CAPITAL BUDGETING
C1
 Outcome
is uncertain.
 Large amounts of
money are usually
involved.
Capital budgeting:
Analyzing alternative longterm investments and deciding
which assets to acquire or sell.
 Decision may be
difficult or impossible
to reverse.
McGraw-Hill/Irwin
 Investment involves a
long-term commitment.
Slide 1
PAYBACK PERIOD
P1
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.
McGraw-Hill/Irwin
Slide 2
COMPUTING PAYBACK PERIOD
WITH EVEN CASH FLOWS
P1
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
=
period
McGraw-Hill/Irwin
$16,000
$4,100
= 3.9 years
Slide 3
COMPUTING PAYBACK PERIOD
WITH UNEVEN CASH FLOWS
P1
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
McGraw-Hill/Irwin
Slide 4
PAYBACK PERIOD WITH
UNEVEN CASH FLOWS
P1
We recover the $16,000
FasTrac wants to
purchase price between
install a machine
years 4 and 5, about
that
costsfor
$16,000
4.2 years
the
and
has an
8-year
payback
period.
useful life with
zero salvage
value. Annual net
cash flows are:
McGraw-Hill/Irwin
Year
0
1
2
3
4
4.2
5
6
7
8
Annual Net
Cash Flows
$ (16,000)
3,000
4,000
4,000
4,000
5,000
3,000
2,000
2,000
Cumulative
Net Cash
Flows
$ (16,000)
(13,000)
(9,000)
(5,000)
(1,000)
4,000
7,000
9,000
11,000
Slide 5
P1
USING THE PAYBACK PERIOD
The payback period has two major shortcomings.
 It ignores the time value of money.
 It ignores cash flows after the payback period.
Consider the following example where both projects cost
$5,000 and have five-year useful lives:
Year
1
2
3
4
5
Project One
Net Cash
Inflows
$
2,000
2,000
2,000
2,000
2,000
Project Two
Net Cash
Inflows
$
1,000
1,000
1,000
1,000
1,000,000
Would you invest in Project One just because
it has a shorter payback period?
McGraw-Hill/Irwin
Slide 6
P2
ACCOUNTING RATE OF RETURN
Reconsider
the $16,000
investment
beingon
The
accounting
rate of return
focuses
considered by FasTrac. The annual after-tax
annual income instead of cash flows.
net income is $2,100. Compute the
accounting rate of return.
Accounting
rate of return
=
Annual
$2,100 after-tax net income
= 26.25%
$8,000
Annual average investment
Beginning book
$16,000
value
++
$0Ending book value
2 2
McGraw-Hill/Irwin
Slide 7
ACCOUNTING RATE OF RETURN
 Depreciation may
be calculated
several ways.
 Income may vary
from year to year.
So why
would I ever
want to use
this method
anyway?
 Time value of
money is ignored.
McGraw-Hill/Irwin
Slide 8
NET PRESENT VALUE
P3
 Discount
the future
net cash budgeting
flows from the
Now
let’s look
at a capital
investment at the required rate of return.
model that considers the time
 Subtract the initial amount invested from
value
of cash cash
flows.
sum of
the discounted
flows.
FasTrac is considering the purchase of a conveyor
costing $16,000 with an 8-year useful life with zero
salvage value that promises annual net cash flows of
$4,100. FasTrac requires a 12 percent compounded
annual return on its investments.
McGraw-Hill/Irwin
Slide 9
NET PRESENT VALUE
WITH EQUAL CASH FLOWS
P3
Present value factors
Present
Annual Net Value of $1
for 12 percent
Present
Value of
Year
Cash Flows
Factor
Cash Flows
1
$
4,100
0.8929 $
3,661
2
4,100
0.7972
3,269
3
4,100
0.7118
2,918
4
4,100
0.6355
2,606
5
4,100
0.5674
2,326
6
4,100
0.5066
2,077
A positive
net present
indicates that
this
7
4,100 value
0.4523
1,854
project earns
more than
8
4,100 12 percent
0.4039on the investment.
1,656
Total
$
32,800
$
20,367
Amount to be invested
(16,000)
Net present value of investment
$
4,367
McGraw-Hill/Irwin
Slide 10
P3
NET PRESENT VALUE DECISION RULE
If the Net Present
Value is . . .
McGraw-Hill/Irwin
Then the Project is . . .
Positive . . .
Acceptable, since it promises a
return greater than the required
rate of return.
Zero . . .
Acceptable, since it promises a
return equal to the required rate
of return.
Negative . . .
Not acceptable, since it
promises a return less than the
required rate of return.
Slide 11
P3
NET PRESENT VALUE
WITH UNEVEN CASH FLOWS
Net Cash Flows
Year
A
B
C
1
$ 5,000
$ 8,000
$ 1,000
2
5,000
5,000
5,000
3
5,000
2,000
9,000
Total
$ 15,000
$ 15,000
$ 15,000
Amount invested
Net Present Value
Present
Value of
$1 Factor
at 10%
0.9091
0.8264
0.7513
PV of Net Cash Flows
A
B
C
$ 4,546 $ 7,273 $
909
4,132
4,132
4,132
3,757
1,503
6,762
$ 12,435 $ 12,908 $ 11,803
(12,000)
(12,000)
(12,000)
$
435 $
908 $ (197)
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.
McGraw-Hill/Irwin
Slide 12
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 equal zero.
McGraw-Hill/Irwin
Slide 13
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 . . .
McGraw-Hill/Irwin
Slide 14
P4
INTERNAL RATE OF RETURN (IRR)
1. Determine the present value factor.
$12,000 ÷ $5,000 per year = 2.40
2. Using present value of annuity table
In
that
IRR
is row,
the
Locate
the
row
locate the
interest
rate
whose
number
interest
factor
of
the column
equals the
closest
in
in
which
the
periods in the
amount
to
the
present
value
project’s life.
present
value
factor
is found.
factor.
McGraw-Hill/Irwin
Periods
1
2
3
4
5
10%
0.90909
1.73554
2.48685
3.16987
3.79079
IRR is
. approximately
..
12%.
12%
0.89286
1.69005
2.40183
3.03735
3.60478
14%
0.87719
1.64666
2.32163
2.91371
3.43308
Slide 15
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 cost of capital.
McGraw-Hill/Irwin
Slide 16
Comparing Methods
C2
Basis of
measurement
Measure
expressed as
Strengths
Limitations
Payback
period
Cash
flows
Number
of years
Easy to
Understand
Easy to
Understand
Net present
Internal rate
value
of return
Cash flows
Cash flows
Profitability
Profitability
Dollar
Percent
Amount
Considers time Considers time
value of money value of money
Allows
Allows
Accommodates
Allows
comparison
comparison
different risk
comparisons
across projects across projects
levels over
of dissimilar
a project's life
projects
Doesn't
Doesn't
Difficult to
Doesn't reflect
consider time consider time
compare
varying risk
value of money value of money
dissimilar
levels over the
projects
project's life
Doesn't
consider cash
flows after
payback period
McGraw-Hill/Irwin
Accounting
rate of return
Accrual
income
Percent
Doesn't give
annual rates
over the life
of a project
Slide 17
DECISION MAKING
C3
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.
McGraw-Hill/Irwin
Slide 18
RELEVANT COSTS
C3
 Costs that are applicable
to a particular decision.
 Costs that should have a
bearing on which alternative
a manager selects.
 Costs that are avoidable.
 Future costs that differ
between alternatives.
McGraw-Hill/Irwin
Slide 19
RELEVANT COSTS
C3
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.
McGraw-Hill/Irwin
Slide 20
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.
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Administrative expenses
Total expenses
Operating income
McGraw-Hill/Irwin
Per Unit
$ 10.00
3.50
2.20
1.10
1.40
0.80
$
9.00
$
1.00
$
$
$
Total
1,000,000
350,000
220,000
110,000
140,000
80,000
900,000
100,000
Slide 21
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?
McGraw-Hill/Irwin
Slide 22
A1
ACCEPTING ADDITIONAL BUSINESS
First let’s look at incorrect reasoning
that leads to an incorrect decision.
Our cost is $9.00
per unit. I can’t sell
for $8.50 per unit.
McGraw-Hill/Irwin
Slide 23
A1
ACCEPTING ADDITIONAL BUSINESS
This analysis leads to the correct decision.
Current
Additional
Business
Business
Combined
Sales
$ 1,000,000
$
85,000
$ 1,085,000
Even
though the$ $8.50
selling $
price35,000
is less than
the
Direct
materials
350,000
$ 385,000
normal
FasTrac should
the
Direct
labor $10 selling price,
220,000
22,000 accept 242,000
offer
because net income
by $20,000.
Factory
overhead
110,000will increase
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 10,000
new
10,000
units
new
×units
$8.50
units
×
$3.50
= $35,000
= $85,000
new
×selling
$2.20
=price
$22,000
McGraw-Hill/Irwin
Slide 24
MAKE OR BUY DECISIONS
A1
 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.
McGraw-Hill/Irwin
Slide 25
MAKE OR BUY DECISIONS
A1
FasTrac currently makes part #417,
assigning overhead at 100 percent of direct
labor cost, with the following unit cost:
Cost to Make Part #417
Direct materials
Direct labor
Factory overhead
Total cost to make
McGraw-Hill/Irwin
Make
$ 0.45
0.50
0.50
$ 1.45
Slide 26
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
Direct materials
Direct labor
Factory overhead
Purchase price
Total incremental costs
Make
$ 0.45
0.50
0.25
?
---1.20
?
Buy
---------$ 1.20
$ 1.20
We must eliminate $.25 per unit of overhead,
leaving a maximum of $0.25 per unit.
McGraw-Hill/Irwin
Slide 27
SCRAP OR REWORK
A1
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.
McGraw-Hill/Irwin
Slide 28
A1
SCRAP OR REWORK
FasTrac has 10,000 defective units that cost $1.00
each to make. The units can be scrapped now for
$.40 each or reworked at an additional cost of $.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?
McGraw-Hill/Irwin
Slide 29
SCRAP OR REWORK
A1
FasTrac
should
scrap
theper
units
10,000
units ×
$0.80
unitnow.
Sale of Defects
Less rework costs
Less opportunity cost
Net return
Scrap
Now
$ 4,000
$ 4,000
Rework
$ 15,000
(8,000)
(5,000)
2,000
If FasTrac
fails
to include
the opportunity cost,
10,000
units
× $0.40
per unit
the rework option would show a return of $7,000,
10,000 units × ($1.50 - $1.00) per unit
mistakenly making rework appear more favorable.
10,000 units × $1.50 per unit
McGraw-Hill/Irwin
Slide 30
SELL OR PROCESS
A1
 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:
McGraw-Hill/Irwin
Slide 31
SELL OR PROCESS
A1
Product
X
Y
Z
Spoilage
Total
Price
$
4.00
6.00
8.00
-
Units
10,000
22,000
6,000
2,000
40,000
Revenue
$
40,000
132,000
48,000
$ 220,000
Revenue
if processed
$ continue
220,000
Should
FasTrac
sell product Q or
Revenue if sold as is
(50,000)
processing into products X, Y, and
Z?
Incremental revenue
Cost to process
Incremental net income
170,000
(80,000)
$ 90,000
FasTrac should continue processing. The earlier $30,000 cost
for product Q is sunk and therefore irrelevant to the decision.
McGraw-Hill/Irwin
Slide 32
A1
SALES MIX SELECTION
 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.
McGraw-Hill/Irwin
Slide 33
SALES MIX SELECTION
A1
the following
for that
two demand,
If demandConsider
for A is limited,
producedata
to meet
then
use the remaining
produce B.
products
made andfacilities
sold bytoFasTrac.
Per unit amounts
Product
B has a greater
Selling
price
contribution
costs margin than
Variable
Product
A, but it
Contribution
margin
requires
more
machine
Machine
hours
required
to
hours per
produce
oneunit
unitto produce.
Contribution per machine hour
Product
A
$
5.00
3.50
$
1.50
Product
B
$
7.50
5.50
$
2.00
1.0
1.50
2.0
1.00
$
$
If each product requires the same time to
make, and
the demand
With unlimited
demand
for A andis
B,unlimited,
produce asFasTrac
many units of
Consider
this
additional
information.
produce
only Product
B.hour worked.
A as possible should
since A provides
more
dollars per
McGraw-Hill/Irwin
Slide 34
SEGMENT ELIMINATION
A1
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.
McGraw-Hill/Irwin
Slide 35
A1
SEGMENT ELIMINATION
Total
Expenses
$
30,200
Avoidable
Expenses
$ 30,200
7,900
200
7,900
Cost of goods sold
Direct expenses:
Salaries
Equipment depreciation
Indirect expenses:
Rent and utilities
Advertising
Insurance
Service department costs:
Departmental office
Purchasing
Total
$
McGraw-Hill/Irwin
3,150
200
400
3,060
3,190
48,300
Unavoidable
Expenses
$
200
3,150
Let’s
200 identify
avoidable
300 expenses.
100
2,200
1,000
$ 41,800
$
860
2,190
6,500
Slide 36
SEGMENT ELIMINATION
A1
Sales
Avoidable expenses
Decrease in income
$ 47,800
41,800
$ 6,000
Do not eliminate
the Treadmill Division!
McGraw-Hill/Irwin
Slide 37