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Special Business Decisions and Capital Budgeting Chapter 25 Copyright © 2007 Prentice-Hall. All rights Special Business Decisions and Capital Budgeting Chapter 25 Copyright © 2007 Prentice-Hall. All rights reserved 1

Objective 1 Identify the relevant information for a special business decision Copyright © 2007 Objective 1 Identify the relevant information for a special business decision Copyright © 2007 Prentice-Hall. All rights reserved 2

Relevant Information • Affects the future …and… • Differs among alternative courses of action Relevant Information • Affects the future …and… • Differs among alternative courses of action Copyright © 2007 Prentice-Hall. All rights reserved 3

Objective 2 Make five types of short-term special decisions Copyright © 2007 Prentice-Hall. All Objective 2 Make five types of short-term special decisions Copyright © 2007 Prentice-Hall. All rights reserved 4

Relevant Information Approach (Incremental Approach) • • • Special sales orders Dropping a business Relevant Information Approach (Incremental Approach) • • • Special sales orders Dropping a business segment Product mix Outsourcing - make or buy Selling as-is or processing further Copyright © 2007 Prentice-Hall. All rights reserved 5

Two Keys • Focus on relevant revenues, costs, and profits • Use contribution margin Two Keys • Focus on relevant revenues, costs, and profits • Use contribution margin approach – Variable costs – Fixed costs Copyright © 2007 Prentice-Hall. All rights reserved 6

Special Sales Order DECISION RULE: Accept special order? Is increase in revenues > increase Special Sales Order DECISION RULE: Accept special order? Is increase in revenues > increase in variable and fixed costs? Is increase in revenues < increase in variable and fixed costs? Accept the special order Reject the special order Copyright © 2007 Prentice-Hall. All rights reserved 7

E 25 -16 (1) Fixed costs would be incurred whether you accept the offer E 25 -16 (1) Fixed costs would be incurred whether you accept the offer or not. It is not a relevant cost in this Free. Style case Incremental the special sales Decision: Accept Analysis of Special Sales Order order Expected increase in revenues (5, 000 bags $3. 00) $ 15, 000 Expected increase in expenses: Variable manufacturing cost: (5, 000 $2. 75) (13, 750) Expected increase in operating income $ 1, 250 Copyright © 2007 Prentice-Hall. All rights reserved 8

E 25 -16 (2) This will lower overall profits…reject the order Free. Style Incremental E 25 -16 (2) This will lower overall profits…reject the order Free. Style Incremental Analysis of Special Sales Order Expected increase in revenues (5, 000 bags $3. 00) $ 15, 000 Expected increase in expenses: Variable manufacturing cost: (5, 000 $3. 15) (15, 750) Expected decrease in operating income $ (750) Copyright © 2007 Prentice-Hall. All rights reserved 9

Dropping A Business Segment, Products, Departments, or Territories DECISION RULE: Drop a business segment? Dropping A Business Segment, Products, Departments, or Territories DECISION RULE: Drop a business segment? Are lost revenues > its relevant costs? Are lost revenues < its relevant costs? Keep the segment Eliminate the segment Copyright © 2007 Prentice-Hall. All rights reserved 10

E 25 -16 (1) Decision: Do not drop the line. It is incorrect to E 25 -16 (1) Decision: Do not drop the line. It is incorrect to conclude that dropping rolling backpacks would add $40, 000 to operating income. Cal. Paks This incorrect conclusion ignores the nature of fixed Incremental Analysis of Dropping Rolling expenses. If the company drops the rolling Backpacks Line backpacks product line, it will still incur the $70, 000 ($55, 000 + $15, 000) of fixed expenses allocated to rolling backpacks Expected decrease in revenues $ (120, 000) Expected decrease in expenses: Variable costs 90, 000 Expected decrease in operating income $(30, 000) Copyright © 2007 Prentice-Hall. All rights reserved 11

Product Mix If there are factors that are limiting the company output, you need Product Mix If there are factors that are limiting the company output, you need to determine how to best utilize the limited resource (constraint) to achieve the highest profits. Constraints might be labor hours or raw materials DECISION RULE: available, amount of display space. If a company manufactures two or more products, it must decide Which product to which products to manufacture first emphasize? 1. Compute contribution margin per unit for each product 2. Compute contribution margin per constrained resource Emphasize the product with the highest contribution margin per constrained resource Copyright © 2007 Prentice-Hall. All rights reserved 12

What is the constraint in this exercise? Floor space Decision: Emphasize moderately priced items What is the constraint in this exercise? Floor space Decision: Emphasize moderately priced items E 25 -20 Designer Moderate $115. 00 $60. 00 Contribution margin per unit Units displayed per sq ft. 300/10, 000 x. 030 700/10, 000 x. 070 Contribution margin per sq ft of display space $3. 45 $4. 20 Capacity – sq ft of display space x 10, 000 Total contribution margin at capacity $34, 500 $42, 200 Copyright © 2007 Prentice-Hall. All rights reserved 13

Outsourcing (Make or Buy) DECISION RULE: Make a product in-house or buy from outside Outsourcing (Make or Buy) DECISION RULE: Make a product in-house or buy from outside company? Are relevant costs to make > relevant costs to buy? Are relevant costs to make < relevant costs to buy? Buy Make Copyright © 2007 Prentice-Hall. All rights reserved 14

E 25 -21 Decision: Make the snowboards Make Buy Difference Incremental cost per unit: E 25 -21 Decision: Make the snowboards Make Buy Difference Incremental cost per unit: Direct materials $18 Direct labor 6 0 Variable overhead 3 Purchase price Incremental cost per unit $0 6 0 $38 $27 Copyright © 2007 Prentice-Hall. All rights reserved $18 3 (38) $38 $(11) 15

E 25 -22 Make Incremental cost per unit: Number of snowboards Total incremental costs E 25 -22 Make Incremental cost per unit: Number of snowboards Total incremental costs $27 10, 000 $27, 000 Buy and leave facilities idle Incremental cost per unit: Number of snowboards Total incremental costs $38 10, 000 $38, 000 Copyright © 2007 Prentice-Hall. All rights reserved 16

E 25 -22 Decision: Outsource the snowboards and use the facilities to manufacture the E 25 -22 Decision: Outsource the snowboards and use the facilities to manufacture the other product Buy and use facilities for other product Incremental cost per unit: $38 Number of snowboards 10, 000 Total incremental costs to buy $38, 000 Expected profit contribution from other product (30, 000) Expected net cost $8, 000 Copyright © 2007 Prentice-Hall. All rights reserved 17

Sell As-Is or Process Further DECISION RULE: Sell as is or process further? Are Sell As-Is or Process Further DECISION RULE: Sell as is or process further? Are extra revenues from processing further > extra cost to process further? Are extra revenues from processing further < extra cost to process further? Process further Sell as is Copyright © 2007 Prentice-Hall. All rights reserved 18

E 25 -23 Decision: Process further. The advantage to processing further by repairing the E 25 -23 Decision: Process further. The advantage to processing further by repairing the damage is $100 ($2, 600 – Process $2, 500) Sell As Is Further Expected revenue $2, 500 Expected additional costs Expected net revenue $2, 500 $3, 100 -0 - (500) $2, 600 Copyright © 2007 Prentice-Hall. All rights reserved 19

Short-term vs Long-term Decisions Short-term • Many costs are fixed • No need to Short-term vs Long-term Decisions Short-term • Many costs are fixed • No need to consider the time value of money Long-term • Few costs are fixed • Need to consider time value of money Copyright © 2007 Prentice-Hall. All rights reserved 20

Objective 3 Use payback and accounting rate of return to make longer-term capital budgeting Objective 3 Use payback and accounting rate of return to make longer-term capital budgeting decisions Copyright © 2007 Prentice-Hall. All rights reserved 21

Capital Budgeting • Budgeting for the acquisition of “capital assets” - assets used over Capital Budgeting • Budgeting for the acquisition of “capital assets” - assets used over a long time (several years) • Capital budgeting models (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return Copyright © 2007 Prentice-Hall. All rights reserved 22

Payback Period • Time period required to recover in net cash receipts the dollars Payback Period • Time period required to recover in net cash receipts the dollars of the investment Amount invested in the asset Expected annual net cash receipts Copyright © 2007 Prentice-Hall. All rights reserved 23

Payback Period DECISION RULE: Payback Period Invest only if payback is shorter than the Payback Period DECISION RULE: Payback Period Invest only if payback is shorter than the assets’ useful life Investments with shorter payback periods are more desirable, all else being equal Copyright © 2007 Prentice-Hall. All rights reserved 24

Decision: Payback occurs before the machine must be replaced. This supports purchasing the asset Decision: Payback occurs before the machine must be replaced. This supports purchasing the asset E 25 -24 Amount invested Expected annual net cash inflow $120, 000 $25, 000 = 4. 8 years Copyright © 2007 Prentice-Hall. All rights reserved 25

Payback Period • Pros – Easy to use – Used to eliminate proposals that Payback Period • Pros – Easy to use – Used to eliminate proposals that are too risky • Cons – Ignores profitability Copyright © 2007 Prentice-Hall. All rights reserved 26

Accounting Rate of Return Average annual operating income from asset Average amount invested in Accounting Rate of Return Average annual operating income from asset Average amount invested in asset = Original Investment + Residual Value 2 Note: ARR uses operating income (revenues – operating expenses). If you are given annual cash flows, you must subtract deprecation expense to get operating income Copyright © 2007 Prentice-Hall. All rights reserved 27

Accounting Rate of Return Compare accounting rate of return to company’s required minimum rate Accounting Rate of Return Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk Copyright © 2007 Prentice-Hall. All rights reserved 28

Accounting Rate of Return DECISION RULE: Invest in capital assets? Is expected accounting rate Accounting Rate of Return DECISION RULE: Invest in capital assets? Is expected accounting rate of return > the required rate of return? Invest Do not invest Copyright © 2007 Prentice-Hall. All rights reserved 29

E 25 -25 Ward 250, 000 (1, 000 + 0)/2 Vargas 240, 500 (1, E 25 -25 Ward 250, 000 (1, 000 + 0)/2 Vargas 240, 500 (1, 200, 000+100, 000)/2 50% 37% Decision: Ward equipment offers the higher accounting rate of return Copyright © 2007 Prentice-Hall. All rights reserved 30

Objective 4 Use discounted cash flow models to make longer-term capital budgeting decisions Copyright Objective 4 Use discounted cash flow models to make longer-term capital budgeting decisions Copyright © 2007 Prentice-Hall. All rights reserved 31

Discounted Cash Flows Models • Recognize time value of money • Two methods – Discounted Cash Flows Models • Recognize time value of money • Two methods – Net present value – Internal rate of return Copyright © 2007 Prentice-Hall. All rights reserved 32

Net Present Value Method • Discount cash inflows to their present value and then Net Present Value Method • Discount cash inflows to their present value and then compare with capital outlay required by the investment • Discount rate (hurdle rate or required rate of return) - required minimum rate of return given riskiness of investment • Proposal is acceptable when NPV is ≥ zero • The higher the NPV, the more attractive the investment Copyright © 2007 Prentice-Hall. All rights reserved 33

Net Present Value DECISION RULE: Invest in capital assets? Is NPV positive? Is NPV Net Present Value DECISION RULE: Invest in capital assets? Is NPV positive? Is NPV negative? Invest Do not invest Copyright © 2007 Prentice-Hall. All rights reserved 34

E 25 -26 Cash Flow When? Type of PV factor cash flow 14% Project E 25 -26 Cash Flow When? Type of PV factor cash flow 14% Project A (275, 000) Now 55, 000 NPV PV (275, 000) Yrs 1 -8 Annuity 4. 639 255, 145 $(19, 855) Since NPV is negative, this is not an acceptable investment. The maximum acceptable price is $255, 145 Copyright © 2007 Prentice-Hall. All rights reserved 35

E 25 -26 Cash Flow When? Type of PV factor cash flow 14% PV E 25 -26 Cash Flow When? Type of PV factor cash flow 14% PV Project B (380, 000) Now 72, 000 NPV (380, 000) Yrs 1 -9 Annuity 5. 328 383, 616 $3, 616 Since NPV is positive, this is an acceptable investment. The maximum acceptable price if $380, 000 Copyright © 2007 Prentice-Hall. All rights reserved 36

Net Present Value When annual cash inflows are unequal you must use the present Net Present Value When annual cash inflows are unequal you must use the present value of one table applied to each annual cash inflow Copyright © 2007 Prentice-Hall. All rights reserved 37

Internal Rate of Return • Rate of return a company can expect to earn Internal Rate of Return • Rate of return a company can expect to earn by investing in the project • The discount rate that will cause the present value to equal zero Copyright © 2007 Prentice-Hall. All rights reserved 38

Internal Rate of Return Step 1: Identify the expected net cash receipts Step 2: Internal Rate of Return Step 1: Identify the expected net cash receipts Step 2: Find the discount rate that makes total present value of net cash receipts = present value of cash outflows Annuity PV factor = Investment ÷ Annual Net Cash Receipts Copyright © 2007 Prentice-Hall. All rights reserved 39

Internal Rate of Return Step 3: On the present value of an annuity of Internal Rate of Return Step 3: On the present value of an annuity of $1 table, scan the row corresponding to the expected life Choose column closest to annuity factor you calculated in Step 2 Copyright © 2007 Prentice-Hall. All rights reserved 40

Internal Rate of Return DECISION RULE: Invest in capital assets? Does the IRR exceed Internal Rate of Return DECISION RULE: Invest in capital assets? Does the IRR exceed the required rate of return? Is the IRR less than the required rate of return? Invest Do not invest Copyright © 2007 Prentice-Hall. All rights reserved 41

E 25 -27 Project A: PVAo = Rent x Factor 275, 000 = 55, E 25 -27 Project A: PVAo = Rent x Factor 275, 000 = 55, 000 x Factor 5. 0000 = Factor Close to 12% Copyright © 2007 Prentice-Hall. All rights reserved 42

E 25 -27 Project B: Decision: Project B is better PVAo = Rent X E 25 -27 Project B: Decision: Project B is better PVAo = Rent X Factorbecause it has a higher IRR 380, 000=72, 000 x. Factor 5. 2777 = Factor Between 12 and 14% Copyright © 2007 Prentice-Hall. All rights reserved 43

Objective 5 Compare and contrast the four capital budgeting methods Copyright © 2007 Prentice-Hall. Objective 5 Compare and contrast the four capital budgeting methods Copyright © 2007 Prentice-Hall. All rights reserved 44

Comparison of Capital Budgeting Models Method Strengths Payback Easy to understand Based on cash Comparison of Capital Budgeting Models Method Strengths Payback Easy to understand Based on cash flows Highlights risks ARR Based on profitability NPV & IRR Weaknesses Ignores profitability and the time value of money Ignores time value of money Based on cash Difficult to flows, profitability & determine discount time value of money rate Copyright © 2007 Prentice-Hall. All rights reserved 45

End of Chapter 25 Copyright © 2007 Prentice-Hall. All rights reserved 46 End of Chapter 25 Copyright © 2007 Prentice-Hall. All rights reserved 46