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Capital Budgeting-Management Advisory Services_CPAR

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MANAGEMENT ADVISORY SERVICES

CAPITAL BUDGETING

THEORY

1. Capital budgeting techniques are least likely to be used in evaluating the

A. Acquisition of new aircraft by a cargo company.

B. Design and implementation of a major advertising program.

C. Trade for a star quarterback by a football team.

D. Adoption of a new method of allocating non-traceable costs to product lines.

2. The inflation element refers to the

A. Impact that future price increases will have on the original cost of a capital expenditure.

B. Fact that the real purchasing power of a monetary unit usually increases over time.

C. Future deterioration of the general purchasing power of the monetary unit.

D. Future increases in the general purchasing power of the monetary unit.

3. Mahlin Movers, Inc. is planning to purchase equipment to make its operations more efficient.

This equipment has an estimated useful life of six years. As part of this acquisition, a

P150,000 investment in working capital is required. In a discounted cash flow analysis, this

investment in working capital should be

A. Amortized over the useful life of the equipment.

B. Disregarded because no cash is involved.

C. Treated as a recurring annual cash flow that is recovered at the end of six years.

D. Treated as an immediate cash outflow that is recovered at the end of six years.

4. To

A.

B.

C.

D.

Added back to net income because it is an inflow of cash.

Subtracted from net income because it is an outflow of cash.

Subtracted from net income because it is an expense.

Added back to net income because it is not an outflow of cash.

5. In capital expenditures decisions, the following are relevant in estimating operating costs

except

A. Future costs.

B. Cash costs.

C. Differential costs. D. Historical costs.

6. Which of the following best identifies the reason for using probabilities in capital budgeting

is

A. Different life of projects.

C. Uncertainty.

B. Cost of capital.

D. Time value of money.

7. In capital budgeting decisions, the following items are considered among others:

1. Cash outflow for the investment.

2. Increase in working capital requirements.

3. Profit on sale of old asset

4. Loss on write-off of old asset.

For which of the above items would taxes be relevant?

A. Items 1 and 3 only.

C. All items.

B. Items 3 and 4 only.

D. Items 1, 3 and 4 only.

8. Your company is purchasing a transport equipment as part of its territorial expansion

strategy. The technical services department indicated that this equipment needs overhauling

in year 4 or year 5 of its useful life. The overhauling cost will be expected during the year

MSQ-06

Page 1

the overhauling is done. The finance officer insists that the overhauling be done in year 4,

not in year 5. The most likely reason is

A. There is lower tax rate in year 5.

C. The time value of money is considered.

B. There is higher tax rate in year 5

D. Due statements A and C above.

9. An

A.

B.

C.

D.

optimal capital budget is determined by the point where the marginal cost of capital is

Minimized.

Equal to the average cost of capital.

Equal to the rate of return on total assets.

Equal to the marginal rate of return on investment.

10. The following statements refer to the accounting rate of return (ARR)

1. The ARR is based on the accrual basis, not cash basis.

2. The ARR does not consider the time value of money.

3. The profitability of the project is considered.

From the above statements, which are considered limitations of the ARR concept?

A. Statements 2 and 3 only.

C. All the 3 statements.

B. Statements 3 and 1 only.

D. Statements 1 and 2 only.

11. The payback method assumes that all cash inflows are reinvested to yield a return equal to

A. the discount rate.

C. the internal rate of return.

B. the hurdle rate.

D. zero.

12. As a capital budgeting technique, the payback period considers depreciation expenses (DE)

and time value of money (TVM) as follows:

A.

B.

C.

D.

DE

relevant

irrelevant

Irrelevant

relevant

TVM

relevant

irrelevant

Relevant

irrelevant

13. The bailout payback period is

A. The payback period used by firms with government insured loans.

B. The length of time for payback using cash flows plus the salvage value to recover the

original investment

C. (a) and (b)

D. None of the above.

14. Which of the following methods measures the cash flows and outflows of a project as if they

occurred at a single point in time?

A. Cash flow based payback period.

C. Payback method.

B. Capital budgeting.

D. Discounted cash flow.

15. When using one of the discounted-cash-flow methods to evaluate the feasibility of a capital

budgeting project, which of the following factors generally is not important?

A. The method of financing the project under consideration.

B. The impact of the project on income taxes to be paid.

C. The timing of cash flows relating to the project.

D. The amount of cash flows relating to the project.

16. In an investment in plant the return that should keep the market price of the firm stock

unchanged is

A. Payback

C. Net present value

B. Discounted rate of return

D. Cost of capital

17. The excess present value method is anchored on the theory that the future returns, expressed

in terms of present value, must at least be

A. Equal to the amount of investment

C. More than the amount of investment

B. Less than the amount of investment

D. Cannot be determined

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18. A company had made the decision to finance next years capital projects through debt rather

than additional equity. The benchmark cost of capital for these projects should be

A. The before-tax cost of new-debt financing. C. The cost of equity financing.

B. The after-tax cost of new-debt financing. D. The weighted-average cost of capital.

19. All of the following refer to the discount rate used by a firm in capital budgeting except

A. Hurdle rate.

C. Opportunity cost.

B. Required rate of return.

D. Opportunity cost of capital.

20. If a firm identifies (or creates) an investment opportunity with a present value <List A> its

cost, the value of the firm and the price of its common stock will <List B>

A.

B.

C.

D.

List A

Greater than

Greater than

Equal to

Equal to

List B

Increase

Decrease

Increase

Decrease

21. The common assumption in capital budgeting analysis is that cash inflows occur in lump

sums at the end of individual years during the life of an investment project when in fact they

flow more or less continuously during those years

A. Results in understated estimates of NPV.

B. Is done because present value tables for continuous flows cannot be constructed.

C. Will result in inconsistent errors being made on estimating NPVs such that project cannot

be evaluated reliably.

D. Results in higher estimate for the IRR on the investment.

22. An advantage of the net present value method over the internal rate of return model in

discounted cash flow analysis is that the net present value method

A. Computes a desired rate of return for capital projects.

B. Can be used when there is no constant rate of return required for each year of the project.

C. Uses a discount rate that equates the discounted cash inflows with the outflows.

D. Uses discounted cash flows whereas the internal rate of return model does not.

23. When using the net present value method for capital budgeting analysis, the required rate of

return is called all of the following except the

A. Risk-free rate.

B. Cost of capital.

C. Discount rate.

D. Cutoff rate.

24. A projects net present value, ignoring income tax considerations, is normally affected by the

A. Proceeds from the sale of the asset to be replaced.

B. Carrying amount of the asset to be replaced by the project.

C. Amount of annual depreciation on the asset to be replaced.

D. Amount of annual depreciation on fixed assets used directly on the project.

25. You have determined the profitability of a planned project by finding the present value of all

the cash flows from that project. Which of the following would cause the project to look less

appealing, that is, have a lower present value?

A. The discount rate increases.

B. The cash flows are extended over a longer period of time.

C. The investment cost decreases without affecting the expected income and life of the

project.

D. The cash flows are accelerated and the project life is correspondingly shortened.

26. How are the following used in the calculation of the internal rate of return of a proposed

project? Ignore income tax considerations.

A.

B.

C.

D.

Residual sales value of project

Exclude

Include

Exclude

Include

Depreciation expense

Include

Include

Exclude

Exclude

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27. The discount rate that equates the present value of the expected cash flows with the cost of

the investment is the

A. Net present value

C. Accounting rate of return

B. Internal rate of return

D. Payback period.

28. Which of the following characteristics represent an advantage of the internal rate of return

techniques over the accounting rate of return technique in evaluating a project?

I Recognition of the projects salvage value.

II Emphasis on cash flows.

III Recognition of the time value of money.

A. I only.

B. I and II.

C. II and III.

D. I, II, and III.

29. Polo Co. requires higher rates of return for projects with a life span greater than 5 years.

Projects extending beyond 5 years must earn a higher specified rate of return. Which of the

following capital budgeting techniques can readily accommodate this requirement?

A.

B.

C.

D.

Internal Rate of Return

Yes

No

No

Yes

Net Present Value

No

Yes

No

Yes

30. Which of the following combinations is NOT possible?

Profitability Index

NPV

A. Greater than 1

Positive

B. Equals 1

Zero

C. Less than 1

Negative

D. Less than 1

Positive

IRR

More than cost of capital

Equals cost of capital

Less than cost of capital

Less than cost of capital

31. Which of the following is always true with regard to the net present value (NPV) approach?

A. If a project is found to be acceptable under the NPV approach, it would also be

acceptable under the internal rate of return (IRR) approach.

B. The NPV and the IRR approaches will always rank projects in the same order.

C. If a project is found to be acceptable under the NPV approach, it would also be

acceptable under the payback approach.

D. The NPV and payback approaches will always rank projects in the same order.

32. When ranking two mutually exclusive investments with

management should give first priority to the project

A. That generates cash flows for the longer period of time.

B. Whose net after-tax flows equal the initial investment.

C. That has the greater accounting rate of return.

D. That has the greater profitability index.

different

initial

amounts,

33. Which mutually exclusive project would you select, if both are priced at $1,000 and your

discount rate is 15%; Project A with three annual cash flows of $1,000, or Project B, with 3

years of zero cash flow followed by 3 years of $1,500 annually?

A. Project A.

B. Project B.

C. The IRRs are equal, hence you are indifferent.

D. The NPVs are equal, hence you are indifferent.

34. Payback period (PP), profitability index (PI), and simple accounting rate of return (SARR)

are some of the capital budgeting techniques. What is the effect of an increase in the cost of

capital on these techniques?

A.

B.

C.

D.

PP

Increase

No change

No change

Decrease

PI

Decrease

Decrease

Increase

No change

SARR

Increase

No change

Decrease

No change

MSQ-06

Page 4

35. A company is evaluating three possible investments. Information relating to the company and

the investments follow:

Fisher rate for the three projects

7%

Cost of capital

8%

Based on this information, we know that

A. all three projects are acceptable.

B. none of the projects are acceptable.

C. the capital budgeting evaluation techniques profitability index, net present value, and

internal rate of return will provide a consistent ranking of the projects.

D. the net present value method will provide a ranking of the projects that is superior to the

ranking obtained using the internal rate of return method.

36. Several proposed capital projects which are economically acceptable may have to be ranked

due to constraints in financial resources. In ranking these projects, the least pertinent is this

statement.

A. If the internal rate of return method is used in the capital rationing problem, the higher

the rate, the better the project.

B. In selecting the required rate of return, one may either calculate the organizations cost of

capital or use a rate generally acceptable in the industry.

C. A ranking procedure on the basis of quantitative criteria may be established by specifying

a minimum desired rate of return, which rate is used in calculating the net present value

of each project.

D. If the net present value method is used, the profitability index is calculated to rank the

projects. The lower the index, the better the project.

37. Capital budgeting methods are often divided into two classifications: project screening and

project ranking. Which one of the following is considered a ranking method rather than a

screening method?

A. Net present value.

C. Profitability index.

B. Time-adjusted rate of return.

D. Accounting rate of return.

38. A company has analyzed seven new projects, each of which has its own internal rate of

return. It should consider each project whose internal rate of return is _____ its marginal cost

of capital and accept those projects in _____ order of their internal rate of return.

A. Below; decreasing.

C. Above; increasing.

B. Above; decreasing.

D. Below; increasing.

39. Velasquez & Co. is considering an investment proposal for P10 million yielding a net present

value of P450,000. The project has a life of 7 years with salvage value of P200,000. The

company uses a discount rate of 12%. Which of the following would decrease the net

present value?

A. Extend the project life and associated cash inflows.

B. Increase discount rate to 15%.

C. Decrease the initial investment amount to P9.0 million.

D. Increase the salvage value.

40. What is the effect of changes in cash inflows, investment cost and cash outflows on

profitability (present value) index (PI)

A. PI will increase with an increase in cash inflows, a decrease in investment cost, or a

decrease in cash outflows.

B. PI will increase with an increase in cash inflows, an increase in investment cost, or an

increase in cash outflows.

C. PI will decrease with an increase in cash inflows, a decrease in investment cost, or a

decrease in cash outflows.

D. PI will decrease with an increase in cash outflows, an increase in investment cost, or an

increase in cash inflows.

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Page 5

PROBLEMS

1. Acme is considering the sale of a machine with a book value of $80,000 and 3 years

remaining in its useful life. Straight-line depreciation of $25,000 annually is available. The

machine has a current market value of $100,000. What is the cash flow from selling the

machine if the tax rate 40%.

A. $25,000

B. $80,000

C. $92,000

D. $100,000

2

remaining useful life of 5 years, and annual straight-line depreciation of $80,000. The

existing machine has a current market value of $400,000. The replacement machine would

cost $550,000, have a 5-year life, and save $75,000 per year in cash operating costs. If the

replacement machine would be depreciated using the straight-line method and the tax rate is

40%, what would be the net investment required to replace the existing machine?

A. $90,000.

B. $150,000

C. $330,000

D. $550,000

3. Diliman Republic Publishers, Inc. is considering replacing an old press that cost P800,000 six

years ago with a new one that would cost P2,250,000. Shipping and installation would cost

an additional P200,000. The old press has a book value of P150,000 and could be sold

currently for P50,000. The increased production of the new press would increase inventories

by P40,000, accounts receivable by P160,000 and accounts payable by P140,000. Diliman

Republics net initial investment for analyzing the acquisition of the new press assuming a

35% income tax rate would be

A. P2,450,000

B. P2,425,000

C. P2,600,000

D. P2,250,000

4. Key Corp. plans to replace a production machine that was acquired several years ago.

Acquisition cost is P450,000 with salvage value of P50,000. The machine being considered

is worth P800,000 and the supplier is willing to accept the old machine at a trade-in value of

P60,000. Should the company decide not to acquire the new machine, it needs to repair the

old one at a cost of P200,000. Tax-wise, the trade-in transaction will not have any

implication but the cost to repair is tax-deductible. The effective corporate tax rate is 35% of

net income subject to tax. For purposes of capital budgeting, the net investment in the new

machine is

A. P540,000

B. P610,000

C. P660,000

D. P800,000

5. Great Value Company is planning to purchase a new machine costing P50,000 with freight

and installation costs amounting to P1,500. The old unit is to be traded-in will be given a

trade-in allowance of P7,500. Other assets that are to be retired as a result of the acquisition

of the new machine can be salvaged and sold for P3,000. The loss on retirement of these

other assets is P1,000 which will reduce income taxes of P400. If the new equipment is not

purchased, repair of the old unit will have to be made at an estimated cost of P4,000. This

cost can be avoided by purchasing the new equipment. Additional gross working capital of

P12,000 will be needed to support operation planned with the new equipment.

The net investment assigned to the new machine for decision analysis is

A. P50,200

B. P52,600

C. P53,600

D. P57,600

6. Hooker Oak Furniture Company is considering the purchase of wood cutting equipment.

Data on the equipment are as follows:

Original investment

$30,000

Net annual cash inflow

$12,000

Expected economic life in years

5

Salvage value at the end of five years

$3,000

The company uses the straight-line method of depreciation with no mid-year convention.

What is the accounting rate of return on original investment rounded off to the nearest

percent, assuming no taxes are paid?

A. 40.0%

B. 20.0%

C. 24.0%

D. 22.0%

7. A company is considering putting up P50,000 in a three-year project.

The companys

MSQ-06

Page 6

expected rate of return is 12%. The present value of P1.00 at 12% for one year is 0.893, for

two years is 0.797, and for three years is 0.712. The cash flow, net of income taxes will be

P18,000 (present value of P16,074) for the first year and P22,000 (present value of P17,534)

for the second year. Assuming that the rate of return is exactly 12%, the cash flow, net of

income taxes, for the third year would be

A. P7,120

B. P10,000

C. P16,392

D. P23,022

8. Lor Industries is analyzing a capital investment proposal for new machinery to produce a

new product over the next ten years. At the end of the ten years, the machinery must be

disposed of with a zero net book value but with a scrap salvage value of P20,000. It will

require some P30,000 to remove the machinery. The applicable tax rate is 35%. The

appropriate end-of-life cash flow based on the foregoing information is

A. Inflow of P30,000.

C. Outflow of P10,000.

B. Outflow of P6,500.

D. Outflow of P17,000.

9. C Corp. faces a marginal tax rate of 35 percent. One project that is currently under evaluation

has a cash flow in the fourth year of its life that has a present value of $10,000 (after-tax). C

Corp. assumes that all cash flows occur at the end of the year and the company uses 11

percent as its discount rate. What is the pre-tax amount of the cash flow in year 4? (Round to

the nearest dollar.)

A. $15,181

B. $23,356

C. $9,868

D. $43,375

10. Maxwell Company has an opportunity to acquire a new machine to replace one of its present

machines. The new machine would cost $90,000, have a 5-year life, and no estimated

salvage value. Variable operating costs would be $100,000 per year. The present machine

has a book value of $50,000 and a remaining life of 5 years. Its disposal value now is

$5,000, but it would be zero after 5 years. Variable operating costs would be $125,000 per

year. Ignore income taxes. Considering the 5 years in total, what would be the difference in

profit before income taxes by acquiring the new machine as opposed to retaining the present

one?

A. $10,000 decrease B. $15,000 decrease C. $35,000 increase D. $40,000 increase

11. A project under consideration by the White Corp. would require a working capital investment

of $200,000. The working capital would be liquidated at the end of the project's 10-year life.

If White Corp. has an after-tax cost of capital of 10 percent and a marginal tax rate of 30

percent, what is the present value of the working capital cash flow expected to be received in

year 10?

A. $36,868

B. $77,100

C. $53,970

D. $23,130

12. Lyben Inc. is planning to produce a new product. To do this, it is necessary to acquire a new

equipment that will cost the company P100,000. The estimated life of the new equipment is

five years with no salvage value. The estimated income and costs based on expected sales of

P10,000 units per year are:

Sales @ P10.00 per unit

P100,000

Costs @ P8.00 per unit

80,000

Net income

P 20,000

The accounting rate of return based on initial investment is 20%

What will be the accounting rate of return based on initial investment of P100,000 if

management decrease its selling price of the new product by 10%?

A. 5%

B. 10%

C. 15%

D. 20%

13. MLF Corporation is evaluating the purchase of a P500,000 die attach machine. The cash

inflows expected from the investment is P145,000 per year for five years with no equipment

salvage value. The cost of capital is 12%. The net present value factor for five (5) years at

12% is 3.6048 and at 14% is 3.4331. The internal rate of return for this investment is

A. 3.45%

B. 2.04%

C. 13.8%

D. 15.48%

MSQ-06

Page 7

14. APJ, Inc. is planning to purchase a new machine that will take six years to recover the cost.

The new machine is expected to produce cash flow from operations, net of income taxes, of

P4,500 a year for the first three years of the payback period and P3,500 a year of the last

three years of the payback period. Depreciation of P3,000 a year shall be charged to income

of the six years of the payback period. How much shall the machine cost?

A. P12,000

B. P18,000

C. P24,000

D. P36,000

15. Sweets, Etc., Inc. plans to undertake a capital expenditure requiring P2 million cash outlay.

Below are the projected after-tax cash inflow for the five year period covering the useful life.

The companys tax rate is 35%.

Year

1

2

3

4

5

P000

600

700

480

400

400

The founder and president of the candy company believes that the best gauge for capital

expenditure is cash payback period and that the recovery period should not be more than

75% of the useful life of the project or the asset. Should the company undertake the project?

A. No, since the payback period is 4 years or 80% of the useful life of the project.

B. Yes, since the payback period is 3.55 years or 71% of the useful life of the project.

C. No, since the payback period extends beyond the life of the project.

D. Yes, since the payback period is 4 years and still shorter than the useful life of the

project.

16. Womark Company purchased a new machine on January 1 of this year for $90,000, with an

estimated useful life of 5 years and a salvage value of $10,000. The machine will be

depreciated using the straight-line method. The machine is expected to produce cash flow

from operations, net of income taxes, of $36,000 a year in each of the next 5 years. The new

machines salvage value is $20,000 in years 1 and 2, and $15,0000 in years 3 and 4. What

will be the bailout period (rounded) for the new machine?

A. 1.4 years.

B. 2.2 years.

C. 1.9 years.

D. 3.4 years.

17. It is the start of the year and St. Tropez Co. plans to replace its old sing-along equipment.

These information are available:

Old

New

Equipment cost

P70,000

P120,000

Current salvage value

10,000

Salvage value, end of useful life

2,000

16,000

Annual operating costs

56,000

38,000

Accumulated depreciation

55,300

Estimated useful life

10 years

10 years

The companys income tax rate is 35% and its cost of capital is 12%. What is the present

value of all the relevant cash flows at time zero?

A. (P54,000)

B. (P110,000)

C. (P120,000)

D. (P124,700)

18. Cramden Armored Car Co. is considering the acquisition of a new armored truck. The truck

is expected to cost $300,000. The company's discount rate is 12 percent. The firm has

determined that the truck generates a positive net present value of $17,022. However, the

firm is uncertain as to whether it has determined a reasonable estimate of the salvage value of

the truck. In computing the net present value, the company assumed that the truck would be

salvaged at the end of the fifth year for $60,000. What expected salvage value for the truck

would cause the investment to generate a net present value of $0? Ignore taxes.

A. $30,000

B. $0

C. $55,278

D. $42,978

19. Booker Steel Inc. is considering an investment that would require an initial cash outlay of

$400,000 and would have no salvage value. The project would generate annual cash inflows

of $75,000. The firm's discount rate is 8 percent. How many years must the annual cash

flows be generated for the project to generate a net present value of $0?

A. between 5 and 6 years

C. between 7 and 8 years

B. between 6 and 7 years

D. between 8 and 9 years

MSQ-06

Page 8

20. Salvage Co. is considering the purchase of a new ocean-going vessel that could potentially

reduce labor costs of its operation by a considerable margin. The new ship would cost

$500,000 and would be fully depreciated by the straight-line method over 10 years. At the

end of 10 years, the ship will have no value and will be sunk in some already polluted harbor.

The Salvage Co.'s cost of capital is 12 percent, and its marginal tax rate is 40 percent. If the

ship produces equal annual labor cost savings over its 10-year life, how much do the annual

savings in labor costs need to be to generate a net present value of $0 on the project? (Round

to the nearest dollar.)

A. $68,492

B. $114,154

C. $88,492

D. $147,487

21. The McNally Co. is considering an investment in a project that generates a profitability index

of 1.3. The present value of the cash inflows on the project is $44,000. What is the net

present value of this project?

A. $10,154

B. $13,200

C. $57,200

D. $33,846

22. The Zeron Corporation wants to purchase a new machine for its factory operations at a cost

of $950,000. The investment is expected to generate $350,000 in annual cash flows for a

period of four years. The required rate of return is 14%. The old machine can be sold for

$50,000. The machine is expected to have zero value at the end of the four-year period. What

is the net present value of the investment? Would the company want to purchase the new

machine? Income taxes are not considered.

A. $119,550; yes

B. $69,550; no

C. $1,019,550; yes

D. $326,750; no

23. Drillers Inc. is evaluating a project to produce a high-tech deep-sea oil exploration device.

The investment required is $80 million for a plant with a capacity of 15,000 units a year for 5

years. The device will be sold for a price of $12,000 per unit. Sales are expected to be 12,000

units per year. The variable cost is $7,000 and fixed costs, excluding depreciation, are $25

million per year. Assume Drillers employs straight-line depreciation on all depreciable

assets, and assume that they are taxed at a rate of 36%. If the required rate of return is 12%,

what is the approximate NPV of the project?

A. $17,225,000

B. $21,511,000

C. $26,780,000

D. $56,117,000

24. JJ Corp. is considering the purchase of a new machine that will cost P320,000. It has an

estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated

in the first year, 40% in the second year, and 30% in the third year. It has a resale value of

P20,000 at the end of its economic life. Savings are expected from the use of machine

estimated at P170,000 annually. The company has an effective tax rate of 40%. It uses 16%

as hurdle rate in evaluating capital projects. Should the company proceed with the P320,000

capital investment?

Year

Present Value of P1

Present Value of an Ordinary Annuity of P1

1

0.862

0.862

2

0.743

1.605

3

0.641

2.246

A. Yes, due to NPV of P6,556.

C. Yes, due to NPV of P61,820.

B. Yes, due to NPV of P11,684.

D. No, due to negative NPV of P1,136

25. A company's marginal cost of new capital (MCC) is 10% up to $600,000. MCC increases

.5% for the next $400,000 and another .5% thereafter. Several proposed capital projects are

under consideration, with projected cost and internal rates of return (IRR) as follows:

Project

Cost

IRR

A

$100,000

10.5%

B

$300,000

14.0%

C

$450,000

10.8%

D

$350,000

13.5%

E

$400,000

12.0%

What should the company's capital budget be?

A. $0

B. $1,050,000

C. $1,500,000

D. $1,600,000

MSQ-06

Page 9

26. The following forecasts have been prepared for a new investment by Oxford Industries of

$20 million with an 8-year life:

Pessimistic

Expected

Optimistic

Market size

60,000

90,000

140,000

Market share, %

25

30

35

Unit price

$750

$800

$875

Unit variable cost

$500

$400

$350

Fixed cost, millions

$7

$4

$3.5

Assume that Oxford employs straight-line depreciation, and that they are taxed at 35%.

Assuming an opportunity cost of capital of 14%, what is the NPV of this project, based on

expected outcomes?

A. $2,626,415

B. $4,563,505

C. $6,722,109

D. $8,055,722

27. The following data pertain to Sunlight Corp., whose management is planning to purchase an

automated tanning equipment.

1. Economic life of equipment 8 years.

2. Disposal value after 8 years nil.

3. Estimated net annual cash inflows for each of the 8 years P81,000.

4. Time-adjusted internal rate of return 14%

5. Cost of capital of Sunlight Corp 16%

6. The table of present values of P1 received annually for 8 years has these factors: at

14% = 4.639, at 16% = 4.344

7. Depreciation is approximately P46,970 annually.

Find the required increase in annual cash inflows in order to have the time-adjusted rate of

return approximately equal the cost of capital.

A. P5,501

B. P6,501

C. P4,344

D. P5,871

28. Payback Company is considering the purchase of a copier machine for P42,825. The copier

machine will be expected to be economically productive for 4 years. The salvage value at

the end of 4 years is negligible. The machine is expected to provide 15% internal rate of

return. The company is subject to 40% income tax rate. The present value of an ordinary

annuity of 1 for 4 periods is 2.85498. In order to realize the IRR of 15%, how much is the

estimated before-tax cash inflow to be provided by the machine?

A. P17,860

B. P15,000

C. P25,000

D. P35,700

29. Para Co. is reviewing the following data relating to an energy saving investment proposal:

Cost

$50,000

Residual value at the end of 5 years

10,000

Present value of an annuity of 1 at 12% for 5 years

3.60

Present value of 1 due in 5 years at 12%

0.57

What would be the annual savings needed to make the investment realize a 12% yield?

A. $8,189

B. $11,111

C. $12,306

D. $13,889

30. Smoot Automotive has implemented a new project that has an initial cost, and then generates

inflows of $10,000 a year for the next seven (7) years. The project has a payback period of

4.0 years. What is the project's internal rate of return (IRR)?

A. 14.79%

B. 16.33%

C. 18.54%

D. 15.61%

31. Berry Products is considering two pieces of machinery. The first machine costs P50,000

more than the second machine. During the two-year life of these two alternatives, the first

machine has P155,000 more cash flow in year one and a P110,000 less cash flow in year two

than the second machine. All cash flows occur at year-end. The present value of 1 at 15%

end of 1 period and 2 periods are 0.86957 and 0.75614, respectively. The present value of 1

at 8% end of period 1 is 0.92593 and period 2 is 0.85734.

At what discount rate would Machine 1 equally acceptable as machine 2?

A. 9%

B. 10%

C. 11%

D. 12%

MSQ-06

Page 10

32. The Zeron Corporation recently purchased a new machine for its factory operations at a cost

of $921,250. The investment is expected to generate $250,000 in annual cash flows for a

period of six years. The required rate of return is 14%. The old machine has a remaining life

of six years. The new machine is expected to have zero value at the end of the six-year

period. The disposal value of the old machine at the time of replacement is zero. What is the

internal rate of return?

A. 15%

B. 16%

C. 17%

D. 18%

33. Rohan Transport is considering two alternative buses to transport people between cities that

are in the Southeastern U.S., such as Baton Rouge and Gainesville. A gas-powered bus has a

cost of $55,000, and will produce end-of-year net cash flows of $22,000 per year for 4 years.

A new electric bus will cost $90,000, and will produce cash flows of $28,000 per year for 8

years. The company must provide bus service for 8 years, after which it plans to give up its

franchise and to cease operating the route. Inflation is not expected to affect either costs or

revenues during the next 8 years. If Rohan Transport's cost of capital is 17 percent, by what

amount will the better project increase the company's value?

A. $5,350

B. -$17,441

C. $10,701

D. $27,801

34. Union Electric Company must clean up the water released from its generating plant. The

company's cost of capital is 11 percent for average projects, and that rate is normally adjusted

up or down by 2 percentage points for high- and low-risk projects. Clean-Up Plan A, which

is of average risk, has an initial cost of $10 million, and its operating cost will be $1 million

per year for its 10-year life. Plan B, which is a high-risk project, has an initial cost of $5

million, and its annual operating cost over Years 1 to 10 will be $2 million. What is the

approximate PV of costs for the better project? (VD)

A. -$5.9 million.

B. -$15.9 million. C. -$16.8 million.

D. -$17.8 million.

35. Mulva Inc. is considering the following five independent projects:

Project

Required Amount of Capital

IRR

A

$300,000

25.35%

B

500,000

23.22%

C

400,000

19.10%

D

550,000

9.25%

E

650,000

8.50%

The company has a target capital structure which is 40 percent debt and 60 percent equity.

The company can issue bonds with a yield to maturity of 10 percent. The company has

$900,000 in retained earnings, and the current stock price is $40 per share. The flotation costs

associated with issuing new equity are $2 per share. Mulva's earnings are expected to

continue to grow at 5 percent per year. Next year's dividend (D1) is forecasted to be $2.50.

The firm faces a 40 percent tax rate. What is the size of Mulva's capital budget?

A. $1,200,000

B. $1,750,000

C. $2,400,000

D. $800,000

36. A tax-exempt foundation, Sincerely Foundation, Inc. intends to invest P1 million in a fiveyear project. The foundation estimates that the annual savings from the project will amount

to P325,000. The P1 million asset is depreciable over five (5) years on a straight-line basis.

The foundations hurdle rate is 12% and as a consultant of the foundation, you are asked to

determine the internal rate of return and advise if the project should be pursued.

To facilitate computations, below are present value factors:

N=5

12%

14%

16%

Present value of P1

0.57

0.52

0.48

Present value of an annuity of P1

3.60

3.40

3.30

Your advice is

A. To proceed due to an estimated IRR of less than 14% but not more than 12%.

B. To proceed due to an estimated IRR of less than 16% but not more than 14%.

C. Not to proceed due to an estimated IRR of less than 12%.

D. To proceed due to an estimated IRR of more than 16%.

MSQ-06

Page 11

37. The following data relate to two capital-budgeting projects of equal risk:

Present Value of Cash Flows

Period

Project A

Project B

0

$(10,000)

$(30,000)

1

4,550

13,650

2

4,150

12,450

3

3,750

11,250

Which of the projects will be selected using the profitability index (PI) approach and the

NPV approach?

A.

B.

C.

D.

PI

B

Either

Either

B

NPV

A

B

A

B

38. Five mutually exclusive projects had the following information:

A

B

C

NPV

$500

$(200)

$200

IRR

12%

8%

13%

Which project is preferred?

A. A

C. C

B. B

D. D

D

$1,000

10%

Proposal

Profitability Index

Initial Cash Outlay

1

1.15

P200,000

2

1.13

125,000

3

1.11

175,000

4

1.08

150,000

The firm has a budget constraint of P300,000.

What proposal(s) should be accepted?

A. Proposal 1 because it has the highest profitability index.

B. Proposal 4 because it has the lowest profitability index.

C. Proposals 2 and 3 because their total net present values are the highest among all possible

proposal combinations.

D. Proposals 1 and 2 because their total net present values are the highest among all possible

proposal combinations.

40. Information on three (3) investment projects is given below:

Project

Investment Required

Net Present Value

X

P150,000

P34,005

G

100,000

22,670

W

60,000

13,602

Rank the projects in terms of preference:

A. 1st W; 2nd G; 3rd X.

C. 1st X; 2nd G; 3rd W.

B. 1st G; 2nd W; 3rd X.

D. The ranking is the same.

Problem 41 and 42 are based on the following information.

Daneches, a tax-exempt entity, plans to purchase a new machine which they project to

depreciate over a ten-year period without salvage value. The new machine will cost P200,000

and is expected to generate cash savings of P60,000 per year in operating costs. Daneche's cost

of capital is 12%.

For ten periods at 12%, the present value of P1 is P0.3220, while the present value of an ordinary

annuity of P1 is P5.650.

41. What is the net present value of the proposed investment, assuming Daneche uses a 12%

discount rate?

A. P185,640

B. P69,980

C. P139,000

D. None of the above.

MSQ-06

Page 12

42. With the companys initial investment on the new machine, the accounting rate of return is

A. 15%

B. 20%

C. 25%

D. None of the above.

Questions 43 and 44 are based on the following information.

The construction of a waste treatment plant was arrived at after a careful cost-benefit analysis.

During the construction period a status report was presented for your review:

completed cost as originally estimated, P5 million

% of actual completion to date, 65%

actual cost to date, P3.75 million

43. Assuming cost is evenly distributed throughout the construction period, how much will the

completion cost be most likely?

A. The original cost estimate of P5 million.

B. P5 million plus a cost overrun of about P769,000

C. P500,000 less than the original cost at completion.

D. About P100,000 above the original cost at completion.

44. What would be an appropriate action to take considering the situation in number 28?

A. No need to take any action.

B. Immediately stop further work on the project.

C. Recommend immediate review with the project implementation team to determine the

cause of overrun and the corrective actions to be taken.

D. Wait for the next quarterly status report on the project.

Questions 45 and 46 are based on the following information.

Beta Company plans to replace its company car with a new one. The new car costs P120,000

and its estimated useful life is five years without scrap value. The old car has a book value of

P15,000 and can be sold at P12,000. The acquisition of the new car will yield annual cash

savings of P20,000 before income tax. Income tax rate is 25%. (M)

45. The net investment of the new car is

A. P108,000

B. P108,750

C. P107,250

A. 5.14 years

B. 5.18 years

C. 5.11 years

D. P107,000

D. 5.095 years

47. Telephone Corp. is contemplating four projects: L, M, N, and O. The capital costs for the

initiation of each mutually-exclusive project and its estimated after-tax, net cash flow are

listed below. The companys desired after-tax opportunity costs is 12%. It has P900,000

capital budget for the year. Idle funds cannot be reinvested at greater than 12%.

In Thousand Pesos

L

M

N

O

Initial cost

400

470

380

420

Annual cash flows

Year 1

113

180

90

80

2

113

170

110

100

3

113

150

130

120

4

113

110

140

130

5

113

100

150

150

Net present value

P7,540

P59,654

P54,666

P(15,708)

Internal rate of return

12.7%

17.6%

17.2%

10.6%

Excess present value index

1.02

1.13

1.14

0.96

The company will choose

A. Projects M & N.

B. Projects L & N. C. Projects L & M.

D. Projects M, N & O.

MSQ-06

Page 13

The Burgos Corporation is considering investing in a project. It requires an immediate cash

outlay of P100,000. It has a life of four years and will be depreciated on a straight-line basis (no

salvage value). The firms tax rate is 25% and requires a return of 10%. Income before

depreciation is projected to be:

YEAR

1

2

3

4

Income before depreciation

P30,000

P30,000

P40,000

P40,000

The present value factors for P1 at 10% is

Year

1

2

3

4

Present Value Factor

0.909

0.826

0.751

0.683

48. The net cash flow for year 1 is

A. P25,850

B. P28,750

C. P31,250

D. P34,450

A. P35,850

B. P35,950

C. P30,150

D. P36,250

A. 3 years

B. 3.17 years

C. 3.5 years

D. 4 years.

A. 7%

B. 9%

C. 12%

D. 15%

A. P23,747.50

B. P25,856.25

C. P26,100.75

D. P29,750.75

A. P95,650.15

B. P98,151.25

C. P101,863.75

D. P104,750.25

54. The profitability index of the project (rounded to the nearest hundredth) is

A. 0.96

B. 0.98

C. 1.02

D. 1.05

55. The project would be accepted on the basis of the

A. Payback and present value results.

B. Accounting rate of return and profitability index results.

C. Payback results only

D. a and b combined

MSQ-06

Page 14

Answer Sheet

Theory

1. D

2. C

3. D

4. D

5. D

6. C

7. B

8. A

9. D

10. D

11. D

12. B

13. B

14. D

15. A

16. D

17. A

18. D

19. C

20. A

21.

22.

23.

24.

25.

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

40.

A

B

A

A

A

D

B

C

D

D

A

D

A

B

C

D

C

B

B

A

Problem

1. C

2. B

3. B

4. B

5. A

6. D

7. D

8. B

9. B

10. D

11. B

12. B

13. C

14. C

15. B

16. C

17. B

18. A

19. C

20. B

21.

22.

23.

24.

25.

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

40.

A

A

B

B

B

B

A

A

C

B

B

B

D

B

B

D

B

D

C

D

41.

42.

43.

44.

45.

46.

47.

48.

49.

50.

51.

52.

53.

54.

55.

C

B

B

C

C

C

A

B

D

B

D

A

C

C

D

MSQ-06

Page 15

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