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CAPITAL BUDGETING

Outcome is uncertain. Large amounts of money are usually involved. Decision may be difficult or impossible to reverse. Investment involves a long-term commitment. CAPITAL BUDGETING. C 1.

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CAPITAL BUDGETING

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  1. Outcomeis uncertain. • Large amounts ofmoney are usuallyinvolved. • Decision may bedifficult or impossibleto reverse. • Investment involves along-term commitment. CAPITAL BUDGETING C 1 Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell.

  2. PAYBACK PERIOD P 1 The payback period of an investmentis the time expected to recoverthe initial investment amount. Managers prefer investing in projects with shorter payback periods.

  3. Payback period Cost of Investment Annual Net Cash Flow = Payback period $16,000 $4,100 = = 3.9 years COMPUTING PAYBACK PERIODWITH EVEN CASH FLOWS P 1 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 flowsof $4,100. The machine is expected to have an 8-year useful life with no salvage value. Calculate the payback period.

  4. $5,000 $4,100 COMPUTING PAYBACK PERIODWITH UNEVEN CASH FLOWS P 1 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.

  5. 4.2 PAYBACK PERIOD WITHUNEVEN CASH FLOWS P 1 We recover the $16,000 purchase price between years 4 and 5, about4.2 years for the payback period. 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:

  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?

  7. Accounting Annual after-tax net incomerate of return Annual average investment Accounting $2,100rate of return $8,000 = = = 26.25% ACCOUNTING RATE OF RETURN P 2 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute theaccounting rate of return. The accounting rate of return focuses onannual income instead of cash flows. Beginning book value + Ending book value2 $16,000 + $02

  8. Depreciation may be calculated several ways. Income may vary from year to year. Time value ofmoney is ignored. ACCOUNTING RATE OF RETURN So why would I ever want to use this method anyway?

  9. NET PRESENT VALUE P 3 • 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. Now let’s look at a capital budgetingmodel that considers the timevalue of 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.

  10. NET PRESENT VALUEWITH EQUAL CASH FLOWS P 3 Present value factorsfor 12 percent A positive net present value indicates that thisproject earns more than 12 percent on the investment.

  11. NET PRESENT VALUE DECISION RULE P 3

  12. NET PRESENT VALUEWITH UNEVEN CASH FLOWS P 3 Although all projects require the same investment and havethe same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1.

  13. Presentvalue ofcash inflows Presentvalue ofcash outflows = INTERNAL RATE OF RETURN (IRR) P 4 The interest rate that makes . . . • The net present value equal zero.

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

  15. INTERNAL RATE OF RETURN (IRR) P 4 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.40 2. Using present value of annuitytable . . . IRR isapproximately12%. In that row,locate theinterest factorclosest inamount to thepresent valuefactor. IRR is theinterest rateof the columnin which thepresent valuefactor is found. Locate the rowwhose numberequals the periods in theproject’s life.

  16. INTERNAL RATE OF RETURN (IRR) P 4 Uneven Cash Flows If cash inflows are unequal, trial and error solutionwill result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. 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.

  17. C 2

  18. DECISION MAKING C 3 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.

  19. 1 2 RELEVANT COSTS C 3 • Costs that are applicableto a particular decision. • Costs that should have a bearing on which alternative a manager selects. • Costs that are avoidable. • Future costs that differbetween alternatives.

  20. RELEVANT COSTS C 3 Sunk costs are the result of past decisions andcannot be changed by any current or future decisions.Sunk costs are irrelevant to current or future decisions. Out- of-pocket costs are future outlaysof 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.

  21. ACCEPTING ADDITIONAL BUSINESS A 1 The decision to accept additional business should be based on incremental costsand incremental revenues. Incremental amounts are those that occur if the company decides to acceptthe new business. FasTrac currently sells 100,000 units of its product.The company has revenue and costs as shown.

  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?

  23. ACCEPTING ADDITIONAL BUSINESS A 1 First let’s look at incorrect reasoningthat leads to an incorrect decision. Our cost is $9.00per unit. I can’t sell for $8.50 per unit.

  24. ACCEPTING ADDITIONAL BUSINESS A 1 This analysis leads to the correct decision. Even though the $8.50 selling price is less than the normal $10 selling price, FasTrac should accept theoffer because net income will increase by $20,000. 10,000 new units × $8.50 selling price = $85,000 10,000 new units × $2.20 = $22,000 10,000 new units × $3.50 = $35,000

  25. MAKE OR BUY DECISIONS A 1 • Incrementalcosts 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 notuse the predetermined overhead rate to determine product cost.

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

  27. MAKE OR BUY DECISIONS A 1 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? We must eliminate $.25 per unit of overhead,leaving a maximum of $0.25 per unit.

  28. SCRAP OR REWORK A 1 Costs incurred in manufacturing units of product that do not meet quality standards are sunk costsand cannot be recovered. As long as rework costsare recovered through sale of the product, and reworkdoes not interfere with normal production,we should rework rather than scrap.

  29. SCRAP OR REWORK A 1 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?

  30. SCRAP OR REWORK A 1 FasTrac should scrap the units now. 10,000 units × $0.80 per unit If FasTrac fails to include the opportunity cost,the rework option would show a return of $7,000,mistakenly making rework appear more favorable. 10,000 units × $0.40 per unit 10,000 units × ($1.50 - $1.00) per unit 10,000 units × $1.50 per unit

  31. SELL OR PROCESS A 1 • 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. 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:

  32. SELL OR PROCESS A 1 Should FasTrac sell product Q or continueprocessing into products X, Y, and Z? FasTrac should continue processing. The earlier $30,000 costfor product Q is sunk and therefore irrelevant to the decision.

  33. 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, Thefacilitiesrequired to produce each product and any constraints on the facilities, and The demand for each product. SALES MIX SELECTION A 1

  34. SALES MIX SELECTION A 1 Consider the following data for twoproducts made and sold by FasTrac. If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B. Product B has a greater contribution margin than Product A, but it requires more machine hours per unit to produce. If each product requires the same time tomake, and the demand is unlimited, FasTracshould produce only Product B. Withunlimited demandfor A and B, produce as many units ofA as possible since A provides more dollars per hour worked. Consider this additional information.

  35. SEGMENT ELIMINATION A 1 A segment is a candidate for elimination if its revenues are less than itsavoidableexpenses. FasTrac is considering eliminating its TreadmillDivision because total expenses of $48,300 aregreater than its sales of $47,800.

  36. SEGMENT ELIMINATION A 1 Let’s identifyavoidable expenses.

  37. Do not eliminatethe Treadmill Division! SEGMENT ELIMINATION A 1

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