Slide 6-1

26

Capital Budgeting and Managerial Decisions

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Slide 6-2

Capital Budgeting
Outcome
is uncertain.

Large amounts of
money are usually involved.

Capital budgeting: Analyzing alternative longterm investments and deciding which assets to acquire or sell.

Decision may be
difficult or impossible to reverse.

Investment involves a
long-term commitment.

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Slide 6-3

Payback Period

Exh. 26-2

The payback period of an investment The payback period of an investment is the time expected to recover is the time expected to recover the initial investment amount. the initial investment amount.
Payback Cost of Investment = period Annual Net Cash Flow
Managers prefer investing in projects with shorter payback periods.

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Slide 6-4

Payback Period Even Cash Flows

FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows of $4,100. The machine is expected to have an 8-year useful life with no salvage value.

Calculate the payback period.

Payback Cost of Investment = period Annual Net Cash Flow Payback = period $16,000 $4,100 = 3.9 years

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Slide 6-5

Payback Period Uneven Cash Flows

In the previous example, we assumed that the increase in cash flows would be the same each year. Now, lets look at an example where the cash flows vary each year.
$5,000 $4,100

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Slide 6-6

Payback Period Uneven Cash Flows

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:
Year 0 1 2 3 4 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000

Exh. 26-3

Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000) 4,000 7,000 9,000 11,000

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Slide 6-7

Payback Period Uneven Cash Flows

Year 0 1 2 3 4 4.2 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000

Exh. 26-3

We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period.

Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000) 4,000 7,000 9,000 11,000

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Slide 6-8

Using the Payback Period

Ignores the time value of money.

Unacceptable for projects with long lives where time value of money effects are major.

Ignores cash flows after the payback period.

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Slide 6-9

Using the Payback Period

Consider two projects, each with a five-year life and each costing $6,000.
Project One Net Cash Inflows $ 2,000 2,000 2,000 2,000 2,000 Project Two Net Cash Inflows $ 1,000 1,000 1,000 1,000 1,000,000

Year 1 2 3 4 5

Would you invest in Project One just because it has a shorter payback period?

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Slide 6-10

Accounting Rate of Return

The accounting rate of return focuses on annual income instead of cash flows.

Exh. 26-5,6

Accounting Accounting rate of return rate of return

Annual after-tax net income Annual after-tax net income Annual average investment Annual average investment

Beginning book value + Ending book value 2

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Slide 6-11

Accounting Rate of Return

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

Exh. 26-5,6

Accounting Accounting rate of return rate of return

Annual after-tax net income Annual after-tax net income Annual average investment Annual average investment

Beginning book value + Ending book value 2

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Slide 6-12

Accounting Rate of Return

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

Cash flow Depreciation Income

$ 4,100 2,000 $ 2,100

Exh. 26-5,6

Depreciation = ($16,000 - 0) 8 years

Accounting Accounting rate of return rate of return

Annual after-tax net income Annual after-tax net income Annual average investment Annual average investment

Beginning book value + Ending book value 2

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Slide 6-13

Accounting Rate of Return

Exh. 26-5,6

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 Accounting rate of return rate of return

$2,100 $2,100 $8,000 $8,000

26.25%

$16,000 + $0 2

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Slide 6-14

Using Accounting Rate of Return

Depreciation may be

calculated several ways.

Income may vary from

year to year.
Time value of

So why would I ever want to use this method anyway?

money is ignored.

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Slide 6-15

Net Present Value

Now lets look at a capital budgeting model that considers the time value of cash flows.

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Slide 6-16

Net Present Value

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.

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Slide 6-17

Net Present Value with Even Cash Flows

Present Present Annual Net Value of $1 Value of Year Cash Flows Factor Cash Flows 1 $ 4,100 0.8929 $ 3,661 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 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

Exh. 26-7

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Slide 6-18

Net Present Value with Even Cash Flows

Present Present value factors Annual Net Value of $1 for 12 percent Year Cash Flows Factor 1 $ 4,100 0.8929 2 4,100 0.7972 3 4,100 0.7118 4 4,100 0.6355 5 4,100 0.5674 6 4,100 0.5066 7 4,100 0.4523 8 4,100 0.4039 Total $ 32,800 Amount to be invested Net present value of investment Present Value of Cash Flows $ 3,661 3,269 2,918 2,606 2,326 2,077 1,854 1,656 $ 20,367 (16,000) $ 4,367

Exh. 26-7

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Slide 6-19

Net Present Value with Even Cash Flows

Present Present Annual Net Value of $1 Value of Year Cash Flows Factor Cash Flows 1 $ 4,100 0.8929 $ 3,661 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 A positive net present value indicates that this 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656 project earns more than 12 percent on the investment. Total $ 32,800 $ 20,367 Amount to be invested (16,000) Net present value of investment $ 4,367

Exh. 26-7

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Slide 6-20

Using Net Present Value

General decision rule . . .
If the Net Present Value is . . . Positive . . . Then the Project is . . . Acceptable, since it promises a return greater than the required rate of return. Acceptable, since it promises a return equal to the required rate of return. Not acceptable, since it promises a return less than the required rate of return.

Zero . . .

Negative . . .

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Slide 6-21

Net Present Value with Uneven Cash Flows

Present Value of $1 Factor at 10% 0.9091 0.8264 0.7513

Exh. 26-8

Net Cash Flows Year A B C 1 $ 5,000 $ 8,000 $ 1,000 2 5,000 5,000 5,000 3 5,000 2,000 9,000 Total $ 15,000 $ 15,000 $ 15,000 Amount invested Net Present Value

PV of Net Cash Flows A B C $ 4,546 $ 7,273 $ 909 4,132 4,132 4,132 3,757 1,503 6,762 $ 12,435 $ 12,908 $ 11,803 (12,000) (12,000) (12,000) $ 435 $ 908 $ (197)

Although all projects require the same investment and have the same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1.

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Slide 6-22

Internal Rate of Return (IRR)

The interest rate that makes . . .

Present

value of cash inflows

Present value of cash outflows

The net present value equal zero.

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Slide 6-23

Internal Rate of Return

Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project.

Exh. 26-9

1.

Compute present value factor.

2. Using present value of annuity table . . .

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Slide 6-24

Internal Rate of Return

Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project.

Exh. 26-9

1.

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

2. Using present value of annuity table . . .

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Slide 6-25

Internal Rate of Return

1. Determine the present value factor. $12,000 $5,000 per year = 2.4000 2. Using present value of annuity table . . .
Periods 1 2 3 4 5 10% 0.90909 1.73554 2.48685 3.16987 3.79079 12% 0.89286 1.69005 2.40183 3.03735 3.60478

Exh. 26-9

Locate the row whose number equals the periods in the projects life.

14% 0.87719 1.64666 2.32163 2.91371 3.43308

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Slide 6-26

Internal Rate of Return

1. Determine the present value factor. $12,000 $5,000 per year = 2.4000 2. Using present value of annuity table . . .
Periods 1 2 3 4 5 10% 0.90909 1.73554 2.48685 3.16987 3.79079 12% 0.89286 1.69005 2.40183 3.03735 3.60478

Exh. 26-9

In that row, locate the interest factor closest in amount to the present value factor.

14% 0.87719 1.64666 2.32163 2.91371 3.43308

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Slide 6-27

Internal Rate of Return

1. Determine the present value factor. $12,000 $5,000 per year = 2.4000 2. Using present value of annuity table . . .
Periods 1 2 3 4 5 10% 0.90909 1.73554 2.48685 3.16987 3.79079 12% 0.89286 1.69005 2.40183 3.03735 3.60478

Exh. 26-9

IRR is approximately 12%.

14% 0.87719 1.64666 2.32163 2.91371 3.43308

IRR is the interest rate of the column in which the present value factor is found.

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Slide 6-28

Internal Rate of Return Uneven Cash Flows

If cash inflows are unequal, trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.

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Slide 6-29

Using Internal Rate of Return

Internal Rate of Return
q Compare the internal rate

of return on a project to a predetermined hurdle rate (cost of capital).

q To be acceptable, a

projects rate of return cannot be less than the cost of capital.

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Slide 6-30

Comparing Methods
Basis of measurement Measure expressed as Payback period Cash flows Number of years Easy to Understand Allows comparison across projects Accounting rate of return Accrual income Percent Easy to Understand

Exh. 26-10

Net present Internal rate value of return Cash flows Cash flows Profitability Profitability Dollar Percent Amount Considers time Considers time value of money value of money

Strengths

Limitations

Allows Accommodates Allows comparison different risk comparisons across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flows after payback period Doesn't give annual rates over the life of a project

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Slide 6-31

Managerial Decisions

Lets change topics.

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Slide 6-32

Decision Making
Decision making involves five steps: Define the problem. Identify alternatives. Collect relevant information on alternatives. Select the preferred alternative. Analyze decisions made.

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Slide 6-33

Relevant Costs
Costs

that are applicable to a particular decision. Costs that should have a bearing on which alternative a manager selects. Costs that are avoidable. Future costs that differ between alternatives.

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Slide 6-34

Classification by Relevance: Sunk Costs

All costs incurred in the past that cannot be changed All costs incurred in the past that cannot be changed by any decision made now or in the future. by any decision made now or in the future. Sunk costs should not be considered in decisions. Sunk costs should not be considered in decisions.
Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

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Slide 6-35

Classification by Relevance: Out-of-Pocket Costs

Future outlays of cash associated Future outlays of cash associated with a particular decision. with 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.

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Slide 6-36

Classification by Relevance: Opportunity Costs

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 cost of attending college for one year is $20,000.

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Slide 6-37

Managerial Decision Tasks We will now examine several different types of managerial decisions.

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Slide 6-38

Accepting Additional Business

The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to accept the new business.

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Slide 6-39

Accepting Additional Business

Exh. 26-12

FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:
Per Unit $ 10.00 3.50 2.20 1.10 1.40 0.80 $ 9.00 $ 1.00 Total 1,000,000 350,000 220,000 110,000 140,000 80,000 900,000 100,000

Sales Direct materials Direct labor Factory overhead Selling expenses Administrative expenses Total expenses Operating income

$ $

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Slide 6-40

Accepting Additional Business

FasTrac is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit. If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000. Should FasTrac accept the offer?

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Slide 6-41

Accepting Additional Business

First lets look at incorrect reasoning First lets look at incorrect reasoning that leads to an incorrect decision. that leads to an incorrect decision.

Our cost is $9.00 per unit. I cant sell for $8.50 per unit.

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Slide 6-42

Accepting Additional Business

Current Business $ 1,000,000 $ 350,000 220,000 110,000 140,000 80,000 $ 900,000 $ 100,000 Additional Business $ 85,000 $ 35,000 22,000 5,000 2,000 1,000 $ 65,000 $ 20,000

Exh. 26-14

Sales Direct materials Direct labor Factory overhead Selling expenses Admin. expenses Total expenses Operating income

Combined $ 1,085,000 $ 385,000 242,000 115,000 142,000 81,000 $ 965,000 $ 120,000

This analysis leads to the correct decision.

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Slide 6-43

Accepting Additional Business

Current Business $ 1,000,000 $ 350,000 220,000 110,000 140,000 80,000 $ 900,000 $ 100,000 Additional Business $ 85,000 $ 35,000 22,000 5,000 2,000 1,000 $ 65,000 $ 20,000

Exh. 26-14

Sales Direct materials Direct labor Factory overhead Selling expenses Admin. expenses Total expenses Operating income

Combined $ 1,085,000 $ 385,000 242,000 115,000 142,000 81,000 $ 965,000 $ 120,000

10,000 new units $8.50 selling price = $85,000

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Slide 6-44

Accepting Additional Business

Current Business $ 1,000,000 $ 350,000 220,000 110,000 140,000 80,000 $ 900,000 $ 100,000 Additional Business $ 85,000 $ 35,000 22,000 5,000 2,000 1,000 $ 65,000 $ 20,000

Exh. 26-14

Sales Direct materials Direct labor Factory overhead Selling expenses Admin. expenses Total expenses Operating income

Combined $ 1,085,000 $ 385,000 242,000 115,000 142,000 81,000 $ 965,000 $ 120,000

10,000 new units $3.50 = $35,000

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Slide 6-45

Accepting Additional Business

Current Business $ 1,000,000 $ 350,000 220,000 110,000 140,000 80,000 $ 900,000 $ 100,000 Additional Business $ 85,000 $ 35,000 22,000 5,000 2,000 1,000 $ 65,000 $ 20,000

Exh. 26-14

Sales Direct materials Direct labor Factory overhead Selling expenses Admin. expenses Total expenses Operating income

Combined $ 1,085,000 $ 385,000 242,000 115,000 142,000 81,000 $ 965,000 $ 120,000

10,000 new units $2.20 = $22,000

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Slide 6-46

Accepting Additional Business

Exh. 26-14

Current Additional Business Business Combined Sales $ 1,000,000 $ 85,000 $ 1,085,000 Even though $8.50 selling price 35,000 than the is less $ 385,000 Direct materials the$ 350,000 $ normal Direct labor $10 selling price, FasTrac should accept the 220,000 22,000 242,000 offer because Factory overhead net income will increase by $20,000. 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

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Slide 6-47

Make or Buy Decisions

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.

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Slide 6-48

Make or Buy Decisions

FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost:
Cost to Make Part #417 Direct materials Direct labor Factory overhead Total cost to make Make $ 0.45 0.50 0.50 $ 1.45

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Slide 6-49

Make or Buy Decisions

Exh. 26-15

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 vs. Buy Analysis Direct materials Direct labor Factory overhead Purchase price Total incremental costs Make $ 0.45 0.50 ? ---? Buy ---------$ 1.20 $ 1.20

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Slide 6-50

Make or Buy Decisions

Exh. 26-15

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 aMake vs. Buyof $0.25 per unit. maximum Analysis
Direct materials Direct labor Factory overhead Purchase price Total incremental costs Make $ 0.45 0.50 0.25 ---1.20 Buy ---------$ 1.20 $ 1.20

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Slide 6-51

Scrap or Rework Defects

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.

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Slide 6-52

Scrap or Rework Defects

FasTrac has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or reworked at an additional cost of $.80 per unit. If reworked, the units can be sold for the normal selling price of $1.50 each. Reworking the defective units will prevent the production of 10,000 new units that would also sell for $1.50. Should FasTrac scrap or rework?

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Slide 6-53

Scrap or Rework Defects

Exh. 26-16

Sale of Defects Less rework costs Less opportunity cost Net return

Scrap Now $ 4,000 $ 4,000

Rework $ 15,000

10,000 units $0.40 per unit 10,000 units $1.50 per unit

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Slide 6-54

Scrap or Rework Defects

10,000 units $0.80 per unit
Scrap Now $ 4,000 $ 4,000 Rework $ 15,000 (8,000) (5,000) 2,000

Exh. 26-16

Sale of Defects Less rework costs Less opportunity cost Net return

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

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Slide 6-55

Scrap or Rework Defects

FasTrac should scrap the units now.
Scrap Now $ 4,000 $ 4,000 Rework $ 15,000 (8,000) (5,000) 2,000

Exh. 26-16

Sale of Defects Less rework costs Less opportunity cost Net return

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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Slide 6-56

Sell or Process
q Businesses are often faced with the decision to

sell partially completed products or to process them to completion. q As a general rule, we process further only if incremental revenues exceed incremental costs.

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Slide 6-57

Sell or Process

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

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Slide 6-58

Sell or Process
Product X Y Z Spoilage Total $ Price 4.00 6.00 8.00 Units 10,000 22,000 6,000 2,000 40,000 Revenue $ 40,000 132,000 48,000 $ 220,000

Exh. 26-17

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

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Slide 6-59

Sell or Process
Product X Y Z Spoilage Total $ Price 4.00 6.00 8.00 Units 10,000 22,000 6,000 2,000 40,000 Revenue $ 40,000 132,000 48,000 $ 220,000 (50,000) $ 170,000 (80,000) $ 90,000

Exh. 26-17,18

Revenue, if sold as Q Incremental revenue Cost to process X, Y, and Z Incremental income

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

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Slide 6-60

Selecting Sales Mix

When a company sells a variety of products,

some are likely to be more profitable than others. must consider . . .

To make an informed decision, management

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.

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Slide 6-61

Selecting Sales Mix

Consider the following data for two products made and sold by FasTrac.
Per unit amounts Selling price Variable costs Contribution margin Product A $ 5.00 3.50 $ 1.50 Product B $ 7.50 5.50 $ 2.00

Exh. 26-19

If each product requires the same time to make, and the demand is unlimited, FasTrac should produce only Product B.

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Slide 6-62

Selecting Sales Mix

Consider the following data for two products made and sold by FasTrac.
Per unit amounts Selling price Variable costs Contribution margin Machine hours required to produce one unit Contribution per machine hour Product A $ 5.00 3.50 $ 1.50 1.0 1.50 Product B $ 7.50 5.50 $ 2.00 2.0 1.00

Exh. 26-19

Consider this additional information.

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Slide 6-63

Selecting Sales Mix

Consider the following data for two products Product B has a greater made and sold by FasTrac.
Product A $ 5.00 3.50 $ 1.50 1.0 1.50 Product B $ 7.50 5.50 $ 2.00 2.0 1.00

Exh. 26-19

contribution margin than Product A, but it Per unit amounts requires more machine Selling price hours per unit to produce.

Variable costs Contribution margin Machine hours required to produce one unit Contribution per machine hour

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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Slide 6-64

Selecting Sales Mix

Consider the following data for two products made and sold by FasTrac.
Per unit amounts Selling price Variable costs Contribution margin Machine hours required to produce one unit Contribution per machine hour Product A $ 5.00 3.50 $ 1.50 1.0 1.50 Product B $ 7.50 5.50 $ 2.00 2.0 1.00

Exh. 26-19

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

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Slide 6-65

Eliminating a Segment
A segment is a candidate for elimination if its revenues are less than its avoidable expenses. FasTrac is considering eliminating its Treadmill Division because total expenses of $48,300 are greater than its sales of $47,800. Continue

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Slide 6-66

Analysis of Divisional Operating Expenses

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

Exh. 26-20

Lets identify avoidable expenses.

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Slide 6-67

Analysis of Divisional Operating Expenses

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

Exh. 26-20

Unavoidable Expenses

200 3,150

200 300 2,200 1,000 $ 41,800

100 860 2,190 6,500

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Slide 6-68

Eliminating a Segment

Sales Sales Avoidable expenses Avoidable expenses Decrease in income Decrease in income

$ 47,800 $ 47,800 41,800 41,800 $ 6,000 $ 6,000

Do not eliminate the Treadmill Division!

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Slide 6-69

Qualitative Factors in Decisions

Qualitative factors are involved in most all managerial decisions. For example: Quality. Delivery schedule. Supplier reputation. Employee morale. Customer opinions.

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Slide 6-70

Break-Even Time

Break-even time incorporates time value Break-even time incorporates time value of money into the payback period method of money into the payback period method of evaluating capital investments. of evaluating capital investments.

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Slide 6-71

End of Chapter 26
Thats All.

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