Capital Budgeting

FAR EASTERN UNIVERSITY

Institute of Accounts Business and Finance
FINANCIAL MANAGEMENT II
PRACTICE PROBLEMS – CAPITAL BUDGETING
BRYAN TRINIDAD

PROBLEM NO. 1.
Label Company is planning to purchase a new machine for P840,000. The installation of the new machine costs and
testing runs amount to P60,000. This new machine shall replace an old unit that was acquired 2 years ago at a cost of
P600,000 with an annual depreciation of P120,000. The old unit can be sold at P210,000. If the new equipment is not
purchased, extensive repairs on the old machine will have to be made immediately at a cost of P60,000. The purchase
of the new machine will immediately require P200,000 working capital in order to support the operations. The new
machine will be depreciated for 3 years without any salvage value. The company is subject to 40 percent income tax
and requires a discount rate of 8 for this type of asset. Compute the net cost of investment for the new machine.

PROBLEM NO. 2.
Markado Manufacturing is considering buying an automated machine that costs P3,000,000. Annual cash savings
are anticipated to be P900,000 for five years. The company uses straight-line depreciation. The salvage value at
the end of five years is expected to be P80,000. Assume 8 percent discount rate and 40 percent tax rate.

Requirements:
1. accrual accounting rate of return based on the initial investment;
2. payback period and payback reciprocal;
3. net present value;
4. profitability index;
5. breakeven time;
6. internal rate of return.

PROBLEM NO. 3.
Keila Company manufactures copier equipment and has the opportunity to replace one of its existing machine with a
new model. The existing machine has a net book value of P150,000 and a market value of P70,000. It has an estimated
remaining life of four years at which time it will have no salvage value. The company uses straight-line depreciation of
P37,500 per year on the machine, and its annual cash operating costs are P280,000.

The new model costs P600,000 and has a four-year estimated life with no salvage value. Its annual cash operating
costs are estimated at P170,000. The firm will use straight-line depreciation. The tax rate is 40% and cost of capital is
12%. The purchase of the new more efficient machine will enable the company to reduce its investment in inventory by
P100,000.

Requirements:
1. Determine the investment required to obtain the new machine.
2. Determine the present value of the net cash flows expected from the investment and the NPV of the investment.
3. Suppose that the new machine has a salvage value of P50,000. The company will consider the salvage value in
determining annual depreciation. Determine the NPV of the investment.
4. Suppose that the new machine has a salvage value of P50,000. The company will ignore the salvage value in
determining annual depreciation. Determine the NPV of the investment.

PROBLEM NO. 4.
Soda Company is considering the purchase of a special-purpose bottling machine for P2,800,000. It is expected to
have a useful life of 7 years with a zero terminal disposal price. The plant manager estimates the following savings in
cash-operating costs:
Year Amount
1 P1,400,000
2 1,100,000
3 800,000
4 600,000
5 400,000
6 300,000
7 300,000
Soda Company uses a required rate of return of 16% in its capital-budgeting decisions. Incremental tax rate is 40%.
The company uses straight-line depreciation.

Requirements:
1. Compute the payback period.
2. Compute the net present value.
3. Compute the internal rate of return.
4. Compute the accrual accounting rate of return based on net initial investment.
5. Compute the PV of the net advantage of using SYD instead of straight-line method of computing depreciation.

FIN MGT 2 PRACTICE PROBLEMS – 1 of 2

 Capital Budgeting

PROBLEM NO. 5.
Lina Company expects to sell 90,000 units annually for the next four years at P8 each, with variable costs of P3 per
unit, and annual cash fixed costs of P250,000. The product requires machinery costing P300,000 with a four-year life
and no salvage value. The company will depreciate the machinery using straight-line depreciation. Additionally, working
capital (in form of receivables and inventory) will increase by P150,000. This additional working capital will be returned
in full at the end of the four years. The tax rate is 40% and cost of capital is 10%. Determine the net present value of
the investment.

PROBLEM NO. 6.
National Company is considering the purchase of a P600,000 machine, which will be depreciated on the straight -
line method over an 8-year period with no salvage value for both book and tax purposes. The machine is expected
to generate an annual before-tax cash inflow of P175,000. The income tax rate is 40%.

Requirements:
1. Determine the payback period.
2. Compute the accounting rate of return based on; a) original investment; b) average investment.
3. Assuming that the company considers the use of 10 years for book depreciation and 8 years for income tax
depreciation, what is the payback period?

PROBLEM NO. 7.
Punchline Corp. will invest P130,000 in a project that will begin to produce returns by the end of the third year
until the end of the 12 th year. The annual cash flow will be P40,000. If the cost of capital is 15 percent, should this
project be undertaken?

PROBLEM NO. 8.
Trulife Insurance Company’s management is considering an advertising program that would require an initial
expenditure of P165,500 and bring in additional sales over the next five years. The projected additional sales revenue
in year 1 is P75,000, with associated expenses of P25,000. The additional sales revenue and expenses from the
advertising program are projected to increase by 10 percent each year. Loyalty’s tax rate is 40 percent.

Requirements:
1. Compute the payback period for the advertising program.
2. Calculate the advertising program’s net present value, assuming an after-tax hurdle rate of 9 percent.

PROBLEM NO. 9.
The manager of Countryside Company is considering the purchase of a new computer for P150,000. A cost study
indicates that the new computer should save the company P30,000, measured in real pesos, during each of the next
ten years. The real interest rate is 10 percent and the inflation rate is 5 percent. The company is exempted from paying
income taxes.

Requirements:
1. Using cash flows measured in real pesos, compute the net present value of the proposed computer. Use a real
discount rate equal to the real interest rate.
2. Compute the nominal interest rate.
3. Using cash flows measured in nominal pesos, compute the net present value of the proposed computer acquisition.
Use a nominal discount rate equal to the nominal interest rate.

PROBLEM NO. 10.

Ocean View Hospital has purchased new lab equipment for P150,000. The equipment is expected to last for three years
and to provide cash inflows as follows:
Year 1 P45,000
Year 2 60,000
Year 3 ?
Assuming that the equipment will yield exactly a 10% rate of return, what is the expected cash inflows for year 3?

PROBLEM NO. 11.

Quality Products Co. is investigating the purchase of a piece of automated equipment that will save P100,000 each year
in direct labor and inventory carrying costs. This equipment costs P750,000 and is expected to have a 10-year useful
life with no salvage value. The company requires a minimum 15% return on all equipment purchases. Management
anticipates that this equipment will provide intangible benefits such as greater flexibility and higher quality output.
What peso value per year would these intangible benefits have to have in order to make the equipment an acceptable
investment?

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FIN MGT 2 PRACTICE PROBLEMS – 2 of 2