Special Business Decisions and Capital Budgeting

1. Special Business Decisionsand Capital Budgeting Chapter 25

2. Objective 1 Identify the relevant information for a special business decision

3. Relevant Information • Affects the future …and… • Differs among alternative courses of action

4. Objective 2 Make five types of short-term special decisions

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. Two Keys • Focus on relevant revenues, costs, and profits • Use contribution margin approach • Variable costs • Fixed costs

7. Special Sales Order

8. E25-16 (1) 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 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

9. E25-16 (2) This will lower overall profits…reject the order 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)

10. Dropping A Business Segment, Products, Departments, or Territories

11. E25-16 (1) 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 CalPaks Incremental Analysis of Dropping Rolling Backpacks Line Expected decrease in revenues $ (120,000) Expected decrease in expenses: Variable costs 90,000 Expected decrease in operating income $(30,000)

12. Product Mix 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. E25-20 What is the constraint in this exercise? Floor space Decision: Emphasize moderately priced items 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 ftof display space $3.45 $4.20 Capacity – sq ft of display space x10,000 x10,000 Total contribution margin atcapacity $34,500 $42,200

14. Outsourcing (Make or Buy)

15. E25-21 Decision: Make the snowboards Make Buy Difference Incremental cost per unit: Direct materials $18 $0 $18 Direct labor 6 0 6 Variable overhead 303 Purchase price $38 (38) Incremental cost per unit $27 $38 $(11)

16. E25-22 Make Incremental cost per unit: $27 Number of snowboards 10,000 Total incremental costs $27,000 Buy and leave facilities idle Incremental cost per unit: $38 Number of snowboards 10,000 Total incremental costs $38,000

17. E25-22 Decision: Outsource the snowboards and use the facilities to manufacture the other product Buy and use facilities for other product Incremental cost per unit: $38 Number of snowboards 10,000 Total incremental costs to buy $38,000 Expected profit contribution fromother product (30,000) Expected net cost $8,000

18. Sell As-Is or Process Further

19. E25-23 Decision: Process further. The advantage to processing further by repairing the damage is $100 ($2,600 – $2,500) Process Sell As Is Further Expected revenue $2,500 $3,100 Expected additional costs -0- (500) Expected net revenue $2,500 $2,600

20. 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 Short-term vs Long-term Decisions

21. Objective 3 Use payback and accounting rate of return to make longer-term capital budgeting decisions

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. 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. Payback Period

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

26. Payback Period • Pros • Easy to use • Used to eliminate proposals that are too risky • Cons • Ignores profitability

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. Accounting Rate of Return Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk

29. Accounting Rate of Return

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

31. Objective 4 Use discounted cash flow models to make longer-term capital budgeting decisions

32. Discounted Cash Flows Models • Recognize time value of money • Two methods • Net present value • Internal rate of return

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. Net Present Value

35. E25-26 (275,000) Now (275,000) 55,000 Yrs 1-8 Annuity 4.639 255,145 $(19,855) Since NPV is negative, this is not an acceptable investment. The maximum acceptable price is $255,145

36. E25-26 (380,000) Now (380,000) 72,000 Yrs 1-9 Annuity 5.328 383,616 $3,616 Since NPV is positive, this is an acceptable investment. The maximum acceptable price if $380,000

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. 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. 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. 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. Internal Rate of Return

42. E25-27 Project A: PVAo = Rent x Factor 275,000 = 55,000 x Factor 5.0000 = Factor Close to 12%

43. E25-27 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. Objective 5 Compare and contrast the four capital budgeting methods

45. Comparison of CapitalBudgeting Models

46. End of Chapter 25