Chapter 25

CAPITAL BUDGETING AND

MANAGERIAL DECISIONS

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 25 - 2

CAPITAL BUDGETING
 Large amounts of
 Outcome money are usually
is uncertain.
involved.

Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire or sell.

 Decision may be  Investment involves a

difficult or impossible
long-term commitment.
to reverse.
 25 - 3

P1

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.
 25 - 4

P1 COMPUTING PAYBACK PERIOD

WITH EVEN CASH FLOWS
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 Cost of Investment
=
period Annual Net Cash Flow

Payback $16,000
= = 3.9 years
period $4,100
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P1 COMPUTING PAYBACK PERIOD

WITH UNEVEN CASH FLOWS

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.

$5,000

$4,100
 25 - 6

P1 COMPUTING PAYBACK PERIOD

WITH UNEVEN CASH FLOWS
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 is Cumulative
Annual Net Net Cash
about
Year Cash Flows Flows
4.2 years.
0 $ (16,000) $ (16,000)
1 3,000 (13,000)
2 4,000 (9,000)
3 4,000 (5,000)
4.2
4 4,000 (1,000)
5 5,000 4,000
6 3,000 7,000
7 2,000 9,000
8 2,000 11,000
 25 - 7

USING THE PAYBACK PERIOD

P1

The payback period has two major shortcomings:

 It ignores the time value of money; and
 It ignores cash flows after the payback period.
Consider the following example where both projects cost
$5,000 and have five-year useful lives:
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 $ 2,000 $ 1,000
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000

Would you invest in Project One over Project Two

just because it has a shorter payback period?
 25 - 8

P2

ACCOUNTING RATE OF RETURN

Choose the project with the

least risk, the shortest payback
period, and the highest return
for the longest time period is
often identified as the best.
 25 - 9

P2

ACCOUNTING RATE OF RETURN

Let’s revisit the $16,000 investment being considered
by FasTrac. The new machine has an annual after-tax
net income of $2,100.

Compute the accounting rate of return.

Annual Average Investment Calculation

Beginning book value $16,000 + Ending book value $0
2

Accounting $2,100
= = 26.25%
rate of return $8,000
 25 - 10

P2

ACCOUNTING RATE OF RETURN

 Depreciation may be
calculated several
ways.
 Income may vary
from year to year.
 Time value of
money is ignored.
 25 - 11

P3

NET PRESENT VALUE

Net present value analysis applies the time value
of money to future cash inflows and cash
outflows so management can evaluate a project’s
benefits and costs at one point in time.

 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.
 25 - 12

P3 NET PRESENT VALUE

WITH EQUAL CASH FLOWS
FasTrac is considering the purchase of a conveyor costing
$16,000, with an 8-year useful life and zero salvage value, that
promises annual net cash flows of $4,100. FasTrac requires a
12 percent compounded annual return on its investments.
 25 - 13

P3 NET PRESENT VALUE DECISION

RULE
 25 - 14

P3 NET PRESENT VALUE

WITH UNEVEN CASH FLOWS

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.
 25 - 15

P4

INTERNAL RATE OF RETURN (IRR)

The interest rate that makes . . .

 Present Present
value of = value of
cash inflows cash outflows

 The net present value equals zero.

 25 - 16

P4

INTERNAL RATE OF RETURN (IRR)

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.

$12,000 ÷ $5,000 per year = 2.40

2. Using present value of annuity table . . .

 25 - 17

P4

INTERNAL RATE OF RETURN (IRR)

1. Determine the present value factor.

$12,000 ÷ $5,000 per year = 2.40

IRR is
2. Using present value of annuity table.approximately
..
12%.
Periods 10% 12% 14%
Locate the row 1 0.90909 0.89286 0.87719
where the 2 1.73554 1.69005 1.64666
number equals 3 2.48685 2.40183 2.32163
the periods in 4 3.16987 3.03735 2.91371
the project’s life. 5 3.79079 3.60478 3.43308
 25 - 18

P4

INTERNAL RATE OF RETURN (IRR)

Uneven Cash Flows
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.

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 company’s cost of capital.
 25 - 19

P4 COMPARING CAPITAL
BUDGETING METHODS
 25 - 20

C1

DECISION MAKING
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.
 25 - 21

C1

RELEVANT COSTS
 Costs that are applicable
to a particular decision.
 Costs that should have a 2

1
bearing on which alternative
a manager selects.
 Costs that are avoidable.
 Future costs that differ
between alternatives.
 25 - 22

C1

RELEVANT COSTS
Sunk costs are the result of past decisions and
cannot be changed by any current or future decisions.
Sunk costs are irrelevant to current or future decisions.

Out-of-pocket costs are future outlays

of 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.
 25 - 23

A1

ACCEPTING ADDITIONAL BUSINESS

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.
FasTrac currently sells 100,000 units of its product.
The company has revenue and costs as shown.
Per Unit Total
Sales $ 10.00 $ 1,000,000
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Administrative expenses 0.80 80,000
Total expenses $ 9.00 $ 900,000
Operating income $ 1.00 $ 100,000
 25 - 24

A1

ACCEPTING ADDITIONAL BUSINESS

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?
 25 - 25

A1

ACCEPTING ADDITIONAL BUSINESS

FasTrac should accept the offer.
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $2.20 = $22,000

10,000 new units × $8.50 selling price = $85,000
 25 - 26

A1

MAKE OR BUY DECISIONS

 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.
 25 - 27

A1

MAKE OR BUY DECISIONS

FasTrac currently makes Part 417,
assigning overhead at 100 percent of direct
labor cost, with the following unit cost:

Cost to Make Part 417

Make
Direct materials $ 0.45
Direct labor 0.50
Factory overhead 0.50
Total cost to make $ 1.45
 25 - 28

A1

MAKE OR BUY DECISIONS

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?

Make vs. Buy Analysis

Make Buy
Direct materials $ 0.45 ----
Direct labor 0.50 ----
Factory overhead 0.25 ----
Purchase price ---- $ 1.20
Total incremental costs $1.20 $ 1.20

We must eliminate $0.25 per unit of overhead,

leaving a maximum of $0.25 per unit.
 25 - 29

A1

SCRAP OR REWORK
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.
 25 - 30

A1

SCRAP OR REWORK
FasTrac has 10,000 defective units that cost $1.00
each to make. The units can be scrapped now for
$0.40 each or reworked at an additional cost of
$0.80 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?
 25 - 31

A1

SCRAP OR REWORK
10,000 units × $1.50 per unit
10,000 units × $0.80 per unit
Scrap
Now Rework
Sale of Defects $ 4,000 $ 15,000
Less rework costs - (8,000)
Less opportunity cost - (5,000)
Net return $ 4,000 2,000

10,000 units × $0.40 per unit

10,000 units × ($1.50 - $1.00) per unit

FasTrac should scrap the units now.

 25 - 32

A1
SELL OR PROCESS
 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:
 25 - 33

SELL OR PROCESS
A1

Product Price Units Revenue

X $ 4.00 10,000 $ 40,000
Y 6.00 22,000 132,000
Z 8.00 6,000 48,000
Spoilage - 2,000 -
Total 40,000 $ 220,000

Revenue if processed $ 220,000

Revenue if sold as is (50,000)
Incremental revenue 170,000
Cost to process (80,000)
Incremental net income $ 90,000

FasTrac should continue processing. The earlier $30,000 cost

for product Q is sunk and therefore irrelevant to the decision.
 25 - 34

SALES MIX SELECTION

A1

 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.
 25 - 35

A1
SALES MIX SELECTION
Consider the following data for two
products made and sold by FasTrac.

However, it takes one hour to produce one unit of Product

A, while it takes two hours to produce one unit of Product B.
 25 - 36

A1

SEGMENT ELIMINATION

A segment is a candidate for elimination

if its revenues are less than its
avoidable expenses.

FasTrac is considering eliminating its Treadmill

Division because total expenses of $48,300 are
greater than its sales of $47,800.
 25 - 37

A1

SEGMENT ELIMINATION
 25 - 38

A1

SEGMENT ELIMINATION

Sales $ 47,800
Avoidable expenses 41,800
Decrease in income $ 6,000

Do not eliminate
the Treadmill Division!
 25 - 39

A1

QUALITATIVE FACTORS IN DECISIONS

Qualitative factors are involved in

most all managerial decisions.
 Quality.
 Delivery schedule.
 Supplier reputation.
 Employee morale.
 Customer opinions.
 25 - 40

A2

BREAK-EVEN TIME

Break-even time incorporates time value

of money into the payback period method
of evaluating capital investments.
 25 - 41

APPENDIX 25A: USING EXCEL TO

COMPUTE NPV AND IRR
 25 - 42

END OF CHAPTER 25