chapter 20 - answer

CHAPTER 18

MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 20 Capital Budgeting DecisionsCapital Budgeting Decisions Chapter 20

CHAPTER 20CAPITAL BUDGETING DECISIONS

I.Questions1.A capital investment involves a current commitment of funds with the expectation of generating a satisfactory return on these funds over a relatively extended period of time in the future.

2.Cost of capital is the weighted minimum desired average rate that a company must pay for long-term capital while discounted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project.

3.The basic principles in capital budgeting are:

1. Capital investment models are focused on the future cash inflows and outflows - rather than on net income.

2. Investment proposals should be evaluated according to their differential effects on the companys cash flows as a whole.

3. Financing costs associated with the project are excluded in the analysis of incremental cash flows in order to avoid the double-counting of the cost of money.

4. The concept of the time value of money recognizes that a peso of present return is worth more than a peso of future return.

5. Choose the investments that will maximize the total net present value of the projects subject to the capital availability constraint.

4.The major classifications as to purpose are:

1.Replacement projects

-those involving replacements of worn-out assets to avoid disruption of normal operations, or to improve efficiency.

2.Product or process improvement

-projects that aim to produce additional revenue or to realize cost savings.

3.Expansion

-projects that enhance long-term returns due to increased profitable volume.

5.Greater amounts of capital may be used in projects whose combined returns will exceed any alternate combination of total investment.

6.No. This implies that any equity funds are cost free and this is a dangerous position because it ignores the opportunity cost or alternative earnings that could be had from the fund.

7.Yes, if there are alternative earnings foregone by stockholders.

8.Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as a 15% rate of return. Capital budgeting preference decisions are concerned with choosing from among two or more alternative investment projects, each of which has passed the hurdle.

9.The time value of money refers to the fact that a peso received today is more valuable than a peso received in the future. A peso received today can be invested to yield more than a peso in the future.

10.Discounting is the process of computing the present value of a future cash flow. Discounting gives recognition to the time value of money and makes it possible to meaningfully add together cash flows that occur at different times.

11. Accounting net income is based on accruals rather than on cash flows. Both the net present value and internal rate of return methods focus on cash flows.

12. One simplifying assumption is that all cash flows occur at the end of a period. Another is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

13. No. The cost of capital is not simply the interest paid on long-term debt. The cost of capital is a weighted average of the individual costs of all sources of financing, both debt and equity.

14. The internal rate of return is the rate of return on an investment project over its life. It is computed by finding that discount rate that results in a zero net present value for the project.

15. The project profitability index is computed by dividing the net present value of the cash flows from an investment project by the investment required. The index measures the profit (in terms of net present value) provided by each peso of investment in a project. The higher the project profitability index, the more desirable is the investment project.

16. Neither the payback method nor the simple rate of return method considers the time value of money. Under both methods, a peso received in the future is weighed the same as a peso received today. Furthermore, the payback method ignores all cash flows that occur after the initial investment has been recovered.

II.Matching Type1. a6. h

2. c7. d

3. f8. g

4. b9. j

5. i10. e

III.ExercisesExercise 1 (Simple Rate of Return Method)

The annual incremental net operating income is determined by comparing the operating cost of the old machine to the operating cost of the new machine and the depreciation that would be taken on the new machine:

Operating cost of old machine

P33,000

Less operating cost of new machine

10,000

Less annual depreciation on the new machine (P80,000 10 years)

8,000

Annual incremental net operating income

P15,000

Cost of the new machine

P80,000

Less scrap value of old machine

5,000

Initial investment

P75,000

Exercise 2 (Basic Present Value Concepts)

1.a.P400,000 0.794 = P317,600.

b.P400,000 0.712 = P284,800.

2.a.P5,000 4.355 = P21,775.

b.P5,000 3.685 = P18,425.

3.The factor for 10% for 20 years is 8.514. Thus, the present value of Toms winnings would be:

P50,000 8.514 = P425,700.

Whether or not Tom really won a million pesos depends on your point of view. She will receive a million pesos over the next 20 years; however, in terms of its value right now she won much less than a million pesos as shown by the present value computation above.

Exercise 3 (After-Tax Costs)

a.Management consulting fee

P100,000

Multiply by 1 0.30

0.70

After-tax cost

P70,000

b.Increased revenues

P40,000

Multiply by 1 0.30

0.70

After-tax cash flow (benefit)

P28,000

c.The depreciation deduction is P210,000 7 years = P30,000 per year, which has the effect of reducing taxes by 30% of that amount, or P9,000 per year.

Exercise 4 (Basic Net Present Value Analysis)

Year(s)Amount of Cash Flows12% FactorPresent Value of Cash Flows

Purchase of the stock

NowP(18,000)1.000P(18,000)

Annual dividends*

1-4P7203.0372,187

Sale of the stock

4P22,5000.63614,310

Net present value

P(1,503)

*900 shares P0.80 per share per year = P720 per year.

No, Ms. Cruz did not earn a 12% return on the share. The negative net present value indicates that the rate of return on the investment is less than the discount rate of 12%.

Exercise 5 (Internal Rate of Return and Net Present Value)

1.

A factor of 5.468 represents an internal rate of return of 16%.

2.ItemYear(s)Amount of Cash Flows16% FactorPresent Value of Cash Flows

Initial investment

NowP(136,700)1.000P(136,700)

Net annual cash inflows

1-14P25,0005.468136,700

Net present value

P0

The reason for the zero net present value is that 16% (the discount rate) represents the machines internal rate of return. The internal rate of return is the rate that causes the present value of a projects cash inflows to just equal the present value of the investment required.

3.

The 6.835 factor is closest to 6.982, the factor for the 11% rate of return. Thus, to the nearest whole percent, the internal rate of return is 11%.

Exercise 6 (Basic Net Present Value and Internal Rate of Return Analysis)

1.ItemYear(s)Amount of Cash Flows15% FactorPresent Value of Cash Flows

Initial investment

NowP(40,350)1.000P(40,350)

Annual cash inflows

1-4P15,0002.85542,825

Net present value

P2,475

Yes, this is an acceptable investment. Its net present value is positive, which indicates that its rate of return exceeds the minimum 15% rate of return required by the company.

2.

A factor of 5.575 represents an internal rate of return of 16%.

3.

A factor of 5.650 represents an internal rate of return of 12%. The company did not make a wise investment because the return promised by the machine is less than the required rate of return.

IV.ProblemsProblem 1 (Equipment Replacement Sensitivity Analysis)

Requirement 1Total Present Value

A.New Situation:

Recurring cash operating costs (P26,500 x 2.69)P 71,285

Cost of new equipment 44,000

Disposal value of old equipment now (5,000)

Present value of net cash outflowsP110,285

B.Present Situation:

Recurring cash operating costs (P45,000 x 2.69)P121,050

Disposal value of old equipment four years hence

(P2,600 x 0.516) (1,342)

Present value of net cash inflowsP119,708

Difference in favor of replacementP 9,423

Requirement 2

Payback period for the new equipment=

=2.1 years

Requirement 3Let X = annual cash savings

Let O = net present value

X (2.69) + P5,000 - P44,000 - P1,342=O

2.69X =P40,342

X =P14,997

If the annual cash savings decrease from P18,850 to P14,997 or by P3,503, the point of indifference will be reached.

Another alternative way to get the same answer would be to divide the net present value of P9,423 by 2.690.

Problem 2

Annual cash expenses of the manual bookkeeping

machine system, P9,800 x 12

P117,600

Annual cash expenses of computerized data processing 53,600Annual cash savings before taxes

P 64,000Year 1 Year 2Year 3

Annual cash savings (a)P64,000P64,000P64,000

Depreciation 20,000 16,000 12,800

Inflow before taxP44,000P48,000P51,200

Income tax (50%) (b) 22,000 24,000 25,600

Cash inflow after tax (a - b)P42,000P40,000P38,400

After Tax Cash InflowsPV FactorPV

Year 1P42,000x0.909 P 38,178

Year 240,000x0.82633,040

Year 338,400x 0.75028,800

Year 3Salvage20,000x0.75015,000

Year 3Tax loss15,600*x0.750 11,700

P126,718

Investment (I) 100,000

Net present value (NPV)P 26,718

_________________

*The P15,600 tax benefit of the loss on the disposal of the computer at the end of year 3 is computed as follows:

Estimated salvage value

P 20,000

Estimated book value:

Historical costP100,000

Accumulated depreciation 48,800 51,200

Estimated loss

P(31,200)

Tax rate

50%

Tax effect of estimated loss

P(15,600)

Since the net present value is positive, the computer should be purchased replacing the manual bookkeeping system.

Problem 3

Requirement 1

(a)Purchase price of new equipment

P(300,000)

Disposal of existing equipment:

Selling priceP 0

Book value 60,000

Loss on disposal P60,000

Tax rate 0.4

Tax benefit of loss on disposal

24,000

Required investment (I)

P(276,000)

(b)Increased cash flows resulting from

change in contribution margin:

Using new equipment [18,000 (P20 - P7)] *

P234,000

Using existing equipment [11,000 (P20 - P9)] 121,000

Increased cash flows

113,000

Less: Taxes (0.40 x P113,000)

45,200

Increased cash flows after taxes

P 67,800

Depreciation tax shield:

Depreciation on new equipment

(P300,000 ( 5)P60,000

Depreciation on existing equipment

(P60,000 ( 5) 12,000

Increased depreciation chargeP48,000

Tax rate 0.40

Depreciation tax shield

19,200

Recurring annual cash flows

P 87,000_________________

*The new equipment is capable of producing 20,000 units, but ETC Products can sell only 18,000 units annually.

The sales manager made several errors in his calculations of required investment and annual cash flows. The errors are as follows:

Required investment:

-The cost of the market research study (P44,000) is a sunk cost because it was incurred last year and will not change regardless of whether the investment is made or not.

-The loss on the disposal of the existing equipment does not result in an actual cash cost as shown by the sales manager. The loss on disposal results in a reduction of taxes, which reduces the cost of the new equipment.

Annual cash flows:-The sales manager considered only the depreciation on the new equipment rather than just the additional depreciation which would result from the acquisition of the new equipment.

-The sales manager also failed to consider that the depreciation is a noncash expenditure which provides a tax shield.

-The sales managers use of the discount rate (i.e., cost of capital) was incorrect. The discount rate should be used to reduce the value of future cash flows to their current equivalent at time period zero.

Requirement 2

Present value of future cash flows (P87,000 x 3.36)P292,320

Required investment (I) 276,000Net present valueP 16,320

Problem 4 Requirement 1: P(507,000)

Requirement 2: P(466,200)

Requirement 3: P(23,400)

Problem 5

1.The net annual cost savings is computed as follows:

Reduction in labor costs

P240,000

Reduction in material costs

96,000

Total cost reductions

336,000

Less increased maintenance costs (P4,250 12)

51,000

Net annual cost savings

P285,000

2.Using this cost savings figure, and other data provided in the text, the net present value analysis is:

Year(s)Amount of Cash Flows18% FactorPresent Value of Cash Flows

Cost of the machine

NowP(900,000)1.000P(900,000)

Installation and software

NowP(650,000)1.000(650,000)

Salvage of the old machine

NowP70,0001.00070,000

Annual cost savings

1-10P285,0004.4941,280,790

Overhaul required

6P(90,000)0.370(33,300)

Salvage of the new machine

10P210,0000.19140,110

Net present value

P(192,400)

No, the etching machine should not be purchased. It has a negative net present value at an 18% discount rate.

3.The intangible benefits would have to be worth at least P42,813 per year as shown below:

Thus, the new etching machine should be purchased if management believes that the intangible benefits are worth at least P42,813 per year to the company.

Problem 6

Items and ComputationsYear(s)(1) Amount(2) Tax Effect(1) (2) After-Tax Cash Flows12% FactorPresent Value of Cash Flows

Investment in new trucks

NowP(450,000)P(450,000)1.000P(450,000)

Salvage from sale of the old trucks

NowP30,0001 0.30P21,0001.00021,000

Net annual cash receipts

1-8P108,0001 0.30P75,6004.968375,581

Depreciation deductions*

1-8P56,2500.30P16,8754.96883,835

Overhaul of motors

5P(45,000)1 0.30P(31,500)0.567(17,861)

Salvage from the new trucks

8P20,0001 0.30P14,0000.4045,656

Net present value

P18,211

* P450,000 8 years = P56,250 per year

Since the project has a positive net present value, the contract should be accepted.Problem 7

1.

A factor of 3.812 equals an 18% rate of return.

Verification of the 18% rate of return:

ItemYear(s)Amount of Cash Flows18% FactorPresent Value of Cash Flows

Investment in equipment

NowP(142,950)1.000P(142,950)

Annual cash inflows

1-7P37,5003.812142,950

Net present value

P0

2.

We know that the investment is P142,950, and we can determine the factor for an internal rate of return of 14% by looking at the PV table along the 7-period line. This factor is 4.288. Using these figures in the formula, we get:

Therefore, the annual cash inflow would have to be:

P142,950 4.288 = P33,337.

3.a.5-year life for the equipment:

The factor for the internal rate of return would still be 3.812 [as computed in (1) above]. Reading along the 5-period line of the PV table, a factor of 3.812 is closest to 3.791, the factor for 10%. Thus, to the nearest whole percent, the internal rate of return is 10%.

b.9-year life for the equipment:

The factor of the internal rate of return would again be 3.812. From the PV table, reading along the 9-period line, a factor of 3.812 is closest to 3.786, the factor for 22%. Thus, to the nearest whole percent, the internal rate of return is 22%.

The 10% return in part (a) is less than the 14% minimum return that Dr. Blue wants to earn on the project. Of equal or even greater importance, the following diagram should be pointed out to Dr. Blue:

As this illustration shows, a decrease in years has a much greater impact on the rate of return than an increase in years. This is because of the time value of money; added cash inflows far into the future do little to enhance the rate of return, but loss of cash inflows in the near term can do much to reduce it. Therefore, Dr. Blue should be very concerned about any potential decrease in the life of the equipment, while at the same time realizing that any increase in the life of the equipment will do little to enhance her rate of return.

4.a.The expected annual cash inflow would be:

P37,500 x 120% = P45,000

Reading along the 7-period line of the PV table, a factor of 3.177 is closest to 3.161, the factor for 25%, and is between that factor and the factor for 24%. Thus, to the nearest whole percent, the internal rate of return is 25%.

b.The expected annual cash inflow would be:

P37,500 x 80% = P30,000

Reading along the 7-period line of the PV table, a factor of 4.765 is closest to 4.712, the factor for 11%. Thus, to the nearest whole percent, the internal rate of return is 11%.

Unlike changes in time, increases and decreases in cash flows at a given point in time have basically the same impact on the rate of return, as shown below:

5.Since the cash flows are not even over the five-year period (there is an extra P61,375 cash inflow from sale of the equipment at the end of the fifth year), some other method must be used to compute the internal rate of return. Using trial-and-error or more sophisticated methods, it turns out that the actual internal rate of return will be 12%:

ItemYear(s)Amount of Cash Flows12% FactorPresent Value of Cash Flows

Investment in the equipment

NowP(142,950)1.000P(142,950)

Annual cash inflow

1-5P30,0003.605108,150

Sale of the equipment

5P61,3750.56734,800

Net present value

P0

Problem 8

1.The income statement would be:

Sales revenue

P200,000

Less commissions (40% P200,000)

80,000

Contribution margin

120,000

Less fixed expenses:

Maintenance

P50,000

Insurance

10,000

Depreciation*

36,000

Total fixed expenses

96,000

Net operating income

P24,000

*P180,000 5 years = P36,000 per year

2.The initial investment in the simple rate of return calculations is net of the salvage value of the old equipment as shown below:

Yes, the games would be purchased. The return exceeds the 14% threshold set by the company.

3.The payback period would be:

*Net annual cash inflow = Net operating income + Depreciation

= P24,000 + P36,000 = P60,000.

Yes, the games would be purchased. The payback period is less than the 3 years.IV.Multiple Choice Questions1. D11. D21. C31. D

2. C12. D22. B32. C

3. B13. D23. C33. C

4. B14. C24. D34. D

5. A15. C25. C35. D

6. C16. D26. C36. B

7. D17. D27. D37. B

8. B18. B28. B38. B

9. B19. A29. D39. D

10. A20. A30. A40. B

20%

=

P15,000

P75,000

=


Initial investment

=

Simple rate

of return

P44,000 P5,000

P18,500

5.468

=

P136,700

P25,000

=

Required investment

Annual cash inflow

=

Factor of the internal rate of return

6.835

=

P136,700

P20,000

=

Required investment

Annual cash inflow

=


5.575

=

P111,500

P20,000

=

Investment required

Net annual cash inflow

=


5.650

=

P14,125

P2,500

=

Investment required


=


Required increase in net present value

Factor for 10 years

=

P192,400

4.494

=

P42,813

3.812

=

P142,950

P37,500

=

Required investment

Annual cash inflow

=


4.288

=

P142,950

Annual cash inflow

3.177

Required investment

Annual cash inflow

=


=

P142,950

P45,000

P142,950

P30,000

=

4.765

16%

=

P24,000

P180,000 P30,000

=


Initial investment

=

Simple

rate of return

P24,000

P150,000

=

P150,000

P60,000

=

2.5 years

=

P180,000 P30,000

P60,000*

=

Investment required


=

Payback

period

20-120-1620-15

chapter 20 - answer

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