1. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-1 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 16 Costs for Decision Making

2. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-2 Relevant Cost Information L O 1

3. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-3 Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000. Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice. Opportunity Cost L O 1

4. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-4 The decision to accept additional business should be based on incremental costs and incremental revenues. The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those amounts that occur if the company decides to accept the new business. Incremental amounts are those amounts that occur if the company decides to accept the new business. The decision to accept additional business should be based on incremental costs and incremental revenues. The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those amounts that occur if the company decides to accept the new business. Incremental amounts are those amounts that occur if the company decides to accept the new business. The Special Pricing Decision L O 3

5. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-5 The Make or Buy Decision The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier. The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier. Decision rule: Costs avoided must be greater than outside supplier’s price to consider buying the component. Decision rule: Costs avoided must be greater than outside supplier’s price to consider buying the component. L O 3

6. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-6 Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Short-Term Allocation of Scarce Resources L O 3

7. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-7 Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Ê Outcome is uncertain. Ë Large amounts of money are usually involved. Ì Investment involves a long-term commitment. Í Decision may be difficult or impossible to reverse. Capital Budgeting L O 4

8. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-8 ? ? ? Limited Investment Funds Plant Expansion New Equipment Office Renovation I will choose the project with the most profitable return on available funds. Investment Decision Special Considerations L O 4

9. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-9 The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate used to calculate the present value of the investment proposal being analyzed. The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate used to calculate the present value of the investment proposal being analyzed. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. Cost of Capital L O 6

10. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-10 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-10 Capital Budgeting Techniques Methods that use present value analysis: Net present value (NPV). Internal rate of return (IRR). Methods that use present value analysis: Net present value (NPV). Internal rate of return (IRR). Methods that do not use present value analysis: Payback. Accounting rate of return. Methods that do not use present value analysis: Payback. Accounting rate of return. L O 6

11. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-11 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-11  Chose a discount rate – the minimum required rate of return.  Calculate the present value of cash inflows .  Calculate the present value of cash outflows . NPV =  –  Net Present Value (NPV) L O 7

12. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-12 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-12 General decision rule... Net Present Value (NPV) L O 7

13. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-13 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-13 Internal Rate of Return (IRR) L O 7 If annual cash inflows are unequal, trial and error solution will result if present value tables are used. If annual 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. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. If annual cash inflows are unequal, trial and error solution will result if present value tables are used. If annual 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. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. The actual rate of return that will be earned by a proposed investment. The actual rate of return that will be earned by a proposed investment. The interest rate that equates the present value of inflows and outflows from an investment project – the discount rate at which NPV = 0. The interest rate that equates the present value of inflows and outflows from an investment project – the discount rate at which NPV = 0.

14. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-14 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-14 Some Analytical Considerations Sensitivity analysis and post audits are helpful in dealing with estimates. Sensitivity analysis and post audits are helpful in dealing with estimates. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows are assumed to occur at the end of the year. Cash flows are assumed to occur at the end of the year. Some projects will require additional investments over time. Some projects will require additional investments over time. Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income. Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life. Least cost projects, often required by law, will have negative NPV’s. Least cost projects, often required by law, will have negative NPV’s. Sensitivity analysis and post audits are helpful in dealing with estimates. Sensitivity analysis and post audits are helpful in dealing with estimates. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows are assumed to occur at the end of the year. Cash flows are assumed to occur at the end of the year. Some projects will require additional investments over time. Some projects will require additional investments over time. Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income. Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life. Least cost projects, often required by law, will have negative NPV’s. Least cost projects, often required by law, will have negative NPV’s. L O 8

15. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-15 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-15 Payback Period The payback period of an investment is the number of years it will take to recover the amount of the investment. Managers prefer investing in projects with shorter payback periods. L O 9 Ignores the time value of money. Ignores cash flows after the payback period.

16. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-16 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-16 The accounting rate of return focuses on accounting income instead of cash flows. The accounting rate of return focuses on accounting income instead of cash flows. Accounting Rate of Return Accounting Operating income rate of return Average investment = L O 10