Exam (elaborations) TEST BANK FOR CAPITAL BUDGETING CHADRA SEKRAH

Exam (elaborations) TEST BANK FOR CAPITAL BUDGETING CHADRA SEKRAH Which of the following about capital budgeting and capital budget is incorrect? a. Capital budgeting is the process of planning expenditures for assets, the return on which are expected to be realized within one year. b. Once capital decisions are made, they tend to be relatively inflexible because the commitments extend well into the future. c. In capital budgeting, accurate forecasting is needed to anticipate changes in the demand for the product so that the firm may realize full economic benefits when the capital asset is available for use. d. In capital budgeting, planning is important because of possible changes in inflation, the money supply and interest rates. ANSWER: A Capital Budgeting is the process of planning expenditures for assets, the return on which are expected to continue beyond one year. 2. The capital budget is a (an) a. plan that coordinates and communicates a company’s plan for the coming year to all the segments of the organization. b. plan that assesses the firm’s expenditures for long-lived assets. c. plan to insure that there is enough working capital for the company’s needs. d. a plan that establishes the firm’s long-term goals in the context of relevant factors in the firm’s environment. ANSWER: B A Capital Budget is a plan that assesses the firm’s expenditures for long-lived assets.  The plan that coordinates and communicates a company’s plan for the coming year to all the segments of the organization is called operating budget.  A capital budget involves long-term investment needs, not working capital for operating needs.  Strategic planning establishes the firm’s long-term goals in the context of relevant factors in the firm’s environment. 3. Capital budgeting techniques are least likely to be used in evaluating a. a disinvestment decision, such as sale of unprofitable business segment. b. the acquisition of a new ship by a shipping line. c. the adoption of the ABC system in allocating costs to product lines. d. the implementation of a major advertising program that will have long-term effects on the company. ANSWER: C Capital budgeting involves planning expenditures for long-term investments, as well as the financing ramifications of such investments. The ABC system, which is a method of allocating costs to product lines, has no effect on the firms’ cash flows, does not relate to acquisition of long-term assets, and is not concerned with financing. Hence, the capital budgeting techniques have nothing to do with such allocation method.  A disinvestments decision, such as a sale of unprofitable business segment should be evaluated using capital budgeting techniques. 4. The following items are included in the computation of the net cost of investment, except: a. The initial cash outlay covering all expenditures on the investment project up to the time when it is ready for use or operation. b. Working capital requirement to operate the capital investment project. c. Avoidable cost of immediate repairs on old asset to be replaced, net of tax. d. The book value of the old asset to be replaced. ANSWER: D The book value of an old asset to be replaced is irrelevant, and therefore not included in the computation of the net cost of investment. 5. In evaluating capital investment proposals, the project’s expected rate of return is compared with a hurdle rate, or a desired rate of return. This standard rate may be the weighted-average rate of return of the company must pay to its long-term creditors and shareholders for the use of their funds. It is the cost of using funds and is more commonly called as: 1 a. discount rate b. capital c. capital expense d. cost of capital ANSWER: D Cost of capital is the cost of using funds. It is also called hurdle rate, minimum desired rate of return, and standard rate. It may be used as a discount rate to convert future cash flows to present value. The project’s expected rate of return is compared with this hurdle rate or standard rate. It is the weighted-average rate of return the company must pay to its long-term creditors and shareholders for the use of heir funds. 6. Which of the following statements about cash flow determination for capital budgeting purposes is incorrect? a. Relevant opportunity costs are included in the cash flow forecast. b. Tax savings due to depreciation expense must be considered. c. Depreciation is relevant because it affects net income. d. Changes in net working capital should be included in the cash flow forecast. ANSWER: C Depreciation, although an expense, is a non-cash item, so it does not affect the projected cash flow of an investment project. What is relevant is the tax savings due to depreciation expense. 7. The discounted cash flow model is ordinarily considered the best model for long-range decision-making. It may be characterized as follows, except: a. The discounted cash flow model considers the time value of money. b. The discounted cash flow model involves interest factors and risk. c. The accounting rate of return and net present value methods are among the methods used in the discounted cash flow model. d. The model involves the use of present value factors to discount the future cash flows to present values. ANSWER: C The discounted cash flow model considers the time value of money. The internal rate of return and net present value methods are among the methods used in this model.  The accounting rate of return which does not consider the time value of money is not a method under the discounted cash flow model. 8. Sandy Corporation is planning to buy a new equipment costing P150,000 to replace an old one purchased 6 years ago for P90,000. The old equipment is being depreciated on a straight-line basis over 10 years to a zero salvage value. The same method and useful life will be used to depreciate the new equipment. Sandy Corporation pays tax at a rate of 32% of income before tax. If the old equipment is sold for P30,000 and the new one is purchased, the net cash investment at the time of purchase of the new one is a. P118,080 b. P150,000 c. P121,920 d. P120,000 ANSWER: A SOLUTION: Purchase price of the new equipment P150,000 Less: Proceeds from sale of old equipment P30,000 Tax savings due to loss on sale of old equipment: Sales value P30,000 Less book value: Acquisition cost P90,000 Accum. Dep’n ([P90,000/10] x 6years) 54,000 Book value P36,000 Loss on sale P 6,000 x Tax rate 32%1,920 31,920 Net cash investment on the new equipment P118,080 9. Ojie, Inc. provides hot, ready-to-eat meals to construction workers. The company is considering the purchase of a new truck to replace an old truck now in use in delivering meals to construction sites. The new truck would cost P2M. 2 If the new truck is purchased, the old truck will be sold as is to another company for P400,000. This old truck was acquired for P1.2M and has a current book value of P500,000. If the new truck is not purchased, the company will have to continue using the old one, although extensive repairs would be needed that will cost P250,000. This repairs cost will be expensed, for tax purposes, in the year incurred. The income tax rate for corporations is 32%. If the new truck is purchased, the net cost of investment for decision-making purposes is: a. P1,398,000 b. P2,000,000 c. P1,350,000 d. P1,462,000 ANSWER: A SOLUTION: Purchase cost of new truck P2,000,000 Less: Proceeds from sale of old truck, including Tax savings due to loss on sale Sales proceeds P400,000 Tax savings due to loss on sale: Sales proceeds P400,000 Book value 500,000 Loss P100,000 x Tax rate 32% 32,000 Avoidable cost of repairs, net of tax (P250,000 x 68%) 170,000 602,000 Net cost of investment for decision-making purposes P1,398,000 ITEMS 10 AND 11 ARE BASED ON THE FOLLOWING INFORMATION: ACR Company, which operates a school canteen, is planning to buy a dough-nut making machine for P300,000. The machine is expected to produce 36,000 units of doughnuts per year which can be sold for P10 each. Variable cost to produce and sell the doughnut is P4 per unit. Incremental fixed costs, exclusive of depreciation, is estimated at P56,000 per year. The doughnut-making machine will be depreciated on a straight-line basis for 5 years to a zero salvage value. The company pays income tax at a rate of 32%. 10. What is the expected annual return (accounting net income) to be earned from the doughnut-making machine? a. P108,800 b. P128,000 c. P100,000 d. P 68,000 ANSWER: D SOLUTION: Sales (P36,000 x P10) P360,000 Less variable costs (36,000 x P4) 144,000 Contribution margin P216,000 Less fixed costs: Cash fixed costs P56,000 Depreciation (P300,000/5years) 60,000 116,000 Income before tax P100,000 Less tax (32%) 32% Accounting net income P 68,000 11. What is the annual net cash inflows from the doughnut-making machine? a. P108,800 b. P128,000 c. P100,000 d. P 68,000 ANSWER: B SOLUTION: Net Income (from Item #10) P 68,000 Add depreciation 60,000 Net cash inflows P128,000 3 Alternative Solution 1 (Data taken from Solution to Item #10): Cash inflow (sales) P360,000 Less cash outflows: Variable costs P144,000 Cash fixed costs 56,000 Tax 32,000 232,000 Net cash inflows P128,000 Alternative Solution 2: Sales P360,000 Less cash costs: Variable P144,000 Fixed 56,000 200,000 Cash inflows before depreciation and tax P160,000 Less tax (P160,000-depreciation of P60,000)32% 32,000 Net cash inflows P128,000 In computing net income, depreciation expense is deducted because it is a tax deductible expense. When net cash inflows is computed, depreciation is added back to net income because it (depreciation) is a non-cash expense. Thus, only the tax effect of depreciation is considered in the computation of net cash inflows. Alternative Solution 3: Cash inflow before depreciation and tax (from Alternative Solution 2) P160,000 Less: Tax (32%) P51,200 Tax savings due to depreciation (P60,000 x 32%) (19,200) 32,000 Net cash inflows P128,000 Depreciation serves as a tax shield because it reduces taxable income. In this case, the tax savings due to the depreciation tax shield is P19,200 (P20,000 x 32%). ITEMS 12 AND 14 ARE BASED ON THE FOLLOWING INFORMATION: Fermin Printers, Inc. is planning to replace its present printing equipment with a more efficient unit. The new equipment will cost P400,000, with a five-year useful life, no salvage value. The old unit was acquired three years ago for P500,000. The company uses the straight-line method in depreciating its depreciable assets. The old unit is being depreciated at P62,500 per year. If the new equipment is acquired, the old one will be sold for P100,000. Otherwise, the company will just continue using it for five years. Cash operating costs are P100,000 and P220,000 for the new and old equipment, respectively. Income tax is at the rate of 32% of income before tax. 12. The increase in annual net income as a result of acquiring the new equipment is: a. P27,200 b. P31,900 c. P69,700 d. P87,200 ANSWER: C SOLUTION: Savings in cash operating costs (P220,000 – P100,000) P120,000 Less incremental depreciation: New equipment (P400,000/5) P80,000 Old equipment 62,500 17,500 Savings or income before tax P102,500 Less tax (32%) 32,000 Incremental annual net income P 69,700 13. What is the expected increase in annual net cash inflows if the new equipment is acquired? a. P52,200 b. P87,200 c. P 69,700 d. P149,700 ANSWER: B SOLUTION: 4 Annual net income (from Item #12) P69,700 Add incremental depreciation 17,500 Net cash inflows P87,200 14. What is the net cost of investment in the new equipment for decision-making purposes? a. P232,000 b. P400,000 c. P300,000 d. P368,000 ANSWER: A SOLUTION: Purchase cost of new equipment P400,000 Less proceeds from sale of old equipment, including Tax savings due to loss on sale: Proceeds from sale P100,000 Tax savings due to loss on sale (P100,000-[P500,000-{P62,500x3}]x32% 68,000 168,000 Net cost of investment for decision-making purposes P232,000 ITEMS 15 AND 18 ARE BASED ON THE FOLLOWING INFORMATION: The Super Carry, a domestic shipping line, has recently commissioned a new passenger ship, the SC-20. The new ship can carry up to 2,000 passengers. It was purchased by Super Carry at a cost of P300 million. Its estimated service life is 10 years, with a salvage value of P40 million at the end of its service life. SC-20 is expected to have 300 voyage-days per year with an average of 80% occupancy rate. The revenue from each passenger is estimated at P250 per day, while daily variable costs per passenger is P100. Annual fixed costs of operating the ship, exclusive of depreciation, is estimated at P20 million per year. Super Carry pays tax at a rate of 32% of income before tax. 15. What is the annual net cash inflow from operating SC-20? a. P17,680,000 b. P43,680,000 c. P26,000,000 d. P61,360,000 ANSWER: B SOLUTION: Contribution margin ([250-P100] x300 days x 2,000pax x80%) P72,000,000 Less fixed costs: Depreciation ([P300M – P40M] /10 years P26,000,000 Others 20,000,000 46,000,000 Income before tax P26,000,000 Les tax (32%) 8,320,000 Net income P17,680,000 Add depreciation 26,000,000 Annual net cash inflows P43,680,000 16. In how many years can Super Carry recover the initial cost of investment in SC-20? a. 5.95 years b. 4.17 years c. 6.87 years d. 10 years ANSWER: C SOLUTION: The payback period, or the length of time Super Carry can recover the initial cost of investment in SC-20 is Payback period = Net cost of initial investment Annual net cash inflows = P300 million P43.68 million = 6.87 years 17. What is the expected accounting rate of return based on initial investment in SC-20? a. 5.89% b. 13.60% 5 c. 10.40% d. 11.78% ANSWER: A SOLUTION: Accounting Rate of Return = Accounting net income on Initial Investment Initial Investment = P17,680,000 = 5.89% P300M 18. What is the accounting rate of return based on the average investment in SC-20? a. 5.89% b. 13.60% c. 10.40% d. 11.78% ANSWER: C SOLUTION: Accounting Rate of Return = Accounting net income based on Average Investment Average Investment* =___P17,680,000___ P300M+P40M 2 = 10.40% Average Investment = Initial investment + Salvage value 2 19. Which of the following statements is not correct? a. Both the payback and accounting rate of return methods do not consider the time value of money. b. The payback method is often used in practice because of its simplicity and effectiveness in risk management and cash conservation. c. The bailout payback method eliminates the disposal value from the payback calculation. d. The accounting rate of return (ARR) method compares the project’s ARR with a hurdle rate of a desired rate of return. ANSWER: C The bailout payback method measures the length of time required for the sum of cumulative cash inflow from an investment’s operations and its salvage value to equal the initial or original investment. Thus, the disposal value is included in the calculation. The payback bailout method measures the risk if the project is terminated. 20. Djorn Corporation has determined that if a new equipment costing P120,000 is purchased, the company’s net income will increase by P10,000 per year. If the new equipment will be depreciated using the straight-line method over a period of six years to a zero salvage value, the payback period is: a. 6 years b. 12 years c. 0.25 years d. 4 years ANSWER: D SOLUTION: Payback period = Investment______ = P120,000 = 4 years Annual net cash inflow* P30,000 *Net income P10,000 Add depreciation (P120,000/6years) 20,000 Annual net cash inflow P30,000 21. A new machine is expected to produce the following after-tax cash inflows over a period of 5 years: After-tax cash inflows Year Per Year Cumulative 1 P 16,000 P 16,000 2 12,000 28,000 3 20,000 48,000 4 8,000 56,000 5 6,000 62,000 6 If the machine will cost P40,000, its payback period is: a. 5 years b. 3 years c. 2.60 years d. 3.23 years ANSWER: C SOLUTION: Cost of the machine P40,000 Less cumulative cash flows for 2years 28,000 Amount to be recorded in Year 3 P12,000 / Total cash inflow in Year 3 20,000 fraction of Year 3 required to fully recover the cost of investment 0.6 year Payback period = 2 years + 0.6 year = 2.6 years 22. A new system will require an increase in working capital of P50,000, but it is expected to generate additional sales of P100,000 per year. If the gross profit rate is 40% and incremental fixed costs is P20,000, the payback period in years (ignore income taxes) is: a. 20% b. 2 years c. 2.50 years d. 0.50 years ANSWER: C SOLUTION: Incremental annual sales P100,000 x Gross profit rate 40% Gross profit P 40,000 Less incremental fixed costs 20,000 Net cash inflows (or income before tax) P 20,000 Payback period = Investment______ = P50,000 = 2.5 years Annual net cash inflow P20,000 In this case, the cost of investment in the new system is the required increase in working capital. Depreciation is not considered in the computation because working capital is not depreciable. ITEMS 23 AND 24 ARE BASED ON THE FOLLOWING INFORMATION: For new equipment acquisitions, Melba C. Corporation has set a payback goal of 3 years and a desired rate of return of 25% based on initial investment. An equipment to be used in Melba C. Corporation’s Forming Department is being evaluated. Data pertaining to the equipment are a follows: Cost of the equipment P1,800,000 Useful life 10 years Salvage value at the end of the useful life 0 Melba C. Corporation is subject to 40% income tax rate. It uses the straight-line method in computing depreciation. 23. To meet Melba C. Corporation’s payback goal, the new equipment must generate savings in annual cash operating costs of: a. P600,000 b. P880,000 c. P700,000 d. P420,000 ANSWER: B SOLUTION: Required annual net cash inflows (P1,800,000/3years) P600,000 Less depreciation (P1,800,000/10years) 180,000 Required net income (after tax) P420,000 / (100% - Tax rate of 40%) 60% 7 Income before tax P700,000 Add depreciation 180,000 Required savings in annual cash operating costs P880,000 24. The new equipment’s accounting rate of return will: a. be lower than the desired rate of return. b. exceed the desired rate of return. c. be exactly equal to the desired rate of return. d. exceed its payback period. ANSWER: A SOLUTION: Accounting Rate of Return = Accounting net income on Initial Investment Initial Investment = P420,000 P1,800,000 = 23.33% The expected accounting rate of return (ARR) based on the initial investment on the new equipment is 23.33%, lower than the desired rate of return (DRR) of 25%. If the equipment is evaluated using the accounting rate of return method, it is not acceptable because the expected ARR is lower than the DRR. 25. Maliya Corporation is planning to buy a new machine costing P450,000. The new machine’s useful life is 5 years. Its estimated disposal values are: Year Disposal Value 1 P 100,000 2 100,000 3 75,000 4 75,000 5 50,000 If the new machine is expected to generate cash inflows from operations, net of tax, of P180,000 per year, its bailout period is: a. 2 years b. 2.5 years c. 1.04 years d. 1.94 years ANSWER: D SOLUTION: If the machine is disposed in the first year, the total cash inflows will be P280,000 (P180,000 + P100,000), which is less than the cost of investment of P450,000. Hence, the company should continue operating the machine. In the second year, the cumulative cash inflows from operations is P360,000 (P180,000 in the first year and P180,000 in the second year). If the machine is disposed this year, the disposal value is P100,000, bringing the total cash inflows to P460,000, which is more than the amount of P450,000 that the company wants to recover. Hence, only a fraction of the second year is required to attain full