Problems lecture - Capital Budgeting berbano PDF

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CAPITAL BUDGETINGAL F. BERBANODefinition Capital Budgeting- is the process of identifying, evaluating, planning and financing capital investment projects (capital expenditures) of an organization.Characteristics of Capital Investment Decisions 1. Capital investment decisions usually require relative...

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CAPITAL BUDGETING AL F. BERBANO Definition Capital Budgeting- is the process of identifying, evaluating, planning and financing capital investment projects (capital expenditures) of an organization. Characteristics of Capital Investment Decisions 1. Capital investment decisions usually require relatively large commitments of resources. 2. Most capital investment decisions involve long- term commitments of resources. 3. Capital investment decisions are more difficult to reverse than short- term decisions. The Capital Budgeting Process 1. Identification of potential projects 2. Estimation of costs and benefits 3. Evaluation 4. Development of the capital budget 5. Reevaluation Capital Investment Factors 1. Net investment 2. Net returns 3. Cost of capital In capital budgeting discussions, the major concerns are: 1. Net cost of investment How much is the net cost of investment? How much money is needed? 2. Net returns

How should the investment be returned?

3. Project evaluation techniques

Which investment proposal would give the highest return on investment, profitability-wise and liquidity wise?

4. Cost of capital

How much is the cost of capital?

COMPUTATION OF NET COST OF INVESTMENT Cash outflows: Net purchase price of the new asset (net of discount, whether taken or not taken). Additional or incidental costs paid or incurred to prepare the asset for use. Increase in working capital base. Additional tax paid or incurred in case of gain from sale or disposal of old asset. Additional tax paid from savings on avoided cost of repairs, if the old asset is replaced. Cash inflows: Proceeds from sale or trade-in allowance from disposal of old asset. Tax savings from loss on sale of old asset Savings from avoided repairs and maintenance, if the old asset is replaced. Net cost of investment

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PROBLEM EXERCISES: Net Cost of Investment 1. The management of True Value Company plans to replace a sorting machine that was acquired several years ago at a cost of P120,000. The machine has been depreciated to its salvage value of P12,000. A new sorter can be purchased for P140,000. The dealer will grant a trade-in allowance of P7,000 on the old machine. If a new machine is not purchased, True Value will spend P25,000 to repair the old machine. Gains and losses on trade-in transactions are not subject to income tax. The cost to repair the old machine can be deducted in the first year for computing income tax. Income tax rate is 40%. Required: What is the net investment assigned to the new machine for decision analysis? 2. Pelicans Corporation is planning to purchase a new machine costing P4,800,000. Likewise, freight and installation costs amounts to P45,000. The old unit will be given a trade-in allowance of P200,000. Other assets that are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P12,000. The loss on the retirement of these other assets amounting to P20,000 will reduce taxes by P8,000. If the new machine is not purchased, extensive repairs on the old machine will have to be made at an estimated cost of P400,000. This cost can be avoided by purchasing the new machine. Additional gross working capital of P350,000 will be needed to support operations planned with the new machine. Required: What is the net investment assigned to the new machine for decision analysis? 3. Amelia Company plans to acquire a new equipment costing P900,000 to replace the equipment that is being used. Freight charges on the new equipment are estimated at P25,000 and it will cost P22,000 to install. Special attachments to be used with this unit will be needed and will cost P55,000. If the new equipment is acquired, operations will be expanded and this will require additional working capital of P110,000. The old equipment has a net book value of P60,000 and will be sold for P22,000. If the new equipment is not purchased, the old equipment must be overhauled at a cost of P120,000. This cost is deductible for tax purposes in the year incurred. Tax rate is 25%. What is the net investment assigned to the new machine for decision analysis? 4. The Sagipbuhay Lending Company plans to open a new branch office wherein the company shall invest P500,000 in the furnishings of the office and equipment to be used in its operations. Another P200,000 shall be used for rental deposits to the lessee. Sales from this new branch are estimated at P9,000,000 a year. One-third of these sales will be in the form of accounts receivable at any given time. Cost of goods sold are estimated to be two-thirds of sales. The investment in merchandise inventory will amount to approximately P400,000 at any time during the year. Cash of P120,000 will be needed to meet payments for operating expenses. Required: Compute the total amount to be invested in the new branch for decision making purposes.

5. Net returns. The new Angelic Corporation is planning to add a new product line to its present business. The new product will require a new equipment costing P1,200,000, having a five-year useful life with no salvage value. The following estimates are made available: Annual Sales Annual Costs and Expenses: Materials Labor Factory overhead (excluding depreciation of the new equipment) Selling and administrative expenses Income Tax Rate, 30% Required:

P6,000,000 800,000 1,200,000 540,000 700,000

1. Annual income after tax. 2. Annual net cash flow after tax.

6. Payback period, playback reciprocal, and accounting rate of return, even cash flows. Dayanara Company is planning to buy a new machine costing P500,000 with a useful life of five years, with no salvage value. Other data were made available; Expected annual sales revenue Annual out-of-pocket costs Income tax rate Depreciation method, straight-line

P600,000 450,000 40%

Required: Determine the following: 1. Payback period 2. Payback reciprocal. 3. Accounting rate of return on original investment. 4. Accounting rate return on average investment. 7. Payback period, unequal cash flows. An investment of P400,000, can bring in the following annual cash income, net of tax: First year P70,000 Second year 90,000 Third year 85,000 Fourth year 160,000 Fifth year 75,000 Sixth year 70,000 Required: Determine the payback period. 8. Payback bailout method. An equipment costing P1,000,000 is expected to yield the following net cash inflows and salvage values: Year 01 02 03 04

Net cash inflow P 300,000 400,000 200,000 150,000

Salvage Value, net of tax P 200,000 100,000 50,000 20,000

Required: Determine the payback bailout period. 9. Accounting rate of return. The AFB Company is considering the production of a new product line which will require an investment of P1,000,000, with no scrap value. The investment will have a useful life of 10 years, during which annual net cash inflows before taxes of P200,000 are expected. The income tax rate is 40%. Required: a. Annual net income for purposes of computing the accounting rate of return. b. Accounting rate of return based on original and average investment. 10. Payback and accounting rate return. Allaine Company is considering the purchase of a P40,000 machine, which will be depreciated on the straight-line basis over an 8-year period with no salvage value for both book and tax purposes. The machine is expected to generate an annual pretax cash inflow of P15,000. The income tax rate is 40%. Required: 1. Determine the payback period. 2. Compute the accounting rate return on the original investment. 11. Net present value, profitability index, net present value index, even cash inflows. An equipment costing P800,000 will produce annual net cash inflows of P300,000. At the end of its useful life of five years, the equipment will have a salvage value of P20,000. The desired rate of return is 18%. Required: Calculate the following in relation to the proposed investment in equipment: 1. Net present value. 2. Profitability index. 3. Net present value index. 12. Net present value, uneven cash inflows. An equipment costing P600,000, with a residual value P30,000 at its useful life of five years, is expected to bring the following net cash inflows:...