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Accounting 4E Chapter 23Accounting, Fourth Edition

Describe the concept of incremental analysis.

Identify the relevant costs in accepting an order at a special price.

Identify the relevant costs in a make-or-buy decision.

Chapter 23-*

Study Objectives

Give the decision rule for whether to sell or process materials further.

Identify the relevant costs to be considered in retaining or replacing equipment.

Explain the relevant factors in whether to eliminate an unprofitable segment.

Chapter 23-*

Study Objectives

Determine which products to make and sell when resources are limited.

Contrast annual rate of return and cash payback in capital budgeting.

10. Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Preview of Chapter

An important purpose of management accounting is to provide managers with relevant information for decision making.

All companies must make product decisions – to cut prices to increase market share, to produce a higher priced product, to change their product mix, etc.

Management frequently uses a decision-making process called incremental analysis.

Chapter 23-*

Management’s Decision-Making Process

Decision-making is an important management function that does not always follow a set pattern.

Steps in management’s decision-making process:

Accounting helps management in making decisions by evaluating possible courses of action (step 2) and reviewing results (step 4).

SO 1: Identify the steps in management’s decision-making process.

Illustration 23-1

Chapter 23-*

Decisions vary in scope, urgency and importance.

Financial information includes revenues and costs as well as their effect on profitability.

Nonfinancial information relates to factors such as: the effect of the decision on employee turnover, the environment, or overall company image.

SO 1: Identify the steps in management’s decision-making process.

1

Decisions involve a choice among alternative courses of action.

Financial data relevant to a decision are the data that vary in the future among alternatives.

Both costs and revenues may vary,

or

Chapter 23-*

Incremental Analysis

Process used to identify the financial data that change under alternative courses of action.

Identifies the probable effects of decisions on future earnings.

Involves estimates and uncertainty.

Incremental analysis is also called differential analysis because it focuses on differences.

SO 2: Describe the concept of incremental analysis.

Chapter 23-*

ENGINEERS

ACCOUNTANTS

NEED TO PRODUCE THE MOST RELIABLE INFORMATION AVAILABLE AT THE TIME THE DECISION MUST BE MADE.

Incremental Analysis

Chapter 23-*

Illustration 23-2

Comparing alternative B to A, the incremental revenue will be $15,000 less under alternative B than under alternative A. However, a $20,000 incremental cost saving will be realized with alternative B. Thus, alternative B will produce $5,000 more net income than A.

Chapter 23-*

Incremental analysis is the process of identifying the financial data that:

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. No correct answer is given.

Let’s Review

Chapter 23-*

Sell products or process further.

Retain or replace equipment.

Allocate limited resources.

Chapter 23-*

Obtain additional business by making price concessions to a specific customer.

Assumes sales of the product in other markets would not be affected by this special order.

Assumes 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

Chapter 23-*

Accept an Order at a Special Price

Mexico Co. offers to buy a special order of 2,000 blenders at $11 per unit from Sunbelt.

No effect on normal sales; sufficient plant capacity.

Operating at 80 percent capacity = 100,000 units.

Current fixed manufacturing costs = $400,000 or $4 per unit.

Variable manufacturing cost = $8 per unit.

Normal selling price = $20 per unit.

Based strictly on total cost of $12 per unit ($8 + $4), reject offer as cost exceeds selling price of $11.

Within existing capacity, thus no change in fixed costs, so they are not relevant for this decision.

SO 3: Identify the relevant costs in accepting an order at a special price.

Chapter 23-*

Offer 2,000 units @ $11 per unit/ Normal sales Price $ 20 unit

Fixed costs do not change.

Variable manufacturing cost = $8 per unit.

Total variable costs change – thus they are relevant.

Revenue increases $22,000; variable costs increase $16,000.

Income increases by $6,000. Accept the Special Order.

SO 3: Identify the relevant costs in accepting an order at a special price.

Illustration 23-3

Chapter 23-*

It costs a company $14 of variable costs and $6 of fixed costs to produce product Z200 that sells for $30. A foreign buyer offers to purchase 3,000 units at $18 each. If the special offer is accepted and produced with unused capacity, net income will:

a. decrease $6,000.

b. increase $6,000.

c. increase $12,000.

d. increase $9,000.

Let’s Review

SO 3: Identify the relevant costs in accepting an order at a special price.

$18 - $14= $4

Management must decide whether to make or buy components.

The decision to buy parts or services rather than making them is called outsourcing.

Example: Costs to produce 25,000 switches.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 23-4

Chapter 23-*

Make or Buy –

Switches can be purchased for $8 per switch (25,000 × $8 = $200,000).

At first look, the switches should be purchased; thus saving $1 per unit.

Buying the switches eliminates all variable costs, but only $10,000 of fixed costs ($ 60,000 -10,000) = $50,000 of fixed cost will remain.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 23-4

Chapter 23-*

The relevant costs for incremental analysis are:

Baron Company will incur $25,000 additional cost if switches are purchased.

Continue to make switches.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 23-5

Chapter 23-*

Opportunity Costs

Definition: The potential benefits that may be obtained from following an alternative course of action.

Assume Baron Company can use the newly available productive capacity from buying the switches to generate additional income of $28,000 by making another product.

If Baron makes the switches, this income is lost.

SO 4: Identify the relevant costs in a make-or-buy decision.

Chapter 23-*

SO 4: Identify the relevant costs in a make-or-buy decision.

This opportunity cost, the lost income, is added to the “Make” column as an additional “cost” for comparative purposes.

It is now advantageous to buy the switches.

Baron Company will be $3,000 better off.

Illustration 23-6

Chapter 23-*

c. Opportunity costs.

Let’s Review

SO 4: Identify the relevant costs in a make-or-buy decision.

Chapter 23-*

Sell or Process Further

Many manufacturers have the option of selling a product now or continuing to process hoping to sell at a higher price.

Decision Rule:

the incremental revenue from

such processing exceeds the

to sell or process materials further.

Chapter 23-*

Cost to manufacture one unfinished table:

Selling price of unfinished unit is $50; unused capacity can be used to finish the tables to sell for $60.

Relevant unit costs of finishing tables:

Direct materials increase $2; Direct labor increases $4.

Variable manufacturing overhead costs increase by $2.40

(60 percent of direct labor increase).

Fixed manufacturing costs will not increase.

Illustration 23-7

to sell or process materials further.

Chapter 23-*

Process further.

to sell or process materials further.

Chapter 23-*

The decision rule in a sell-or-process-further decision is process further as long as the incremental revenue from processing exceeds:

a. Incremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

Let’s Review

to sell or process materials further.

Chapter 23-*

Retain or Replace Equipment

Management must decide whether a company should continue to use an asset or replace it.

Example: Assessment of replacement of a factory machine:

Variable costs:

retaining or replacing equipment.

Old Machine New Machine

Scrap value - 0 - - 0 -

Retain or Replace Equipment - Example

Replace the equipment - Lower variable manufacturing costs more than offset cost of new equipment.

The book value of the old machine does not affect the decision – it is a sunk cost.

However, any trade-in allowance or cash disposal value of the old asset is relevant.

Illustration 23-9

retaining or replacing equipment.

Chapter 23-*

In a decision to retain or replace equipment, the book value of the old equipment is a/an:

a. Opportunity cost.

b. Sunk cost.

c. Incremental cost.

d. Marginal cost.

Let’s Review

retaining or replacing equipment.

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:

exceed the contribution margin lost.

SO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.

Chapter 23-*

Martina Company manufactures three models of tennis racquets: Profitable lines: Pro and Master Unprofitable line: Champ

Condensed income statement data:

SO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.

Illustration 23-10

Chapter 23-*

Eliminate an Unprofitable Segment

If Champ is eliminated, allocate its $30,000 share of fixed costs: 2/3 to Pro and 1/3 to Master.

Revised income statement data:

SO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.

Illustration 23-11

Chapter 23-*

Decision: Do not eliminate Champ.

Illustration 23-12

Chapter 23-*

If an unprofitable segment is eliminated:

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.

Let’s Review

to eliminate an unprofitable segment .

Chapter 23-*

Many decisions involving incremental analysis have important qualitative features that must be considered in addition to the quantitative factors.

Example – cost of lost morale due to outsourcing or eliminating a plant.

Incremental analysis is completely consistent with activity-based costing (ABC).

ABC often results in better identification of relevant costs and, thus, better incremental analysis.

Chapter 23-*

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.

Chapter 23-*

pencil sets

Limiting resource:

Deluxe set has higher contribution margin: $8

Standard set takes fewer machine hours per unit

Illustration 23-13

SO 8: Determine which products to make and sell when resources are limited.

Chapter 23-*

Must compute contribution margin per unit of limited resource

Standard sets have higher contribution margin per unit of limited resources

Decision: Shift sales mix to standard sets or increase machine capacity

Illustration 23-14

SO 8: Determine which products to make and sell when resources are limited.

Chapter 23-*

Alternative: Increase machine capacity from 3,600 to 4,200 machine hours

To maximize net income, all the additional 600 hours should be used to produce standard sets

SO 8: Determine which products to make and sell when resources are limited.

Illustration 23-15

Chapter 23-*

Capital Budgeting

The process of making capital expenditure decisions in business is known as

Capital Budgeting

The amount of possible capital expenditures usually exceeds the funds available for such expenditures

Capital budgeting involves choosing among various capital projects to find the one(s) that will

Maximize a company’s return on investment

Chapter 23-*

Capital Budgeting Evaluation Process

Most methods to evaluate capital budgeting decisions employ cash flow numbers rather than accrual revenues and expenses.

For capital budgeting, estimated cash inflows and outflows are the preferred inputs.

WHY?

Ultimately the value of financial investments is determined by the value of the cash flows received or paid.

Chapter 23-*

Evaluation Process

Providing management with relevant data for capital budgeting decisions requires familiarity with quantitative techniques.

The most common techniques are:

Annual Rate of Return

Chapter 23-*

Evaluation Process

These techniques will be illustrated using the following data for Tappan Company:

Investment in new equipment: $130,000

Useful life of new equipment: 10 years

Zero salvage and straight-line depreciation

The expected annual revenues and costs of the new product that will be produced from the investment are:

Illustration 23-16

Chapter 23-*

Annual Rate of Return Formula

The annual rate of return technique is based on accounting data. It indicates the profitability of a capital expenditure. The formula is:

The annual rate of return is compared with its required

minimum rate of return for investments of similar risk.

This minimum return is based on the company’s cost of capital,

which is the rate of return that management expects to pay on

all borrowed and equity funds.

SO 8 Describe the annual rate of return method.

Illustration 23-17

Chapter 23-*

For Tappan Company the average investment is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

[($130,00 + $0) ÷ 2] = $65,000

Annual Rate of Return

The expected rate of return for Tappan Company’s investment in new equipment is:

The decision rule is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

A project is acceptable if its rate of return is greater than management’s minimum rate of return. When choosing among several acceptable projects, the project with the higher rate of return is generally more attractive.

$13,000 ÷ $65,000 = 20%

Simplicity of calculations

Management’s familiarity with accounting terms used in the calculation

Major limitation of the technique:

It does not consider the time value of money

As noted in Appendix D, recognition of the time value of money can make a significant difference between the present and future values of an investment.

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Chapter 23-*

Cash Payback

Identifies the time period required to recover the cost of the investment

Uses the net annual cash flow produced from the investment

Net annual cash flow can be approximated by taking net income and adding back depreciation

The formula for computing the cash payback period is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Illustration 23-19

Chapter 23-*

Cash Payback

Example:

Tappan Company has net annual cash inflows of $26,000 ( Net Income $13,000 + Depreciation $13,000)

The cash payback period is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

$130,000 ÷ $26,000 = 5 years

Chen Company has uneven net annual cash inflows

Now the cash payback period is determined when the cumulative net cash flows equal the cost of the investment

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Illustration 23-21

Chapter 23-*

Which of the following is incorrect about the annual rate of return technique?

a. The calculation is simple.

b. The accounting terms used are familiar to management.

c. The timing of the cash inflows is not considered.

d. The time value of money is considered.

REVIEW

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Review Question

Chapter 23-*

Discounted Cash Flow

Discounted cash flow techniques generally recognized as best approach to making capital budgeting decisions

Techniques consider both:

Estimated total cash inflows, and

The time value of money

Two methods generally used with the discounted cash flow techniques are

Net Present Value Method

Internal Rate of Return Method

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Net Present Value Method

NPV method compares the present value of the cash inflows to the capital outlay required by the investment

The difference between the two amounts is referred to as the net present value

The interest rate used to discount the cash flow is the required minimum rate of return

A proposal is acceptable when the NPV is zero or positive

The higher the positive NPV, the more attractive the investment

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Net Present Value Decision Criteria

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-22

Chapter 23-*

Example: Equal Annual Cash Flows

Annual cash flows of $26,000 uniform over asset’s useful life

Calculation of present value of annual cash flows (annuity) at 2 different discount rates:

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-23

Chapter 23-*

Analysis of proposal using net present values

NPV positive for both discount rates

Accept proposed capital expenditure at either discount rate

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-24

Chapter 23-*

Example: Unequal Annual Cash Flows

Different cash flows each year over asset’s useful life; calculation of PV of annual cash flows at 2 different discount rates:

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-25

Chapter 23-*

Analysis of proposal using net present values

NPV positive for both discount rates

Accept proposed capital expenditure at either discount rate

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-26

Chapter 23-*

IRR method finds the interest yield of the potential investment

IRR – 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.

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Example:

IRR factor for Tappan Company, assuming equal annual cash inflows:

$130,000 ÷ $26,000 = 5.0

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-27

Chapter 23-*

Example - Continued

Step 2: IRR is the discount factor closest to the IRR factor for the time period covered by the annual cash flows.

Closest discount factor to 5.0 is 5.01877; thus IRR is approximately 15%

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Compare IRR to management’s required minimum rate of return

Decision Rule:

Accept the project when the IRR is equal to or greater than the required rate of return.

Assuming a minimum rate of return for Tappan of 10%, project is accepted since IRR of 15% is greater than the required rate.

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Internal Rate of Return Method

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-28

Chapter 23-*

Comparison of Discounted Cash Flow Methods

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-29

Chapter 23-*

A positive net present value means that the:

a. Project’s rate of return is less than the cutoff rate.

b. Project’s rate of return exceeds the required rate of return.

c. Project’s rate of return equals the required rate of return.

d. Project is unacceptable.

REVIEW

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

A $60,000 project has net cash inflows for 10 years of $9,349. Compute the internal rate of return from this investment.

8%.

10%.

9%.

11.

=

Chapter 23-*

Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright

Describe the concept of incremental analysis.

Identify the relevant costs in accepting an order at a special price.

Identify the relevant costs in a make-or-buy decision.

Chapter 23-*

Study Objectives

Give the decision rule for whether to sell or process materials further.

Identify the relevant costs to be considered in retaining or replacing equipment.

Explain the relevant factors in whether to eliminate an unprofitable segment.

Chapter 23-*

Study Objectives

Determine which products to make and sell when resources are limited.

Contrast annual rate of return and cash payback in capital budgeting.

10. Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Preview of Chapter

An important purpose of management accounting is to provide managers with relevant information for decision making.

All companies must make product decisions – to cut prices to increase market share, to produce a higher priced product, to change their product mix, etc.

Management frequently uses a decision-making process called incremental analysis.

Chapter 23-*

Management’s Decision-Making Process

Decision-making is an important management function that does not always follow a set pattern.

Steps in management’s decision-making process:

Accounting helps management in making decisions by evaluating possible courses of action (step 2) and reviewing results (step 4).

SO 1: Identify the steps in management’s decision-making process.

Illustration 23-1

Chapter 23-*

Decisions vary in scope, urgency and importance.

Financial information includes revenues and costs as well as their effect on profitability.

Nonfinancial information relates to factors such as: the effect of the decision on employee turnover, the environment, or overall company image.

SO 1: Identify the steps in management’s decision-making process.

1

Decisions involve a choice among alternative courses of action.

Financial data relevant to a decision are the data that vary in the future among alternatives.

Both costs and revenues may vary,

or

Chapter 23-*

Incremental Analysis

Process used to identify the financial data that change under alternative courses of action.

Identifies the probable effects of decisions on future earnings.

Involves estimates and uncertainty.

Incremental analysis is also called differential analysis because it focuses on differences.

SO 2: Describe the concept of incremental analysis.

Chapter 23-*

ENGINEERS

ACCOUNTANTS

NEED TO PRODUCE THE MOST RELIABLE INFORMATION AVAILABLE AT THE TIME THE DECISION MUST BE MADE.

Incremental Analysis

Chapter 23-*

Illustration 23-2

Comparing alternative B to A, the incremental revenue will be $15,000 less under alternative B than under alternative A. However, a $20,000 incremental cost saving will be realized with alternative B. Thus, alternative B will produce $5,000 more net income than A.

Chapter 23-*

Incremental analysis is the process of identifying the financial data that:

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. No correct answer is given.

Let’s Review

Chapter 23-*

Sell products or process further.

Retain or replace equipment.

Allocate limited resources.

Chapter 23-*

Obtain additional business by making price concessions to a specific customer.

Assumes sales of the product in other markets would not be affected by this special order.

Assumes 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

Chapter 23-*

Accept an Order at a Special Price

Mexico Co. offers to buy a special order of 2,000 blenders at $11 per unit from Sunbelt.

No effect on normal sales; sufficient plant capacity.

Operating at 80 percent capacity = 100,000 units.

Current fixed manufacturing costs = $400,000 or $4 per unit.

Variable manufacturing cost = $8 per unit.

Normal selling price = $20 per unit.

Based strictly on total cost of $12 per unit ($8 + $4), reject offer as cost exceeds selling price of $11.

Within existing capacity, thus no change in fixed costs, so they are not relevant for this decision.

SO 3: Identify the relevant costs in accepting an order at a special price.

Chapter 23-*

Offer 2,000 units @ $11 per unit/ Normal sales Price $ 20 unit

Fixed costs do not change.

Variable manufacturing cost = $8 per unit.

Total variable costs change – thus they are relevant.

Revenue increases $22,000; variable costs increase $16,000.

Income increases by $6,000. Accept the Special Order.

SO 3: Identify the relevant costs in accepting an order at a special price.

Illustration 23-3

Chapter 23-*

It costs a company $14 of variable costs and $6 of fixed costs to produce product Z200 that sells for $30. A foreign buyer offers to purchase 3,000 units at $18 each. If the special offer is accepted and produced with unused capacity, net income will:

a. decrease $6,000.

b. increase $6,000.

c. increase $12,000.

d. increase $9,000.

Let’s Review

SO 3: Identify the relevant costs in accepting an order at a special price.

$18 - $14= $4

Management must decide whether to make or buy components.

The decision to buy parts or services rather than making them is called outsourcing.

Example: Costs to produce 25,000 switches.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 23-4

Chapter 23-*

Make or Buy –

Switches can be purchased for $8 per switch (25,000 × $8 = $200,000).

At first look, the switches should be purchased; thus saving $1 per unit.

Buying the switches eliminates all variable costs, but only $10,000 of fixed costs ($ 60,000 -10,000) = $50,000 of fixed cost will remain.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 23-4

Chapter 23-*

The relevant costs for incremental analysis are:

Baron Company will incur $25,000 additional cost if switches are purchased.

Continue to make switches.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 23-5

Chapter 23-*

Opportunity Costs

Definition: The potential benefits that may be obtained from following an alternative course of action.

Assume Baron Company can use the newly available productive capacity from buying the switches to generate additional income of $28,000 by making another product.

If Baron makes the switches, this income is lost.

SO 4: Identify the relevant costs in a make-or-buy decision.

Chapter 23-*

SO 4: Identify the relevant costs in a make-or-buy decision.

This opportunity cost, the lost income, is added to the “Make” column as an additional “cost” for comparative purposes.

It is now advantageous to buy the switches.

Baron Company will be $3,000 better off.

Illustration 23-6

Chapter 23-*

c. Opportunity costs.

Let’s Review

SO 4: Identify the relevant costs in a make-or-buy decision.

Chapter 23-*

Sell or Process Further

Many manufacturers have the option of selling a product now or continuing to process hoping to sell at a higher price.

Decision Rule:

the incremental revenue from

such processing exceeds the

to sell or process materials further.

Chapter 23-*

Cost to manufacture one unfinished table:

Selling price of unfinished unit is $50; unused capacity can be used to finish the tables to sell for $60.

Relevant unit costs of finishing tables:

Direct materials increase $2; Direct labor increases $4.

Variable manufacturing overhead costs increase by $2.40

(60 percent of direct labor increase).

Fixed manufacturing costs will not increase.

Illustration 23-7

to sell or process materials further.

Chapter 23-*

Process further.

to sell or process materials further.

Chapter 23-*

The decision rule in a sell-or-process-further decision is process further as long as the incremental revenue from processing exceeds:

a. Incremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

Let’s Review

to sell or process materials further.

Chapter 23-*

Retain or Replace Equipment

Management must decide whether a company should continue to use an asset or replace it.

Example: Assessment of replacement of a factory machine:

Variable costs:

retaining or replacing equipment.

Old Machine New Machine

Scrap value - 0 - - 0 -

Retain or Replace Equipment - Example

Replace the equipment - Lower variable manufacturing costs more than offset cost of new equipment.

The book value of the old machine does not affect the decision – it is a sunk cost.

However, any trade-in allowance or cash disposal value of the old asset is relevant.

Illustration 23-9

retaining or replacing equipment.

Chapter 23-*

In a decision to retain or replace equipment, the book value of the old equipment is a/an:

a. Opportunity cost.

b. Sunk cost.

c. Incremental cost.

d. Marginal cost.

Let’s Review

retaining or replacing equipment.

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:

exceed the contribution margin lost.

SO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.

Chapter 23-*

Martina Company manufactures three models of tennis racquets: Profitable lines: Pro and Master Unprofitable line: Champ

Condensed income statement data:

SO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.

Illustration 23-10

Chapter 23-*

Eliminate an Unprofitable Segment

If Champ is eliminated, allocate its $30,000 share of fixed costs: 2/3 to Pro and 1/3 to Master.

Revised income statement data:

SO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.

Illustration 23-11

Chapter 23-*

Decision: Do not eliminate Champ.

Illustration 23-12

Chapter 23-*

If an unprofitable segment is eliminated:

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.

Let’s Review

to eliminate an unprofitable segment .

Chapter 23-*

Many decisions involving incremental analysis have important qualitative features that must be considered in addition to the quantitative factors.

Example – cost of lost morale due to outsourcing or eliminating a plant.

Incremental analysis is completely consistent with activity-based costing (ABC).

ABC often results in better identification of relevant costs and, thus, better incremental analysis.

Chapter 23-*

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.

Chapter 23-*

pencil sets

Limiting resource:

Deluxe set has higher contribution margin: $8

Standard set takes fewer machine hours per unit

Illustration 23-13

SO 8: Determine which products to make and sell when resources are limited.

Chapter 23-*

Must compute contribution margin per unit of limited resource

Standard sets have higher contribution margin per unit of limited resources

Decision: Shift sales mix to standard sets or increase machine capacity

Illustration 23-14

SO 8: Determine which products to make and sell when resources are limited.

Chapter 23-*

Alternative: Increase machine capacity from 3,600 to 4,200 machine hours

To maximize net income, all the additional 600 hours should be used to produce standard sets

SO 8: Determine which products to make and sell when resources are limited.

Illustration 23-15

Chapter 23-*

Capital Budgeting

The process of making capital expenditure decisions in business is known as

Capital Budgeting

The amount of possible capital expenditures usually exceeds the funds available for such expenditures

Capital budgeting involves choosing among various capital projects to find the one(s) that will

Maximize a company’s return on investment

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Capital Budgeting Evaluation Process

Most methods to evaluate capital budgeting decisions employ cash flow numbers rather than accrual revenues and expenses.

For capital budgeting, estimated cash inflows and outflows are the preferred inputs.

WHY?

Ultimately the value of financial investments is determined by the value of the cash flows received or paid.

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Evaluation Process

Providing management with relevant data for capital budgeting decisions requires familiarity with quantitative techniques.

The most common techniques are:

Annual Rate of Return

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Evaluation Process

These techniques will be illustrated using the following data for Tappan Company:

Investment in new equipment: $130,000

Useful life of new equipment: 10 years

Zero salvage and straight-line depreciation

The expected annual revenues and costs of the new product that will be produced from the investment are:

Illustration 23-16

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Annual Rate of Return Formula

The annual rate of return technique is based on accounting data. It indicates the profitability of a capital expenditure. The formula is:

The annual rate of return is compared with its required

minimum rate of return for investments of similar risk.

This minimum return is based on the company’s cost of capital,

which is the rate of return that management expects to pay on

all borrowed and equity funds.

SO 8 Describe the annual rate of return method.

Illustration 23-17

Chapter 23-*

For Tappan Company the average investment is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

[($130,00 + $0) ÷ 2] = $65,000

Annual Rate of Return

The expected rate of return for Tappan Company’s investment in new equipment is:

The decision rule is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

A project is acceptable if its rate of return is greater than management’s minimum rate of return. When choosing among several acceptable projects, the project with the higher rate of return is generally more attractive.

$13,000 ÷ $65,000 = 20%

Simplicity of calculations

Management’s familiarity with accounting terms used in the calculation

Major limitation of the technique:

It does not consider the time value of money

As noted in Appendix D, recognition of the time value of money can make a significant difference between the present and future values of an investment.

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

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Cash Payback

Identifies the time period required to recover the cost of the investment

Uses the net annual cash flow produced from the investment

Net annual cash flow can be approximated by taking net income and adding back depreciation

The formula for computing the cash payback period is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Illustration 23-19

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Cash Payback

Example:

Tappan Company has net annual cash inflows of $26,000 ( Net Income $13,000 + Depreciation $13,000)

The cash payback period is:

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

$130,000 ÷ $26,000 = 5 years

Chen Company has uneven net annual cash inflows

Now the cash payback period is determined when the cumulative net cash flows equal the cost of the investment

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Illustration 23-21

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Which of the following is incorrect about the annual rate of return technique?

a. The calculation is simple.

b. The accounting terms used are familiar to management.

c. The timing of the cash inflows is not considered.

d. The time value of money is considered.

REVIEW

SO 9: Contrast annual rate of return and cash payback in capital budgeting.

Review Question

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Discounted Cash Flow

Discounted cash flow techniques generally recognized as best approach to making capital budgeting decisions

Techniques consider both:

Estimated total cash inflows, and

The time value of money

Two methods generally used with the discounted cash flow techniques are

Net Present Value Method

Internal Rate of Return Method

SO 10: Distinguish between the net present value and internal rate of return methods.

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Net Present Value Method

NPV method compares the present value of the cash inflows to the capital outlay required by the investment

The difference between the two amounts is referred to as the net present value

The interest rate used to discount the cash flow is the required minimum rate of return

A proposal is acceptable when the NPV is zero or positive

The higher the positive NPV, the more attractive the investment

SO 10: Distinguish between the net present value and internal rate of return methods.

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Net Present Value Decision Criteria

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-22

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Example: Equal Annual Cash Flows

Annual cash flows of $26,000 uniform over asset’s useful life

Calculation of present value of annual cash flows (annuity) at 2 different discount rates:

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-23

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Analysis of proposal using net present values

NPV positive for both discount rates

Accept proposed capital expenditure at either discount rate

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-24

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Example: Unequal Annual Cash Flows

Different cash flows each year over asset’s useful life; calculation of PV of annual cash flows at 2 different discount rates:

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-25

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Analysis of proposal using net present values

NPV positive for both discount rates

Accept proposed capital expenditure at either discount rate

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-26

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IRR method finds the interest yield of the potential investment

IRR – 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.

SO 10: Distinguish between the net present value and internal rate of return methods.

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Example:

IRR factor for Tappan Company, assuming equal annual cash inflows:

$130,000 ÷ $26,000 = 5.0

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-27

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Example - Continued

Step 2: IRR is the discount factor closest to the IRR factor for the time period covered by the annual cash flows.

Closest discount factor to 5.0 is 5.01877; thus IRR is approximately 15%

SO 10: Distinguish between the net present value and internal rate of return methods.

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Compare IRR to management’s required minimum rate of return

Decision Rule:

Accept the project when the IRR is equal to or greater than the required rate of return.

Assuming a minimum rate of return for Tappan of 10%, project is accepted since IRR of 15% is greater than the required rate.

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

Internal Rate of Return Method

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-28

Chapter 23-*

Comparison of Discounted Cash Flow Methods

SO 10: Distinguish between the net present value and internal rate of return methods.

Illustration 23-29

Chapter 23-*

A positive net present value means that the:

a. Project’s rate of return is less than the cutoff rate.

b. Project’s rate of return exceeds the required rate of return.

c. Project’s rate of return equals the required rate of return.

d. Project is unacceptable.

REVIEW

SO 10: Distinguish between the net present value and internal rate of return methods.

Chapter 23-*

A $60,000 project has net cash inflows for 10 years of $9,349. Compute the internal rate of return from this investment.

8%.

10%.

9%.

11.

=

Chapter 23-*

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