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    Chapter 28 - Answer

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    wynellamae
    This document provides solutions to review questions and problems related to capital budgeting basics. Key points covered include: - Only cash flows, not accounting profits, should be considered in capital budgeting analysis. Sunk costs are irrelevant, while opportunity costs and externalities must be included if they are affected by the decision. - Projects typically require an increase in net working capital that must be financed, so this is included as an initial outflow. At project end, working capital is returned, providing an inflow. - Depreciation is added back when calculating cash flows since it is a non-cash expense. The weighted average cost of capital reflects financing costs so interest should not be double counted. -

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    Chapter 28 - Answer

    Uploaded by

    wynellamae
    4K views6 pages
    This document provides solutions to review questions and problems related to capital budgeting basics. Key points covered include: - Only cash flows, not accounting profits, should be considered in capital budgeting analysis. Sunk costs are irrelevant, while opportunity costs and externalities must be included if they are affected by the decision. - Projects typically require an increase in net working capital that must be financed, so this is included as an initial outflow. At project end, working capital is returned, providing an inflow. - Depreciation is added back when calculating cash flows since it is a non-cash expense. The weighted average cost of capital reflects financing costs so interest should not be double counted. -

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    This document provides solutions to review questions and problems related to capital budgeting basics. Key points covered include: - Only cash flows, not accounting profits, should be considered in capital budgeting analysis. Sunk costs are irrelevant, while opportunity costs and externalities must be included if they are affected by the decision. - Projects typically require an increase in net working capital that must be financed, so this is included as an initial outflow. At project end, working capital is returned, providing an inflow. - Depreciation is added back when calculating cash flows since it is a non-cash expense. The weighted average cost of capital reflects financing costs so interest should not be double counted. -

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    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    4K views6 pages

    Chapter 28 - Answer

    Uploaded by

    wynellamae
    This document provides solutions to review questions and problems related to capital budgeting basics. Key points covered include: - Only cash flows, not accounting profits, should be considered in capital budgeting analysis. Sunk costs are irrelevant, while opportunity costs and externalities must be included if they are affected by the decision. - Projects typically require an increase in net working capital that must be financed, so this is included as an initial outflow. At project end, working capital is returned, providing an inflow. - Depreciation is added back when calculating cash flows since it is a non-cash expense. The weighted average cost of capital reflects financing costs so interest should not be double counted. -

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    Solutions Manual

    CHAPTER 28
    BASICS OF CAPITAL BUDGETING
    SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
    I. Questions
    1. Only cash can be spent or reinvested, and since accounting profits do not
    necessarily represent all cash, they are of less fundamental importance
    than cash flows for investment analysis.
    2. Capital budgeting analysis should only include those cash flows that will
    be affected by the decision. Sunk costs are unrecoverable and cannot be
    changed, so they have no bearing on the capital budgeting decision.
    Opportunity costs represent the cash flows the firm gives up by investing
    in this project rather than its next best alternative, and externalities are
    the cash flows (both positive and negative) to other projects that result
    from the firm undertaking this project. These cash flows occur only
    because the firm took on the capital budgeting project; therefore, they
    must be included in the analysis.
    3. When a firm takes on a new capital budgeting project, it typically must
    increase its investment in receivables and inventories, over and above the
    increase in payables and accruals, thus increasing its net operating
    working capital (NOWC). Since this increase must be financed, it is
    included as an outflow in Year 0 of the analysis. At the end of the
    projects life, inventories are depleted and receivables are collected.
    Thus, there is a decrease (or reduction) in NOWC, which represents an
    inflow in the final year of the projects life.
    4. The costs associated with financing are reflected in the weighted average
    cost of capital. To include interest expense in the capital budgeting
    analysis would double count the cost of debt financing.
    5. Daily cash flows would be theoretically best, but they would be costly to
    estimate and probably no more accurate than annual estimates because
    we simply cannot forecast accurately at a daily level. Therefore, in most
    cases we simply assume that all cash flows occur at the end of the year.
    However, for some projects it might be useful to assume that cash flows
    occur at mid-year, or even quarterly or monthly. There is no clear
    upward or downward bias on NPV since both revenues and costs are
    28-1

    Chapter 28

    Basics of Capital Budgeting

    being recognized at the end of the year. Unless revenues and costs are
    distributed radically different throughout the year, there should be no
    bias.
    6. In replacement projects, the benefits are generally cost savings, although
    the new machinery may also permit additional output. The data for
    replacement analysis are generally easier to obtain than for new products,
    but the analysis itself is somewhat more complicated because almost all
    of the cash flows are incremental, found by subtracting the new cost
    numbers from the old numbers. Similarly, differences in depreciation
    and any other factor that affects cash flows must also be determined.
    II. Problems
    Problem 1
    (a)

    Equipment purchase
    NOWC investment
    Initial investment outlay

    (P 9,000,000)
    (3,000,000)
    (P12,000,000)

    (b) No, last years P50,000 expenditure is considered a sunk cost and does not
    represent an incremental cash flow. Hence, it should not be included in the
    analysis.
    (c) The potential sale of the building represents an opportunity cost of
    conducting the project in that building. Therefore, the possible proceeds
    after taxes and commissions must be charged against the project as a cost.
    Problem 2
    (a) The projected cash flow for the first year is:
    Project cash flows: t = 1
    Sales revenues
    Operating costs
    Depreciation
    EBIT
    Taxes (40%)
    EBIT (1 T)
    Add back depreciation
    Project cash flow = EBIT (1 T) + DEP
    28-2

    P10,000,000
    7,000,000
    2,000,000
    P 1,000,000
    400,000
    P 600,000
    2,000,000
    P 2,600,000

    Basics of Capital Budgeting

    Chapter 28

    Problem 3
    Equipments original cost
    Depreciation (80%)
    Book value

    P250 M
    200 M
    P 50 M

    Loss on sale = P5 M P50 M


    = P45 M
    Tax savings = P45 M (0.4)
    = P18 M
    After-tax salvage value = P5 M + P18M
    = P23 M
    Problem 4
    Level of working capital for old machine

    = P25,000 P5,000
    = P20,000

    Level of working capital for new machine

    = P20,000 P5,000
    = P15,000

    Incremental investment in net working capital

    = P15,000 P20,000
    = P5,000

    Problem 5
    Level of working capital for old machine

    = P20,000 P5,000
    = P15,000

    Level of working capital for new machine

    = P30,000 P10,000
    = P20,000

    Incremental investment in net working capital

    = P20,000 P15,000
    = P5,000

    28-3

    Chapter 28

    Basics of Capital Budgeting

    Problem 6
    Investment in net working capital

    P1,000,000 + (P750,000 x 0.40)


    (P1,000,000 x 0.50)

    P800,000

    P175,000 + P25,000 + (P50,000


    P22,500)

    P227,500

    (P120,000 P50,000) (0.66) +


    (P50,000) (0.34)

    P63,200

    (P50,000) (0.66) + (P50,000


    P22,500)

    P60,500

    Problems 7 through 9:
    Problem 7
    Net investment cash flow

    Problem 8
    Operating cash flow

    Problem 9
    Disposal cash flow

    Problems 10 through 13:

    Assume that the equipment has 3-year life for tax


    purposes using straight line method. Hence no
    depreciation can be claimed in the 4 th and 5th years
    of the project.

    Problem 10
    Net investment in cash flow

    P175,000 + (P15,000 x 0.60)

    P184,000

    (P80,000 P10,000) (0.66) +


    (175,000 x 0.3333) (0.34)

    P66,033

    Problem 11
    Operating cash flow (1st year)

    28-4

    Basics of Capital Budgeting

    Chapter 28

    Problem 12
    Operating cash flow (2nd year)

    (P80,000 P10,000) (0.66) +


    (175,000 x .3333) (0.34)

    P66,033

    Problem 13 (Total Cash Flows in the 4th year)


    Operating cash flow

    (P80,000 P10,000) (0.66)

    P46,200

    Proceeds for sale (no gains for loss asset


    fully depreciated)
    Recovery working capital (P15,000 x 0.60)
    Project-disposal cash flow
    Total cash flow

    Problems 14 through 19:

    P10,000
    9,000
    P19,000

    P46,200 + P19,000

    P65,200

    Assume that the equipment has an economic life of 3


    years and will be depreciated over that period using
    straight line method.

    Problem 14
    Net investment in cash flow

    P2,000,000 + (P250,000 x 0.40)

    P2,100,000

    (P800,000 P350,000) (0.66) +

    Problem 15
    Operating cash flow (1st year)

    P2,000,000 P1,000,000
    3

    P512,333

    (P800,000 P350,000) (0.66) +


    (P215,333)

    Problem 16
    Operating cash flow (2nd year)

    28-5

    (0.34)

    Chapter 28

    Basics of Capital Budgeting

    P512,333

    (P800,000 P350,000) (0.66) +


    (P215,333)

    P512,333

    P2,000,000 P1,900,000

    P100,000. If sold for P100,000, no

    Problem 17
    Operating cash flow (3rd year)

    Problem 18
    Book value

    gain or loss will occur.


    Taxes

    (P100,000 P100,000) (0.34)

    P0

    Problem 19
    Project-disposal cash flow (end of 3rd year)
    Recovery of net working capital (P250,000 x .40)
    Proceeds from sale of equipment
    Total

    28-6

    P100,000
    100,000
    P200,000

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