AE 23-CAPITAL BUDGETING/CAPITAL INVESTMENT DECISIONS

A. COST OF INVESTMENT/CASH FLOWS

1) ABC Company is expanding its manufacturing plant, which requires an investment of P4.0M in new equipment
and plant modifications. ABC's sales are expected to increase by P3.0M per year as a result of the expansion.
Cash investment in current assets average 30% of sales; accounts payable and other current liabilities are 10% of
sales. What is the estimated total investment for the expansion?

2) ABC Company is deciding whether to purchase a new equipment costing P135,000 and replace an old one
purchased 10 years ago. The old equipment had a cost of P81,000 and has a remaining useful life of 6 years.
Based on market studies, the old equipment can be sold for P52,000. ABC Company pays tax at the rate of 30%
of income before tax. What is the net cash investment at the time of purchase of the new equipment?

3) ABC Company is replacing a machine purchased 5 years ago for P45,000 with a new one with cost of P75,000
cash. The old machine is being depreciated on a straight line basis over 15 years to a zero-salvage value. ABC will
sell the old equipment to a third party for P18,000 cash. The new equipment will be depreciated on straight line
basis over 10 years to a zero salvage value. Assuming a 30% tax rate, ABC's net cash investment on the new
machine is _____________.

4) ACR Company is planniing to buy a doughnut 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 machine will be depreciated using straight line basis for 5 years to a zero salvage value. The company's
tax rate is 32%.
a) What is the expected annual return (accoounting net income) to be earned from the doughnut making machine?
b) What is the annual net cash inflow from the machine?

5) ABC Printers is planning to replace its present printing equipment with a more efficient unit. The new equipment
will cost P400,000, with a 5 year useful life and zero 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 printer is being depreciated at P62,500 per year. If the new printer
is acquired, the old one will be sold for P100,000. Otherwise, the company will just continue using it for 5 years.

Cash operating costs are P100,000 and P220,000 for the new and old equipments, respectively. Income tax
rate is 32%.
a) The increase in annual net income as a result of acquiring the new equipment is ______________
b) What is the expected increase in annual net cash inflows if the new equipment is acquired?
c) What is the net cost of investment in the new machine for decision making purposes?

B. ACCOUNTING RATE OF RETURN

1) An investment of P600,000 provides an average net cash flow of P38,400. Depreciation is P4,200 per year.
What is the accounting rate of return using the amount of original investment?

2) R. Santos is considering investing P250,000 in a project with the following projected annual cash revenue and
expenses. Year Cash revenue Cash expenses
1 P 100,000 P 100,000
2 150,000 100,000
3 187,500 112,500
4 250,000 125,000
5 250,000 125,000
Depreciation will be P50,000 per year. What is the accounting rate of return on the investment?
3) ABC Company is considering the purchase of a used machine for P500,000. The machine would generate a net
cash inflow of P200,000 per year for 5 years. The machine has no salvage value. The company's cost of capital is
12%., The company uses straight line basis in computing depreciation.
What is the accounting rate of return on the original investment assuming no taxes are paid.

4) A. David is considering the purhase of a new equipment that will cost P640,000 and have a life of 5 years with no
residual value. The expected cash flows from the new equipment will be:
Year Cash revenues Cash expense and depreciation
1 P 600,000 P 360,000
2 600,000 360,000
3 600,000 360,000
4 600,000 360,000
5 600,000 360,000

What is the accounting rate of return on the project?

5) Using the same information in No.4 but the expected cash flows are as follows:
Year Cash revenues Cash expense and depreciation
1 P 250,000 P 150,000
2 375,000 225,000
3 375,000 225,000
4 750,000 450,000
5 750,000 450,000
What is the accounting rate of return on the project?

C. PAYBACK PERIOD
1) A. Cruz has just invested P600,000 in a restaurant business. He expects to receive cash income of P75,000 a
year. What is the payback period?

2) A.Cruz investmed P300,000 in a project that pays her an even amount per year for 10 years. The payback period
is 6 years. What is the annual cash inflow from the project?

3) A. Cruz invested in a project with a payback period of 5 years. The project brings P28,800 per year for a period
of 9 years. What was the cost of the initial investment?

ANSWERS
A. COST OF INVESTMENT/CASH INFLOW
1) Cost of investment 4,000,000
Increase in working capital:
Increase in Current assets (P3.0M x 30%) 900,000
Increase in Current Liabilities (P3.0M x 10) -300,000 600,000
Total cost of investment 4,600,000

2) Cost of new equipment 135,000

Less proceeds from disposal/sale of old equipment:
Sales value 52,000
Less tax on gain on disposal* -1,020 50,080
Net cost of investment 84,920

Selling price(52,000) less book/carrying value (48,600= gain on disposal of - 3,400

tax rate x 30%
tax due on gain 1,020
3) Cost of new machine 75,000
Less proceeds from disposal/sale of old equipment:
Sales value 18,000
Add tax savings on loss on disposal* 3,600 21,600
net cost of investment 53,400

Selling price (18,000) less carrying value (P30,000) = loss on disposal of- 12,000
x tax rate x 30%
Tax savings on loss on sale 3,600

4) Contribution margin (36,000 units x P6) 216,000

Less: cash expenses 56,000
Depreciation of new machine (300,000/5 years) 60,000 116,000
Income before tax 100,000
Less income tax 32,000
Accounting net income 68,000 (a)
Add depreciation 60,000
annual net cash inllow 128,000 (b)

5) Savings in cash operating costs (220,000-100,000) 120,000

Less increase in depreciation:
Depreciation of new machione (400,000/5 years) 80,000
Depreciation of old machine (given in the problem) 62,500 17,500
Net savings before tax 102,500
Less tax (32%) 32,800
Increase /incremental annual income 69,700 (a)
Add increase in annual depeeciation 17,500
Increase in annual net cash inflow 87,200 (b)

Cost of new machine 400,000

Less proceeds from disposal of new machine:
Sales value 100,000
add tax savings on loss on disposal* 68,000 168,000
net cost of investment 232,000 ( c )

Sellng price(P100,000) less carrying value(62,500 x 5 years or P312,500)= loss on disposal- 212,500
tax rate x 32%
tax savings on loss on disposal 68,000

B. ACCOUNTING RATE OF RETURN

1) Accounting net income 34,200
Add depreciation 4,200
Net cash flow 38,400

2) Compute net income for he 5-year period (add depreciation to the cash expenses), then divide total net income
by 5 years. average net income (125,000/5) 25,000
Divide by cost of investment 250,000
Accounting rate of return 10%
3) Accounting net income 100,000
Add depreciation (500,000 / 5 years) 100,000
Annual cash inflow 200,000

ARR (acctg rate of return)= 100,000/500,000 = 20%

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