FINANCIAL MANAGEMENT PART II

CAPITAL BUDGETING

1. Which of the following about capital budgeting and capital budget is incorrect?
a. Capital budgeting is the process of planning expenditures of assets, the return on which are expected to be re -
alized within one year.
b. One capital decision 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 change in the demand for the product so that
the firm may realize full economics benefits when the capital asset is available for use.
d. In capital budgeting, planning is important because of possible change in inflation, the money supply, and in -
terest rates.

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 orga -
nization.
b. Plan that assesses the firm 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.

3. Capital budgeting techniques are least likely to be used in evaluating.

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a. A disinvestment decision, such as a sale of unprofitable business segment.

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b. The acquisition of a new ship by a shipping line.
c. The adoption of the ABC system in allocating costs to product lines.

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d. The implementation of a major advertising program that will have long-term effects the company.

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4. The following items are included in the computation of the net cost investment, except;
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a. The initial cash outlay covering all expenditures on the investment project up to the time when it is ready for
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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.
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a. A book value of the old assets to be replaced.

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5. In evaluating capital investment proposals, the project expected rate of return is compare with a hurdle rate, or a
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desire rate of return. This standard rate may be the weighted-average rate of return 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
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called as
a. Discount rate.
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a. Capital.
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a. Capital expense.
b. Cost of capital.

6. Which of the following statements about cash flow determination for capital budgeting purpose is incorrect?
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a. Relevant opportunity costs are included in the cash flow forecast.

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a. Tax savings due to depreciation expense must be considered.

b. Depreciation is relevant because it affects net income.
c. Change in net working capital should be included in the cash flow forecast
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7. The discounted cash flow model is ordinarily considered the best mode for long-range decision-making. It may be
characterized as follows, except:
a. The discounted cash flow model considers the time value if 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.

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
32% of income before tax.

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 FINANCIAL MANAGEMENT PART II
If the old equipment is sold for P30,000 and the new one is purchased, the net cash investment at the time of pur -
chase of the new one is
118,080
7. 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.

If the new truck purchased, the old truck will be sold as is to another company for P400,000. This old truck was ac-
quired 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 corporation is 32%.

If the new truck is purchased, the net cost of investment for decision-making purpose is
1,398.000

ITEMS 10 and 11 BASED ON THE FOLLOWING INFORMATION:

ACR Company, which operates a school canteen, is planning to buy a doughnut-making machine for P300,000. The

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machine is expected to produce 36,000 units of doughnut per year which can be sold for P10 each. Variable cost to

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produce and sell the doughnut is P4 per unit. Incremental fixed costs, exclusive of deprecation, is estimated at

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P56,000 per year. The doughnut-making machine will be depreciated on a straight-line basis for 5 years to a zero sal -
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vage value. The company pays income tax at a rate of 32%.

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8. What is the expected annual return (accounting net income) to be earned from the doughnut making ma-
chine?
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68,000
1. What is the annual net cash inflows from the doughnut-making machine?
128,000
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ITEMS 12 to 14 ARE BASED ON THE FOLLOWING INFORMATION:

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Fermin Printers, Inc. is planning to replace its present printing equipment with a more efficient unit. The equipment
will cost P400,000, with a five-year useful life, no salvage value
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The old unit was acquired three years ago for P500,000. The company uses the straight-line method in depreciating
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its depreciable assets. The old unit is being depreciated at P63,500 per year. If the new equipment is acquired, the
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old one will be sold for P100,000. Otherwise, the company will just continue it for 5 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.
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1. The increase in annual net income as a result of acquiring the new equipment is
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69,700
2. What is the expected increase in annual net cash inflows if the new equipment is acquired?
87,200
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3. What is the net cost of investment in the new equipment for decision-making purpose?
232,000

ITEMS 15 to 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 P300 million. Its estimated service life is
10 years, wih 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 if depreciation, is estimated at P20 million per year.

Super Carry pays tax at a rate 32% of income before tax.

4. What is the annual net cash inflow from operating SC-20?

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43,680,000

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 FINANCIAL MANAGEMENT PART II
5. In how many years can Super Carry recover the initial cost of investment in SC-20?
6.87 years

6. What is the expected accounting rate return based on initial investment in SC-20
5.89%

7. What is the accounting rate of return based on the average investment in SC-20
10.40%

1. Which of the following statement 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 methods eliminates the disposal value from the payback calculation.
d. The accounting rate of (ARR) method compares the project’s expected ARR with a hurdle rate or a desired
rate of return

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
4 years

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21. A new machine is expected to produce the following after-tax cash inflows over a period of 5 years:

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Year
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Per Year Cumulative

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1 P16,000 P16,000
2 12,000 12,000
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3 20,000 48,000
4 8,000 56,000
5 6,000 62,000
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If the machine will cost P40,000, its payback period is

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2.60 years
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1. A new system will require an increase in working capital of P50,000, but it is expected to generate additional
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sales of P100,000 per year. If the gross profit rate 40% and incremental fixed costs is P20,000 the payback period
in years (ignore income taxes) is
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2.50 years
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ITEMS 23 to 24 ARE BASED ON THE FOLLOWING INFORMATION:

For new equipment acquisition, 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 be-
is

ing evaluated. Data pertaining to the equipment are as follows:

Cost of the equipment 1,800,000
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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
sh

1. To meet Melba C. Corporation’s payback goal, the new equipment must generate savings in annual cash oper -
ating costs of
880,000
2. 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

25. Maliya Corporation is planning to buy a new machine costing P450,000. The new machine’s useful life 5 years.
Its estimated disposal values are:
Year Disposal Value
1. P100,000
2. 100,000
3. 75,000
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4. 75,000

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 FINANCIAL MANAGEMENT PART II
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
1.94 years
26. RPI, Inc., a printing and publishing firm, is considering to invest in another offset printing machine that will
cost P1.80 million. The machine will have a useful life of four (4) years. Its estimated salvage value at the end of
Year 4 is equal to its net book value. Annual fixed running costs total P1,656,000, including straight-line deprecia -
tion pf P420,000

The new machine’s printing capacity estimated at 36 million copies per annum for each of the first two years and
30 million copies for each of the last two years of its life. The company can sell all the copies that the new machine
will print at an average contribution margin of P800 per 10,000 copies. The company is subject to a 32% tax rate.

What is the average accounting rate of return based on the initial investment in the new machine?
37.17%
ITEMS 27 and 28 ARE BASED ON THE FOLLOWING INFORMATION:
Following are selected data pertaining to Sabon Corporation’s Bath Soap division for the year 200A:
Sales P500,000
Variable Costs 300,000
Direct fixed costs P 50,000
Average invested capital 100,000

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Imputed interest rate on average invested capital 10%

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For the year 200Bm the Bath Soap Division is considering to acquire a new soap-making equipment fo

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P150,000. The equipment is expected to result in a decrease of P60,000 in cash operating expenses per year.
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The equipment will be depreciated on a straight-line basis over a period of five year to a zero salvage value.
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26. For the new equipment, the accounting rate of return (ARR) based on initial investment would be
20%
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1. If income tax is ignored, the payback period for the new machine would be
2.50 years
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27. Doodoy Corporation is planning to acquire a new machine that will have an estimated payback period of five
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(5) years. It will be depreciated on a straight-line basis at P10,000 per year. It is expected to produce cash flows
from operations, net of income taxes, of P20,000 per year in each of the first 2 years of the payback period and
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P12,000 per year in each of the last three years of the payback period. Doodoy Corporation is subject to 32% in-
come tax rate.
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How much will the new machine cost?

76,000
28. Boogoy Corporation is planning to invest P420,000 in a new machine which it will depreciate on a straight-
is

line basis over 10 years with zero salvage value. The new machine is expected to generate cash flows from opera -
tions, net of income taxes, of P50,000 per year in each of the first six years and P60,000 per year in each of the last
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four years of its life.

What is the payback period?

8.0 years
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29. Buknay Corporation is planning to purchase a new machine for P140,000. The machine has an estimated use-
ful life for four (4) year with no salvage value. It will be depreciated on a straight-line basis.

In evaluating the proposal to acquire the new machine, the company’s calculated the book value rate of return to be
10% based on the initial investment in the new machine.

The new machine is expected to produce annual net after-tax cash inflows from operation of
49,000

30. Which of the following statements is not correct?

a. In the accounting rate of return method, the investment project’s undiscounted net income is divided by
the original or average investment cost to determine a rate of profitability of the project.
b. The payback method measures the length of time required to complete the return of the original invest-
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 FINANCIAL MANAGEMENT PART II
c. The net present value (NVP) method computes the discounted present value of future cash inflows to de-
termine whether it is greater than the initial cash outflows.
d. The discount rate ordinarily used in present value calculations is the internal rate of return.

33. The capital budgeting technique that considers the time value of money by discounting the project’s future after-
tax cash inflows to time-period zero using the firm’s minimum desired rate of return is the
a. Payback method
b. Net present value method
c. Accounting rate of return method
d. Bailout method

34. Which of the following statements is correct?

a. The net present value method of capital budgeting assumes that ash flows are reinvested at the internal
rate of return.
b. The internal rate of return is the return for which the net present value is greater than zero.
c. The profitability index method considers the time value of money and is computed by dividing the present
value of the future after-tax net cash inflows that have been discounted at the company’s desired discount
rate by the initial cash outlay for the investment
d. The return used in the calculation of the accounting rate of return (ARR) is the expected after-tax net cash
inflows from the project

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35. Capital investment proposal may be subjected to sensitivity analysis, which is a
a. “what if”, trial-and-error technique that determines how a given outcome will change if the original esti-

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mates of the capital budgeting model are changed.
b. Technique that can only be used with capital budgeting evaluation methods that consider the time value of

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money.
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c. “what if” technique that can be used only when cash flows are known with certainty.
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d. Ranking technique that is used to rank capital investment projects.

36. When using the net present value method in an inflationary environment, adjustments should be made to increase
the
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a. Estimated cash flow only.

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b. Discount rate only

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c. Both the estimated cash flows and discount rate.

d. Useful life of the project.
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37. Which of the following is incorrect?

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a. The present value method consider the time value of the cash flows over the life of capital investment
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project.
b. If a firm invests in an investment project with a present value of cash inflows greater than its cost, the
value of the firm and the price of its common stocks will increase.
c. An advantage of the net present value method is that it provides the true rate of return on investment
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d. In capital investment decisions, all the evaluation methods use the net cash inflows as the return, except
the accounting rate of return which uses the acoounting net income.
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38. If an investment project has a profitability index of 1.25, the project’s

a. Cost of capital is greater than its internal rate of return.
b. Discounted cash flow rate of return is 25%.
sh

c. Net present value is positive, meaning that present value of cash inflows is greater than the present value
of the cash outflows
d. Time-adjusted rate of return is greater than its internal rate of return

39. When using the different evaluation techniques in capital investment decision, following are the decision
rules which management may consider, except:
a. Accounting rate of return(ARR) must be greater than the minimum desired rate of return
b. For payback period, the shorter, the better.
c. The internal rate of return must exceed the accounting rate of return
d. The present value of cash inflows must be greater than the present value of cash outflows.

40. Kevin Corporation is considering the purchase of a new machine costing P450,000. The machine will have an eco -
nomic life of 5years with no salvage value at the end of its life. It will be depreciated using the straight-line method
and is expected to produce annual cash flows from operations, net of income taxes, of P150,000. Kevin Corpora -
tion’s cost of capital is 10%. It is subject to an income tax rate of 32%.
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 FINANCIAL MANAGEMENT PART II

What is the net present value of this capital investment project?

118,650
31. Kyla Corporation is planning to buy a new equipment costing P600,000. The equipment will be depreciated
using the straight-lined method over a period of 5 years. It is expected to have a salvage value of P10,000 at the
end of its life.

The equipment will produce annual cash flows from operations, net of income taxes, of P180,000 per year. The in -
come tax rate is 32%. The compan’s hurdle rate is 12%.

What is the net present value?

54,570
2. Ysabelle Corporation is planning to buy production machinery costing P380,000. The machine’s estimated useful
life is five (5) years, with a residual value of P5,000 at the end of its useful life.

Ysabelle Corporation requires a rate of return of 20% and has calculated the following annual cash inflows, net of
income tax, pertaining to the operations of the new machine:
Year Annual Net Cash Inflows
1. P 240,000
2. 120,000

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3. 80,000

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4. 80,000

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5. 80,000
Total
eH w P600,000

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The machine’s net present value is
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22,250
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43. Beatrice Corporation is planning to buy a Sorting Machine for P500,000. The machine will be depreciated over five
(5) year at P100,000 per year. It is expected to produce annual cash flows from operations, before income taxes, of
P200,000. Assuming that Beatrice Corporation uses a discount rate of 14% and that its income tax rate will be 32%
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for all years, the net present value of the machine is

76,744
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ITEMS 44 and 45 ARE BASED ON THE FOLLOWING INFORMATION:

Kingzie Corporation will launch its latest addition to its product line next year. Kingzie Corporation’s managers be -
lieve that the company can sell an average of 35,000 units of the new product per year. The product will be sold at
y

P25 per unit. Its units variable cost is estimated at P10.

ed d
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The new product will require the acquisition of a special equipment costing P300,000 and an increase in working
capital of P80,000. The special equipment will have a six-year useful life with no salvage value at the end of six the
depreciation cost of the special equipment.
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At the end of the life of the special equipment, the company will stop producing and selling the product. Kingzie
Corporation pays income tax at the rate of 32% of income before tax. For capital budgeting purposes, it uses a hur -
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dle rate of 16%.

1. What is the net cost of this investment opportunity?

380,000
sh

2. What is the net present value of this investment opportunity?

150,275
ITEMS 46 AND 47 ARE BASED ON THE FOLLOWING INFORMATION:
At the beginning of the year, Gaby Corporation purchased a new equipment for P360,000. The machine has an esti -
mated useful life of four(4) years with no salvage value. It is expected to produce cash flows from operations, net of
income taxes of 32%, as follows:
Year 1 P 192,000
Year 2 168,000
Year 3 216,000
Year 4 144,000
Gaby Corporation uses the SYD method in computing depreciation of its depreciable assets. The company’s cost of
capital is 10%.

1. What is the present value of the

equipment?
213,864
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 FINANCIAL MANAGEMENT PART II
2. If Gaby Corporation used the
straight-line method of depreciation instead of the SYD method, the net present value provided by the equipment
would increase (decrease) by?
(4,308.48)

3. Kelsey Corporation is considering

to replace an old equipment with a new one that will require net cash outflows at present value of P720,000. The
old equipment, which has no terminal disposal price, has a remaining useful life of 10 years and as being depreci -
ated at P90,000 per year. Its annual cash operating costs is P300,000.

The company is subject to an income tax rate of 32%. In evaluating capital investment projects, it uses a hurdle
rate.

What is the net present value difference in favor of replacing the old equipment?
126,741.60

ITEMS 49 TO 53 ARE BASED ON THE FOLLOWING INFORMATION:

Lalaine Corporation’s expansion program requires the use of a special equipment costing P200,000. The company
can either lease or purchase the special equipment.

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If the equipment is purchased, it will be totally financed with a 12% loan requiring equal annual year-end pay -

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ments over 5 years. The equipment will be depreciated using the straight-line method over its 5-year life. A salvage
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value of P40,000 is anticipated at the end of the equipment’s life.

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If the equipment is leased, the contract will require equal annual year-end lease payments that will enable the
lessor to earn 14% on his investment.
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Lalaine Corporation is subject to a 32% income tax rate. It uses a minimum desired rate of return of 6% in evaluat-
ing capital investment projects.
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3. How much is the annual lease payments required in order to give the lessor his desired return?
vi re

58.258.08

4. If the equipment is purchased, how much is the annual loan payments including the 12% interest?
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55,478.50
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5. How much is the after-tax cash outflow associated with the lease alternative?
ar stu

39,615.49

6. How much is the total after-tax cash outflow for 5 years associated with the purchase alternative?
201,420
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7. Using the present value method, which alternative, purchase or lease, would you recommend?
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a. The lease alternative, because the present value of the after-tax cash outflows is lower by P27,769.65.

b. The purchased alternative, because the present value of the after-tax cash outflows is lower by P27,769.65

c. The purchase alternative, because the present value of the after-tax cash outflows is lower by P2,110.35.
sh

d. Neither of the two alternatives is acceptable.

ITEMS 54 TO 57 ARE BASED ON THE FOLLOWING INFORMATION:

In order to increase production capacity, Gunning Industries is considering replacing an existing production ma-
chine with a new technologically improves machine effective January 1. The following is being considered by Gun-
ning Industries.

· The new machine would be purchased for P160,000 in cash. Shipping Installation, and testing would cost
an additional P30,000.

· The new machine is expected to increase annual safes by P20,000 units at a sales price of P40 per unit. In -
cremental operating costs include P30 per unit invariable costs and total fixed costs of P40,000 per year.

· The investment in the new machine will require an immediate increase in working capital of P35,000. This
cash outflow will be recovered at the end of year 5.
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 FINANCIAL MANAGEMENT PART II
· Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new ma-
chine has an estimated useful life of 5 years and zero salvage value.

· Gunning is subject to a 40% corporate income tax rate

Gunning uses the net present value method to analyze investments and will employ the following factors and rates.

Period PV of 1 at 10% PVOA at 10%

1 .909 .909
2 .826 1.736
3 .751 2.487
4 .683 3.170
5 .621 3.791

54. Gunning Industries net cash flow in capital budgeting decision is ?

225,000

2. Gunning industries’ discounted annual depreciation tax shield for the year of replacement is?
13,817

3. The acquisition of the new production machine by Gunning Industries will contribute a discounted net of tax con-
tribution margin of ?
454,920

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4. The overall discounted cash flow impact of Gunning Industries’ working capital investment for the new production

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machine eH w would be?
(13,265)

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ITEMS 58 TO 60 ARE BASED ON THE FOLLOWING INFORMATION:

Maloney Company uses a 12% hurdle rate for all capital expenditures and has done the following analysis for four
projects for the upcoming year:
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Project 1 Project 2 Project 3 Project 4

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Initial Outlay P 4,960,000 5,440,000 4,000,000 5,960,000

vi re

Annual net cash inflows

Year 1 1,600,000 1,900,000 1,300,000 2,000,000
Year 2 1,900,000 2,500,000 1,400,000 2,700,000
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Year 3 1,800,000 1,800,000 1,600,000 1,800,000

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Year 4 1,600,000 1,200,000 800,000 1,300,000

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Net present value 281.280 293,240 (75,960) 85,520

Profitability index 106 % 105 % 99 % 101 %
Internal rate of return 14 % 15 % 11 % 13 %
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5. Which project(s) should undertake during the upcoming year assuming it has no budget restrictions?
Projects 1,2 and 4
Th

6. Which projects should Maloney undertake during the upcoming year if it has only P12,000,000 of investment funds
available?
Projects 1 and 2
sh

7. Which project(s) should Maloney undertake during the upcoming year if it has only 6,000,000 of funds available?
Project 1

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JDLBCPA – FINANCIAL MANAGEMENT PART II : CAPITAL BUDGETING 8

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