Accounting Principles, 7th Edition Weygandt • Kieso • Kimmel Chapter 27 Incremental Analysis and Capital Budgeting Prepared by Naomi Karolinski Monroe Community College and Marianne Bradford Bryant College CHAPTER 27 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING After studying this chapter, you should be able to: Identify the steps in management’s decision-making process Describe the concept of incremental analysis Identify the relevant costs in accepting an order at a special price Identify the relevant costs in a make-or-buy decision Give the decision rule for whether to sell or process materials further Identify the factors to be considered in retaining or replacing equipment CHAPTER 27 INCREMENTAL ANALYSIS AND CAPITAL BUDGETING After studying this chapter, you should be able to: Explain the relevant factors in deciding whether to eliminate an unprofitable segment Determine which products to make and sell when a company’s resources are limited 10 Contrast the annual rate of return and cash payback techniques in capital budgeting Distinguish between the net present value and internal rate of return methods Management’s DecisionMaking Process Study Objective Management's decision-making process frequently involves the following steps: 1) Identify the problem and assign responsibility 2) Determine and evaluate possible courses of action 3) Make a decision 4) Review results of the decision Incremental Analysis Study Objective • Business decisions involve a choice among alternative courses of action • In making such decisions, management ordinarily considers both financial and nonfinancial information • The process used to identify the financial data that change under alternative courses of action is called incremental analysis Incremental Analysis • Incremental analysis includes the probable effects of the decision on future earnings • Data for incremental analysis involves estimates and uncertainty • Gathering data may involve market analysts, engineers, and accountants • In incremental analysis, both costs and revenues may change However, in some cases: – – (1) variable costs may not change under the alternative courses of action, and (2) fixed costs change Basic Approach in Incremental Analysis The basic approach in incremental analysis is illustrated in the following example: $(15,000) 20,000 $ 5,000 In this example, alternative B is being compared with alternative A The net income column shows the differences between the alternatives Alternative B will produce $5,000 more net income than alternative A Types of Incremental Analysis A number of different types of decisions involve incremental analysis The more common types of decisions are whether to: 1) Accept an order at a special price 2) Make or buy 3) Sell or process further 4) Retain or replace equipment 5) Eliminate an unprofitable business segment 6) Allocate limited resources Accept an Order at a Special Price Study Objective • Sometimes, a company may have an opportunity to obtain additional business if it is willing to make major price concessions to a specific customer • An order at a special price should be accepted when the incremental revenue from the order exceeds the incremental costs • It is assumed that sales in other markets will not be affected by the special order • If the units can be produced within existing plant capacity, generally only variable costs will be affected Accept an Order at a Special Price To illustrate, assume that Sunbelt Company produces 100,000 automatic blenders per month, which is 80% of plant capacity Variable manufacturing costs are $8 per unit, and fixed manufacturing costs are $400,000, or $4 per unit The blenders are normally sold to retailers at $20 each PROBLEM: Sunbelt has an offer from Mexico Co to purchase an additional 2,000 blenders at $11 per unit Acceptance of this offer would not affect normal sales of the product, and the additional units can be manufactured without increasing plant capacity Discounted Cash Flow Study Objective 10 • The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions • This technique considers both the estimated total cash inflows and the time value of money • Two methods are used with the discounted cash flow technique: 1) net present value and 2) internal rate of return Net Present Value Method • Under the net present value method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment • The interest rate used in discounting the future cash inflows is the required minimum rate of return • A proposal is acceptable when NPV is zero or positive • The higher the positive NPV, the more attractive the investment Net Present Value Decision Criteria Present Value of Annual Cash Inflows-Equal Annual cash Flows Tappan Company’s annual cash inflows are $26,000 If we assume this amount is uniform over the asset’s useful life, the present value of the annual cash inflows can be computed by using the present value of an annuity of for 10 periods The computations at rates of return of 12% and 15%, respectively are: $146,906 $130,488 Computation of Net Present Values The analysis of the proposal by the net present value method is as follows: Positive (negative) net present value $16,906 $488 The proposed capital expenditure is acceptable at a required rate of return of both 12% and 15% because the net present values are positive Present Value of Annual Cash Inflowsunequal Annual Cash Flows When annual cash inflows are unequal, we cannot use annuity tables to calculate their present value Instead tables showing the present value of a single future amount must be applied to each annual cash inflow $260,000 $155,667 $140,061 Analysis of Proposal Using Net Present Value Method Therefore, the analysis of the proposal by the net present value method is as follows: Positive (negative) net present value $ 25,667 $10,061 In this example, the present values of the cash inflows are greater than the $130,000 capital investment Thus the project is acceptable at both a 12% and 15% required rate of return Formula for Internal Rate of Return Factor • The internal rate of return method finds the interest yield of the potential investment • This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows • Determining the true interest rate involves two steps: STEP 1.Compute the internal rate of return factor using this formula: Internal Rate of Return Method The computation for the Tappan Company, assuming equal annual cash inflows is: $130,000 / $26,000 = 5.0 Internal Rate of Return Method STEP Use the factor and the present value of an annuity of table to find the internal rate of return • The internal rate of return is found by locating the discount factor that is closest to the internal rate of return factor for the time period covered by the annual cash flows • For Tappan Co., the annual cash flows are expected to continue for 10 years In the table below, the closest discount factor to 5.0 is 5.01877, which represents an interest rate of approximately 15% Internal Rate of Return Decision Criteria The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return Reject the project when the internal rate of return is less than the required rate Comparison of Discounted Cash Flow Methods • In practice, the internal rate of return and cash payback methods are most widely used • A comparative summary of the two discounted cash flow methodsnet present value and internal rate of return- is presented below: If the contribution margin per unit is $15 and it takes 3.0 machine hours to produce theunit, the contribution margin per unit of limited resource is: a $25 b $5 c $45 d No correct answer is given If the contribution margin per unit is $15 and it takes 3.0 machine hours to produce theunit, the contribution margin per unit of limited resource is: a $25 b $5 c $45 d No correct answer is given COPYRIGHT Copyright © 2005 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein ... salvage value at the end of its useful life The straight-line method of depreciation is used for accounting purposes The expected annual revenues and costs of the new product that will be produced... Annual Rate of Return Formula Study Objective • The annual rate of return technique is based on accounting data It indicates the profitability of a capital expenditure The formula is: The annual