CAPITAL BUDGETING

Question 1

1. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
   a. Book value of the existing machine
   b. Original cost of the existing machine
   c. Depreciated cost of the existing machine
   d. Expected resale price of the existing machine

Answer 1

d. Expected resale price of the existing machine

Question 2

2. In capital budgeting, which of the following is NOT considered in the net investment for decision making purposes?
   a. Additional working capital requirements
   b. Tax shield on loss of disposal of old machine
   c. Salvage value of the old machine to be replaced
   d. Salvage value of the new machine for replacement

Question 3

3. Bangtan Company considers replacing old equipment that has a net book value of P 100,000, remaining useful life of 4 years with P 25,000 depreciation each year. The old equipment can be sold for P 80,000. The new equipment costs P 160,000 and has a 4-year useful life. Cash savings on operating expenses before 40% taxes amount to P 50,000 per year. What is the amount of initial net cash outflow in the new equipment?
   a. P 160,000
   b. P 80,000
   c. P 72,000
   d. P 68,000

Answer 3

c. P 72,000
Solution: Net investment: costs – savings = present cash OUT – present cash IN = 160,000 – (80,000 + 8,000*)
* Tax savings from loss on sale of old equipment: 40% (80,000 – 100,000)

Question 4

4. In computing the initial investment for decision-making, taxes would be relevant for all of the following, EXCEPT:
   a. Avoidable repairs of old asset
   b. Profit on sale of old asset replaced by a new one
   c. Increase in working capital required to support new capital investment
   d. Loss on write-off of other assets disposed because of new capital investment

Answer 4

c. Increase in working capital required to support new capital investment

Question 5

5. Army Industries invested in a new machine that cost P 80,000. The machine being depreciated over 5 years using
   straight-line depreciation with no salvage value. The machine is expected to produce incremental cash revenues of
   P 100,000 per year and incremental cash expenses of P 30,000 per year. The tax rate is 25%. Calculate Army Industries’ incremental operating after-tax cash flows.
   a. P 70,000
   b. P 56,500
   c. P 52,500
   d. P 40,500

Answer 5

Solution: After-tax cash flow: (100,000 – 30,000) 75% = 52,500
Tax shield of depreciation: (80,000 ÷ 5 years) 25% = 4,000

Question 7

7. As a capital budgeting technique, the payback period considers depreciation expense (DE) and time value of money
   (TMV) as follows:
   a. DE, relevant and TVM, relevant
   b. DE, irrelevant and TVM, irrelevant
   c. DE, irrelevant and TVM, relevant
   d. DE, relevant and TVM, irrelevant

Question 8

8. The payback method assumes that all cash inflows are reinvested to yield a return equal to
   a. The discount rate
   b. The hurdle rate
   c. The internal rate of return
   d. Zero

Answer 8

d. Zero

Question 10

10. What is the net present value of the project?
    a. P 36,000
    b. P 57,000
    c. P 68,000
    d. P 250,000

Answer 10

Solution: Net present value = 130,000 (3.6) – 400,000
Incidentally, Profitability index = 468,000 ÷ 400,000 = 1.17 times

Question 11

11. What is the internal rate of return on the project?
    a. Less than 12%
    b. Less than 14%, but more than 12%
    c. Less than 16%, but more than 14%
    d. More than 16%

Answer 11

Solution: PV factor: 400,000 ÷ 130,000 = 3.076

Question 12

12. The calculation of the net present value of an investment project requires that the depreciation tax shield be
    included at:
    a. the amount of the depreciation times the tax rate.
    b. the amount of the depreciation with no adjustment for taxes.
    c. the amount of the depreciation times one minus the tax rate.
    d. zero, since depreciation is not relevant to the calculation of net present value.

Question 13

13. In an investment in plant asset, the return that keeps the market price of the firm stock unchanged is
    a. Net present value
    b. Cost of capital
    c. Adjusted rate of return
    d. Unadjusted rate of return

Answer 13

b. Cost of capital

Question 14

14. Which capital budgeting method assumes that the funds are reinvested at the company’s cost of capital?
    a. Payback
    b. Accounting rate of return
    c. Net present value
    d. Time adjusted rate of return

Question 15

15. The internal rate of return method assumes that the project funds are reinvested at the
    a. Hurdle rate
    b. Cost of debt capital
    c. Cost of equity capital
    d. Rate of return earned on the project

Question 16

16. Everything else being equal, the internal rate of return (IRR) of an investment project will be lower if:
    a. Cash inflows are larger
    b. The investment cost is lower
    c. The project has a shorter payback period
    d. Cash inflows are received later in project life

Answer 16

d. Cash inflows are received later in project life

Question 17

17. All other factors equal, which will affect a project’s internal rate of return, net present value and payback period?
    a. An increase in discount rate
    b. A decrease in the life of the project
    c. An increase in the initial cost of the project
    d. All of the choices

Answer 17

c. An increase in the initial cost of the project

Question 18

18. If a capital project’s sophisticated rate falls below the hurdle rate, then its
    a. NPV < 0
    b. NPV > 0
    c. NPV = 0
    d. NPV = 1

Answer 18

a. NPV < 0

Question 19

19. Capital rationing
    a. Is another term for Capital Budgeting
    b. Is not necessary when interest rates are low
    c. Is not a problem for firms that have a high cost of capital
    d. Is the process of selecting the more desirable projects from all those available.

Answer 19

d. Is the process of selecting the more desirable projects from all those available.

Question 20

20. Consider the following two mutually exclusive projects: Project X costs P 500 and has cash flows of P 400 in each
    of the next 2 years. Project Y also costs P 500, and generates cash flows of P 600 and P 100 for the next 2 years,
    respectively. Which project(s) should the firm choose if the cost of capital is 25%?
    a. Project X only
    b. Project Y only
    c. Both Projects
    d. Neither of the Two Projects

Answer 20

Solution: Project X: NPV = 400 (1.44) – 500 = 76 Project Y: NPV = 600 (0.8) + 100 (0.64) – 500 = 44

Question 21

21. A project that when accepted or rejected will not affect the cash flows of another project refers to:
    a. Dependent projects
    b. Independent projects
    c. Mutually inclusive projects
    d. Mutually exclusive projects

Answer 21

b. Independent projects