#### Transcript Wild FAP 19th Edition Chapter 25

CAPITAL BUDGETING C1 Outcome is uncertain. Large amounts of money are usually involved. Capital budgeting: Analyzing alternative longterm investments and deciding which assets to acquire or sell. Decision may be difficult or impossible to reverse. McGraw-Hill/Irwin Investment involves a long-term commitment. Slide 1 PAYBACK PERIOD P1 The payback period of an investment is the time expected to recover the initial investment amount. Managers prefer investing in projects with shorter payback periods. McGraw-Hill/Irwin Slide 2 COMPUTING PAYBACK PERIOD WITH EVEN CASH FLOWS P1 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. Payback Cost of Investment = period Annual Net Cash Flow Payback = period McGraw-Hill/Irwin $16,000 $4,100 = 3.9 years Slide 3 COMPUTING PAYBACK PERIOD WITH UNEVEN CASH FLOWS P1 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. $5,000 $4,100 McGraw-Hill/Irwin Slide 4 PAYBACK PERIOD WITH UNEVEN CASH FLOWS P1 We recover the $16,000 FasTrac wants to purchase price between install a machine years 4 and 5, about that costsfor $16,000 4.2 years the and has an 8-year payback period. useful life with zero salvage value. Annual net cash flows are: McGraw-Hill/Irwin Year 0 1 2 3 4 4.2 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000 Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000) 4,000 7,000 9,000 11,000 Slide 5 P1 USING THE PAYBACK PERIOD The payback period has two major shortcomings. It ignores the time value of money. It ignores cash flows after the payback period. Consider the following example where both projects cost $5,000 and have five-year useful lives: Year 1 2 3 4 5 Project One Net Cash Inflows $ 2,000 2,000 2,000 2,000 2,000 Project Two Net Cash Inflows $ 1,000 1,000 1,000 1,000 1,000,000 Would you invest in Project One just because it has a shorter payback period? McGraw-Hill/Irwin Slide 6 P2 ACCOUNTING RATE OF RETURN Reconsider the $16,000 investment beingon The accounting rate of return focuses considered by FasTrac. The annual after-tax annual income instead of cash flows. net income is $2,100. Compute the accounting rate of return. Accounting rate of return = Annual $2,100 after-tax net income = 26.25% $8,000 Annual average investment Beginning book $16,000 value ++ $0Ending book value 2 2 McGraw-Hill/Irwin Slide 7 ACCOUNTING RATE OF RETURN Depreciation may be calculated several ways. Income may vary from year to year. So why would I ever want to use this method anyway? Time value of money is ignored. McGraw-Hill/Irwin Slide 8 NET PRESENT VALUE P3 Discount the future net cash budgeting flows from the Now let’s look at a capital investment at the required rate of return. model that considers the time Subtract the initial amount invested from value of cash cash flows. sum of the discounted flows. FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its investments. McGraw-Hill/Irwin Slide 9 NET PRESENT VALUE WITH EQUAL CASH FLOWS P3 Present value factors Present Annual Net Value of $1 for 12 percent Present Value of Year Cash Flows Factor Cash Flows 1 $ 4,100 0.8929 $ 3,661 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 A positive net present indicates that this 7 4,100 value 0.4523 1,854 project earns more than 8 4,100 12 percent 0.4039on the investment. 1,656 Total $ 32,800 $ 20,367 Amount to be invested (16,000) Net present value of investment $ 4,367 McGraw-Hill/Irwin Slide 10 P3 NET PRESENT VALUE DECISION RULE If the Net Present Value is . . . McGraw-Hill/Irwin Then the Project is . . . Positive . . . Acceptable, since it promises a return greater than the required rate of return. Zero . . . Acceptable, since it promises a return equal to the required rate of return. Negative . . . Not acceptable, since it promises a return less than the required rate of return. Slide 11 P3 NET PRESENT VALUE WITH UNEVEN CASH FLOWS Net Cash Flows Year A B C 1 $ 5,000 $ 8,000 $ 1,000 2 5,000 5,000 5,000 3 5,000 2,000 9,000 Total $ 15,000 $ 15,000 $ 15,000 Amount invested Net Present Value Present Value of $1 Factor at 10% 0.9091 0.8264 0.7513 PV of Net Cash Flows A B C $ 4,546 $ 7,273 $ 909 4,132 4,132 4,132 3,757 1,503 6,762 $ 12,435 $ 12,908 $ 11,803 (12,000) (12,000) (12,000) $ 435 $ 908 $ (197) Although all projects require the same investment and have the same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1. McGraw-Hill/Irwin Slide 12 P4 INTERNAL RATE OF RETURN (IRR) The interest rate that makes . . . Present Present value of value of = cash inflows cash outflows The net present value equal zero. McGraw-Hill/Irwin Slide 13 P4 INTERNAL RATE OF RETURN (IRR) Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.40 2. Using present value of annuity table . . . McGraw-Hill/Irwin Slide 14 P4 INTERNAL RATE OF RETURN (IRR) 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.40 2. Using present value of annuity table In that IRR is row, the Locate the row locate the interest rate whose number interest factor of the column equals the closest in in which the periods in the amount to the present value project’s life. present value factor is found. factor. McGraw-Hill/Irwin Periods 1 2 3 4 5 10% 0.90909 1.73554 2.48685 3.16987 3.79079 IRR is . approximately .. 12%. 12% 0.89286 1.69005 2.40183 3.03735 3.60478 14% 0.87719 1.64666 2.32163 2.91371 3.43308 Slide 15 P4 INTERNAL RATE OF RETURN (IRR) Uneven Cash Flows If 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 Return Compare 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 cost of capital. McGraw-Hill/Irwin Slide 16 Comparing Methods C2 Basis of measurement Measure expressed as Strengths Limitations Payback period Cash flows Number of years Easy to Understand Easy to Understand Net present Internal rate value of return Cash flows Cash flows Profitability Profitability Dollar Percent Amount Considers time Considers time value of money value of money Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flows after payback period McGraw-Hill/Irwin Accounting rate of return Accrual income Percent Doesn't give annual rates over the life of a project Slide 17 DECISION MAKING C3 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. McGraw-Hill/Irwin Slide 18 RELEVANT COSTS C3 Costs that are applicable to 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. McGraw-Hill/Irwin Slide 19 RELEVANT COSTS C3 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. Out- of-pocket costs are future outlays of cash associated with a particular decision. Out-of-pocket costs are relevant to decisions. Opportunity costs are the potential benefits given up when one alternative is selected over another. Opportunity costs are relevant to decisions. McGraw-Hill/Irwin Slide 20 A1 ACCEPTING ADDITIONAL BUSINESS The 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 revenue and costs as shown. Sales Direct materials Direct labor Factory overhead Selling expenses Administrative expenses Total expenses Operating income McGraw-Hill/Irwin Per Unit $ 10.00 3.50 2.20 1.10 1.40 0.80 $ 9.00 $ 1.00 $ $ $ Total 1,000,000 350,000 220,000 110,000 140,000 80,000 900,000 100,000 Slide 21 A1 ACCEPTING ADDITIONAL BUSINESS FasTrac is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit. If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000. Should FasTrac accept the offer? McGraw-Hill/Irwin Slide 22 A1 ACCEPTING ADDITIONAL BUSINESS First let’s look at incorrect reasoning that leads to an incorrect decision. Our cost is $9.00 per unit. I can’t sell for $8.50 per unit. McGraw-Hill/Irwin Slide 23 A1 ACCEPTING ADDITIONAL BUSINESS This analysis leads to the correct decision. Current Additional Business Business Combined Sales $ 1,000,000 $ 85,000 $ 1,085,000 Even though the$ $8.50 selling $ price35,000 is less than the Direct materials 350,000 $ 385,000 normal FasTrac should the Direct labor $10 selling price, 220,000 22,000 accept 242,000 offer because net income by $20,000. Factory overhead 110,000will increase 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses $ 900,000 $ 65,000 $ 965,000 Operating income $ 100,000 $ 20,000 $ 120,000 10,000 10,000 new 10,000 units new ×units $8.50 units × $3.50 = $35,000 = $85,000 new ×selling $2.20 =price $22,000 McGraw-Hill/Irwin Slide 24 MAKE OR BUY DECISIONS A1 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. McGraw-Hill/Irwin Slide 25 MAKE OR BUY DECISIONS A1 FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost: Cost to Make Part #417 Direct materials Direct labor Factory overhead Total cost to make McGraw-Hill/Irwin Make $ 0.45 0.50 0.50 $ 1.45 Slide 26 A1 MAKE OR BUY DECISIONS FasTrac 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 Direct materials Direct labor Factory overhead Purchase price Total incremental costs Make $ 0.45 0.50 0.25 ? ---1.20 ? Buy ---------$ 1.20 $ 1.20 We must eliminate $.25 per unit of overhead, leaving a maximum of $0.25 per unit. McGraw-Hill/Irwin Slide 27 SCRAP OR REWORK A1 Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. 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. McGraw-Hill/Irwin Slide 28 A1 SCRAP OR REWORK FasTrac has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or reworked at an additional cost of $.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? McGraw-Hill/Irwin Slide 29 SCRAP OR REWORK A1 FasTrac should scrap theper units 10,000 units × $0.80 unitnow. Sale of Defects Less rework costs Less opportunity cost Net return Scrap Now $ 4,000 $ 4,000 Rework $ 15,000 (8,000) (5,000) 2,000 If FasTrac fails to include the opportunity cost, 10,000 units × $0.40 per unit the rework option would show a return of $7,000, 10,000 units × ($1.50 - $1.00) per unit mistakenly making rework appear more favorable. 10,000 units × $1.50 per unit McGraw-Hill/Irwin Slide 30 SELL OR PROCESS A1 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: McGraw-Hill/Irwin Slide 31 SELL OR PROCESS A1 Product X Y Z Spoilage Total Price $ 4.00 6.00 8.00 - Units 10,000 22,000 6,000 2,000 40,000 Revenue $ 40,000 132,000 48,000 $ 220,000 Revenue if processed $ continue 220,000 Should FasTrac sell product Q or Revenue if sold as is (50,000) processing into products X, Y, and Z? Incremental revenue Cost to process Incremental net income 170,000 (80,000) $ 90,000 FasTrac should continue processing. The earlier $30,000 cost for product Q is sunk and therefore irrelevant to the decision. McGraw-Hill/Irwin Slide 32 A1 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. McGraw-Hill/Irwin Slide 33 SALES MIX SELECTION A1 the following for that two demand, If demandConsider for A is limited, producedata to meet then use the remaining produce B. products made andfacilities sold bytoFasTrac. Per unit amounts Product B has a greater Selling price contribution costs margin than Variable Product A, but it Contribution margin requires more machine Machine hours required to hours per produce oneunit unitto produce. Contribution per machine hour Product A $ 5.00 3.50 $ 1.50 Product B $ 7.50 5.50 $ 2.00 1.0 1.50 2.0 1.00 $ $ If each product requires the same time to make, and the demand With unlimited demand for A andis B,unlimited, produce asFasTrac many units of Consider this additional information. produce only Product B.hour worked. A as possible should since A provides more dollars per McGraw-Hill/Irwin Slide 34 SEGMENT ELIMINATION A1 A segment is a candidate for elimination if its revenues are less than its avoidable expenses. FasTrac is considering eliminating its Treadmill Division because total expenses of $48,300 are greater than its sales of $47,800. McGraw-Hill/Irwin Slide 35 A1 SEGMENT ELIMINATION Total Expenses $ 30,200 Avoidable Expenses $ 30,200 7,900 200 7,900 Cost of goods sold Direct expenses: Salaries Equipment depreciation Indirect expenses: Rent and utilities Advertising Insurance Service department costs: Departmental office Purchasing Total $ McGraw-Hill/Irwin 3,150 200 400 3,060 3,190 48,300 Unavoidable Expenses $ 200 3,150 Let’s 200 identify avoidable 300 expenses. 100 2,200 1,000 $ 41,800 $ 860 2,190 6,500 Slide 36 SEGMENT ELIMINATION A1 Sales Avoidable expenses Decrease in income $ 47,800 41,800 $ 6,000 Do not eliminate the Treadmill Division! McGraw-Hill/Irwin Slide 37