CAPITAL BUDGETING
Answers to item 11: A) Payback period: 400,000 ÷ 160,000 = 3.5 years years B) Accounting rate of return (based on original investments): 80,000 ÷ 400,000 = 20% C) Net present value: 2160,000 (3.433) – (3.433) – 400,000 400,000 = P 149,280 D) Profitability index: 549,280 ÷ 400,000 = 1.37 times E) Internal rate of return: 28.65% (approximation through trial and error or interpolation) 12. RELATIONSHIPS – DISCOUNTED
TECHNIQUES Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful life of ten (10) years and no salvage value. Round off factors to three decimal places. Project 1 2 3 4
Annual Cash Flow P 45,000 P 75,000 P 62,073 P 100,000
Investment P 188,640 P 337,050 P 300,000 P 450, 000
Cost of Capital 14% 12% 10% 12%
IRR 20% 18% 16% 14-16%
NPV P 76,080 P 86,700 P 81,440 P 115,000
13. CAPITAL RATIONING-
RANKING PROJECTS Case- Zone Corporation is considering five different investment opportunities. The company’s cost of capital is 12%.
Project 1 2 3 4 5
Investment P 35,000 20,000 25,000 10,000 9,000
PV – Cash Flow P 39,325 22,930 27,453 10,854 8,749
NPV P 4,325 2,930 2,543 854 (251)
IRR (%) 16 15 14 18 11
P. Index 1.12 1.15 1.10 1.09 0.97
REQUIRED: A) Rank the projects in descending order of preference according to NPV, IRR and benefit/cost ratio. B) If only a budget of P 55,000 is available, which projects should be chosen? SOLUTION GUIDE Project 1 2 3 4 5
NPV 1st 2nd 3rd 4th 5th
IRR 2nd 3rd 4th 1st 5th
P. Index 2nd 1st 3rd 4th 5th
WRAP-UP EXERCISE (TRUE or FALSE; MULTIPLE CHOICE) 1.
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A project’s salvage value, realizable at the end of life of the project, is considered in the computation of the net investments for decision-making purposes. FALSE The payback period emphasizes the profitability of a capital project while the accounting rate of return, on the other hand, emphasizes the project’s liquidity. FALSE Annual cash inflows from the capital projects are measured in terms of a. Income after depreciation and taxes b. Income before depreciation and taxes c. Income before depreciation but after taxes d. Income after depreciation but before taxes When computing for the accounting rate of return (ARR), which of the following is used? a. Income after depreciation and taxes b. Income before depreciation and taxes c. Income before depreciation but after taxes d. Income after depreciation but before taxes What technique does not use cash flow for capital investment decisions? a. Payback c. ARR b. NPV d. IRR Which of the following groups of capital budgeting techniques uses the time value of money? a. Book rate of return, payback and profitability index b. IRR, payback and NPC c. IRR, ARR and profitability index d. IRR, NPC and profitability index
CAPITAL BUDGETING 7.
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10.
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14.
Cost of capital is 3%; economic life in years = 4 years; what is the simple PV factor for year 4? a. 0.915 c. 0.455 b. 0.888 d. 0.350 Discount rate is 11%; economic life in years = 3 years; what is the PV annuity factor for 3 years? a. 0.731 c. 2.444 b. 1.713 d. 3.102 As the discount rate increases, a. Present value factors increase b. Present value factors decrease c. Present value factors remain constant d. It is impossible to tell what happens to the factors What is the PV factor of any amount at year zero or zero percent? a. Zero b. 0.50 c. 1.00 d. An amount that cannot be determined without more information The present value of P 50,000 due in five years would be highest if discounted at a rate of a. 0% b. 10% c. 15% d. 20% A capital project with a positive NPV also has a. A profitability index of one b. A positive profitability index c. A profitability index less than one d. A profitability index greater than one A capital project that has a positive NPV based on a discount rate of 12% also has an IRR of a. Zero b. 12% c. Less than 12% d. Greater than 12% Which of the following combinations is possible? a. b. c. d.
Profitability Index Greater than 1 Greater than 1 Less than 1 Less than 1
NPV Positive Negative Negative Positive
IRR Equals cost of capital Less than cost of capital Less than cost of capital Less than cost of capital
15. The net present value method assume that the project’s cash flows are reinvested at the a. Internal rate of return b. Simple rate of return c. Cost of capital d. Payback period 16. The internal rate of return method assumes that the project’s cash flows are reinvested at the a. Required rate of return b. Internal rate of return c. Simple rate of return d. Payback period 17. Which of the methods is a project ranking method rather than a project screening method? a. Net present value b. Profitability index c. Simple rate of return d. Sophisticated rate of return 18. If the IRR on an investment is zero, a. Its NPV is positive b. It is generally a wise investment c. Its cash fows decrease over its life d. Its annual cash flows equal its required investment
CAPITAL BUDGETING
89. The NPV and IRR methods are a. The same decision (i.e , accept or reject) for any single investment project b. The same choice from among mutually exclusive investments c. The same ranking of projects with unequal lives d. The same rankings of projects with different required investments 90. Qualitative issues could increase the acceptability of a project under which of the following conditions? a. The IRR is more than the company’s cutoff rate b. The project has a positive NPV c. The payback period is shorter than the industry standards for payback d. All of the above 91. If applied in capital budgeting evaluation, sensitivity analysis a. Is used extensively when cash flows are known with certainty b. Is a ‘what if” technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed c. Measures the amount of time it will take for a project to recover its initial capital outflow d. Is a technique used to rank various capital projects
Items 92 to 95 are based on the following information Isarog Company has gathered the following data on a proposed investment project. Investment required in equipment P 142,500 Annual cash inflows 30,000 Life of the investment 8 years Required rate of return 10% 92. The payback period for the investment is closest to
a. 93.
94.
95.
96.
97.
98.
8.00 years
c. 4.75 years
b. 1.42 years d. 0.21 years The simple rate of return on the investment is closest to a. 8.55% b. 10.00% c. 21.05% d. 33.55% The net present value on this investment is closest to a. P 300,000 c. P 58,800 b. P 76,024 d. P 17,550 The internal rate of return on the investment is closest to a. 13% b. 15% c. 14% d. 12% The relationship between payback period and IRR is that a. A payback period of less than one-half the life of a project will yield an IRR lower than the target rate b. The payback period is the present value factor for the IRR c. A project whose payback period does not meet the company’s cutoff rate for payback will not meet the company’s criterion for IRR d. Both methods are discounted techniques If the present value of the future cash flows for an investment equals the required investment, the IRR is a. Equal to the cutoff rate b. Equal to the cost of borrowed capital c. Equal to zero d. Lower than the company’s cutoff rate of return A profitability index greater than one for a project indicates that a. The discount rate is less than the internal rate of return b. There has been a calculation error c. The project in unattractive and should not be pursued d. The company should reevaluate its cost of capital
CAPITAL BUDGETING EFFECT on NPV of a CHANGE in DEPRECIATION METHOD
WRONG notion 1: Since depreciation reduces income, NPV will decrease WRONG notion 2: The higher the depreciation, the lower the NPV will be.
Depreciation is a non- cash expense. As such, it has no effect on Net Present Value since NPV is a discounted cash flow technique; however, since depreciation expense reduces the income subject to tax, the tax savings (tax shield) of depreciation has as effect on NPV. Consequently, higher depreciation means higher tax savings (effectively a cash inflow); therefore, the higher the depreciation, the higher the NPV will be. Refer to page 9, item 65: The company is to change from SYD to straight-line basis of depreciation: Depreciation Year Straight-line* SYD Difference Tax Rate 1 P 90,000 P 150,000 ( P 60,000 ) 40% 2 P 90,000 P 120,000 ( P 30,000 ) 40% 3 P 90,000 P 90,000 40% 4 P 90,000 P 60,000 P 30,000 40% 5 P 90,000 P 30,000 P 60,000 40% *Based on the cost of P 450,000 divided evenly throughout 5-year life
Tax Savings ( P 24,000 ) ( P 12,000 ) P 12,000 P 24,000
PV Factors 0.89280 0.79719 0.71178 0.63552 0.56743 TOTAL Rounded off answer:
NPV Effect ( P 21,427.20 ) ( P 9,566.28 ) P 7,626.24 P 13,618.32 ( P 9,748.92 ) ( P 9,750.00 )
Take note that the only effect of depreciation on NPB is the tax savings out of depreciation expense. Accordingly, computation shall emphasize the tax savings effect on NPV. Since depreciation will be lower in the early years of the project life under the straight- line method (as opposed to SYD method), then the over-all NPV will be definitely lower based on time value of money, as represented by the present value factors. Consider this: lower depreciation → lower tax savings (shield) → lower cash inflow → lower NPV. Alternative solution: Based on above computations. The difference in depreciation method in multiplied to a common 40% tax rate to compute the tax shield for each year. This common factor (tax of 40%) being multiplied every year makes the calculation somewhat inefficient. We could then initially ignore the common tax factor of 40% in the discounting process and shorten the computation as follows: Difference ( P 60,000 ) ( P 30,000 ) P 30,000 P 60,000
PV Factors 0.89280 0.79719 0.71178 0.63552 0.56743
NPV Pre-tax Effect ( P 53,568.00 ) ( P 23,915.00 ) P 29,065.60 P 34,045.80 ( P 24,372.30 )
Tax x 40%
NPV Effect = ( P 9,748.20 )
The same thing could be done to page 8, item 61: First step is to compute the first year after=40%-tax return: Before tax: P 75,000 – P 25,000 = P 50,000
After tax: P 50,000 x 60% = P 30,000
Second step is to compute yearly discounted cash flow: Year 1 2 3 4 5
After-tax Return* P 30,000 P 33,000 P 36,300 P 39,930 P 43,923
PV Factors PV of Cash Inflows 0.90909 P 27,272.70 0.82545 P 27,272.85 0.75121 P 27,268.92 0.68301 P 27,272.59 0.62092 P 27,272.67 TOTAL P 136,359.73 *NOTE: After-tax return is to increase by 10% annually thereafter. The investment, in the form of ads expense, is computed net of related tax: P 165,500 (60%) = P 99,300 NPV = 136,359.73 – 99,300 = P 37,059.73 (with rounding-off errors) or P 37,064 (based on choice A). Alternative solution: Since the annual increase in returns is 10% and the discount rate is also 10%, the effect is somewhat offsetting. Notice the last column of the solution, the investment is supposed to have a uniform cash flow every year: P 27,272.70. Hence, P 27,272.20 x 5 years = P 136,364 (rounded) is the total present value of cash inflow. Apparently, choice A is based on this: NPV = 136,364 – 99,300 = P 37,064.
Management Services
INSTRUCTIONS: Select the correct answer for each of the following questions. Mark only one answer for each item by shading the box corresponding to the letter of your choice on the answer sheet provided. STRICTLY NO ERASURES ALLOWED. Use pencil no. 2 only.
Set B
1.
Monumento Company manufactures products LRT and MRT from a joint process. Product LRT has been allocated P 5,000 of total joint costs of P 40,000 for the 1,000 units produces. LRT can be sold at the split-off point for P 6 per unit, or it can be processed further with additional costs of P 2,000 and sold for P 1 0 per unit. If LRT is process further and sold, the result would be an a. Over-all loss of P 2,000 b. Over-all loss of P 3,000 c. Additional gain of P 2,000 from further processing d. Additional gain of P 4,000 from further processing
2. North Avenue Company plans to replace an old machine with a new one. For capital budgeting purposes, which of the following shall be considered in the calculation of initial cost of net investment? a. Cost of the old machine and salvage value of the new machine b. Cost of the new machine and salvage value of the old machine c. Cost and salvage value of the old machine d. Cost and salvage value of the new machine 3.
Shaw Boulevard Company’s present current ratio is 4 times. What transaction will most l ikely cause the current ratio of the company to increase? a. Purchase of inventory on credit b. Collection of trade receivables c. Payment of current tax obligations d. Borrowing of cash based 12-month loan
4.
Quezon Avenue Company is preparing its cash budget for November. Quezon Avenue expects 50% of credit sales to be paid in the month of sale. 30% in the month following the sale. And the remainder paid two months after the month of sale. Quezon Avenue expects the following cash and credit sales.
November October September August
Cash P 17,000 ??? P 15,000 P 18,000
Credit P 100,000 P 90,000 P 80,000 P 95,000
Assuming no bad debts and a projected total cash inflow of P 107,000 in October, what is Quezon Avenue’s expected October cash sales? a. b. c. d.
P 20,000 P 19,000 P 16,000 P 14,000
5.
In an income statement prepared as an internal report using the variable costing method, variable selling and administrative expenses would: a. b. c. d.
6.
Be considered in computing gross profit and operating income Be considered in computing operating income and contribution margin Be considered in computing operating income but not considered in computing contribution margin Be considered in computing contribution margin but not considered in computing gross profit and operating income
Tayuman Company has average daily cash collections of P 3 million, based on a 360-day year. A new system is estimated to reduce the average collection period by two days without affecting sales. The new system’s annual cost is P 100,000 plus 0.01& of collections. Tayuman estimates that it would earn 6%on additional funds. What is the estimated annual net benefit from the new system? a. P 152,000 b. P 180,000 c. P 260,000 d. P 360,000
7.
Two goods, Alpha and Beta, are substitutes. What will an increase in the price of Beta cause? a. b. c. d.
8.
At 40% capacity, overhead cost if P 1,450; at 75% capacity, overhead cost is P 2,150. Determine the variable overhead cost at 80% capacity. a. b. c. d.
9.
The demand curve for Alpha to shift right The supply curve for Alpha to shift right The demand curve for Alpha to shift left The supply curve for Alpha to shift left
P 20 P 650 P 1,600 P 2,250
The contribution margin ratio always increases when the a. b. c. d.
Breakeven point increases Breakeven point decreases Variable costs as a percentage of net sales increase Variable costs as a percentage of net sales decrease
10. The following information regarding a capital project was given for consideration: Estimated life Cost of capital Initial investment Cash inflows per year Straight-line depreciation
What is the unadjusted rate of return of the capital project? a. b. c. d.
15.38% 20.77% 30.77% Cannot be determined from the given information
10 years 20% P 6,500 P 1,000 P 325
11. What would a business most likely offer credit terms of 2/10, n/30? a. b. c. d.
The business can borrow funds only at a rate higher than the effective annual interest rate of these terms. The business can borrow funds at a rate lower than the effective annual interest rate of these terms. Competitors are offering the same terms and the business has a cash shortage. Competitors are not offering terms and the business has a cash surplus.
12. Baclaran Corporation has preferred stock with a market value of P 107 per share, a face value of P 100 per share, underwriting costs of P 5 per shar e, and annual dividends of P 10. Baclaran’s tax rate is 30%. What is Baclaran’s approximate cost of capital for preferred stock? a. b. c. d.
6.9% 9.3% 9.8% 10.5%
13. What attribute is least descriptive of an accounting information system? a. b. c. d.
Date records are chiefly financial Data records typically are historical Most data records are quantifiable in nature Output include answers to problems through use of a knowledge base
Items 14 and 15 are based on the following information The manufacturing capacity of Carriedo Company’s facilities is 30,000 units of products a year. A summary of operating results for calendar Year 1 is as follows: Sales (P 50 per unit) Variable manufacturing and selling costs Contribution Margin Fixed Costs Operating Income
P 900,000 ( 495,000 ) 405,000 ( 247,500 ) P 157,500
14. What is Carriedo’s margin of safety in Year 1? a. b. c. d.
11,000 units 9,000 units 7,000 units 5,000 units
15. Assume a tax rate of 25%, how many more units shall be sold in year 2 to earn an after-tax profit of P 236,250? a. b. c. d.
25,000 units 21,500 units 7,000 units 3,500 units
16. What is the characteristic of a period of rising inflation? a. b. c. d.
Increases the purchasing power of money Increases the price level and decreases the purchasing power of money Increases the price level, which benefits anyone who is owed a specific amount of money Benefits anyone who is owed a specific amount of money and harms anyone who owes specific amount
17. A project’s net present value, ignoring income tax considerations, is normally affected by the a. Proceeds from the sale of the asset to be replaced b. Amount of annual depreciation on the asset to be replaced c. Carrying amount of the assets to be replaced by the project d. Amount of annual depreciation on fixed assets used directly on the project
Items 18 and 19 are based on the following information Inventory balances and manufacturing cost data for the month of January for Santolan Company. Under Santolan’s cost system, any over- or under-applied overhead is closed to the cost of goods sold account at the end of the calendar year. Inventories: Direct materials Work-in-process Finished goods
Cost of goods manufactured Factory overhead applied Direct materials used Actual factory overhead
Beginning P 15,000 7,500 32,500
Ending P 20,000 10,000 25,000
Month of January P 257,500 75,000 95,000 72,000
18. What was the total amount of direct material purchases during January? a. b. c. d.
P 90,000 P 95,000 P 97,500 P 100,000
19. How much direct labor cost was incurred during January? a. b. c. d.
P 85,000 P 87,500 P 90,000 P 93,000
20. Why is equity capital generally more expensive than debt financing? a. b. c. d.
Interest on bonds is a legal obligation Dividends fluctuate more than interest rates Investors expect to be paid more for exposure to higher risk Investors gave a greater demand for equity investments than for debt investments
21. Libertad Company sells 500,000 bottles of condiments annually at P 3 per bottle. Variable costs are P 0.60 per bottle and fixed costs are P 110,000 annually. Libertad has annual interest expense of P 60,000 and a 30% income tax rate. What is Libertad’s approximate degree of financial leverage? a. b. c. d.
1.04 1.06 1.08 1.10
22. When a flexible budget is used, an increase in production levels within the relevant range would a. Change total fixed costs b. Not change total variable costs c. Not change fixed costs per unit d. Not change variable costs per unit
