# 26-1. 26-2 CHAPTER26 Incremental Analysis and Capital Budgeting.

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26-1 26-2 CHAPTER26 Incremental Analysis and Capital Budgeting 26-3 PreviewofCHAPTER26 26-4 Important management function. Does not always follow a set pattern. Decisions vary in scope, urgency, and importance. Steps usually involved in process include: SO 1 Identify the steps in managements decision-making process. Illustration 26-1 Managements Decision-Making Process 26-5 Considers both: Financial information includes revenues and costs as well as their effect on overall profitability. Non-financial information includes effect on employee turnover, the environment, or overall company image. SO 1 Identify the steps in managements decision-making process. Managements Decision-Making Process 26-6 Decisions involve a choice among alternative actions. Process used to identify the financial data that change under alternative courses of action. Both costs and revenues may vary. Only revenues may vary. Only costs may vary. SO 2 Describe the concept of incremental analysis. The Incremental Analysis Approach Managements Decision-Making Process 26-7 SO 2 Describe the concept of incremental analysis. Comparison of Alternative B with Alternative A: Incremental revenue is $15,000 less under Alternative B. Incremental cost savings of $20,000 is realized. Alternative B produces $5,000 more net income. Illustration 26-2 Managements Decision-Making Process How Incremental Analysis Works 26-8 Important concepts used in incremental analysis: Relevant cost. Opportunity cost. Sunk cost. SO 2 Describe the concept of incremental analysis. Managements Decision-Making Process How Incremental Analysis Works 26-9 Sometimes involves changes that seem contrary to intuition. Variable costs sometimes do not change under alternatives. Fixed costs sometimes change between alternatives. Incremental analysis not the same as CVP analysis. SO 2 Describe the concept of incremental analysis. Managements Decision-Making Process How Incremental Analysis Works 26-10 a.Do not change under alternative courses of action. b. Change under alternative courses of action. c. Are mixed under alternative courses of action. d. None of the above. Incremental analysis is the process of identifying the financial data that SO 2 Describe the concept of incremental analysis. Managements Decision-Making Process Question 26-11 26-12 Common Types of Decisions: 1. 1.Accept an order at a special price Make or buy Sell or process further Retain or replace equipment Eliminate an unprofitable business segment Allocate limited resources. Types of Incremental Analysis 26-13 Obtain additional business by making a major price concession to a specific customer. Assumes that sales of products in other markets are not affected by special order. Assumes that company is not operating at full capacity. SO 3 Identify the relevant costs in accepting an order at a special price. Accept an Order at a Special Price Types of Incremental Analysis 26-14 Illustration: Sunbelt Company produces 100,000 automatic blenders per month, which is 80 percent of plant capacity. Variable manufacturing costs are $8 per unit. Fixed manufacturing costs are $400,000, or $4 per unit. The blenders are normally sold directly to retailers at $20 each. Sunbelt has an offer from Mexico Co. (a foreign wholesaler) to purchase an additional 2,000 blenders at $11 per unit. Acceptance of the offer would not affect normal sales of the product, and the additional units can be manufactured without increasing plant capacity. What should management do? SO 3 Identify the relevant costs in accepting an order at a special price. Types of Incremental Analysis Accept an Order at a Special Price 26-15 SO 3 Identify the relevant costs in accepting an order at a special price. Fixed costs do not change since within existing capacity thus fixed costs are not relevant. Variable manufacturing costs and expected revenues change thus both are relevant to the decision. Illustration 26-3 Types of Incremental Analysis Accept an Order at a Special Price 26-16 Illustration: Baron Company incurs the following annual costs in producing 25,000 ignition switches for motor scooters. Make or Buy SO 4 Identify the relevant costs in a make-or-buy decision. Instead of making its own switches, Baron Company might purchase the ignition switches at a price of $8 per unit. What should management do? Illustration 26-4 Annual product cost data Types of Incremental Analysis 26-17 Total manufacturing cost is $1 higher than purchase price. Must absorb at least $50,000 of fixed costs under either option. Illustration 26-5 SO 4 Identify the relevant costs in a make-or-buy decision. Types of Incremental Analysis Make or Buy 26-18 SO 4 Identify the relevant costs in a make-or-buy decision. Opportunity Cost Types of Incremental Analysis Potential benefit that may be obtained from following an alternative course of action. Foregoing make-or-buy analysis is complete only if the productive capacity used to make the ignition switches cannot be converted to another purpose. 26-19 Illustration: Assume that through buying the switches, Baron Company can use the released productive capacity to generate additional income of $28,000 from producing a different product. This lost income is an additional cost of continuing to make the switches in the make-or-buy decision. SO 4 Identify the relevant costs in a make-or-buy decision. Illustration 26-6 Types of Incremental Analysis Make or Buy Opportunity Cost 26-20 a.Manufacturing costs that will be saved. b. The purchase price of the units. c. Opportunity costs. d. All of the above. In a make-or-buy decision, relevant costs are: SO 4 Identify the relevant costs in a make-or-buy decision. Types of Incremental Analysis Question 26-21 26-22 May have option to sell product at a given point in production or to process further and sell at a higher price. Decision Rule: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. SO 5 Give the decision rule for whether to sell or process materials further. Sell or Process Further Types of Incremental Analysis 26-23 Illustration: Woodmasters Inc. makes tables. The cost to manufacture an unfinished table is $35. The selling price per unfinished unit is $50. Management concludes that some of the unused capacity may be used to finish the tables and sell them at $60 per unit. For a finished table, direct materials will increase $2 and direct labor costs will increase $4. Variable manufacturing overhead costs will increase by $2.40 (60% of direct labor). No increase is anticipated in fixed manufacturing overhead. Illustration 26-7 SO 5 Give the decision rule for whether to sell or process materials further. Sell or Process Further Types of Incremental Analysis 26-24 Should Woodmasters sell or process further? Incremental analysis on a per unit basis is as follows. Illustration 26-8 SO 5 Give the decision rule for whether to sell or process materials further. Sell or Process Further Types of Incremental Analysis 26-25 a.Incremental processing costs. b. Variable processing costs. c. Fixed processing costs. d. No correct answer is given. The decision rule is a sell-or-process-further decision. Process further as long as the incremental revenue from processing exceeds: SO 5 Give the decision rule for whether to sell or process materials further. Sell or Process Further Question 26-26 Illustration: Jeffcoat Company is considering replacing a factory machine with a new machine. The existing factory machine has a book value of $40,000 and a remaining useful life of four years. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four-year useful life. If Jeffcoat acquires the new machine, variable manufacturing costs are expected to decrease from $160,000 to $125,000 annually, and the old unit will be scrapped. Prepare the incremental analysis for the four-year period. SO 6 Identify the factors to be considered in retaining or replacing equipment. Retain or Replace Equipment Types of Incremental Analysis 26-27 Retain or Replace? Prepare the incremental analysis for the four-year period. Illustration 26-9 Types of Incremental Analysis SO 6 Identify the factors to be considered in retaining or replacing equipment. Retain or Replace Equipment 26-28 Additional Considerations Book value of old machine does not affect the decision. Book value is a sunk cost. Costs which cannot be changed by future decisions (sunk cost) are not relevant in incremental analysis. Any trade-in allowance or cash disposal value of the existing asset is relevant. Types of Incremental Analysis SO 6 Identify the factors to be considered in retaining or replacing equipment. Retain or Replace Equipment 26-29 Key: Focus on Relevant Costs. Consider effect on related product lines. Fixed costs allocated to the unprofitable segment must be absorbed by the other segments. Net income may decrease when an unprofitable segment is eliminated. Decision Rule: Retain the segment unless fixed costs eliminated exceed contribution margin lost. SO 7 Explain the relevant factors in whether to eliminate an unprofitable segment. Eliminate an Unprofitable Segment Types of Incremental Analysis 26-30 Illustration: Martina Company manufactures three models of tennis rackets: Profitable lines: Pro and Master Unprofitable line: Champ Illustration Segment income data Should Champ be eliminated? Types of Incremental Analysis SO 7 Explain the relevant factors in whether to eliminate an unprofitable segment. Eliminate an Unprofitable Segment 26-31 Total income is decreased by $10,000. Prepare income data after eliminating Champ product line. Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master. Types of Incremental Analysis SO 7 Explain the relevant factors in whether to eliminate an unprofitable segment. Eliminate an Unprofitable Segment Illustration Income data after eliminating unprofitable product line 26-32 Incremental analysis of Champ provided the same results: Do Not Eliminate Champ Illustration Types of Incremental Analysis SO 7 Explain the relevant factors in whether to eliminate an unprofitable segment. Eliminate an Unprofitable Segment 26-33 a.Net income will always increase. b. Variable expenses of the eliminated segment will have to be absorbed by other segments. c. Fixed expenses allocated to the eliminated segment will have to be absorbed by other segments. d. Net income will always decrease. If an unprofitable segment is eliminated: Types of Incremental Analysis SO 7 Explain the relevant factors in whether to eliminate an unprofitable segment. Question 26-34 26-35 Resources are always limited. Floor space for a retail firm. Raw materials, direct labor hours, or machine capacity for a manufacturing firm. Management must decide which products to make and sell to maximize net income. SO 8 Determine which products to make and sell when resources are limited. Types of Incremental Analysis Allocate Limited Resources 26-36 Allocate Limited Resources Illustration: Collins Company manufactures deluxe and standard pen and pencil sets. The limiting resource is machine capacity, which is 3,600 hours per month. Relevant data consist of the following. Illustration Contribution margin and machine hours Compute contribution margin per unit of limited resource. SO 8 Determine which products to make and sell when resources are limited. 26-37 Allocate Limited Resources Compute contribution margin per unit of limited resource. Company should shift the sales mix to standard sets or should increase machine capacity. Illustration SO 8 Determine which products to make and sell when resources are limited. 26-38 Allocate Limited Resources Illustration: Assume Collins is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the standard or deluxe pen and pencil sets. Determine the total contribution margin under each alternative. Illustration SO 8 Determine which products to make and sell when resources are limited. 26-39 Capital Budgeting is the process of making capital expenditure decisions in business. Amount of possible capital expenditures usually exceeds the funds available for such expenditures. Involves choosing among various capital projects to find the one(s) that will maximize a companys return on investment. Capital Budgeting 26-40 Many companies follow a carefully prescribed process in capital budgeting. Evaluation Process Illustration Corporate capital budget authorization process 26-41 Providing management with relevant data for capital budgeting decisions requires familiarity with quantitative techniques. Most common techniques are: 1. 1.Annual Rate of Return 2. 2.Cash Payback 3. 3.Discounted Cash Flow Evaluation Process 26-42 26-43 Indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment. Illustration Annual Rate of Return SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-44 Illustration: Tappan Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. Tappan uses the straight-line method of depreciation for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Illustration Annual Rate of Return SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-45 Expected annual rate of return Illustration Formula for computing average investment = $65, , $13,000 $65,000 = 20% A project is acceptable if its rate of return is greater than managements required rate of return. Annual Rate of Return Computing Average Investment SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-46 Annual Rate of Return Principal advantages: Simplicity of calculation. Managements familiarity with the accounting terms used in the computation. Major limitation: Does not consider the time value of money. SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-47 $130,000 $26,000 = 5 years Cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment. Cash Payback Illustration Computation of net annual cash flow Illustration Cash payback formula SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-48 The shorter the payback period, the more attractive the investment. In the case of uneven net annual cash flows, the company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment. Cash Payback SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-49 Illustration: Chen Company proposes an investment in a new website that is estimated to cost $300,000. Cash payback should not be the only basis for capital budgeting decision as it ignores expected profitability of the project. Cash Payback SO 9 Contrast annual rate of return and cash payback in capital budgeting. Illustration Net annual cash flow schedule 26-50 (a) Average investment = ($250, ) 2 = $125,000 Annual rate of return = $25,000 $125,000 = 20% (b) Net annual cash flow = $25,000 + $50,000 = $75,000 Cash payback period = $250,000 $75,000 = 3.3 years Rochelle Company is considering purchasing new equipment for $250,000. The equipment has a 5-year useful life, and depreciation would be $50,000 (assuming straight-line depreciation and zero salvage value). The purchase of the equipment should increase net income by $25,000 each year for 5 years. (a) Compute the annual rate of return. (b) Compute the cash payback period. Cash Payback SO 9 Contrast annual rate of return and cash payback in capital budgeting. 26-51 A $100,000 investment with a zero scrap value has an 8- year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. a. a.8.00 years. b. b.3.08 years. c. c.5.00 years. d. d years. Cash Payback SO 9 Contrast annual rate of return and cash payback in capital budgeting. Question 26-52 Discounted cash flow technique: Generally recognized as the best approach. Considers both the estimated total cash inflows and the time value of money. Two methods: Net present value. Internal rate of return. Discounted Cash Flow SO 10 Distinguish between the net present value and internal rate of return methods. 26-53 Cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. Interest rate used in discounting is the required minimum rate of return. Proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment. Discounted Cash Flow SO 10 Distinguish between the net present value and internal rate of return methods. Net Present Value Method 26-54 Illustration Net present value decision criteria A proposal is acceptable when net present value is zero or positive. Discounted Cash Flow SO 10 26-55 Illustration: Tappen Companys annual cash flows are $26,000. If we assume this amount is uniform over the assets useful life, we can compute the present value of the net annual cash flows. Equal Net Annual Cash Flows Illustration Discounted Cash Flow SO 10 Distinguish between the net present value and internal rate of return methods. Calculate the net present value. 26-56 The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. Illustration: Calculate the net present value. Discounted Cash Flow SO 10 Distinguish between the net present value and internal rate of return methods. Equal Net Annual Cash Flows Illustration 26-25 26-57 Illustration: Tappan Company management expects the same aggregate net annual cash flow ($260,000) over the life of the investment. But because of a declining market demand for the new product over the life of the equipment, the net annual cash flows are higher in the early years and lower in the later years. Discounted Cash Flow SO 10 Distinguish between the net present value and internal rate of return methods. Unequal Net Annual Cash Flows 26-58 Illustration Computing present value of unequal annual cash flows Discounted Cash Flow Unequal Net Annual Cash Flows SO 10 26-59 The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. Illustration: Calculate the net present value. Discounted Cash Flow SO 10 Distinguish between the net present value and internal rate of return methods. Unequal Net Annual Cash Flows Illustration Analysis of proposal using net present value method 26-60 26-61 IRR method finds the interest yield of the potential investment. IRR is the rate that will cause the PV of the proposed capital expenditure to equal the PV of the expected annual cash inflows. Two steps in method: Compute the interval rate of return factor. Use the factor and the PV of an annuity of 1 table to find the IRR. Discounted Cash Flow Internal Rate of Return Method SO 10 Distinguish between the net present value and internal rate of return methods. 26-62 Step 1. Compute the internal rate of return factor. Discounted Cash Flow Internal Rate of Return Method Illustration For Tappan Company: $130,000 $26,000 = 5.0 SO 10 Distinguish between the net present value and internal rate of return methods. 26-63 Step 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Discounted Cash Flow Internal Rate of Return Method Assume a minimum rate of return for Tappan of 10%. Decision Rule: Accept the project when the IRR is equal to or greater than the required rate of return. SO 10 Distinguish between the net present value and internal rate of return methods. 26-64 Illustration Internal Rate of Return Method SO 10 Distinguish between the net present value and internal rate of return methods. 26-65 Illustration Discounted Cash Flow Comparing Discounted Cash Flow Methods SO 10 Distinguish between the net present value and internal rate of return methods. 26-66 a.Projects rate of return is less than the cutoff rate. b. Projects rate of return exceeds the required rate of return. c. Projects rate of return equals the required rate of return. d. Project is unacceptable. A positive net present value means that the: Discounted Cash Flow Question SO 10 Distinguish between the net present value and internal rate of return methods. 26-67 Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. Management has a required rate of return of 9%. Calculate the net present value on this project. Discounted Cash Flow 26-68 Calculate the net present value on this project. Watertown should accept the project. Discounted Cash Flow 26-69 Copyright 2011 John Wiley & Sons, Inc. All rights reserved. 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