ICARE ACCOUNTANCY REVIEW CAPITAL BUDGETING PART 2

MANAGEMENT SERVICES HANDOUT

MS12: CAPITAL BUDGETING PART 2

THE CONCEPT OF CAPITAL BUDGETING

Capital budgeting deals with allocating resources for the acquisition of
long-lived or noncurrent assets. Because it involves acquisition of long-
lived or noncurrent assets, capital budgeting decisions involves large amount
of funds tied up for a long period of time. As such, the risk that a certain
capital budgeting decision may not be successful increases due to the time
factor involved.

TYPES OF CAPITAL BUDGETING DECISIONS

The ultimate goal of a certain management accountant is to aid management in
their capital budgeting decisions. Thus, the initial stage of capital
budgeting is to develop reports presenting analysis on why certain projects
must be accepted or rejected. Furthermore, management accountants shall also
be the review past decisions made to determine weaknesses in the capital
budgeting decision making process.

a. Acceptance or Reject Decisions – this type of decision normally involves

a single independent project without any resource limitation.
b. Mutually Exclusive Decisions – this type of decision requires the
rejection of the other alternative once a decision has been made.
c. Capital Rationing Decisions – this type of decision normally involves a
various projects with resource limitation. Thus, our evaluation should
deal which projects will bring forth more profits into the company.

CORNERSTONES OF CAPITAL BUDGETING EVALUATION

In evaluating capital budgeting decisions, management should focus on the
cash flows over the life of the asset rather than its income. Before starting
to evaluate capital budgeting decisions, management should know how to
compute for the net investment, yearly net cash inflow, and terminal net cash
flow.

Net Investment and the Concept of Tax Shielding – the net investment pertain
to the entire net cash outflow as of year 0 (date of initial investment) that
are necessary to acquire a certain capital asset. Note that it should not
ignore tax implications.

Acquisition cost and other incidental cost XXX

Additional working capital investment XXX
Total outflows necessary at year 0 XXX
Less: Net cash inflow from the sale of old ( XXX)
asset
Avoidable cost, net of tax had there ( XXX)
been no investment
Net Investment XXX

Yearly Cash Flow After Tax – the yearly cash flow after tax is just the
difference between the expected cash inflows (in the form of additional
revenue or cash savings) during the life of the project and the expected cash
outflows during the life of the project.

Incremental revenue or savings XXX

Incremental cash and noncash cost XXX
Incremental net income before tax XXX
Incremental tax expense ( XXX)
Incremental net income after tax XXX
Add: Incremental depreciation and other noncash ( XXX)
cost
Incremental yearly cash flow after tax XXX

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Terminal Cash Flow and related tax effect (End of Life Cash flow) – the
terminal cash flow pertain to all the net cash inflow at the end of the
equipment’s useful life (date of retirement or disposal) net of related tax
effect. This should be included in the cash flow at the end of the year.

Incremental disposal value (new equipment), net XXX

of tax
Recovery of working capital investment XXX
Less: Necessary cost at end of life, net of tax XXX
Terminal cash flow/End-of-life cash flow XXX

CAPITAL BUDGETING EVALUATION

As managers want to evaluate various capital budgeting decisions, various
techniques were designed and developed to aid managers in their capital
budgeting process. There are two general types of evaluation techniques
namely (1) non-discounted techniques and (2) discounted techniques. Non-
discounted techniques ignore the concept of time value of money and are
relatively simpler to understand while discounted techniques consider the
concept of time value of money are relatively more complex.

NON-DISCOUNTED TECHNIQUES
Non-discounted techniques in capital budgeting ignore the concept of time
value of money. Furthermore, measures under this category normally make use
of selective cash flows only and sometimes the use of accounting income.
These techniques are normally favored due to its simplicity and
understandability.

Payback Period: It pertains to the number of period required for the company
to recover its initial net investment. It does not focus on how much earnings
the company can earn on the decision but on how long will it take for the
company to “technically breakeven”. The payback period is favored due to its
simplicity ability to screen investments with faster investment recovery.
However, note that its major drawbacks are the following: (a) it ignores time
value and (b) it ignores cash after the payback period and (c) it ignores the
salvage value.

Payback Period = Net Investment/Yearly Cash Flow after Tax; if even cash
flows
Payback period = preparation of timeline and computation of fractional year;
if uneven cash flows

Rule: If the payback period is within the acceptable limits of the company,
accept the investment. Furthermore, generally projects with shorter payback
period are less risky and more liquid but not necessarily more profitable.

Payback Bailout Period: it follows the same concept with payback period but
this method works on the assumption that the asset’s salvage value
contributes to the recovery of the initial investment.

Payback bailout period = preparation of timeline and computation of

fractional year; like uneven cash flows

Rule: If the payback bailout period is within the acceptable limits of the
company, accept the investment. Furthermore, generally projects with shorter
payback bailout period are less risky and more liquid but not necessarily
more profitable.

Accounting Rate of Return: it measures the profitability of a certain project

based on accounting income. It is relatively easy to understand but it
ignores the time value of money. It may also be called as simple rate of
return, book value rate of return, approximate rate of return, financial
statement rate of return, or unadjusted rate of return.

Accounting Rate of Return = Average accounting income/Net Investment*

(original or average)

Rule: If the accounting rate of return is greater than the minimum required
return of the company, accept the investment. Note that it pertains to
profitability but not necessarily investment recovery.

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INDEPENDENT PROJECTS (ACCEPT OR REJECT DECISIONS)

In an independent project decision, management is only bound to accept or
reject a project depending on their capital budgeting rules and guidelines as
set. It must be noted that independent projects are evaluated using the
methods discussed above.

MUTUALLY EXCLUSIVE PROJECTS – INCREMENTAL ANALYSIS

In a mutually exclusive capital budgeting decision, a manager is confronted
with two options that are not bound to be accepted together. Thus, the
acceptance of the first option would automatically invalidate the second
option. In this instance, the use of NPV and IRR may produce different
decisions due to its differing assumptions. Note that NPV analysis work on
the assumption that cash flows are reinvested at the cost of capital while
IRR works on the assumption that cash flows are reinvested at the internal
rate of return. Certain authors would note that the use of NPV is more
preferable as it uses a realistic hurdle rate. Furthermore, NPV is assumed to
be the value of additional wealth being contributed by the project to the
company.

CAPITAL RATIONING DECISIONS

Capital rationing decisions pertain to those that require proper allocation
of resources to various investments. Note that this work on the assumption
that cash is not sufficient to invest in all desirable projects. In deciding,
NPV, IRR and Profitability index may result in different project rankings. As
scuh, projects to be chosen must be based on NPV because it would yield to
the highest addition in shareholder’s wealth. Potential project combinations
must also be considered. Qualitative factors must also be considered.

DISCOUNTED TECHNIQUES
In order to overcome the weaknesses of the non-discounted techniques, various
methods of evaluating capital budgeting decisions were made to incorporate
the time value of money. Specifically, it deals with the use of weighted
average cost of capital (or hurdle rate, cut-off rate, and minimum desired
rate of return) or internal rate of return. The discounted techniques are
favoured as it takes into account time value of money and all cash flows (not
accounting income) are considered in the analysis. However, some managers opt
not to use it due to complexity, cash flow data until the end of the useful
life are necessary to be estimated, and it requires the use of a certain
discount rate.

Net Present Value Method: the net present value method computes for the
excess of the discounted yearly net cash inflows and terminal cash inflow
over the net investment. As such, it is a measure of the total net savings to
be earned discounted using a certain rate.

Net Present Value = Present Value of all cash flows after tax less the net
investment

Rule: If the net present value is positive or zero, management may accept the
investment.

Profitability Index: Profitability index is the ratio of present value of

yearly net cash flow and terminal net cash flow over the net investment.
Mathematically, investments with positive NPV will have a profitability index
greater than 1, investments with zero NPV will have profitability index equal
to 1, and investments with negative NPV will have profitability index less
than 1.

Profitability index = Present value of cash flows after tax/Net Investment

Rule: Profitability index greater than or equal to 1, management may accept

the investment. Furthermore, this technique allows comparison of differently
sized investments. This is used in ranking various investments for capital
rationing.

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Internal Rate of Return: Internal rate of return is the rate of return that
will result in a net present value of zero or profitability index of 1.

PVIF = Net Investment/Annual cash flow after tax; interpolate rate to get
PVIF; for even cash flows
PV

Rule: If the IRR is greater than the cost of capital, management may accept
the investment.

Discounted Payback Period: The discounted payback period/breakeven time works

with the same principle of the payback period. However, the cash flows are
discounted using the cost of capital to incorporate time value of money.

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PROBLEM 1
The following are independent scenarios:

1. Hailey Corporation is considering replacing an old equipment that cost

P4,800,000 six years ago with a new one that would cost P13,500,000.
Shipping and installation would cost an additional P1,200,000. The old
equipment has a book value of P900,000 and could be sold currently for
P300,000. The increased production of the new equipment would increase
inventories by P240,000, accounts receivable by P960,000 and accounts
payable by P840,000. Assuming a 20% income tax rate, what is the net
investment?

2. Mr. Pete owns a dormitory located near CAA, Las Pinas. As the owner, Mr.
Pete is contemplating to install a milk tea vending machines in its
dormitory. The milk tea vending machines are expected to produce annual
sales of 7,500 units at a price of P70 per unit. Variable costs are
estimated at P50 per unit and incremental annual cash fixed costs P80,000.
The milk tea vending machine will be purchase for P250,000 which includes
freight costs of P25,000. The machine is expected to have a service life
of 5 years, with no salvage value. Depreciation will be computed on a
straight-line basis. The company’s income tax rate is 20%. What is the
incremental yearly cash flow after tax? What is the incremental net income
after tax?

3. Undoy Industries is analyzing a capital investment proposal for new

machinery to produce a new product over the next ten years. At the end of
the ten years, the machinery must be disposed of with a zero net book
value but with a scrap salvage value of P120,000. It will require some
P180,000 to remove the machinery. Working capital amounting to P300,000
will also be recovered at the end of useful life. The applicable tax rate
is 20%. What is the appropriate “end-of-life” cash flow based on the
foregoing information?

REQUIRED: Answer the corresponding questions for each scenario.

PROBLEM 2
In 2023, a massive fire dealt a huge damage to an old equipment of one of the
factories of ELLAY CORPORATION located in Bacoor, Cavite. The operations of
the said factory halted for a week leading to the management of the company
to call for an emergency meeting.

Eyah, the Productions Head, suggested that it would be necessary to replace

the old equipment with a new one due to the significant damage. This new
machinery costs P25,000,000 with a salvage value of P2,500,000 at the end of
its useful life of 10 years. This asset is expected to yield annual
production of 275,000 units. The replacement would require additional working
capital amounting to P3,750,000. Moreover, some damaged equipment parts
recovered after the incident may be salvaged at P250,000. The book value of
the old equipment immediately before the fire is P1,000,000 which was reduced
to NIL as a result of fire.

Ellay’s product is selling at P80 per unit, with a contribution margin ratio
of 40%. The company’s minimum rate of return is 10% and the tax rate is 20%.

REQUIRED: Compute for the following:

1. Relevant costs of acquisition
2. Annual net cash inflow, after tax
3. Payback period
4. Accounting rate of return
5. Net present value
6. Profitability index
7. Internal rate of return (choose among the choices below)
a. Less than 22%
b. More than 22% but less than 23%
c. More than 23%
d. 23.52%

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PROBLEM 3
The following are the after-tax annual net cash inflows of independent
projects brought for discussion in the annual meeting of Dunot Incorporated:

After-tax Cash Petpet Blythe Elly

flows
Year 1 P2,000,000 P1,000,000 P4,000,000
Year 2 2,000,000 1,000,000 –
Year 3 2,000,000 3,000,000 4,000,000
Year 4 2,000,000 3,000,000 –

The net investment and the acquisition costs of these projects amounted to
P5,000,000. The company’s cost of capital is 12% and the tax rate is 20%.

REQUIRED: Compute the following under each scenario

1. Undiscounted payback period
2. Payback reciprocal
3. Accounting rate of return
4. Net present value
5. Benefit cost ratio

PROBLEM 4
1. Chin Company purchased a new machine on January 1 of this year for
P9,000,000, with an estimated useful life of 5 years and a salvage value
of P3,000,000. The machine will be depreciated using the straight-line
method. The machine is expected to produce after-tax cash flow from
operations, of P3,600,000 a year in each of the next 5 years. The new
machine’s salvage value, net of tax is P2,000,000 at the end of year 1,
P1,600,000 at the end of year 2, and P1,250,000 in years 3 and 4. Compute
the bailout period.

2. A company is considering putting up P10,000,000 in a three-year project.

The company’s expected rate of return is 10%. The present value of P1.00
at 10% for one year is 0.9091, for two years is 0.8264, and for three
years is 0.7513. The after-tax cash inflow are as follows: P3,500,000 for
the first year and P5,000,000 for the second year. Assuming that the rate
of return is exactly 10%, the cash flow, net of income taxes, for the
third year would be:

REQUIRED: Answer each scenario based on the specified requirements

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PROBLEM 5
On December 31, 2021, Kanna Company is considering to replace its old machine
acquired at an original cost of P1,500,000 with a total estimated useful life
of 8 years. The machine has been four years depreciated as of December 31,
2021 with no estimated salvage value. If the company decides to not to
replace the old machine, it must be repaired for P200,000. On the other hand,
if the company decides to replace the old machine, the company can sell it
for P500,000. The annual cash operating costs of the old machine is
P1,030,000.

The new machine being considered has a cost of P1,800,000 with an estimated
useful life of 4 years. Freight and installation cost must also be incurred
to put the asset into operation amounting to P50,000. Additional working
capital in the form of receivables and inventories are also necessary
amounting to P120,000. The annual cash operating costs of the new machine is
P557,000. At the end of the useful life, the new machine has a salvage value
of P200,000 (which is ignored in computing depreciation) and the company must
incur cost to remove the new machine amounting to P20,000.

The company uses a tax rate of 30%, discount rate of 12%, payback period of
2.5 years or less, accounting rate of return of 15% and above, net present
value greater than zero, internal rate of return greater than 12%,
profitability index of greater than 1, and discounted payback period of 2.5
years or less.

REQUIRED: Compute for the following items:

1. Net present value – P157,585
2. Profitability index – 1.13
3. Net present value index – 0.13
4. Internal rate of return. – 17.32%
5. Discounted payback period – 3.995 years

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INSTRUCTION: Select the best answer from the choices provided. Sources:
AICPA/RPCPA/CMA/ Various test banks

1. What does the Payback Period method in capital budgeting measure?

a. The total profits generated by an investment.
b. The time it takes to recoup the initial investment of an investment.
c. The present value of future cash flows from an investment
d. The rate of return on an investment

2. What is one of the main limitations of using the Payback Period method for
investment analysis?
a. It doesn't consider liquidity concerns.
b. It provides a comprehensive view of a project's profitability.
c. It ignores the timing of cash flows beyond the payback period.
d. It only works for projects with short payback periods.

3. What does the Accounting Rate of Return (ARR) method measure?

a. The time it takes for an investment to recoup its initial cost.
b. The profitability of an investment based on its accounting income
and initial investment.
c. The present value of future cash flows from an investment
d. The rate of return on an investment's market value

4. Which financial metric does the Accounting Rate of Return method use in
its calculation?
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Annual cash flows
d. Average accounting income

5. What is one of the limitations of using the Accounting Rate of Return

method for investment analysis?
a. It considers the time value of money.
b. It provides a precise measure of an investment's long-term
profitability.
c. It only focuses on accounting information and ignores cash flows.
d. It is complex and requires advanced mathematical calculations.

6. What does the Net Present Value (NPV) method assess in capital budgeting?
a. The total profits generated by an investment.
b. The time it takes to recoup the initial investment of an investment.
c. The present value of future cash flows from an investment
d. The accounting income of an investment

7. How does a positive NPV value influence investment decisions?

a. It indicates that the investment will generate a loss.
b. It suggests the investment is risky and should be avoided.
c. It implies the investment will recoup its initial cost but may not
be highly profitable.
d. It signifies that the investment is likely to be profitable and
should be considered.

8. Which of the following is a key factor considered in NPV calculations?

a. Initial investment only
b. Future cash flows without discounting
c. Timing of cash flows and the discount rate
d. Accounting income

9. How is NPV calculated when considering the time value of money?

a. NPV = Initial Investment / Discount Rate
b. NPV = Total Cash Inflows / Total Cash Outflows
c. NPV = Future Cash Flows - Initial Investment
d. NPV = ∑ (Cash Flows / (1 + Discount Rate)^n), where n is the period

10. What does a negative NPV value indicate?

a. The investment will generate significant profits.
b. The investment's payback period is short.
c. The investment is expected to be unprofitable.
d. The investment is not affected by the time value of money.

11. How is the Profitability Index (PI) calculated?

a. PI = Initial Investment / Discount Rate
b. PI = Total Cash Inflows / Total Cash Outflows
c. PI = Net Present Value (NPV) / Initial Investment
d. PI = PV of Cash Inflows / Initial Investment

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12. How does the Profitability Index (PI) guide investment decisions?
a. It suggests the investment is risky and should be avoided
b. It indicates that the investment will generate a loss.
c. A higher PI value implies a more attractive investment opportunity.
d. It solely considers the initial investment amount.

13. These decisions are concerned with the process of planning, setting goals
and priorities, arranging financing, and identifying criteria for making
long-term investments.
a. Limited resource planning
b. Capital Investment
c. Long range budgeting
d. Pricing

14. If a company is not subject to income tax, which of the following is true
of a proposed investment?
a. The project’s IRR equals the entity’s cost of capital.
b. The project’s NPV is zero.
c. Depreciation on assets required for the project is irrelevant to the
evaluation.
d. The expected annual increase in future cash flows equals the
investment required to undertake the project.

15. In deciding whether to replace a machine, which of the following is not a

sunk cost for capital budgeting purposes?
a. The book value of the existing machine.
b. The expected resale price of the existing machine.
c. The original cost of the existing machine.
d. The depreciated cost of the existing machine.

16. These are projects that when accepted or rejected will not affect the cash
flows of another project.
a. Independent projects
b. Mutually exclusive projects
c. Dependent projects
d. Non-exclusive projects.

17. Which of the following methods uses income instead of cash flows in
evaluating capital investment decisions?
a. payback
b. accounting rate of return
c. internal rate of return
d. net present value

18. Characteristics of the capital budget include:

a. A large commitment of resources and long-range projects.
b. Approval by a vote of shareholders and a large commitment of
resources.
c. Independence from the master budget and approval by the vote of
shareholders.
d. Long-range projects and independence from the master budget

19. The yield to maturity on a bond:

a. is fixed in the indenture.
b. is lower for higher-risk bonds.
c. is generally equal to the coupon interest rate.
d. is the required return on the bond.

20.Common stock value is primarily based on:

a. book value.
b. total assets.
c. expected dividends.
d. time value of money

21. Which of the following statements is false?

a. Preferred stock is similar to bonds in that the dividend of a
preferred stock is fixed much like the interest payment on a bond is
fixed.
b. Preferred stock, like common stock, usually has no maturity; i.e.,
the corporation does not pay back the investment.
c. Preferred stockholders are entitled to dividends before common
stockholders can receive dividends.
d. Preferred dividend payments are a tax-deductible expenditure.

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22. If two projects are completely independent, the measure of correlation

between them is:
a. 0
b. 1
c. Lower than 0
d. Cannot be determined

23. Kohara Company has an opportunity to acquire a new machine to replace one
of its present machines. The new machines would cost P90,000, have a five-
year life, and no estimated salvage value. Variable operating costs would
be P100,000 per year. The present machine has a book value of P50,000 and
a remaining life of five years. Its disposal value now is P5,000, but it
would be zero after five years. Variable operating costs would be P125,000
per year. Ignore present value calculations and income taxes. Considering
the five years in total, what would be the difference in profit before
income taxes by acquiring the new machine as opposed to retaining the
present one?
a. P10,000 decrease
b. P35,000 increase
c. P15,000 decrease
d. P40,000 increase

24. Maeno Company is considering replacing a machine with a book value of

P100,000, a remaining useful life of 5 years, and annual straight-line
depreciation of P20,000. The existing machine has a current market value
of P100,000. The replacement machine would cost P150,000, have a 5-year
life, and save P50,000 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 economic values relevant to me
decision?

a. b. c. d.
Net Investment P50,000 P50,000 P150,000 P150,000
Net Incremental Cash Flow P34,000 P42,000 P34,000 P42,000
Annual Income Taxes P16,000 P16,000 P3,000 P8,000

25. Nobunaga is considering the sale of a machine with a book value of P80,000
and 3 years remaining in its useful life. Straight-line depreciation of
P25,000 annually is available. The machine has a current market value of
P100,000. What is the cash flow from selling the machine if the tax rate
40%?
a. P25,000
b. P92,000
c. P80,000
d. P100,000

26. Reina Company is considering replacing an equipment with a carrying amount

of P400,000, a remaining useful life of 5 years. The existing equipment
has a fair value of P400,000. The new equipment would cost P550,000, have
a 5-year life, and save P75,000 per year in cash operating costs. If the
replacement equipment would be depreciated using the straight-line method
and the tax rate is 40%, what would be the relevant cost to replace the
existing machine?
a. P90,000
b. P330,000
c. P150,000
d. P550,000

27. Saito Publishers, Inc. is considering replacing an old printing equipment

that cost P800,000 six years ago with a new one that would cost
P2,250,000. Freight and insurance would cost an additional P200,000. The
old press has a book value of P150,000 and could be sold currently for
P50,000. The increased production of the new printing equipment would
increase inventories by P40,000, accounts receivable by P160,000 and
accounts payable by P140,000. Saito’s net initial investment for
analyzing the acquisition of the new press assuming a 35% income tax rate
would be
a. P2,250,000
b. P2,450,000
c. P2,425,000
d. P2,600,000

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28. Kensho Corp. plans to replace a heavy equipment that was acquired several
years ago. Acquisition cost is P450,000 with salvage value of
P50,000. The heavy equipment being considered is worth P800,000 and the
supplier is willing to accept the old equipment at a trade-in value of
P60,000. Should the company decide not to acquire the new equipment, it
needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in
transaction will not have any implication but the cost to repair is tax-
deductible. The effective corporate tax rate is 35% of net income subject
to tax. For purposes of capital budgeting, the net investment in the new
machine is
a. P540,000
b. P660,000
c. P610,000
d. P800,000

29. Toriumi, Inc. is considering an investment of P8 million in a new product

line. The investment is expected to have an economic life of 10 years with
no salvage value. A selling price of P40 per unit is decided upon; unit
variable cost is P18, and cash operating fixed costs are estimated at
P1,400,000 per year. The sales division believes that a sales estimate of
150,000 units per year is realistic. Income tax is estimated at 30% of
income before tax. Compute for the annual net cash inflow after tax.
a. P1,570,000
b. P1,750,000
c. P1,330,000
d. P770,000

30. Which of the following statements is correct?

a. If the NPV of a project is greater than 0, its PI will equal 0.
b. If the IRR of a project is 0%, its NPV, using a discount rate, k,
greater than 0, will be 0.
c. If the PI of a project is less than 1, its NPV should be less than
0.
d. If the IRR of a project is greater than the discount rate, k, its PI
will be less than 1 and its NPV will be greater than 0.

31. The discount rate at which two projects have identical ____ is referred to
as Fisher's rate of intersection.
a. present values
b. net present values
c. IRRs
d. profitability indexes

32. The _____ method provides correct rankings of mutually exclusive projects,
when the firm is subject to capital rationing.
a. net present value
b. internal rate of return
c. payback period
d. profitability index

33. In choosing from among mutually exclusive investments, the manager should
normally select the one with the highest
a. NPV
b. IRR
c. Profitability index
d. Accounting rate of return

34. Which of the following combinations is possible?

Profitability Index NPV IRR

a. greater than 1 positive higher than cost of capital
b. greater than 1 negative less than cost of capital
c. less than 1 negative equals cost of capital
d. less than 1 zero less than cost of capital

35. Which of the following methods uses income instead of cash flows in
evaluating capital investment decisions?
a. payback
b. accounting rate of return
c. internal rate of return
d. net present value

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36. A firm is evaluating a project that has a net present value of P0 when a
discount rate of 10% is used. A discount rate of 9% will result in:
a. a negative net present value
b. a positive net present value
c. a net present value of P0
d. the question cannot be answered based upon the information.

37. A decrease in the discount rate

a. Will increase present values of future cash flows
b. Results from the risk of the project being low
c. Will always result to positive NPV
d. Choices A and B are correct

38. A company with a beta of 0 suggests

a. that the company’s stocks are more volatile than the market
b. that the company’s stocks are less volatile than the market
c. that the company’s stocks are as volatile as the market
d. that the company’s stocks are not affected by the market

39. Which of the following statements is false?

a. The discount rate does not need to be determined in advance for the
IRR method
b. The discount rate does not need to be determined in advance for the
NPV method
c. The discount rate does not need to be determined in advance for the
payback method
d. The discount rate does not need to be determined in advance for the
accrual accounting rate of return method

40. As the number of periods increases for a project having uniform cash
flows, the present value of each future discounted cash flow becomes
a. Smaller
b. Does not change
c. Irrelevant
d. Larger

41. Kumoko is considering an investment in a new cheese-cutting machine to

replace its existing cheese cutter. Information on the existing machine and
the replacement machine follow.

Cost of the new machine P40,000

Net annual savings in operating costs 9,000
Salvage value now of the old machine 6,000
Salvage value of the old machine in 8 years 0
Salvage value of the new machine in 8 years 5,000
Estimated life of the new machine 8 years

What is the expected payback period for the new machine?

a. 4.44 years
b. 8.50 years
c. 2.67 years
d. 3.78 years

42. Shirahori Corporation uses net present value techniques in evaluating its
capital investment projects. The company is considering a new equipment
acquisition that will cost P100,000 fully installed and have a zero salvage
value at the end of its five-year productive life. Shirahori will
depreciate the equipment on a straight-line bases for both financial and
tax purposes. Shirahori estimates P70,000 in annual recurring operating
cash income and P20,000 in annual recurring operating cash expenses.
Shirahori’s cost of capital is 12% and its effective income tax rate is
40%. What is the net present value of this investment on an after tax
basis?
a. P8,150
b. P28,840
c. P36,990
d. P80,250

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ICARE ACCOUNTANCY REVIEW CAPITAL BUDGETING PART 2
MANAGEMENT SERVICES HANDOUT

43. The following information is available on a new piece of equipment:

Cost of the equipment ........................................P21,720

Annual cash inflows ...........................................P5,000
Internal rate of return .........................................16%
Required rate of return .........................................10%

The life of the equipment is approximately:

a. 6 years.
b. 4.3 years.
c. 8 years.
d. It is impossible to determine from the data given.

44. Itsuki Co. is considering an investment in a machine that would reduce

annual labor costs by P30,000. The machine has an expected life of 10 years
with no salvage value. The machine would be depreciated according to the
straight-line method over its useful life. The company’s marginal tax rate
is 30%. Assume that the company will invest in the machine of it generates
a pre-tax internal rate of return of 16%. What is the maximum amount the
company can pay for the machine and still meet the internal rate of return
criterion?
a. P180,000
b. P210,000
c. P187,500
d. P144,996

45. Kawaki Corporation has estimated that a proposed project’s 10-year annual
net cash inflow will be P220,093 with an additional terminal benefit of
P50,000 at the end of the project. Assuming that these cash inflows satisfy
Kawaki’s acceptable sophisticated rate of return of 8 percent, what is the
net investment?
a. P2,751,159
b. P1,476,840
c. P1,500,000
d. Cannot be determined

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