C a. Current disposal price of old equipment c. Original fair market value of the old equipment
b. Operating costs of the old equipment d. Cost of the new equipment
7. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
A 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
8. Naga Company is considering the sale of a machine with a book value of P 80,000 and 3 years remaining in its useful
life. Straight-line depreciation of P 25,000 annually is available. The machine has a current market value of P
100,000. What is the cash flow from selling the machine if the tax rate is 40%?
C a. P 80,000 c. P 92,000
b. P 88,000 d. P 100,000
9. A company is considering replacing a machine with one that will save P 50,000 per year in cash operating costs and
has P 20,000 more depreciation expense per year than the existing machine. The tax rate is 40%. Buying the new
machine will increase annual net cash flows of the company by
A a. P 38,000 c. P 20,000
b. P 30,000 d. P 12,000
10. Legaspi Company is considering replacing a machine with a book value of P 400,000, a remaining useful life of 5 years,
and annual straight-line depreciation of P 80,000. The existing machine has a current market value of P 400,000. The
replacement machine would cost P 550,000, have a 5-year life, and save P 75,000 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 would be
the net investment required to replace the existing machine?
B a. P 90,000 c. P 330,000
b. P 150,000 d. P 550,00
11. Old equipment with a book value of P 15,000 will be replaced by new equipment with a purchase price of P 50,000,
exclusive of freight charges of P 2,000. The market value of the old equipment is P 11,000. Repair costs of P 2,000
can be avoided if the new equipment is acquired. Assume a tax rate of 35%, what is the net investment of the project?
B a. P 33,800 c. P 39,700
b. P 38,300 d. P 52,000
Costs (Cash outflows): 50,000 + 2,000 = P 52,000
Savings (Cash inflows): 11,000 + 0.35 (15,000 – 11,000) + 2,000 (1 – 0.35) = P 13,700
12. A company is considering a project that requires a P 50,000 working capital investment. The company’s tax rate is
40%. In a capital budgeting analysis, the initial investment in working capital should be:
C a. Multiplied by (1-0.40) and shown as a net P 30,000 cash outflow
b. Multiplied by the rate (0.40) and shown as a net P 20,000 cash outflow
c. Shown as a cash outflow of P 50,000
d. Ignored
13. Sipocot Company owns a building that originally cost P 400,000 and has a current book value of P 250,000. The
building was financed by a loan that has one payment of P 20,000 outstanding, which must be paid off upon the sale
of the building. Sipocot would like to purchase a new building for P 600,000. If the new building is purchased, the
existing building would be sold for P 380,000. Sipocot Company’s income tax rate is 40%. If the new building is
purchased, the relevant initial cash flows would total
B a. P 272,000 c. P 372,000
b. P 292,000 d. P 392,000
14. In computing the initial investment for decision-making, taxes would be relevant for all of the following, EXCEPT:
C a. Avoidable repairs of old asset
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b. Profit on sale of old asset replaced by a new one 0
c. Increase in working capital required to support new capital investment
d. Loss on write-off of other assets disposed because of new capital investment
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