review materials on capital budgeting

7/23/2019 Review Materials on Capital Budgeting

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Review Materials – Management ServicesCapital Budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine whether anorganisation's long term investments such as new machinery, replacement machinery, new plants, new products,

and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.• Capital udgeting is a project selection exercise performed by the business enterprise.

• Capital budgeting uses the concept of present value to select the projects.

• Capital budgeting uses tools such as pay bac! period, net present value, accounting rate of return, internal

rate of return, profitability index to select projects.

Payback Period

"aybac! period is the time duration re#uired to recoup the investment committed to a project. usinessenterprises following paybac! period use $stipulated paybac! period$, which acts as a standard for screening the project.

A. Computation Of Payback Period

•

%hen the cash inflows are uniform the formula for paybac! period is cash outflow divided by annualcash inflow

• %hen the cash inflows are uneven, the cumulative cash inflows are to be arrived at and then the

paybac! period has to be calculated through interpolation. &ere paybac! period is the time whencumulative cash inflows are e#ual to the outflows.

• he paybac! period is stated in terms of years. his can be stated in terms of percentage also. his is

the paybac! reciprocal rate.

• eciprocal of paybac! period *+paybac! period- x +

B. Decision Rules

• /elect the projects which have paybac! periods lower than or e#uivalent to the stipulated paybac!

period.

• 0rrange these selected projects in increasing order of their respective paybac! periods.

• /elect those projects from the top of the list till the capital budget is exhausted.

• In the case of two mutually exclusive projects, the one with a lower paybac! period is accepted, when

the respective paybac! periods are less than or e#uivalent to the stipulated paybac! period.

Accounting Rate Of Return

0ccounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) asgiven in the income statement as a percentage of the total investment or average investment. he accounting rateof return is based on accounting profits. 0ccounting profits are different from the cash flows from a project andhence, in many instances, accounting rate of return might not be used as a project evaluation decision. 0ccountingrate of return does find a place in business decision ma!ing when the returns expected are accounting profits and

not merely the cash flows.0. Computation Of Accounting Rate Of Return

• The accounting rate of return using total investment; or

• /ometimes average rate of return is calculated by using the following formula1 2et profit after tax0verage investment

. Decision Rules

3 /elect the projects whose rates of return are higher than the cut4off rate3 0rrange them in the declining order of their rate of return and3 /elect projects starting from the top of the list till the capital available is exhausted.

Net Present Value (Np!

2et present value of an investmentproject is the difference between present value of cash inflows andcash outflows. he present values of cash flows are obtained at a discount rate e#uivalent to the cost of capital.

A. Decision Rules

3 $Capital ationing$ situation

/elect projects whose 2"5 is positive or e#uivalent to 6ero.

0rrange in the descending order of 2"5s.

/elect "rojects starting from the list till the capital budget allows.

3 $2o capital ationing$ /ituation

/elect every project whose 2"5 7

3 8utually 9xclusive "rojects

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http://en.wikipedia.org/wiki/Capital_(economics)

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/elect the one with a higher 2"5.

"nternal Rate Of Return ("rr!

he Internal ate of eturn is also !nown as the yield method. he I of a projectinvestment is definedas the rate of discount at which the present value of cash inflows and present value of cash outflows are e#ual.

I can be restated as the rate of discount, at which the present value of cash flow (inflows and outflows)associated with a project e#ual 6ero.

A. Decision Rules• $Capital ationing$ /ituation

/elect those projects whose I (r) !, where ! is the cost of capital.

0rrange all the projects in the descending order of their Internal ate of eturn.

/elect projects from the top till the capital budget allows.

• $2o Capital ationing$ /ituation

0ccept every project whose I (r) !, where ! is the cost of capital.

• 8utually 9xclusive "rojects eturn

S elect the one with higher I.

Profitability "nde# (Pi!

"rofitability ratio is otherwise referred to as enefitCost ratio. his is an extension of the 2et "resent

5alue 8ethod. his is a relative valuation index and hence is comparable across different types of projectsre#uiring different #uantum of initial investments. "rofitability index ("I) is the ratio of present value of cash

inflows to the present value of cash outflows. he present values of cash flows are obtained at a discount ratee#uivalent to the cost of capital.

A. Computation Of Profitability "nde# (Pi!

• "rofitability index is always expressed on net basis.

• ;ormula for "rofitability Index is

"resent value of cash inflows"resent value of cash outflows

B. Decision Rule

• $Capital ationing$ /ituation

/elect all projects whose profitability index is greater than or e#uivalent to +. an! them in the descending order of their profitability indices.

/elect projects starting from the top of the list till the capital budget

• $2o Capital ationing$ /ituation

/elect every project whose "I 7 +.

• 8utually 9xclusive "rojects

/elect the project with higher "I.

+. Capital budgeting techni#ues are least li!ely to be used in evaluating the0. 0c#uisition of new aircraft by a cargo company.. <esign and implementation of a major advertising program.C. rade for a star #uarterbac! by a football team.<. 0doption of a new method of allocating non4traceable costs to product lines.

=. 8ahlin 8overs, Inc. is planning to purchase e#uipment to ma!e its operations more efficient. his e#uipmenthas an estimated useful life of six years. 0s part of this ac#uisition, a "+>, investment in wor!ing capitalis re#uired. In a discounted cash flow analysis, this investment in wor!ing capital should be0. 0morti6ed over the useful life of the e#uipment.. <isregarded because no cash is involved.

C. reated as a recurring annual cash flow that is recovered at the end of six years.<. reated as an immediate cash outflow that is recovered at the end of six years.

?. o approximate annual cash inflow, depreciation is0. 0dded bac! to net income because it is an inflow of cash.. /ubtracted from net income because it is an outflow of cash.C. /ubtracted from net income because it is an expense.<. 0dded bac! to net income because it is not an outflow of cash.

@. 0n optimal capital budget is determined by the point where the marginal cost of capital is0. 8inimi6ed.. 9#ual to the average cost of capital.

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MULTIPLE CHOICE THEORIES! PROBLEMS"



C. 9#ual to the rate of return on total assets.<. 9#ual to the marginal rate of return on investment.

>. In capital budgeting decisions, the following items are considered among others1+. Cash outflow for the investment.=. Increase in wor!ing capital re#uirements.?. "rofit on sale of old asset

@. Aoss on write4off of old asset.;or which of the above items would taxes be relevantB0. Items + and ? only. C. 0ll items.. Items ? and @ only. <. Items +, ? and @ only.

. he following statements refer to the accounting rate of return (0)+. he 0 is based on the accrual basis, not cash basis.=. he 0 does not consider the time value of money.?. he profitability of the project is considered.

;rom the above statements, which are considered limitations of the 0 conceptB0. /tatements = and ? only. C. 0ll the ? statements.. /tatements ? and + only. <. /tatements + and = only.

:. he paybac! method assumes that all cash inflows are reinvested to yield a return e#ual to0. the discount rate. C. the internal rate of return.. the hurdle rate. <. 6ero.

D. 0s a capital budgeting techni#ue, the paybac! period considers depreciation expenses (<9) and time value of money (58) as follows1

0. . C. <.

<9 relevant irrelevant Irrelevant relevant58 relevant irrelevant elevant irrelevant

E. he bailout paybac! period is0. he paybac! period used by firms with government insured loans.. he length of time for paybac! using cash flows plus the salvage value to recover the original investmentC. (a) and (b)<. 2one of the above.

+. %hich of the following methods measures the cash flows and outflows of a project as if they occurred at asingle point in timeB0. Cash flow based paybac! period. C. "aybac! method.. Capital budgeting. <. <iscounted cash flow.

++. he excess present value method is anchored on the theory that the future returns, expressed in terms of present value, must at least be0. 9#ual to the amount of investment C. 8ore than the amount of investment. Aess than the amount of investment <. Cannot be determined

+=. 0ll of the following refer to the discount rate used by a firm in capital budgeting except0. &urdle rate. C. Fpportunity cost.. e#uired rate of return. <. Fpportunity cost of capital.

+?. If a firm identifies (or creates) an investment opportunity with a present value GAist 07 its cost, the value of

the firm and the price of its common stoc! will GAist 70. . C. <.

Aist 0 Hreater than Hreater than 9#ual to 9#ual toAist Increase <ecrease Increase <ecrease

+@. 0n advantage of the net present value method over the internal rate of return model in discounted cash flowanalysis is that the net present value method0. Computes a desired rate of return for capital projects.. Can be used when there is no constant rate of return re#uired for each year of the project.C. ses a discount rate that e#uates the discounted cash inflows with the outflows.<. ses discounted cash flows whereas the internal rate of return model does not.

+>. %hen using the net present value method for capital budgeting analysis, the re#uired rate of return is calledall of the following except the

0. is!4free rate. . Cost of capital. C. <iscount rate. <. Cutoff rate.+. 0 projectJs net present value, ignoring income tax considerations, is normally affected by the

0. "roceeds from the sale of the asset to be replaced.. Carrying amount of the asset to be replaced by the project.C. 0mount of annual depreciation on the asset to be replaced.<. 0mount of annual depreciation on fixed assets used directly on the project.

+:. &ow are the following used in the calculation of the internal rate of return of a proposed projectB Ignoreincome tax considerations.

0. . C. <.

esidual sales value of project 9xclude Include 9xclude Include

"age ? of :



<epreciation expense Include Include 9xclude 9xclude

+D. %hich of the following characteristics represent an advantage of the internal rate of return techni#ues over theaccounting rate of return techni#ue in evaluating a projectBI ecognition of the projectJs salvage value.II 9mphasis on cash flows.

III ecognition of the time value of money.0. I only. . I and II. C. II and III. <. I, II, and III.+E. "olo Co. re#uires higher rates of return for projects with a life span greater than > years. "rojects extending

beyond > years must earn a higher specified rate of return. %hich of the following capital budgetingtechni#ues can readily accommodate this re#uirementB

0. . C. <.

Internal ate of eturn Kes 2o 2o Kes 2et "resent 5alue 2o Kes 2o Kes

=. %hich of the following combinations is 2F possibleB

"rofitability Index 2"5 I

0. Hreater than + "ositive 8ore than cost of capital. 9#uals + Lero 9#uals cost of capital

C. Aess than + 2egative Aess than cost of capital<. Aess than + "ositive Aess than cost of capital

=+. &atchet Company is considering replacing a machine with a boo! value of M@,, a remaining useful lifeof > years, and annual straight4line depreciation of MD,. he existing machine has a current mar!et valueof M@,. he replacement machine would cost M>>,, have a >4year life, and save M:>, per year incash operating costs. If the replacement machine would be depreciated using the straight4line method and thetax rate is @N, what would be the net investment re#uired to replace the existing machineB0. ME,. . M+>, C. M??, <. M>>,

==. Oey Corp. plans to replace a production machine that was ac#uired several years ago. 0c#uisition cost is"@>, with salvage value of ">,. he machine being considered is worth "D, and the supplier is willing to accept the old machine at a trade4in value of ",. /hould the company decide not to ac#uirethe new machine, it needs to repair the old one at a cost of "=,. ax4wise, the trade4in transaction will

not have any implication but the cost to repair is tax4deductible. he effective corporate tax rate is ?>N of netincome subject to tax. ;or purposes of capital budgeting, the net investment in the new machine is0. ">@, . "+, C. ", <. "D,

=?. &oo!er Fa! ;urniture Company is considering the purchase of wood cutting e#uipment. <ata on thee#uipment are as follows1

Friginal investment M?, 2et annual cash inflow M+=,9xpected economic life in years >/alvage value at the end of five years M?,

he company uses the straight4line method of depreciation with no mid4year convention.%hat is the accounting rate of return on original investment rounded off to the nearest percent, assuming notaxes are paidB

0. @.N . =.N C. [email protected] <. ==.N=@. 8axwell Company has an opportunity to ac#uire a new machine to replace one of its present machines. he

new machine would cost ME,, have a >4year life, and no estimated salvage value. 5ariable operating costswould be M+, per year. he present machine has a boo! value of M>, and a remaining life of >years. Its disposal value now is M>,, but it would be 6ero after > years. 5ariable operating costs would beM+=>, per year. Ignore income taxes. Considering the > years in total, what would be the difference in profit before income taxes by ac#uiring the new machine as opposed to retaining the present oneB0. M+, decrease . M+>, decrease C. M?>, increase <. M@, increase

=>. Ayben Inc. is planning to produce a new product. o do this, it is necessary to ac#uire a new e#uipment thatwill cost the company "+,. he estimated life of the new e#uipment is five years with no salvage value.he estimated income and costs based on expected sales of "+, units per year are1

/ales P "+. per unit "+,

Costs P "D. per unit D, 2et income " =,

he accounting rate of return based on initial investment is =N%hat will be the accounting rate of return based on initial investment of "+, if management decrease itsselling price of the new product by +NB0. >N . +N C. +>N <. =N

=. 8A; Corporation is evaluating the purchase of a ">, die attach machine. he cash inflows expectedfrom the investment is "+@>, per year for five years with no e#uipment salvage value. he cost of capitalis +=N. he net present value factor for five (>) years at +=N is ?.@D and at +@N is ?.@??+. he internalrate of return for this investment is

"age @ of :



0. ?.@>N . =.@N C. +?.DN <. +>.@DN

=:. /weets, 9tc., Inc. plans to underta!e a capital expenditure re#uiring "= million cash outlay. elow are the projected after4tax cash inflow for the five year period covering the useful life. he companyJs tax rate is?>N.

Kear + = ? @ >

"J : @D @ @he founder and president of the candy company believes that the best gauge for capital expenditure is cash paybac! period and that the recovery period should not be more than :>N of the useful life of the project or the asset. /hould the company underta!e the projectB0. 2o, since the paybac! period is @ years or DN of the useful life of the project.. Kes, since the paybac! period is ?.>> years or :+N of the useful life of the project.C. 2o, since the paybac! period extends beyond the life of the project.<. Kes, since the paybac! period is @ years and still shorter than the useful life of the project.

=D. 0"Q, Inc. is planning to purchase a new machine that will ta!e six years to recover the cost. he newmachine is expected to produce cash flow from operations, net of income taxes, of "@,> a year for the firstthree years of the paybac! period and "?,> a year of the last three years of the paybac! period.<epreciation of "?, a year shall be charged to income of the six years of the paybac! period. &ow much

shall the machine costB0. "+=, . "+D, C. "=@, <. "?,

=E. %omar! Company purchased a new machine on Qanuary + of this year for ME,, with an estimated usefullife of > years and a salvage value of M+,. he machine will be depreciated using the straight4linemethod. he machine is expected to produce cash flow from operations, net of income taxes, of M?, ayear in each of the next > years. he new machineJs salvage value is M=, in years + and =, and M+>,in years ? and @. %hat will be the bailout period (rounded) for the new machineB0. +.@ years. . =.= years. C. +.E years. <. ?.@ years.

?. It is the start of the year and /t. rope6 Co. plans to replace its old sing4along e#uipment. hese informationare available1

Fld 2ew

9#uipment cost ":, "+=,

Current salvage value +, 4/alvage value, end of useful life =, +,0nnual operating costs >, ?D,0ccumulated depreciation >>,? 49stimated useful life + years + years

he companyJs income tax rate is ?>N and its cost of capital is +=N. %hat is the present value of all therelevant cash flows at time 6eroB0. (">@,) . ("++,) C. ("+=,) <. ("+=@,:)

?+. Cramden 0rmored Car Co. is considering the ac#uisition of a new armored truc!. he truc! is expected tocost M?,. he company's discount rate is += percent. he firm has determined that the truc! generates a positive net present value of M+:,==. &owever, the firm is uncertain as to whether it has determined areasonable estimate of the salvage value of the truc!. In computing the net present value, the company

assumed that the truc! would be salvaged at the end of the fifth year for M,. %hat expected salvagevalue for the truc! would cause the investment to generate a net present value of MB Ignore taxes.0. M?, . M C. M>>,=:D <. M@=,E:D

?=. he 8c2ally Co. is considering an investment in a project that generates a profitability index of +.?. he present value of the cash inflows on the project is M@@,. %hat is the net present value of this projectB0. M+,+>@ . M+?,= C. M>:,= <. M??,D@

??. he Leron Corporation wants to purchase a new machine for its factory operations at a cost of ME>,. heinvestment is expected to generate M?>, in annual cash flows for a period of four years. he re#uired rateof return is +@N. he old machine can be sold for M>,. he machine is expected to have 6ero value at theend of the four4year period. %hat is the net present value of the investmentB %ould the company want to purchase the new machineB Income taxes are not considered.0. M++E,>>R yes . ME,>>R no C. M+,+E,>>R yes <. M?=,:>R no

?@. <rillers Inc. is evaluating a project to produce a high4tech deep4sea oil exploration device. he investmentre#uired is MD million for a plant with a capacity of +>, units a year for > years. he device will be soldfor a price of M+=, per unit. /ales are expected to be +=, units per year. he variable cost is M:, andfixed costs, excluding depreciation, are M=> million per year. 0ssume <rillers employs straight4linedepreciation on all depreciable assets, and assume that they are taxed at a rate of ?N. If the re#uired rate of return is +=N, what is the approximate 2"5 of the projectB0. M+:,==>, . M=+,>++, C. M=,:D, <. M>,++:,

?>. /moot 0utomotive has implemented a new project that has an initial cost, and then generates inflows of M+, a year for the next seven (:) years. he project has a paybac! period of @. years. %hat is the project's internal rate of return (I)B

"age > of :



0. +@.:EN . +.??N C. +D.>@N <. +>.+N

?. QQ Corp. is considering the purchase of a new machine that will cost "?=,. It has an estimated useful lifeof ? years. 0ssume that ?N of the depreciable base will be depreciated in the first year, @N in the secondyear, and ?N in the third year. It has a resale value of "=, at the end of its economic life. /avings areexpected from the use of machine estimated at "+:, annually. he company has an effective tax rate of

@N. It uses +N as hurdle rate in evaluating capital projects. /hould the company proceed with the"?=, capital investmentB

Kear "resent 5alue of "+ "resent 5alue of an Frdinary 0nnuity of "+

+ .D= .D== .:@? +.>? .@+ =.=@

0. Kes, due to 2"5 of ",>>. C. Kes, due to 2"5 of "+,D=.. Kes, due to 2"5 of "++,D@. <. 2o, due to negative 2"5 of "+,+?

?:. 0 company's marginal cost of new capital (8CC) is +N up to M,. 8CC increases .>N for the nextM@, and another .>N thereafter. /everal proposed capital projects are under consideration, with projected cost and internal rates of return (I) as follows1

"roject Cost I

0 M+, +.>N M?, [email protected] M@>, +.DN< M?>, +?.>N9 M@, +=.N

%hat should the company's capital budget beB0. M . M+,>, C. M+,>, <. M+,,

?D. he following forecasts have been prepared for a new investment by Fxford Industries of M= million with anD4year life1

"essimistic 9xpected Fptimistic

8ar!et si6e , E, +@,8ar!et share, N => ? ?>nit price M:> MD MD:>nit variable cost M> M@ M?>;ixed cost, millions M: M@ M?.>

0ssume that Fxford employs straight4line depreciation, and that they are taxed at ?>N. 0ssuming anopportunity cost of capital of +@N, what is the 2"5 of this project, based on expected outcomesB0. M=,=,@+> . M@,>?,>> C. M,:==,+E <. MD,>>,:==

?E. "aybac! Company is considering the purchase of a copier machine for "@=,D=>. he copier machine will beexpected to be economically productive for @ years. he salvage value at the end of @ years is negligible.he machine is expected to provide +>N internal rate of return. he company is subject to @N income taxrate. he present value of an ordinary annuity of + for @ periods is =.D>@ED. In order to reali6e the I of +>N, how much is the estimated before4tax cash inflow to be provided by the machineB0. "+:,D . "+>, C. "=>, <. "?>,:

@. erry "roducts is considering two pieces of machinery. he first machine costs ">, more than thesecond machine. <uring the two4year life of these two alternatives, the first machine has "+>>, more cashflow in year one and a "++, less cash flow in year two than the second machine. 0ll cash flows occur atyear4end. he present value of + at +>N end of + period and = periods are .DE>: and .:>+@, respectively.he present value of + at DN end of period + is .E=>E? and period = is .D>:?@. 0t what discount rate would8achine + e#ually acceptable as machine =B0. EN . +N C. ++N <. +=N

@+. he Leron Corporation recently purchased a new machine for its factory operations at a cost of ME=+,=>. heinvestment is expected to generate M=>, in annual cash flows for a period of six years. he re#uired rateof return is +@N. he old machine has a remaining life of six years. he new machine is expected to have 6erovalue at the end of the six4year period. he disposal value of the old machine at the time of replacement is6ero. %hat is the internal rate of returnB

0. +>N . +N C. +:N <. +DN@=. ;ive mutually exclusive projects had the following information1

0 C <

2"5 M> M(=) M= M+,I +=N DN +?N +N

%hich project is preferredB0. 0 C. C. <. <

"age of :



"age : of :

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