26 Incremental Analysis and Capital Budgeting Learning Objectives 26-1 Describe management’s decision-making process and incremental analysis Analyze the relevant costs in various decisions involving incremental analysis Contrast annual rate of return and cash payback in capital budgeting Distinguish between the net present value and internal rate of return methods LEARNING OBJECTIVE Describe management’s decision-making process and incremental analysis Making decisions is an important management function Does not always follow a set pattern Decisions vary in scope, urgency, and importance Steps usually involved in process include: Illustration 26-1 Management’s decision-making process 26-2 LO Decision-Making Process In making business decisions, Considers both financial and non-financial information Financial information 26-3 ► Revenues and costs, and ► Effect on overall profitability Nonfinancial information ► Effect on employee turnover ► The environment ► Overall company image LO Incremental Analysis Approach 26-4 Decisions involve a choice among alternative actions Process used to identify the financial data that change under alternative courses of action ► Both costs and revenues may vary or ► Only revenues may vary or ► Only costs may vary LO How Incremental Analysis Works Illustration 26-2 Basic approach in incremental analysis Alternative B Incremental revenue is $15,000 less Incremental cost savings of $20,000 is realized Produces 26-5 $5,000 more net income LO How Incremental Analysis Works Important concepts used in incremental analysis: 26-6 Relevant cost Opportunity cost Sunk cost LO How Incremental Analysis Works 26-7 Sometimes involves changes that seem contrary to intuition Variable costs sometimes not change under alternatives Fixed costs sometimes change between alternatives LO Service Company Insight American Express That Letter from AmEx Might Not Be a Bill No doubt every one of you has received an invitation from a credit card company to open a new account—some of you have probably received three in one day But how many of you have received an offer of $300 to close out your credit card account? American Express decided to offer some of its customers $300 if they would give back their credit card You could receive the $300 even if you hadn’t paid off your balance yet, as long as you agreed to give up your credit card Source: Aparajita Saha-Bubna and Lauren Pollock, “AmEx Offers Some Holders $300 to Pay and Leave,” Wall Street Journal Online (February 23, 2009) 26-8 LO Types of Incremental Analysis Common types of decisions involving incremental analysis: Accept an order at a special price Make or buy component parts or finished products Sell or process further them further Repair, retain, or replace equipment Eliminate an unprofitable business segment or product 26-9 LO Incremental Analysis Question Incremental analysis is the process of identifying the financial data that 26-10 a Do not change under alternative courses of action b Change under alternative courses of action c Are mixed under alternative courses of action d None of the above LO Net Present Value Method EQUAL NET ANNUAL CASH FLOWS Illustration: Calculate the net present value Illustration 26-23 The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive 26-60 LO Net Present Value Method UNEQUAL NET ANNUAL CASH FLOWS Illustration: Reno Company management expects the same aggregate net annual cash flow ($195,000) over the life of the investment But because of a declining market demand for the new product over the life of the equipment, the net annual cash flows are higher in the early years and lower in the later years 26-61 LO Net Present Value Method UNEQUAL NET ANNUAL CASH FLOWS Illustration 26-24 Computing present value of unequal annual cash flows 26-62 LO Net Present Value Method UNEQUAL NET ANNUAL CASH FLOWS Illustration: Calculate the net present value Illustration 26-25 Analysis of proposal using net present value method The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive 26-63 LO Management Insight Sharp Wide-Screen Capacity Building a new factory to produce 60-inch TV screens can cost $4 billion But for more than 10 years, manufacturers of these screens have continued to build new plants By building so many plants, they have expanded productive capacity at a rate that has exceeded the demand for big-screen TVs In fact, during one recent year, the supply of big-screen TVs was estimated to exceed demand by 12%, rising to 16% in the future One state-of-the-art plant built by Sharp was estimated to be operating at only 50% of capacity Experts say that the price of big-screen TVs will have to fall much further than they already have before demand may eventually catch up with productive capacity Source: James Simms, “Sharp’s Payoff Delayed,” Wall Street Journal Online (September 14, 2010) 26-64 LO Internal Rate of Return Method 26-65 IRR method finds the interest yield of the potential investment IRR is the rate that will cause the PV of the proposed capital expenditure to equal the PV of the expected annual cash inflows Two steps in method: ► Compute the internal rate of return factor ► Use the factor and the PV of an annuity of table to find the IRR LO Internal Rate of Return Method Step Compute the internal rate of return factor Illustration 26-26 For Reno Company: $130,000 26-66 ÷ $39,000 = 3.3333 LO 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 Assume a required rate of return for Reno of 10% Decision Rule: Accept the project when the IRR is equal to or greater than the required rate of return 26-67 LO Internal Rate of Return Method 26-68 Illustration 26-27 Internal rate of return decision criteria LO Comparing Discounted Cash Flow Method Illustration 26-28 Comparison of discounted cash flow methods 26-69 LO Discounted Cash Flow Question A positive net present value means that the: a b Project’s rate of return exceeds the required rate of return c Project’s rate of return equals the required rate of return d 26-70 Project’s rate of return is less than the cutoff rate Project is unacceptable LO DO IT! Discounted Cash Flow Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard The machine would cost $900,000 It would have an estimated life of years and no salvage value The company estimates that annual revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000 Management has a required rate of return of 9% (a) (b) 26-71 Calculate the net present value on this project Calculate the internal rate of return on this project, and discuss whether it should be accepted LO DO IT! (a) Discounted Cash Flow Calculate the net present value on this project Watertown should accept the project 26-72 LO DO IT! (b) Discounted Cash Flow Calculate the internal rate of return on this project, and discuss whether it should be accepted $900,000 ÷ 210,000 = 4.285714 Since the project has an internal rate that is greater than 10% and the required rate of return is only 9%, Watertown should accept the project 26-73 LO Copyright “Copyright © 2015 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 permission 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 backup 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.” 26-74 ... Illustration 26- 1 Management’s decision-making process 26- 2 LO Decision-Making Process In making business decisions, Considers both financial and non-financial information Financial information 26- 3... make-or-buy decision 26- 20 Illustration 26- 7 Incremental analysis—make or buy, with opportunity cost LO Make or Buy Question In a make-or-buy decision, relevant costs are: 26- 21 a Manufacturing... manufacturing overhead Illustration 26- 8 Per unit cost of unfinished table 26- 27 LO Sell or Process Further The incremental analysis on a per unit basis is as follows Illustration 26- 9 Incremental analysis—