1. Copyright © 2007 Prentice-Hall. All rights reserved 1 Special Business Decisions and Capital Budgeting Chapter 25

2. Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Identify the relevant information for a special business decision

3. Copyright © 2007 Prentice-Hall. All rights reserved 3 Relevant Information Affects the future …and… Differs among alternative courses of action

4. Copyright © 2007 Prentice-Hall. All rights reserved 4 Objective 2 Make five types of short-term special decisions

5. Copyright © 2007 Prentice-Hall. All rights reserved 5 Relevant Information Approach (Incremental Approach) Special sales orders Dropping a business segment Product mix Outsourcing - make or buy Selling as-is or processing further

6. Copyright © 2007 Prentice-Hall. All rights reserved 6 Two Keys Focus on relevant revenues, costs, and profits Use contribution margin approach –Variable costs –Fixed costs

7. Copyright © 2007 Prentice-Hall. All rights reserved 7 Special Sales Order DECISION RULE: Accept special order? Is increase in revenues > increase in variable and fixed costs? Accept the special order Is increase in revenues < increase in variable and fixed costs? Reject the special order

8. Copyright © 2007 Prentice-Hall. All rights reserved 8 E25-16 (1) FreeStyle Incremental Analysis of Special Sales Order Expected increase in revenues (5,000 bags  $3.00)$ 15,000 Expected increase in expenses: Variable manufacturing cost: (5,000  $2.75)(13,750) Expected increase in operating income$ 1,250 Fixed costs would be incurred whether you accept the offer or not. It is not a relevant cost in this case Decision: Accept the special sales order Fixed costs would be incurred whether you accept the offer or not. It is not a relevant cost in this case Decision: Accept the special sales order

9. Copyright © 2007 Prentice-Hall. All rights reserved 9 E25-16 (2) FreeStyle Incremental Analysis of Special Sales Order Expected increase in revenues (5,000 bags  $3.00)$ 15,000 Expected increase in expenses: Variable manufacturing cost: (5,000  $3.15)(15,750) Expected decrease in operating income$ (750) This will lower overall profits…reject the order

10. Copyright © 2007 Prentice-Hall. All rights reserved 10 Dropping A Business Segment, Products, Departments, or Territories DECISION RULE: Drop a business segment? Are lost revenues > its relevant costs? Keep the segment Are lost revenues < its relevant costs? Eliminate the segment

11. Copyright © 2007 Prentice-Hall. All rights reserved 11 E25-16 (1) CalPaks Incremental Analysis of Dropping Rolling Backpacks Line Expected decrease in revenues$ (120,000) Expected decrease in expenses: Variable costs90,000 Expected decrease in operating income$(30,000) Decision: Do not drop the line. It is incorrect to conclude that dropping rolling backpacks would add $40,000 to operating income. This incorrect conclusion ignores the nature of fixed expenses. If the company drops the rolling backpacks product line, it will still incur the $70,000 ($55,000 + $15,000) of fixed expenses allocated to rolling backpacks Decision: Do not drop the line. It is incorrect to conclude that dropping rolling backpacks would add $40,000 to operating income. This incorrect conclusion ignores the nature of fixed expenses. If the company drops the rolling backpacks product line, it will still incur the $70,000 ($55,000 + $15,000) of fixed expenses allocated to rolling backpacks

12. Copyright © 2007 Prentice-Hall. All rights reserved 12 Product Mix DECISION RULE: Which product to emphasize? Emphasize the product with the highest contribution margin per constrained resource If there are factors that are limiting the company output, you need to determine how to best utilize the limited resource (constraint) to achieve the highest profits. Constraints might be labor hours or raw materials available, amount of display space. If a company manufactures two or more products, it must decide which products to manufacture first 1. Compute contribution margin per unit for each product 2. Compute contribution margin per constrained resource If there are factors that are limiting the company output, you need to determine how to best utilize the limited resource (constraint) to achieve the highest profits. Constraints might be labor hours or raw materials available, amount of display space. If a company manufactures two or more products, it must decide which products to manufacture first 1. Compute contribution margin per unit for each product 2. Compute contribution margin per constrained resource

13. Copyright © 2007 Prentice-Hall. All rights reserved 13 E25-20E25-20 Designer Moderate Contribution margin per unit$115.00$60.00 Units displayed per sq ft. 300/10,000 x.030 700/10,000 x.070 Contribution margin per sq ft of display space$3.45$4.20 Capacity – sq ft of display space x10,000 x10,000 Total contribution margin at capacity $34,500 $42,200 What is the constraint in this exercise? Floor space Decision: Emphasize moderately priced items

14. Copyright © 2007 Prentice-Hall. All rights reserved 14 Outsourcing (Make or Buy) DECISION RULE: Make a product in- house or buy from outside company? Are relevant costs to make > relevant costs to buy? Buy Are relevant costs to make < relevant costs to buy? Make

15. Copyright © 2007 Prentice-Hall. All rights reserved 15 E25-21E25-21 Make Buy Difference Incremental cost per unit: Direct materials$18$0$18 Direct labor606 Variable overhead303 Purchase price $38(38) Incremental cost per unit$27$38$(11) Decision: Make the snowboards

16. Copyright © 2007 Prentice-Hall. All rights reserved 16 E25-22E25-22 Make Incremental cost per unit:$27 Number of snowboards10,000 Total incremental costs$27,000 Buy and leave facilities idle Incremental cost per unit:$38 Number of snowboards10,000 Total incremental costs$38,000

17. Copyright © 2007 Prentice-Hall. All rights reserved 17 E25-22E25-22 Buy and use facilities for other product Incremental cost per unit:$38 Number of snowboards10,000 Total incremental costs to buy$38,000 Expected profit contribution from other product(30,000) Expected net cost$8,000 Decision: Outsource the snowboards and use the facilities to manufacture the other product

18. Copyright © 2007 Prentice-Hall. All rights reserved 18 Sell As-Is or Process Further DECISION RULE: Sell as is or process further? Are extra revenues from processing further > extra cost to process further? Process further Are extra revenues from processing further < extra cost to process further? Sell as is

19. Copyright © 2007 Prentice-Hall. All rights reserved 19 E25-23E25-23 Process Sell As IsFurther Expected revenue$2,500$3,100 Expected additional costs -0-(500) Expected net revenue$2,500$2,600 Decision: Process further. The advantage to processing further by repairing the damage is $100 ($2,600 – $2,500)

20. Copyright © 2007 Prentice-Hall. All rights reserved 20 Short-term vs Long-term Decisions Short-term Many costs are fixed No need to consider the time value of money Long-term Few costs are fixed Need to consider time value of money

21. Copyright © 2007 Prentice-Hall. All rights reserved 21 Objective 3 Use payback and accounting rate of return to make longer-term capital budgeting decisions

22. Copyright © 2007 Prentice-Hall. All rights reserved 22 Capital Budgeting Budgeting for the acquisition of “capital assets” - assets used over a long time (several years) Capital budgeting models (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return

23. Copyright © 2007 Prentice-Hall. All rights reserved 23 Payback Period Time period required to recover in net cash receipts the dollars of the investment Amount invested in the asset Expected annual net cash receipts

24. Copyright © 2007 Prentice-Hall. All rights reserved 24 Payback Period DECISION RULE: Payback Period Invest only if payback is shorter than the assets’ useful life Investments with shorter payback periods are more desirable, all else being equal

25. Copyright © 2007 Prentice-Hall. All rights reserved 25 E25-24E25-24 Amount invested Expected annual net cash inflow $120,000 $25,000 = 4.8 years Decision: Payback occurs before the machine must be replaced. This supports purchasing the asset

26. Copyright © 2007 Prentice-Hall. All rights reserved 26 Payback Period Pros –Easy to use –Used to eliminate proposals that are too risky Cons –Ignores profitability

27. Copyright © 2007 Prentice-Hall. All rights reserved 27 Accounting Rate of Return Average annual operating income from asset Average amount invested in asset Average amount invested in asset = Original Investment + Residual Value 2 Note: ARR uses operating income (revenues – operating expenses). If you are given annual cash flows, you must subtract deprecation expense to get operating income

28. Copyright © 2007 Prentice-Hall. All rights reserved 28 Accounting Rate of Return Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk

29. Copyright © 2007 Prentice-Hall. All rights reserved 29 Accounting Rate of Return DECISION RULE: Invest in capital assets? Is expected accounting rate of return > the required rate of return? Invest Is expected accounting rate of return > the required rate of return? Do not invest

30. Copyright © 2007 Prentice-Hall. All rights reserved 30 E25-25E25-25 Ward 250,000 (1,000,000 + 0)/2 50% Vargas 240,500 (1,200,000+100,000)/2 37% Decision: Ward equipment offers the higher accounting rate of return

31. Copyright © 2007 Prentice-Hall. All rights reserved 31 Objective 4 Use discounted cash flow models to make longer-term capital budgeting decisions

32. Copyright © 2007 Prentice-Hall. All rights reserved 32 Discounted Cash Flows Models Recognize time value of money Two methods –Net present value –Internal rate of return

33. Copyright © 2007 Prentice-Hall. All rights reserved 33 Net Present Value Method Discount cash inflows to their present value and then compare with capital outlay required by the investment Discount rate (hurdle rate or required rate of return) - required minimum rate of return given riskiness of investment Proposal is acceptable when NPV is ≥ zero The higher the NPV, the more attractive the investment

34. Copyright © 2007 Prentice-Hall. All rights reserved 34 Net Present Value DECISION RULE: Invest in capital assets? Is NPV positive? Invest Is NPV negative? Do not invest

35. Copyright © 2007 Prentice-Hall. All rights reserved 35 E25-26E25-26 Cash Flow When?Type of cash flow PV factor 14% PV Project A NPV (275,000) Now 55,000Yrs 1-8Annuity4.639255,145 $(19,855) Since NPV is negative, this is not an acceptable investment. The maximum acceptable price is $255,145

36. Copyright © 2007 Prentice-Hall. All rights reserved 36 Cash Flow When?Type of cash flow PV factor 14% PV Project B NPV E25-26E25-26 (380,000) Now 72,000Yrs 1-9Annuity5.328383,616 $3,616 Since NPV is positive, this is an acceptable investment. The maximum acceptable price if $380,000

37. Copyright © 2007 Prentice-Hall. All rights reserved 37 Net Present Value When annual cash inflows are unequal you must use the present value of one table applied to each annual cash inflow

38. Copyright © 2007 Prentice-Hall. All rights reserved 38 Internal Rate of Return Rate of return a company can expect to earn by investing in the project The discount rate that will cause the present value to equal zero

39. Copyright © 2007 Prentice-Hall. All rights reserved 39 Internal Rate of Return Step 1: Identify the expected net cash receipts Step 2: Find the discount rate that makes total present value of net cash receipts = present value of cash outflows Annuity PV factor = Investment ÷ Annual Net Cash Receipts

40. Copyright © 2007 Prentice-Hall. All rights reserved 40 Internal Rate of Return Step 3: On the present value of an annuity of $1 table, scan the row corresponding to the expected life Choose column closest to annuity factor you calculated in Step 2

41. Copyright © 2007 Prentice-Hall. All rights reserved 41 Internal Rate of Return DECISION RULE: Invest in capital assets? Does the IRR exceed the required rate of return? Invest Is the IRR less than the required rate of return? Do not invest

42. Copyright © 2007 Prentice-Hall. All rights reserved 42 E25-27E25-27 Project A: PVAo = Rent x Factor 275,000 = 55,000 x Factor 5.0000 = Factor Close to 12%

43. Copyright © 2007 Prentice-Hall. All rights reserved 43 E25-27E25-27 Project B: PVAo = Rent X Factor 380,000=72,000xFactor 5.2777 = Factor Between 12 and 14% Decision: Project B is better because it has a higher IRR

44. Copyright © 2007 Prentice-Hall. All rights reserved 44 Objective 5 Compare and contrast the four capital budgeting methods

45. Copyright © 2007 Prentice-Hall. All rights reserved 45 Comparison of Capital Budgeting Models MethodStrengthsWeaknesses PaybackEasy to understand Based on cash flows Highlights risks Ignores profitability and the time value of money ARRBased on profitability Ignores time value of money NPV & IRR Based on cash flows, profitability & time value of money Difficult to determine discount rate

46. Copyright © 2007 Prentice-Hall. All rights reserved 46 End of Chapter 25