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5 Capital Budgeting - Solution

a.  P86,600 
                                                                  Cash Flow 
    Cash operating savings                                         P200,000  
    Present value factor, 5 years, 14%                                3.433  
    Present value of future flows                                  P686,600  
    Investment                                                      600,000  
    Net present value                                              P 86,600 
 
c.  Nearly 20%.  The factor is 3.0 (P600,000/P200,000), which is closest to 
    2.991, the factor for 20%.  Because the 3.0 is greater than the 20% factor,
    the IRR is less than 20%. 

e.  3 years, as calculated in requirement 2.

g.  About 27%, income of P80,000 (P200,000 ­ P120,000 depreciation) divided by 
    P300,000 average investment.

b.  Negative P23,260
                                                    
  Tax           Cash Flow 
 Cash savings                                     P200,000        P200,000
 Depreciation (P600,000/5)                         120,000
 Increase in pretax income                          80,000
 Income tax at 40%                                P 32,000          32,000
 Net cash flow                                                     168,000
 Present value factor, 14%, five years                               3.433
 Present value of future flows, rounded                          P 576,740
 Investment                                                        600,000
 Net present value                                              (P  23,260)
  
d.  The IRR is a bit over 12%.  The factor is 3.571 (P600,000/P168,000), which 
is closest to 3.605, the 12% factor. 

f.  3.571 years, as calculated in requirement 2.

h.  16%, income of P48,000 (P80,000 ­ taxes of P32,000) divided by P300,000 
average investment.

             Total
            Present                 Profitability
             
 Value     Investment       Index          Decision
    i       P686,600     P600,000         1.144         accept
    j        576,740      600,000         0.961         reject

2. (a)   A 2.0 years
         B 2.6 years
         C 3.5 years

   (b)   C, B, A
                                           
   A             B           C  
 Average income                        P 1,250       P10,000     P12,500
 Divided by average investment
   P70,000/2                           P35,000       P35,000     P35,000
 Equals book rate of return               3.6%         28.6%       35.7%

   (c)  B, C, A.  Investment B is the only one with a positive NPV.  

                
   A                    B                      C          
                  Present                Present               Present
 Year   Cash Flow  Value     Cash Flow    Value*    Cash Flow   Value 
  1      P35,000  P30,170     P35,000    P30,170    P 4,000    P 3,448
  2       35,000   26,005      10,000      7,430      8,000      5,944

1
  3          0          0      45,000     28,845     10,000      6,410
  4        5,000    2,760      20,000     11,040     98,000     54,096
 Total            P58,935                P77,485               P69,898
 Investment        70,000                 70,000                70,000
 NPV             (P11,065)               P 7,485              (P   102)

 * Present value factors are .862, .743, .641, and .552.

c.  The results show that payback and book­rate­of­return rankings do not 
necessarily indicate relative profitability.  B is the only desirable 
investment, using discounted cash flow analysis. 

     Investment A illustrates that payback ignores profitability; the project 
has the quickest payback but little cash flow after the payback period. 
Investment C has high income, but much of it comes in the last year, when the 
cash flow is worth less than it would have been earlier.  Investment C returns 
more in total than does A, but the wait is too long to be worthwhile at 16%.  

d. discounted cashflow method or NPV is best because it considers the time 
value of money. Below is profitability index analysis:

             Total
            Present                 Profitability
 Project     Value     Investment       Index          Rank
    A       P58,935     P70,000          .842            3
    B        77,485      70,000         1.107            1
    C        69,898      70,000          .999            2

In this case, the rankings are the same as when the projects were analyzed 
using the net present value method. 

3.
a.  Negative P2,150
                                                         
  Tax     Cash Flows
 Annual savings (P600,000 x .10)                       P60,000    P 60,000 
 Depreciation (P240,000/10)                             24,000 
 Increase in taxable income                            P36,000 
 Increase in taxes at 40%                               14,400      14,400
 Net cash savings                                                 P 45,600 
 Present value factor, 10 years, 14%                                 5.216 
 Present value of future flows                                    P237,850
 Cost of project, investment                                       240,000 
 Net present value                                               (P  2,150)
 
b.  P60,687

  Net present value, from requirement 1                          (P 2,150) 
  Divided by present value factor, 10 years, 14%                    5.216  
  Required increase in after­tax annual flows                     P   412  
  Divided by (1 ­ 40% tax rate)                                       60%  
  Equals required increase in before­tax cash savings             P   687  
  Plus expected savings                                            60,000  
  Equals required savings                                         P60,687  

c.  Yes, the advantage is P17,679.       
                                                           
  Tax     Cash Flow
 Savings with new machine                                P 60,000   P 60,000 
 Extra depreciation: 
   New machine                               P24,000 
   Old machine (P66,000/10)                    6,600       17,400
 Increase in taxable income                              P 42,600 
 Increase in taxes at 40%                                  17,040     17,040 
 After­tax cash flow increase                                       P 42,960
 Present value factor, 14%, 10 years                                   5.216 
 Present value of future flows                                      P224,079
 Cost of new machine: 
   Cost of machine                                       P240,000 
   Less proceeds from sale of old machine                  12,000 

2
                                                         P228,000 
   Less tax saving, loss on sale of old machine
      [(P66,000 ­ P12,000) x 40%]                          21,600  
   Net cost of new machine                                           206,400 
 Difference, in favor of new machine                                P 17,679

4.
a.  P84,800
                                                          
  Tax      Cash Flow 
 Cost of new lathe                                                 P100,000 
 Resale price of existing lathe                         P12,000     (12,000) 
 Book value                                              20,000      
 Loss for tax purposes                                  P 8,000 
 Tax saving at 40%                                                  ( 3,200) 
 Net required investment                                           P 84,800 
 
b.  P91,215 present value, for an NPV of P6,415
                                                          
  Tax      Cash Flow 
 Savings in cash costs (P63,000 ­ P22,000)              P41,000    P 41,000 
 Additional depreciation (P25,000 ­ P5,000)              20,000 
 Increase in taxable income                             P21,000 
 Increased income taxes at 40%                            8,400       8,400 
 Net cash flow                                                     P 32,600 
 Present value factor, 4 years, 16%                                   2.798 
 Present value of future cash flows                                P 91,215
 Cost of new investment (requirement 1)                              84,800  
 Net present value                                                 P  6,415

     The net present value is positive and reasonably high.  The company should
accept the investment on economic grounds.    

c.  NPV increases by P1,656, to P8,071. Because salvage value is ignored for 
depreciation purposes, nothing changes until the last flow. 
 
 Salvage value net of tax (P5,000 x 60%)                             P 3,000 
 Present value factor, single payment, 4 years, 16%                     .552 
 Present value of recovery                                           P 1,656 

5.
P46,262
                                                            
   Tax    Cash Flow
 Contribution margin [60,000 x (P9 ­ P4)]                P300,000   P300,000 
 Cash fixed costs                                         140,000    140,000 
 Pretax cash flow                                         160,000    160,000 
 Depreciation (P300,000/4)                                 75,000 
 Increase in taxable income                              P 85,000 
 Increased income taxes at 40%                             34,000     34,000 
 Net cash flow                                                       126,000 
 Present value factor, 4 years, 12%                                    3.037  
 Present value of operating flows                                   P382,662
 Present value of return on working capital*                          63,600 
 Total present value                                                 446,262 
 Investment (P300,000 + P80,000 + P20,000)                           400,000 
 Net present value                                                  P 46,262
 * (P80,000 + P20,000) x .636

6.
About P24.2 million, so the investment is desirable.
                                                             (in millions)
                                                      
 Tax      Cash Flow
Additional cash operating costs                       P1.50       P 1.50
Plus depreciation  (P8.5/5)                            1.70
Decrease in taxable income                            P3.20
Reduced income tax at 40%                              1.28         1.28
Net cash outflow                                                  P 0.22
Present value factor, 5 years, 12%                                 3.605
Present value of future outflows                                 P 0.793       

3
Investment, net inflow, P8.5 ­ P43.7 + P10.2                      25.000
Net present value                                                P24.207

7.
  (a)  P43,757
                                                         
   Tax     Cash Flow 
 Additional contribution margin (50,000 x P3)         P150,000    P150,000
 New cash fixed costs                                   60,000      60,000
 Increase in income before depreciation               P 90,000      90,000
 New depreciation (210,000/6)                           35,000
 Increase in taxable income                           P 55,000
 Increase in taxes, at 45%                              24,750      24,750
 Increase in annual after­tax cash flow                           P 65,250
Present value factor, 14%, 6 years                                  3.889
 Total present value of future cash flows                         P253,757
 Less investment                                                   210,000
 NPV                                                              P 43,757

    (b)  About 21.3%.  Those using tables will find
 Investment                                                      P210,000
 Divided by annual cash flow                                     P 65,250
 Equals present value factor for 6 years                            3.218
 Closest factors:
   For 20%         3.326
   For 22%         3.167

    (c)  1.208   (P253,757/P210,000)

d.  P80,457

NPV (from 2a)                                                     P 43,757    
Divided by present value factor, 14%, 6 years                        3.889
Allowable decrease in annual after­tax cash flows                 P 11,251  
Divided by (1 ­ 45% tax rate)                                           55%    
Equals allowable decrease in before­tax cash flows                P 20,457    
Cash fixed operating costs                                          60,000 
Allowable total cash fixed operating costs                        P 80,457  

e.  More than 4 but less than 5 years.

 Present value factor (computed in 2b)   3.218
 Closest factors for 16%:
   For 4 years      2.798
   For 5 years      3.274

f.  43,181 units
 Estimated sales, in cases                                            50,000
 Allowable decrease in annual before­tax cash flows (from req 3)    P 20,457
 Divided by per­unit contribution margin                                  P3
 Allowable decline in number of units sold                             6,819
 Case sales to achieve 14% IRR                                        43,181

g.  Variable cost could increase about P0.41,   to P5.41.

 Allowable decrease in annual before­tax cash flows (from req 3)    P 20,457
 Divided by expected volume in cases                                  50,000
 Allowable decrease in contribution margin per unit                 P   0.41

8.
A P268,800 difference in present values favors closing the plant.
Total Project Approach
                                                  
 Close plant:
   Increased shipping costs                                     P  900,000
   Tax at 40%                                                      360,000
   Net cash outflow                                                540,000
   Present value factor, 10 years, 14%                               5.216

4
   Present value of increased shipping costs                     2,816,640
   Severance pay, net of tax, P800,000 ­ P320,000                  480,000
   Subtotal                                                      3,296,640
   Less selling price of plant                                     400,000
   Present value of future cash flows                           P2,896,640

Keep plant open:
   Investment required     P4,000,000
   Depreciation tax shield, P4,000,000/10 x 40%    P  160,000
   Present value factor, 10 years, 14%                  5.216
   Present value of future cash inflows                            834,560
   Present value of future cash outflows                        P3,165,440
 
Difference favoring closing plant, P3,165,440 ­ P2,896,640     P  268,800

9.
The smaller expansion, Plan A, should be accepted.  The first step is to 
determine how to use the additional capacity.  The products produce 
contribution margin per machine­hour as follows: 101­X, P9; 201­X, P6; 305­X, 
P8.  Therefore, 101­X should be made first, until its sales potential is 
reached, then 305­X, and finally, 201­X. 

     The NPV of Plan A is P497,400.  The NPV of Plan B is P353,400, or 
P144,000 less than that of Plan A.  

Analysis of Plan A

 Computation of product quantities and contribution margin:
  Available machine­hours                                      200,000
  Less production of 30,000 101­Xs (2 x 30,000)                 60,000
  Hours remaining                                              140,000
  Divided by hours required for 305­X                                5
  Equals number of 305­Xs to be made                            28,000
  Contribution margin:
    101­X  (30,000 x P18)                                      540,000
    305­X  (28,000 x P40)                                    1,120,000
  Total contribution margin                                 P1,660,000

                                                       
   Tax         Cash Flows
 Computation of NPV: 
   Contribution margin                              P1,660,000     P1,660,000
   Less additional fixed costs requiring cash          600,000        600,000
   Cash flow before taxes                            1,060,000      1,060,000
   Less depreciation (P4,000,000/10)                   400,000
   Increased taxable income                            660,000
   Increase in income taxes (40%)                      264,000        264,000
   Net cash flow                                                   P  796,000
 Present value factor, 12%, 10 years                                    5.650
 Present value of future flows                                     P4,497,400
 Investment required                                                4,000.000
 Net present value                                                 P  497,400

Analysis of Plan B
 Available machine­hours                                         280,000
  Less hours devoted 
    To 101­X                                                     ( 60,000)
    To 305­X                                                     (140,000)
  Hours available in excess of Plan A                              80,000
  Less hours used for additional production of 305­X 
    (30,000 ­ 28,000) x 5                                        ( 10,000)
  Hours remaining for production of 201­X                          70,000
  Divided by hours required to produce 201­X                            4
  Equals number of 201­Xs to be made                               17,500
  Contribution margin:
    101­X  (30,000 x P18)                                      P  540,000
    305­X  (30,000 x P40)                                       1,200,000
    201­X  (17,500 x P24)                                         420,000

5
  Total contribution margin                                    P2,160,000

Annual cash flows:                                      Tax      Cash Flows
   Contribution margin                               P2,160,000   P2,160,000 
   Less additional fixed costs requiring cash           800,000      800,000
   Cash flow before taxes                             1,360,000    1,360,000
   Less depreciation  (P5,500,000/10)                   550,000
   Increased taxable income                          P  810,000
   Increase in income tax, at 40%                       324,000      324,000
   Net cash flow                                                  P1,036,000
 Present value factor, 12%, 10 years                                   5.650
 Present value of future flows                                    P5,853,400
 Less investment required                                          5,500,000
 Net present value                                                P  353,400

10.
The company should buy the William 350 and replace it in five years.
                                     William 600 
                                                             Present Values 
 Original cost                                                  P 90,000 
 Annual operating costs                           P15,000 
 Plus depreciation (P90,000/10)                     9,000 
 Total expenses                                   P24,000 
 Tax saving at 40% rate                           P 9,600 
 Net cash outflows (P15,000 ­ P9,600)             P 5,400 
 Present value factor, 10 years, 16%                4.833 
 Present value of future annual cash flows                        26,098
 Total present value                                            P116,098 
                        
                                   William 350
                                                             Present Values
 Original cost                                                  P 50,000 
 Annual operating costs, first 5 years            P12,000 
 Depreciation (P50,000/5)                          10,000 
 Total expenses                                   P22,000 
 Tax saving at 40%                                P 8,800 
 Net cash outflows (P12,000 ­ P8,800)             P 3,200 
 Present value factor, 5 years, 16%                 3.274 
 Present value of flows for first 5 years                         10,477 
 Purchase price of replacement machine            P60,000 
 Present value factor, 5 years, 16%                  .476 
 Present value of replacement cost                                28,560 
 Annual operating costs, second 5 years           P12,000 
 Depreciation (P60,000/5)                          12,000 
 Total expense                                    P24,000 
 Tax saving at 40%                                P 9,600 
 Net cash outflows (P12,000 ­ P9,600)             P 2,400 
 Present value of flows*                                           3,742 
 Total present value                                            P 92,779 
 * P2,400 x 1.559, which is the sum of the present value factors for single 
   payments 6, 7, 8, 9, and 10 years hence (.410 + .354 + .305 + .263 + .227).

    Cash flow                                              P2,400
    Times present value annuity factor, 5 years, 16%        3.274
    Equals present value of annuity at beginning of
      6th year (5 years from now)                          P7,858
    Present value factor, single payment 5 years, 16%        .476
    Present value of delayed annuity                       P3,740

Multiple Choice
1c 2b 3d 4a 5a 6a 7c 8c 9d 10a 11 d 12d 13c 14 b
15a 16c 17d 18b 19b 20a 21b 22c 23b 24d 25a 26b
27b 28d