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Management Advisory Services: Capital Budgeting

Batangas CPA Review


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“Committed to your CPA review needs”
RLCAPUNO, CPA, LLB
The Capital Budgeting Evaluation Process
The capital budgeting evaluation process generally has the following steps:
 Project proposals are requested from departments, plants, and authorized personnel.
 Proposals are screened by a capital budget committee.
 Officers determine which projects are worthy of funding; and
 Board of directors approves capital budget.

Cash Flow Information


While accrual accounting has advantages over cash accounting in many contexts, for purposes of capital
budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision
tools.

Sometimes cash flow information is not available, in which case adjustments can be made to accrual
accounting numbers to estimate cash flows.

The capital budgeting decision, under any technique, depends in part on a variety of considerations:
 The availability of funds;
 Relationships among proposed projects;
 The company’s basic decision-making approach; and
 The risk associated with a particular project.

Cash Payback
The cash payback technique identifies the time period required to recover the cost of the capital investment
from the net annual cash inflow produced by the investment. The formula for computing the cash payback
period is:

Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period

Net annual cash flow can be approximated by adding depreciation expense to net income.

The evaluation of the payback period is often related to the expected useful life of the asset.
 With this technique, the shorter the payback period, the more attractive the investment.
 This technique is useful as an initial screening tool.
 This technique ignores both the expected profitability of the investment and the time value of money.

Net Present Value Method


Under the net present value (NPV) method, cash flows are discounted to their present value and then
compared with the capital outlay required by the investment. The difference between these two amounts is
the net present value (NPV).
 The interest rate used in discounting the future net cash flows is the required minimum rate of return.
 A proposal is acceptable when NPV is zero or positive.
 The higher the positive NPV, the more attractive the investment.

When there are equal annual cash inflows, the table showing the present value of an annuity of 1 can be
used in determining present value. When there are unequal annual cash inflows, the table showing the
present value of a single future amount must be used in determining present value.

The discount rate used by most companies is its cost of capital—that is, the rate that the company must
pay to obtain funds from creditors and stockholders.

The net present value method demonstrated in the text requires the following assumptions:
 All cash flows come at the end of each year;
 All cash flows are immediately reinvested in another project that has a similar return; and
 All cash flows can be predicted with certainty.

Intangible Benefits
By ignoring intangible benefits, such as increased quality or improved safety, capital budgeting techniques
might incorrectly eliminate projects that could be financially beneficial to the company. To avoid rejecting
projects that actually should be accepted, two possible approaches are suggested;
 Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask whether
the intangible benefits are worth at least the amount of the negative NPV.
 Project rough, conservative estimates of the value of the intangible benefits, and incorporate these
values into the NPV calculation.

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Mutually Exclusive Projects


In theory, all projects with positive NPVs should be accepted. However, companies rarely are able to adopt all
positive-NPV proposals because (1) the proposals are mutually exclusive (if the company adopts one
proposal, it would be impossible to also adopt the other proposal), and (2) companies have limited resources.

In choosing between two projects, one method that takes into account both the size of the original
investment and the discounted cash flows is the profitability index. The profitability index formula is as
follows:

Present Value of Future Cash Flows ÷ Initial Investment = Profitability Index

The project with the greater profitability index should be the one chosen.

Another consideration made by financial analysts is uncertainty or risk. One approach for dealing with
uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense
of the variability among potential returns. In general, a higher risk project should be evaluated using a higher
discount rate.

Post-Audit of Investment Projects


A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections
made when the project was proposed. Performing a post-audit is beneficial for the following reasons:
 Management will be encouraged to submit reasonable and accurate data when they make investment
proposals;
 A formal mechanism is used for determining whether existing projects should be supported or
terminated;
 Management improves their estimation techniques by evaluating their past successes and failures.

A post-audit involves the same evaluation techniques that were used in making the original capital budgeting
decision—for example, use of the net present value method. The difference is that, in the post-audit, actual
figures are inserted where known, and estimation of future amounts is revised based on new information.

Internal Rate of Return Method


The internal rate of return method results in finding the interest yield of the potential investment. This is
the interest rate that will cause the present value of the proposed capital expenditure to equal the present
value of the expected annual cash inflows. Determining the internal rate of return can be done with a financial
(business) calculator, computerized spreadsheet, or by employing a trial-and-error procedure.

The decision rule is: Accept the project when the internal rate of return is equal to or greater than the
required rate of return, and reject the project when the internal rate of return is less than the required rate.

Annual Rate of Return Method


The annual rate of return method indicates the profitability of a capital expenditure and its formula is:

Expected Annual Net Income ÷ Average Investment = Annual Rate of Return

Average investment is based on the following:

Original investment + Value at end of useful life = Average Investment

The annual rate of return is compared with management’s required minimum rate of return for investments of
similar risk. The minimum rate of return (the hurdle rate or cutoff rate) is generally based on the company’s
cost of capital. The decision rule is: A project is acceptable if its rate of return is greater than management’s
minimum rate of return; it is unacceptable when the reverse is true.

When the rate of return technique is used in deciding among several acceptable projects, the higher the rate
of return for a given risk, the more attractive the investment.

LET’s REVIEW
Theory
1. The capital budget for the year is approved by a company's
a. board of directors.
b. capital budgeting committee.
c. officers.
d. stockholders.

2. All of the following are involved in the capital budgeting evaluation process except a company's
a. board of directors.
b. capital budgeting committee.
c. officers.
d. stockholders.

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3. Most of the capital budgeting methods use


a. accrual accounting numbers.
b. cash flow numbers.
c. net income.
d. accrual accounting revenues.

4. The first step in the capital budgeting evaluation process is to


a. request proposals for projects.
b. screen proposals by a capital budgeting committee.
c. determine which projects are worthy of funding.
d. approve the capital budget.

5. The capital budgeting decision depends in part on the


a. availability of funds.
b. relationships among proposed projects.
c. risk associated with a particular project.
d. all of these.

6. Capital budgeting is the process


a. used in sell or process further decisions.
b. of determining how much capital stock to issue.
c. of making capital expenditure decisions.
d. of eliminating unprofitable product lines.

7. Net annual cash flow can be estimated by


a. deducting credit sales from net income.
b. adding depreciation expense to net income.
c. deducting credit purchases from net income.
d. adding advertising expense to net income.

8. Which of the following is not a typical cash flow related to equipment purchase and replacement
decisions?
a. Increased operating costs
b. Overhaul of equipment
c. Salvage value of equipment when project is complete
d. Depreciation expense

9. Capital expenditure proposals are initially screened by the


a. board of directors.
b. executive committee.
c. capital budgeting committee.
d. stockholders.

10. Capital budgeting decisions depend in part on all of the following except the
a. relationships among proposed projects.
b. profitability of the company.
c. company’s basic decision making approach.
d. risks associated with a particular project.

11. The corporate capital budget authorization process consists of how many steps?
a. 4
b. 3
c. 2
d. 1

12. Which of the following is not a capital budgeting decision?


a. Constructing new studios
b. Replacing old equipment
c. Scrapping obsolete inventory
d. Remodeling an office building

13. Which of the following is a disadvantage of the cash payback technique?


a. It is difficult to calculate
b. It relies on the time value of money
c. It can only be calculated when there are equal annual net cash flows
d. It ignores the expected profitability of a project

14. The payback period is often compared to an asset’s


a. estimated useful life.
b. warranty period.
c. net present value.
d. internal rate of return.

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15. Which of the following ignores the time value of money?


a. Internal rate of return
b. Profitability index
c. Net present value
d. Cash payback

16. Brady Corp. is considering the purchase of a piece of equipment that costs P23,000. Projected net
annual cash flows over the project’s life are:
Year Net Annual Cash Flow
1 P 3,000
2 8,000
3 15,000
4 9,000
The cash payback period is
a. 2.63 years.
b. 2.80 years.
c. 2.20 years.
d. 2.37 years.

17. Bradshaw Inc. is contemplating a capital investment of P85,000. The cash flows over the project’s four
years are:
Expected Annual Expected Annual
Year Cash Inflows Cash Outflows
1 P30,000 P12,000
2 45,000 20,000
3 60,000 25,000
4 50,000 30,000
The cash payback period is
a. 2.17 years.
b. 3.35 years.
c. 2.30 years.
d. 3.47 years.

18. Jordan Company is considering the purchase of a machine with the following data:
Initial cost P130,000
One-time training cost 12,000
Annual maintenance costs 15,000
Annual cost savings 75,000
Salvage value 20,000
The cash payback period is
a. 2.37 years.
b. 2.17 years.
c. 1.89 years.
d. 1.73 years.

19. If project A has a lower payback period than project B, this may indicate that project A may have a
a. lower NPV and be less profitable.
b. higher NPV and be less profitable.
c. higher NPV and be more profitable.
d. lower NPV and be more profitable.

20. Which of the following does not consider a company’s required rate of return?
a. Net present value
b. Internal rate of return
c. Annual rate of return
d. Cash payback

Problems
Cost vs Net Investment
1. An individual is planning to buy a new car costing P1,500,000. The dealer of the car will allow a trade-
in value for his old car at P300,000. If he retains his old car, he needs to overhaul the same for
P35,000. Income taxes are 25%. What is the net investment for decision making purposes?

A company is planning to replace an old machine which is out of order with a new machine. Purchase price
of the new machine is P130,000 exclusive of freight and installation costs of P5,000. The old machine has
a carrying amount of P60,000 and can be sold for P20,000. The old machine will require P30,000 to have
it overhauled. Income taxes are 20%.
2. For bookkeeping purposes, what is the cost of the new machine?
3. For decision making purposes, what is the net investment?
4. Assume that the old machine can be sold instead for P62,000, how much is the net investment for
purposes of using the discounted cash flow for evaluating the investment?

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AB Company is planning to replace an old machine purchased 4 years ago for P120,000. The estimated life
is 15 years with no salvage value. The new machine will cost P200,000 inclusive of freight charges of
P8,000. The old machine can be sold to a third party at P38,000 or traded for P35,000. Income taxes are
40%.
5. If the old machine is sold, what is the net investment?
6. If the old machine is instead traded-in, what is the investment?

7. The management of ABC Company plans to replace an equipment acquired several years ago at a cost
of P80,000. The equipment is fully depreciated but can still be sold for P5,000. It will cost P12,000 to
have it overhauled. Income taxes are 15%. The new equipment costs P180,000. If the new equipment
is acquired, what is the net investment?

8. A new machine was acquired with a net investment of P115,000. Repair cost of P10,000 was avoided
as a result of the acquisition and the old machine with a carrying amount of P50,000 was sold for
P30,000. Income taxes are 30%. What is the cost of the machine for bookkeeping purposes?

9. A company plans to buy a computer costing P160,000. Other assets are to be retired and sold for
P10,000 with a loss on sale of P4,000 which will reduce income taxes by P1,000. The old computer
needs to be repaired at a cost of P6,000. What is the net investment?

10. A company plans to invest P725,000 in furnishing and equipment for a new outlet. Sales for this outlet
are estimated at P1,500,000 a year 1/10 of which remain uncollected at the end of the year. The
gross profit rate is 25%. The investment in inventory will be P240,000 with estimated accounts
payable of P80,000 at the end of the year. Cash of P120,000 will be needed to meet operating
expenses. What is the net investment?

Capital Investment
Problem 1
The following relevant data pertains to a proposed capital investment:
Cost of machine P160,000
Life 10 years
Salvage value P10,000
The acquisition of the machine will generate cash savings of P47,000 annually. Income taxes are 35%.

Required: Evaluate the desirability of acquiring the machine by computing the following:
a. Payback
b. Payback period
c. Accounting rate of return on the original cost of investment
d. Accounting rate of return on the average cost of investment

Problem 2
ABC Corporation is considering the acquisition of a mini-computer which costs P120,000 with an economic
useful life of 12 years and a terminal salvage value of P12,000. It is estimated that the annual net income
before taxes from this investment will amount to P7,000. Income taxes are 35%. The company uses the
straight line method for computing depreciation.
Required: Determine the following:
a. What is the annual cash income after taxes?
b. What is the payback and payback reciprocal?
c. What is the accounting rate of return on the original and average cost of investment?
d. What is the annual tax shield?

Problem 3
MX Company acquired a new machine for P160,000 which it will depreciate on a straight line basis over ten
years. The accounting rate of return on the original cost of investment (after-taxes) is computed at 12%.
Required: Determine the following:
a. How much is the annual cash income after taxes?
b. What is the payback and payback reciprocal?
c. What is the accounting rate of return on the average cost of investment?

Problem 4
A certain investment has a payback reciprocal of 20% (after-taxes). The cost of investment is P40,000.
Salvage value is P10,000. Annual depreciation is P40,000. Income taxes are 20%.
Require: Determine the following:
a. What is the life of the investment?
b. What is the annual net income after taxes?
c. What is the accounting rate of return on the average cost of investment?

Problem 5
Assume the following date:
Annual depreciation (using straight line method) P12,000
Estimated useful life 4 years
Salvage value P2,000
Accounting rate of return on original cost 6.24%

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Require: Determine the following:


a. What is the accounting rate of return on the average cost of investment?
b. How much is the annual cash income?

Problem 6
The average rate of return on the average cost of investment of a certain project is 19%. The average cost of
investment is P326,000. The investment has a terminal salvage value of P8,000.
Required: What is the accounting rate of return on the original cost of investment?

Problem 7
A project costing P142,000 will generate annual cash savings of P45,000. It has an estimated life of 4 years.
The salvage value at the end of the first year is estimated at P30,000 which will decline by P10,000 at the end
of each subsequent years.
Required: What is the bail-out payback of the project

Problem 8
Chipipay Company is considering an investment which will require P200,000. The estimated cash inflows from
the investment are as follows:
End of year 1 P100,000
2 80,000
3 60,000
4 50,000
5 40,000
Required: Ignoring income taxes. Compute the following:
a. Payback
b. ROI
c. Accounting rate of return on the original cost and the average cost of investment

Problem 9
C. Lahis Company plans to acquire a machine costs P150,000 with an estimated useful life of 3 years with no
salvage value. The cash income from this investment is non-uniform. The pattern of the inflows is as follows:
End of year 1 P100,000
2 120,000
3 150,000
Assume a tax rate of 40% each year.
Required: Determine the following:
a. What is the payback period?
b. What is the ROI?
d. What is the accounting rate of return on the original cost and the average cost of investment?

Problem 10
Alanganin Corporation wants to acquire an equipment with a purchase price of P300,000 with a 3-year life and
no salvage value. This equipment is expected to generate additional earnings before taxes as follows:
End of year 1 P100,000
2 150,000
3 200,000
Assume a tax rate of 20% each year.
Required:
a. The number of years to recoup the investment
b. The accounting rate of return on the average cost of investment.

Problem 11
NA-TV Company invested in a project which required an investment of P100,000 with an estimated salvage
value of P10,000 at the end of its life, which is 3 years. The earnings after taxes (40% each year) from this
investment were as follows:
End of year 1 P30,000
2 48,000
3 72,000
The company uses the straight line method for computing depreciation.
Required: Determine the following:
a. Payback period
b. RIO
c. Accounting rate of return on the original cost and the average cost of investment

Problem 12
The management of B-Hon Company has been considering an investment of P240,000 in a project with a 20-
year life. The earnings after taxes are P60,000 per year for 5 years, then P12,000 each year thereafter.
Required: Determine the following:
a. Payback
b. Accounting rate of return on the average cost of investment

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Problem 13
A project requiring an investment of P120,000 with no salvage value and having a 3 year life will generate
cash savings as follows:
End of year 1 P64,000
2 81,000
3 98,000
Required: Determine the following:
a. What is the average ROI?
b. What is the accounting rate of return on the average cost of investment? (The company uses SYD
method)

Problem 14
Assume the following data pertaining to an investment proposal:
Amount of investment require P170,000
Life 4 years
Net income after taxes Salvage value
End of year 1 P10,000 P30,000
2 20,000 20,000
3 11,000 10,000
4 18,000 -
Required: What is the bail-out payback?

Discounted Cash Flow Analysis

Problem 1
The following projects have been submitted for inclusion in the coming year’s capital expenditure budget:

Year Project A Project B Project C Project D Project E Project F Project G


0 (P100,000) (P115,000) (P115,000) (P100,000) (P86,000) (P152,000) (P112,000)
1 28,000 40,000 60,000 10,000 (10,000) - 25,000
2 28,000 50,000 50,000 30,000 5,000 - 25,000
3 28,000 60,000 40,000 20,000 30,000 100,000 25,000
4 28,000 50,000 40,000 120,000 25,000
5 28,000 40,000 75,000 40,000
SV 2,000 1,000 6,000 10,000

Required: Compute the following for each project: (Ignore income taxes)
a. Net present value using desired ROI of 10%
b. Profitability Index
c. Rank the projects in he order of their profitability assuming all projects are independent of one
another.
d. Assume that projects A, D & E are mutually exclusive, which project should be selected?
e. Assume that projects A, D & E are mutually exclusive, rank the projects in the order of their
profitability.
f. Assume that only P260,000 cash is available for investment, which projects should be selected?

Problem 2
Billy Company is considering two projects. Relevant data follows:
Project 1 Project 2
Cost of machine P100,000 P125,000
Estimated life 3 years 3 years
Annual cash income (before taxes)
End of year 1 P60,000 P80,000
2 60,000 70,000
3 60,000 60,000
Salvage value 10,000 20,000
Cost of capital, 12%
Income taxes, 20%

Required: Determine the following:


a. Compute the EPV (excess present value) for each project.
b. Compute the EPV index for each project
c. Assume that the projects are mutually exclusive, which projects should be selected? Why?
d. Assume that the projects are independent of one another, which should be selected? Why?
e. For each project compute the discounted payback.

Problem 3
NA-TV Company acquired a turning machine which generated annual cash income of P20,000. The machine
has a useful life of 10 years with no salvage value. The annual net income after taxes from this investment is

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P7,500. Income taxes are 40% each year. The PV of annuity of 1 for 10 years is 6.145. The cost of capital is
10%. If the NPV is positive P17,175, how much is the amount of investment?

Problem 4
HH Company invested in a project which generated cash inflow after taxes as follows:
End of year 1 P80,000
2 70,000
3 50,000
Cost of capital is 15%.
Required:
a. If the profitability index is 1.25, how much is the amount of investment?
b. If the NPV is P31, 740 and the investment is P150,000, how much should be the cash inflow after
taxes at the end of the 3rd year?

Problem 5
A certain project which requires an investment of P80,000 will produce annual cash savings after taxes of
P20,000 for 8 years. The PV of an annuity of 1 for 8 years at various rates are shown as follows:
15% 16% 18% 20%
8 years 4.487 4.344 4.078 3.837
Required:
a. What is the approximate IRR?
b. What is the exact IRR?

Problem 6
X Company invested in project costing P120,000 with an economic life of 8 years with no salvage value. The
project generated annual earnings after taxes of P21,500. The company’s cost of capital is 14%. The company
evaluates projects using the discounted cash flow analysis.
Required:
a. Did the investment earn at lest the minimum rate of return required?
b. What is the approximate IRR?
c. What is the exact IRR?

Problem 7
Y Company invested in a project costing P160,000 which generated cash inflows from operations after taxes
as follows:
End of year 1 P80,000
2 70,000
3 45,500

The project has a salvage value of P5,500 after 3 years. Cost of capital is 17%.
Required:
a. Compute the RI
b. Compute the exact IRR

Problem 8
The following information is available for a proposed capital investment:
Annual Cash Income PV of P1 at 20% PV of P1 at 30%
End of year 1 P10,000 .781 .769
2 20,000 .610 .592
3 30,000 .477 .455

The project costs P34,000 and the approximate IRR has been computed between 28% and 30%. What is the
exact IRR?

Problem 9
SS Company is planning to invest in a project which will produce the following cash flows after taxes:
End of year 1 P30,000
2 36,000
3 24,500
Required: If the IRR is 10%, how much is the amount of investment?

Problem 10
TH Company is planning to acquire a new machine at a cost of P102,606. The company’s cost of capital is
15%. The PV of 1 at 15% for one year is .870, for two years is .756 and for three years is .658. The cash
flows from operations net of taxes are P42,000 for the first year and P43,000 for the second year. If the IRR is
equal to the cost of capital, what would be the cash flow from operations, net of taxes at the end of the third
year?

Problem 11
Marimar Corporation plans to replace an old machine acquired 5 years ago at cost of P80,000. It has a
remaining useful of 5 years with a salvage value of P4,000. Annual cash operating costs for this old machine
are P75,000. A new machine can be acquired with a life of 5 years at a cost of P88,500. A trade in allowance
of P15,000 on the old machine is to be deducted. This machine will slash annual operating costs by P30,000.
It will have a salvage value of P2,000.

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Required:
a. What is the present value of the net ash outflows if the old machine is kept?
b. What is the present value of the net cash outflows if the new added machine is acquired?
c. Is it advisable to replace the old machine? Why?

Problem 12
Ritzy Company is contemplating buying a new machine with an economic life of 5 years with a salvage value
of P5,000. The annual depreciation is computed at p18,700. At present an old machine is being leased at
P29,000 payable at the end of each year for the 5-year lease term. Cost of money is 18%. Which is better,
buy or lease?

Problem 13
Gary Corporation acquired a building 15 years ago at a cost of P100,000. The estimated life is 20 years with
no salvage value. At present the building is being leased at P15,000 annually payable at the end of each year.
The company can sell now at a price of P60,000. Income taxes are 40%. The PV of an annuity of P1 for 5
years at 16% is 3.374. What is better, sell or lease?

>>>END<<<

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