MANAGEMENT ACCOUNTING (VOLUME II) - Solutions Manual

CHAPTER 20

CAPITAL BUDGETING DECISIONS

I. Questions
1. 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 company’s 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.

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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.

II. Matching Type

1. A 6. H
2. C 7. D
3. F 8. G
4. B 9. J
5. I 10. E

III. Problems

Problem 1 (Equipment Replacement Sensitivity Analysis)

Requirement 1
Total 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 outflows P110,285
B. Present Situation:
Recurring cash operating costs (P45,000 x 2.69) P121,050
Disposal value of old equipment four years
hence (1,342)
(P2,600 x 0.516)
Present value of net cash inflows P119,708
Difference in favor of replacement P 9,423

Requirement 2
P44,000 – P5,000
Payback period for the new equipment =
P18,500

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= 2.1 years
Requirement 3

Let 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 53,600
Annual cash savings before taxes P 64,000

Year 1 Year 2 Year 3

Annual cash savings (a) P64,000 P64,000 P64,000
Depreciation 20,000 16,000 12,800
Inflow before tax P44,000 P48,000 P51,200
Income tax (50%) (b) 22,000 24,000 25,600
Cash inflow after tax (a - b) P42,000 P40,000 P38,400

After Tax
Cash Inflows PV Factor PV
Year 1 P42,000 x 0.909 P 38,178
Year 2 40,000 x 0.826 33,040
Year 3 38,400 x 0.750 28,800
Year 3 Salvage 20,000 x 0.750 15,000
Year 3 Tax loss 15,600* x 0.750 11,700
P126,718
Investment (I) 100,000
Net present value (NPV) P 26,718

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* 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 cost P100,000
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 price P 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 charge P48,000

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Tax rate 0.40

Depreciation tax shield 19,200
Recurring annual cash flows P 87,000
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* 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 manager’s 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) 276,000
Net present value P 16,320

Problem 4

Requirement 1: P(507,000)

Requirement 2: P(466,200)

Requirement 3: P(23,400)

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IV. Multiple Choice Questions

1. D 11. D 21. C 31. D

2. C 12. D 22. B 32. C
3. B 13. D 23. C 33. C
4. B 14. C 24. D 34. D
5. A 15. C 25. C 35. D
6. C 16. D 26. C 36. B
7. D 17. D 27. D 37. B
8. B 18. B 28. B 38. B
9. B 19. A 29. D 39. D
10. A 20. A 30. A 40. B

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