UST - ALFREDO M.

VELAYO COLLEGE OF ACCOUNTANCY

Management Advisory Services

Capital Budgeting (Long-term Investment Decisions

Capital budgeting is the process of making long-term investment decisions. Long-term investments
(major capital assets) pertain to those which have long-term consequences on the company’s
financial position and performance.

Test question. Determine which of the following decisions would most likely involve capital budgeting:
I. Acquisition of a new aircraft by a cargo company
II. Design and implementation of a major advertising program
III. Allocation of a new method of allocating non-traceable costs to product lines
IV. Trade for a star shooting guard by a basketball team
a. I only
b. I and III only
c. I, II, and IV only
d. I, II, III, and IV

These investments in major capital assets are sometimes called projects. Thus, when we speak of
investments or any capital expenditure, we refer to them as projects. There are two types of projects;
independent and mutually exclusive.

1. Independent projects
Accepting independent projects do not disqualify the acceptance of another project.
Thus, in making decisions pertaining to this type of project, your decision alternatives are
whether to accept or to reject the project. It is either, one would push through the project or
not. For example, decisions as to whether to invest in a new ice cream machine and a new
set of chairs in the ice cream stall are independent relative to each other. Investing in a
machine will not prevent one from investing in a new set of chairs, and vice versa.

2. Mutually exclusive projects

As for this type of project, you would have to choose one among a number of projects.
Choosing one would prevent you to choose the rest of them. Thus, the decision alternatives
are whether to accept a certain project or to accept another. For example, the decision as to
whether to demolish and rebuild the ice cream old stall or to merely renovate it are mutually
exclusive. You cannot choose both the demolish and rebuild, and the renovate options.

In capital budgeting, we have so called “models” that aid capital investment decisions. Questions
that can be assisted by these models include:
a. “Should I invest in project A?”
b. “Should I consider investing in project A?”
c. “Should I choose project A over project B?”

I usually divide models based on three criteria. First, as to whether they consider accounting profit or
cash flows; second, as to whether they consider the time value of money or not; and third, as to
whether they measure profitability of the project or not.

Refer to the following table:

Model Profit or cash Time value of Profitability
flows money
1. Accounting rate of return Profit No Measures
2. Payback period Cash Flows No Does not measure
3. Bailout period Cash Flows No Does not measure
4. Net present value Cash Flows Yes Measures
5. Internal rate of return Cash flows Yes Measures
6. Profitability index Cash flows Yes Measures

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I. Accounting rate of Return

Exercise A. FLOWER Corporation considers buying a new machine that costs P500 000. This machine is
expected to increase the net income of FLOWER by P80 000 annually. This machine will be fully
depreciated in 10 years.
1. What is the accounting rate of return based on the initial investment?
2. Continuing from no.3, should FLOWER invest in the investment if it desires a minimum rate of
return of 15%?
3. What is the accounting rate of return based on the average investment?
4. Continuing from no.3, should FLOWER invest in the investment if it desires a minimum rate of
return of 35%?

Problem 1. GENTLE Inc. installed a vendo machine to sell toilet products. This machine costs P50 000
and will be fully depreciated in 10 years. As a result of having the machine, revenues will increase by
P25 000 per annum and cash expenses will increase by P15 000 per annum. Income tax rate of
GENTLE is 30%.
1. What is the accounting rate of return based on initial investment?
2. What is the accounting rate of return based on average investment?
a. 6% and 12%
b. 7% and 14%
c. 8% and 16%
d. 6% and 15%

Problem 2. A new investment in a machine of GOSPEL Corp. costs P425 000. Additional information
relating to the use of the machine is presented below. Discount rate is 10%.

Year Increase in net income Increase in net cash inflows

1 P 120 000 P 270 000
2 100 000 250 000
3 60 000 210 000
4 50 000 200 000
5 10 000 160 000

After 5 years, the machine will have a scrap value of P119 000.
1. What is the accounting rate of return based on initial investment?
2. What is the accounting rate of return based on average investment?
a. 15% and 25%
b. 16% and 25%
c. 17% and 30%
d. 15% and 30%

Problem 3. AMG Enterprise is considering purchasing an ultrasound machine for P950 000. The
machine has a 10-year useful life and an estimated salvage value of P55 000. Installation costs and
freight charges will be P24 200 and P800 respectively. AMG uses the straight-line method of
depreciation.

AMG estimates that the machine will be used five times a week with 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 is 0.422.
1. What is the accounting rate of return provided by the project (use average investment)?
a. 15%
b. 12%
c. 19%
d. 20%

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Side topic. Reconciling accrual net income and cash flows.

Exercise B. MELI Corporation purchased an asset that generates P700 000 revenues incurs cash
expenses of P400 000 a year. The asset costs P800 000 depreciated using the straight-line method
over 8 years.
1. Compute for the annual net income.
2. Compute for the annual cash flows to the company.

For items 3 and 4, assume MELI Corporation is subject to 30% income tax.
3. Compute for the annual net income
4. Compute for the annual cash flows to the company.

II. Payback and bail out period.

Exercise C. The LEO-IBO Dynasty Inc. invests in a new machine costing P1 000 000 that is expected to
generate additional cash inflows of P200 000 a year. Salvage value of the machine is P10 000 at the
end of its 20-year life.
1. What is the payback period?

Problem 4. LAPID Systems implemented a new system that is highly automated costing P400 000. This
new system will decrease cash expenses by P50 000 a year.
1. What is the payback period?
a. 8 years
b. 10 years
c. 12 years
d. 9 years

Problem 5. JACQCHEE Snacks is considering an equipment that will increase annual net cash flows
by the following amounts each year:
Year Increase in cash flows
1 P 100 000
2 70 000
3 70 000
4 60 000
5 20 000

1. If the initial cost of the machine is P300 000, what is the payback period?
2. If the initial cost of the machine is P270 000, what is the payback period?
3. If the initial cost of the machine is P246 000, what is the payback period?
a. 4 years; 3.5 years; 3.1 years
b. 4 years; 3.8 years; 3 years
c. 4 years; 3.5 years; 3 years
d. 3.8 years; 3.5 years; 3.1 years

Problem 6. FERFER Company plans to purchase a cutting machine costing P70 000 that will increase
its efficiency in the production of its goods. Annual increases in cash inflows as a result of using the
machine and the estimated salvage value at any point of each year is given below:
Year Cash inflows Salvage value
1 P 30 000 P 25 000
2 20 000 14 000
3 15 000 5 000
4 15 000 1 000

1. What is the payback period?

2. What is the bailout period?
a. 3 years and 3.5 years
b. 3.5 years and 3 years
c. 3.5 years and 3.2 years
d. 3 years and 3.6 years

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Problem 7. EUNICE Inc. considers purchasing a new pump costing P200 000, that would reduce
annual cash expenses by the amounts stated below. Also given is the salvage value of the pump
should it be disposed at any point each year:

Year Cash outflow savings Salvage value

1 P 80 000 P 90 000
2 70 000 75 000
3 60 000 30 000
1. What is the payback period?
2. What is the bailout period?
a. 2.80 years and 1.60 years
b. 2.83 years and 1.64 years
c. 3.2 years and 2.1 years
d. 3.4 years and 2.4 years

Problem 8. MANTARING Summit is to decide whether to invest in a new plant that would give the
company additional revenues of P50 000 and additional cash expenses of P30 000 each year. The
cost to start the plant is P60 000 (all of which are capitalizable). MANTARING’s policy is to depreciate
the plant in a straight-line basis over a 6-year period.
1. What is the payback period?
2. Assuming MANTARING is subject to a 30% income tax rate, what is the payback period?
a. 3 years and 3.53 years
b. 3.53 years and 4 years
c. 2.55 years and 5.2 years
d. 3 years and 5 years

Side topic 2. Net investment computation.

Exercise D. RABINO Inc. is considering replacing its old equipment with a new one. The old
equipment had a net book value of P100 000 and 4 remaining useful years with P25 000 depreciation
each year. The old equipment can be sold at P80 000. The new equipment costs P160 000, have a
four-year life. Cash savings on operating expenses before 40% taxes amount to P50 000
1. Determine the net investment.
2. Determine the incremental annual depreciation for the next four years.
3. Determine the incremental annual income tax for the next four years.
4. Determine the incremental annual after-tax cash flows for the next four years.

Problem 9. JP RAM Co. is considering the replacement of its fully depreciated machine with a book
value of nil but has a salvage value of P300 000. JP RAM may buy a similar equipment but with
greater capacity with a purchase price of P1 500 000. Due to the higher quality of lubricants and
other supplies needed, working capital needs would increase by P200 000.
1. Determine the net investment.
a. 1,490,000
b. 1,400,000
c. 1,300,000
d. 1,290,000

For item 2, assume JP RAM is subject to 30% corporate income tax.

2. Determine the net investment.
a. 1,490,000
b. 1,400,000
c. 1,300,000
d. 1,290,000

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Problem 10. PELEO Corporation wishes to replace its ice cream vending equipment (book value: P5
000), which recently broke down with the intention to avoid future inefficiencies. The purchase price
of the new ice cream vending equipment is P25 000. Transportation costs and insurance during transit
amount to a total of P500. The old machine could be sold to an external party for P3 500. If the new
machine will be bought, repairs amounting to P2 000 could be avoided. Furthermore, as a result of
using the new machine, an additional working capital of P2 500 will be needed. Assume PELEO is
subject to 30% corporate income tax.

1. Determine the net investment.

2. Determine the amount subject to depreciation.
a. 22,650 and 25,000
b. 22,650 and 25,500
c. 22,000 and 25,500
d. 22,000 and 25,000

III. Net present value (NPV).

Exercise E. REVILLA Enterprise considers buying a new machine for P4 000 000. To satisfy its financers,
expenditures in such a project should earn at least 15% of its initial investment. The new machine is
expected to be used for 3 years and will increase cash flows each year by P2 000 000. The machine
has no value at the end of its 3-year life.
1. Determine the net present value.
2. Is it wise to buy the new machine?

Problem 11. SACDALAN Corporation is evaluating a decision to acquire an equipment costing P3 000
000 that would increase cash flows by P500 000 every year for the next 10 years. The salvage value of
the machine after 10 years is nil. The WACC of SACDALAN is 12%.
1. Determine the net present value.
2. Is it wise to acquire such equipment?
a. 220,000, yes
b. (174,888), no
c. 174,888, yes
d. 222,888, no

Problem 12. JESSICA SANCHEZ, and Co. contemplates on investing in a hotel. The total cost to
construct the building amounts to P4 200 000. To operate the hotel, the company needs P800 000
additional working capital funds for supplies, and other miscellaneous items. The building will operate
for the next 20 years. Revenues of P1 800 000 are expected every year. Cash expenses are projected
to be 40% of revenues. After 20 years, the building will be sold for a salvage value of P200 000. This
however is not considered in the depreciation computation. WACC of JESSICA is 12%. Assume
JESSICA is subject to 30% income tax.
1. Calculate the net investment.
2. Calculate the after-tax cash flows each year.
3. Calculate the NPV
4. Will the net present value differ if the salvage value of the building will be considered in the
depreciation computation?
a. 5,000,000; 819,000; 1,214,920; Yes
b. 5,000,000; 819,000; (214,917); No
c. 5,000,000; 920,000; 1,021,000, Yes
d. 5,000,000; 920,000; (1,021,000), No

IV. Internal rate of return (IRR)

Exercise F. REVILLA Enterprise considers buying a new machine for P4 000 000. To satisfy its financers,
expenditures in such a project should earn at least 15% of its initial investment. The new machine is
expected to be used for 3 years and will increase cash flows each year by P2 000 000. The machine
has no value at the end of its 3-year life.
1. Determine the internal rate of return.

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Problem 13. SACDALAN Corporation is evaluating a decision to acquire an equipment costing P3 000
000 that would increase cash flows by P500 000 every year for the next 10 years. The salvage value of
the machine after 10 years is nil. The WACC of SACDALAN is 12%.
1. Determine the internal rate of return.
a. Between 12% and 13%
b. Between 11% and 12%
c. Between 10% and 11%
d. Between 9% and 10 %

V. Profitability index (PI).

Exercise G. REVILLA Enterprise considers buying a new machine for P4 000 000. To satisfy its financers,
expenditures in such a project should earn at least 15% of its initial investment. The new machine is
expected to be used for 3 years and will increase cash flows each year by P2 000 000. The machine
has no value at the end of its 3-year life.
1. Determine the profitability index.

Problem 14. SACDALAN Corporation is evaluating a decision to acquire an equipment costing P3 000
000 that would increase cash flows by P500 000 every year for the next 10 years. The salvage value of
the machine after 10 years is nil. The WACC of SACDALAN is 12%.
1. Determine the profitability index.
a. 1.21
b. 1.08
c. 0.94
d. 0.82

Problem 15. IRR. A firm with an 18% cost of capital is considering the following projects (on January 1,
year 1): January 1, Year 1 December 31, Year 5 Year 5
Cash outflow Cash inflows IRR
Project A P 3 500 P 7 400 16%
Project B 4 000 9 950 ?

Present Value of P1 due at the End of “N” Periods

N 12% 14% 15% 16% 18% 20% 22%
4 .6355 .5921 .5718 .5523 .5158 .4823 .4230
5 .5674 .5194 .4972 .4761 .4371 .4019 .3411
6 .5066 .4556 .4323 .4104 .3704 .3349 .2751

Project B’s internal rate of return is closest to?

a. 18%
b. 20%
c. 14%
d. 16%

Problem 16. IRR. Jenson Copying Company is planning to buy a copying machine costing P25 310.
The net present value of this investment, at various discount rates, are as follows.
Disc. rate NPV
4% P 2 440
6% 1 420
8% 460
10% (440)

Jenson’s approximate internal rate of return on this investment is?

a. 11%
b. 9%
c. 7%
d. 5%

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Problem 17. IRR. Foster Manufacturing is analyzing a capital investment project that is forecasted to
produce the following cash flows and net income.
Years ATCF Net Inc
0 (P20 000) P0
1 6 000 2 000
2 6 000 2 000
3 6 000 2 000
4 6 000 2 000

The internal rate of return (rounded to the nearest whole percentage) is?
a. Between 5% and 6%
b. Between 6% and 7%
c. Between 7% and 8%
d. Between 8% and 9%

Problem 18. Selecting mutually exclusive projects. Stennet Company is considering two mutually
exclusive projects. The company’s cost of capital is 10%. The NPV profiles of the two projects are as
follows: Discount rate (%) Project A Project B
0 P 2 200 P1 240
10 681 507
12 495 411
14 335 327
16 197 252
18 77 186
20 (26) 128
22 (115) 76
24 (193) 30
26 (260) (11)
28 (318) (47)
The company president is of the view that Project B should be accepted because it has the higher
internal rate of return (IRR). The president requested the CFO to make a recommendation. What
would you recommend if you are the CFO?
a. Choose Project A
b. Choose Project B
c. Choose both projects
d. Choose neither project.

-END-

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