CHAPTER 25 CAPITAL BUDGETING AND MANAGERIAL DECISIONSSP refers to the Serial ProblemES refers to Excel SimulationsAdditional Information on Related Assignment MaterialConnectAvailable on the instructor’s course-specific website) repeats all numerical Quick Studies, all Exercises and Problems Set A. Connect also provides algorithmic versions for Quick Study, Exercises and Problems. It allows instructors to monitor, promote, and assess student learning. It can be used in practice, homework, or exam mode.Connect InsightThe first and only analytics tool of its kind, Connect Insight is a series of visual data displays that are each framed by an intuitive question and provide at-a-glance information regarding how an instructor’s class is performing. Connect Insight is available through Connect titles.The Serial Problem (SP) for Success Systems continues in this chapter.General LedgerAssignable within Connect, General Ledger (GL) problems offer students the ability to see how transactions post from the general journal all the way through the financial statements. Critical thinking and analysis components are added to each GL problem to ensure understanding of the entire process. GL problems are auto-graded and provide instant feedback to the student.Excel SimulationsAssignable within Connect, Excel Simulations allow students to practice their Excel skills—such as basic formulas and formatting—within the context of accounting. These questions feature animated, narrated Help and Show Me tutorials (when enabled). Excel Simulations are auto-graded and provide instant feedback to the student. Synopsis of Chapter RevisionNEW opener—Simply Gum and entrepreneurial assignment.Added exhibit and discussion of capital budgeting process.Added exhibit and discussion of cash inflows and outflows in capital budgeting.Added lists of strengths and weaknesses, with revised discussion, of payback period.Added list of weaknesses of accounting rate of return method.New art showing timeline of NPV calculation.Added discussion of outsourcing in make or buy decisions.Added discussion of capital rationing.Added financial calculator and Excel steps for many calculations.Revised discussion of relevant costs and benefits.Revised Sustainability section on capital budgeting for solar investments and Simply Gum example.Added two Quick Studies on capital budgeting for solar investments.Added Appendix and end of chapter assignments on product pricing.Chapter OutlineNotes Section 1 Capital BudgetingI.Capital budgeting is a process of analyzing alternative long-terminvestments and deciding which assets to acquired or sellA.An objective of capital budgeting decisions is to earn a satisfactoryrate of return.B.The process begins with department or plant managers submittingproposals for new investment in property, plant, and equipment. Acapital budget committee evaluates the proposals and recommendsfor approval or rejection. Finally, board of directors approvescapital expenditures for the year.C.Such decisions require careful analysis because they are difficultand risky.1.Difficult because of need to make predictions of events thatwill occur well into the future.2.Risky because: Outcome is uncertain, large amounts of moneyare involved, a long-term commitment is required, and thedecision may be difficult or impossible to reverse.II.Methods Not Using Time Value of Money Investments areexpected to produce net cash outflows; Net Cash flows equal cashinflows minus cash outflows. Simple analysis methods do not considerthe time value of money.A.Payback Period1.Payback period is the expected amount of time to recover theinitial investment amount.2.Evaluating Payback Period: managers prefer investments withshorter payback periods.a.Shorter payback period reduces risk of an unprofitableinvestment over the long run.pany’s risk due to potentially inaccurate long-termpredictions of future cash flows is reduced.3.To compute payback period, exclude all non-cash revenue andexpenses from computation. Depreciation is a non-cashexpense, so it is not included.a.When annual cash flows are even in amount:Payback Period = Cost of InvestmentAnnual net cash flowsb.When annual cash flows are unequal, payback period iscomputed using the cumulative total of net cash flows(starting with the negative cash flow resulting from theinitial investment); when cumulative net cash flowchanges from positive to negative, the investment is fullyrecovered. (see Exhibit 25.5)4.Payback period has two strengths: it uses cash flows, notincome and it is easy to use.Chapter OutlineNotes5.Payback period has three major weaknesses: it does not reflectdifferences in the timing of net cash flows within the paybackperiod; it ignores all cash flows occurring after the point offully recovered costs; and it ignores the time value of money.B.Accounting Rate of Return1.The percentage accounting return on annual averageinvestment.2.Called “accounting” return because it is based on net incomeinstead of on cash flows.puted as:after tax net incomeaverage annual investment4.Accrual basis after-tax net income is used.pute the average investment:a.If straight-line deprecation is used then:Annual average = (Beg. Book Value + End. Book value)Investment 2where ending book value = salvage value if there is oneb.If the depreciation method is other than straight linemethod then the general formula is:Annual = sum of individual year’s average book valueAve. Invest number of years of the planned investment6.Accounting Rate of Return = After-tax net incomeAverage investment amount7.Risk of an investment should be considered.a.Investment’s return is satisfactory only when related toreturns from other investments with similar lives and risk.b.Capital investment with least risk and highest return forthe longest time is often identified as best; analysis can bechallenging because different investments often yielddifferent rankings depending on measure used.8.Evaluating Accounting Rate of Return – should never be theonly consideration in capital budgeting decisions. Three majorweaknesses:a.It ignores the time value of moneyb.It focuses on income, not cash flows.c.If income varies from year to year, the project mightappear desirable in some years and not in others.Chapter OutlineNotes III.Methods Using Time Value of Money Net present value andinternal rate of return methods consider time value of money. Present Value (see also Appendix B near end of textbook) Present Value (NPV) analysis applies the time value ofmoney to cash inflows and cash outflows so management canevaluate a project’s benefits and cost at one point in time.2.NPV is computed by discounting the future net cash flowsfrom the investment at the required rate of return, and thensubtract the initial amount invested.a.The required rate of return also called the hurdle rate orthe cost of capital that the company must pay to its long-term creditors and shareholders.b.Each annual net cash flow is multiplied by the relatedpresent value of 1 factor or discount factor. (Obtain fromTable B.1 in Appendix B.)i.Discount factors assume that net cash flows arereceived at the end of each year.ii.R ate of return required by the company and number ofyears until cash flow is received are used to determinediscount factors.c.Initial amount invested includes all costs incurred to getasset in proper location and ready to use. Present Value Decision Rule Present Value = PV of cash flows – Amount Investedb.If the NPV is greater than or equal to $0, then asset isexpected to recover its cost and provide a return at least ashigh as that required; invest.c.If NPV is negative, do not invest4.NPV analysis can be used when comparing several investmentopportunities; if investment opportunities have same cost andsame risk, the one with highest NPV is preferred.5.When annual net cash flows are equal in amount, NPVcalculation can be simplified.a.Individual annual present value of $1 factors can besummed, and the total multiplied by annual net cash flowto get total present value of net cash flows.b.To simplify the computation, the present value of anannuity of $1 table may be usedc.Calculator with compound interest function or aspreadsheet program can also be used.6.NPV analysis can also be applied when net cash flows areunequal. (Use procedures and decision-rules above.)7.If salvage value is expected at end of useful life, treat as anadditional net cash flow received at end the of asset’s life.Chapter OutlineNotes8.Accelerated depreciation methods do not change basics ofNPV analysis, but can change results; using accelerateddepreciation for tax reporting affects net present value ofasset’s cash flowsa.Accelerated depreciation produces larger depreciationdeductions in early years of asset’s life and smaller ones inlater years; large net cash inflows are produced in earlyyears and smaller ones in later years.b.Early cash flows are more valuable than later ones; assuch, being able to use accelerated depreciation for taxreporting makes investment more desirable.paring positive NPV projects is of limited value forcomparison purposes if initial investment differs substantiallyacross projects.10.W hen a company can’t fund all positive net present valueprojects , they can be compared using the profitability index:a.Profitability Index = Net present value of cash flowsCost of investmentb. A higher profitability index makes the project moredesirable.11.NPVs should be computed using different discount rates; thegreater the risk, the higher the discount rate.12.Capital rationing – hard rationing is imposed by externalforces and soft rationing is internally imposed bymanagement. Profitability index can be used to select the bestof several competing projects.13.Inflation – net cash flows can be adjusted for inflation byusing future value computations.B.Internal Rate of Return1.IRR is a rate used to evaluate acceptability of an investment; itequals the rate that yields a NPV of zero for an investment.2.T otal present value of project’s net cash flows is computedusing the IRR as the discount rate, and subtracting the initialinvestment from total present value to get a zero NPV.3.Two step process in computing IRR (equal cash flows)a.Step 1: Compute the present value factor for the projectby dividing the amount invested by annual net cash flows.b.Step 2: Find discount rate (IRR) yielding the PV factor.i. A present value of an annuity table (Appendix B) canbe used to determine the discount rate that relates tothis present value factor given the life of the project.ii.If the present value factor in the table does not exactlyequal the one computed, Excel and many calculatorsuse built-in functions can be used.Chapter Outline4.When cash flows are unequal, trial and error must be used;select any reasonable discount rate and compute the NPV.a.If amount is positive, recompute NPV using higherNotes discount rate; if amount is negative, recompute NPV usinglower discount rate.b.Continue steps until two consecutive computations resultin NPVs that have different signs (positive and negative);IRR lies between these two discount rates; value can beestimated.c.Spreadsheet software and calculators can also be used tocompute the IRR. (See Appendix 25A)pare IRR with hurdle rate (or minimum acceptable rate ofreturn); if IRR exceeds hurdle rate, invest.6.If evaluating multiple projects, rank by extent to which IRRexceeds hurdle rate.7.IRR is not subject to limitations of NPV when comparingprojects with different amounts invested; IRR is expressed aspercent rather than an absolute dollar value using NPV.parison of Capital Budgeting Methods (see Exhibit 25.12)1.Payback period and accounting rate of return do not considertime value of money; NPV and IRR do.2.Payback period method is simple; sometimes used whenlimited cash to invest and a number of projects to choosefrom. Gives manager an estimate of how soon the initialinvestment can be recovered.3.Accounting rate of return is a percent computed using accrualincome instead of cash flows, and is an average rate for theentire investment period; annual returns are not reflected. Present Value (NPV):a.Considers all estimated cash flows of project; can beapplied to equal and unequal cash flows.b.Can reflect changes in level of risk over life of project.parisons of projects of unequal sizes is more difficult5.Internal Rate of Return (IRR):a.Considers all estimated cash flows of project.b.Readily computed when cash flows are equal, but requirestrial and error estimation when cash flows are unequal.c.Allows comparisons of projects with different investmentamounts.d.Does not reflect changes in risk over life of project.Chapter OutlineNotes Section 2—Managerial DecisionsEmphasis is on use of quantitative measures to make important short-termdecisions. Costs and other factors relevant to decision must be identified.I.Decisions and InformationA.Decision Making1.Five steps involved in managerial decision making.a.Define the decision taskb.Identify alternative courses of action.c.Collect relevant information and evaluate each alternative.d.Select the preferred course of action.e.Analyze and assess the decision.2.Both managerial and financial accounting information playimportant role in making decisionsa.Accounting system provides primarily financialinformation such as performance reports and budgetanalyses.b.Non-financial information is also relevant, such asenvironmental effects, political sensitivities, and socialresponsibility.B.Relevant Costs and Benefits1.Managers should focus on relevant benefits which exceedrelevant costs.a.Relevant costs are the incremental costs, or differentialcosts which are the additional costs incurred if a companypursues a certain course of action.b.Relevant benefits are the additional or incrementalrevenue generated by selecting a certain course of actionover another. Three types of costs:i.Sunk cost arises from a past decision; cannot beavoided or changed, and not relevant to futuredecisions.ii.Out-of-pocket cost requires future outlay of cash andresults from result of management’s decisions; isrelevant.iii.Opportunity cost is a potential benefit lost by takingspecific action when two or more alternative choicesare available; consideration is important.Chapter OutlineNotes II.Managerial Decision Scenarios consider each decision taskdiscussed below independent from the others.A. Additional Business1.Effect on net income must be considered when decidingwhether to accept or reject an order; reject if loss results.2.Historical costs are not relevant to this decision.3.Incremental or additional costs (also called differential costs)are additional costs incurred if company pursues certaincourse of action; relevant to this decision.4.Minimum acceptable price per unit can be determined bydividing incremental cost by the number of units in the order.5.Incremental costs of additional volume are relevant.6.If additional volume approaches or exceeds existing availablecapacity of factory, incremental costs required to expandcapacity may quickly exceed incremental revenue.7.Accepting order may cause existing sales to decline; thecontribution margin lost from the decline in sales is anopportunity cost and is relevant (if future cash flows overseveral time periods are affected, net present value should becomputed).8.Note – Allocated overhead costs, which are historical costs,should not automatically be considered; only incremental coststo be incurred are relevant.9.Key point: management must not blindly use historical costs,especially allocated to overhead costs. Instead the accountingsystem needs to provide incremental cost information if theadditional business is accepted.B.Make or Buy1.When determining whether to make or buy a component of aproduct, only incremental costs are relevant.2.Only incremental (additional) overhead costs are relevant; anincremental overhead rate should be determined.3.If the incremental costs of making the component exceed thepurchase price paid to buy the component, decision rule wouldbe to buy. Process of buying from an external supplier iscalled outsourcing. Several other factors should beconsidered.a.Product quality.b.Timeliness of delivery (especially in JIT settings).c.Reactions of customers and suppliers.d.Other intangibles (employee morale and workload).e.Must also consider if making the part will requireincremental fixed costs to expand plant capacity.Chapter OutlineNotesC.Scrap or Rework1.Costs already incurred in manufacturing units of product notmeeting quality are sunk costs and are irrelevant in anydecision on whether to sell to substandard units as scrap orrework to meet quality standards.2.Incremental revenues, incremental costs of reworking defects,and opportunity costs (the contribution margin lost if sales ofother units are given up) are all relevant.D.Sell or Process Further1.Partially completed products can be sold as is or they can beprocessed further and then sold as other products.pute incremental revenue from further processing(amount of revenue after further processing less revenue fromselling the products as partially completed)pute incremental cost from further processing.4.Process further and sell if incremental revenue from furtherprocessing exceeds related incremental costs.E.Sales Mix Selection1.When more than one product is sold, some are likely to bemore profitable than others; management should concentratesales efforts on more profitable products.2.If production facilities or other factors are limited, an increasein production and sale of one product usually requiresreduction in production and sale of others.3.The most profitable combination, or sales mix, of productsshould be determined. To identify the best sales mix,management focuses on the contribution margin per unit ofscarce resource. The scarce resource could be the machinesused to make the products.4.Determine the contribution margin of each product, thefacilities required to produce these products and anyconstraints on facilities and markets for the products.5.If demand is unlimited and the products use the same inputsthen the product with the highest contribution margin shouldbe produced.6.If demand is unlimited but the products use different inputsthen determine contribution margin per unit of the constraint(the factor that limits capacity, such as machine timerequired); produce the product with the highest contributionmargin per unit of the constraint.7.If demand is limited then the company should first produce themost profitable product, up to the point of the total demand.The remaining capacity should be used to produce the nextmost profitable product.Chapter OutlineNotesF.Segment Elimination1.If segment, division, or store is performing poorly,management must consider eliminating it.2.It is not sufficient to base the decision on net income (loss) orits contribution to overhead.3.Need to consider avoidable and unavoidable expenses:a.Avoidable (or escapable) expenses are costs or expensesthat would not be incurred if the segment is eliminated.b.Unavoidable (or inescapable) expenses are costs orexpenses that would continue even if the segment iseliminated.4.Decision rule – Segment is candidate for elimination if itsrevenues are less than its avoidable expenses.5.Should also assess impact of elimination on other segments.a.An unprofitable segment might contribute to anothersegment’s revenue and expensesb. A profitable segment might be eliminated if its space,assets and staff can be more profitably used by anothersegment or new segment.G.Keep or Replace Equipment1.Must decide whether the reduction in variable manufacturingcosts over its life is greater than the net purchase price of thenew equipment. purchase price is the cost of the new equipment lessany trade in allowance given or cash receipt for the oldequipment.b.Book value of the old equipment is not used. It is a sunkcost.III.Decision Analysis−Break-Even Time (BET) −A variation of thepayback period method – overcomes the limitation of not using thetime value of moneyA.The future cash flows are restated in terms of their present values;B.The payback period is computed using these present valuesC.Break-even time (BET) is useful measure; managers know whento expect cash flows to yield net positive returns.D.If BET is less than estimated life of investment, positive netpresent value can be expected from investment.E.To compare and rank alternative investment projects, choose theproject with the lowest break-even time.IV.Product Pricing –companies often use cost-plus pricing as a startingpoint in determining selling prices. Many factors determine price.Chapter OutlineNotesA.Target costing – used when competition is high and they havelittle control in setting prices.Target cost = expected selling price – desired profitB.Other Pricing methods – alternatives include approaches based oneither product costs or variable costs. Companies must adjusttheir desired markup percentage upward to ensure that the sellingprice covers all costs.C.Variable cost method – the markup percentage is determined as:Markup % = (Target profit + Fixed OH + Fixed S&A) / Totalvariable costs.D.Selling price = (direct materials + direct labor + OH + sellingcosts + administrative costs) = total cost + markup.Chapter 25 Alternate Demo ProblemA company is planning to buy a new machine at a cost of $200,000. The machine is expected to last for 10 years and have no salvage value at the end of its useful life. Straight-line depreciation will be used. The company expects to save 10,000 hours of direct labor each year because of the new machine, as well as $4,000 each year in other operating costs.Management’s best estimate is that on average the hourly rate for the labor saved will be $5.50. With the exception of the initial purchase, assume all cash flows take place at the end of the year, and a tax rate of 40%.Required:1. Calculate the payback period on the investment in new machinery.2. Calculate the rate of return on the average investment.3. Calculate the net present value of the investment and profitability index:(a) Ignoring income taxes, using a discount rate of 10%.(b) Including the effect of taxes, using a 10% discount rate.Chapter 25 Alternate Demo Problem: Solution1. First, calculate annual net cash flow:Determine increase in after-tax net income:Labor savings: 10,000 hours @ $5.50 per hour $55,000Other operating savings 4,000Annual cash savings before tax 59,000Less: annual depreciation expense 20,000Increase in net income before tax 39,000Less: Increase in annual income tax @ 40% 15,600Increase in net income after tax $23,400 Then, add back depreciation expense (noncash):Increase in net income after tax $23,400Plus annual depreciation expense 20,000Annual net cash flow $43,400 Payback period equals cost of new machine divided by annual net cash flow or $200,000 / $43,400 = 4.6 years.2. The rate of return on average investment equals the increase in net income aftertax divided by the amount of the average investment.The average investment would be $200,000 / 2, or $100,000.Rate of return on average investment = $23,400 / $100,000 = 23.4%3(a) There is a cash savings of $59,000 each year for 10 years if income taxes are ignored. The present value factor for a 10-year annuity at 10% is 6.1446.Present value of cash savings ($59,000 x 6.1446) $362,531 Present value of investment 200,000 Net present value (positive) $162,531 Profitability Index = Net Present Value = $ 162,531 = .813Cost of Investment $ 200,0003(b) There is a cash savings of only $43,400 each year for 10 years if income taxes are considered.Present value of cash savings ($43,400 x 6.1446) $266,676 Present value of investment 200,000 Net present value (positive) $ 66,676 Profitability Index = Net Present Value = $ 66,676 = .333Cost of Investment $ 200,000。
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