ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 19 Professor Jeff Yu

Review: “Make or Buy” Decision DECISION RULE  Step 1: calculate the relevant costs of making each unit of the part after eliminating sunk costs and future costs that do not differ between making or buying the parts.  Step 2: Compare the unit cost calculated from step 1 with the price offered by outside suppliers. Note: watch out for any relevant opportunity costs.

When facing a limited resource constraint, the firm should produce products with the highest contribution margin PER UNIT OF SCARCE RESOURCE. Example: If Machine hour is constrained, then the production order should be: B, C, A Review: Optimal Use of Limited Resources ProductABC CM/unit MH/unit945 CM/MH253.2

Two or more products produced from a common input are called joint products. The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point. Joint costs are costs incurred up to the split-off point and are usually allocated to the end products proportionate to their sales value. Costs incurred after the point of split-off are called Separate Product Costs. Joint Products & Joint Costs

Joint Products Example Separate Processing Separate Processing Final Sale Final Sale Final Sale Joint Input Common Production Process JointCosts Oil Gasoline Chemicals Separate Product Costs Split-OffPoint

Decision: Sell or Process Further? Managers frequently face decisions of whether to sell joint products at split-off or to process some products further. The decision to process further (beyond the split-off point) should be made based on each product’s incremental costs and incremental revenues ONLY! Decision Rule: process further only when the incremental revenue from such processing exceeds the incremental processing cost incurred after the split-off point. Joint costs are irrelevant to the decision. Why?

Cocoa beans costing $500 per ton Joint Production process costing $600 per ton Cocoa butter sales value $750 for 1,500 pounds Cocoa powder sales value $500 for 500 pounds Separate process costing $800 Instant cocoa mix sales value $2,000 for 500 pounds Total joint cost: $1,100 per ton Split-off point Q: Should the cocoa powder be sold now or processed into instant cocoa mix? Practice Problem

Dodd Co. makes 2 joint products with the following data: ProductXY Allocated joint costs$14,000$21,000 Sales value at split-off point--$30,000 Costs of further processing$23,500$16,900 Sales value after further processing$45,500$47,500 Q: (1) what is the profit (loss) from processing Y further? (2) If managers decide to sell 1,000 units of product X at the split-off point, what should be the minimum selling price? Practice Problem

Business investments typically extend over long periods of time and have cash flows that are received in different times. Investments that promise returns earlier in time are preferred to those that promise returns later in time. Capital budgeting is about how managers plan investments in projects that have long-term implications, considering the time value of money. Chapter 14: Capital Budgeting  Screening decisions: whether a proposed project is acceptable or passes a preset hurdle?  Preference decisions: Selecting from among several acceptable alternatives. Two broad categories:

Purpose: Determine the desirable projects to invest after taking into account the time value of money. Popular Method: Discounted-cash-flow (DCF) analysis.  Taking into account the time value of money, will the project’s cash inflows be greater than the cash outflows? In other words, will a project have a positive net present value? Basic tools needed:  PV of one single cash inflow (outflow) in the future  PV of an Annuity (a series of identical cash payments at the end of each period in the future) Screening Decision

Appendix 14A&B: Present Values Present Value of a future dollar amount : If $C will be received in n years and annual interest rate is r, then its present value = C * the PV factor from the table of Exhibit 14B-1. Present Value of an Annuity: If $C will be received at the end of each period for n years and annual interest rate is r, then the present value of this annuity = C * the PV of an annuity factor from the table of Exhibit 14B-2.

Itzak Perlman needs $20,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually? Present Value? Future Value $20,000 Example: Present Value

$20,000 x = $12,710 Future ValueFactorPresent Value Present Value – table approach

Jenny wins $2,000,000 in the state lottery. She will be paid $100,000 at the end of each year for the next 20 years. How much has she actually won? Assume an annual interest rate of 8%. 01 Present Value $100,000100, ,000 Present Value of an Annuity Annuity: A series of identical cash payments made at the end of each period (use Exhibit 14B-2).

$100,000 x = $981,815 ReceiptFactorPresent Value PV of an Annuity – table approach

Practice Problem The Matchless Dating service has made an investment in video & recording equipment that costs $106,700. The equipment is expected to generate cash inflows of $20,000 per year. Q: How many years will the equipment have to be used to earn a 10% rate of return on the investment?  Table: Present Value of an ANNUITY of $1 : periods10%11%12%

DCF Analysis: Two Approaches Net Present Value (NPV) Method Compare PV of all cash inflows with PV of all cash outflows that are associated with the project. If NPV >= 0, accept the project. Otherwise, reject it. Internal Rate of Return (IRR) Method Calculate IRR: the discount rate that sets NPV = 0. Accept the project if IRR >= the required rate of return (cost of capital). Otherwise, reject it.

Net-Present-Value Method Step 1: Determine the cash inflows and outflows for each year of the project. Note: Depreciation is neither cash inflow nor cash outflow! Step 2: Calculate PV of each cash inflow and outflow using the firm’s cost of capital as the discount rate. Step 3: Compute the net present value (PVs of cash inflows minus PVs of cash outflows). Step 4: Accept the project if NPV >= 0 (since it promises a return>=cost of capital, the required rate of return), reject otherwise.

Typical Cash Outflows Repairs and maintenance Incrementaloperatingcosts Initialinvestment WorkingCapital

Typical Cash InflowsReduction of costs Salvagevalue Incrementalrevenues Release of workingCapital (sell off Inventory or collects A/R) or collects A/R)

Practice Problem Mattson Co. has been offered a 5-year contract to provide component parts for a large manufacturer. At the end of 5 years the working capital will be released and may be used elsewhere. Mattson has a hurdle rate of 10%. Q: Should the contract be accepted?.

Practice Problem The Cambro Foundation is planning to invest $104,950 in a project that will last for 3 years. The project will produce net cash inflows of $30,000 in Year 1 and $40,000 in Year 2. Q: What is the expected net cash inflow in Year 3 if the project yields exactly a 12% rate of return?

Internal Rate of Return Method The internal rate of return (IRR) is the interest yield promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero. Investment required Net annual cash inflow PV of Annuity Factor of the IRR = Decision Rule: Accept the project if IRR >= the required rate of return (cost of capital acts as the hurdle rate). Otherwise, reject it. It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return.

IRR: Example Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. Decker’s required rate of return is 12%. The machine has a 10-year life. The IRR is calculated as follows: $104, 320 $20,000 = Check PV of annuity table, with n=10, factor=5.216, the corresponding discount rate, i.e., IRR = 14% > 12% Investment required Net annual cash inflow PV of Annuity Factor of the IRR = =

Practice Problem  The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project?  Table: Present Value of an ANNUITY of $1 :

Comparing the NPV and IRR Methods  Both consider time value of money.  NPV is often simpler to use.  Different assumptions:  IRR method assumes cash inflows are reinvested at the internal rate of return, which is unrealistic especially when IRR is high.  NPV method assumes cash inflows are reinvested at a rate of return equal to the company’s cost of capital, which is more realistic, because such a rate of return can be realized by paying off the creditors and buying back stocks with cash flows from the project.

For Next Class  Continue on Chapter 14.  Attempt the assigned homework problem.

Homework Problem Denny Associates has been offered a 4-year contract to supply the computing requirements for a local bank. The working capital would be released at the end of the contract. Denny Associates requires a 14% return. Q: What is the NPV of the contract?