CAPITAL BUDGETING

CASH FLOWS/ NET PRESENT VALUE/ INTERNAL RATE OF RETURN/ ACCOUNTING RATE OF
RETURN
Problem 1 Cash flows
In 8 years, Karl Garcia will retire. He is exploring the possibility of opening a self-service car wash. The car
wash could be manage In the free time he has available from his regular occupation, and it could be closed
easily when he retires. After careful study, Karl has determined the following:
a. A building in which a car wash could be installed is available under an 8-year lease at a cost of
P2,100 per month. A two- month’s rent is required as deposit to be paid at the beginning of the
contract.
b. Purchase price of the equipment would total P160,000 while installation costs would amount to
P10,000. In 8 years the equipment could be sold for 10% of its original purchase price.
c. An investment of an additional P1,000 would be required to cover working capital needs for
cleaning supplies, changes funds and so forth. After 8 years, this working capital would be released
for investment elsewhere.
d. Both an auto wash and the vacuum service would be offered with a wash priced at P1.60 and the
vacuum price at P0.20 per use.
e. The only variable costs associated with the pertain would be P0.23 per wash for water and P0.1
per use of the vacuum for electricity.
f. In addition to rent, monthly cost of pertain would be: cleaning, P480; insurance, P70; and
maintenance, P520.
g. Gross receipts from the auto wash would be about P1,600 per week. According to the experience
of other self-service car washes, 80% of the customers using the wash would also use the vacuum.
Karl will not open the car wash unless it provides at least an 8% return, since he could earn this rate of
return in high-grade securities.
Required: Compute the initial investment cost, Annual after-tax cash inflow, and the cashflow at disposal
period.
Problem 2
The Chief Financial officer of Pauley Inc. has requested an evaluation of a proposed acquisition of a new
machine at a purchase price of P60,000 and with installation cost of P10,000. A P3,000 increase in working
capital will be required. The company has an old machine that has a book value of P5,000 and can be
sold for P7,000. The new machine will have a useful life of four years after which it can be sold for P10,000
after removal costs amounting to P2,500. The estimated annual incremental operating revenues and cash
operating expenses are P150,000 and P100,000, respectively, for each of the four years. Pauley’s effective
income tax rate is 40% and the cost of capital is 12%. Pauley uses straight-line depreciation for both
financial reporting and income tax purposes however, salvage value will not be considered for income tax
purposes.
Required: Compute the initial investment cost, Annual after-tax cash inflow, and the cash flow at disposal
period.
Problem 3
Tallispan Company has gathered the following data on a proposed investment project:
Cost of the investment P1,200,000
Annual cost inflows 240,000
Estimated salvage value 0
Life of the project 10 years
Discount rate 10%

What is the net present value of this investment?

Problem 4
The Sweetwater Candy Company would like to buy a new Italian-made machine that automatically dips
chocolates. The dipping pertain is currently done by hand. The machine costs P160,000. The machine
would be usable for 12 years but would require the replacement of several key parts at the end of the 6th
year. These parts would cost P8,000, including installation. After 12 years, the machine would be sold for
P7,000. Management estimates that the cost t operate the machine will only P6,500 per year. The present
method of dipping chocolates costs P40,000 per year. In addition to reducing costs, the new machine will
increase production by P5,000 boxes of chocolates per year. The company realizes a contribution margin
of P1.80 per bx. An 18% rate of return is required n all investments.
What is the net present value?

Problem 5
Sta. Ana Corporation recently purchased a P900,000 asset that has three year service life and no salvage
value. The expected pre tax annual cash return is P500,000. The company is subject to a 30% income tax
rate and employs a 20% after tax hurdle rate of return in capital investment decisions. Management is
studying whether to depreciate the asset using the straight-line method or sum-of-the- years’ digit method.
PV factor of an annuity of P1 at 20% 2.106
PV factor of a single payment at 20% Year 1 0.833
Year 2 0.694
Year 3 0.579

1. How much is the net present value if the company uses the straight line method of depreciation?
2. How much is the net present value if the company uses the sum of the years digit method of
depreciation?
3. How much is the total present value of tax shield from depreciation if SYD method is used instead
of a straight line method?

Problem 6
Vigan Corporation invested in a four-year project. The company’s expected rated of return is 10%.
Additional information on the project is as follows:
YEAR AFTER TAX CASH PRESENT
INFLOW FROM VALUE OF P1
OPERATIONS AT 10%
1 40,000 .909
2 44,000 .826
3 48,000 .751
4 52,000 .683
Assuming a positive Net Present Value of P10,000, determine the amount of the original investment.

Problem 7 (Internal Rate of Return)

Gapan Corporation acquired an asset at a cost of P46,000. It had an estimated useful life of 10 years.
Annual after tax benefits are estimated at P10,000 at the end of each year. The following amounts appear
in the interest table for the present value of an annuity of 1 at year end for ten years:
16% - 4.83 18%-4.49 20%-4.19
Determine the internal rate of return.

Problem 8
The following data pertain to an investment in equipment:
Investment Cost P20,000 Pre-tax net annual cash inflow P3,200 Life of the project-8years
5% 6% 7% 8% 9%
PV of 1 (3 digits)
PV of an Ordinary
annuity

Determine the Internal Rate of Return of the Investment

Problem 9 (Accounting rate of return)

The following pertains to Bulacan Corporation’s investment plan
Pretax annual net cash P80,000 Net income P35,000 Useful life 5 years
flow
Equipment P200,000 Salvage Value P50,000 Tax rate 30%
Compute the accounting rate of return of the investment
1. Based on initial investments

2. Based on Average Investments

Problem 10
Pete Samuels has an opportunity to acquire a franchise from Green Tea Inc., to dispense frozen yogurt
products under the Green tea name Mr. Samuels has assembled the following information relating to the
franchise:
a. A suitable location in a large shopping mall can be rented for P8,750 per month
b. Remodeling and necessary equipment would cost P675,000. The equipment would have a 15 year
life and a P45,000 salvage value would be considered in computing depreciation.
c. Based on similar outlets elsewhere, Mr. Swanson estimates that sales would total P750,000 per
year. Ingredients would cost 20% of sales.
 d. Operating costs would include P175,000 per year for salaries, P8,750 per year for insurance, and
P67,000 per year for utilities. In addition, Mr. Swanson would have to pay a commission to Green
Tea Inc of 12.5% of sales
e. Income tax rate is constant at 40%.
Compute the accounting rate of return of the investment
1. Based on Initial Investments
2. Based on Average Investments

Problem 11
Sharkey’s Fun Center contains a number of electronic games as well as a miniature golf course and
various rides located outside the building. Baby Sharkey, the owner, would like to construct a water slide
on one portion of his property. Baby has gathered the following information about the slide:
a. Water slide equipment could be purchased and installed at a cost of P440,000. The slide would be
usable for 5 years after which it would have no salvage value.
b. Baby would use straight-line depreciation on the slide equipment.
c. To make room for the water slide, several rides would be dismantled and sold. These rides are
fully depreciated, but they could be sold for P20,000 to an amusements park in a nearby city.
d. Baby has concluded that water slides would increase ticket sales by P319,000 per year.
e. Based on experience at other water slide, Baby estimates that incremental operating expenses
each year for the slide would be: salaries, P98,000; Insurance P25,000; Utilities P17,000;
Maintenance P28,000.
Required:
1. Prepare an income statement showing the expected net operating income each year from the water
slide.
2. Compute the simple rate of return expected from the water slide. Based on this computation, would
the water slide be constructed if Paul requires a simple rate of return of at least 14% on all investments?

Problem 12
The following pertains to Bataan Corporation’s Investment plan
Investment Costs P400,000
Annual cash savings 250,000

Required:
1. Compute the payback period of the investment in equipment
2. Compute the payback reciprocal of the investment in equipment
3. What is the payback period of the equipment if instead the annual cash savings of P240,000, the
following are the expected annual cash savings:

Period 1 P 180,000
Period 2 P 140,000
Period 3 P 200,000