Capital
Budgeting
1
EXERCISES
NET INVESTMENT:
Bruell Company is considering to replace its old equipment with a new one. The old equipment had a
net book value of P100,000, 4 remaining useful life with P25,000 depreciation each year. The old
equipment can be sold at P80,000. The new equipment costs P160,000, have a 4-year life. Cash
savings on operating expenses before 40% taxes amount to P50,000 per year. What is the amount of
investment in the new equipment?
Initial amount of investment 160,000
Less Cash inflow (decrease in outflow) at period 0:
MV of old equipment 80,000
Tax benefits on loss on sales (20,000 x .4) 8,000 88,000
Net investment 72,000
EXERCISES
Increase in Annual Income Tax:
Mayon Company is considering replacing its old machine with a new and more efficient one. The old machine
has book value of P100,000, a remaining useful life of 4 years, and annual straight-line depreciation of P25,000.
The existing machine has a current market value of P80,000. The replacement machine would cost P160,000,
have a 4-year life, and will 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 should be the increase in annual income
taxes?
Annual savings on expenses P50,000
Less: Additional depreciation (40,000 – 25,000) 15,000
Additional taxable income 35,000
Additional tax (35,000 x 40%) P14,000
Additional depreciation can be easily calculated by subtracting the book value of the old machine from the cost
of new machine and then the difference divided by the useful life (160,000 – 100,000) ÷ 4 = 15,000.
EXERCISES
Accounting Rate of Return: Initial Investment
A piece of labor saving equipment that Marubeni Electronics Company could use to reduce costs in
one of its plants in Angeles City has just come onto the market. Relevant data relating to the
equipment follow:
What is the simple rate of return to be provided by the equipment?
Annual cost savings 90,000
Less depreciation (432,000 ÷ 12) 36,000
Annual income 54,000
Simple Rate of Return: 54,000 ÷ 432,000 12.5 %
EXERCISES
Accounting Rate of Return: Average Investment
The BIBO Company has made an investment in video and recording equipment that costs P106,700.
The equipment is expected to generate cash inflows of P20,000 per year. How many years will the
equipment have to be used to provide the company with a 10 percent average accounting rate of
return on its investment?
The useful life of the project can be calculated by using the computational pattern for Accounting
Rate of Return:
Net investment 106,700
Divide by Depreciation expense
Income / Inflow 20,000
Less: Net income (106,700 x 5%*) 5,335 14,665
Average life (in years) 7.28
* 10% ARR based on average investment = 5% ARR based on initial investment
EXERCISES
Internal Rate of Return: Average Investment
Show Company is negotiating to purchase an equipment that would cost P200,000, with the expectation that
P40,000 per year could be saved in after-tax cash operating costs if the equipment were acquired. The
equipment’s estimated useful life is 10 years, with no salvage value, and would be depreciated by the straight-
line method. Show Company’s minimum desired rate of return is 12 percent. The present value of an annuity of
1 at 12 percent for 10 periods is 5.65. The present value of 1 due in 10 periods, at 12 percent, is 0.322. The
average accrual accounting rate of return (ARR) during the first year of asset’s use is:
ARR = Average annual net income ÷ Average Investment
Annual after-tax cash flow 40,000
Less Depreciation 20,000
Net Income 20,000
Divide by Average Investment (200,000 + 180,000)/2 190,000
ARR: 10.52%
The problem asked for the average accounting rate of return for the first year of asset’s life.
EXERCISES
Net Investment
The Makabayan Company is planning to purchase a new machine which it will depreciate, for book purposes,
on a straight-line basis over a ten-year period with no salvage value and a full year’s depreciation taken in the
year of acquisition. The new machine is expected to produce cash flows from operations, net of income taxes, of
P66,000 a year in each of the next ten years. The accounting (book value) rate of return on the initial investment
is expected to be 12 percent. How much will the new machine cost?
(ATCF – Depreciation) ÷ Initial investment = Accounting Rate of Return
Let X = Initial investment
Net Income: = 66,000 - .10X
AAR = NI/ Investment
.12 = (66,000 - .10X) / X
.12X = 66,000 - .10X
.22 X = 66,000
X = 300,000
EXERCISES
Payback Period
If an asset costs P35,000 and is expected to have a P5,000
salvage value at the end of its ten-year life, and generates
annual net cash inflows of P5,000 each year, the cash payback
period is
Payback period = Initial amount of investment ÷ Annual after-
tax cash flows
P35,000 ÷ P5,000 = 7 years
EXERCISES
Payback Period
Consider a project that requires cash outflow of P50,000 with a life
of eight years and a salvage value of P5,000. Annual before-tax
cash inflow amounts to P10,000 assuming a tax rate of 30% and a
required rate of return of 8%. Salvage value is ignored in
computing depreciation. The project has a payback period of
Net investment 50,000
Divide by CFAT (10,000 x 0.7) + ([50,000 ÷ 8] x 0.3) 8,875
Payback period 5.6 years
EXERCISES
The Leisure Company is considering the purchase of electronic pinball machines to place in
amusement houses. The machines would cost a total of P300,000, have an eight-year useful
life, and have a total salvage value of P20,000. Based on experience with other equipment,
the company estimates that annual revenues and expenses associated with the machines
would be as follows:
Revenues from use P200,000
Less operating expenses
Commissions to amusement houses P100,000
Insurance 7,000
Depreciation 35,000
Maintenance 18,000 160,000
Net income P 40,000
Ignoring the effect of income taxes, the payback period for the pinball machines would be:
EXERCISES
Revenues form use P200,000
Less operating expenses
Commissions to amusement houses P100,000
Insurance 7,000
Depreciation 35,000
Maintenance 18,000 160,000
Net income P 40,000
Ignoring the effect of income taxes, the payback period for the pinball machines would be: 4 years
Before-tax cash flow = 40,000 + 35,000 75,000
Payback period: 300,000 ÷ 75,000 4 years
EXERCISES
Net Present Value
It is the start of the year and Agudelo Company plans to replace its old grinding equipment.
The following information are made available by the management:
What is the present value of all the relevant cash flows at time zero?
There are two cash flows at time zero: P120,000 outflow and P14,000 inflow.
Net cash outflow (120,000 – 14,000) = 106,000
EXERCISES
Profitability Index
The Pambansang Kamao Corporation has to replace its completely damaged boiler machine with a
new one. The old machine has a net book value of P100,000 with zero market value; therefore it will
give a tax shield, based on 35% tax rate if replaced, by P35,000. The company has a 10 percent cost
of capital. Understandably, the new machine, through a uniform decrease in cash operating costs, will
give a positive net present value, because this machine will provide an internal rate of return of 12
percent. The present values at 10% and 12%, respectively, are:
If the machine were to be depreciated using straight-line method for 6 years without any salvage
value, the estimated profitability index is:
The purpose of profitability index is to compare two projects’ profitability by reducing the present
value per 1 peso of investment. Therefore, the ratio of 4.35526 @ 10% to 4.11141 @ 12% indicated
the profitability index.
Profitability index: 4.35526/4.11141 = 1.06
EXERCISES
Required Investment
Kipling Company has invested in a project that has an eight-year life. It is expected
that the annual cash inflow from the project will be P20,000. Assuming that the
project has a internal rate of return of 12%, how much was the initial investment in
the project if the present value of annuity of 1 for 8 periods is 4.968 and the present
value of 1 is 0.404?
The payback period that corresponds to the project’s internal rate of return of 12
percent is 4.968. Therefore, the amount of investment must equal the product of the
payback period and the net cash flows:
Investment: (4.968 x 20,000) = P99,360
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