MAS Part II Illustrative Examples (Capital Budgeting)
MAS Part II Illustrative Examples (Capital Budgeting)
MAS Part II Illustrative Examples (Capital Budgeting)
CAPITAL BUDGETING
ILLUSTRATIVE EXAMPLE
PART I:
Initial Investment
Lilipad Ako Para Sayo Corporation, a large, diversified manufacturer of aircraft components, is trying to determine the
initial investment required to replace an old machine with a new, more sophisticated model. The proposed machine’s
purchase price is P380,000, and an additional P20,000 will be necessary to install it. It is expected to provide benefits to
the firm for 5 years and will be depreciated using the straight‐line method with no residual value. The present (old)
machine was purchased 3 years ago at a cost of P240,000 and was also being depreciated under the straight‐line method
using a 5‐year useful life with no residual value. The firm has found a buyer willing to pay P280,000 for the present machine
and to remove it at the buyer’s expense. The firm also expects that a P35,000 increase in current assets and an P18,000
increase in current liabilities will accompany the replacement. The firm pays taxes at a rate of 40%.
What is the initial investment of Lilipad Ako Para Sayo Corporation on this replacement project?
Operating Cash Inflows
Lilipad Ako Para Sayo Corporation’s estimates of its revenue and expenses (excluding depreciation and interest), with and
without the proposed new machine as follows:
With proposed machine With present machine
Year Revenues Expenses* Revenues Expenses*
1 P2,520,000 P2,300,000 P2,200,000 P1,990,000
2 2,520,000 2,300,000 2,300,000 2,110,000
3 2,520,000 2,300,000 2,400,000 2,230,000
4 2,520,000 2,300,000 2,400,000 2,250,000
5 2,520,000 2,300,000 2,250,000 2,120,000
*excluding depreciation and interest
Compute for the annual operating cash flow over the life of the project.
Terminal Cash Flow
Assume that Lilipad Ako Para Sayo Corporation expects to be able to liquidate the new machine at the end of its 5‐year
usable life to net P50,000 after paying removal and cleanup costs. Had it not been replaced by the new machine, the old
machine would have been liquidated at the end of the 5 years to net P10,000. The firm expects to fully recover its net
working capital investment upon termination of the project. The firm pays taxes at a rate of 40%.
What is the terminal cash flow of the company on this replacement project?
PART II:
Accounting Rate of Return
Lilipad Ako Para Sayo Corporation, a large, diversified manufacturer of aircraft components, is considering the purchase
of a new, more sophisticated model of machine. The proposed machine’s purchase price is P380,000, and an additional
P20,000 will be necessary to install it. It is expected to provide benefits to the firm for 5 years and will be depreciated
using the straight‐line method with no residual value. The company estimates its net income from the proposed new
machine as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 2,200,000 2,300,000 2,400,000 2,400,000 2,250,000
Expenses 1,990,000 2,110,000 2,230,000 2,250,000 2,120,000
Earnings for depreciation, 210,000 190,000 170,000 150,000 130,000
interest and taxes
Depreciation 48,000 48,000 0 0 0
Earnings before interest 162,000 142,000 170,000 150,000 130,000
and taxes
Interest 0 0 0 0 0
Income before taxes 162,000 142,000 170,000 150,000 130,000
Taxes 64,800 56,800 68,000 60,000 52,000
Net income 97,200 85,200 102,000 90,000 78,000
The company considers an acceptable accounting rate of return of at least 30%. Compute for the following:
1. Simple Accounting Rate of Return
2. Average Accounting Rate of Return
Payback Period, Discounted Payback Period, Net Present Value, Profitability Index and Internal Rate of Return
Bakal Bote Company, a medium‐sized metal fabricator, is current contemplating between two projects. Presented below
are the timelines depicting the cash flows of Projects X and Y.
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Project X
1 2 3 4 5
(P42,000)
Project Y
1 2 3 4 5
(P45,000)
The company considers a payback period of at most 3 years to be acceptable. The company has a 10% cost of capital.
Compute for the following for both Project X and Y:
1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Profitability Index
5. Internal Rate of Return
Net Present Value Profile
Bakal Bote Company, a medium‐sized metal fabricator, is current contemplating between two projects. Presented below
are the net present value of Project X and Project Y under various discount rates:
Discount rate Project X Project Y
0% 28,000 25,000
10% 11,071 10,924
10.72% 10,112 10,112
19.86% 0 1,410
21.65% ‐1,607 0
1. Graph the net present value profiles of the two projects.
2. Determine the crossover rate of the two projects.
Conflicting Rankings
COVID‐19, Inc., a maker of personal protective equipment (PPE), is considering four projects. The company has a cost of
capital of 12%. Selected information pertaining to the projects is presented below:
Project 1 Project 2 Project 3 Project 4
Initial Investment (P50,000) (P100,000) (P80,000) (P180,000)
Year 1 20,000 35,000 20,000 100,000
Year 2 20,000 50,000 40,000 80,000
Year 3 20,000 50,000 60,000 60,000
NPV (PHP) (1,963) 6,699 12,452 15,768
IRR (%) 9.70 15.63 19.44 17.51
I. Assuming all the projects are independent and the company has unlimited funds to be able to undertake all
projects with acceptable returns:
1. Select the projects to be undertaken by the company using NPV.
2. Select the projects to be undertaken by the company using IRR.
II. Assuming among all the projects, only project 2 and project 3 are mutually exclusive while the rest are
independent and the company has unlimited funds to be able to undertake all projects with acceptable returns:
1. Select the projects to be undertaken by the company using NPV.
2. Select the projects to be undertaken by the company using IRR.
III. Assuming among all the projects are independent and that the company only has P180,000 available for capital
expenditures:
1. Select the projects to be undertaken by the company using NPV.
2. Select the projects to be undertaken by the company using IRR.
IV. Assuming among all the projects, only project 2 and project 3 are mutually exclusive while the rest are
independent and that the company only has P180,000 available for capital expenditures:
1. Select the projects to be undertaken by the company using NPV.
2. Select the projects to be undertaken by the company using IRR.
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