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McGraw-Hill/Irwin Slide 1 McGraw-Hill/Irwin Slide 1 Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. CAPITAL BUDGETING C 1

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McGraw-Hill/Irwin Slide 2 McGraw-Hill/Irwin Slide 2 PAYBACK PERIOD The payback period of an investment is the time expected to recover the initial investment amount. Managers prefer investing in projects with shorter payback periods. P 1

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McGraw-Hill/Irwin Slide 3 McGraw-Hill/Irwin Slide 3 Payback period = Cost of Investment Annual Net Cash Flow Payback period = $16,000 $4,100 = 3.9 years COMPUTING 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. P 1

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McGraw-Hill/Irwin Slide 4 McGraw-Hill/Irwin Slide 4 $4,100 $5,000 COMPUTING 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, let’s look at an example where the cash flows vary each year. P 1

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McGraw-Hill/Irwin Slide 5 McGraw-Hill/Irwin Slide 5 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: PAYBACK PERIOD WITH UNEVEN CASH FLOWS P 1 4.2 We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period.

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McGraw-Hill/Irwin Slide 6 McGraw-Hill/Irwin Slide 6 USING THE PAYBACK PERIOD P 1 The payback period has two major shortcomings. It ignores the time value of money. It ignores cash flows after the payback period. Consider the following example where both projects cost $5,000 and have five-year useful lives: Would you invest in Project One just because it has a shorter payback period?

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McGraw-Hill/Irwin Slide 7 McGraw-Hill/Irwin Slide 7 The accounting rate of return focuses on annual income instead of cash flows. ACCOUNTING RATE OF RETURN Accounting Annual after-tax net income rate of return Annual average investment = Beginning book value + Ending book value 2 P 2 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return. Accounting $2,100 rate of return $8,000 == 26.25% $16,000 + $0 2

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McGraw-Hill/Irwin Slide 8 McGraw-Hill/Irwin Slide 8 Depreciation may be calculated several ways. Income may vary from year to year. Time value of money is ignored. So why would I ever want to use this method anyway? ACCOUNTING RATE OF RETURN

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McGraw-Hill/Irwin Slide 9 McGraw-Hill/Irwin Slide 9 Now let’s look at a capital budgeting model that considers the time value of cash flows. NET PRESENT VALUE 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. 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. P 3

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McGraw-Hill/Irwin Slide 10 McGraw-Hill/Irwin Slide 10 NET PRESENT VALUE WITH EQUAL CASH FLOWS P 3 Present value factors for 12 percent A positive net present value indicates that this project earns more than 12 percent on the investment.

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McGraw-Hill/Irwin Slide 11 McGraw-Hill/Irwin Slide 11 NET PRESENT VALUE DECISION RULE P 3

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McGraw-Hill/Irwin Slide 12 McGraw-Hill/Irwin Slide 12 Although all projects require the same investment and have the same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1. NET PRESENT VALUE WITH UNEVEN CASH FLOWS P 3

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McGraw-Hill/Irwin Slide 13 McGraw-Hill/Irwin Slide 13 INTERNAL RATE OF RETURN (IRR) The interest rate that makes... Present value of cash inflows Present value of cash outflows = The net present value equal zero. P 4

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McGraw-Hill/Irwin Slide 14 McGraw-Hill/Irwin Slide 14 1. Compute present value factor. 2.Using present value of annuity table... Projects with even annual cash flows INTERNAL RATE OF RETURN (IRR) Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project. P 4 $12,000 ÷ $5,000 per year = 2.40

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McGraw-Hill/Irwin Slide 15 McGraw-Hill/Irwin Slide 15 Locate the row whose number equals the periods in the project’s life. 1.Determine the present value factor. $12,000 ÷ $5,000 per year = 2.40 2.Using present value of annuity table... INTERNAL RATE OF RETURN (IRR) P 4 In that row, locate the interest factor closest in amount to the present value factor. IRR is the interest rate of the column in which the present value factor is found. IRR is approximately 12%.

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McGraw-Hill/Irwin Slide 16 McGraw-Hill/Irwin Slide 16 Uneven Cash Flows If cash inflows are unequal, trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. P 4 INTERNAL RATE OF RETURN (IRR) Use of Internal Rate of Return Compare the internal rate of return on a project to a predetermined hurdle rate (cost of capital). To be acceptable, a project’s rate of return cannot be less than the cost of capital.

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McGraw-Hill/Irwin Slide 17 McGraw-Hill/Irwin Slide 17 C 2

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McGraw-Hill/Irwin Slide 18 McGraw-Hill/Irwin Slide 18 Decision making involves five steps: Define the decision task. Identify alternative actions. Collect relevant information on alternatives. Select the course of action. Analyze and assess decisions made. DECISION MAKING C 3

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McGraw-Hill/Irwin Slide 19 McGraw-Hill/Irwin Slide 19 Costs that are applicable to a particular decision. Costs that should have a bearing on which alternative a manager selects. Costs that are avoidable. Future costs that differ between alternatives. 1 2 RELEVANT COSTS C 3

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McGraw-Hill/Irwin Slide 20 McGraw-Hill/Irwin Slide 20 Sunk costs are the result of past decisions and cannot be changed by any current or future decisions. Sunk costs are irrelevant to current or future decisions. C 3 RELEVANT COSTS Out- of-pocket costs are future outlays of cash associated with a particular decision. Out-of-pocket costs are relevant to decisions. Opportunity costs are the potential benefits given up when one alternative is selected over another. Opportunity costs are relevant to decisions.

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McGraw-Hill/Irwin Slide 21 McGraw-Hill/Irwin Slide 21 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. A 1 FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown.

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McGraw-Hill/Irwin Slide 22 McGraw-Hill/Irwin Slide 22 ACCEPTING ADDITIONAL BUSINESS A 1 FasTrac is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit. If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000. Should FasTrac accept the offer?

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McGraw-Hill/Irwin Slide 23 McGraw-Hill/Irwin Slide 23 First let’s look at incorrect reasoning that leads to an incorrect decision. Our cost is $9.00 per unit. I can’t sell for $8.50 per unit. ACCEPTING ADDITIONAL BUSINESS A 1

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McGraw-Hill/Irwin Slide 24 McGraw-Hill/Irwin Slide 24 This analysis leads to the correct decision. ACCEPTING ADDITIONAL BUSINESS A 1 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 Even though the $8.50 selling price is less than the normal $10 selling price, FasTrac should accept the offer because net income will increase by $20,000.

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McGraw-Hill/Irwin Slide 25 McGraw-Hill/Irwin Slide 25 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. A 1

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McGraw-Hill/Irwin Slide 26 McGraw-Hill/Irwin Slide 26 MAKE OR BUY DECISIONS FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost: A 1

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McGraw-Hill/Irwin Slide 27 McGraw-Hill/Irwin Slide 27 MAKE OR BUY DECISIONS FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we should buy this part? A 1 We must eliminate $.25 per unit of overhead, leaving a maximum of $0.25 per unit.

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McGraw-Hill/Irwin Slide 28 McGraw-Hill/Irwin Slide 28 SCRAP OR REWORK 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. Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. A 1

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McGraw-Hill/Irwin Slide 29 McGraw-Hill/Irwin Slide 29 SCRAP OR REWORK FasTrac has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or reworked at an additional cost of $.80 per unit. If reworked, the units can be sold for the normal selling price of $1.50 each. Reworking the defective units will prevent the production of 10,000 new units that would also sell for $1.50. Should FasTrac scrap or rework? A 1

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McGraw-Hill/Irwin Slide 30 McGraw-Hill/Irwin Slide 30 10,000 units × $1.50 per unit 10,000 units × $0.40 per unit SCRAP OR REWORK A 1 10,000 units × $0.80 per unit 10,000 units × ($1.50 - $1.00) per unit FasTrac should scrap the units now. 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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McGraw-Hill/Irwin Slide 31 McGraw-Hill/Irwin Slide 31 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. A 1 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:

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McGraw-Hill/Irwin Slide 32 McGraw-Hill/Irwin Slide 32 Should FasTrac sell product Q or continue processing into products X, Y, and Z? SELL OR PROCESS A 1 FasTrac should continue processing. The earlier $30,000 cost for product Q is sunk and therefore irrelevant to the decision.

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McGraw-Hill/Irwin Slide 33 McGraw-Hill/Irwin Slide 33 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. A 1

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McGraw-Hill/Irwin Slide 34 McGraw-Hill/Irwin Slide 34 If each product requires the same time to make, and the demand is unlimited, FasTrac should produce only Product B. SALES MIX SELECTION A 1 Consider this additional information. Consider the following data for two products made and sold by FasTrac. With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked. Product B has a greater contribution margin than Product A, but it requires more machine hours per unit to produce. If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B.

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McGraw-Hill/Irwin Slide 35 McGraw-Hill/Irwin Slide 35 FasTrac is considering eliminating its Treadmill Division because total expenses of $48,300 are greater than its sales of $47,800. A segment is a candidate for elimination if its revenues are less than its avoidable expenses. SEGMENT ELIMINATION A 1

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McGraw-Hill/Irwin Slide 36 McGraw-Hill/Irwin Slide 36 Let’s identify avoidable expenses. A 1 SEGMENT ELIMINATION

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McGraw-Hill/Irwin Slide 37 McGraw-Hill/Irwin Slide 37 Do not eliminate the Treadmill Division! SEGMENT ELIMINATION A 1

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