MSQ-08 Capital Budgeting [PDF]

Zitiervorschau

MANAGEMENT ADVISORY SERVICES THEORY Basic concepts 1. Capital budgeting techniques are least likely to be used in evaluating the A. Acquisition of new aircraft by a cargo company. B. Trade for a star quarterback by a football team. C. Design and implementation of a major advertising program. D. Adoption of a new method of allocating non-traceable costs to product lines. 2. The “inflation element” refers to the A. Future increases in the general purchasing power of the monetary unit. B. Future deterioration of the general purchasing power of the monetary unit. C. Fact that the real purchasing power of a monetary unit usually increases over time. D. Impact that future price increases will have on the original cost of a capital expenditure. 3. Which of the following best identifies the reason for using probabilities in capital budgeting is A. Cost of capital. C. Time value of money. B. Different life of projects. D. Uncertainty. 4. In capital budgeting decisions, the following items are considered among others: 1. Cash outflow for the investment. 2. Increase in working capital requirements. 3. Profit on sale of old asset 4. Loss on write-off of old asset. For which of the above items would taxes be relevant? A. Items 1 and 3 only. C. Items 3 and 4 only. B. Items 1, 3 and 4 only. D. All items. Net Investments 5. Mahlin Movers, Inc. is planning to purchase equipment to make its operations more efficient. This equipment has an estimated useful life of six years. As part of this acquisition, a P150,000 investment in working capital is required. In a discounted cash flow analysis, this investment in working capital should be MSQ-08 - CAPITAL BUDGETING

HILARIO TAN A. B. C. D.

Disregarded because no cash is involved. Amortized over the useful life of the equipment. Treated as an immediate cash outflow that is recovered at the end of six years. Treated as a recurring annual cash flow that is recovered at the end of six years.

Operating Cash Flows After Tax 6. To approximate annual cash inflow, depreciation is A. Subtracted from net income because it is an expense. B. Added back to net income because it is an inflow of cash. C. Subtracted from net income because it is an outflow of cash. D. Added back to net income because it is not an outflow of cash. 7. In capital expenditures decisions, the following are relevant in estimating operating costs except A. Cash costs. C. Future costs. B. Differential costs. D. Historical costs. Accounting Rate of Return 8. The following statements refer to the accounting rate of return (ARR) 1. The ARR is based on the accrual basis, not cash basis. 2. The ARR does not consider the time value of money. 3. The profitability of the project is considered. From the above statements, which are considered limitations of the ARR concept? A. Statements 1 and 2 only. C. Statements 3 and 1 only. B. Statements 2 and 3 only. D. All the 3 statements. Payback Period 9. The payback method assumes that all cash inflows are reinvested to yield a return equal to A. the discount rate. C. the internal rate of return. B. the hurdle rate. D. zero.

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MANAGEMENT ADVISORY SERVICES 10. As a capital budgeting technique, the payback period considers depreciation expenses (DE) and time value of money (TVM) as follows: A. B. C. D. DE relevant relevant Irrelevant irrelevant TVM relevant irrelevant Relevant irrelevant Bailout Payback 11. The bailout payback period is A. The payback period used by firms with government insured loans. B. The length of time for payback using cash flows plus the salvage value to recover the original investment C. (A) and (B) D. None of the above. Discounted Cash Flow Method 12. Which of the following methods measures the cash flows and outflows of a project as if they occurred at a single point in time? A. Capital budgeting. C. Discounted cash flow. B. Cash flow based payback period. D. Payback method. 13. When using one of the discounted-cash-flow methods to evaluate the feasibility of a capital budgeting project, which of the following factors generally is not important? A. The timing of cash flows relating to the project. B. The amount of cash flows relating to the project. C. The impact of the project on income taxes to be paid. D. The method of financing the project under consideration. 14. Your company is purchasing a transport equipment as part of its territorial expansion strategy. The technical services department indicated that this equipment needs overhauling in year 4 or year 5 of its useful life. The overhauling cost will be expected during the year the overhauling is done. The finance officer insists that the overhauling be done in year 4, not in year 5. MSQ-08 - CAPITAL BUDGETING

HILARIO TAN The most likely reason is A. There is lower tax rate in year 5. B. There is higher tax rate in year 5.

C. The time value of money is considered. D. Due to statements A and C above.

15. In an investment in plant the return that should keep the market price of the firm stock unchanged is A. Cost of capital C. Net present value B. Discounted rate of return D. Payback 16. If a firm identifies (or creates) an investment opportunity with a present value its cost, the value of the firm and the price of its common stock will A. B. C. D. List A Equal to Equal to Greater than Greater than List B Decrease Increase Decrease Increase 17. The common assumption in capital budgeting analysis is that cash inflows occur in lump sums at the end of individual years during the life of an investment project when in fact they flow more or less continuously during those years A. Results in understated estimates of NPV. B. Results in higher estimate for the IRR on the investment. C. Is done because present value tables for continuous flows cannot be constructed. D. Will result in inconsistent errors being made on estimating NPVs such that project cannot be evaluated reliably. 18. Polo Co. requires higher rates of return for projects with a life span greater than 5 years. Projects extending beyond 5 years must earn a higher specified rate of return. Which of the following capital budgeting techniques can readily accommodate this requirement? A. B. C. D. Internal Rate of Return Yes Yes No No Net Present Value Yes No Yes No

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MANAGEMENT ADVISORY SERVICES 19. Payback period (PP), profitability index (PI), and simple accounting rate of return (SARR) are some of the capital budgeting techniques. What is the effect of an increase in the cost of capital on these techniques? A. B. C. D. PP Decrease Increase No change No change PI No change Decrease Decrease Increase SARR No change Increase No change Decrease Net Present Value 20. A company had made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be A. The after-tax cost of new-debt financing. C. The cost of equity financing. B. The before-tax cost of new-debt financing. D. The weighted-average cost of capital. 21. All of the following refer to the discount rate used by a firm in capital budgeting except A. Hurdle rate. C. Opportunity cost of capital. B. Opportunity cost. D. Required rate of return. 22. The excess present value method is anchored on the theory that the future returns, expressed in terms of present value, must at least be A. Equal to the amount of investment C. More than the amount of investment B. Less than the amount of investment D. Cannot be determined 23. An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method A. Computes a desired rate of return for capital projects. C. Uses a discount rate that equates the discounted cash inflows with the outflows. D. Uses discounted cash flows whereas the internal rate of return model does not. B. Can be used when there is no constant rate of return required for each year of the project.

MSQ-08 - CAPITAL BUDGETING

HILARIO TAN 24. When using the net present value method for capital budgeting analysis, the required rate of return is called all of the following except the A. Cost of capital. C. Discount rate. B. Cutoff rate. D. Risk-free rate. 25. A project’s net present value, ignoring income tax considerations, is normally affected by the A. Proceeds from the sale of the asset to be replaced. B. Carrying amount of the asset to be replaced by the project. C. Amount of annual depreciation on the asset to be replaced. D. Amount of annual depreciation on fixed assets used directly on the project. 26. You have determined the profitability of a planned project by finding the present value of all the cash flows from that project. Which of the following would cause the project to look less appealing, that is, have a lower present value? A. The discount rate increases. B. The cash flows are extended over a longer period of time. C. The cash flows are accelerated and the project life is correspondingly shortened. D. The investment cost decreases without affecting the expected income and life of the project. 27. Which of the following is always true with regard to the net present value (NPV) approach? A. The NPV and the IRR approaches will always rank projects in the same order. B. The NPV and payback approaches will always rank projects in the same order. C. If a project is found to be acceptable under the NPV approach, it would also be acceptable under the payback approach. D. If a project is found to be acceptable under the NPV approach, it would also be acceptable under the internal rate of return (IRR) approach. 28. Velasquez & Co. is considering an investment proposal for P10 million yielding a net present value of P450,000. The project has a life of 7 years with salvage value of P200,000. The company uses a discount rate of 12%. Which of the following would decrease the net present value? Page 3 of 14

MANAGEMENT ADVISORY SERVICES A. B. C. D.

Increase the salvage value. Increase discount rate to 15%. Extend the project life and associated cash inflows. Decrease the initial investment amount to P9.0 million.

Profitability Index 29. What is the effect of changes in cash inflows, investment cost and cash outflows on profitability (present value) index (PI) A. PI will increase with an increase in cash inflows, a decrease in investment cost, or a decrease in cash outflows. B. PI will increase with an increase in cash inflows, an increase in investment cost, or an increase in cash outflows. C. PI will decrease with an increase in cash inflows, a decrease in investment cost, or a decrease in cash outflows. D. PI will decrease with an increase in cash outflows, an increase in investment cost, or an increase in cash inflows. Internal Rate of Return 30. Which of the following characteristics represent an advantage of the internal rate of return techniques over the accounting rate of return technique in evaluating a project? I Recognition of the project’s salvage value. II Emphasis on cash flows. III Recognition of the time value of money. A. I only. C. II and III. B. I and II. D. I, II, and III. 31. How are the following used in the calculation of the internal rate of return of a proposed project? Ignore income tax considerations. A. B. C. D. Residual sales value of project Include Include Exclude Exclude Depreciation expense Include Exclude Include Exclude MSQ-08 - CAPITAL BUDGETING

HILARIO TAN 32. The discount rate that equates the present value of the expected cash flows with the cost of the investment is the A. Accounting rate of return C. Net present value B. Internal rate of return D. Payback period. 33. A company has analyzed seven new projects, each of which has its own internal rate of return. It should consider each project whose internal rate of return is _____ its marginal cost of capital and accept those projects in _____ order of their internal rate of return. A. Above; decreasing. C. Below; decreasing. B. Above; increasing. D. Below; increasing. Relationship of NPV, PI & IRR 34. Which of the following combinations is NOT possible? Profitability Index NPV A. Equals 1 Zero B. Greater than 1 Positive C. Less than 1 Negative D. Less than 1 Positive

IRR Equals cost of capital More than cost of capital Less than cost of capital Less than cost of capital

Investment Decisions – Independent Projects 35. A company is evaluating three possible investments. Information relating to the company and the investments follow: Fisher rate for the three projects 7% Cost of capital 8% Based on this information, we know that A. all three projects are acceptable. B. none of the projects are acceptable. C. the net present value method will provide a ranking of the projects that is superior to the ranking obtained using the internal rate of return method. D. the capital budgeting evaluation techniques profitability index, net present value, and internal rate of return will provide a consistent ranking of the projects. Page 4 of 14

MANAGEMENT ADVISORY SERVICES Investment Decisions – Mutually Exclusive Projects 36. When ranking two mutually exclusive investments with different initial amounts, management should give first priority to the project A. That has the greater profitability index. B. That has the greater accounting rate of return. C. Whose net after-tax flows equal the initial investment. D. That generates cash flows for the longer period of time. 37. Which mutually exclusive project would you select, if both are priced at $1,000 and your discount rate is 15%; Project A with three annual cash flows of $1,000, or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A. Project A. B. Project B. C. The IRRs are equal, hence you are indifferent. D. The NPVs are equal, hence you are indifferent. Investment Decisions – Capital Rationing 38. Capital budgeting methods are often divided into two classifications: project screening and project ranking. Which one of the following is considered a ranking method rather than a screening method? A. Accounting rate of return. C. Profitability index. B. Net present value. D. Time-adjusted rate of return. 39. Several proposed capital projects which are economically acceptable may have to be ranked due to constraints in financial resources. In ranking these projects, the least pertinent is this statement. A. If the internal rate of return method is used in the capital rationing problem, the higher the rate, the better the project. B. If the net present value method is used, the profitability index is calculated to rank the projects. The lower the index, the better the project. C. In selecting the required rate of return, one may either calculate the organization’s cost of capital or use a rate generally acceptable in the industry. MSQ-08 - CAPITAL BUDGETING

HILARIO TAN D. A ranking procedure on the basis of quantitative criteria may be established by specifying a minimum desired rate of return, which rate is used in calculating the net present value of each project. Optimal Capital Budget 40. An optimal capital budget is determined by the point where the marginal cost of capital is A. Minimized. B. Equal to the average cost of capital. C. Equal to the rate of return on total assets. D. Equal to the marginal rate of return on investment.

PROBLEMS Net Investments 1. Acme is considering the sale of a machine with a book value of $80,000 and 3 years remaining in its useful life. Straight-line depreciation of $25,000 annually is available. The machine has a current market value of $100,000. What is the cash flow from selling the machine if the tax rate 40%. A. $25,000 C. $92,000 B. $80,000 D. $100,000 2

Hatchet Company is considering replacing a machine with a book value of $400,000, a remaining useful life of 5 years, and annual straight-line depreciation of $80,000. The existing machine has a current market value of $400,000. The replacement machine would cost $550,000, have a 5-year life, and save $75,000 per year in cash operating costs. If the replacement machine would be depreciated using the straight-line method and the tax rate is 40%, what would be the net investment required to replace the existing machine? A. $90,000. C. $330,000 B. $150,000 D. $550,000 Page 5 of 14

MANAGEMENT ADVISORY SERVICES 3. Diliman Republic Publishers, Inc. is considering replacing an old press that cost P800,000 six years ago with a new one that would cost P2,250,000. Shipping and installation would cost an additional P200,000. The old press has a book value of P150,000 and could be sold currently for P50,000. The increased production of the new press would increase inventories by P40,000, accounts receivable by P160,000 and accounts payable by P140,000. Diliman Republic’s net initial investment for analyzing the acquisition of the new press assuming a 35% income tax rate would be A. P2,250,000 C. P2,450,000 B. P2,425,000 D. P2,600,000 4. Key Corp. plans to replace a production machine that was acquired several years ago. Acquisition cost is P450,000 with salvage value of P50,000. The machine being considered is worth P800,000 and the supplier is willing to accept the old machine at a trade-in value of P60,000. Should the company decide not to acquire the new machine, it needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in transaction will not have any implication but the cost to repair is tax-deductible. The effective corporate tax rate is 35% of net income subject to tax. For purposes of capital budgeting, the net investment in the new machine is A. P540,000 C. P660,000 B. P610,000 D. P800,000 5. Great Value Company is planning to purchase a new machine costing P50,000 with freight and installation costs amounting to P1,500. The old unit is to be traded-in will be given a trade-in allowance of P7,500. Other assets that are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P3,000. The loss on retirement of these other assets is P1,000 which will reduce income taxes of P400. If the new equipment is not purchased, repair of the old unit will have to be made at an estimated cost of P4,000. This cost can be avoided by purchasing the new equipment. Additional gross working capital of P12,000 will be needed to support operation planned with the new equipment. The net investment assigned to the new machine for decision analysis is A. P50,200 C. P53,600 B. P52,600 D. P57,600 MSQ-08 - CAPITAL BUDGETING

HILARIO TAN 6. It is the start of the year and St. Tropez Co. plans to replace its old sing-along equipment. These information are available: Old New Equipment cost P70,000 P120,000 Current salvage value 10,000 Salvage value, end of useful life 2,000 16,000 Annual operating costs 56,000 38,000 Accumulated depreciation 55,300 Estimated useful life 10 years 10 years The company’s income tax rate is 35% and its cost of capital is 12%. What is the present value of all the relevant cash flows at time zero? A. (P54,000) C. (P120,000) B. (P110,000) D. (P124,700) Operating Cash Flows After Tax 7. C Corp. faces a marginal tax rate of 35 percent. One project that is currently under evaluation has a cash flow in the fourth year of its life that has a present value of $10,000 (after-tax). C Corp. assumes that all cash flows occur at the end of the year and the company uses 11 percent as its discount rate. What is the pre-tax amount of the cash flow in year 4? (Round to the nearest dollar.) A. $9,868 C. $23,356 B. $15,181 D. $43,375 8. Maxwell Company has an opportunity to acquire a new machine to replace one of its present machines. The new machine would cost $90,000, have a 5-year life, and no estimated salvage value. Variable operating costs would be $100,000 per year. The present machine has a book value of $50,000 and a remaining life of 5 years. Its disposal value now is $5,000, but it would be zero after 5 years. Variable operating costs would be $125,000 per year. Ignore income taxes. Considering the 5 years in total, what would be the difference in profit before income taxes by acquiring the new machine as opposed to retaining the present one? A. $10,000 decrease C. $35,000 increase B. $15,000 decrease D. $40,000 increase Page 6 of 14

MANAGEMENT ADVISORY SERVICES End-of-Life Cash Flows 9. Lor Industries is analyzing a capital investment proposal for new machinery to produce a new product over the next ten years. At the end of the ten years, the machinery must be disposed of with a zero net book value but with a scrap salvage value of P20,000. It will require some P30,000 to remove the machinery. The applicable tax rate is 35%. The appropriate “end-oflife” cash flow based on the foregoing information is A. Inflow of P30,000. C. Outflow of P10,000. B. Outflow of P6,500. D. Outflow of P17,000. 10. A project under consideration by the White Corp. would require a working capital investment of $200,000. The working capital would be liquidated at the end of the project's 10-year life. If White Corp. has an after-tax cost of capital of 10 percent and a marginal tax rate of 30 percent, what is the present value of the working capital cash flow expected to be received in year 10? A. $23,130 C. $53,970 B. $36,868 D. $77,100 Accounting Rate of Return 11. Lyben Inc. is planning to produce a new product. To do this, it is necessary to acquire a new equipment that will cost the company P100,000. The estimated life of the new equipment is five years with no salvage value. The estimated income and costs based on expected sales of 10,000 units per year are: Sales @ P10.00 per unit P100,000 Costs @ P8.00 per unit 80,000 Net income P 20,000 The accounting rate of return based on initial investment is 20% What will be the accounting rate of return based on initial investment of P100,000 if management decrease its selling price of the new product by 10%? A. 5% C. 15% B. 10% D. 20%

MSQ-08 - CAPITAL BUDGETING

HILARIO TAN 12. Hooker Oak Furniture Company is considering the purchase of wood cutting equipment. Data on the equipment are as follows: Original investment $30,000 Net annual cash inflow $12,000 Expected economic life in years 5 Salvage value at the end of five years $3,000 The company uses the straight-line method of depreciation with no mid-year convention. What is the accounting rate of return on original investment rounded off to the nearest percent, assuming no taxes are paid? A. 20.0% C. 24.0% B. 22.0% D. 40.0% Payback Period 13. APJ, Inc. is planning to purchase a new machine that will take six years to recover the cost. The new machine is expected to produce cash flow from operations, net of income taxes, of P4,500 a year for the first three years of the payback period and P3,500 a year of the last three years of the payback period. Depreciation of P3,000 a year shall be charged to income of the six years of the payback period. How much shall the machine cost? A. P12,000 C. P24,000 B. P18,000 D. P36,000 14. Sweets, Etc., Inc. plans to undertake a capital expenditure requiring P2 million cash outlay. Below are the projected after-tax cash inflow for the five year period covering the useful life. The company’s tax rate is 35%. Year 1 2 3 4 P’000 600 700 480 400 The founder and president of the candy company believes that the best gauge for capital expenditure is cash payback period and that the recovery period should not be more than 75% of the useful life of the project or the asset. Should the company undertake the project? A. No, since the payback period extends beyond the life of the project. B. No, since the payback period is 4 years or 80% of the useful life of the project. C. Yes, since the payback period is 3.55 years or 71% of the useful life of the project. D. Yes, since the payback period is 4 years and still shorter than the useful life of the project. Page 7 of 14

MANAGEMENT ADVISORY SERVICES Bailout Payback 15. Womark Company purchased a new machine on January 1 of this year for $90,000, with an estimated useful life of 5 years and a salvage value of $10,000. The machine will be depreciated using the straight-line method. The machine is expected to produce cash flow from operations, net of income taxes, of $36,000 a year in each of the next 5 years. The new machine’s salvage value is $20,000 in years 1 and 2, and $15,0000 in years 3 and 4. What will be the bailout period (rounded) for the new machine? A. 1.4 years. C. 2.2 years. B. 1.9 years. D. 3.4 years. Net Present Value 16. The McNally Co. is considering an investment in a project that generates a profitability index of 1.3. The present value of the cash inflows on the project is $44,000. What is the net present value of this project? A. $10,154 C. $33,846 B. $13,200 D. $57,200 17. The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $50,000. The machine is expected to have zero value at the end of the four-year period. What is the net present value of the investment? Would the company want to purchase the new machine? Income taxes are not considered. A. $69,550; no C. $326,750; no B. $119,550; yes D. $1,019,550; yes 18. Drillers Inc. is evaluating a project to produce a high-tech deep-sea oil exploration device. The investment required is $80 million for a plant with a capacity of 15,000 units a year for 5 years. The device will be sold for a price of $12,000 per unit. Sales are expected to be 12,000 units per year. The variable cost is $7,000 and fixed costs, excluding depreciation, are $25 million per year. Assume Drillers employs straight-line depreciation on all depreciable assets, and assume that they are taxed at a rate of 36%. MSQ-08 - CAPITAL BUDGETING

HILARIO TAN If the required rate of return is 12%, what is the approximate NPV of the project? A. $17,225,000 C. $26,780,000 B. $21,511,000 D. $56,117,000 19. JJ Corp. is considering the purchase of a new machine that will cost P320,000. It has an estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the second year, and 30% in the third year. It has a resale value of P20,000 at the end of its economic life. Savings are expected from the use of machine estimated at P170,000 annually. The company has an effective tax rate of 40%. It uses 16% as hurdle rate in evaluating capital projects. Should the company proceed with the P320,000 capital investment? Year Present Value of P1 Present Value of an Ordinary Annuity of P1 1 0.862 0.862 2 0.743 1.605 3 0.641 2.246 A. Yes, due to NPV of P6,556. C. Yes, due to NPV of P61,820. B. Yes, due to NPV of P11,684. D. No, due to negative NPV of P1,136 20. The following forecasts have been prepared for a new investment by Oxford Industries of $20 million with an 8-year life: Pessimistic Expected Optimistic Market size 60,000 90,000 140,000 Market share, % 25 30 35 Unit price $750 $800 $875 Unit variable cost $500 $400 $350 Fixed cost, millions $7 $4 $3.5 Assume that Oxford employs straight-line depreciation, and that they are taxed at 35%. Assuming an opportunity cost of capital of 14%, what is the NPV of this project, based on expected outcomes? A. $2,626,415 C. $6,722,109 B. $4,563,505 D. $8,055,722 Page 8 of 14

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HILARIO TAN

21. Cramden Armored Car Co. is considering the acquisition of a new armored truck. The truck is expected to cost $300,000. The company's discount rate is 12 percent. The firm has determined that the truck generates a positive net present value of $17,022. However, the firm is uncertain as to whether it has determined a reasonable estimate of the salvage value of the truck. In computing the net present value, the company assumed that the truck would be salvaged at the end of the fifth year for $60,000. What expected salvage value for the truck would cause the investment to generate a net present value of $0? Ignore taxes. A. $0 C. $42,978 B. $30,000 D. $55,278

24. Berry Products is considering two pieces of machinery. The first machine costs P50,000 more than the second machine. During the two-year life of these two alternatives, the first machine has P155,000 more cash flow in year one and a P110,000 less cash flow in year two than the second machine. All cash flows occur at year-end. The present value of 1 at 15% end of 1 period and 2 periods are 0.86957 and 0.75614, respectively. The present value of 1 at 8% end of period 1 is 0.92593 and period 2 is 0.85734. At what discount rate would Machine 1 equally acceptable as machine 2? A. 9% C. 11% B. 10% D. 12%

22. Rohan Transport is considering two alternative buses to transport people between cities that are in the Southeastern U.S., such as Baton Rouge and Gainesville. A gas-powered bus has a cost of $55,000, and will produce end-of-year net cash flows of $22,000 per year for 4 years. A new electric bus will cost $90,000, and will produce cash flows of $28,000 per year for 8 years. The company must provide bus service for 8 years, after which it plans to give up its franchise and to cease operating the route. Inflation is not expected to affect either costs or revenues during the next 8 years. If Rohan Transport's cost of capital is 17 percent, by what amount will the better project increase the company's value? A. -$17,441 C. $10,701 B. $5,350 D. $27,801

Internal Rate of Return 25. Smoot Automotive has implemented a new project that has an initial cost, and then generates inflows of $10,000 a year for the next seven (7) years. The project has a payback period of 4.0 years. What is the project's internal rate of return (IRR)? A. 14.79% C. 16.33% B. 15.61% D. 18.54%

23. Union Electric Company must clean up the water released from its generating plant. The company's cost of capital is 11 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects. Clean-Up Plan A, which is of average risk, has an initial cost of $10 million, and its operating cost will be $1 million per year for its 10-year life. Plan B, which is a high-risk project, has an initial cost of $5 million, and its annual operating cost over Years 1 to 10 will be $2 million. What is the approximate PV of costs for the better project? (VD) A. -$5.9 million. C. -$16.8 million. B. -$15.9 million. D. -$17.8 million. Fisher rate MSQ-08 - CAPITAL BUDGETING

26. MLF Corporation is evaluating the purchase of a P500,000 die attach machine. The cash inflows expected from the investment is P145,000 per year for five years with no equipment salvage value. The cost of capital is 12%. The net present value factor for five (5) years at 12% is 3.6048 and at 14% is 3.4331. The internal rate of return for this investment is A. 2.04% C. 13.8% B. 3.45% D. 15.48% 27. The Zeron Corporation recently purchased a new machine for its factory operations at a cost of $921,250. The investment is expected to generate $250,000 in annual cash flows for a period of six years. The required rate of return is 14%. The old machine has a remaining life of six years. The new machine is expected to have zero value at the end of the six-year period. The disposal value of the old machine at the time of replacement is zero. What is the internal rate of return? A. 15% C. 17% B. 16% D. 18% Page 9 of 14

MANAGEMENT ADVISORY SERVICES 28. A tax-exempt foundation, Sincerely Foundation, Inc. intends to invest P1 million in a five-year project. The foundation estimates that the annual savings from the project will amount to P325,000. The P1 million asset is depreciable over five (5) years on a straight-line basis. The foundation’s hurdle rate is 12% and as a consultant of the foundation, you are asked to determine the internal rate of return and advise if the project should be pursued. To facilitate computations, below are present value factors: N=5 12% 14% 16% Present value of P1 0.57 0.52 0.48 Present value of an annuity of P1 3.60 3.40 3.30 Your advice is A. To proceed due to an estimated IRR of more than 16%. B. Not to proceed due to an estimated IRR of less than 12%. C. To proceed due to an estimated IRR of less than 14% but not more than 12%. D. To proceed due to an estimated IRR of less than 16% but not more than 14%. 29. Para Co. is reviewing the following data relating to an energy saving investment proposal: Cost $50,000 Residual value at the end of 5 years 10,000 Present value of an annuity of 1 at 12% for 5 years 3.60 Present value of 1 due in 5 years at 12% 0.57 What would be the annual savings needed to make the investment realize a 12% yield? A. $8,189 C. $12,306 B. $11,111 D. $13,889 30. Payback Company is considering the purchase of a copier machine for P42,825. The copier machine will be expected to be economically productive for 4 years. The salvage value at the end of 4 years is negligible. The machine is expected to provide 15% internal rate of return. The company is subject to 40% income tax rate. The present value of an ordinary annuity of 1 for 4 periods is 2.85498. In order to realize the IRR of 15%, how much is the estimated before-tax cash inflow to be provided by the machine? A. P15,000 C. P25,000 B. P17,860 D. P35,700 MSQ-08 - CAPITAL BUDGETING

HILARIO TAN 31. Salvage Co. is considering the purchase of a new ocean-going vessel that could potentially reduce labor costs of its operation by a considerable margin. The new ship would cost $500,000 and would be fully depreciated by the straight-line method over 10 years. At the end of 10 years, the ship will have no value and will be sunk in some already polluted harbor. The Salvage Co.'s cost of capital is 12 percent, and its marginal tax rate is 40 percent. If the ship produces equal annual labor cost savings over its 10-year life, how much do the annual savings in labor costs need to be to generate a net present value of $0 on the project? (Round to the nearest dollar.) A. $68,492 C. $114,154 B. $88,492 D. $147,487 32. A company is considering putting up P50,000 in a three-year project. The company’s expected rate of return is 12%. The present value of P1.00 at 12% for one year is 0.893, for two years is 0.797, and for three years is 0.712. The cash flow, net of income taxes will be P18,000 (present value of P16,074) for the first year and P22,000 (present value of P17,534) for the second year. Assuming that the rate of return is exactly 12%, the cash flow, net of income taxes, for the third year would be A. P7,120 C. P16,392 B. P10,000 D. P23,022 33. The following data pertain to Sunlight Corp., whose management is planning to purchase an automated tanning equipment. 1. Economic life of equipment – 8 years. 2. Disposal value after 8 years – nil. 3. Estimated net annual cash inflows for each of the 8 years – P81,000. 4. Time-adjusted internal rate of return – 14% 5. Cost of capital of Sunlight Corp – 16% 6. The table of present values of P1 received annually for 8 years has these factors: at 14% = 4.639, at 16% = 4.344 7. Depreciation is approximately P46,970 annually.

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MANAGEMENT ADVISORY SERVICES

HILARIO TAN

Find the required increase in annual cash inflows in order to have the time-adjusted rate of return approximately equal the cost of capital. A. P4,344 C. P5,871 B. P5,501 D. P6,501 34. Booker Steel Inc. is considering an investment that would require an initial cash outlay of $400,000 and would have no salvage value. The project would generate annual cash inflows of $75,000. The firm's discount rate is 8 percent. How many years must the annual cash flows be generated for the project to generate a net present value of $0? A. between 5 and 6 years C. between 7 and 8 years B. between 6 and 7 years D. between 8 and 9 years Project Screening – Independent Projects 35. The following data relate to two capital-budgeting projects of equal risk: Present Value of Cash Flows Period Project A Project B 0 $(10,000) $(30,000) 1 4,550 13,650 2 4,150 12,450 3 3,750 11,250 Which of the projects will be selected using the profitability index (PI) approach and the NPV approach? A. B. C. D. PI B Either Either B NPV A B A B Project Screening – Mutually Exclusive Projects 36. Five mutually exclusive projects had the following information: A B NPV $500 $(200) IRR 12% 8% MSQ-08 - CAPITAL BUDGETING

C $200 13%

D $1,000 10%

Which project is preferred? A. A B. B

C. C D. D

Capital Rationing & Optimal Capital Budget 37. Information on three (3) investment projects is given below: Project Investment Required Net Present Value X P150,000 P34,005 G 100,000 22,670 W 60,000 13,602 Rank the projects in terms of preference: A. 1st W; 2nd G; 3rd X. C. 1st X; 2nd G; 3rd W. B. 1st G; 2nd W; 3rd X. D. The ranking is the same. 38. Telephone Corp. is contemplating four projects: L, M, N, and O. The capital costs for the initiation of each mutually-exclusive project and its estimated after-tax, net cash flow are listed below. The company’s desired after-tax opportunity costs is 12%. It has P900,000 capital budget for the year. Idle funds cannot be reinvested at greater than 12%. In Thousand Pesos L M N O Initial cost 400 470 380 420 Annual cash flows Year 1 113 180 90 80 2 113 170 110 100 3 113 150 130 120 4 113 110 140 130 5 113 100 150 150 Net present value Internal rate of return Excess present value index

P7,540 12.7% 1.02

P59,654 17.6% 1.13

P54,666 17.2% 1.14

P(15,708) 10.6% 0.96 Page 11 of 14

MANAGEMENT ADVISORY SERVICES The company will choose A. Projects L & M. B. Projects L & N.

HILARIO TAN C. Projects M & N. D. Projects M, N & O.

39. The Nativity Corporation has the following investment opportunities: Proposal Profitability Index Initial Cash Outlay 1 1.15 P200,000 2 1.13 125,000 3 1.11 175,000 4 1.08 150,000 The firm has a budget constraint of P300,000. What proposal(s) should be accepted? A. Proposal 4 because it has the lowest profitability index. B. Proposal 1 because it has the highest profitability index. C. Proposals 1 and 2 because their total net present values are the highest among all possible proposal combinations. D. Proposals 2 and 3 because their total net present values are the highest among all possible proposal combinations. 40. A company's marginal cost of new capital (MCC) is 10% up to $600,000. MCC increases .5% for the next $400,000 and another .5% thereafter. Several proposed capital projects are under consideration, with projected cost and internal rates of return (IRR) as follows: Project Cost IRR A $100,000 10.5% B $300,000 14.0% C $450,000 10.8% D $350,000 13.5% E $400,000 12.0% What should the company's capital budget be? A. $0 C. $1,500,000 B. $1,050,000 D. $1,600,000 MSQ-08 - CAPITAL BUDGETING

41. Mulva Inc. is considering the following five independent projects: Project Required Amount of Capital IRR A $300,000 25.35% B 500,000 23.22% C 400,000 19.10% D 550,000 9.25% E 650,000 8.50% The company has a target capital structure which is 40 percent debt and 60 percent equity. The company can issue bonds with a yield to maturity of 10 percent. The company has $900,000 in retained earnings, and the current stock price is $40 per share. The flotation costs associated with issuing new equity are $2 per share. Mulva's earnings are expected to continue to grow at 5 percent per year. Next year's dividend (D1) is forecasted to be $2.50. The firm faces a 40 percent tax rate. What is the size of Mulva's capital budget? A. $800,000 C. $1,750,000 B. $1,200,000 D. $2,400,000 Comprehensive Problem 42 and 43 are based on the following information. Daneche’s, a tax-exempt entity, plans to purchase a new machine which they project to depreciate over a ten-year period without salvage value. The new machine will cost P200,000 and is expected to generate cash savings of P60,000 per year in operating costs. Daneche's cost of capital is 12%. For ten periods at 12%, the present value of P1 is P0.3220, while the present value of an ordinary annuity of P1 is P5.650. 42. What is the net present value of the proposed investment, assuming Daneche uses a 12% discount rate? A. P69,980 C. P185,640 B. P139,000 D. None of the above. 43. With the company’s initial investment on the new machine, the accounting rate of return is A. 15% C. 25% B. 20% D. None of the above. Page 12 of 14

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Questions 43 and 44 are based on the following information. The construction of a waste treatment plant was arrived at after a careful cost-benefit analysis. During the construction period a status report was presented for your review:  completed cost as originally estimated, P5 million  % of actual completion to date, 65%  actual cost to date, P3.75 million 44. Assuming cost is evenly distributed throughout the construction period, how much will the completion cost be most likely? A. The original cost estimate of P5 million. B. P5 million plus a cost overrun of about P769,000 C. P500,000 less than the original cost at completion. D. About P100,000 above the original cost at completion. 45. What would be an appropriate action to take considering the situation in number 28? A. No need to take any action. B. Immediately stop further work on the project. C. Wait for the next quarterly status report on the project. D. Recommend immediate review with the project implementation team to determine the cause of overrun and the corrective actions to be taken. Questions 46 and 47 are based on the following information. Beta Company plans to replace its company car with a new one. The new car costs P120,000 and its estimated useful life is five years without scrap value. The old car has a book value of P15,000 and can be sold at P12,000. The acquisition of the new car will yield annual cash savings of P20,000 before income tax. Income tax rate is 25%. (M) 46. The net investment of the new car is A. P107,000 B. P107,250

MSQ-08 - CAPITAL BUDGETING

C. P108,000 D. P108,750

47. The payback period of the investment is (M) A. 5.095 years B. 5.11 years

C. 5.14 years D. 5.18 years

Questions 48 through 55 are based on the following information. The Burgos Corporation is considering investing in a project. It requires an immediate cash outlay of P100,000. It has a life of four years and will be depreciated on a straight-line basis (no salvage value). The firm’s tax rate is 25% and requires a return of 10%. Income before depreciation is projected to be: YEAR 1 2 3 4 Income before depreciation P30,000 P30,000 P40,000 P40,00 0 The present value factors for P1 at 10% is Year 1 2 3 4 Present Value Factor 0.909 0.826 0.751 0.683 48. The net cash flow for year 1 is A. P25,850 B. P28,750

C. P31,250 D. P34,450

49. The net cash flow for year 4 is A. P30,150 B. P35,850

C. P35,950 D. P36,250

50. The payback period for the project is A. 3 years B. 3.17 years

C. 3.5 years D. 4 years.

51. The accounting rate of return of the project is A. 7% C. 12% B. 9% D. 15% Page 13 of 14

MANAGEMENT ADVISORY SERVICES 52. The present value of year two’s cash flow is A. P23,747.50 B. P25,856.25

HILARIO TAN

C. P26,100.75 D. P29,750.75

53. The present value of the project’s net cash flow is A. P95,650.15 C. P101,863.75 B. P98,151.25 D. P104,750.25 54. The profitability index of the project (rounded to the nearest hundredth) is A. 0.96 C. 1.02 B. 0.98 D. 1.05 55. The project would be accepted on the basis of the A. Payback and present value results. B. Accounting rate of return and profitability index results. C. Payback results only D. A and B combined

MSQ-08 - CAPITAL BUDGETING

Theory 1. D 2. B 3. D 4. C 5. C 6. D 7. D 8. A 9. D 10. D 11. B 12. C 13. D 14. A 15. A 16. D 17. A 18. A 19. C 20. D

21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

B A B D A A D B A C B B A D D A A C B D

Problem 1. C 2. B 3. B 4. B 5. A 6. B 7. C 8. D 9. B 10. D 11. B 12. B 13. C 14. C 15. B 16. A 17. B 18. B 19. B 20. B

21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

B D B B C C B A C B C D B C B D D C D B

41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55.

C B B B D B B B D B D A C C D

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