Capital Budgeting

I. Cost of Investment
Chorva Company plans to replace a unit of equipment that was acquired 3 years ago and
is now recorded at a net book value of P65,000. This equipment can be sold now for
P75,000. Tax rate is 30%

New equipment can be acquired from Echos Company at a list price of P200,000. Echos
will grant a 2% cash discount if the equipment is paid for within 30 days from acquisition
date. Shipping, installation and testing charges to be paid are estimated at P17,500.

Other assets with a book value of P12,000 that are to be retired as a result of the
acquisition of the new machine can be salvaged and sold for P10,000

Additional working capital of P25,000 will be needed to support operations planned

with the new equipment.

The annual cash flow after income tax from the operation of the new equipment has
been estimated at P50,000. The equipment is expected to have a useful life of 5 years
with a salvage value of P4,000 at the end of 5 years.

What is the initial cost of net investments for decision making?

II. Weighted Average Cost of Capital (WACC)

The Chenes Company wants to determine the wacc that can use to evaluate capital
investment proposals. The company’s capital structure with corresponding market
values follows:

8% Term Bonds P 600,000

5% Preferred stock (P100 par) 200,000
Common Stock (no par, 10,000 shared outstanding) 400,000
Retained Earnings 800,000
P 2,000,000

Additional Data:
Current market price per share:
Preferred Stock P50 Expected common dividend P2 per share
Common Stock P40 Dividend growth rate 4%
Corporate tax rate 30%

1. Given an operating income of P500,000, how much is the earnings per share?
 2. Determine the wacc

III. N et Returns (Increase in Revenues)

The management of Star Company plans to install coffee vending machines costing
P200,000 in its movie house. Annual sales of coffee are estimated at 10,000 cups at a
price of P15 per cup. Variable costs are estimated at P6 per cup, while incremental fixed
cash costs, excluding depreciation, at P20,000 per year. The machines are expected to
have a service life of five years, with no salvage value. Depreciation will be computed on
a straight line basis. The company’s income tax rate is 30%.

Assume that the vending machines are installed.

1. The increase in annual net income

2. The annual cash inflows that will be generated by the project.

IV. Net Returns (Cost Savings)

Sun Corporation is planning to buy cleaning equipment that can reduce car wash service
cost and other cash expenses by an average of P70,000 per year. The new cleaning
equipment will cost P100,000 and will be depreciated for 5 years on a straight line basis.
No salvage value is expected at the end of the equipment’s life. Income tax is estimated
at 32% of income before tax.

Determine the cash inflows that will be generated by the project.

V. Payback Period & Accounting Rate of Return ( with Even Cash Flows)

Green Company considers the replacement of some old equipment. The cost of the new
equipment is P90,000, with a useful life estimate of 8 years and a salvage value of
P10,000. The annual pre-tax cash savings from the use of the new equipment is P40,000.
The old equipment has zero market value and is fully depreciated. The company uses a
cost of capital of 25%.

Assuming that the income tax rate is 40%

1. Payback Period
2. Accounting rate of return on original investment
3. Accounting rate of return on average investment

VI. Payback Period & Accounting Rate of Return ( with Unven Cash Flows)
 Pole Company has an investment opportunity costing P90,000 that is expected to yield
the following cash flows over the next five years. (assume a cut-off rate of 30%)

Year Amount

1 P 40,000
2 35,000
3 30,000
4 20,000
5 10,000
P135,000
1. Payback period
2. Book rate of return

VII. Bail Out Payback Period

A project costing of P 180,000 will produce the following annual cash benefits and salvage value
Year Cash Benefits Salvage Value
1 P 50,000 P65,000
2 50,000 50,000
3 50,000 35,000
4 50,000 20,000

Bail Out Payback Period.