Capital Budgeting

I. F Company plans to replace its machinery with a new one costing

P200,000 with a n estimated useful life of 10 years without scrap value. The
old machinery has a book value of P20,000 and can be sold for P15,000. The
acquisition of the new machinery will yield an annual cash savings of
P45,000 before income tax. Income tax rate is 35%.
Required : 1. Net investment
Solution : Purchase price 200,000
Proceeds from sale of old machine
( 15,000)
Tax savings due to loss on sale (15,000-20,000) x 35% ( 1,750)
Net investment 183,250
2. Net income after tax
Cash savings before tax 45,000
Less : Depreciation (200,000/10 years)_
20,000
Income before tax 25,000
Less ; Tax ( 35%) 8,750
Income after tax 16,250
3. Annual net cash flows
Income after tax 16,250
Add back : Depreciation 20,000
Annual cash flow ,net 36,250
4. Payback period
Net investment/ ACF, net 183,250/36,250 =
5. Accounting rate of return based on 5.06 years
a. Initial investment
NIAT/Net investment 16,250/183,250 =
8.87%
b. Average investment 8.87 % x 2 = 17.74 %
6.Net present value, assuming that the minimum required rate of return is
15%
Present value of Cash inflows ( 36,250 x 5.019) 181,938.75
Less: Net investment 183,250
Net present value
( 1,311.25)
7.Discounted cash flow rate of return (IRR)
PVF(DCFRR) = Investment/ ACF,net 183,250/36,250 5.055
From the present value table of 1 received annually for
10 years, 5.055 is
Between 5.019( 15%) and 5.216 ( 14%). It is therefore between
14% and 15%
Exact rate :

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 At 14% 5.216 5.216
Exact rate 5.055
At 15% 5.019
Difference .161 .197

Exact rate= 14% + (.161/,197 x .01)

= 14% + .82% = 14.82%
8.Profitability index
Pv OF Annual cash inlows/ Net investment = 181,938.75/183,250= .99
2. An investment of P200,000 can bring in the following annual cash
income, net of tax :
First year 40,000
Second year 45,000
Third year 42,500
Fourth year 50,000
Fifth year 37,500 Sixth year 35,000
Required : Determine the payback period.
Solution :
Year Amt to be recovered ACF Balance Payback years
1 200,000 40,000 160,000 1
2 160,000 45,000 115,000 1
3 115,000 42,500 72,500 1
4 72,500 50,000 22,500 1
5 22,500 37,500 (22,500/37,500) .6
Payback period 4.6 years

3.An equipment costing P180,000 is expected to have the following net

cash inflows and scrap values:
Year ACF, net Salvage value, end of year
1 36,000 90,000
2 54,000 60,000
3 60,000 30,000
4 48,000 6,000
Required : Determine the payback bail out period.
Amt to be recovered ACF, net SV Total Cash inflows Balance Years
180,000 36,000 90,000 126,000 54,000 1
144,000 54,000 60,000 114,000 30,000 1
90,000 60,000 30,000 90,000 - 1
Payback bail out years 3 years

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 3a. An equipment costing P1,000,000 is expected to yield the following
net cash inflows and salvage values :
Year ACF , net Residual value
1 300,000 200,000
2 400,000 100,000
3 200,000 50,000
4 150,000 20,000
Required : Determine the payback bail out period.
Amt to be recovered ACF net SV Total Cash Flows Balance Years
1,000,000 300,000 200,000 500,000 500,000 1
700,000 400,000 100,000 500,000 200,000 1
300,000 200,000 50,000 250,000 50,000 1
100,000 150,000 20,000 170,000 .53*
Payback bail out years 3.53
years *To be recovered in year 4 100,000-20,000
150,000
= . 533 years

4.An equipment costing P120,000 with an estimated economic life of five

years, no salvage value, is expected to bring in net cash inflow of P70,000
in the first year of operations, P50,000 in the second year, P30,000 in the
third year, P20,000 in the fourth year, and P10,000 in the fifth year.
Required : determine the net present value assuming a desired rate of
return of 18%. Solution :
Year ACF, net PV Factor @ 18% PV of cash inflows
1 70,000 .847 59,290
2 50,000 .718 35,900
3 30,000 .609 18,270
4 20,000 .516 10,320
5 10,000 .437 4,370
Pv of cash flows 28,150
Less : Net cost of investment 120,000
Net present value 8,150
5.Refer to number 4, compute the net present value, assuming that the
asset is expected to have a scrap value of P10,000 at the end of the 5th
year.
Solution :
PV of regular cash inflows from # 4 128,150
Add: PV of salvage value (10,000 x .437) 4,370
Total Present values 132,520
Less: Cost of investment 120,000
Net present value 12,520

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 6.The Liquid Company contemplates the replacement of certain machinery.
The annual cost of operating the old machinery is P138,600, excluding
depreciation, while the estimate for the new machinery is P91,300. The
cost of the new machinery is P160,000, net of trade in allowance with an
estimated life of 8 years, no residual value. Tax rate is 40%. The cost of
capital is 8% and straight line method of depreciation is P20,000 per
year. Book value of the old machine is zero. PVF = 5.747 Required :
1. Payback period 160,000/ 36,380 = 4.4 years
Annual operating cost, old machine 138,60
0
Less : Annual operating costs , new 91,30
machine 0
Annual cash savings before dep 47,30
0
Less : Depreciation 20,00
0
IBT 27,30
0
Less: Tax ( 40 %) 10,92
0
NIAT 16,38
0
Add Back : depreciation 20,0
00
ACF, net 36,3
80
2. Payback reciprocal 1/4.4 = 22.73%
3. ARR based on initial investment 16,380/ 160,000 =10.24%
4. ARR based on average investment 10.24 x 2 = 20.48%
5. Net present value 209,076 - 160,000 = 49,076
PV of ACF , net ( 36,380 x 5.747 ) = 209,076
6. Profitability index 209,076/ 160,000 =1.31
7. Internal rate of return PVF=4.398
At 15% 4.487 4.487
Exact rate 4.398
At 16% 4.344
Difference .089 .143
Exact rate = 15% + ( .089/.143 x .01) = 15.62%

7.An investment of P400,000 can bring in the following annual cash

income, net of tax :
First year 70,000
Second year 90,000

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 Third year 85,000
Fourth year 90,000
Fifth year 75,000
Sixth year 80,000
Determine the payback period. 4.87 years
( 4 years) + ( 65,000/75,000) = 4.87 years

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