TEST BANK FOR CAPITAL BUDGETING CHADRA SEKRAH

1. Which of the following about capital budgeting and capital budget is incorrect?
a. Capital budgeting is the process of planning expenditures for assets, the return on which are expected to be
realized within one year.
b. Once capital decisions are made, they tend to be relatively inflexible because the commitments extend well
into the future.
c. In capital budgeting, accurate forecasting is needed to anticipate changes in the demand for the product so
that the firm may realize full economic benefits when the capital asset is available for use.
d. In capital budgeting, planning is important because of possible changes in inflation, the money supply and
interest rates.
ANSWER: A
Capital Budgeting is the process of planning expenditures for assets, the return on which are expected to
continue beyond one year.
2. The capital budget is a (an)
a. plan that coordinates and communicates a company’s plan for the coming year to all the segments of the
organization.
b. plan that assesses the firm’s expenditures for long-lived assets.
c. plan to insure that there is enough working capital for the company’s needs.
d. a plan that establishes the firm’s long-term goals in the context of relevant factors in the firm’s environment.
ANSWER: B
A Capital Budget is a plan that assesses the firm’s expenditures for long-lived assets.
 The plan that coordinates and communicates a company’s plan for the coming year to all the segments of
the organization is called operating budget.
 A capital budget involves long-term investment needs, not working capital for operating needs.
 Strategic planning establishes the firm’s long-term goals in the context of relevant factors in the firm’s
environment.
3. Capital budgeting techniques are least likely to be used in evaluating
a. a disinvestment decision, such as sale of unprofitable business segment.
b. the acquisition of a new ship by a shipping line.
c. the adoption of the ABC system in allocating costs to product lines.
d. the implementation of a major advertising program that will have long-term effects on the company.
ANSWER: C
Capital budgeting involves planning expenditures for long-term investments, as well as the financing
ramifications of such investments.
The ABC system, which is a method of allocating costs to product lines, has no effect on the firms’ cash
flows, does not relate to acquisition of long-term assets, and is not concerned with financing. Hence, the capital
budgeting techniques have nothing to do with such allocation method.
 A disinvestments decision, such as a sale of unprofitable business segment should be evaluated using
capital budgeting techniques.
4. The following items are included in the computation of the net cost of investment, except:
a. The initial cash outlay covering all expenditures on the investment project up to the time when it is ready for
use or operation.
b. Working capital requirement to operate the capital investment project.
c. Avoidable cost of immediate repairs on old asset to be replaced, net of tax.
d. The book value of the old asset to be replaced.
ANSWER: D
The book value of an old asset to be replaced is irrelevant, and therefore not included in the
computation of the net cost of investment.
5. In evaluating capital investment proposals, the project’s expected rate of return is compared with a hurdle rate, or a
desired rate of return. This standard rate may be the weighted-average rate of return of the company must pay to its
long-term creditors and shareholders for the use of their funds. It is the cost of using funds and is more commonly
called as:
1
a. discount rate
b. capital
c. capital expense
d. cost of capital
ANSWER: D
Cost of capital is the cost of using funds. It is also called hurdle rate, minimum desired rate of return, and
standard rate. It may be used as a discount rate to convert future cash flows to present value. The project’s expected
rate of return is compared with this hurdle rate or standard rate. It is the weighted-average rate of return the company
must pay to its long-term creditors and shareholders for the use of heir funds.
6. Which of the following statements about cash flow determination for capital budgeting purposes is incorrect?
a. Relevant opportunity costs are included in the cash flow forecast.
b. Tax savings due to depreciation expense must be considered.
c. Depreciation is relevant because it affects net income.
d. Changes in net working capital should be included in the cash flow forecast.
ANSWER: C
Depreciation, although an expense, is a non-cash item, so it does not affect the projected cash flow of an
investment project. What is relevant is the tax savings due to depreciation expense.
7. The discounted cash flow model is ordinarily considered the best model for long-range decision-making. It may be
characterized as follows, except:
a. The discounted cash flow model considers the time value of money.
b. The discounted cash flow model involves interest factors and risk.
c. The accounting rate of return and net present value methods are among the methods used in the
discounted cash flow model.
d. The model involves the use of present value factors to discount the future cash flows to present values.
ANSWER: C
The discounted cash flow model considers the time value of money. The internal rate of return and net
present value methods are among the methods used in this model.
 The accounting rate of return which does not consider the time value of money is not a method under the
discounted cash flow model.
8. Sandy Corporation is planning to buy a new equipment costing P150,000 to replace an old one purchased 6 years
ago for P90,000. The old equipment is being depreciated on a straight-line basis over 10 years to a zero salvage
value.
The same method and useful life will be used to depreciate the new equipment. Sandy Corporation pays tax at a
rate of 32% of income before tax.
If the old equipment is sold for P30,000 and the new one is purchased, the net cash investment at the time of
purchase of the new one is
a. P118,080
b. P150,000
c. P121,920
d. P120,000
ANSWER: A
SOLUTION:
Purchase price of the new equipment P150,000
Less: Proceeds from sale of old equipment P30,000
Tax savings due to loss on sale of old equipment:
Sales value P30,000
Less book value: Acquisition cost P90,000
Accum. Dep’n
([P90,000/10] x 6years) 54,000
Book value P36,000
Loss on sale P 6,000
x Tax rate 32%1,920 31,920
Net cash investment on the new equipment P118,080
9. Ojie, Inc. provides hot, ready-to-eat meals to construction workers. The company is considering the purchase of a
new truck to replace an old truck now in use in delivering meals to construction sites. The new truck would cost P2M.
2
If the new truck is purchased, the old truck will be sold as is to another company for P400,000. This old truck was
acquired for P1.2M and has a current book value of P500,000.
If the new truck is not purchased, the company will have to continue using the old one, although extensive
repairs would be needed that will cost P250,000. This repairs cost will be expensed, for tax purposes, in the year
incurred.
The income tax rate for corporations is 32%.
If the new truck is purchased, the net cost of investment for decision-making purposes is:
a. P1,398,000
b. P2,000,000
c. P1,350,000
d. P1,462,000
ANSWER: A
SOLUTION:
Purchase cost of new truck P2,000,000
Less: Proceeds from sale of old truck, including
Tax savings due to loss on sale
Sales proceeds P400,000
Tax savings due to loss on sale:
Sales proceeds P400,000
Book value 500,000
Loss P100,000
x Tax rate 32% 32,000
Avoidable cost of repairs, net of tax
(P250,000 x 68%) 170,000 602,000
Net cost of investment for decision-making purposes P1,398,000
ITEMS 10 AND 11 ARE BASED ON THE FOLLOWING INFORMATION:
ACR Company, which operates a school canteen, is planning to buy a dough-nut making machine for P300,000. The
machine is expected to produce 36,000 units of doughnuts per year which can be sold for P10 each. Variable cost to
produce and sell the doughnut is P4 per unit. Incremental fixed costs, exclusive of depreciation, is estimated at
P56,000 per year. The doughnut-making machine will be depreciated on a straight-line basis for 5 years to a zero
salvage value. The company pays income tax at a rate of 32%.
10. What is the expected annual return (accounting net income) to be earned from the doughnut-making machine?
a. P108,800
b. P128,000
c. P100,000
d. P 68,000
ANSWER: D
SOLUTION:
Sales (P36,000 x P10) P360,000
Less variable costs (36,000 x P4) 144,000
Contribution margin P216,000
Less fixed costs: Cash fixed costs P56,000
Depreciation (P300,000/5years) 60,000 116,000
Income before tax P100,000
Less tax (32%) 32%
Accounting net income P 68,000
11. What is the annual net cash inflows from the doughnut-making machine?
a. P108,800
b. P128,000
c. P100,000
d. P 68,000
ANSWER: B
SOLUTION:
Net Income (from Item #10) P 68,000
Add depreciation 60,000
Net cash inflows P128,000
3
Alternative Solution 1 (Data taken from Solution to Item #10):
Cash inflow (sales) P360,000
Less cash outflows: Variable costs P144,000
Cash fixed costs 56,000
Tax 32,000 232,000
Net cash inflows P128,000
Alternative Solution 2:
Sales P360,000
Less cash costs: Variable P144,000
Fixed 56,000 200,000
Cash inflows before depreciation and tax P160,000
Less tax (P160,000-depreciation of P60,000)32% 32,000
Net cash inflows P128,000
In computing net income, depreciation expense is deducted because it is a tax deductible expense. When net cash
inflows is computed, depreciation is added back to net income because it (depreciation) is a non-cash expense.
Thus, only the tax effect of depreciation is considered in the computation of net cash inflows.
Alternative Solution 3:
Cash inflow before depreciation and tax
(from Alternative Solution 2) P160,000
Less: Tax (32%) P51,200
Tax savings due to depreciation
(P60,000 x 32%) (19,200) 32,000
Net cash inflows P128,000
Depreciation serves as a tax shield because it reduces taxable income. In this case, the tax savings due to the
depreciation tax shield is P19,200 (P20,000 x 32%).
ITEMS 12 AND 14 ARE BASED ON THE FOLLOWING INFORMATION:
Fermin Printers, Inc. is planning to replace its present printing equipment with a more efficient unit. The new
equipment will cost P400,000, with a five-year useful life, no salvage value.
The old unit was acquired three years ago for P500,000. The company uses the straight-line method in depreciating
its depreciable assets. The old unit is being depreciated at P62,500 per year. If the new equipment is acquired, the
old one will be sold for P100,000. Otherwise, the company will just continue using it for five years.
Cash operating costs are P100,000 and P220,000 for the new and old equipment, respectively. Income tax is at the
rate of 32% of income before tax.
12. The increase in annual net income as a result of acquiring the new equipment is:
a. P27,200
b. P31,900
c. P69,700
d. P87,200
ANSWER: C
SOLUTION:
Savings in cash operating costs (P220,000 – P100,000) P120,000
Less incremental depreciation:
New equipment (P400,000/5) P80,000
Old equipment 62,500 17,500
Savings or income before tax P102,500
Less tax (32%) 32,000
Incremental annual net income P 69,700
13. What is the expected increase in annual net cash inflows if the new equipment is acquired?
a. P52,200
b. P87,200
c. P 69,700
d. P149,700
ANSWER: B
SOLUTION:
4
Annual