MANAGEMENT ACCOUNTING PART 2

TOPIC V: CAPITAL BUDGETING

COST OF CAPITAL

1. Abnoy Corporation has sold P100 Million of P1000 par value, 10%
coupon bonds. The bonds were sold at a premium and the
corporation received P1,200 bonds. If the corporate tax rate is
30%, what is the after tax cost of these bonds for the first
year?

2. A corporation has a 6%, P1000 par value bond outstanding with 10

years to maturity. The bond is currently selling for P1200. The
corporation pays the corporate tax rate of 30%. It wishes to know
what the after-tax cost of a new bond issue is likely to be. The
yield to maturity (YTM) on the new issue will be the same as the
yield to maturity on the old issue because the risk and maturity
date will be similar.
A. Compute the approximate YTM on the old issue and use this as
the yield for the new issue. What is the after-tax cost of
debt?
B. Compute the new after-tax cost of debt if the bond is issued
at P980 per bond.

3. Iya Corporation is selling P40M of cumulative, non-participating

preferred stock. The issue will have a par value of P70 per share
with a dividend rate of 8%. The issue will be sold to investors
for P80 per share, and issuance costs will be P5 per share. The
income tax rate is 30%. What is the cost of preferred stock to
Iya Corporation?

4. The preferred stock of C Corporation pays an annual dividend of

P4.80. It has a required rate of return of 8%. Compute the price
of the preferred stock.

5. D Corporation paid a dividend of P3.00 per share on its common

stocks last year. Over the next 12 months, the dividend is
expected to grow at 6%, which is the constant growth rate (g) for
the firm. The common stock currently sells for P50 per share.
Compute the required rate of return on the common stock.

6. F Corporation just paid a dividend of P4.00 per share on its

stock. The dividends are expected to grow at a constant rate of
7% per year, indefinitely.
A. If investors require a 12% return on F Corporation stocks,
what is the current price?
B. What will the price be in two years?
MANAGEMENT ACCOUNTING PART 2
TOPIC V: CAPITAL BUDGETING

7. Using the equation for the Capital Asset Pricing Model (CAPM) to
work on each of the following:
A. Find the Require Rate of Return for an asset with a beta of
1.20 when the risk-free rate and market-return are 7% and 12%,
respectively.
B. Find the required rate of return for an asset with a beta of
0.80 when the risk-free rate of return is 6%, and the market
risk premium is 4%.
C. Find the beta for an asset with a required rate of return of
7.4% when the risk-free rate and market return are 6% and 8%,
respectively.

8. A firm’s new financing will be in proportion to the market value

of its current financing shown below:
Carrying Amount
Long-term debt P7,000,000
Preferred Stock (100,000 shares) 1,000,000
Common Stock (200,000 shares) 7,000,000

The firm’s bonds are currently selling at 80% of par, generally a

current market yield of 9%, and the corporation has 40% tax rate. The
preferred stock is selling at its par value and pays a 6% dividend.
The common stock has a current market value of P40 and is expected to
pay a P1.20 per share this year. Dividend growth is expected to be 10%
per year, and floatation costs are negligible. What is the firm’s
weighted average cost of capital?

NET INVESTMENT AND RETURNS

9. Harry Potter is planning to purchase a new equipment costing

P500,000. Freight and installation costs is P10,000. The new
equipment will be purchased to replace an old unit that was
acquired several years ago at a cost of P200,000 for which an
accumulated depreciation of P120,000 has been recorded.
The old unit will be sold for P60,000. Other assets that are to
be retired as a result of the acquisition of the new machine can
be salvaged and solved for P80,000. The gain on the retirement of
these others assets is P15,000, which will increase income taxes
by P4,500.
If the new equipment is not purchased, extensive repairs on the
old equipment will have to be made at an estimated cost of
P30,000. This repairs expense can be avoided by purchasing the
equipment.
MANAGEMENT ACCOUNTING PART 2
TOPIC V: CAPITAL BUDGETING

Additional gross working capital of P20,000 will be needed to

support operations planned with the new equipment.
Compute the amount of investment for decision-making purposes.

10. The management of Hogwarts plans to install popcorn vending

machines in its premises. Annual sales of popcorn are estimated
at P20,000 units at a price of P20 per unit. Variable cost is
estimated at P12 per unit, while incremental fixed costs,
excluding depreciation, at P80,000 per year. The school will
acquire four vending machines at P25,000 each, including
installation costs of P2,000 per machine. The machines are
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 30%.
A. Determine the increase in annual net income if the popcorn
vending machines were installed.
B. Determine the annual net cash inflows that will be generated
by the project.

11. Draco Malfoy is considering the purchase of a robotic

machine that would replace a manual labor production task. This
project would require an upfront cash commitment of P500,000 to
purchase and install the equipment. The equipment would have an
expected life of 10 years and generate annual labor cost savings
of P90,000. The corporation pays the prevailing income tax rate.
Determine the annual net cash inflows net returns and (net
income) for the proposed investment.

12. Ron Weasley uses a labor-intensive manufacturing process.

Existing equipment has a book value of P20,000, a 5-year
remaining life, and a P25,000 market value. Cash operating costs
is P75,000. The proposed process requires machinery costing
P120,000 with a useful life of 5 years and no salvage value. The
new machinery, which will replace the old one, requires P35,000
in annual cash costs. The tax rate is 30% and the cost of capital
is 12%. What is the annual net cash inflow from the new
equipment?

EVALUATION TECHNIQUES

13. A company is considering the purchase of new production

technology that would require an initial investment of P500,000
and have an expected life of 5 years. At the end of its life, the
equipment would have no salvage value. By installing the new
MANAGEMENT ACCOUNTING PART 2
TOPIC V: CAPITAL BUDGETING

equipment, the firm’s annual labor and quality costs would

decline by P200,000. The tax rate is 30%.
A. Compute the payback period for this investment.
B. Assume instead that the annual cash inflows would vary
according to the following schedule:
Years Annual Net Cash Inflows
1 P160,000
2 150,000
3 140,000
4 120,000
5 100,000

Compute the payback period under the revised circumstances.

14. Harbor Port Services creates and maintains shipping

channels at various ports around the world. The company is
considering the purchase of a P140M ocean-going dredge that has a
5-year life and no salvage value. The company depreciates assets
on a straight-line basis. The expected annual cash flow on a
before-tax basis for this equipment is P50M. Harbor requires that
an investment be recouped in less than 3 years and have an
accounting rate of return of at least 15%. The tax rate is 30%.
Compute the payback period and accounting rate of return for this
equipment.

15. A company purchased a new machine on January 1 of this year

for P90,000, with an estimated useful life of 5 year and a
salvage value of P10,000. The machine will be depreciated using
the straight-line method. The machine is expected to produce cash
flow from operations, net of income taxes, of P36,000 a year in
each of the next five years. The new machine’s salvage value is
P20,000 in years 1 and 2, and P15,000 in years 3 and 4. Compute
the bailout period for this new machine.

16. Managers of FSI Electric are considering whether to

increase capacity for one of their products. Expanding capacity
by 100,000 will require equipment costing P6,000,000 and having a
five-year economic life with no salvage value. The new machinery
will increase annual cash fixed costs by P2.80M. if they do
increase capacity, they expect annual sales to increase by
100,000 units. The unit sells for P80. Unit variable costs are
P30. The company has a 10% cost of capital and an income tax rate
of 30%. Compute the NPV of the investment.
MANAGEMENT ACCOUNTING PART 2
TOPIC V: CAPITAL BUDGETING

17. FS Corporation gathered the following data on two capital

investment opportunities:

HAND-FED MACHINE SEMI-AUTOMATIC MACHINE

Cost of Investment P800,000 P1,400,000
Discount Rate 14% 14%
Net cash Inflows P365,000 P590,000
For the coming period, the available fund for the capital
investment projects is P1,600,000 only. Both machines have 4-year
lives and no anticipated salvage value. The company uses straight
line depreciation and has a 30% income tax rate.
A. Which alternative has the higher net present value?
B. Using the profitability index method, which alternative is
more attractive?