25 - 1 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D.,

25 - 1

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Capital Budgeting and Managerial Decisions

Chapter 25

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Capital budgeting:Analyzing alternative long-term

investments and deciding which assets to acquire or sell.

Outcomeis uncertain.

Large amounts ofmoney are usually

involved.

Investment involves along-term commitment.

Decision may bedifficult or impossible

to reverse.

Capital Budgeting

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Payback Period

The payback period of an investmentis the time expected to recoverthe initial investment amount.

Managers prefer investing in projects with shorter payback periods.

P 1

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Paybackperiod = Cost of Investment

Annual Net Cash Flow

Paybackperiod = $16,000

$4,100 = 3.9 years

Computing Payback Periodwith Even Cash Flows

FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows of $4,100. The machine is expected to have an 8-year useful life with no

salvage value.

Calculate the payback period.

P 1

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$4,100

$3,000

Computing Payback Periodwith Uneven Cash Flows

In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an example where the cash flows

vary each year.

P 1

$4,000$5,000

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FasTrac wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual

net cash flows are:

Computing Payback Periodwith Uneven Cash Flows

4.2

Payback is about

4.2 years.

P 1

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Using the Payback PeriodThe payback period has two major shortcomings:

It ignores the time value of money; and It ignores cash flows after the payback period.

Consider the following example where both projects cost $5,000 and have five-year useful lives:

Project One Project TwoNet Cash Net Cash

Year Inflows Inflows1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000

Would you invest in Project One over Project Two just because it has a shorter payback period?

P 1

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Accounting Rate of ReturnP 2

Choose the project with the least risk, the shortest payback period, and the highest return for the longest time period is often

identified as the best.

Two Ways to Calculate Average Annual Investment

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Accounting Rate of Return

Annual Average Investment Calculation

Beginning book value $16,000 + Ending book value $02

Let’s revisit the $16,000 investment being considered by FasTrac. The new machine has an annual after-tax net income

of $2,100.

Compute the accounting rate of return.

Accounting $2,100rate of return $8,000= = 26.25%

P 2

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Depreciation may be calculated several ways.

Income may vary from year to year.

Time value ofmoney is ignored.

Accounting Rate of ReturnP 2

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Net Present Value

Discount the future net cash flows from the investment at the required rate of return. Subtract the initial amount invested from sum of the discounted cash flows.

P 3

Net present value analysis applies the time value of money to future cash inflows and cash outflows so

management can evaluate a project’s benefits and costs at one point in time.

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Net Present Valuewith Equal Cash Flows

P 3

FasTrac is considering the purchase of a conveyor costing $16,000, with an 8-year useful life and zero salvage value, that promises annual net cash flows of $4,100. FasTrac requires a 12 percent

compounded annual return on its investments.

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Net Present Value Decision RuleP 3

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Although all projects require the same investment and havethe same total net cash flows, Project B has a higher net present

value because of a larger net cash flow in Year 1.

Net Present Valuewith Uneven Cash Flows

P 3

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Internal Rate of Return (IRR)

The interest rate that makes . . .

Presentvalue of

cash inflows

Presentvalue of

cash outflows=

The net present value equals zero.

P 4

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1. Compute present value factor.

2. Using present value of annuity table . . .

Projects with even annual cash flows

Internal Rate of Return (IRR)

Project life = 3 yearsInitial cost = $12,000

Annual net cash inflows = $5,000Determine the IRR for this project.

$12,000 ÷ $5,000 per year = 2.40

P 4

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1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.40

2. Using present value of annuity table. . .

Internal Rate of Return (IRR)

IRR isapproximately

12%.

P 4

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Uneven Cash FlowsIf cash inflows are unequal, trial and error solution will result if

present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these

problems.

Use of Internal Rate of ReturnCompare the internal rate of return on a project to a predetermined

hurdle rate (cost of capital). To be acceptable, a project’s rate of return cannot be less than the company’s cost of capital.

P 4

Internal Rate of Return (IRR)

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Comparing Capital Budgeting Methods

P 4

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Decision making involves five steps: Define the decision task. Identify alternative actions. Collect relevant information on alternatives. Select the course of action. Analyze and assess decisions made.

Decision MakingC 1

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– Costs that are applicableto a particular decision.

– Costs that should have a bearing on which alternative a manager selects.

– Costs that are avoidable.– Future costs that differ

between alternatives.

Relevant CostsC 1

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Relevant Costs Sunk costs are the result of past decisions and

cannot be changed by any current or future decisions.Sunk costs are irrelevant to current or future decisions.

Opportunity costs are the potential benefits given up when one alternative is selected over another. Opportunity costs

are relevant to decisions.

C 1

Out-of-pocket costs are future outlaysof cash associated with a particular

decision. Out-of-pocket costs are relevant to decisions.

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Accepting Additional BusinessThe decision to accept additional business should be based on

incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides

to accept the new business.

FasTrac currently sells 100,000 units of its product. The company has per unit and annual total sales and costs as shown.

A 1

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Accepting Additional BusinessA current buyer of FasTrac’s products wants to purchase additional units of its product and export them to another country. This buyer offers to buy 10,000 units of the product at $8.50 per unit, or $1.50 less than the current price. The offer price is low, but FasTrac is considering the proposal because this sale would be several times larger than any single previous sale and it would use idle capacity.

Should FasTrac accept the offer?

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Accepting Additional BusinessFasTrac should accept the offer.

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Make or Buy Decisions Incremental costs also are important in the decision to make a product or purchase it from a supplier. The cost to produce an item must include: (1) direct materials, (2) direct labor, and (3) incremental overhead. We should not use the predetermined overhead rate to determine product cost.

A 1

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Cost to Make Part 417

MakeDirect materials 0.45$ Direct labor 0.50 Factory overhead 0.50 Total cost to make 1.45$

Make or Buy DecisionsFasTrac currently makes Part 417, assigning

overhead at 100 percent of direct labor cost, with the following unit cost:

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Make or Buy DecisionsFasTrac can buy Part 417 from a supplier for $1.20. How much overhead do we have to eliminate before we should buy this part?

Make vs. Buy Analysis

Make BuyDirect materials 0.45$ ----Direct labor 0.50 ----Overhead costs 0.25 ----Purchase price ---- 1.20$ Total incremental costs $1.20 1.20$

We must eliminate $0.25 per unit of overhead,leaving a maximum difference of $0.25 per unit.

A 1

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Scrap or Rework

As long as rework costs are recovered through sale of the product, and rework

does not interfere with normal production,we should rework rather than scrap.

Costs incurred in manufacturing units of product that do not meet quality standards are sunk

costs and cannot be recovered.

A 1

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Scrap or Rework

FasTrac has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $0.40 each or

reworked at an additional cost of $0.80 per unit. If reworked, the units can be sold for the normal selling

price of $1.50 each. Reworking the defective units will prevent the production of 10,000 new units that would

also sell for $1.50.

Should FasTrac scrap or rework?

A 1

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Scrap or Rework

10,000 units × ($1.50 - $1.00) per unit

FasTrac should scrap the units now.

A 1

10,000 units × $1.50 per unit

10,000 units × $0.80 per unit

10,000 units × $0.40 per unit

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Sell or Process Businesses are often faced with the decision to sell partially completed products or to process them to completion. As a general rule, , we process further only if incremental revenues exceed incremental costs.

FasTrac has 40,000 units of partially finished product Q. Processing costs to date are $30,000. The 40,000 unfinished units can be sold as is for $50,000 or they

can be processed further to produce finished products X, Y, and Z. The additional processing will cost $80,000 and result in the following revenues:

A 1

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Sell or Process

FasTrac should continue processing. The earlier $30,000 costfor product Q is sunk and therefore irrelevant to the decision.

A 1

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Sales Mix Selection When a company sells a variety of

products, some are likely to be more profitable than others.

To make an informed decision, management must consider . . .– The contribution margin of each

product,– The facilities required to produce

each product and any constraints on the facilities, and

– The demand for each product.

A 1

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Sales Mix SelectionConsider the following data for two

products made and sold by FasTrac.

A 1

However, it takes one hour to produce one unit of Product A, while it takes two hours to produce one unit of Product B.

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FasTrac is considering eliminating its Treadmill Division because total

expenses of $48,300 are greater than its sales of $47,800.

A segment is a candidate for elimination if its revenues are less than its

avoidable expenses.

Segment EliminationA 1

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Segment EliminationA 1

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Sales 47,800$ Avoidable expenses 41,800 Decrease in income 6,000$

Do not eliminatethe Treadmill Division!

Segment EliminationA 1

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Qualitative factors are involved in most all managerial decisions.

Quality. Delivery schedule. Supplier reputation. Employee morale. Customer opinions.

Qualitative Factors in DecisionsA 1

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Break-even time incorporates time valueof money into the payback period method

of evaluating capital investments.

Break-Even TimeA 2

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Appendix 25A: Using Excel to Compute NPV and IRR

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End of Chapter 25