Fin102/103: Exercises on Capital Budgeting

1. The Ateneo Multi-purpose Cooperative has been operating a cafeteria for all the people within the area of
Bellarmine Hall, but it is considering a conversion from this form of food service to a completely automated set
of coin-vending machines, in which case the old machine would be sold now for whatever cash it may bring.
The vending machines will be purchased for cash immediately. A catering firm will take complete
responsibility for servicing and replenishing the vending machines with inventory, and would simply pay the
cooperative a predetermined percentage of the gross vending receipts. The following data are available (in
thousands of pesos). Ignore taxes. Compute for the projects NPV.
CAFETERIA DATA
Cafeteria cash revenues per year
P120
Cafeteria cash expenses per year
P124
Present cafeteria equipment:
Net book value
P84
Annual depreciation expense
P6
Current cash value (0 value in 10 years)
P4
NEW VENDING MACHINE DATA
Purchase price
P64
Estimated useful life
10 years
Forecast terminal value
P5
Expected annual gross receipts (net of expenses)
P80
Citys share of receipts
10%
2. Pong Lim is trying to choose between a square egg maker (Project A) and an egg scrambler (Project B) as a
promotional gimmick for her new coffee shop. If she chooses one, she will not choose the other (i.e., she
considers them mutually exclusive projects). The square egg makers would require a net initial outlay of
P21,000, and have no salvage value in six years. They would generate sales of P11,000 and have operating
expenses of P3,500 annually. The egg scramblers would cost P21,500 today and have a salvage value of
P14,000 in eight years. They would generate sales of P10,000 and operating expenses of P4,000 annually.
Pong uses straight-line depreciation and her tax rate is 40 percent.
Compute the cash flows for the two projects.
If the discount rate is 10%, find the net present value of projects A and B. Which project should be
accepted?
3. The general manager of the Global Farms, Inc. is considering a proposal for the installation of nest conveyor
belts in order to automate the farms egg collection process. Costs and other data are presented as follows:
Invoice price per belt
Installation cost per belt
Estimated useful life
No. of belts needed by GFI
Salvage value per belt

P22,000
P9,100
5 years
6
P2,000

The seller will grant a 2% discount if the company will buy 5 belts. Automation will reduce the cost of
manual labor by an estimated P42,000 a year. In addition, the incidence of breakages will decrease,
resulting in a P72,000 increase in annual revenues. Service fees and other maintenance fees would require
an additional P48,000 a year. With respect to cashflows, a net cash inflow of P53,600 per year is expected.
Corporate income tax is at 35%. Compute the NPV if i = 15%
4. Mike Bukala of the Aleta Shoe Corporation is trying to choose between two machines to manufacture a new
line of shoes. Machine X requires a net initial outlay of P20,000, has a salvage value of P4,000 in eight years,
and has annual operating expenses of P3,200 and annual revenues of P12,000. Machine Y requires an initial
outlay of P14,000, has a salvage value of P2,000 in four years, and has annual operating expenses of P2,800
and annual revenues of P11,500. Aleta uses straight-line depreciation and has a marginal tax rate of 40%.
Mike has determined that these projects are of above-average risk and he is using a rate of 16% to value the
project.
Required:
1. For each project, find the payback period, the discounted payback and the net present value.
2. Suppose that Mike has determined that Machine Y can be used for 8 years but will have no salvage value
then. Prepare an analysis if NPV is used as the decision criteria.

5. The CA Corporation sells computer services to its clients. The company completed a feasibility study and
decided to obtain an additional computer on January 1, 1996. Information regarding the new computer follows:
1) The purchase price of the computer is P115,000. Maintenance, taxes, and insurance will be P10,000 per
year. If the computer is rented, the annual rent will be P42,500 plus 5% of annual billings.
2) Due to competitive conditions, the company feels it will be necessary to replace the computer at the end of
three years with one that is layer and more advanced. It is estimated that the computer will have a resale
value of P55,000 at the end of three years. The computer will be depreciated on a straight-line bases for
both financial reporting and income tax purposes.
3) The income tax rate is 50 percent.
4) The estimated annual billing for the services of the new computer will be P110,000 during the first year and
P130,000 during each of the second and third years. The estimated annual expense of operating the
computer is P40,000, in addition to the expenses mentioned above. An additional P5,000 of start-up
expenses will be incurred during the first year.
5) If the computer is purchased, the amount of investment recovered during each of the three years can be
reinvested immediately at a 15% rate of return.
Required:
(a) Prepare a schedule of cash flows comparing the annual income from the new computer under the purchase
plan and under the rental plan.
(b) Prepare a schedule showing the annual cash flows under the purchase plan & under the rental plan.
(c) Compare the net present values of the cash flows under each of the two plans. Which plan would you
recommend?

6. Thoma Pharmaceutical Company may buy DNA testing equipment costing 60,000. This equipment is
expected to reduce clinical staff labor costs by 20,000 annually. The equipment is expected to reduce
clinical staff labor costs by 20,000 annually. The equipment has a useful life of 5 years and no salvage
value is expected at the end. The corporate tax rate for Thoma is 38 percent and its required rate of
return is 15 percent.
a.) Is the project acceptable using NPV?
b.) Suppose 6 percent inflation in labor cost savings is expected over the last 4 years, so that
savings in the first year are 20,000, savings in the second year are 21,200, and so forth. What
is the NPV?
c.) If the working capital requirement of 10,000 were required in addition to the cost of the
equipment and this additional investment were needed over the life of the project, what would
be the effect on net present value?
7. M. Higgins, Inc. is considering the purchase of a new grading machine to replace an existing one. The
existing machine was purchased three years ago at an installed cost of 20,000. It was being
depreciated using a five-year recovery. The existing machine is expected to have a usable life of at
least five more years. The new machine would cost 35,000 and 5,000 in installation costs. It would
be depreciated using a five-year recovery period. The existing machine can currently be sold for
25,000, without incurring any removal costs. The firm pays 40 percent taxes on both ordinary income
and capital gains. Calculate the initial investment associated with the proposed purchase of new
grading machine.
8. A firm is considering renewing its equipment to meet increased demand for its product. The cost of
equipment modifications will be 1.9 million plus 100,000 in installation costs. The firm will
depreciate the equipment modifications using a five-year recovery. Additional sales revenue from the
renewal should amount to 1.2 million per year, additional operating expenses and other costs will
amount to 40 percent of additional sales. The firm has an ordinary tax rate of 40 percent. (Answer the
following questions for each of the next five years.)
a.) What incremental earnings before depreciation and taxes will result from the renewal?
b.) What incremental earnings after taxes will result from the renewal?
c.) What incremental operating cash inflow will result from the renewal?