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 futur
Trang 1CHAPTER 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
5 Greater amounts of capital may be used in projects whose combined returns will exceed any alternate combination of total investment
Trang 26 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
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
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
Disposal value of old equipment four years
hence
(P2,600 x 0.516)
(1,342) Present value of net cash inflows P119,708 Difference in favor of replacement P 9,423
Requirement 2
Payback period for the new equipment =
= 2.1 years
Requirement 3
P44,000 – P5,000 P18,500
Trang 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
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
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
P126,718
_
* 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 book value:
Historical cost P100,000
Trang 4Accumulated depreciation 48,800 51,200
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:
Tax rate 0.4
Tax benefit of loss on disposal 24,000
(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
Less: Taxes (0.40 x P113,000) 45,200 Increased cash flows after taxes P 67,800 Depreciation tax shield:
Depreciation on new equipment
Depreciation on existing equipment
Increased depreciation charge P48,000
Depreciation tax shield 19,200
_
* 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:
Trang 5Required 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
Problem 4
Requirement 1: P(507,000)
Requirement 2: P(466,200)
Requirement 3: P(23,400)
IV Multiple Choice Questions
Trang 68 B 18 B 28 B 38 B