Introduction to Accounting
FINAL EXAM REVIEW
Chapters 10,11,12, 13, 14, & 15
Prof. W. Bentz
A&MIS 212
1
Standard Cost Card – Variable
Production Cost
A standard cost card for one unit of product
might look like this:
Inputs
Direct materials
Direct labor
Variable mfg. overhead
Total standard unit cost
Prof. W. Bentz
A
B
AxB
Standard
Quantity
or Hours
Standard
Price
or Rate
Standard
Cost
per Unit
3.0 lbs.
2.5 hours
2.5 hours
A&MIS 212
$
$ 4.00 per lb.
14.00 per hour
3.00 per hour
$
12.00
35.00
7.50
54.50
2
Standards vs. Budgets
A standard is the
expected cost for one
unit.
A budget is the
expected cost for all
units.
Are standards the
same as budgets?
Prof. W. Bentz
A&MIS 212
3
A General Model of Variances
Actual Quantity
×
Actual Price
Actual Quantity
×
Standard Price
Price Variance
Standard Quantity
×
Standard Price
Quantity Variance
Standard price is the amount that should
have been paid for the resources acquired.
Prof. W. Bentz
A&MIS 212
4
A General Model of Variances
Actual Quantity
×
Actual Price
Actual Quantity
×
Standard Price
Price Variance
Standard Quantity
×
Standard Price
Quantity Variance
Standard quantity is the quantity allowed for
the actual good output.
Prof. W. Bentz
A&MIS 212
5
A General Model of Variances
Actual Quantity
×
actual price
Actual Quantity
×
standard price
Price Variance
Quantity Variance
AQP(ap - sp)
sp(AQU - SQ)
AQP = Actual Quantity
ap = Actual Price
Prof. W. Bentz
Standard Quantity
×
standard price
A&MIS 212
sp = Standard Price
SQ = Standard Quantity
6
Material Variances Example
Zippy
Hanson Inc. has the following direct material
standard to manufacture one Zippy:
1.5 pounds per Zippy at $4.00 per pound
Last week 1,700 pounds of material were
purchased for $3.90 per pound, at total cost of
$6,630, and used to make 1,000 Zippies.
Prof. W. Bentz
A&MIS 212
7
Material Price Variance
 Based on purchases:
AQP(ap - sp)
= 1,700 lbs.  ($3.90 - $4.00)
= - $170 Favorable
 Based on usage:
AQU(ap - sp)
= 1,700 lbs.  ($3.90 - $4.00)
= - $170 Favorable
Prof. W. Bentz
A&MIS 212
8
Material Quantity Variance
Standard quantity = output  sq per unit
= 1,000 units  1.5 lbs./unit
= 1,500 lbs.
Quantity variance = (AQ – SQ)  sp
= (1,700 -1,500 lbs.)  $4
= $800 Unfavorable
Prof. W. Bentz
A&MIS 212
9
Material Variances Summary
Actual Quantity
×
Actual Price
Actual Quantity
×
Standard Price
Zippy
Standard Quantity
×
Standard Price
1,700 lbs.
×
$3.90 per lb.
1,700 lbs.
×
$4.00 per lb.
1,500 lbs.
×
$4.00 per lb.
= $6,630
= $ 6,800
= $6,000
Price variance
$170 favorable
Prof. W. Bentz
Quantity variance
$800 unfavorable
A&MIS 212
10
Material Variances
Hanson purchased and
used 1,700 pounds.
How are the variances
computed if the amount
purchased differs from
the amount used?
Prof. W. Bentz
A&MIS 212
The price variance is
computed on the entire
quantity purchased.
The quantity variance is
computed only on the
quantity used.
11
Material Variances Continued
Zippy
Hanson Inc. has the following material
standard to manufacture one Zippy:
1.5 pounds per Zippy at $4.00 per pound
Last week 2,800 pounds of material were
purchased at a total cost of $10,920, and
1,700 pounds were used to make 1,000
Zippies. Compute the price variance.
Prof. W. Bentz
A&MIS 212
12
Material Variances Continued
Actual Quantity
Purchased
×
Actual Price
Actual Quantity
Purchased
×
Standard Price
2,800 lbs.
×
$3.90 per lb.
2,800 lbs.
×
$4.00 per lb.
= $10,920
= $11,200
Price variance increases
because quantity
purchased increases.
Price variance
$280 favorable
Prof. W. Bentz
Zippy
A&MIS 212
13
Material Variances Continued
Zippy
Actual Quantity
Used
×
Standard Price
1,700 lbs.
×
$4.00 per lb.
1,500 lbs.
×
$4.00 per lb.
= $6,800
= $6,000
Quantity variance is
unchanged because
actual and standard
quantities are unchanged.
Prof. W. Bentz
Standard Quantity
×
Standard Price
A&MIS 212
Quantity variance
$800 unfavorable
14
Labor Variances Example
Zippy
Hanson Inc. has the following direct labor
standard to manufacture one Zippy:
1.5 standard hours per finished Zippy at
$6.00 per direct labor hour
Last week 1,550 direct labor hours were
worked at an average cost of $6.20 per hour,
for a total labor cost of $9,610, to make
1,000 Zippies.
Prof. W. Bentz
A&MIS 212
15
Labor Rate Variance
Zippy
Based on labor usage:
AQ  (ar - sr)
= 1,550 hrs.($6.20 - $6.00)
= $310 Unfavorable
Prof. W. Bentz
A&MIS 212
16
Labor Quantity Variance
Standard quantity = output  sq per unit
= 1,000 units  1.5 hrs./unit
= 1,500 hrs.
Quantity variance = (AQ – SQ)  sp
= (1,550 -1,500 hrs.)  $6
= $300 Unfavorable
Zippy
Prof. W. Bentz
A&MIS 212
17
Labor Variances Summary
Actual Hours
×
Actual Rate
Zippy
Actual Hours
×
Standard Rate
Standard Hours
×
Standard Rate
1,550 hours
×
$6.20 per hour
1,550 hours
×
$6.00 per hour
1,500 hours
×
$6.00 per hour
= $9,610
= $9,300
Rate variance
$310 unfavorable
Prof. W. Bentz
= $9,000
Efficiency variance
$300 unfavorable
A&MIS 212
18
Labor Efficiency Variance –
A Closer Look
Poorly
trained
workers
Poor
quality
materials
Unfavorable
Efficiency
Variance
Poor
supervision
of workers
Prof. W. Bentz
Poorly
maintained
equipment
A&MIS 212
19
Variable Overhead Variances
(VOH) Example
Zippy
Hanson Inc. has the following variable
manufacturing overhead standard to
manufacture one Zippy
1.5 standard hours per Zippy at $3.00 per
direct labor hour
Last week 1,550 hours were worked to make
1,000 Zippies, and $5,115 was spent for
variable manufacturing overhead.
Prof. W. Bentz
A&MIS 212
20
VOH Spending Variance
Zippy
Based on labor usage:
AQ  (ar - sr)
= 1,550 hrs.  ($3.30 - $3.00)
= $465 Unfavorable
Prof. W. Bentz
A&MIS 212
21
Variable Efficiency Variance
Standard quantity = output  sq per unit
= 1,000 units  1.5 hrs./unit
= 1,500 hrs.
Efficiency variance = (AQ – SQ)  sp
= (1,550 -1,500 hrs.)  $3
= $150 Unfavorable
Zippy
Prof. W. Bentz
A&MIS 212
22
Variable Manufacturing
Overhead Variances
Zippy
Actual Hours
×
Actual Rate
Actual Hours
×
Standard Rate
Standard Hours
×
Standard Rate
1,550 hours
×
$3.30 per hour
1,550 hours
×
$3.00 per hour
1,500 hours
×
$3.00 per hour
= $5,115
= $4,650
Spending variance
$465 unfavorable
Prof. W. Bentz
= $4,500
Efficiency variance
$150 unfavorable
A&MIS 212
23
Fixed Manufacturing Overhead
Suppose budgeted fixed overhead associated
with the production of Zippys is $9,000 and the
budgeted labor hours at standard total 1,800
hours per period. The standard fixed overhead
cost per unit is determined as follows:
POR = $9,000/1,800 standard hours (DQ)
= $5 per standard labor hour
Prof. W. Bentz
A&MIS 212
24
Unit FOH Standard
The standard fixed overhead cost per unit
is computed as
= sq  POR
= 1.5 hours  $5 per standard hour
= $7.50 per complete unit
Prof. W. Bentz
A&MIS 212
25
Fixed Overhead Variances
Assume the fixed overhead cost incurred
(actual) was $9,350.
Fixed overhead budget variance (BV)
= Actual – Budgeted fixed overhead
= $9,350 - $9,000
= $350, Unfavorable
Prof. W. Bentz
A&MIS 212
26
Fixed Overhead Variances
Fixed overhead volume variance (VV)
= Budgeted FOH – Applied FOH
= $9,000 – 1,000 units @ $7.50
= $9,000 - $7,500
= $1,500, Unfavorable
Prof. W. Bentz
A&MIS 212
27
Volume Variance Check
What was the production level used to find the
denominator quantity (DQ)?
1,800 standard hours/1.5 hours per unit
= 1,200 units
Volume variance in unit = 1,000 – 1,200 U
Volume variance in $
= 200 units @ $7.50
= $1,500, Unfavorable
Prof. W. Bentz
A&MIS 212
28
Per Unit Standard Cost
Zippy
Direct material (1.5 lbs. @ $5)
$ 7.50
Direct labor (1.5 hrs. @ $6)
9.00
Variable overhead (1.5 hrs. @ $3) 4.50
Fixed overhead (1.5 hrs. @ $5)
7.50
Total standard cost per unit
$28.50
Prof. W. Bentz
A&MIS 212
29
Chapter 12 Topics
 Segment margin





Prof. W. Bentz
Report format
Omission of costs
Treatment of traceable costs
Treatment of common costs
Telescoping of segments
A&MIS 212
30
E12-2
Parts 1 & 2
Raner, Harris & Chan
Income Statement
For the Year Ending December 31, 2001
Total Company
Chicago
Sales
$ 500,000 100.0% $ 200,000 100.0%
Variable expenses
240,000
48.0%
60,000 30.0%
Contribution margin
$ 260,000
52.0% $ 140,000 70.0%
Traceable fixed costs
126,000
25.2%
78,000 39.0%
Office segment margin $ 134,000
26.8% $ 62,000 31.0%
Common expenses
63,000
12.6%
Net income
$ 71,000
14.2%
Prof. W. Bentz
A&MIS 212
$
$
$
Minneapolis
300,000 100.0%
180,000 60.0%
120,000 40.0%
48,000 16.0%
72,000 24.0%
31
E12-2
E12-2
Raner, Harris & Chan
Income Statement
For the Year Ending December 31, 2001
Sales
Variable expenses
Contribution margin
Traceable fixed costs
Office segment margin
Common expenses
Net income
Prof. W. Bentz
Minneapolis
Medical
$ 300,000
100.0% $ 200,000 100.0%
180,000
60.0%
128,000
64.0%
$ 120,000
40.0% $ 72,000
36.0%
33,000
11.0%
12,000
6.0%
$ 87,000
29.0% $ 60,000
30.0%
15,000
5.0%
$ 72,000
24.0%
A&MIS 212
Dental
$ 100,000 100.0%
52,000
52.0%
$ 48,000
48.0%
21,000
21.0%
$ 27,000
27.0%
32
Chapter 12 Topics
 Return on investment
 ROI = Net income from operations
Average Operating Assets
 ROI = Margin  Turnover
 ROI = NIO/Sales  Sales/Avg. Op. Assets
Prof. W. Bentz
A&MIS 212
33
Chapter 12 Topics
 Residual income
 RI = NIO – (Cost of Capital  Average
Operating Assets
 Instead of the cost of capital, a problem
might refer to the rate of return required
by management, or the minimum rate of
return expected
Prof. W. Bentz
A&MIS 212
34
Example
Sales
Net operating income
Average operating assets
Prof. W. Bentz
A&MIS 212
$25,000,000
$ 3,000,000
$10,000,000
35
Example
ROI
= $3,000,000/$10,000,000
= 30%
Or
Margin = $3M/$25M = 12%
Turnover = $25M/$10M = 2.5
ROI
= 12%  2.5 = 30%
Prof. W. Bentz
A&MIS 212
36
Example
 Residual income
= $3M – 20%  $10M
= $3M - $2M
= $1M
Prof. W. Bentz
A&MIS 212
37
Points Regarding ROI & RI
 Both start with net income from
operations (aka, operating income)
 Both utilize average operating assets
as their measures of investment
 Both would exclude non-operating
items from consideration because the
purpose is to monitor operations.
Prof. W. Bentz
A&MIS 212
38
Other Comments
 The discussion of ROI in chapter 12 is
in the context or evaluations the
accounting return on investment
earned by an entity (division or
investment center), not a project being
evaluated. In chapters 13, 14, and 15,
we sometimes talk about the
incremental ROI of a project, which is
somewhat different, yet similar.
Prof. W. Bentz
A&MIS 212
39
Overview of Ch. 13
In chapter 13, we consider the use of
accounting information to analyze the
impact of decisions on the profitability of
an organization. In general, profitability is
a function of the income and cash flow
generated by a business. Specific
projects or options about which a decision
must be made are the subject of this
chapter.
Prof. W. Bentz
A&MIS 212
40
Chapter 13 - Assumptions
 The approach to decisions outlined in
chapter 13 is based on some key
assumptions
◈ The incremental investment is too
small to affect the decision under
consideration
◈ Revenues, variable costs and fixed
costs can be adequately modeled
with linear models.
Prof. W. Bentz
A&MIS 212
41
Chapter 13 - Assumptions
◈ Total fixed costs will not change
unless a problem or case specifies
otherwise.
◈ As in chapter 6, any changes in perunit prices or variable costs will be
made explicit. Otherwise, assume no
changes in the per-unit amounts
Prof. W. Bentz
A&MIS 212
42
Maximizing Income
 Given the above assumptions, one
can focus on the impact of decision
options on the income from operations
and ignore changes in investment.
Also, since the incremental investment
is small, we can ignore the time value
of money (chapter 14).
Prof. W. Bentz
A&MIS 212
43
Decisions Mentioned in Ch. 13






Replace equipment (or not)
Adding or dropping product lines
Make or buy component parts
Accept or reject special order
Utilizing constrained resources
Sell or process further
Prof. W. Bentz
A&MIS 212
44
Incremental Perspective
The first four categories of decisions
mentioned above can be approached by
looking at changes in contribution margin
less any change in fixed costs incurred to
determine the impact on income from
operations. If you are not told of any
specific change in total fixed cost, then
assume that it is indeed fixed.
Prof. W. Bentz
A&MIS 212
45
 Resource Environments
 Unconstrained – If there are no
important constraints, then we will
evaluate the effects of the decision
options on contribution margin or
income from operations. If fixed costs
do not change, then we can focus on
the effects on contribution margin. If
fixed costs do change, then evaluate
the effects on income from operations.
Prof. W. Bentz
A&MIS 212
46
 Resource Environments
 Single constraint – If there is a single
binding constraint, we must determine
the contribution margin per unit of the
constrained resource. Then we use
this information to determine how best
to use the constrained resource to
maximize contribution margin and
income from operations.
Prof. W. Bentz
A&MIS 212
47
Example of a Single Constraint
Unit Information
Selling price
Variable cost
Contribution margin
$
$
Product
X
Y
40 $
30 $
24
16
16 $
14 $
Capacity (labor hours)
Maximum demand for X (units)
Maximum demand for Y (units)
Maximum demand for Z (units)
Prof. W. Bentz
A&MIS 212
Z
35
20
15
60,000
10,000
8,000
9,000
48
Unconstrained Production
Sales With No Constraint on Production
Product Unit cm
Units
CM
X
$ 16.00
10,000 $ 160,000
Y
$ 14.00
8,000
112,000
Z
$ 15.00
9,000
135,000
Total $ 15.07
27,000 $ 407,000
Production capacity unconstrained
Prof. W. Bentz
A&MIS 212
49
Constrained Labor Case
Unit Information
Selling price
Variable cost
Contribution margin
Direct labor hours
Contribution margin
per labor hour
Prof. W. Bentz
X
$
$
$
40
24
16
4
Product
Y
$
30 $
16
$
14 $
2
4 $
A&MIS 212
7 $
Z
35
20
15
3
5
50
Constrained Labor Case
Sales With Constrained* Labor Hours
Product Labor Hrs.
Units
Hrs. Req.
X ($4**)
4.00
4,250
17,000
Y ($7)
2.00
8,000
16,000
Z ($5)
3.00
9,000
27,000
Total
2.82
21,250
60,000
*Constrained to 60,000 labor hours
**cm per labor hour
Prof. W. Bentz
A&MIS 212
51
Constrained Labor Case
Sales With Constraint on Direct Labor
Product cm/hour
Units
CM
X
$ 16.00
4,250 $ 68,000
Y
$ 14.00
8,000
112,000
Z
$ 15.00
9,000
135,000
Total
$ 14.82
21,250 $ 315,000
Constrained to 60,000 direct labor hours
Prof. W. Bentz
A&MIS 212
52
Constrained Machine Hours
Unit Information
Selling price
Variable cost
Contribution margin
Machine hours
Contribution margin
per machine hour
Prof. W. Bentz
X
$
$
40
24
16
5
$
A&MIS 212
Product
Y
$
30 $
16
$
14 $
7
3 $
2 $
Z
35
20
15
4
4
53
Constrained Machine Hours
Sales With Constrained* Machine Hours
Product Mach. Hrs.
Units
Hrs. Req.
X ($3**)
5.00
10,000
50,000
Y ($2)
7.00
2,000
14,000
Z ($4)
4.00
9,000
36,000
Total
4.76
21,000 100,000
*Constrained to 100,000 machine hours
**cm per machine hour
Prof. W. Bentz
A&MIS 212
54
CM - Constrained Mach. Hrs.
Sales With Constrained* Machine Hours
Product Unit cm
Units
CM
X
$ 16.00
10,000 $ 160,000
Y
$ 14.00
2,000
28,000
Z
$ 15.00
9,000
135,000
Total
$ 15.38
21,000 $ 323,000
*Constrained to 100,000 machine hours
Prof. W. Bentz
A&MIS 212
55
Recapitulation
Recap:
Unconstained case
Constrained labor case
Constrained machine hours
Prof. W. Bentz
A&MIS 212
CM
$ 407,000
$ 315,000
$ 323,000
56
Resource Environments
 Multiple constraints – In the case of
multiple constraints in a complex
environment, we would maximize an
objective function subject to a set of
constraints (in Mgt. Sci. 331 & A&MIS
525).
Prof. W. Bentz
A&MIS 212
57
 Sell or Process Further
A
Sales value at split-off
Sales value after further processing
Allocated joint costs
Separable cost of processing
$
B
120 $
160
80
50
C
150 $
240
100
60
60
90
40
10
Pp. 636-9 of text
Prof. W. Bentz
A&MIS 212
58
Sell or Process Further
Analysis of Sell or Process Further
A
Incremetal revenue:
Sales value after further processing
Sales value at split-off point
Incremental revenue
Cost of further processing
Incremental operating income
$
$
$
B
160 $
120
40 $
50
(10) $
C
240 $
150
90 $
60
30 $
90
60
30
10
20
Pp. 636-9 of text
Prof. W. Bentz
A&MIS 212
59
Introduction to Accounting
Capital Budgeting
Prof. W. Bentz
A&MIS 212
60
Objective
To initiate and maintain projects and
activities that earn an adequate rate of
return on the required investment. To be
adequate, the returns must be consistent
with investor expectations, management
plans, and business opportunities.
Prof. W. Bentz
A&MIS 212
61
Capital Budgeting
Capital budgeting concerns the analysis
and evaluation of projects that require
investment in working capital or property,
plant & equipment. These tend to be
large projects that involve significant cash
inflows and outflows over several fiscal
years. However, the methods covered
are applicable to investment decisions
made by individuals as well as
organizations.
Prof. W. Bentz
A&MIS 212
62
Internal rate of return
The internal rate of return (IRR) is that
interest return, positive or negative, that
equates the present value of the
investment with the present value of the
cash inflows. In cases where there are
multiple investments over time, it is that
rate that equates the present value of the
cash inflows with the present value of the
cash outflows.
Prof. W. Bentz
A&MIS 212
63
Internal rate of return
Thus, it as the discounted rate of return
for which the net present value is zero.
Prof. W. Bentz
A&MIS 212
64
Internal rate of return
Symbolically,
PV = Ni =0CFi (1+r)-i
To find the internal rate of return, find
that value of r such that
0.0 = i=0CFi (1+r)-i
Prof. W. Bentz
A&MIS 212
65
Internal Rate of Return (IRR)
Alternatively, one can write out the terms
of the above expression as follows:
0 = CF0 + CF1(1+r)-I + CF2(1+r)-2 +… +
CFN(1+r)-N
Again, the objective is to find a rate r such
the above expression is satisfied.
Prof. W. Bentz
A&MIS 212
66
Internal rate of return
Next we illustrate use of the annuity table
to find IRR when the cash flows are
uniform from one period to the next
Prof. W. Bentz
A&MIS 212
67
Interpolation Example (p. 676)
Investment required
Annual cost savings
Life of project
Prof. W. Bentz
A&MIS 212
$6,000
$1,500
15 years
68
Table method (equal cash flow)
PV = CF [1 – (1 + r)-N] / r
$6,000 = $1,500  PVOA (10 periods, r %)
PVOA (10, r %) = $6,000 = 4.000
$1,500
Prof. W. Bentz
A&MIS 212
69
Factor Interpolation
20% factor (table)
Project factor (computed)
22% factor (table)
Difference
Prof. W. Bentz
A&MIS 212
4.192 4.192
4.000
3.923
0.192 0.269
70
For example one
Investment of $6,000 and annual cash flows
of $1,500 for 10 years:
0.0 = - $6,000 + $1,500(1+ r)-1 +
$1,500(1+ r)-2 +  + $1,500(1+ r)-10
IRR (r) = 21.406% (using Excel worksheet)
Prof. W. Bentz
A&MIS 212
71
IRR Interpolation
IRR = 20% + (0.192 / 0.269)  (2%)
IRR = 20% + 0.7137  (2%)
IRR = 20% + 1.4247%
IRR = 21.4247%
Note that the true IRR was 21.406%
Prof. W. Bentz
A&MIS 212
72
Example 2
PV
= CF [1 – (1 + r)-N] / r
$10,000 = $2,432.50 [1 – (1 + r)-N] / r
$10,000 = $2,432.50 
PVOA (6 years, r %)
PVOA (6 years, r %) = $10,000.00
$ 2,432.50
= 4.111
Prof. W. Bentz
A&MIS 212
73
Example 2
 From Exhibit 14C-4, we see that in row
6 (6 periods) we find the PVOA factor
4.111 in the column 12%. What luck!
The internal rate of return on this
project is exactly 12% per year.
Prof. W. Bentz
A&MIS 212
74
Example 3
 Investment is $10,000
 Annual cash flows are $3,000 per year
for six years
0.0 = -$10,000 + $3,000(1+ r)-1 +
$3,000(1+ r)-2 +  + $3,000(1+ r)-6
IRR (r) = 19.905% (using Excel worksheet)
Prof. W. Bentz
A&MIS 212
75
Example 3
PV
= CF [1 – (1 + r)-N] / r
$10,000 = $3,000  [1 – (1 + r)-N] / r
$10,000 = $3,000  PVOA (6 years, r %)
PVOA (6 years, r %) = $10,000/$ 3,000
= 3.333
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Example 3
 From Exhibit 14C-4, we see that in row
6 (6 periods) we find the PVOA factor
3.333 is between the columns for 18
and 20%. What rotten luck! The
internal rate of return on this project
has to be estimated by interpolation!
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Factor Interpolation
18% factor (table)
Project factor (computed)
20% factor (table)
Difference
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3.498 3.498
3.333
3.326
0.165 0.172
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IRR Interpolation
IRR = 18% + (0.165 / 0.172)  (2%)
IRR = 18% + 0.9593  (2%)
IRR = 18% + 1.9186%
IRR = 19.9186%
Notice that this is very close to the true
IRR of 19.905%
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IRR Summary
 The internal rate of return is a method
that recognizes the time-value of
money through determining the
interest return earned by investments.
 If cash flows are constant from period
to period, we can use the annuity table
to approximate the IRR.
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IRR Summary
 If the cash flows vary from period to
period, the best way to determine an
IRR is to use a financial calculator or a
computer program such as Excel to
compute an exact rate.
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Project ROI
Project ROI (Simple rate of return) =
Incremental income from operations
Incremental investment
Incremental revenue –incremental expenses
Incremental investment
OR
ΔROI =
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Incremental IO
Incremental investment
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Payback period
Payback period is the number of periods it
takes to recover the cash investment in a
project without regard to any income on
that investment.
Payback period = Project investment
Annual net cash inflow
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Payback for Example 3 Above
Payback = $10,000/$3,000
= 3.33 years or
3 years, 4 months
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Payback for Example 4
Period Investment Cash inflow
1
$2,000
$8,000
2
$4,000
$4,000
3
$6,000
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$10,000
Unrecovered
Investment
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Payback: Uneven Cash Flows
Payback = 2 + (4,000 / 6,000)
= 2 2/3 years or 2 years, 8 mo.
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Assumptions for Chapter 14
 When working with discounted cash
flow, assume cash inflows come at
period end. (p. 672)
 Assume all cash flows generated by
an investment are immediately
reinvested at the project discount rate.
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Discount rate for NPV
 Cost of capital
 Target rate of return set by financial
managers for this purpose
 The opportunity cost of capital
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Chapter 15
 Chapter 15 brings the issue of taxes
into our study of capital budgeting.
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Taxable Events
The following events affect income taxes
and should be analyzed on an aftertax basis on the exam for capital
budgeting questions.
1. Revenue from operations
2. Operating expenses (other than
depreciation)
3. Income tax savings due to the
reduction in income for depreciation
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Taxable Events
4. Disposal of an asset for gain or loss
5. Disposal of a fully-depreciated asset
(tax methods) for its salvage value
6. Special expenses usually described as
repairs, overhaul, or renovation, which
represent tax-deductible items
7. Dividend income, interest income, and
interest expense
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Non-taxable Events
The following events do not affect income
taxes when they occur and should be
analyzed on a pre-tax basis on the
exam for capital budgeting purposes.
1. Deposits made for possible damages
or the return of equipment if the
deposits are returnable.
2. Increases and decreases in working
capital
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Non-taxable Events
3. Purchase of an operating asset or an
investment
4. Borrowing money (taking out a loan)
5. Repaying the principal (not the
interest) on a loan
6. Payment of dividends by a corporation
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