01_CAPITAL BUDGETING

PROBLEMS

1. AA Company is considering a new product that will sell for P11 per unit and have variable
costs of P8 per unit and annual cash fixed costs of P90,000. Equipment required to produce the
product costs P210,000 and is expected to last, and be depreciated on a straight-line basis, for 6
years, with no expected salvage value. AA estimates that sales of the new product will be
60,000 units per year for six years. AA's income tax rate is 40% and its cost of capital is 14%.

a. What is the expected increase in future annual after-tax cash flows if the project is accepted?

b. What is the NPV of the project?

c. For this question only, suppose the project also involves an increase in inventories and
receivables totaling P40,000. What is the NPV of the project?

d. What is the profitability index for the project?

e. What is the payback period for project?

f. What is the approximate IRR for the project?

Excerpt of PVA table
Periods 20% 21% 22% 23% 24% 25%
6 3.326 3.245 3.167 3.092 3.020 2.951

g. What annual unit volume must the company sell to earn a return just equal to the 14% cost
capital?

2. BB Company is considering machinery that costs P282,000 and has a useful life of four years.
The production manager believes that the machinery could reduce annual material and labor
costs by P100,000. BB pays a 30% income tax rate and requires a 12% return. BB uses
straight-line depreciation.

a. What is the IRR of this project ?

Excerpt of PVA table
Periods 9% 10% 11% 12% 13% 14%
4 3.240 3.170 3.102 3.037 2.974 2.914

b. What is the NPV of this project?

c. What is the PI on this project?

d. What must annual savings be for the project to have a 12% IRR?

e. For this question only, assume that BB could depreciate the asset evenly over three years for
tax purposes, though the life of the project and the asset are still four years. What would the NPV
of this project be?

f. For this question only, assume that undertaking this project means BB must increase its
working capital by P12,000. What effect would this new information have on the NPV of this
project?

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 g. Assume that the asset in this project is actually a replacement for one now in use that has a
remaining life of four years, a book value (and tax basis) of P25,000, and a current market value
of P40,000, what is the NPV of the project?

3. CC Company is considering purchasing an asset for P60,000 that would have a useful life of 5
years and would have a salvage value of P7,000. For tax purposes, the entire original cost of
the asset would be depreciated over 5 years using the straight-line method and the salvage
value would be ignored. The asset would generate annual net cash inflows of P27,000
throughout its useful life. The project would require additional working capital of P1,000,
which would be released at the end of the project. The company's tax rate is 30% and its
discount rate is 10%.

What is the net present value of the asset?

4. DD Company is considering purchasing an asset for P50,000 that would have a useful life of 5
years and no salvage value. For tax purposes, the entire original cost of the asset would be
depreciated over 5 years using the straight-line method. The asset would generate annual net
cash inflows of P20,000 throughout its useful life. The project would require additional
working capital of P7,000, which would be released at the end of the project. The company's
tax rate is 30% and its discount rate is 13%.

What is the net present value of the asset?

5. FF Inc. is considering a project that would require an initial investment of P462,000 and would
have a useful life of 7 years. The annual cash receipts would be P300,000 and the annual cash
expenses would be P120,000. The salvage value of the assets used in the project would be
P69,000. The company's tax rate is 30%. For tax purposes, the entire initial investment without
any reduction for salvage value will be depreciated over 5 years. The company uses a discount
rate of 18%.

Compute the net present value of the project.

6. GG Company purchased a new machine to stamp the company logo on its products. The cost
of the machine was P250,000 and it has an estimated useful life of 5 years with an expected
salvage value at the end of its useful life of P50,000. The company uses the straight-line
depreciation method.

The new machine is expected to save P125,000 annually in operating cost. The company's tax
rate is 40%, and it uses a 10% discount rate to evaluate capital expenditures.

a. What is the traditional payback period for the new stamping machine?

b. What is the accounting rate of return on the average investment in the new stamping
machine?

c. What is the net present value of the new stamping machine?

7. HH Co. is considering an investment in a new product line. The investment would require an
immediate outlay of P100,000 for equipment, and an immediate investment of P200,000 in
working capital. The Investment is expected to generate a net cash inflow of P100,000 In year
1, P150,000 in year 2, and P200,000 in years 3 and 4. The equipment would be scrapped (for
no salvage) at the end of the fourth year and the working capital would be liquidated. The
equipment would be fully depreciated by the straight line method over its four-year life.

a. If HH uses a discount rate of 16 percent, what is the NPV of the proposed product line
investment?

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b. What is the traditional payback period for the investment?

c. What is the discounted payback period for the investment?

8. II Company has an opportunity to invest in a project that will yield four annual payments
of P12,000 with no salvage. The first payment will be received in exactly one year. On
low-risk projects of this type, the company requires a return of 6 percent. Based on the
requirement, the project generates a profitability index of 1.03953 or 103.953%

a. How much is required to invest in this project?

b. What is the internal rate of return on the project?

Excerpt of PVA table
Periods 5% 6% 7% 8% 9% 10%
4 3.546 3.465 3.387 3.312 3.240 3.170

9. JJ Company has an auxiliary generator that is used when power failures occur. The generator is
in bad repair and must be either overhauled or replaced with a new generator. The hospital has
assembled the following information:
Present Generator New Generator
Purchase cost new P16,000 P20,000
Remaining book value 9,000 -
Overhaul needed now 8,000 -
Annual cash operating cost 12,500 7,500
Salvage value-now 4,000 -
Salvage value-eight years from now 3,000 6,000

If the company keeps and overhauls its present generator, then the generator will be useable for
eight more years. If a new generator is purchased, it will be used for eight years, after which It
will be replaced. The new generator would be diesel powered, resulting in a substantial reduction
in annual operating costs, as shown above.

The company computes depreciation on a straight-line basis. All equipment purchases are
evaluated using a 16% discount rate. INCOME TAX IS IGNORED.

Compute the net present value

10. LL Co. is considering the acquisition of a new, more efficient press. The cost of the press is
P360,000, and the press has an estimated 6-year life with zero salvage value. LL uses straight-
line depreciation for both financial reporting and income tax reporting purposes and has a 40%
corporate income tax rate. In evaluating equipment acquisitions of this type, LL uses a goal of
a 4-year payback period. To meet LL's desired payback period, the press must produce a
minimum annual before-tax operating cash savings of _____________________

11. MM Industries is replacing a grinder purchased 5 years ago for P15,000 with a new one
costing P25,000 cash. The original grinder is being depreciated on a straight-line basis over 15
years to a zero salvage value; MM will sell this old equipment to a third party for P6,000 cash.
The new equipment will be depreciated on a straight-line basis over 10 years to a zero salvage
value: Assuming a 40% marginal tax rate, MM's net cash investment at the time of purchase if
the old grinder is sold and the new one purchased is _______________

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