MANAGEMENT ACCOUNTING & CONTROLLERSHIP

CAPITAL BUDGETING

Learning Activity 20. Capital Budgeting Techniques

Problem 1. Permalino, Inc. is planning to acquire a new machine at a total cost of Php
360,000. The estimated life of the machine is six years with no salvage value. The straight-line
method of depreciation will be used. Permalino estimates that the annual cash flow from
operations, before income taxes, from using the machine amounts to Php 90,000. Assume that
Permalino’s cost of capital is 8% and the income tax rate is 40%. The present vale of P1 at 8%
for 6 years is 0.630. The present value of an annuity of P1 in arrears at 8% for 6 years is 4.623.

a. What would be the payback period for the machine?

b. What would be the net present value?

Problem 2. Tenorio Company is planning to invest Php 40,000 in a 3-year project.

Tenorio’s expected rate of return is 10%. The present value of P1 at 10% for 1 year is .909, for 2
years is .826 and for 3 years is .751. The cash flow net of income taxes will be Php 15,000 for
the 1st year (PV of Php 13,635) and Php 18,000 for the 2nd year (PV of Php 14,868).

Assuming the rate is exactly 10%, what would the cash flow, net of income taxes be for
the 3rd year?

Problem 3. Paunil Books is considering the purchase of a new binding equipment that will
reduce operating costs. The cost of the equipment will be Php 70,000, which will be depreciated
straight line over 5 years to a zero-salvage value. Sales are expected to increase Php 65,000 per
year, with an expected cash flow earnings before depreciation and taxes/sales ratio of 60%.

What is the expected after-tax cash flows from the project if the tax rate is 40%?

Solutions for problems:

Problem 1:
A. Annual cash flow before taxes 90,000 90,000
Less Depreciation: (360,000/6) 60,000
Taxable Income 30,000
Income Tax x 40% 12,000
Annual Cash flow after taxes 78,000

Payback Period: (360,000/78,000) 4.6 years

B. Present value of cash flow after taxes (78,000 x 4.623) 360,590
Cost of Machine 360,000
Net Present Value 590

Problem 2:

PV Factor Present
Cashflow
Year @ 10% (B) Value
(A)
(A) X (B)
1 15,000.00 0.91 13,635.00
2 18,000.00 0.83 14,868.00
Total 28,503.00

If the rate of return is exactly 10% Present value of cash inflow and present value of cash
outflow will be equal.

Present value of Outflow 40,000.00

Less: Present value of Inflow for two years 28,503.00
Present Value cash inflow for 3rd year 11,497.00

Cash flow net of taxes for 3rd year = Present value of cash inflow/Pv factor for 3rd year
= 11,497/0.751
Cash flow net of taxes for 3rd year = 15,308.95

Problem 3:
Depreciation per annum = 70,000 / 5
= 14,000

Increase in sales ₱65,000.00

Cash Flow before depreciation and tax (65,000 x 60%) 39,000.00
Less: Depreciation 14,000.00
Earning before tax 25,000.00
Less: Tax (40%) 10,000.00
Earning after Tax 15,000.00
Add: Depreciation 14,000.00
Cash Flow after tax per annum ₱ 29,000.00

Cash flow after tax for 6 Year = 29,000 x 6

Cash flow after tax for 6 Year = 174,000