capital budgeting and managerial decisions

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© The McGraw-Hill Companies, Inc., 2005

Capital Budgeting and Managerial Decisions

Chapter

2525

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1. Capital Budgeting Method Not using Time Value of Money

Method using Time Value of Money

2. Managerial Decision Decision and Information

Managerial Decision Scenarios

3. Decision Analysis Break-Even Time

Learning objectivesLearning objectives Exh. 25-5,6

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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.

1. Capital Budgeting- Risks of Capital Budgeting

1. Capital Budgeting- Risks of Capital Budgeting

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Paybackperiod

= Cost of Investment Annual Net Cash Flow

Method Not using Time Value of Money- Payback PeriodMethod Not using Time Value of Money- Payback Period

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

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

Managers prefer investing in projects with shorter payback periods.

Exh. 25-2

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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.

Paybackperiod

= Cost of Investment Annual Net Cash Flow

Paybackperiod

= $16,000

$4,100= 3.9 years

Payback Period with Even Cash FlowsPayback Period with Even Cash Flows

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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.

$4,100

$5,000

Payback Period with Uneven Cash FlowsPayback Period with Uneven Cash Flows

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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:

YearAnnual Net Cash Flows

Cumulative Net Cash

Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000

Payback Period with Uneven Cash FlowsPayback Period with Uneven Cash FlowsExh. 25-3

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Cumulative Net Cash

Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000

4.2

We recover the $16,000purchase price between

years 4 and 5, about4.2 years for the payback period.

Payback Period with Uneven Cash FlowsPayback Period with Uneven Cash FlowsExh. 25-3

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Ignores the time valueof money.

Ignores cashflows after the payback

period.

Unacceptable forprojects with longlives where time

value ofmoney effects

are major.

Using the Payback PeriodUsing the Payback Period

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Consider two projects, each with a five-year lifeand each costing $6,000.

Project One Project TwoNet Cash Net Cash

Year Inflows Inflows

1 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 just because it has a shorter payback period?

Using the Payback PeriodUsing the Payback Period

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The accounting rate of return focuses onannual income instead of cash flows.

Method Not using Time Value of Money- Accounting Rate of ReturnMethod Not using Time Value of Money- Accounting Rate of Return

Accounting Annual after-tax net incomerate of return Annual average investment


=

Beginning book value + Ending book value2

Exh. 25-5,6

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=

Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the

accounting rate of return.


Accounting Rate of ReturnAccounting Rate of Return Exh. 25-5,6

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=



Accounting Rate of ReturnAccounting Rate of Return


Exh. 25-5,6

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Accounting $2,100rate of return $8,000

Accounting $2,100rate of return $8,000

= = 26.25%

$16,000 + $02

Accounting Rate of ReturnAccounting Rate of Return



Exh. 25-5,6

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Depreciation may be calculated several ways.

Income may vary from year to year.

Time value ofmoney is ignored.

So why would I ever want to use this method

anyway?

Using Accounting Rate of ReturnUsing Accounting Rate of Return

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Future value of $100 today compounded for 5 years at 10 percent.

TodayToday 11 22 33 44 FutureFuture

FV FV = $161= $161

$100$100

Compound at 10%

$110$110 $121$121 $133$133 $146$146

× 1.1

× 1.1

× 1.1

× 1.1

× 1.1

Method using Time Value of Money - Time Value of MoneyMethod using Time Value of Money - Time Value of Money

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Present value of $100 paid in 5 years discounted at 10 percent.

TodayToday 11 22 33 44 FutureFuture

PV = PV = $62.1$62.1

$100$100

Discount at 10%

90.990.982.682.675.175.168.368.3

÷1.1÷1.1÷1.1÷1.1÷1.1

Method using Time Value of Money - Present ValueMethod using Time Value of Money - Present Value

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Method using Time Value of Money - Present Value TableMethod using Time Value of Money - Present Value Table

Periods 6% 8% 10% 12% 25 0.2330 0.1460 0.0923 0.0588 30 0.1741 0.0994 0.0573 0.0334 35 0.1301 0.0676 0.0356 0.0189

PV = $1,000 X 0.0994 = $99.4

The government will pay you $1,000 30 years later. There is no annual interest payment. If the market interest rate is 8%, how much is the price for the

bond? (using Table I)

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Now let’s look at a capital budgeting modelthat considers the time value of cash flows.

Method using Time Value of Money - Net Present ValueMethod using Time Value of Money - Net Present Value

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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.

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.

Net Present ValueNet Present Value

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Present Value of $1

Factor

Present Value of

Cash Flows1 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 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656

Total 32,800$ 20,367$

Amount to be invested (16,000) Net present value of investment 4,367$

Net Present Value with Even Cash FlowsNet Present Value with Even Cash FlowsExh. 26-7

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Present Value of $1

Factor

Present Value of

Cash Flows1 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 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656

Total 32,800$ 20,367$


Present value factorsfor 12 percent


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Present Value of $1

Factor

Present Value of

Cash Flows1 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 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656

Total 32,800$ 20,367$


A positive net present value indicates that thisproject earns more than 12 percent on the investment.


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General decision rule . . .If the Net Present

Value is . . . Then the Project is . . .

Positive . . . Acceptable, since it promises areturn greater than the required

rate of return.

Zero . . . Acceptable, since it promises areturn equal to the required rate

of return.

Negative . . . Not acceptable, since it

promises a return less than therequired rate of return.

Using Net Present ValueUsing Net Present Value

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PresentVa lue of

Net Cash Flow s $1 Factor PV of Net Cash Flow sYear A B C at 10% A B C

1 5,000$ 8,000$ 1,000$ 0.9091 4,546$ 7,273$ 909$ 2 5,000 5,000 5,000 0.8264 4,132 4,132 4,132 3 5,000 2,000 9,000 0.7513 3,757 1,503 6,762

Tota l 15,000$ 15,000$ 15,000$ 12,435$ 12,908$ 11,803$

Amount invested (12,000) (12,000) (12,000) Net Present Va lue 435$ 908$ (197)$

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 Value with Uneven Cash FlowsNet Present Value with Uneven Cash Flows

Exh. 26-8

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Method using Time Value of Money - Internal Rate of Return (IRR)Method using Time Value of Money - Internal Rate of Return (IRR)

The interest rate that makes . . .

Presentvalue of

cash inflows

Presentvalue of

cash outflows=

The net present value equal zero.

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Projects with even annual cash flows

Project life = 3 yearsInitial cost = $12,000

Annual net cash inflows = $5,000

Determine the IRR for this project.

1. Compute present value factor.

2. Using present value of annuity table . . .

Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9

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1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4000


Projects with even annual cash flows


Project life = 3 yearsInitial cost = $12,000

Annual net cash inflows = $5,000

Determine the IRR for this project.

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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308

Locate the rowwhose number

equals the periods in theproject’s life.

1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000



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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308

In that row,locate the

interest factorclosest in

amount to thepresent value

factor.




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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308



IRR is theinterest rate

of the columnin which the

present valuefactor is found.

IRR isapproximately

12%.


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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.

Internal Rate of Return – Uneven Cash FlowsInternal Rate of Return – Uneven Cash Flows

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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 thecost of capital.

Using Internal Rate of ReturnUsing Internal Rate of Return

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Exh. 25-10

Payback Accounting Net present Internal rateperiod rate of return value of return

Basis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability

Measure Number Percent Dollar Percentexpressed as of years Amount

Easy to Easy to Considers time Considers timeUnderstand Understand value of money value of money

Strengths Allows Allows Accommodates Allowscomparison comparison different risk comparisons

across projects across projects levels over of dissimilara project's life projects

Doesn't Doesn't Difficult to Doesn't reflectconsider time consider time compare varying risk

value of money value of money dissimilar levels over theLimitations projects project's life

Doesn't Doesn't giveconsider cash annual rates

flows after over the lifepayback period of a project

Comparing Methods

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Let’s change topics.

2. Managerial Decisions2. Managerial Decisions

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Decision making involves five steps: Define the problem. Identify alternatives. Collect relevant information on

alternatives. Select the preferred alternative. Analyze decisions made.

Decision and Information- Decision MakingDecision and Information- Decision Making Exh.

25-11

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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.

1

2

Decision and Information- Relevant CostsDecision and Information- Relevant Costs

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All costs incurred in the past that cannot be changed by any decision made now or in the future.

Sunk costs should not be considered in decisions.

All costs incurred in the past that cannot be changed by any decision made now or in the future.

Sunk costs should not be considered in decisions.

Classification by Relevance:Sunk CostsClassification by Relevance:Sunk Costs

Example: You bought an automobile that cost$10,000 two years ago. The $10,000 cost is sunkbecause whether you drive it, park it, trade it, or sellit, you cannot change the $10,000 cost.

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Future outlays of cash associatedwith a particular decision.

Future outlays of cash associatedwith a particular decision.

Example: Considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation.

Classification by Relevance:Out-of-Pocket CostsClassification by Relevance:Out-of-Pocket Costs

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The potential benefit that is given up when one alternative is selected over another.Example: If you were

not attending college,you could be earning$20,000 per year. Your opportunity costof attending college for one year is $20,000.

Classification by Relevance: Opportunity CostsClassification by Relevance: Opportunity Costs

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We will now examine several

different types of managerial

decisions.

2. Managerial Decisions - Managerial Decision Tasks2. Managerial Decisions - Managerial Decision Tasks

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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.

Managerial Decision Tasks - Accepting Additional BusinessManagerial Decision Tasks - Accepting Additional Business

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FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:

Per Unit Total Sales 10.00$ 1,000,000$ Direct materials 3.50 350,000 Direct labor 2.20 220,000 Factory overhead 1.10 110,000 Selling expenses 1.40 140,000 Administrative expenses 0.80 80,000 Total expenses 9.00$ 900,000$ Operating income 1.00$ 100,000$

Accepting Additional BusinessAccepting Additional Business Exh. 25-12

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FasTrac is approached by an overseascompany that offers to purchase10,000 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?

Accepting Additional BusinessAccepting Additional Business

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First let’s look at incorrect reasoningthat leads to an incorrect decision.

First let’s look at incorrect reasoningthat leads to an incorrect decision.

Our cost is $9.00per unit. I can’t sell for $8.50 per unit.

Accepting Additional BusinessAccepting Additional Business

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Current Business

Additional Business Combined

Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 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 new units × $8.50 selling price = $85,000

10,000 new units × $3.50 = $35,000

10,000 new units × $2.20 = $22,000

This analysis leads to the correct decision.

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Current Business

Additional Business Combined

Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 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$

Even though the $8.50 selling price is less than thenormal $10 selling price, FasTrac should accept theoffer because net income will increase by $20,000.

Accepting Additional BusinessAccepting Additional Business Exh. 25-14

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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.

Managerial Decision Tasks - Make or Buy DecisionsManagerial Decision Tasks - Make or Buy Decisions

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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$

FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with

the following unit cost:

Make or Buy DecisionsMake or Buy Decisions

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Make vs. Buy Analysis

Make BuyDirect materia ls 0.45$ ----Direct labor 0.50 ----Factory overhead ? ----Purchase price ---- 1.20$Tota l incremental costs ? 1.20$

FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we

can continue to make this part?

Make or Buy DecisionsMake or Buy Decisions Exh. 25-15

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Make vs. Buy Analysis

Make BuyDirect materia ls 0.45$ ----Direct labor 0.50 ----Factory overhead 0.25 ----Purchase price ---- 1.20$Tota l incremental costs 1.20 1.20$

FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we

can continue to make this part?

We must eliminate $.25 per unit of overhead,leaving a maximum of $0.25 per unit.

Make or Buy DecisionsMake or Buy Decisions Exh. 25-15

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Make or Buy DecisionsMake or Buy Decisions

The company currently makes 1,000 units of part #417. The incremental factory overhead is $100. The overhead per unit is $0.1. (Make)

The company currently makes 1,000 units of part #417. The incremental factory overhead is $500. The overhead per unit is $0.5. (Buy)

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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.

Managerial Decision Tasks - Scrap or ReworkManagerial Decision Tasks - Scrap or Rework

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FasTrac has 10,000 defective units thatcost $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?

Scrap or ReworkScrap or Rework

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Scrap Now Rework

Sale of Defects 4,000$ 15,000$ Less rework costs - (8,000) Less opportunity cost - (5,000) Net return 4,000$ 2,000

10,000 units × $0.80 per unit

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

Scrap or ReworkScrap or Rework Exh. 25-16

If FasTrac fails to include the opportunity cost,the rework option would show a return of $7,000,

mistakenly making rework appear more favorable.

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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.

Managerial Decision Tasks - Sell or ProcessManagerial Decision Tasks - Sell or Process

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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:

Continue

Sell or ProcessSell or Process

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Product Price Units Revenue

X 4.00$ 10,000 40,000$ Y 6.00 22,000 132,000 Z 8.00 6,000 48,000

Spoilage - 2,000 - Total 40,000 220,000$

Should FasTrac sell product Q or continueprocessing into products X, Y, and Z?

Sell or ProcessSell or Process Exh. 25-17

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Product Price Units Revenue

X 4.00$ 10,000 40,000$ Y 6.00 22,000 132,000 Z 8.00 6,000 48,000

Spoilage - 2,000 - Total 40,000 220,000$

FasTrac should continue processing. Note that the earlier $30,000cost for product Q is sunk and therefore irrelevant to the decision.

Sell or ProcessSell or Process

Should FasTrac sell product Q or continueprocessing into products X, Y, and Z?

Exh. 25-17,18

Revenue if processed $220,000 Revenue if sold directly (50,000) Incremental revenue 170,000 Cost if processed (80,000)Incremental net income $ 90,000

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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.

If there is constraints on the facilities, then decision is based on contribution margin of constraint factor

Managerial Decision Tasks - Sales Mix SelectionManagerial Decision Tasks - Sales Mix Selection

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Consider the following data for two products made and sold by FasTrac.

Per unit amounts Product

A Product

B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$

If each product requires the same time tomake, and the demand is unlimited, FasTrac

should produce only Product B.

Sales Mix SelectionSales Mix Selection Exh. 25-19

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Consider this additional information.




A Product

B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$

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A Product


Consider the following data for two products made and sold by FasTrac.Product B has a greater

contribution margin thanProduct A, but it

requires more machine hours per unit to produce.

With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked.


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A Product


If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B.



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FasTrac is considering eliminating its TreadmillDivision 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.

Continue

Managerial Decision Tasks - Segment EliminationManagerial Decision Tasks - Segment Elimination

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TotalExpenses

Cost of goods sold 30,200$ Direct expenses: Salaries 7,900 Equipment depreciation 200 Indirect expenses: Rent and utilities 3,150 Advertising 200 Insurance 400 Service department costs: Departmental office 3,060 Purchasing 3,190 Total 48,300$

Let’s identifyavoidable expenses.

Analysis of DivisionalOperating ExpensesAnalysis of DivisionalOperating Expenses Exh.

25-20

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Total Avoidable UnavoidableExpenses Expenses Expenses

Cost of goods sold 30,200$ 30,200$ Direct expenses: Salaries 7,900 7,900 Equipment depreciation 200 200$ Indirect expenses: Rent and utilities 3,150 3,150 Advertising 200 200 Insurance 400 300 100 Service department costs: Departmental office 3,060 2,200 860 Purchasing 3,190 1,000 2,190 Total 48,300$ 41,800$ 6,500$

Analysis of DivisionalOperating ExpensesAnalysis of DivisionalOperating Expenses Exh.

25-20

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

Sa les 47,800$ Avoidable expenses 41,800 Decrease in incom e 6,000$

Do not eliminatethe Treadmill Division!

Segment EliminationSegment Elimination

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Qualitative factors are involved in most all managerial decisions. For example:

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

Managerial Decision Tasks - Qualitative Factors in DecisionsManagerial Decision Tasks - Qualitative Factors in Decisions

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

of evaluating capital investments.

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

of evaluating capital investments.

3. Decision Analysis - Break-Even Time3. Decision Analysis - Break-Even Time

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End of Chapter 25End of Chapter 25

capital budgeting and managerial decisions

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