Capital Budgets and Managerial Decisions

1
Capital Budgeting and Managerial Decisions
Chapter
25
2
Learning objectives
Exh. 25-5,6

• Capital Budgeting
• Method Not using Time Value of Money
• Method using Time Value of Money
• Managerial Decision
• Decision and Information
• Managerial Decision Scenarios
• Decision Analysis
• Break-Even Time

3
Capital Budgeting- Risks of Capital Budgeting
Capital budgetingAnalyzing alternative
long-term investments and deciding which assets
to acquire or sell.
4
Method Not using Time Value of Money- Payback
Period
Exh. 25-2
The payback period of an investmentis the time
expected to recoverthe initial investment amount.
Managers prefer investing in projects with
shorter payback periods.
5
Payback Period with 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.

6
Payback Period with 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.

7
Payback Period with Uneven Cash Flows
Exh. 25-3
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
8
Payback Period with Uneven Cash Flows
Exh. 25-3
We recover the 16,000 purchase price
between years 4 and 5, about4.2 years for the
payback period.
9
Using the Payback Period
Ignores the time value of money.
Ignores cash flows after the payback period.
10
Using the Payback Period

• Consider two projects, each with a five-year
  lifeand each costing 6,000.

Would you invest in Project One just because it
has a shorter payback period?
11
Method Not using Time Value of Money- Accounting
Rate of Return
Exh. 25-5,6

• The accounting rate of return focuses onannual
  income instead of cash flows.

Beginning book value Ending book value2
12
Accounting Rate of Return
Exh. 25-5,6

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

Beginning book value Ending book value2
13
Accounting Rate of Return
Exh. 25-5,6

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

Beginning book value Ending book value2
14
Accounting Rate of Return
Exh. 25-5,6

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

16,000 02
15
Using Accounting Rate of Return
So why would I ever want to use this method
anyway?

• Depreciation may be calculated several ways.
• Income may vary from year to year.
• Time value ofmoney is ignored.

16
Method using Time Value of Money - Time Value of
Money
Future value of 100 today compounded for 5 years
at 10 percent.
3
4
1
2
Future
Today
Compound at 10
FV 161
100
110
121
133
146
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Method using Time Value of Money - Present Value
Present value of 100 paid in 5 years discounted
at 10 percent.
2
3
4
Future
Today
1
Discount at 10
PV 62.1
100
90.9
82.6
75.1
68.3
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Method using Time Value of Money - Present Value
Table
The government will pay you 1,000 30 years
later. There is no annual interest payment. If
the market interest rate is 8, how much is the
price for the bond? (using Table I)
Periods 6 8 10 12
25 0.2330 0.1460 0.0923 0.0588
30 0.1741 0.0994 0.0573
0.0334 35 0.1301 0.0676 0.0356
0.0189
PV 1,000 X 0.0994 99.4
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Method using Time Value of Money - Net Present
Value

• Now lets look at a capital budgeting
  modelthat considers the time value of cash
  flows.

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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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Net Present Value with Even Cash Flows
Exh. 26-7
22
Net Present Value with Even Cash Flows
Exh. 26-7
Present value factorsfor 12 percent
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Net Present Value with Even Cash Flows
Exh. 26-7
A positive net present value indicates that
thisproject earns more than 12 percent on the
investment.
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Using Net Present Value

• General decision rule . . .

25
Net Present Value with Uneven Cash Flows
Exh. 26-8
Although all projects require the same investment
and havethe same total net cash flows, project B
has a higher net present value because of a
larger net cash flow in year 1.
26
Method using Time Value of Money - Internal Rate
of Return (IRR)
The interest rate that makes . . .

• The net present value equal zero.

27
Internal Rate of Return (IRR)
Exh. 26-9

• Projects with even annual cash flows

Project life 3 yearsInitial cost
12,000Annual net cash inflows
5,000 Determine the IRR for this project.
1. Compute present value factor.
2. Using present value of annuity table . .
.
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Internal Rate of Return (IRR)
Exh. 26-9

• Projects with even annual cash flows

Project life 3 yearsInitial cost
12,000Annual net cash inflows
5,000 Determine the IRR for this project.
1. Compute present value factor.
12,000 5,000 per year 2.4000 2. Using
present value of annuity table . . .
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Internal Rate of Return (IRR)
Exh. 26-9

• 1. Determine the present value factor.
  12,000 5,000 per year 2.4000
• 2. Using present value of annuity table . . .

Locate the rowwhose numberequals the periods
in theprojects life.
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Internal Rate of Return (IRR)
Exh. 26-9

• 1. Determine the present value factor.
  12,000 5,000 per year 2.4000
• 2. Using present value of annuity table . . .

In that row,locate theinterest factorclosest
inamount to thepresent valuefactor.
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Internal Rate of Return (IRR)
Exh. 26-9

• 1. Determine the present value factor.
  12,000 5,000 per year 2.4000
• 2. Using present value of annuity table . . .

IRR isapproximately12.
IRR is theinterest rateof the columnin which
thepresent valuefactor is found.
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Internal Rate of Return Uneven Cash Flows

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

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Using Internal Rate of Return

• Internal Rate of Return
• Compare the internal rateof return on a project
  to a predetermined hurdle rate (cost of capital).
• To be acceptable, a projects rate of return
  cannot be less than thecost of capital.

34
Comparing Methods
Exh. 25-10
35
2. Managerial Decisions

• Lets change topics.

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Decision and Information- Decision Making
Exh. 25-11

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

37
Decision and Information- Relevant Costs

• Costs that are applicableto a particular
  decision.
• Costs that should have a bearing on which
  alternative a manager selects.
• Costs that are avoidable.
• Future costs that differbetween alternatives.

38
Classification by RelevanceSunk Costs

• All costs incurred in the past that cannot be
  changed by any decision made now or in the
  future.
• Sunk costs should not be considered in decisions.

Example You bought an automobile that
cost10,000 two years ago. The 10,000 cost is
sunkbecause whether you drive it, park it, trade
it, or sellit, you cannot change the 10,000
cost.
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Classification by RelevanceOut-of-Pocket Costs

• 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.

Future outlays of cash associatedwith a
particular decision.
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Classification by Relevance Opportunity Costs

• The potential benefit that is given up when
  one alternative is selected over another.
• Example If you werenot attending college,you
  could be earning20,000 per year. Your
  opportunity costof attending college for one
  year is 20,000.

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2. Managerial Decisions - Managerial
Decision Tasks
We will now examine several different types of
managerial decisions.
42
Managerial Decision Tasks - 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.

43
Accepting Additional Business
Exh. 25-12

• FasTrac currently sells 100,000 units of its
  product. The company has revenue and costs as
  shown below

44
Accepting Additional Business

• FasTrac is approached by an overseascompany
  that offers to purchase10,000 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 increaseby 1,000.
• Should FasTrac accept the offer?

45
Accepting Additional Business
First lets look at incorrect reasoningthat
leads to an incorrect decision.
Our cost is 9.00per unit. I cant sell for
8.50 per unit.
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10,000 new units 8.50 selling price 85,000
10,000 new units 3.50 35,000
10,000 new units 2.20 22,000
This analysis leads to the correct decision.
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Accepting Additional Business
Exh. 25-14
Even though the 8.50 selling price is less than
the normal 10 selling price, FasTrac should
accept theoffer because net income will increase
by 20,000.
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Managerial Decision Tasks - 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.

49
Make or Buy Decisions

• FasTrac currently makes part 417, assigning
  overhead at 100 percent of direct labor cost,
  withthe following unit cost

50
Make or Buy Decisions
Exh. 25-15

• 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?

51
Make or Buy Decisions
Exh. 25-15

• 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 a maximum of 0.25 per unit.
52
Make or Buy Decisions

• The company currently makes 1,000 units of part
  417. The incremental factory overhead is 100.
  The overhead per unit is 0.1. (Make)
• The company currently makes 1,000 units of part
  417. The incremental factory overhead is 500.
  The overhead per unit is 0.5. (Buy)

53
Managerial Decision Tasks - Scrap or Rework

• 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.

54
Scrap or Rework

• FasTrac has 10,000 defective units thatcost
  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?

55
Scrap or Rework
Exh. 25-16
10,000 units 0.80 per unit
10,000 units (1.50 - 1.00) per unit
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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Managerial Decision Tasks - Sell or Process

• Businesses are often faced with the decision to
  sell partially completed products or to process
  them to completion.
• As a general rule, we process further only if
  incremental revenues exceed incremental costs.

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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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Sell or Process
Exh. 25-17
Should FasTrac sell product Q or
continueprocessing into products X, Y, and Z?
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Sell or Process
Exh. 25-17,18
Revenue if processed 220,000
Revenue if sold directly (50,000)
Incremental revenue 170,000
Cost if processed
(80,000) Incremental net income
90,000
Should FasTrac sell product Q or
continueprocessing into products X, Y, and Z?
FasTrac should continue processing. Note that
the earlier 30,000cost for product Q is sunk
and therefore irrelevant to the decision.
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Managerial Decision Tasks - Sales Mix Selection

• When a company sells a variety of products, some
  are likely to be more profitable than others.
• To make an informed decision, management must
  consider . . .
• 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.
• If there is constraints on the facilities, then
  decision is based on contribution margin of
  constraint factor

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Sales Mix Selection
Exh. 25-19

• Consider the following data for two products made
  and sold by FasTrac.

If each product requires the same time tomake,
and the demand is unlimited, FasTracshould
produce only Product B.
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Sales Mix Selection
Exh. 25-19

• Consider the following data for two products made
  and sold by FasTrac.

Consider this additional information.
63
Sales Mix Selection
Exh. 25-19

• Consider the following data for two products made
  and sold by FasTrac.

Product B has a greater contribution margin
than Product A, but it requires more machine
hours per unit to produce.
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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Sales Mix Selection
Exh. 25-19

• Consider the following data for two products made
  and sold by FasTrac.

If demand for A is limited, produce to meet that
demand, then use the remaining facilities to
produce B.
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Managerial Decision Tasks - Segment Elimination
A segment is a candidate for elimination if its
revenues are less than itsavoidable expenses.
FasTrac is considering eliminating its
TreadmillDivision because total expenses of
48,300 aregreater than its sales of 47,800.
Continue
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Analysis of DivisionalOperating Expenses
Exh. 25-20
Lets identifyavoidable expenses.
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Analysis of DivisionalOperating Expenses
Exh. 25-20
68
Segment Elimination
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Managerial Decision Tasks - 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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3. Decision Analysis - Break-Even Time
Break-even time incorporates time valueof money
into the payback period methodof evaluating
capital investments.
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End of Chapter 25