Analysis for Decision Making

1
Chapter 27

• Analysis for Decision Making

2
Short-Run Decision Analysis and the Management
Cycle

• Objective 1
• Explain how managers make short-run decisions in
  the management cycle

3
Short-Run Decision Analysis and the Management
Cycle

• Readers of financial reports are interested in
  knowing what happened to produce those particular
  results
• Answer this question using the historical
  information in these reports
• Provides financial and nonfinancial quantitative
  information
• Should be relevant, timely, and presented in a
  format that is easy to use in decision making

4
Short-Run Decision Analysis and the Management
Cycle (contd)

• Short-run decision analysis
• The systematic examination of any decision whose
  effects will be felt over the course of the next
  year
• Managers frequently take five predictable actions
  when deciding what to do
• First four actions
• During the planning stage
• Last action
• During the reviewing stage

5
Planning

• Managers take the following four actions during
  the planning stage when performing short-run
  decision analysis
• Discover a problem or need
• Identify all reasonable courses of action
• Prepare a thorough analysis of each possible
  solution
• Identify total costs, savings, and other
  financial effects
• Select the best course of action

6
Planning (contd)

• The following qualitative factors will influence
  a bank managers decision to keep or eliminate a
  branch location
• Competition
• Do competitors have a branch office located here?
• Economic conditions
• Does this branch location benefit the community
  we serve?
• Product or service quality
• Can we attract more business because of the
  service quality of this branch?
• Timeliness
• Does the branch promote customer service?

7
Executing

• Stage in which managers
• Must adapt to changing environments
• Take advantage of opportunities that will improve
  the organizations profitability and liquidity in
  the short-run
• During this stage a bank manager may choose to
• Eliminate a branch office
• Because costs exceed revenues
• Keep a branch office
• Because the community expects the organization to
  provide this service

8
Reviewing

• Managers evaluate each decision to determine
  whether it produced the forecasted results
• This is the fifth predictable action when
  performing short-run decision analysis
• If results fell short, managers identify and
  prescribe corrective action
• If the solution is not satisfactory or the
  problem remains, the management cycle begins again

9
Reporting

• Managers prepare reports related to short-run
  decisions throughout the management cycle
• Develop budgets that show estimated costs and
  revenues related to alternative courses of action
• Compile analyses of data that support their
  decisions

10
Discussion

• What are the five predictable actions frequently
  taken by managers during short-run decision
  analysis?

11
Discussion

• What are the five predictable actions frequently
  taken by managers during short-run decision
  analysis?
• Discover a problem or need
• Identify all reasonable courses of action
• Prepare a thorough analysis of each possible
  solution
• Identify total costs, savings, and other
  financial effects
• Select the best course of action
• Evaluate each decision to determine whether it
  produced the forecasted results

12
Incremental Analysis for Short-Run Decisions

• Objective 2
• Define incremental analysis and describe how it
  applies to short-run decision analysis

13
Incremental Analysis

• is a method of comparing alternatives by
  focusing on the differences in their projected
  revenues and costs
• Also called differential analysis if it ignores
  revenues or costs that stay the same or do not
  differ among alternatives

14
Irrelevant Costs and Revenues

• Differential cost
• A cost that changes between alternatives
• Also referred to as an incremental cost
• Irrelevant revenue
• Revenues that will not differ between
  alternatives
• Irrelevant cost
• A cost that does not differ between alternatives
• Includes sunk costs
• Costs that were incurred because of a previous
  decision and cannot be recovered through the
  current decision

15
Irrelevant Costs and Revenues (contd)
Home State Bank managers must decide to buy one
of two ATM machinesC or W. The machines have
the same purchase price but different revenues
and cost characteristics. The company currently
owns ATM B, which it bought 3 years ago for
15,000 and which has accumulated depreciation of
9,000. It is now obsolete and cannot be sold or
traded in
The accountant has collected the following annual
revenue and operating cost estimates for the two
new machines
16
Irrelevant Costs and Revenues (contd)
Home State Bank managers must decide to buy one
of two ATM machinesC or W. The machines have
the same purchase price but different revenues
and cost characteristics. The company currently
owns ATM B, which it bought 3 years ago for
15,000 and which has accumulated depreciation of
9,000. It is now obsolete and cannot be sold or
traded in

• The first step in incremental analysis is to
  eliminate any irrelevant revenues and costs
• Sunk costs
• The book value of ATM B
• Represents money that was spent in the past and
  does not affect the decision about whether to
  replace the old ATM with a new one

ATM B would be of interest only if it could be
sold or traded in
17
Irrelevant Costs and Revenues (contd)

• Recall the annual revenue and operating cost
  estimates for the two new machines
• The costs of direct materials and fixed overhead
  are the same under both alternatives
• These are irrelevant costs and can also be
  eliminated from the analysis

18
Irrelevant Costs and Revenues (contd)

• The incremental analysis is prepared using only
  the differential revenues and costs that will
  change between the alternative ATMs

19
Incremental Analysis
20
Opportunity Costs

• are the benefits that are forfeited or lost
  when one alternative is chosen over another

21
Opportunity Costs (contd)

• When deciding between alternatives, managers
• Use incremental analysis
• Simplifies managements evaluation of a decision
• Reduces time needed to choose the best course of
  action
• Determine opportunity costs
• Must consider other issues, such as quality and
  reputation

22
Opportunity Costs (contd)
A plant nursery has been in operation for many
years at the intersection of two highways. A
bank has offered the owner a high price for the
land

• The interest that could be earned from the
  proceeds of the sale is an opportunity cost for
  the nursery owner
• It is revenue the owner has chosen to forego to
  continue operating the nursery in that location

23
Opportunity Costs (contd)
A bank teller is deciding whether to go back to
school full time to earn a degree in finance.
What is the opportunity cost?
24
Opportunity Costs (contd)
A bank teller is deciding whether to go back to
school full time to earn a degree in finance

• The salary the teller would lose by returning to
  school is an opportunity cost
• The total cost of school includes not only
  tuition, books, supplies, and living expenses,
  but also the amount of salary foregone while the
  teller is a full-time student

25
Opportunity Costs (contd)

• Opportunity costs often come into play when a
  company is operating at or near full capacity and
  must choose what products or services to offer

26
Discussion

• What is an opportunity cost?

27
Discussion

• What is an opportunity cost?
• A benefit that is given up because one course of
  action is taken instead of another

28
Application of Incremental Analysis and Short-Run
Decisions

• Objective 3
• Perform incremental analysis for outsourcing
  decisions, special order decisions, segment
  profitability decisions, sales mix decisions
  involving constrained resources, and sell or
  process-further decisions

29
Application of Incremental Analysis and Short-Run
Decisions

• Incremental analysis can be applied to the
  following common situations
• Outsourcing decisions
• Special order decisions
• Segment profitability decisions
• Sales mix decisions involving constrained
  resources
• Sell or process-further decisions

30
Incremental Analysis for Outsourcing Decisions

• Outsourcing
• The use of suppliers outside the organization to
  perform services or produce goods that could be
  performed or produced internally
• Make-or-buy decisions
• Decisions about whether to make a part internally
  or buy it from an external supplier
• May lead to outsourcing

31
Incremental Analysis for Outsourcing Decisions
(contd)

• Core competencies
• The activities an organization performs best
• Many companies focus their resources on their
  core competencies to
• Improve operating income
• Compete effectively in global markets

32
Incremental Analysis for Outsourcing Decisions
(contd)

• Organizations may outsource expensive,
  nonvalue-adding activities
• Payroll processing
• Training
• Managing fleets of vehicles
• Sales and marketing
• Custodial services
• Information management

Many areas that are outsourced involve either
relatively low skill areas or highly specialized
knowledge that can be better acquired from
experts outside the company
33
Incremental Analysis for Outsourcing Decisions
(contd)

• Outsourcing production or operating activities
  can reduce a companys
• Investment in physical assets and human resources
• Improves cash flow
• Operating costs
• Improves operating income

34
Incremental Analysis for Outsourcing Decisions
(contd)

• A common decision facing managers is whether to
  make or buy a part
• Goal
• Select the most profitable alternative
• Must identify the costs of each alternative and
  their effects on revenues and existing costs

35
Incremental Analysis for Outsourcing Decisions
(contd)

• Managers need the following information for
  analysis

36
Incremental Analysis for Outsourcing Decisions
(contd)
For the past five years, Box Company has
purchased packing cartons from an outside
supplier at a cost of 1.25 per carton. The
supplier has just informed Box Company that it
will be raising the price to 1.50 per carton,
effective immediately

• Box Company has idle machinery that could be
  adjusted and used to produce packing cartons
• Annual production and usage would be 20,000
  cartons
• Estimated cost of direct materials is .84 per
  carton
• Workers earn 8.00 per hour and can produce 20
  cartons per hour (.40 per carton)
• Cost of variable manufacturing OH will be 4 per
  direct labor hour and 1,000 direct labor hours
  will be required
• Fixed overhead per year includes 4,000 of
  depreciation and 6,000 of other fixed costs
• There is space to produce the cartons and the
  machines will remain idle if the part is purchased

37
Incremental Analysis for Outsourcing Decisions
(contd)

• Irrelevant costs
• Depreciation costs and other fixed manufacturing
  OH costs
• Machinery and factory space have no other use
• Costs are the same for both alternatives
• Relevant costs and revenues
• Compared for each alternative in an incremental
  analysis

38
Incremental Analysis Outsourcing Decision
The company will save 1,200 if it decides to
make the cartons
39
Incremental Analysis for Special Order Decisions

• Special order decisions
• Decisions about whether to accept or reject
  special orders at prices below normal market
  prices
• Usually involve large numbers of similar items
  that are sold in bulk
• Are not expected and so are not included in
  annual cost or sales estimates
• Are one-time events and should not be included in
  revenue or cost estimates for subsequent years

40
Incremental Analysis for Special Order Decisions
(contd)

• Before accepting a special product order
• Ensure that the products involved are
  sufficiently different from the regular product
  line to avoid
• Violating federal price discrimination laws
• Reducing unit sales from the full-priced regular
  product line

41
Incremental Analysis for Special Order Decisions
(contd)

• A special product order should be accepted only
  if it maximizes operating income
• Based on
• The organizations strategic plan and objectives
• Relevant costs of the special order
• Qualitative factors

42
Incremental Analysis for Special Order Decisions
(contd)

• Approaches to determining whether a special order
  should be accepted
• Compare special order price to relevant costs to
  produce, package, and ship the order
• Relevant costs include
• Variable costs
• Variable selling costs, if any
• Other costs directly associated with the special
  order (e.g., freight, insurance, packaging, and
  labeling the product)
• Prepare a special order bid price
• Calculate a minimum selling price
• Equals relevant costs plus an estimated profit

43
Incremental Analysis for Special Order Decisions
(contd)

• Costs that may be excluded from a special order
  decision analysis
• Sales commission expenses
• Customer may have contacted the company directly
• Fixed costs of existing facility
• Do not change if the company accepts the special
  order

44
Incremental Analysis for Special Order Decisions
(contd)

• Costs relevant to the decision
• Fixed costs that must be incurred to fill the
  special order
• Purchase of additional machinery
• Increase in supervisory help
• Increase in insurance premiums

45
Incremental Analysis for Special Order Decisions
(contd)
Home State Bank has been approved to provide and
service four ATMs at a special event. The event
sponsors want the fee per ATM transaction to be
.50. Past ATM usage at special events has
averaged 2,000 transactions per machine. The
bank has located four idle ATMs for the event
Based on the following cost data, should Home
State Bank accept the special event offer?
46
Incremental Analysis for Special Order Decisions
(contd)

• Irrelevant costs
• Fixed costs
• The only costs affected by the order are
• Direct materials
• Direct labor
• Variable overhead

47
Incremental Analysis Special Order Decision
Accepting the special offer will increase
contribution margin, and therefore operating
income, by 1,200
48
Incremental Analysis for Segment Profitability
Decisions

• Managers must decide whether to keep or drop
  unprofitable segments
• Product lines
• Services
• Sales territories
• Divisions
• Departments
• Stores
• Outlets

49
Incremental Analysis for Segment Profitability
Decisions (contd)

• Management must select the alternative that
  maximizes operating income based on
• The organizations strategic plan and objectives
• Relevant revenues and costs
• Qualitative factors
• Objective of this analysis
• Identify the segments that have a negative
  segment margin

50
Incremental Analysis for Segment Profitability
Decisions (contd)

• Segment margin
• A segments sales revenue minus its direct costs
  (direct variable costs and direct fixed costs
  traceable to the segment)
• Such costs are assumed to be avoidable costs
• Can be eliminated if the segment were dropped

51
Incremental Analysis for Segment Profitability
Decisions (contd)

• If a segment has a positive segment margin, it
  should be kept
• It is able to cover its own direct costs
• Can contribute a portion of its revenue to cover
  common costs and add to operating income
• If a segment has a negative segment margin, it
  should be eliminated
• However, the remaining segments must be able to
  cover the unavoidable costs
• Common cost that will be incurred regardless of
  the decision

52
Incremental Analysis for Segment Profitability
Decisions (contd)

• To analyze segment profitability
• Prepare a segmented income statement
• Use variable costing to identify variable and
  fixed costs
• Direct fixed costs
• The fixed costs that are traceable to the
  segments
• Common costs
• The remaining fixed costs
• Are not assigned to segments

53
Incremental Analysis for Segment Profitability
Decisions (contd)
Once the segmented income statement has been
completed, an incremental analysis can be prepared
Incremental analysis shows that operating income
will increase by 9,000 if the Safe Deposit
Division is dropped
54
Incremental Analysis for Segment Profitability
Decisions (contd)
Assume that Bank Operations sales will decrease
20 percent if management eliminates the Safe
Deposit Division
Incremental analysis now shows that operating
income will decrease by 7,500 if the Safe
Deposit Division is dropped
55
Incremental Analysis for Sales Mix Decisions

• Resource constraints
• Limits on resources may restrict types or
  quantities of products or services a company can
  provide
• Machine time
• Available labor
• Other activities
• Inspection
• Equipment setup

56
Incremental Analysis for Sales Mix Decisions
(contd)

• Organizations must decide which products or
  services contribute the most to company
  profitability in relation to the amount of
  capital assets or other constrained resources
  needed to offer these items
• Identify by calculating the contribution margin
  per constrained resource for each product or
  service

57
Incremental Analysis for Sales Mix Decisions
(contd)

• Sales mix decision
• To select the alternative that maximizes the
  contribution margin per constrained resource
• Based on the organizations
• Strategic plan and objectives
• Relevant revenues and costs
• Qualitative factors
• Use incremental analysis

58
Incremental Analysis for Sales Mix Decisions
(contd)

• Decision analysis uses two steps
• Calculate contribution margin per unit for each
  product or service affected by the constrained
  resource
• Equals selling price per unit less variable costs
  per unit
• Calculate contribution margin per unit of the
  constrained resource
• Equals contribution margin per unit divided by
  the quantity of the constrained resource required
  per unit

59
Incremental Analysis for Sales Mix Decisions
(contd)
Home State Bank offers three types of loans
commercial loans, auto loans, and home loans.
Current loan application capacity is 100,000
processing hours
The product line data are as follows
Question 1 Which product line should be
advertised and promoted initially because it is
the most profitable for the bank? Which should
be second? Which should be last?
60
Incremental Analysis Sales Mix Decision
Involving Constrained Resources
61
Incremental Analysis for Sales Mix Decisions
(contd)

• Loans that provide the highest contribution
  margin per processing hour should be sold first
• The analysis indicates that the loans should be
  sold in the following order
• Auto loans
• Home loans
• Commercial loans

62
Incremental Analysis for Sales Mix Decisions
(contd)
Home State Bank offers three types of loans
commercial loans, auto loans, and home loans.
Current loan application capacity is 100,000
processing hours
The product line data are as follows
Question 2 How many of each type of loan should
be sold to maximize the companys contribution
margin based on current loan activity of 100,000
processing hours? What is the total contribution
margin for that combination?
63
Incremental Analysis for Sales Mix Decisions
(contd)

• Compare current loan application activity to the
  required loan activity to meet the current loan
  demand

The current demand exceeds the current capacity
by 15,000 processing hours
64
Incremental Analysis for Sales Mix Decisions
(contd)

• Management must determine the sales mix that
  maximizes the companys contribution margin
• Will also maximize its operating income

65
Incremental Analysis Sales Mix Decision
Involving Constrained Resources
66
Incremental Analysis for Sales Mix Decisions
(contd)
67
Incremental Analysis for Sell or Process-Further
Decisions

• Some companies offer products or services that
  can either be sold in a basic form or be
  processed further and sold as a more refined
  product or service to a different market
• Example
• Meatpacking company
• Can sell sides of beef and pounds of bones to
  other companies for further processing
• Can decide to cut and package meet, process bone
  into fertilizer, and tan hides into leather

68
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Sell or process-further decision
• A decision about whether to sell a joint product
  at the split-off point or sell it after further
  processing
• Joint products
• Two or more products, made from a common material
  or process, that cannot be identified as separate
  products or services during some or all of the
  processing
• Split-off point
• A specific point where joint products or services
  become separate and identifiable
• Point at which a company may choose to sell or
  process further

69
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Objective
• Select the alternative that maximizes operating
  income
• Based on
• Organizations strategic plan and objectives
• Relevant revenues and costs
• Qualitative factors

70
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Steps in incremental analysis process
• Calculate incremental revenue
• Difference between total revenue if sold at
  split-off point and total revenue if sold after
  processing further
• Compare incremental revenue to incremental costs
  of processing further
• Choose to process further if incremental revenue
  exceeds incremental costs
• If incremental costs exceed incremental revenue,
  choose to sell at the split-off point

71
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Joint costs, or common costs, are ignored in the
  analysis
• They are incurred before the split-off point and
  do not change if further processing occurs

Even though joint costs are assigned to products
or services when valuing inventories and
calculating cost of goods sold, they are not
relevant to a sell or process further decision
72
Incremental Analysis for Sell or Process-Further
Decisions (contd)
Home State Banks management is looking for new
markets for banking services. They are
considering adding two levels of service beyond
the Basic Checking account services, Premier
Checking and Personal Banker

• Basic Checking
• Online checking account, debit card, and online
  bill payment with a required minimum average
  balance (RMAB) of 500
• Premier Checking
• Paper and online checking account, debit card, a
  credit card, and a small life insurance policy
  equal to the maximum credit limit on the credit
  card. RMAB 1,000
• Personal Banker
• All the features of Premier Checking plus a safe
  deposit box, 5,000 personal line of credit at
  prime, financial investment advice, and a toaster
  on opening the account. RMAB 5,000

73
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• The bank can earn sales revenue of 5 percent on
  its checking account balances
• The total cost of Basic Checking is currently
  50,000
• The banks accountant provided the following data
  per account

74
Incremental Analysis Sell or Process-Further
Decision
75
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• The analysis indicates that the bank should offer
  personal banking services in addition to Basic
  Checking accounts

Notice that the 50,000 joint costs of Basic
Checking were ignored because they are sunk costs
that will not influence the decision
76
Discussion

• What should all decisions based on incremental
  analysis take into account?

77
Discussion

• What should all decisions based on incremental
  analysis take into account?
• Final decisions should always take into account
  the organizations strategic plan and objectives,
  relevant revenues and costs, and qualitative
  factors

78
Capital Investment Decisions

• Objective 4
• Identify types of projected costs and revenues
  used to evaluate alternatives for capital
  investment

79
Capital Investment Decisions

• are decisions about when and how much to spend
  on capital facilities and other long-term
  projects
• May include
• Machinery, systems, or processes
• Building additions, renovations, or new
  structures
• Entire new divisions or product lines
• Distribution and software systems

Capital investments are expensive and decisions
about them must be made carefully
80
Capital Investment Analysis

• is the process of making decisions about
  capital invesments
• Also called capital budgeting
• Consists of
• Identifying the need for a capital investment
• Analyzing courses of action to meet that need
• Preparing reports for managers
• Choosing the best alternative
• Allocating funds among competing needs

81
Capital Investment Analysis (contd)

• Every part of the organization participates in
  the process
• Financial analysts
• Supply a target cost of capital or desired rate
  of return and an estimate of how much money can
  be spent annually on capital facilities
• Marketing specialists
• Predict trends and new product demands
• Helps in determining which operations need
  expansion or new equipment
• Managers at all levels
• Help identify facility needs
• Prepare preliminary cost estimates for the
  desired capital investment

82
Measures Used in Capital Investment Analysis

• Managers must predict how the new asset will
  perform and how it will benefit the company
• Use various measures to estimate the benefits to
  be derived from a capital investment

83
Measures Used in Capital Investment Analysis
(contd)

• Two methods of measuring the expected benefit
  from an investment project
• Net income
• Managers determine increases in net income
  resulting from the capital investment for each
  alternative
• Net cash inflows
• Balance of increases in projected cash receipts
  over increases in projected cash payments
  resulting from a capital investment
• More widely used measure

84
Measures Used in Capital Investment Analysis
(contd)

• Equipment replacement decisions may involve
  alternatives for which revenues are the same
  among alternatives
• Benefits are measured in cost savings

85
Measures Used in Capital Investment Analysis
(contd)

• Either net cash inflows or cost savings can be
  used as the basis for evaluation
• If analysis involves
• Cash receipts
• Use net cash inflows
• Cash outlays
• Use cost savings

86
Measures Used in Capital Investment Analysis
(contd)

• Equal cash flows
• Projected cash flows are the same from year to
  year
• Unequal cash flows
• Projected cash flows vary from year to year
• Are common
• Require a more detailed analysis

87
Measures Used in Capital Investment Analysis
(contd)

• Carrying value of an asset
• Is the undepreciated portion of the original cost
  of a fixed asset
• Cost of the asset less its accumulated
  depreciation
• Is irrelevant in capital investment analysis
• It is a past, or historical, cost and will not be
  altered by the decision
• Net proceeds from the sale or disposal of an
  asset
• Are relevant
• Affect cash flow and may differ for each
  alternative

88
Measures Used in Capital Investment Analysis
(contd)

• Income taxes alter the amount and timing of cash
  flows of projects under consideration by
  for-profit companies
• The effects of taxes must be included in capital
  investment analyses
• Depreciation expense is tax-deductible
• Strongly influences the amount of income taxes a
  company pays
• Can lead to significant tax savings

89
Measures Used in Capital Investment Analysis
(contd)

• Assume a company has a tax rate of 30 percent on
  taxable income
• It is considering a capital project that will
  make the following annual contribution to
  operating income

90
Measures Used in Capital Investment Analysis
(contd)

• Net cash flows for this project can be determined
  in two ways
• Net cash inflowsreceipts and disbursements
• Net cash inflowsincome adjustment procedure

91
Measures Used in Capital Investment Analysis
(contd)

• Net cash inflowsreceipts and disbursements
  (similar to the direct method for Statement of
  CFs)

92
Measures Used in Capital Investment Analysis
(contd)

• Net cash inflowsincome adjustment procedure
  (similar to the indirect method for Statement of
  CFs)

In both computations, net cash inflows are
170,000, and the total effect of income taxes is
to lower the net cash inflows by 30,000
93
Measures Used in Capital Investment Analysis
(contd)

• Other cash inflows relevant to evaluating a
  proposed capital investment
• Disposal of an asset
• Proceeds from the sale of an old asset are
  current cash inflows
• Projected disposal or residual values of
  replacement equipment
• Represent future cash inflows and usually differ
  among alternatives
• Sometimes called disposal or salvage value

94
Discussion

• What is the carrying value of an asset, and is it
  relevant to a capital investment analysis?
• Carrying value of an asset is the undepreciated
  portion of the original cost of a fixed asset.
  It is equal to the cost of the asset less its
  accumulated depreciation
• It is irrelevant in capital investment analysis
  because it is a past, or historical, cost and
  will not be altered by the decision

95
The Time Value of Money

• Objective 5
• Apply the concept of the time value of money

96
The Time Value of Money

• is the concept that cash flows of equal dollar
  amounts separated by an interval of time have
  different present values because of the effect of
  compound interest
• The notions of interest, present value, and
  future value are all related to the time value of
  money

97
Interest

• is the cost associated with the use of money
  for a specific period of time
• Is an important consideration in any business
  decision

98
Interest (contd)

• Simple interest
• The interest cost for one or more periods when
  the amount on which the interest is computed
  stays the same from period to period
• Compound interest
• The interest cost for two periods or more when
  the amount on which interest is computed changes
  in each period to include all interest paid in
  previous periods

99
Example Simple Interest
Jo Sanka accepts an 8 percent, 30,000 note due
in 90 days
How much will Sanka receive in total when the
note comes due?
The formula for calculating simple interest is as
follows
The total Sanka will receive is computed as
follows
If the interest is paid and the note is renewed
for an additional 90 days, the interest
calculation will remain the same
100
Example Compound Interest
Andy Clayburn deposits 5,000 in an account that
pays 6 percent interest. The interest is paid at
the end of the year, and that interest is added
to the principal at that time. This total in
turn earns interest. He expects to leave the
principal and accumulated interest in the account
for 3 years
What will be his account total at the end of
three years?
Note that the annual amount of interest increases
each year by the interest rate times the interest
of the previous year
101
Present Value

• What is the difference between receiving 100
  today or one year from now?
• If received today
• Can invest the amount and earn interest on it
• If received one year from now
• The opportunity to earn interest over the year is
  foregone
• An amount to be received in the future (future
  value) is not worth as much today as the same
  amount to be received today (present value)
  because of the cost associated with the passage
  of time

102
Present Value (contd)

• Present Value
• The amount that must be invested now at a given
  rate of interest to produce a given future value
• Future value
• The amount an investment will be worth at a
  future date if it is invested at compound interest

Present value and future value are closely related
103
Present Value (contd)
Daschel Company needs 1,000 one year from now.
How much should the company invest today to
achieve the goal if the interest rate is 5
percent?
Interest of 5 percent on 952.38 for one year
equals 47.62, and the two amounts added together
equal 1,000.00
104
Present Value of a Single Sum Due in the Future
Reza Company wants to be sure of having 4,000 at
the end of 3 years. How much should the company
invest today to achieve the goal if the interest
rate is 5 percent?
The preceding equation can be adapted to compute
this amount
Reza Company must invest 3,455.34 today to have
4,000.00 in three years
105
Present Value of a Single Sum Due in the Future
(contd)
Reza Company wants to be sure of having 4,000 at
the end of 3 years. How much should the company
invest today to achieve the goal if the interest
rate is 5 percent?
Use Table 3 to compute the amount Reza Company
must invest today






Look down the 5 percent column and across the row
for 3 periods to find the factor 0.864
Except for a difference of 0.66, the answer is
the same as the earlier one
106
Present Value of an Ordinary Annuity

• Ordinary annuity
• A series of equal payments or receipts that will
  begin one time period from the current date
• Present value of an ordinary annuity
• The present value of amounts equally spaced over
  a period of time

107
Present Value of an Ordinary Annuity (contd)
Foder Company has sold a piece of property and is
to receive 15,000 in three equal annual payments
of 5,000, beginning one year from today. The
current interest rate is 5
What is the present value of this sale?
The present value of each payment to Foder
Company can be calculated separately using Table
3 and then summed for the total present value
The present value of this sale is 13,615
108
Present Value of an Ordinary Annuity (contd)
Foder Company has sold a piece of property and is
to receive 15,000 in three equal annual payments
of 5,000, beginning one year from today. The
current interest rate is 5
Use Table 4 to compute the present value of the
payments Foder will receive






Look down the 5 percent column and across the row
for 3 periods to find the factor 2.723
The answer is the same as the earlier one
109
Present Value of an Ordinary Annuity (contd)

• If Foder Company is willing to accept a 5 percent
  rate of return, management will be equally
  satisfied to receive (PV of O.A. PV of L.S. in
  this case)
• A single cash payment of 13,615 today
• Three equal annual cash payments of 5,000 spread
  over the next three years

110
Discussion

• What is the difference between simple and
  compound interest?
• For simple interest calculations, the amount on
  which interest is calculated stays the same from
  period to period
• When calculating compound interest, the amount
  on which interest is calculated increases at the
  end of each period by the amount of interest for
  that period

111
The Net Present Value Methods of Evaluating
Proposed Capital Investments

• Objective 6
• Analyze capital investment proposals using the
  net present value method

112
The Net Present Value Methods of Evaluating
Proposed Capital Investments

• When evaluating a proposed capital investment,
  managers must predict how the new asset will
• Perform
• Benefit the company
• Net present value method
• Most important measure used to estimate the
  benefits to be derived from a capital investment

113
Net Present Value

• evaluates a capital investment by discounting
  its future cash flows to their present values and
  subtracting the amount of the initial investment
  from their sum
• NPV PV initial investment cost
• The net present values for all proposed projects
  are compared
• Those with net present values that exceed the
  initial investment are selected for implementation

114
Advantages of the Net Present Value Method

• Incorporates the time value of money into the
  analysis
• Future cash inflows and outflows are discounted
  by the companys minimum rate of return (the
  interest rate used for the PV) to determine their
  present values
• The minimum rate of return should be greater than
  or equal to the companys cost of capital (this
  number will be given to you)

115
Advantages of the Net Present Value Method
(contd)

• Cost of capital
• Weighted-average rate of return (WACC from your
  finance classes) a company must pay to its
  long-term creditors and shareholders for the use
  of their funds

116
Advantages of the Net Present Value Method
(contd)

• Each future cash inflow and outflow over the life
  of the assets is discounted to the present
• Single amount
• Use Table 3
• Series of equal periodic amounts
• Use Table 4

117
Advantages of the Net Present Value Method
(contd)

• Positive net present value
• Total of the discounted net cash inflows exceeds
  the cash investment at the beginning
• NPV PV initial investment cost
• Rate of return on investment exceeds company's
  minimum rate of return (also called the hurdle
  rate)
• Project can be accepted

118
Advantages of the Net Present Value Method
(contd)

• Negative net present value
• Initial cash investment exceeds the total of the
  discounted net cash inflows
• NPV PV initial investment cost
• Rate of return on investment is less than the
  company's minimum rate of return (hurdle rate)
• Project should be rejected

If the net present value is zero, the project
meets the minimum rate of return and can be
accepted
119
Net Present Value Method Illustrated
Open Imaging Company is considering the purchase
of a magnetic resonance imaging (MRI) machine to
improve the efficiency of its Radiology
Department. Management must decide between Model
M and Model N

• Model M
• Cost of 17,500
• Estimated residual value of 2,000 after 5 years
• Projected cash inflows of 6,000, 5,500, 5,000,
  4,500, and 4,000 during its five-year life
• Model N
• Cost of 21,000
• Estimated residual value of 2,000 after 5 years
• Projected cash inflows of 6,000 per year for 5
  years

120
Net Present Value Method Illustrated

• Determine the net present value for Model M
• Must use Table 3 because of unequal cash flows

The cash outflow for the purchase is not
discounted because it occurs at time zero
The residual value is discounted because it
represents a cash inflow that will take place at
the end of year 5
121
Net Present Value Method Illustrated (contd)

• Determine the net present value for Model N
• Table 4 is used because the cash inflows are
  expected to be equal amounts in each year
• However, Table 3 must still be used to determined
  the present value of the machines residual value

122
Net Present Value Method Illustrated (contd)

• Results of the two analyses
• Net present value of Model M is 303.50
• Net present value of Model N is (404.00)
• Model M should be chosen because it
• Has a positive net present value
• Is expected to exceed the companys minimum rate
  of return
• Model N should be rejected because it has a
  negative net present value

123
Discussion

• What does a negative net present value indicate?
• It indicates that a proposed capital projects
  expected rate of return is less than the
  company's minimum rate of return. The project
  should be rejected

124
Other Methods of Capital Investment Analysis

• Objective 7
• Analyze capital investment proposals using the
  payback period (PBP) method and the accounting
  rate-of-return (ARR) method

125
Other Methods of Capital Investment Analysis

• Two other commonly used methods for capital
  investment analysis
• Payback period method
• Accounting rate-of-return method
• Provide rough guides to evaluating capital
  investments
• Net present value method is best

126
The Payback Period Method

• bases the decision to invest in a capital
  project on the minimum length of time it will
  take to recover the amount of the initial
  investment
• (Denominator Cash Revenues Cash expenses)

127
The Payback Period Method
Gordon Company is interested in purchasing a new
bottling machine that costs 51,000 and has a
residual value of 3,000. The machine is
expected to increase revenues by 17,900 per year
and increase operating costs by 11,696 per year
(including depreciation and taxes). The company
uses the straight-line method of depreciation and
the machine is expected to have a ten-year
service life
The only noncash expense or revenue is
depreciation, which must be removed from the
operating costs
128
The Payback Period Method (contd)
Gordon Company is interested in purchasing a new
bottling machine that costs 51,000 and has a
residual value of 3,000. The machine is
expected to increase revenues by 17,900 per year
and increase operating costs by 11,696 per year
(including depreciation and taxes). The company
uses the straight-line method of depreciation and
the machine is expected to have a ten-year
service life
The payback period is computed as follows
If the companys payback period is 5 years or
less, this proposal would be approved
129
From the previous slide

• The 17,900 revenues are assumed to be all cash
  revenues (not accrual revenuescash revenues
  non-cash revenues)
• The 11,696 expenses are accrual expenses (cash
  expenses and non-cash expenses)

130
The Payback Period Method (contd)

• Calculating payback period for capital investment
  proposals with unequal annual net cash inflows
• Subtract each annual amount, in chronological
  order, from the cost of the capital facility
• When a zero balance is reached, the payback
  period has been determined
• May occur in the middle of a year
• Compute portion of the final year by dividing
  amount needed to reach zero by the entire years
  estimated cash inflow

131
The Payback Period Method (contd)

• Widely used
• Is easy to compute and understand
• Useful in areas where technology changes rapidly
• Disadvantages
• Does not measure profitability
• Does not adjust cash flows for the time value of
  money
• Emphasize the time it takes to recover the
  investment rather than the long-term return on
  the investment
• Ignores all future cash flows after the payback
  period

Disadvantages of the payback period method
significantly outweigh its advantages
132
The Accounting Rate-of-Return Method

• is a method of evaluating capital investment
  proposals by dividing the projects annual
  after-tax net income by the average cost of the
  investment
• Is imprecise, but easy
• Uses financial statement information

133
The Accounting Rate-of-Return Method (contd)
The following formula is used to calculate
accounting rate of return
To compute average annual net income, use the
cost and revenue data prepared for evaluating the
project
The following formula is used to calculate
average investment cost
134
The Accounting Rate-of-Return Method (contd)
Gordon Company is interested in purchasing a new
bottling machine that costs 51,000 and has a
residual value of 3,000. The machine is
expected to increase revenues by 17,900 per year
and increase operating costs by 11,696 per year
(including depreciation and taxes). The company
uses the straight-line method of depreciation and
the machine is expected to have a ten-year
service life. Only projects that are expected to
yield more than 16 return are accepted
The projected rate of return is higher than the
minimum 16, so management should seriously
consider making this investment
135
The Accounting Rate-of-Return Method (contd)

• Widely used
• Easy to understand and apply
• Disadvantages
• Not a reliable figure
• Net income is averaged over the life of the
  investment
• Unreliable if estimated annual income differs
  from year to year
• Cash flows are ignored
• Does not consider the time value of money

136
Discussion

• A machine costs 10,000, has an expected life of
  4 years, and a residual value of 2,000. If
  purchased, it is expected to increase revenues by
  5,000 per year and expenses by 3,500 per year.
  What is the payback period?