1. McGraw-Hill/Irwin 25-1 © The McGraw-Hill Companies, Inc., 2005 Capital Budgeting and Managerial Decisions Chapter 25

2. McGraw-Hill/Irwin 25-2 © The McGraw-Hill Companies, Inc., 2005 1.Capital Budgeting  Method Not using Time Value of Money  Method using Time Value of Money 2.Managerial Decision  Decision and Information  Managerial Decision Scenarios 3.Decision Analysis  Break-Even Time Learning objectives Exh. 25-5,6

3. McGraw-Hill/Irwin 25-3 © The McGraw-Hill Companies, Inc., 2005 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. 1.Capital Budgeting - Risks of Capital Budgeting

4. McGraw-Hill/Irwin 25-4 © The McGraw-Hill Companies, Inc., 2005 Payback period = Cost of Investment Annual Net Cash Flow Method Not using Time Value of Money - 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. Exh. 25-2

5. McGraw-Hill/Irwin 25-5 © The McGraw-Hill Companies, Inc., 2005 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. Payback period = Cost of Investment Annual Net Cash Flow Payback period = $16,000 $4,100 = 3.9 years Payback Period with Even Cash Flows

6. McGraw-Hill/Irwin 25-6 © The McGraw-Hill Companies, Inc., 2005 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. $4,100 $5,000 Payback Period with Uneven Cash Flows

7. McGraw-Hill/Irwin 25-7 © The McGraw-Hill Companies, Inc., 2005 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 Exh. 25-3

8. McGraw-Hill/Irwin 25-8 © The McGraw-Hill Companies, Inc., 2005 4.2 We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period. Payback Period with Uneven Cash Flows Exh. 25-3

9. McGraw-Hill/Irwin 25-9 © The McGraw-Hill Companies, Inc., 2005 Ignores the time value of money. Ignores cash flows after the payback period. Unacceptable for projects with long lives where time value of money effects are major. Using the Payback Period

10. McGraw-Hill/Irwin 25-10 © The McGraw-Hill Companies, Inc., 2005 Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period? Using the Payback Period

11. McGraw-Hill/Irwin 25-11 © The McGraw-Hill Companies, Inc., 2005 The accounting rate of return focuses on annual income instead of cash flows. Method Not using Time Value of Money - Accounting Rate of Return Accounting Annual after-tax net income rate of return Annual average investment = Beginning book value + Ending book value 2 Exh. 25-5,6

12. McGraw-Hill/Irwin 25-12 © The McGraw-Hill Companies, Inc., 2005 Accounting Annual after-tax net income rate of return Annual average investment = Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return. Beginning book value + Ending book value 2 Accounting Rate of Return Exh. 25-5,6

13. McGraw-Hill/Irwin 25-13 © The McGraw-Hill Companies, Inc., 2005 Accounting Annual after-tax net income rate of return Annual average investment = 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 Rate of Return Beginning book value + Ending book value 2 Exh. 25-5,6

14. McGraw-Hill/Irwin 25-14 © The McGraw-Hill Companies, Inc., 2005 Accounting $2,100 rate of return $8,000 == 26.25% $16,000 + $0 2 Accounting Rate of Return Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return. Exh. 25-5,6

15. McGraw-Hill/Irwin 25-15 © The McGraw-Hill Companies, Inc., 2005 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? Using Accounting Rate of Return

16. McGraw-Hill/Irwin 25-16 © The McGraw-Hill Companies, Inc., 2005 Future value of $100 today compounded for 5 years at 10 percent. Today 12 34 Future FV = $161 $100 Compound at 10% $110$121$133$146 × 1.1 Method using Time Value of Money - Time Value of Money

17. McGraw-Hill/Irwin 25-17 © The McGraw-Hill Companies, Inc., 2005 Present value of $100 paid in 5 years discounted at 10 percent. Today1 234Future PV = $62.1 $100 Discount at 10% 90.982.675.168.3 ÷1.1 Method using Time Value of Money - Present Value

18. McGraw-Hill/Irwin 25-18 © The McGraw-Hill Companies, Inc., 2005 Method using Time Value of Money - Present Value Table Periods 6% 8% 10% 12% 25 0.2330 0.14600.0923 0.0588 30 0.1741 0.0994 0.0573 0.0334 35 0.1301 0.06760.0356 0.0189 PV = $1,000 X 0.0994 = $99.4 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)

19. McGraw-Hill/Irwin 25-19 © The McGraw-Hill Companies, Inc., 2005 Now let’s look at a capital budgeting model that considers the time value of cash flows. Method using Time Value of Money - Net Present Value

20. McGraw-Hill/Irwin 25-20 © The McGraw-Hill Companies, Inc., 2005  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. Net Present Value

21. McGraw-Hill/Irwin 25-21 © The McGraw-Hill Companies, Inc., 2005 Net Present Value with Even Cash Flows Exh. 26-7

22. McGraw-Hill/Irwin 25-22 © The McGraw-Hill Companies, Inc., 2005 Present value factors for 12 percent Net Present Value with Even Cash Flows Exh. 26-7

23. McGraw-Hill/Irwin 25-23 © The McGraw-Hill Companies, Inc., 2005 A positive net present value indicates that this project earns more than 12 percent on the investment. Net Present Value with Even Cash Flows Exh. 26-7

24. McGraw-Hill/Irwin 25-24 © The McGraw-Hill Companies, Inc., 2005 General decision rule... Using Net Present Value

25. McGraw-Hill/Irwin 25-25 © The McGraw-Hill Companies, Inc., 2005 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 Exh. 26-8

26. McGraw-Hill/Irwin 25-26 © The McGraw-Hill Companies, Inc., 2005 Method using Time Value of Money - 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.

27. McGraw-Hill/Irwin 25-27 © The McGraw-Hill Companies, Inc., 2005 Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor. 2.Using present value of annuity table... Internal Rate of Return (IRR) Exh. 26-9

28. McGraw-Hill/Irwin 25-28 © The McGraw-Hill Companies, Inc., 2005 1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... Projects with even annual cash flows Internal Rate of Return (IRR) Exh. 26-9 Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project.

29. McGraw-Hill/Irwin 25-29 © The McGraw-Hill Companies, Inc., 2005 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 = 2.4000 2.Using present value of annuity table... Internal Rate of Return (IRR) Exh. 26-9

30. McGraw-Hill/Irwin 25-30 © The McGraw-Hill Companies, Inc., 2005 In that row, locate the interest factor closest in amount to the present value factor. 1.Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... Internal Rate of Return (IRR) Exh. 26-9

31. McGraw-Hill/Irwin 25-31 © The McGraw-Hill Companies, Inc., 2005 1.Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... IRR is the interest rate of the column in which the present value factor is found. IRR is approximately 12%. Internal Rate of Return (IRR) Exh. 26-9

32. McGraw-Hill/Irwin 25-32 © The McGraw-Hill Companies, Inc., 2005 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. Internal Rate of Return – Uneven Cash Flows

33. McGraw-Hill/Irwin 25-33 © The McGraw-Hill Companies, Inc., 2005 Internal Rate of Return l Compare the internal rate of return on a project to a predetermined hurdle rate (cost of capital). l To be acceptable, a project’s rate of return cannot be less than the cost of capital. Using Internal Rate of Return

34. McGraw-Hill/Irwin 25-34 © The McGraw-Hill Companies, Inc., 2005 Exh. 25-10 Comparing Methods

35. McGraw-Hill/Irwin 25-35 © The McGraw-Hill Companies, Inc., 2005 Let’s change topics. 2. Managerial Decisions

36. McGraw-Hill/Irwin 25-36 © The McGraw-Hill Companies, Inc., 2005 Decision making involves five steps:  Define the problem.  Identify alternatives.  Collect relevant information on alternatives.  Select the preferred alternative.  Analyze decisions made. Decision and Information - Decision Making Exh. 25-11

37. McGraw-Hill/Irwin 25-37 © The McGraw-Hill Companies, Inc., 2005 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 Decision and Information - Relevant Costs

38. McGraw-Hill/Irwin 25-38 © The McGraw-Hill Companies, Inc., 2005 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. 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. Classification by Relevance: Sunk Costs Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

39. McGraw-Hill/Irwin 25-39 © The McGraw-Hill Companies, Inc., 2005 Future outlays of cash associated with a particular decision. 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. Classification by Relevance: Out-of-Pocket Costs

40. McGraw-Hill/Irwin 25-40 © The McGraw-Hill Companies, Inc., 2005 The potential benefit that is given up when one alternative is selected over another. 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. Classification by Relevance: Opportunity Costs

41. McGraw-Hill/Irwin 25-41 © The McGraw-Hill Companies, Inc., 2005 We will now examine several different types of managerial decisions. 2. Managerial Decisions - Managerial Decision Tasks

42. McGraw-Hill/Irwin 25-42 © The McGraw-Hill Companies, Inc., 2005 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. Managerial Decision Tasks - Accepting Additional Business

43. McGraw-Hill/Irwin 25-43 © The McGraw-Hill Companies, Inc., 2005 FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below: Accepting Additional Business Exh. 25-12

44. McGraw-Hill/Irwin 25-44 © The McGraw-Hill Companies, Inc., 2005 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? Accepting Additional Business

45. McGraw-Hill/Irwin 25-45 © The McGraw-Hill Companies, Inc., 2005 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

46. McGraw-Hill/Irwin 25-46 © The McGraw-Hill Companies, Inc., 2005 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.

47. McGraw-Hill/Irwin 25-47 © The McGraw-Hill Companies, Inc., 2005 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. Accepting Additional Business Exh. 25-14

48. McGraw-Hill/Irwin 25-48 © The McGraw-Hill Companies, Inc., 2005 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. Managerial Decision Tasks - Make or Buy Decisions

49. McGraw-Hill/Irwin 25-49 © The McGraw-Hill Companies, Inc., 2005 FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost: Make or Buy Decisions

50. McGraw-Hill/Irwin 25-50 © The McGraw-Hill Companies, Inc., 2005 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? Make or Buy Decisions Exh. 25-15

51. McGraw-Hill/Irwin 25-51 © The McGraw-Hill Companies, Inc., 2005 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. Make or Buy Decisions Exh. 25-15

52. McGraw-Hill/Irwin 25-52 © The McGraw-Hill Companies, Inc., 2005 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. McGraw-Hill/Irwin 25-53 © The McGraw-Hill Companies, Inc., 2005 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. Managerial Decision Tasks - Scrap or Rework

54. McGraw-Hill/Irwin 25-54 © The McGraw-Hill Companies, Inc., 2005 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? Scrap or Rework

55. McGraw-Hill/Irwin 25-55 © The McGraw-Hill Companies, Inc., 2005 10,000 units × $0.80 per unit 10,000 units × ($1.50 - $1.00) per unit Scrap or Rework Exh. 25-16 If FasTrac fails to include the opportunity cost, the rework option would show a return of $7,000, mistakenly making rework appear more favorable.

56. McGraw-Hill/Irwin 25-56 © The McGraw-Hill Companies, Inc., 2005 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. Managerial Decision Tasks - Sell or Process

57. McGraw-Hill/Irwin 25-57 © The McGraw-Hill Companies, Inc., 2005 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 Sell or Process

58. McGraw-Hill/Irwin 25-58 © The McGraw-Hill Companies, Inc., 2005 Should FasTrac sell product Q or continue processing into products X, Y, and Z? Sell or Process Exh. 25-17

59. McGraw-Hill/Irwin 25-59 © The McGraw-Hill Companies, Inc., 2005 FasTrac should continue processing. Note that the earlier $30,000 cost for product Q is sunk and therefore irrelevant to the decision. Sell or Process Should FasTrac sell product Q or continue processing into products X, Y, and Z? 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

60. McGraw-Hill/Irwin 25-60 © The McGraw-Hill Companies, Inc., 2005 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 Managerial Decision Tasks - Sales Mix Selection

61. McGraw-Hill/Irwin 25-61 © The McGraw-Hill Companies, Inc., 2005 Consider the following data for two products made and sold by FasTrac. If each product requires the same time to make, and the demand is unlimited, FasTrac should produce only Product B. Sales Mix Selection Exh. 25-19

62. McGraw-Hill/Irwin 25-62 © The McGraw-Hill Companies, Inc., 2005 Consider this additional information. Consider the following data for two products made and sold by FasTrac. Sales Mix Selection Exh. 25-19

63. McGraw-Hill/Irwin 25-63 © The McGraw-Hill Companies, Inc., 2005 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. Sales Mix Selection Exh. 25-19

64. McGraw-Hill/Irwin 25-64 © The McGraw-Hill Companies, Inc., 2005 If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B. Consider the following data for two products made and sold by FasTrac. Sales Mix Selection Exh. 25-19

65. McGraw-Hill/Irwin 25-65 © The McGraw-Hill Companies, Inc., 2005 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. Continue Managerial Decision Tasks - Segment Elimination

66. McGraw-Hill/Irwin 25-66 © The McGraw-Hill Companies, Inc., 2005 Let’s identify avoidable expenses. Analysis of Divisional Operating Expenses Exh. 25-20

67. McGraw-Hill/Irwin 25-67 © The McGraw-Hill Companies, Inc., 2005 Analysis of Divisional Operating Expenses Exh. 25-20

68. McGraw-Hill/Irwin 25-68 © The McGraw-Hill Companies, Inc., 2005 Do not eliminate the Treadmill Division! Segment Elimination

69. McGraw-Hill/Irwin 25-69 © The McGraw-Hill Companies, Inc., 2005 Qualitative factors are involved in most all managerial decisions. For example: Quality. Delivery schedule. Supplier reputation. Employee morale. Customer opinions. Managerial Decision Tasks - Qualitative Factors in Decisions

70. McGraw-Hill/Irwin 25-70 © The McGraw-Hill Companies, Inc., 2005 Break-even time incorporates time value of money into the payback period method of evaluating capital investments. 3. Decision Analysis - Break-Even Time

71. McGraw-Hill/Irwin 25-71 © The McGraw-Hill Companies, Inc., 2005 End of Chapter 25