ACTIVITY 1: Capital Budgeting

1. Net cost of investment. The Hill Top Company plans to open a new branch office wherein the
company shall invest P900,000 in furnishings and equipment. Construction costs, lease deposits, and
other initialization outlays are estimated at P1,200,000. Sales from this new branch are estimated at
P9,000,000 a year. One-fourth of these sales will be in the form of accounts receivable at any given
time. Cost of goods sold are estimated to be 75% of sales. The investment in merchandise inventory
will amount to approximately P800,000 at any given time during the year. Cash of P220,000 will be
needed to meet payments for operating expenses. Accounts payable and other current liabilities will
increase by P650,000.

Required: Compute the total amount to be invested in the new branch for decision-making purposes.

Answer:

Furnishings and equipment 900,000

Construction and other outlays 1,200,000

Cash 220,000

A/R 2,250,000

Inventory 800,000

TOTAL 5,370,000

Current liabilities 650,000

Net cost of investment 5,370,000 – 650,000

= 4,720,000
2. Net returns. The Cebu Corporation is planning to add a
new product line to its present business. The new product
will require a new equipment costing P2,500,000, having a
five-year useful life with no residual value. The following Indirect Direct
estimates are made available: Sales 28,000 28,000
Annual sales P 28,000,000 - Mat (10,000) (10,000)
Annual costs and expenses: - DL
Materials 10,000,000 - FOH
- MDE
Labor 5,000,000
- D/Expense n.a.
Factory overhead (excluding
PBT / CFBT
depreciation on new equipment) 8,000,000
- Tax
Marketing and distribution
PAT
expenses 1,000,000
+ D/Exp n.a.
Income tax rate, 40%. ACI

Required:
a. Annual income after tax.
b. Annual net cash flow after tax.

Answer:
a. Annual Income after Tax

Sales 28,000,000
Costs and exp.
Material -10,000,000
Labor -5,000,000
FOH -8,000,000
Depreciation -500,000
Marketing Expenses -1,000,000
PBT 3,500,000
Tax at (40%) -1,400,000
Annual Income after tax 2,100,000

b. Annual Net Cash flows after tax

Annual Income after tax 2,100,000

Depreciation 500,000

Annual net cash flow after tax 2,600,000

3. Payback period, payback reciprocal, and accounting rate of return,even cash flows.
Melanie Company is planning to buy a new machine costing P3,650,000 with a useful life
of five years, P150,000 residual value, and working capital of P800,000. Other data were
made available:
Expected annual sales revenue 9,800,000
Annual out-of-pocket costs 7,500,000
Income tax rate 40%
Depreciation method, straight-line
PP COI/ACI
Required: Determine the following:
a.Payback period. PR1/PP
b. Payback reciprocal.
c.Simple accounting rate of return. SARR P / OI
d. Average accounting rate of return.
ARR P / Ave.
(ave) Inv.

Answer:

Depreciation 3650000 - 150,000 / 5 = 700,000

Cash Flow
calculation
Sales 9,800,000
Less: Expenses 7,500,000
Less: Depreciation 700,000
Less: Income tax at
40% 640,000
Profit after tax 960,000
Cash Flow 960,000+700,000 = 1,660,000
Payback Period 3,650,000/1,660,000 = 2.19 YRS
Payback Reciprocal 1/2.19 = 0.456
SARR 960,000*100/3,650,000= 26.35%
1/2(initial investment-SV)+SV+WC=
Average Investment 2,700,000
AARR 960,000*100/2,700,000 = 35.50%
4. Payback period, unequal cash flows. An investment of P3,500,000, can bring in the
following annual cash income, net of tax:
First year P 900,000
n Annual Cash to Payback
Second year 800,000
Cash date Years
Third year 650,000 Income
Fourth year 1,400,000 1 900 900 1
Fifth year 750,000 2 800 1,700 1
Sixth year 70,000 3 650 2,350 1
4 1,400 3,500 ?

Required: Determine the PP, PR, SARR,

and AARR.

Answer:

YEARS CASH FLOW CUMULATIVE

1 900,000 900,000

2 800,000 1,700,000
3 650,000 2,350,000
4 1,400,000 3,750,000
5 750,000 4,500,000
6 70,000 4,570,000

Payback Period 3 yrs + (3500-2350)/1400 = 3.82 YRS

Payback
Reciprocal 1/3.82 = 0.26

Average Profit 4,570,000/6 = 761,666.60

SARR 761,666.60/ 3,500,000 0.22
AARR 761,666.60/3,500,000*100 21.76%
5. Payback bailout method. An equipment costing P2,400,000 is expected to yield the
following net cash inflows and residual values:

Year Net cash inflow Residual value, net of tax

1 P 800,000 P 400,000
2 800,000 100,000
3 600,000 50,000
4 300,000 20,000

Required: Determine the payback bailout period.

n Annual Cash Res Total Payback

Cash to date Value Cash Bailout
Income Years
1 800 800 400 1,200 1
2 800 1,600 100 1,700 1
3 600 2,200 50 2,250 1
4 300 2,500 20 2,400 ?

Answer:

Annual
Cash to Residual Total
n Cash
date Value Cash
Income
1 800 800 400 1200
2 800 1600 100 1700
3 600 2200 50 2250
4 300 2500 20 2520

Since $2400000 are recovered in between year 3 and 4 the payback bailout period will be
= Years before full recovery + (unrecovered cost at start of year / cash flow during the year)

= 3 + (2400-2250) / 2520

= 3.05
 6. Accounting rate of
return. The Clean
Company is
considering the
production of a new
product line which will
require an investment
of P1,000,000,, no
scrap value. The
investment will have a
useful life of ten years,
during which annual
net cash inflows before
taxes of P200,000 are
expected. The income
tax rate is 40%.
Required:
1. Annual net
income for
purposes of
computing the
accounting rate of
return.
2. Accounti
ng rate of
return
based on
original
and
average
investme
nt.

Answer:

= PV of cash
inflows Accounting rate of return =
=A
CI Average Annual profit /
= RV
Average investments
5
= WC
= 5-
Cost of
investment
= Eqpt
0
= WC
= 0NP
V
=P
I= NP
V
= Inde
x
 PBT 100,000
- Tax 40,000
PAT 60,000
CFBT 200,000 SARR 6%
- DExp 100,000 ARR (Ave) 12%

Average Annual Profit = Total profit over Investment Period / Number of Years

Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2

Calculation of Average annual profit = $60,000 [since annual cash inflows and all other values are
constant for all 10 years the average profit will be same as annual profits.]

Average Investment = ($1000000 + 0) / 2 = $500,000

[since there is no scrap value the book value at end of useful life is also 0]

ARR = P 60000 / P 500000 = 12%

If ARR was calculated based on original investment:

= P 60000 / P 1000000 = 6%

7. Net present value, profitability index, net present value index, even cash inflows. An
equipment costing P1,400,000 will produce annual net
cash inflows of P510,000. At the end of the its useful
life of five years, the equipment will have a net residual
value of P90,000. The required increase in working
capital for this equipment is P310,000. The desired rate
of return is 12%.

Required: Calculate the following in relation to the

proposed investment in equipment:
a. Net present value.
b. Profitability index.
c. Net present value index. PVCI/PVCO
NPV/COI
Answer:

Net Present Value Index= Net Present Value / Present Value of Outflows =
355409.80 / 1710000 = 0.2078

Profitability Index =Present Value of Inflows / Present Value of Outflows = A/B = 2065409.80
/ 1710000 = 1.2078

Discounting Factor
Years @12%
1 0.89286
2 0.79719
3 0.71178
4 0.63552
5 0.56743
Annuity
Factor

(12%, 5 Yrs.) 3.60478

8. Net present value, uneven even cash inflows. An

equipment costing P900,000, with a residual value of a. NPV = ?
n ACI PVF@10% PVCI
P30,000 at its useful life of five years, is expected to bring
the following net cash inflows: 1 610,000 0.909
First year P 610,000 2 460,000 0.826
Second year 460,000 3 280,000 0.751
Third year 280,000 4 100,000 0.683
Fourth year 100,000 5 70,000 0.621
RV5 30,000 0.621
Fifth year 70,000
WC5 260,000 0.621
Working capital of P110,000 is expected to be - PV of outflows:
infused at the initial year of the equipment. At the COI 900,000
end of the second year, the working capital shall be WC0 110,000
increased by P150,000 Also, the equipment is WC2 150,000 0.826
expected to undergo a major repair to increase its Mrep3 120,000 0.751
Total PVCO
productivity and efficiency by the end of the third
Net present value
year that will cost the company P120,000. The
company uses a 10% discount rate. b. PI = PVCI/PVCO

c. NPVI = NPV/PVCO
Answer:

Profitability Index = Present Value of Inflows / Present Value of Outflows = A/B =

1436590 / 1224020 = 1.1737

Net Present Value Index =Net Present Value / Present Value of Outflows = 212570 /
1224020 = 0.1737

9. Capital rationing. Blue and Green Company has available P50 million for capital
investments. The company is considering the following business projects:
Profitability Index
Proposal Cost

A P10 M 1.26

B 28 M 1.89
C 20 M 1.75

D 25 M 1.14
E 30 M 1.93

The company uses a 12% discount rate. In what project proposals should the company
invest its money?

Answer:

Cost COI To
Profitability COI(C=A x
Proposal in Date Ranking
Index(B) B)
P(A) (D=C-A)
A 10 M 1.26 12.6 2.6 5
B 28 M 1.89 52.92 24.92 2
C 20 M 1.75 35 15 3
D 25 M 1.14 28.5 3.5 4
E 30 M 1.93 57.9 27.9 1

Based on the Profitabilty Index and COI to date, the proposals C and E are accepted as it
ensures higher Profit and also higher COI to date. The proposal also does not have any
unutilized money. We do not consider Project B because even if we combine Proposal B
and C combined, it has unutilized money of P2 M out of 50M and it also has lower COI to
date when compared to C and E projects combined.
10. Net present value. Old Style Corporation is considering the following investment
alternatives:
Net cash flows after tax
Project 1 Project 2 Project 3
Year 0 P (5,000,000) P (8,000,000)P (1,400,000)
Year 1 2,400,000 5,500,000 200,000
Year 2 2,200,000 2,600,000 600,000
Year 3 1,800,000 700,000 1,000,000
Year 4 1,100,000 200,000 800,000
SV 200,000 200,000 80,000
The company has P13,500,000 available money for investment. The effective cost of
capital is 14%.

Required: Determine in which project(s) should the company invest its

limited money, using the following models of evaluating project
proposals:
a. Net present value. P1 P2 P3

b. Profitability index model, NPV

PI

Answer:

Project 1

Discount
Cash PV of Cash
Year factor
Flow Flow
@14%
-
0 5000000 1 -5000000
1 2400000 0.87 2105263
2 2200000 0.76 1692829
3 1800000 0.67 1214949
4 1100000 0.59 651288
SV 200000 0.59 118000

NPV = Total Present Value of Cash Inflows- Initial Investment

= 5782329 - 5000000

NPV of Project 1 is P 782,329

Project 2
Discount
Cash PV of Cash
Year factor
Flow Flow
@14%
-
0 8000000 1 -8000000
1 5500000 0.87 4824561
2 2600000 0.76 2000616
3 700000 0.67 472480
4 200000 0.59 118416
SV 200000 0.59 118000

NPV = Total Present Value of Cash Inflows- Initial Investement

= 7534073 - 8000000

NPV of Project 2 is P (465,927)

Project 3

Discount
Cash PV of Cash
Year factor
Flow @14% Flow
0 -1400000 1 -1400000
1 200000 0.87 175439
2 600000 0.76 461681
3 1000000 0.67 674972
4 800000 0.59 473664
SV 80000 0.59 47200

NPV = Total Present Value of Cash Inflows- Initial Investement

= 1832955- 14000000

NPV of Project 3 is P 432,955

Profitabilty Index of Projects = PV of Cash Inflows/ Initital Investment

Project 1
= 5782329/5000000
Project 1 PI = 1.16

Project 2
=7534073/8000000
Project 2 PI = 0.94

Project 3
=1832955/1400000
Project 3 PI = 1.31

Total Investment Value = 13,500,000

The Company cannot Invest in Project 3 because it lacks initial investment money. Out of
Projects 1 and 2 , only Project 1 has positive NPV and higher PI.
Hence Based on PI and NPV, the company should consider only investing in Project 1 for now.

11. Discounted payback period, even and uneven cash inflows. Globe Corporation is
considering to invest in the following project opportunities:
Project X Project Y
Cost of investment P5,000,000 P5,000,000
Net cash savings, after tax:
Year 1 2,200,000 3,500,000
Year 2 2,200,000 2,500,000
Year 3 2,200,000 1,500,000
Year 4 2,200,000 500,000
Required: Discounted payback period
for each proposed project using a 16%
discount rate.

Answer:

n PVF Disc. Cash Inflows To Date

@16% Proj X Proj Y
1 0.862 P 1,896,551.72 P 3,017,241.38

2 0.743 P 1,634,958,38 P 1,857,907,25

3 0.641 P 1,409,446,88 P 960,986.51

4 0.552 P 1,215,040,42 P 276,145.55

Disc. PP 3.05 yrs 2.13 yrs