Transcript
Page 1: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-1

Page 2: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-2

CHAPTER CHAPTER 2323

INCREMENTAL ANALYSIS AND

CAPITAL BUDGETING

INCREMENTAL ANALYSIS AND

CAPITAL BUDGETING

Accounting, Fourth Edition

Page 3: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-3

Chapter PreviewChapter PreviewChapter PreviewChapter Preview

Page 4: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-4

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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

2. Describe the concept of incremental analysis.

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

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

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Chapter 23-5

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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

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

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

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Chapter 23-6

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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

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

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

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Chapter 23-7

Preview of ChapterPreview of ChapterPreview of ChapterPreview of Chapter

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

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

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

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Chapter 23-8

Management’s Decision-Making Management’s Decision-Making ProcessProcess

Management’s Decision-Making Management’s Decision-Making ProcessProcess

Decision-making is an important management function that does not always follow a set pattern.Steps in management’s decision-making process: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.SO 1: Identify the steps in management’s decision-making process.

Illustration 23-1

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Chapter 23-9

Management’s Decision-Making ProcessManagement’s Decision-Making ProcessManagement’s Decision-Making ProcessManagement’s Decision-Making Process

Both financial and nonfinancial information are considered in decision-making.

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

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Chapter 23-10

Incremental Analysis ApproachIncremental Analysis ApproachIncremental Analysis ApproachIncremental Analysis Approach

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,orOnly revenues may vary,

orOnly costs may vary.

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

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Chapter 23-11

Incremental Analysis Incremental Analysis Incremental Analysis 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.SO 2: Describe the concept of incremental analysis.

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Chapter 23-12

GATHERING DATA MAY INVOLVE:MARKET ANALYSTSENGINEERSACCOUNTANTS

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

Incremental Analysis Incremental Analysis Incremental Analysis Incremental Analysis

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

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Chapter 23-13

How Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis Works

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

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.

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Chapter 23-14

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

a.a. Do not change under alternative courses of Do not change under alternative courses of actionaction.

b. Change under alternative courses of action.

c. Are mixed under alternative courses of action.

d. No correct answer is given.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

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Chapter 23-15

Types of Incremental AnalysisTypes of Incremental AnalysisTypes of Incremental AnalysisTypes of Incremental Analysis

Accept an order at a special price.Accept an order at a special price.

Make or buy components or Make or buy components or finished products.finished products.

Sell products or process further.Sell products or process further.

Retain or replace equipment.Retain or replace equipment.

Eliminate an unprofitable Eliminate an unprofitable business segment.business segment.

Allocate limited resources.Allocate limited resources.

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

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Chapter 23-16

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

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

Assumes company is Assumes company is notnot operating at full capacity.operating at full capacity.

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

Accept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special Price

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Chapter 23-17

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

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Chapter 23-18

Offer 2,000 units @ $11 per unit/ Normal sales Price $ 20 unitFixed 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.SO 3: Identify the relevant costs in accepting an order at a special price.

Illustration 23-3

Accept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special Price

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Chapter 23-19

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

a.a. decrease $6,000decrease $6,000.

b. increase $6,000.

c. increase $12,000.

d. increase $9,000.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

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

$18 - $14= $4$4 × 3,000 units =

$12,000

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Chapter 23-20

Make or BuyMake or BuyMake or BuyMake or Buy

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

Illustration 23-4

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Chapter 23-21

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

Illustration 23-4

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Chapter 23-22

Make or Buy – Make or Buy – Make or Buy – Make or Buy –

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

Illustration 23-5

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Chapter 23-23

Make or BuyMake or BuyMake or BuyMake or Buy

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

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Chapter 23-24

Make or Buy – Opportunity Cost Make or Buy – Opportunity Cost ExampleExample

Make or Buy – Opportunity Cost Make or Buy – Opportunity Cost ExampleExample

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

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Chapter 23-25

In a make-or-buy decision, relevant costs are:In a make-or-buy decision, relevant costs are:

a.a. Manufacturing costs that will be savedManufacturing costs that will be saved.

b. The purchase price of the units.

c. Opportunity costs.

d. All of the above.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

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

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Chapter 23-26

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell 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:

Process further as long as the incremental revenue fromsuch processing exceeds theincremental processing costs.

SO 5: Give the decision rule for whetherSO 5: Give the decision rule for whetherto sell or process materials further.to sell or process materials further.

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Chapter 23-27

Sell or Process Further Sell or Process Further Sell or Process Further Sell or Process Further

Single-Product Case

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

SO 5: Give the decision rule for whetherSO 5: Give the decision rule for whetherto sell or process materials further.to sell or process materials further.

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Chapter 23-28

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

Incremental revenues ($10) exceed incremental costs ($8.40); Income increases $1.60 per unit.

Process further.Process further.SO 5: Give the decision rule for SO 5: Give the decision rule for

whetherwhetherto sell or process materials further.to sell or process materials further.

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Chapter 23-29

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

a.a. Incremental processing costsIncremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

d. No correct answer is given.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

SO 5: Give the decision rule for SO 5: Give the decision rule for whetherwhether

to sell or process materials further.to sell or process materials further.

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Chapter 23-30

Retain or Replace EquipmentRetain or Replace EquipmentRetain or Replace EquipmentRetain 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: Decrease from $160,000to $125,000 annually.

SO 6: Identify the factors to consider inSO 6: Identify the factors to consider inretaining or replacing equipment.retaining or replacing equipment.

Old Machine New Machine Book value $40,000 Cost $120,000Remaining useful life Four years Four yearsScrap value - 0 - - 0 -

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Chapter 23-31

Retain or Replace Equipment - ExampleRetain or Replace Equipment - ExampleRetain or Replace Equipment - ExampleRetain 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

SO 6: Identify the factors to consider inSO 6: Identify the factors to consider inretaining or replacing equipment.retaining or replacing equipment.

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Chapter 23-32

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

a.a. Opportunity costOpportunity cost.

b. Sunk cost.

c. Incremental cost.

d. Marginal cost.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

SO 6: Identify the factors to consider inSO 6: Identify the factors to consider inretaining or replacing equipment.retaining or replacing equipment.

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Chapter 23-33

Eliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable Segment

Should the company eliminate an unprofitable segment?

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 the contribution margin lost.SO 7: Explain the relevant factors in deciding whetherSO 7: Explain the relevant factors in deciding whether

to eliminate an unprofitable segment.to eliminate an unprofitable segment.

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Chapter 23-34

Eliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable Segment

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

Condensed income statement data:

Should the Champ line be eliminated?

SO 7: Explain the relevant factors in deciding whetherSO 7: Explain the relevant factors in deciding whetherto eliminate an unprofitable segment.to eliminate an unprofitable segment.

Illustration 23-10

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Chapter 23-35

Eliminate an Unprofitable Segment Eliminate an Unprofitable Segment Eliminate an Unprofitable Segment 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:

Total income has decreased by $10,000 ($220,000 - $210,000).

SO 7: Explain the relevant factors in deciding whetherSO 7: Explain the relevant factors in deciding whetherto eliminate an unprofitable segment.to eliminate an unprofitable segment.

Illustration 23-11

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Chapter 23-36

Eliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable Segment

Incremental analysis of Champ provides the same results:

Decision: Do not eliminate Champ.Illustration 23-12

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Chapter 23-37

If an unprofitable segment is eliminated:If an unprofitable segment is eliminated:

a.a. Net income will always increaseNet 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 ReviewLet’s ReviewLet’s ReviewLet’s Review

SO 23: Identify the relevant costs in deciding whetherSO 23: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment .to eliminate an unprofitable segment .

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Chapter 23-38

Other Considerations in Decision MakingOther Considerations in Decision MakingOther Considerations in Decision MakingOther Considerations in Decision Making

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.

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Chapter 23-39

Allocate Limited ResourcesAllocate Limited ResourcesAllocate Limited ResourcesAllocate Limited Resources

Resources are always Resources are always limitedlimited

Floor space for a retail firmRaw materials, direct labor hours, or machine capacity for a manufacturing firm

Management must decide which products to make which products to make and sell to maximize net and sell to maximize net incomeincome

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

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Chapter 23-40

Allocate Limited ResourcesAllocate Limited ResourcesAllocate Limited ResourcesAllocate Limited Resources

Example:Example: Collins Company manufacturesdeluxe and standard pen andpencil sets

Limiting resource:3,600 machine hours per month

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

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Chapter 23-41

Allocate Limited ResourcesAllocate Limited ResourcesAllocate Limited ResourcesAllocate Limited Resources

Example: Example: Must compute contribution margin per unit of limited resource

Standard sets have higher contribution margin per unit of limited resources

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

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Chapter 23-42

Allocate Limited ResourcesAllocate Limited ResourcesAllocate Limited ResourcesAllocate Limited Resources

Example: Example:

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

Illustration 23-15

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Chapter 23-43

Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting

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

Capital BudgetingCapital 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 investmentMaximize a company’s return on investment

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Chapter 23-44

CapitalCapital Budgeting Authorization Budgeting Authorization ProcessProcess

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Chapter 23-45

Capital Budgeting Evaluation Capital Budgeting Evaluation ProcessProcess

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

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

WHY?WHY? Ultimately the value of financial Ultimately the value of financial

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

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Chapter 23-46

Evaluation ProcessEvaluation ProcessEvaluation ProcessEvaluation Process

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

The most common techniques are:

Annual Rate of ReturnAnnual Rate of Return

Cash PaybackCash Payback

Discounted Discounted Cash FlowCash Flow

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Chapter 23-47

Evaluation ProcessEvaluation ProcessEvaluation ProcessEvaluation Process

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

Investment in new equipment: $130,000Useful life of new equipment: 10 yearsZero salvage and straight-line depreciationThe expected annual revenues and costs of the new product that will be produced from the investment are:

Illustration 23-16

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Chapter 23-48

Annual Rate of Return FormulaAnnual Rate of Return Formula

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

The annual rate of return is compared with its requiredminimum 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.SO 8 Describe the annual rate of return method.

Illustration 23-17

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Chapter 23-49

Annual Rate of ReturnAnnual Rate of ReturnAnnual Rate of ReturnAnnual Rate of Return

The average investment is derived from the The average investment is derived from the following formula:following formula:

For Tappan Company the average investment is:

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

[($130,00 + $0) ÷ 2] = $65,000

Illustration 23-18

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Chapter 23-50

Annual Rate of ReturnAnnual Rate of ReturnAnnual Rate of ReturnAnnual Rate of Return

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

The decision rule is:

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

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Chapter 23-51

Annual Rate of ReturnAnnual Rate of ReturnAnnual Rate of ReturnAnnual Rate of Return

Principal advantages of the annual rate of return technique:

Simplicity of calculationsManagement’s familiarity with accounting terms used in the calculation

Major limitation of the technique:

It does not consider the time value of moneyIt 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 SO 9: Contrast annual rate of return and cash payback in capital budgeting.payback in capital budgeting.

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

Illustration 23-19

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Chapter 23-53

Cash PaybackCash PaybackCash PaybackCash Payback

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

$130,000 ÷ $26,000 = 5 $130,000 ÷ $26,000 = 5 yearsyears

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Chapter 23-54

Cash PaybackCash PaybackCash PaybackCash Payback

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

Illustration 23-21

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Chapter 23-55

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

a.a. The calculation is simpleThe 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.

REVIEWREVIEWREVIEWREVIEW

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

Review Question

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Chapter 23-56

Discounted Cash FlowDiscounted Cash FlowDiscounted Cash FlowDiscounted Cash Flow

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

Techniques consider both:Estimated total cash inflows, andThe 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 SO 10: Distinguish between the net present value and internal rate of return methods. value and internal rate of return methods.

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Chapter 23-57

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

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

The differencedifference between the two amounts is referred to as the net present valuenet 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 positivezero or positive

The higher the positive NPV, the more attractive the investment

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

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Chapter 23-58

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

Net Present Value Decision CriteriaNet Present Value Decision Criteria

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

Illustration 23-22

Page 59: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-59

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

Example: Equal Annual Cash FlowsExample: 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 SO 10: Distinguish between the net present value and internal rate of return methods. value and internal rate of return methods.

Illustration 23-23

Page 60: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-60

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

Example: Equal Annual Cash Flows - ContinuedExample: Equal Annual Cash Flows - Continued

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

Illustration 23-24

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Chapter 23-61

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

Example: Unequal Annual Cash FlowsExample: 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 SO 10: Distinguish between the net present value and internal rate of return methods. value and internal rate of return methods.

Illustration 23-25

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Chapter 23-62

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

Example: Unequal Annual Cash Flows - Example: Unequal Annual Cash Flows - ContinuedContinued

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

Illustration 23-26

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Chapter 23-63

Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method

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

1. Compute the interval rate of return factor

2. Use the factor and the PV of an annuity of 1 table to find the IRR.

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

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Chapter 23-64

Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method

Example: Example:

Step 1: The formula for computing the IRR factor:

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

$130,000 ÷ $26,000 = 5.0$130,000 ÷ $26,000 = 5.0

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

Illustration 23-27

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Chapter 23-65

Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method

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

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Chapter 23-66

Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method

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

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Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method

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

Illustration 23-28

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Chapter 23-68

Comparison of Discounted Cash Flow Comparison of Discounted Cash Flow MethodsMethodsComparison of Discounted Cash Flow Comparison of Discounted Cash Flow MethodsMethods

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

Illustration 23-29

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Chapter 23-69

A positive net present value means that the:A positive net present value means that the:

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

REVIEWREVIEWREVIEWREVIEW

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

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Chapter 23-70

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

a.a. 8%.8%.

b.b. 10%.10%.

c.c. 9%.9%.

d.d. 11.11.

Review QuestionReview Question

SO 7 Explain the internal rate of return method.

SO 7 Explain the internal rate of return method.

Capital Investment 60,000Net Annual Cash Flows 9,349

= = 6.4177

Page 71: Chapter 23-1. Chapter 23-2 CHAPTER 23 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING Accounting, Fourth Edition

Chapter 23-71

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