special business decisions and capital budgeting l.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Special Business Decisions and Capital Budgeting PowerPoint Presentation
Download Presentation
Special Business Decisions and Capital Budgeting

Loading in 2 Seconds...

play fullscreen
1 / 46

Special Business Decisions and Capital Budgeting - PowerPoint PPT Presentation


  • 129 Views
  • Uploaded on

Special Business Decisions and Capital Budgeting. Chapter 25. Objective 1. Identify the relevant information for a special business decision. Relevant Information. Affects the future …and… Differs among alternative courses of action. Objective 2. Make five types of short-term

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Special Business Decisions and Capital Budgeting' - Thomas


Download Now An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
objective 1

Objective 1

Identify the relevant information

for a special business decision

relevant information
Relevant Information
  • Affects the future

…and…

  • Differs among alternative courses of action
objective 2

Objective 2

Make five types of short-term

special decisions

relevant information approach incremental approach
Relevant Information Approach(Incremental Approach)
  • Special sales orders
  • Dropping a business segment
  • Product mix
  • Outsourcing - make or buy
  • Selling as-is or processing further
two keys
Two Keys
  • Focus on relevant revenues, costs, and profits
  • Use contribution margin approach
    • Variable costs
    • Fixed costs
e25 16 1
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

e25 16 2
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)

e25 16 111
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)

product mix
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

e25 20
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

e25 21
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)

e25 22
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

e25 2217
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

e25 23
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

short term vs long term decisions
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
objective 3

Objective 3

Use payback and accounting rate of return to make longer-term capital budgeting decisions

capital budgeting
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

payback period
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

e25 24
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

payback period26
Payback Period
  • Pros
    • Easy to use
    • Used to eliminate proposals that are too risky
  • Cons
    • Ignores profitability
accounting rate of return
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

accounting rate of return28
Accounting Rate of Return

Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk

e25 25
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

objective 4

Objective 4

Use discounted cash flow models to make longer-term capital budgeting decisions

discounted cash flows models
Discounted Cash Flows Models
  • Recognize time value of money
  • Two methods
    • Net present value
    • Internal rate of return
net present value method
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
e25 26
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

e25 2636
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

net present value37
Net Present Value

When annual cash inflows are unequal you must use the present value of one table applied to each annual cash inflow

internal rate of return
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
internal rate of return39
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

internal rate of return40
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

e25 27
E25-27

Project A:

PVAo = Rent x Factor

275,000 = 55,000 x Factor

5.0000 = Factor

Close to 12%

e25 2743
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

objective 5

Objective 5

Compare and contrast the four

capital budgeting methods