Make It or Buy It?
When is a manufacturer not a manufacturer? When it outsources. An extension of the classic “make or buy” decision, outsourcing involves hiring other companies to make all or part of a product or to perform services. Who is outsourcing? Nike, General Motors, Sara Lee, and Hewlett-Packard, to name a few. Even a recent trade journal article for small cabinetmakers outlined the pros and cons of building cabinet doors and drawers internally, or outsourcing them to other shops.
Gibson Greetings, Inc., one of the country's largest sellers of greeting cards, has experienced both the pros and cons of outsourcing. In April one year, it announced it would outsource the manufacturing of all of its cards and gift wrap. Gibson's stock price shot up quickly because investors believed the strategy could save the company $10 million a year, primarily by reducing manufacturing costs. But later in the same year, Gibson got a taste of the negative side of outsourcing: When one of its suppliers was unable to meet its production schedule, about $20 million of Christmas cards went to stores a month later than scheduled.
Outsourcing is often a point of dispute in labor negotiations. Although many of the jobs lost to outsourcing go overseas, that is not always the case. In fact, a recent trend is to hire out work to vendors located close to the company. This reduces shipping costs and can improve coordination of efforts.
One company that has benefited from local outsourcing is Solectron Corporation in Silicon Valley. It makes things like cell phones, printers, and computers for high-tech companies in the region. To the surprise of many, it has kept thousands of people employed in California rather than watching those jobs go overseas. What is its secret? It produces high-quality products efficiently. Solectron has to be efficient because it operates on a very thin profit margin—that is, it makes a tiny amount of money on each part—but it makes millions and millions of parts. It has proved the logic of outsourcing as a management decision, both for the companies for which it makes parts and for its owners and employees.
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After studying this chapter, you should be able to:
[1] Identify the steps in management's decision-making process.
[2] Describe the concept of incremental analysis.
[3] Identify the relevant costs in accepting an order at a special price.
[4] Identify the relevant costs in a make-or-buy decision.
[5] Identify the relevant costs in determining whether to sell or process materials further.
[6] Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
[7] Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
[8] Determine which products to make and sell when resources are limited.
[9] Contrast annual rate of return and cash payback in capital budgeting.
[10] Distinguish between the net present value and internal rate of return methods.
Preview of Chapter 26
An important purpose of management accounting is to provide managers with relevant information for decision-making. Companies of all sorts must make product decisions. Philip Morris decided to cut prices to raise market share. Oral-B Laboratories opted to produce a new, higher-priced ($5) toothbrush. General Motors discontinued making the Buick Riviera and announced the closure of its Oldsmobile Division. Quaker Oats decided to sell off a line of beverages, at a price more than $1 billion less than it paid for that product line only a few years before. Ski manufacturers like Dynastar had to decide whether to use their limited resources to make snowboards instead of downhill skis.
This chapter begins with an explanation of management's decision-making process. It then considers the topics of incremental analysis and capital budgeting. The content and organization of Chapter 26 are as follows.
Incremental Analysis
Management's Decision-Making Process
Making decisions is an important management function. Management's decision-making process does not always follow a set pattern because decisions vary significantly in their scope, urgency, and importance. It is possible, though, to identify some steps that are frequently involved in the process. These steps are shown in Illustration 26-1.
Accounting's contribution to the decision-making process occurs primarily in Steps 2 and 4—evaluating possible courses of action, and reviewing results. In Step 2, for each possible course of action, relevant revenue and cost data are provided. These show the expected overall effect on net income. In Step 4, internal reports are prepared that review the actual impact of the decision.
Illustration 26-1
Management's decision-making process
In making business decisions, management ordinarily considers both financial and nonfinancial information. Financial information is related to revenues and costs and their effect on the company's overall profitability. Nonfinancial information relates to such factors as the effect of the decision on employee turnover, the environment, or the overall image of the company in the community. (These are considerations that we touched on in our Chapter 19 discussion of corporate social responsibility.) Although nonfinancial information can be as important as financial information, we will focus primarily on financial information that is relevant to the decision.
Incremental Analysis Approach
Decisions involve a choice among alternative courses of action. Suppose you face the personal financial decision of whether to purchase or lease a car. The financial data relate to the cost of leasing versus the cost of purchasing. For example, leasing would involve periodic lease payments; purchasing would require “up-front” payment of the purchase price. In other words, the financial data relevant to the decision are the data that would vary in the future among the possible alternatives. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. In some cases, you will find that when you use incremental analysis, both costs and revenues will vary. In other cases, only costs or revenues will vary.
Alternative Terminology
Incremental analysis is also called differential analysis because the analysis focuses on differences.
Just as your decision to buy or lease a car will affect your future financial situation, similar decisions, on a larger scale, will affect a company's future. Incremental analysis identifies the probable effects of those decisions on future earnings. Such analysis inevitably involves estimates and uncertainty. Gathering data for incremental analyses may involve market analysts, engineers, and accountants. In quantifying the data, the accountant is expected to produce the most reliable information available at the time the decision must be made.
How Incremental Analysis Works
The basic approach in incremental analysis is illustrated in the following example.
Illustration 26-2
Basic approach in incremental analysis
This example compares alternative B with alternative A. The net income column shows the differences between the alternatives. In this case, incremental revenue will be $15,000 less under alternative B than under alternative A. But a $20,000 incremental cost savings will be realized.1 Thus, alternative B will produce $5,000 more net income than alternative A.
In the following pages, you will encounter three important cost concepts used in incremental analysis, as defined and discussed in Illustration 26-3.
Illustration 26-3
Key cost concepts in incremental analysis
Incremental analysis sometimes involves changes that at first glance might seem contrary to your intuition. For example, sometimes variable costs do not change under the alternative courses of action. Also, sometimes fixed costs do change. For example, direct labor, normally a variable cost, is not an incremental cost in deciding between two new factory machines if each asset requires the same amount of direct labor. In contrast, rent expense, normally a fixed cost, is an incremental cost in a decision whether to continue occupancy of a building or to purchase or lease a new building.
It is also important to understand that the approaches to incremental analysis discussed in this chapter do not take into consideration the time value of money. That is, amounts to be paid or received in future years are not discounted for the cost of interest. Time value of money is addressed later in this chapter as well as in Appendix G.
A number of different types of decisions involve incremental analysis. The more common types of decisions are whether to:
1. Accept an order at a special price.
2. Make or buy component parts or finished products.
3. Sell products or process them further.
4. Repair, retain, or replace equipment.
5. Eliminate an unprofitable business segment or product.
We will consider each of these types of decisions in the following pages.
SERVICE COMPANY INSIGHT
That Letter from AmEx Might Not Be a Bill 
No doubt every one of you has received an invitation from a credit card company to open a new account—some of you have probably received three in one day. But how many of you have received an offer of $300 to close out your credit card account? American Express decided to offer some of its customers $300 if they would give back their credit card. You could receive the $300 even if you hadn't paid off your balance yet, as long as you agreed to give up your credit card.
Source: Aparajita Saha-Bubna and Lauren Pollock, “AmEx Offers Some Holders $300 to Pay and Leave,” Wall Street Journal Online (February 23, 2009).
What are the relevant costs that American Express would need to know in order to determine to whom to make this offer? (See page 1271.)
Accept an Order at a Special Price
Sometimes a company may have an opportunity to obtain additional business if it is willing to make a major price concession to a specific customer. To illustrate, assume that Sunbelt Company produces 100,000 Smoothie blenders per month, which is 80% of plant capacity. Variable manufacturing costs are $8 per unit. Fixed manufacturing costs are $400,000, or $4 per unit. The Smoothie blenders are normally sold directly to retailers at $20 each. Sunbelt has an offer from Kensington Co. (a foreign wholesaler) to purchase an additional 2,000 blenders at $11 per unit. Acceptance of the offer would not affect normal sales of the product, and the additional units can be manufactured without increasing plant capacity. What should management do?
If management makes its decision on the basis of the total cost per unit of $12 ($8 variable + $4 fixed), the order would be rejected because costs per unit ($12) would exceed revenues per unit ($11) by $1 per unit. However, since the units can be produced within existing plant capacity, the special order will not increase fixed costs. Let's identify the relevant data for the decision. First, the variable manufacturing costs will increase $16,000 ($8 × 2,000). Second, the expected revenue will increase $22,000 ($11 × 2,000). Thus, as shown in Illustration 26-4, Sunbelt will increase its net income by $6,000 by accepting this special order.
Illustration 26-4
Incremental analysis—accepting an order at a special price
Two points should be emphasized. First, we assume that sales of the product in other markets would not be affected by this special order. If other sales were affected, then Sunbelt would have to consider the lost sales in making the decision. Second, if Sunbelt is operating at full capacity, it is likely that the special order would be rejected. Under such circumstances, the company would have to expand plant capacity. In that case, the special order would have to absorb these additional fixed manufacturing costs, as well as the variable manufacturing costs.
SERVICE COMPANY INSIGHT
Giving Away the Store?
In an earlier chapter, we discussed Amazon.com's incredible growth. However, some analysts have questioned whether some of the methods that Amazon uses to increase its sales make good business sense. For example, a few years ago, Amazon initiated a “Prime” free-shipping subscription program. For a $79 fee per year, Amazon's customers get free shipping on as many goods as they want to buy. At the time, CEO Jeff Bezos promised that the program would be costly in the short-term but benefit the company in the long-term. Six years later, it was true that Amazon's sales had grown considerably. It was also estimated that its Prime customers buy two to three times as much as non-Prime customers. But, its shipping costs rose from 2.8% of sales to 4% of sales, which is remarkably similar to the drop in its gross margin from 24% to 22.3%. Perhaps even less easy to justify is a proposal by Mr. Bezos to start providing a free Internet movie-streaming service to Amazon's Prime customers. Perhaps some incremental analysis is in order?
Source: Martin Peers, “Amazon's Prime Numbers,” Wall Street Journal Online (February 3, 2011).
What are the relevant revenues and costs that Amazon should consider relative to the decision whether to offer the Prime free-shipping subscription? (See page 1271.)
Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to make a product that normally sells for $42. A foreign wholesaler offers to buy 5,000 units at $25 each. Cobb will incur additional shipping costs of $1 per unit. Compute the increase or decrease in net income Cobb will realize by accepting the special order, assuming Cobb has excess operating capacity. Should Cobb Company accept the special order?
Action Plan
Identify all revenues that will change as a result of accepting the order.
Identify all costs that will change as a result of accepting the order, and net this amount against the change in revenues.
Solution
Related exercise material: BE26-3, E26-2, E26-3, and DO IT! 26-1.
Make or Buy
When a manufacturer assembles component parts in producing a finished product, management must decide whether to make or buy the components. The decision to buy parts or services is often referred to as outsourcing. For example, as discussed in the Feature Story, a company such as General Motors Corporation may either make or buy the batteries, tires, and radios used in its cars. Similarly, Hewlett-Packard Corporation may make or buy the electronic circuitry, cases, and printer heads for its printers. Boeing recently sold some of its commercial aircraft factories in an effort to cut production costs and focus instead on engineering and final assembly rather than manufacturing. The decision to make or buy components should be made on the basis of incremental analysis.
Baron Company makes motorcycles and scooters. It incurs the following annual costs in producing 25,000 ignition switches for scooters.
Illustration 26-5
Annual product cost data
Instead of making its own switches, Baron Company might purchase the ignition switches from Ignition, Inc. at a price of $8 per unit. What should management do?
At first glance, it appears that management should purchase the ignition switches for $8 rather than make them at a cost of $9. However, a review of operations indicates that if the ignition switches are purchased from Ignition, Inc., all of Baron's variable costs but only $10,000 of its fixed manufacturing costs will be eliminated (avoided). Thus, $50,000 of the fixed manufacturing costs will remain if the ignition switches are purchased. The relevant costs for incremental analysis, therefore, are as shown below.
Illustration 26-6
Incremental analysis—make or buy
This analysis indicates that Baron Company would incur $25,000 of additional costs by buying the ignition switches rather than making them. Therefore, Baron should continue to make the ignition switches even though the total manufacturing cost is $1 higher per unit than the purchase price. The primary cause of this result is that, even if the company purchases the ignition switches, it will still have fixed costs of $50,000 to absorb.
Ethics Note 
In the make-or-buy decision, it is important for management to take into account the social impact of its choice. For instance, buying may be the most economically feasible solution, but such action could result in the closure of a manufacturing plant that employs many good workers.
OPPORTUNITY COST
The foregoing make-or-buy analysis is complete only if it is assumed that the productive capacity used to make the ignition switches cannot be converted to another purpose. If there is an opportunity to use this productive capacity in some other manner, then this opportunity cost must be considered. As indicated earlier, opportunity cost is the potential benefit that may be obtained by following an alternative course of action.
To illustrate, assume that through buying the switches, Baron Company can use the released productive capacity to generate additional income of $38,000 from producing a different product. This lost income is an additional cost of continuing to make the switches in the make-or-buy decision. This opportunity cost is therefore added to the “Make” column for comparison. As shown in Illustration 26-7, it is now advantageous to buy the ignition switches. The company's income would increase by $13,000.
Illustration 26-7
Incremental analysis—make or buy, with opportunity cost
The qualitative factors in this decision include the possible loss of jobs for employees who produce the ignition switches. In addition, management must assess how well the supplier will be able to satisfy the company's quality control standards at the quoted price per unit.
DO IT!
Make or Buy
Juanita Company must decide whether to make or buy some of its components for the appliances it produces. The costs of producing 166,000 electrical cords for its appliances are as follows.
| Direct materials | $90,000 |
| Direct labor | $20,000 |
| Variable overhead | $32,000 |
| Fixed overhead | $24,000 |
Instead of making the electrical cords at an average cost per unit of $1.00 ($166,000 ÷ 166,000), the company has an opportunity to buy the cords at $0.90 per unit. If the company purchases the cords, all variable costs and one-fourth of the fixed costs will be eliminated.
(a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. (b) Will your answer be different if the released productive capacity will generate additional income of $5,000?
Action Plan
Look for the costs that change.
Ignore the costs that do not change.
Use the format in the chapter for your answer.
Recognize that opportunity cost can make a difference.
Solution
Related exercise material: BE26-4, E26-4, and DO IT! 26-2.
Sell or Process Further
Identify the relevant costs in determining whether to sell or process materials further.
Many manufacturers have the option of selling products at a given point in the production cycle or continuing to process with the expectation of selling them at a later point at a higher price. For example, a bicycle manufacturer such as Trek could sell its bicycles to retailers either unassembled or assembled. A furniture manufacturer such as Ethan Allen could sell its dining room sets to furniture stores either unfinished or finished. The sell-or-process-further decision should be made on the basis of incremental analysis. The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.
Assume, for example, that Woodmasters Inc. makes tables. It sells unfinished tables for $50. The cost to manufacture an unfinished table is $35, computed as follows.
Illustration 26-8
Per unit cost of unfinished table
Woodmasters currently has unused productive capacity that is expected to continue indefinitely. Some of this capacity could be used to finish the tables and sell them at $60 per unit. For a finished table, direct materials will increase $2 and direct labor costs will increase $4. Variable manufacturing overhead costs will increase by $2.40 (60% of direct labor). No increase is anticipated in fixed manufacturing overhead.
Should the company sell the unfinished tables, or should it process them further? The incremental analysis on a per unit basis is as follows.
Helpful Hint Current net income is known. Net income from processing further is an estimate. In making its decision, management could add a “risk” factor for the estimate.
Illustration 26-9
Incremental analysis—sell or process further
It would be advantageous for Woodmasters to process the tables further. The incremental revenue of $10.00 from the additional processing is $1.60 higher than the incremental processing costs of $8.40.
Repair, Retain, or Replace Equipment
Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
Management often has to decide whether to continue using an asset, repair, or replace it. For example, Delta Airlines must decide whether to replace old jets with new, more fuel-efficient ones. To illustrate, assume that Jeffcoat Company has a factory machine that originally cost $110,000. It has a balance in Accumulated Depreciation of $70,000, so its book value is $40,000. It has a remaining useful life of four years. The company is considering replacing this machine with a new machine. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four-year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160,000 to $125,000 annually, and the old unit could be sold for $5,000. The incremental analysis for the four-year period is as follows.
Illustration 26-10
Incremental analysis—retain or replace equipment
In this case, it would be to the company's advantage to replace the equipment. The lower variable manufacturing costs due to replacement more than offset the cost of the new equipment. Note that the $5,000 received from the sale of the old machine is relevant to the decision because it will only be received if the company chooses to replace its equipment. In general, any trade-in allowance or cash disposal value of existing assets is relevant to the decision to retain or replace equipment.
One other point should be mentioned regarding Jeffcoat's decision: The book value of the old machine does not affect the decision. Book value is a sunk cost, which is a cost that cannot be changed by any present or future decision. Sunk costs are not relevant in incremental analysis. In this example, if the asset is retained, book value will be depreciated over its remaining useful life. Or, if the new unit is acquired, book value will be recognized as a loss of the current period. Thus, the effect of book value on current and future earnings is the same regardless of the replacement decision.
Eliminate an Unprofitable Segment or Product
Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
Management sometimes must decide whether to eliminate an unprofitable business segment or product. For example, in recent years, many airlines quit servicing certain cities or cut back on the number of flights. Goodyear quit producing several brands in the low-end tire market. Again, the key is to focus on the relevant costs—the data that change under the alternative courses of action. To illustrate, assume that Venus Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and Master are profitable lines. Champ (highlighted in red in Illustration 26-11) operates at a loss. Condensed income statement data are as follows.
Illustration 26-11
Segment income data
Helpful Hint A decision to discontinue a segment based solely on the bottom line—net loss—is inappropriate.
You might think that total net income will increase by $20,000 to $240,000 if the unprofitable Champ line of racquets is eliminated. However, net income may actually decrease if the Champ line is discontinued. The reason is that the fixed costs allocated to the Champ racquets will have to be absorbed by the other products. To illustrate, assume that the $30,000 of fixed costs applicable to the unprofitable segment are allocated ⅔ to the Pro model and ⅓ to the Master model if the Champ model is eliminated. Fixed costs will increase to $100,000 ($80,000 + $20,000) in the Pro line and to $60,000 ($50,000 + $10,000) in the Master line. The revised income statement is:
Illustration 26-12
Income data after eliminating unprofitable product line
Total net income has decreased $10,000 ($220,000 − $210,000). This result is also obtained in the following incremental analysis of the Champ racquets.
Illustration 26-13
Incremental analysis—eliminating unprofitable segment with no reduction in fixed costs
The loss in net income is attributable to the Champ line's contribution margin ($10,000) that will not be realized if the segment is discontinued.
In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related product lines. It may be possible for continuing product lines to obtain some or all of the sales lost by the discontinued product line. In some businesses, services or products may be linked—for example, free checking accounts at a bank, or coffee at a donut shop. In addition, management should consider the effect of eliminating the product line on employees who may have to be discharged or retrained.
MANAGEMENT INSIGHT
Time to Move to a New Neighborhood? 
If you have ever moved, then you know how complicated and costly it can be. Now consider what it would be like for a manufacturing company with 260 employees and a 170,000-square-foot facility to move from southern California to Idaho. That is what Buck Knives did in order to save its company from financial ruin. Electricity rates in Idaho were half those in California, workers’ compensation was one-third the cost, and factory wages were 20% lower. Combined, this would reduce manufacturing costs by $600,000 per year. Moving the factory would cost about $8.5 million, plus $4 million to move key employees. Offsetting these costs was the estimated $11 million selling price of the California property. Based on these estimates, the move would pay for itself in three years.
Ultimately, the company received only $7.5 million for its California property, only 58 of 75 key employees were willing to move, construction was delayed by a year which caused the new plant to increase in price by $1.5 million, and wages surged in Idaho due to low unemployment. Despite all of these complications, though, the company considers the move a great success.
Source: Chris Lydgate, “The Buck Stopped,” Inc. Magazine (May 2006), pp. 87–95.
What were some of the factors that complicated the company's decision to move? How should the company have incorporated such factors into its incremental analysis? (See page 1271.)
DO IT!
Unprofitable Segments
Lambert, Inc. manufactures several types of accessories. For the year, the knit hats and scarves line had sales revenue of $400,000, variable expenses of $310,000, and fixed expenses of $120,000. Therefore, the knit hats and scarves line had a net loss of $30,000. If Lambert eliminates the knit hats and scarves line, $20,000 of fixed costs will remain. Prepare an analysis showing whether the company should eliminate the knit hats and scarves line.
Action Plan
Identify the revenues that will change as a result of eliminating a product line.
Identify all costs that will change as a result of eliminating a product line, and net the amount against the revenues.
Solution
The analysis indicates that Lambert should eliminate the knit hats and scarves line because net income will increase $10,000.
Related exercise material: BE26-7, E26-8, E26-9, and DO IT! 26-3.
Allocate Limited Resources
Companies, like individuals, face limited resources. For a retail department store, the limited resource may be floor space. For a manufacturing company, the limited resource may be raw materials, direct labor hours, or machine capacity. When a company has limited resources, management must decide which products to make and sell in order to maximize net income.
To illustrate, assume that Collins Company manufactures deluxe and standard pen and pencil sets. The limiting resource is machine capacity, which is 3,600 hours per month. Relevant data consist of the following.
Illustration 26-14
Contribution margin and machine hours
The deluxe sets may appear to be more profitable since they have a higher contribution margin ($8) than the standard sets ($6). However, the standard sets take fewer machine hours to produce than the deluxe sets. Therefore, it is necessary to find the contribution margin per unit of limited resource—in this case, contribution margin per machine hour. This is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product, as shown in Illustration 26-15.
Helpful Hint CM alone is not enough in this decision. The key factor is CM per unit of limited resource.
Illustration 26-15
Contribution margin per unit of limited resource
The computation shows that the standard sets have a higher contribution margin per unit of limited resource. This would suggest that, given sufficient demand for standard sets, the company should shift the sales mix to produce more standard sets or increase machine capacity. If Collins Company is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the standard or deluxe pen and pencil sets. The total contribution margin under each alternative is found by multiplying the machine hours by the contribution margin per unit of limited resource, as shown below.
Illustration 26-16
Incremental analysis—computation of total contribution margin
From this analysis, we see that to maximize net income, all of the increased capacity should be used to make and sell the standard sets.
Capital Budgeting
Individuals make capital expenditures when they buy a new home, car, or television set. Similarly, businesses make capital expenditures when they modernize plant facilities or expand operations. Companies like Holland America Line must constantly determine how to invest their resources. Other examples: Dell announced plans to spend $1 billion on data centers for cloud computing. Exxon announced that two wells off the Brazilian coast, which it had spent hundreds of millions to drill, would produce no oil. Renault and Nissan spent over $5 billion during a nearly 20-year period to develop electric cars, such as the Leaf.
In business, as for individuals, the amount of possible capital expenditures usually exceeds the funds available for such expenditures. Thus, the resources available must be allocated (budgeted) among the competing alternatives. The process of making capital expenditure decisions in business is known as capital budgeting. Capital budgeting involves choosing among various capital projects to find the one(s) that will maximize a company's return on its financial investment.
Evaluation Process
Many companies follow a carefully prescribed process in capital budgeting. At least once a year, top management requests proposals for projects from each department. A capital budgeting committee screens the proposals and submits its findings to the officers of the company. The officers, in turn, select the projects they believe to be most worthy of funding. They submit this list to the board of directors. Ultimately, the directors approve the capital expenditure budget for the year. Illustration 26-17 shows this process.
Illustration 26-17
Corporate capital budget authorization process
The involvement of top management and the board of directors in the process demonstrates the importance of capital budgeting decisions. These decisions often have a significant impact on a company's future profitability. In fact, poor capital budgeting decisions have led to the bankruptcy of some companies.
Accounting data are indispensable in assessing the probable effects of capital expenditures. To provide management with relevant data for capital budgeting decisions, you should be familiar with the quantitative techniques that may be used. The three most common techniques are: (1) annual rate of return, (2) cash payback, and (3) discounted cash flow. We demonstrate each of these techniques in the following sections. To illustrate the three quantitative techniques, assume that Reno Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years and have zero salvage value at the end of its useful life. Reno uses the straight-line method of depreciation for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are:
Illustration 26-18
Estimated annual net income from capital expenditure
MANAGEMENT INSIGHT
Investing for the Future
Monitoring capital expenditure amounts is one way to learn about a company's growth potential. Few companies can grow if they don't make significant capital investments. Here is a list of well-known companies and the amounts and types of their capital expenditures in a recent year.
Why is it important for top management to constantly monitor the nature, amount, and success of a company's capital expenditures? (See page 1271.)
Annual Rate of Return
The annual rate of return method is based directly on accrual accounting data rather than on cash flows. It indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment. Illustration 26-19 shows the formula for computing annual rate of return.
Illustration 26-19
Annual rate of return formula
Expected annual net income is obtained from the projected income statement. Reno Company's expected annual net income is $13,000. Average investment is derived from the following formula.
Illustration 26-20
Formula for computing average investment
The value at the end of useful life is the asset's salvage value, if any. For Reno Company, average investment is $65,000 [($130,000 + $0) ÷ 2]. The expected annual rate of return for Reno's investment in new equipment is therefore 20%, computed as follows.
$13,000 ÷ $65,000 = 20%
Management then compares this annual rate of return with its required rate of return for investments of similar risk. The required rate of return is generally based on the company's cost of capital. The cost of capital is the rate of return that management expects to pay on all borrowed and equity funds. The cost of capital is a company-wide (or sometimes a division-wide) rate; it does not relate to the cost of funding a specific project.
Helpful Hint A capital budgeting decision based on only one technique may be misleading. It is often wise to analyze the investment from a number of different perspectives.
The annual rate of return decision rule is: A project is acceptable if its rate of return is greater than management's required rate of return. It is unacceptable when the reverse is true. When companies use the rate of return technique in deciding among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment.
The principal advantages of this method are the simplicity of its calculation and management's familiarity with the accounting terms used in the computation. A major limitation of the annual rate of return method is that it does not consider the time value of money. For example, no consideration is given as to whether cash inflows will occur early or late in the life of the investment. As explained in Appendix G, recognition of the time value of money can make a significant difference between the future value and the discounted present value of an investment. A second disadvantage is that this method relies on accrual accounting numbers rather than expected cash flows.
DO IT!
Annual Rate of Return
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenue would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. It uses the straight-line method to compute depreciation expense. Management has a required rate of return of 9%. Compute the annual rate of return.
Action Plan
Expected annual net income = Annual revenues − Annual expenses (including depreciation expense).
Annual rate of return = Expected annual net income/Average investment.
Average investment = (Original investment + Value at end of useful life)/2.
Solution
Since the annual rate of return (13.33%) is greater than Watertown's required rate of return (9%), the proposed project is acceptable.
Related exercise material: BE26-10, E26-11, and DO IT! 26-4.
Cash Payback
The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. Illustration 26-21 presents the formula for computing the cash payback period assuming equal annual cash flows.
Illustration 26-21
Cash payback formula
Net annual cash flow is approximated by taking net income and adding back depreciation expense. Depreciation expense is added back because depreciation on the capital expenditure does not involve an annual outflow of cash. Accordingly, the depreciation deducted in determining net income must be added back to determine net annual cash flows.
In the Reno Company example, net annual cash flow is $39,000, as shown below.
Helpful Hint Net annual cash flow can also be approximated by net cash provided by operating activities from the statement of cash flows.
Illustration 26-22
Computation of net annual cash flow
The cash payback period in this example is therefore 3.33 years, computed as follows.
$130,000 ÷ $39,000 = 3.33 years
Evaluation of the payback period is often related to the expected useful life of the asset. For example, assume that at Reno Company a project is unacceptable if the payback period is longer than 60% of the asset's expected useful life. The 3.33-year payback period in this case is 67% of the project's expected useful life. Thus, the project is unacceptable.
It follows that when the payback method is used to decide among acceptable alternative projects, the shorter the payback period, the more attractive the investment. This is true for two reasons. First, the earlier the investment is recovered, the sooner the company can use the cash funds for other purposes. Second, the risk of loss from obsolescence and changed economic conditions is less in a shorter payback period.
The preceding computation of the cash payback period assumes equal net annual cash flows in each year of the investment's life. In many cases, this assumption is not valid. In the case of uneven net annual cash flows, the company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment.
To illustrate, assume that Chen Company proposes an investment in a new website that is estimated to cost $300,000. Illustration 26-23 shows the proposed investment cost, net annual cash flows, cumulative net cash flows, and the cash payback period.
Illustration 26-23
Net annual cash flow schedule
As Illustration 26-23 shows, at the end of year 3, cumulative net cash flow of $240,000 is less than the investment cost of $300,000. However, at the end of year 4, the cumulative net cash flow of $360,000 exceeds the investment cost. The net cash flow needed in year 4 to equal the investment cost is $60,000 ($300,000 − $240,000). Assuming the net cash flow occurs evenly during year 4, we then divide this amount by the net annual cash flow in year 4 ($120,000) to determine the point during the year when the cash payback occurs. Thus, we get 0.50 ($60,000/$120,000), or half of the year, and the cash payback period is 3.5 years.
The cash payback method may be useful as an initial screening tool. It may be the most critical factor in the capital budgeting decision for a company that desires a fast turnaround of its investment because of a weak cash position. Like the annual rate of return, cash payback is relatively easy to compute and understand.
However, cash payback is not ordinarily the only basis for the capital budgeting decision because it ignores the expected profitability of the project. To illustrate, assume that Projects A and B have the same payback period, but Project A's useful life is double that of Project B's. Project A's earning power, therefore, is twice as long as Project B's. A further—and major—disadvantage of this technique is that it ignores the time value of money.
MANAGEMENT INSIGHT
Can You Hear Me—Better?
What's better than 3G wireless service? 4G. But the question for wireless service providers is whether customers will be willing to pay extra for that improvement.Verizon has already spent billions on the upgrade, but customer usage might be slow in coming. First, there aren't that many 4G-compatible devices, and coverage will be spotty. Also, most applications don't really need higher speeds. Verizon is hoping that its investment in 4G works out better than its $23 billion investment in its FIOS fiber-wired network for TV and ultrahigh-speed Internet. One analyst estimates that the present value of each FIOS customer is $800 less than the cost of the connection.
Source: Martin Peers, “Investors: Beware Verizon's Generation GAP,” Wall Street Journal Online (January 26, 2010).
Based on the potentially slow initial adoption of 4G by customers, how might the conclusions of a cash payback analysis of Verizon's 4G investment differ from a present value analysis? (See page 1271.)
DO IT!
Cash Payback Period
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Compute the cash payback period.
Action Plan
Annual cash inflows − Annual cash outflows = Net annual cash flow.
Cash payback period = Cost of capital investment/Net annual cash flow.
Solution
Related exercise material: BE26-9, E26-10, E26-11, and DO IT! 26-4.
Discounted Cash Flow
Distinguish between the net present value and internal rate of return methods.
The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions. This technique considers both the estimated total net cash flows from the investment and the time value of money. The expected total net cash flow consists of the sum of the annual net cash flows plus the estimated liquidation proceeds when the asset is sold for salvage at the end of its useful life. But because liquidation proceeds are generally immaterial, we ignore them in subsequent discussions.
Two methods are used with the discounted cash flow technique: (1) net present value, and (2) internal rate of return. Before we discuss the methods, we recommend that you examine Appendix G if you need a review of present value concepts.
NET PRESENT VALUE METHOD
The net present value (NPV) method involves discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment. The difference between these two amounts is referred to as net present value (NPV). Company management determines what interest rate to use in discounting the future net cash flows. This rate, often referred to as the discount rate or required rate of return, is discussed in a later section.
The NVP decision rule is this: A proposal is acceptable when net present value is zero or positive. At either of those values, the rate of return on the investment equals or exceeds the required rate of return. When net present value is negative, the project is unacceptable. Illustration 26-24 shows the net present value decision criteria.
Illustration 26-24
Net present value decision criteria
Discounted future cash flows may not take into account all of the important considerations needed to make an informed capital budgeting decision. Other issues, for example, could include worker safety, product quality, and environmental impact.
When making a selection among acceptable proposals, the higher the positive net present value, the more attractive the investment. The application of this method to two cases is described in the next two sections. In each case, we assume that the investment has no salvage value at the end of its useful life.
EQUAL NET ANNUAL CASH FLOWS Reno Company's net annual cash flows are $39,000. If we assume this amount is uniform over the asset's useful life, we can compute the present value of the net annual cash flows by using the present value of an annuity of 1 for 5 payments (in Table 2, Appendix G). The computation at a rate of return of 12% is:
Illustration 26-25
Present value of net annual cash flows
The analysis of the proposal by the net present value method is as follows.
Illustration 26-26
Computation of net present value
The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive.
Helpful Hint The ABC Co. expects equal net annual cash flows over an asset's 5-year useful life.
What discount factor should it use in determining present values if management wants (1) a 12% return or (2) a 15% return?
Answer: Using Table 2, the factors are (1) 3.60478 and (2) 3.35216.
UNEQUAL NET ANNUAL CASH FLOWS When net annual cash flows are unequal, we cannot use annuity tables to calculate their present value. Instead, we use tables showing the present value of a single future amount for each net annual cash flow.
To illustrate, assume that Reno Company management expects the same aggregate net annual cash flow ($195,000) over the life of the investment. But because of a declining market demand for the new product over the life of the equipment, the net annual cash flows are higher in the early years and lower in the later years. The present value of the net annual cash flows is calculated as follows using Table 1 in Appendix G.
Illustration 26-27
Computation of present value of unequal annual cash flows
Therefore, the analysis of the proposal by the net present value method is as follows.
Illustration 26-28
Analysis of proposal using net present value method
In this example, the present value of the net annual cash flows is greater than the $130,000 capital investment. Thus, the project is acceptable at a 12% required rate of return. The difference between the present values using the 12% rate under equal net annual cash flows ($140,586) and unequal net annual cash flows ($147,339) is due to the pattern of the net cash flows.
MANAGEMENT INSIGHT
Seeing the Big Picture
Inaccurate trend forecasting and market positioning are more detrimental to capital investment decisions than using the wrong discount rate. Ampex patented the VCR but failed to see its market potential. Westinghouse made the same mistake with the flat-screen video display. More often, companies adopt projects or businesses only to discontinue them in response to market changes. Texas Instruments announced it would stop manufacturing computer chips, after it had made substantial capital investments that enabled it to become one of the world's leading suppliers. The company dropped out of some 12 business lines in only a few years.
Source: World Research Advisory Inc. (London, August 1998), p. 4.
How important is the choice of discount rate in making capital budgeting decisions? (See page 1271.)
INTERNAL RATE OF RETURN METHOD
The internal rate of return method differs from the net present value method in that it finds the interest yield of the potential investment. The internal rate of return (IRR) is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows. Because it recognizes the time value of money, the internal rate of return method is (like the NPV method) a discounted cash flow technique. The determination of the internal rate of return involves two steps.
Step 1. Compute the internal rate of return factor. The formula for this factor is:
Illustration 26-29
Formula for internal rate of return factor
The computation for Reno Company, assuming equal net annual cash flows,2 is:
$130,000 ÷ $39,000 = 3.3333
Step 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Table 2 of Appendix G is used in this step. The internal rate of return is the discount factor that is closest to the internal rate of return factor for the time period covered by the net annual cash flows.
For Reno Company, the net annual cash flows are expected to continue for 5 years. Thus, it is necessary to read across the period-5 row in Table 2 to find the discount factor. The row for 5 periods is reproduced below for your convenience.
In this case, the closest discount factor to 3.3333 is 3.35216, which represents an interest rate of approximately 15%. The rate of return can be further determined by interpolation, but since we are using estimated net annual cash flows, such precision is seldom required.
Once managers know the internal rate of return, they compare it to the company's required rate of return (the discount rate). The IRR decision rule is as follows: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate of return. Illustration 26-30 below shows these relationships. Assuming the required rate of return is 10% for Reno Company, the project is acceptable because the 15% internal rate of return is greater than the required rate.
Illustration 26-30
Internal rate of return decision criteria
The IRR method is widely used in practice. Most managers find the internal rate of return easy to interpret.
Comparing Discounted Cash Flow Methods
Illustration 26-31 compares the two discounted cash flow methods—net present value and internal rate of return. When properly used, either method provides management with relevant quantitative data for making capital budgeting decisions.
Illustration 26-31
Comparison of discounted cash flow methods
DO IT!
Discounted Cash Flow
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Management has a required rate of return of 9%.
(a) Calculate the net present value on this project, and discuss whether it should be accepted.
(b) Calculate the internal rate of return on this project, and discuss whether it should be accepted.
Action Plan
Compute net annual cash flow: Estimated annual cash inflows − Estimated annual cash outflows.
Use the NPV technique to calculate the difference between net cash flows and the initial investment.
Accept the project if the net present value is positive.
Compute the IRR factor: Capital investment ÷ Net annual cash flows.
Look up the factor in the present value of an annuity table to find the internal rate of return.
Accept the project if the internal rate of return is equal to or greater than the required rate of return.
Solution
(b) $900,000 ÷ 210,000 = 4.285714. Using Table 2 of Appendix G and the factors that correspond with the six-period row, 4.285714 is between the factors for 10% and 11%. Since the project has an internal rate that is greater than 10% and the required rate of return is only 9%, Watertown should accept the project.
Related exercise material: BE26-11, BE26-12, BE26-13, E26-10, E26-11, E26-12, E26-13, and DO IT! 26-5.
Sierra Company is considering a long-term capital investment project called ZIP. The project will require an investment of $120,000, and it will have a useful life of 4 years. Annual net income for ZIP is expected to be: Year 1 $12,000; Year 2 $10,000; Year 3 $8,000; and Year 4 $6,000. Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 12%.
Instructions
(a) Compute the annual rate of return for the project.
(b) Compute the cash payback period for the project. (Round to two decimals.)
(c) Compute the net present value for the project. (Round to nearest dollar.)
(d) Should the project be accepted? Why?
Action Plan
To compute annual rate of return, divide expected annual net income by average investment.
To compute cash payback, divide cost of the investment by net annual cash flows.
Recall that net annual cash flow equals annual net income plus annual depreciation expense.
Be careful to use the correct discount factor in using the net present value method.
Solution to Comprehensive DO IT!
(a) $9,000 ($36,000 ÷ 4) ÷ $60,000 ($120,000 ÷ 2) = 15%
(b) Depreciation expense is $120,000 ÷ 4 years = $30,000.
| Net annual cash flows are: | |
| Year 1 | $12,000 + $30,000 = $42,000 |
| Year 2 | $10,000 + $30,000 = $40,000 |
| Year 3 | $8,000 + $30,000 = $38,000 |
| Year 4 | $6,000 + $30,000 = $36,000 |
Cumulative net cash flows would be $82,000 ($42,000 + $40,000) at the end of year 2 and $120,000 ($42,000 + $40,000 + $38,000) at the end of year 3. Since the cumulative net cash flows at the end of year 3 exactly equal the initial cash investment of $120,000, the cash payback period is 3 years.
(d) The annual rate of return of 15% is good. However, the cash payback period is 75% of the project's useful life, and net present value is negative. The recommendation is to reject the project.
SUMMARY OF LEARNING OBJECTIVES
1 Identify the steps in management's decision-making process. Management's decision-making process is: (a) identify the problem and assign responsibility, (b) determine and evaluate possible courses of action, (c) make the decision, and (d) review the results of the decision.
2 Describe the concept of incremental analysis. Incremental analysis identifies financial data that change under alternative courses of action. These data are relevant to the decision because they will vary in the future among the possible alternatives.
3 Identify the relevant costs in accepting an order at a special price. The relevant information in accepting an order at a special price is the difference between the variable costs to produce the special order and expected revenues.
4 Identify the relevant costs in a make-or-buy decision. In a make-or-buy decision, the relevant costs are (a) the manufacturing costs that will be saved, (b) the purchase price, and (c) opportunity costs.
5 Identify the relevant costs in determining whether to sell or process materials further. The decision rule for whether to sell or process materials further is: Process further as long as the incremental revenue from processing exceeds the incremental processing costs.
6 Identify the relevant costs to be considered in repairing, retaining, or replacing equipment. The factors to consider in determining whether equipment should be retained or replaced are the effects on variable costs and the cost of the new equipment. Also, any trade-in allowance or cash disposal value of the existing asset must be considered.
7 Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product. In deciding whether to eliminate an unprofitable segment, determine the contribution margin, if any, produced by the segment and the disposition of the segment's fixed expenses.
8 Determine which products to make and sell when resources are limited. When a company has limited resources, find the contribution margin per unit of limited resource. Then multiply this amount by the units of limited resource to determine which product maximizes net income.
9 Contrast annual rate of return and cash payback in capital budgeting. The annual rate of return is obtained by dividing expected annual net income by the average investment. The higher the rate of return, the more attractive the investment. The cash payback technique identifies the time period to recover the cost of the investment. The formula is: Cost of capital expenditure divided by estimated net annual cash flow equals cash payback period. The shorter the payback period, the more attractive the investment.
10 Distinguish between the net present value and internal rate of return methods. Under the net present value method, compare the present value of future net cash flows with the capital investment to determine net present value. The NPV decision rule is: Accept the project if net present value is zero or positive. Reject the investment if net present value is negative.
Under the internal rate of return method, find the interest yield of the potential investment. The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.
GLOSSARY
Annual rate of return method Determines the profitability of a capital expenditure by dividing expected annual net income by the average investment. (p. 1241).
Capital budgeting The process of making capital expenditure decisions in business. (p. 1240).
Cash payback technique Identifies the time period required to recover the cost of a capital investment from the net annual cash flow produced by the investment. (p. 1243).
Cost of capital The rate of return that management expects to pay on all borrowed and equity funds. (p. 1242).
Discounted cash flow technique Considers both the estimated total net cash flows from the investment and the time value of money. (p. 1245).
Incremental analysis The process of identifying the financial data that change under alternative courses of action. (p. 1228).
Internal rate of return (IRR) The rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows. (p. 1247).
Internal rate of return (IRR) method Finds the interest yield of the potential investment. (p. 1247).
Net present value (NPV) The difference that results when the original capital outlay is subtracted from the discounted net cash flows. (p. 1245).
Net present value (NPV) method Discounts net cash flows to their present value and then compares that present value to the capital outlay required by the investment. (p. 1245).
Opportunity cost The potential benefit that may be obtained from following an alternative course of action. (p. 1229).
Required rate of return The rate that is generally based on the company's cost of capital. (p. 1242).
Sunk cost A cost that cannot be changed by any present or future decision. (p. 1229).
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.
SELF-TEST QUESTIONS
Answers are on page 1271.
(LO 1)
1. Three of the steps in management's decision-making process are as follows. (1) Review results of decision. (2) Identify the problem. (3) Make the decision. The steps are performed in the following order:
(a) (1), (2), (3).
(b) (3), (2), (1).
(c) (2), (1), (3).
(d) (2), (3), (1).
2. Incremental analysis is the process of identifying the financial data that:
(LO 2)
(a) do not change under alternative courses of action.
(b) change under alternative courses of action.
(c) are mixed under alternative courses of action.
(d) No correct answer is given.
(LO 3)
3. It costs a company $14 of variable costs and $6 of fixed costs to produce product A that sells for $30. A foreign buyer offers to purchase 3,000 units at $18 each. If the special offer is accepted and produced with unused capacity, net income will:
(a) decrease $6,000.
(b) increase $6,000.
(c) increase $12,000.
(d) increase $9,000.
(LO 3)
4. Jobart Company is currently operating at full capacity. It is considering buying a part from an outside supplier rather than making it in-house. If Jobart purchases the part, it can use the released productive capacity to generate additional income of $30,000 from producing a different product. When conducting incremental analysis in this make-or-buy decision, the company should:
(a) ignore the $30,000.
(b) add $30,000 to other costs in the “Make” column.
(c) add $30,000 to other costs in the “Buy” column.
(d) subtract $30,000 from the other costs in the “Make” column.
(LO 4)
5. In a make-or-buy decision, relevant costs are:
(a) manufacturing costs that will be saved.
(b) the purchase price of the units.
(c) opportunity costs.
(d) All of these.
(LO 5)
6. The decision rule in a sell-or-process-further decision is: Process further as long as the incremental revenue from processing exceeds:
(a) incremental processing costs.
(b) variable processing costs.
(c) fixed processing costs.
(d) No correct answer is given.
(LO 5)
7. Walton, Inc. makes an unassembled product that it currently sells for $55. Production costs are $20. Walton is considering assembling the product and selling it for $68. The cost to assemble the product is estimated at $12. What decision should Walton make?
(a) Sell before assembly; net income per unit will be $12 greater.
(b) Sell before assembly; net income per unit will be $1 greater.
(c) Process further; net income per unit will be $13 greater.
(d) Process further; net income per unit will be $1 greater.
(LO 6)
8. In a decision to repair, retain, or replace equipment, the book value of the old equipment is a(n):
(a) opportunity cost.
(b) sunk cost.
(c) incremental cost.
(d) marginal cost.
(LO 7)
9. If an unprofitable segment is eliminated:
(a) net income will always increase.
(b) variable expenses of the eliminated segment will have to be absorbed by other segments.
(c) fixed expenses allocated to the eliminated segment will have to be absorbed by other segments.
(d) net income will always decrease.
(LO 7)
10. A segment of Hazard Inc. has the following data.
| Sales revenue | $200,000 |
| Variable costs | $140,000 |
| Fixed costs | $100,000 |
If this segment is eliminated, 50% of the fixed costs will be eliminated, and the rest will be allocated to the remaining segments. What should Hazard do?
(a) Eliminate the segment; net income will be $50,000 greater.
(b) Eliminate the segment; net income will be $10,000 greater.
(c) Keep the segment; net income will be $200,000 greater.
(d) Keep the segment; net income will be $10,000 greater.
(LO 8)
11. If the contribution margin per unit is $15 and it takes 3.0 machine hours to produce the unit, the contribution margin per unit of limited resource is:
(a) $25.
(b) $5.
(c) $45.
(d) No correct answer is given.
(LO 9)
12. Which of the following is incorrect about the annual rate of return method?
(a) The calculation is simple.
(b) The accounting terms used are familiar to management.
(c) The timing of the net cash flows is not considered.
(d) The time value of money is considered.
(LO 9)
13. What is a weakness of the cash payback approach?
(a) It uses accrual-based accounting numbers.
(b) It ignores the time value of money.
(c) It is complicated to compute.
(d) It cannot be used if a project has uneven net annual cash flows.
(LO 10)
14. A project should be accepted if its internal rate of return exceeds:
(a) zero.
(b) the rate of return on a government bond.
(c) the company's required rate of return.
(d) the rate the company pays on borrowed funds.
(LO 10)
15. A positive net present value means that the:
(a) project's rate of return is less than the cutoff rate.
(b) project's rate of return exceeds the required rate of return.
(c) project's rate of return equals the required rate of return.
(d) project is unacceptable.
Go to the book's companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.
QUESTIONS
1. What steps are frequently involved in management's decision-making process?
2. Your roommate, Anna Polis, contends that accounting contributes to most of the steps in management's decision-making process. Is your roommate correct? Explain.
3. “Incremental analysis involves the accumulation of information concerning a single course of action.” Do you agree? Why?
4. Sydney Greene asks your help concerning the relevance of variable and fixed costs in incremental analysis. Help Sydney with his problem.
5. What data are relevant in deciding whether to accept an order at a special price?
6. Emil Company has an opportunity to buy parts at $9 each that currently cost $12 to make. What manufacturing costs are relevant to this make-or-buy decision?
7. Define the term opportunity cost. How may this cost be relevant in a make-or-buy decision?
8. What is the decision rule in deciding whether to sell a product or process it further?
9. Your roommate, Gale Dunham, is confused about sunk costs. Explain to your roommate the meaning of sunk costs and their relevance to a decision to retain or replace equipment.
10. Huang Inc. has one product line that is unprofitable. What circumstances may cause overall company net income to be lower if the unprofitable product line is eliminated?
11. How is the contribution margin per unit of limited resources computed?
12. Describe the process a company may use in screening and approving the capital expenditure budget.
13. Your classmate, Mike Dawson, is confused about the factors that are included in the annual rate of return method. What is the formula for this method?
14. Sveta Pace is trying to understand the term cost of capital. Define the term, and indicate its relevance to the decision rule under the annual rate of return method.
15. Tom Wells claims the formula for the cash payback technique is the same as the formula for the annual rate of return method. Is Tom correct? What is the formula for the cash payback technique?
16. What are the advantages and disadvantages of the cash payback technique?
17. Two types of present value tables may be used with the discounted cash flow technique. Identify the tables and the circumstance(s) when each table should be used.
18. What is the decision rule under the net present value method?
19. Identify the steps required in using the internal rate of return method.
20. El Cajon Company uses the internal rate of return method. What is the decision rule for this method?
BRIEF EXERCISES
Identify the steps in management's decision-making process.
(LO 1)
BE26-1 The steps in management's decision-making process are listed in random order below. Indicate the order in which the steps should be executed.
________ Make a decision.
________ Identify the problem and assign responsibility.
________ Review results of the decision.
________ Determine and evaluate possible courses of action.
Determine incremental changes.
(LO 2)
BE26-2 Bogart Company is considering two alternatives. Alternative A will have revenues of $160,000 and costs of $100,000. Alternative B will have revenues of $180,000 and costs of $125,000. Compare Alternative A to Alternative B showing incremental revenues, costs, and net income.
Determine whether to accept a special order.
(LO 3)
BE26-3 At Jaymes Company, it costs $30 per unit ($20 variable and $10 fixed) to make a product at full capacity that normally sells for $45. A foreign wholesaler offers to buy 3,000 units at $25 each. Jaymes will incur special shipping costs of $2 per unit. Assuming that Jaymes has excess operating capacity, indicate the net income (loss) Jaymes would realize by accepting the special order.
Determine whether to make or buy a part.
(LO 4)
BE26-4 Manson Industries incurs unit costs of $8 ($5 variable and $3 fixed) in making a subassembly part for its finished product. A supplier offers to make 10,000 of the assembly part at $6 per unit. If the offer is accepted, Manson will save all variable costs but no fixed costs. Prepare an analysis showing the total cost saving, if any, Manson will realize by buying the part.
Determine whether to sell or process further.
(LO 5)
BE26-5 Chudrick Inc. makes unfinished bookcases that it sells for $62. Production costs are $36 variable and $10 fixed. Because it has unused capacity, Chudrick is considering finishing the bookcases and selling them for $70. Variable finishing costs are expected to be $7 per unit with no increase in fixed costs. Prepare an analysis on a per unit basis showing whether Chudrick should sell unfinished or finished bookcases.
Determine whether to retain or replace equipment.
(LO 6)
BE26-6 Kobe Company has a factory machine with a book value of $90,000 and a remaining useful life of 5 years. It can be sold for $30,000. A new machine is available at a cost of $300,000. This machine will have a 5-year useful life with no salvage value. The new machine will lower annual variable manufacturing costs from $600,000 to $500,000. Prepare an analysis showing whether the old machine should be retained or replaced.
Determine whether to eliminate an unprofitable segment.
(LO 7)
BE26-7 Lisah, Inc., manufactures golf clubs in three models. For the year, the Big Bart line has a net loss of $10,000 from sales $200,000, variable costs $180,000, and fixed costs $30,000. If the Big Bart line is eliminated, $20,000 of fixed costs will remain. Prepare an analysis showing whether the Big Bart line should be eliminated.
Show allocation of limited resources.
(LO 8)
BE26-8 In Viejo Company, data concerning two products are: Contribution margin per unit—Product A $11, Product B $12; machine hours required for one unit—Product A 2, Product B 2.5. Compute the contribution margin per unit of limited resource for each product.
Compute the cash payback period for a capital investment.
(LO 9)
BE26-9 Bella Company is considering purchasing new equipment for $450,000. It is expected that the equipment will produce net annual cash flows of $50,000 over its 10-year useful life. Annual depreciation will be $45,000. Compute the cash payback period.
Compute annual rate of return.
(LO 9)
BE26-10 Mecha Oil Company is considering investing in a new oil well. It is expected that the oil well will increase annual revenues by $130,000 and will increase annual expenses by $70,000 including depreciation. The oil well will cost $470,000 and will have a $10,000 salvage value at the end of its 10-year useful life. Calculate the annual rate of return.
Compute net present value of an investment.
(LO 10)
BE26-11 Beacon Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $400,000, has an expected useful life of 10 years, a salvage value of zero, and is expected to increase net annual cash flows by $70,000. Project B will cost $280,000, has an expected useful life of 10 years, a salvage value of zero, and is expected to increase net annual cash flows by $50,000. A discount rate of 9% is appropriate for both projects. Compute the net present value of each project. Which project should be accepted?
Calculate internal rate of return.
(LO 10)
BE26-12 Horowitz Company is evaluating the purchase of a rebuilt spot-welding machine to be used in the manufacture of a new product. The machine will cost $176,000, has an estimated useful life of 7 years, a salvage value of zero, and will increase net annual cash flows by $33,740. What is its approximate internal rate of return?
Compute net present value of an investment.
(LO 10)
BE26-13 Hsung Company accumulates the following data concerning a proposed capital investment: cash cost $215,000, net annual cash flows $40,000, present value factor of cash inflows for 10 years 5.65 (rounded). Determine the net present value, and indicate whether the investment should be made.
DO IT! Review
Evaluate special order.
(LO 3)
DO IT! 26-1 Maize Company incurs a cost of $35 per unit, of which $20 is variable, to make a product that normally sells for $58. A foreign wholesaler offers to buy 6,000 units at $30 each. Maize will incur additional costs of $3 per unit to imprint a logo and to pay for shipping. Compute the increase or decrease in net income Maize will realize by accepting the special order, assuming Maize has sufficient excess operating capacity. Should Maize Company accept the special order?
Evaluate make-or-buy opportunity.
(LO 4)
DO IT! 26-2 Rubble Company must decide whether to make or buy some of its components. The costs of producing 60,000 switches for its generators are as follows.
| Direct materials | $30,000 |
| Direct labor | $42,000 |
| Variable overhead | $45,000 |
| Fixed overhead | $60,000 |
Instead of making the switches at an average cost of $2.95 ($177,000 ÷ 60,000), the company has an opportunity to buy the switches at $2.70 per unit. If the company purchases the switches, all the variable costs and one-fourth of the fixed costs will be eliminated. (a) Prepare an incremental analysis showing whether the company should make or buy the switches. (b) Would your answer be different if the released productive capacity will generate additional income of $34,000?
Analyze whether to eliminate unprofitable segment.
(LO 7)
DO IT! 26-3 Gator Corporation manufactures several types of accessories. For the year, the gloves and mittens line had sales revenue of $500,000, variable expenses of $370,000, and fixed expenses of $150,000. Therefore, the gloves and mittens line had a net loss of $20,000. If Gator eliminates the line, $38,000 of fixed costs will remain.
Prepare an analysis showing whether the company should eliminate the gloves and mittens line.
Compute capital budgeting measures.
(LO 9)
DO IT! 26-4 Minkle Company is considering purchasing new equipment for $350,000. The equipment has a 5-year useful life, and depreciation would be $70,000 (assuming straight-line depreciation and zero salvage value). The purchase of the equipment should increase net income by $50,000 each year for 5 years. (a) Compute the annual rate of return. (b) Compute the cash payback period.
Compute discounted cash flow measures.
(LO 10)
DO IT! 26-5 Bentoli Box Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $680,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $300,000 and that annual cash outflows would increase by $140,000. Management has a required rate of return of 10%.
(a) Calculate the net present value on this project, and discuss whether it should be accepted. (b) Calculate the internal rate of return on this project, and discuss whether it should be accepted.
EXERCISES
Analyze statements about decision-making and incremental analysis.
(LO 1, 2)
E26-1 Ortega has prepared the following list of statements about decision-making and incremental analysis.
1. The first step in management's decision-making process is, “Determine and evaluate possible courses of action.”
2. The final step in management's decision-making process is to actually make the decision.
3. Accounting's contribution to management's decision-making process occurs primarily in evaluating possible courses of action and in reviewing the results.
4. In making business decisions, management ordinarily considers only financial information because it is objectively determined.
5. Decisions involve a choice among alternative courses of action.
6. The process used to identify the financial data that change under alternative courses of action is called incremental analysis.
7. Costs that are the same under all alternative courses of action sometimes affect the decision.
8. When using incremental analysis, some costs will always change under alternative courses of action, but revenues will not.
9. Variable costs will change under alternative courses of action, but fixed costs will not.
Instructions
Identify each statement as true or false. If false, indicate how to correct the statement.
Use incremental analysis for special-order decision.
(LO 3)
E26-2 Leno Company manufactures toasters. For the first 8 months of 2014, the company reported the following operating results while operating at 75% of plant capacity:
Cost of goods sold was 70% variable and 30% fixed; operating expenses were 75% variable and 25% fixed.
In September, Leno Company receives a special order for 15,000 toasters at $7.60 each from Centro Company of Ciudad Juarez. Acceptance of the order would result in an additional $3,000 of shipping costs but no increase in fixed operating expenses.
Instructions
(a) Prepare an incremental analysis for the special order.
(b) 
Should Leno Company accept the special order? Why or why not?
Use incremental analysis for special-order decision.
(LO 3)
E26-3 Gruden Company produces golf discs which it normally sells to retailers for $7 each. The cost of manufacturing 20,000 golf discs is:
Gruden also incurs 5% sales commission ($0.35) on each disc sold.
McGee Corporation offers Gruden $4.80 per disc for 5,000 discs. McGee would sell the discs under its own brand name in foreign markets not yet served by Gruden. If Gruden accepts the offer, its fixed overhead will increase from $40,000 to $46,000 due to the purchase of a new imprinting machine. No sales commission will result from the special order.
Instructions
(a) Prepare an incremental analysis for the special order.
(b) Should Gruden accept the special order? Why or why not?
(c) What assumptions underlie the decision made in part (b)?
Use incremental analysis for make-or-buy decision.
(LO 4)
E26-4 Schopp Inc. has been manufacturing its own shades for its table lamps. The company is currently operating at 100% of capacity, and variable manufacturing overhead is charged to production at the rate of 70% of direct labor cost. The direct materials and direct labor cost per unit to make the lamp shades are $4 and $5, respectively. Normal production is 30,000 table lamps per year.
A supplier offers to make the lamp shades at a price of $12.75 per unit. If Schopp Inc. accepts the supplier's offer, all variable manufacturing costs will be eliminated, but the $45,000 of fixed manufacturing overhead currently being charged to the lamp shades will have to be absorbed by other products.
Instructions
(a) Prepare the incremental analysis for the decision to make or buy the lamp shades.
(b) Should Schopp Inc. buy the lamp shades?
(b) Would your answer be different in (b) if the productive capacity released by not making the lamp shades could be used to produce income of $25,000?
Use incremental analysis for sell-or-process-further decision.
(LO 5)
E26-5 Rachel Rey recently opened her own basketweaving studio. She sells finished baskets in addition to the raw materials needed by customers to weave baskets of their own. Rachel has put together a variety of raw material kits, each including materials at various stages of completion. Unfortunately, owing to space limitations, Rachel is unable to carry all varieties of kits originally assembled and must choose between two basic packages.
The basic introductory kit includes undyed, uncut reeds (with dye included) for weaving one basket. This basic package costs Rachel $14 and sells for $30. The second kit, called Stage 2, includes cut reeds that have already been dyed. With this kit the customer need only soak the reeds and weave the basket. Rachel is able to produce the second kit by using the basic materials included in the first kit and adding one hour of her own time, which she values at $18 per hour. Because she is more efficient at cutting and dying reeds than her average customer, Rachel is able to make two kits of the dyed reeds, in one hour, from one kit of undyed reeds. The Stage 2 kit sells for $35.
Instructions
Determine whether Rachel's basketweaving shop should carry the basic introductory kit with undyed and uncut reeds or the Stage 2 kit with reeds already dyed and cut. Prepare an incremental analysis to support your answer.
E26-6 Loh Gear Bikes could sell its bicycles to retailers either assembled or unassembled. The cost of an unassembled bike is as follows.
Use incremental analysis for sell-or-process-further decision.
(LO 5)
The unassembled bikes are sold to retailers at $400 each.
Loh Gear currently has unused productive capacity that is expected to continue indefinitely; management has concluded that some of this capacity can be used to assemble the bikes and sell them at $440 each. Assembling the bikes will increase direct materials by $10 per bike, and direct labor by $10 per bike. Additional variable overhead will be incurred at the normal rates, but there will be no additional fixed overhead as a result of assembling the bikes.
Instructions
(a) Prepare an incremental analysis for the sell-or-process-further decision.
(b) Should Loh Gear sell or process further? Why or why not?
E26-7 Johnson Enterprises uses a computer to handle its sales invoices. Lately, business has been so good that it takes an extra 3 hours per night, plus every third Saturday, to keep up with the volume of sales invoices. Management is considering updating its computer with a faster model that would eliminate all of the overtime processing.
Use incremental analysis for retaining or replacing equipment decision.
(LO 6)
If sold now, the current machine would have a salvage value of $6,000. If operated for the remainder of its useful life, the current machine would have zero salvage value. The new machine is expected to have zero salvage value after 5 years.
Instructions
Should the current machine be replaced?
E26-8 Judy Jean, a recent graduate of Rolling's accounting program, evaluated the operating performance of Artie Company's six divisions. Judy made the following presentation to Artie's board of directors and suggested the Huron Division be eliminated. “If the Huron Division is eliminated,” she said, “our total profits would increase by $26,000.”
Use incremental analysis concerning elimination of division.
(LO 7)
In the Huron Division, cost of goods sold is $61,000 variable and $15,000 fixed, and operating expenses are $26,000 variable and $24,000 fixed. None of the Huron Division's fixed costs will be eliminated if the division is discontinued.
Instructions
Is Judy right about eliminating the Huron Division? Prepare a schedule to support your answer.
E26-9 Cawley Company makes three models of tasers. Information on the three products is given as follows.
Use incremental analysis for elimination of a product line.
(LO 7)
Fixed expenses consist of $300,000 of common costs allocated to the three products based on relative sales, and additional fixed expenses of $30,000 (Tingler), $80,000 (Shocker), and $35,000 (Stunner). The common costs will be incurred regardless of how many models are produced. The other fixed expenses would be eliminated if a model is phased out.
James Watt, an executive with the company, feels the Stunner line should be discontinued to increase the company's net income.
Instructions
(a) Compute current net income for Cawley Company.
(b) Compute net income by product line and in total for Cawley Company if the company discontinues the Stunner product line. (Hint: Allocate the $300,000 common costs to the two remaining product lines based on their relative sales.)
(c) Should Cawley eliminate the Stunner product line? Why or why not?
Compute cash payback period and net present value.
(LO 10)
E26-10 Doug's Custom Construction Company is considering three new projects, each requiring an equipment investment of $22,000. Each project will last for 3 years and produce the following net annual cash flows.
The equipment's salvage value is zero, and Doug uses straight-line depreciation. Doug will not accept any project with a cash payback period over 2 years. Doug's required rate of return is 12%.
Instructions
(a) Compute each project's payback period, indicating the most desirable project and the least desirable project using this method. (Round to two decimals and assume in your computations that cash flows occur evenly throughout the year.)
(b) Compute the net present value of each project. Does your evaluation change? (Round to nearest dollar.)
Compute annual rate of return, cash payback period, and net present value.
(LO 9, 10)
E26-11 Vilas Company is considering a capital investment of $190,000 in additional productive facilities. The new machinery is expected to have a useful life of 5 years with no salvage value. Depreciation is by the straight-line method. During the life of the investment, annual net income and net annual cash flows are expected to be $12,000 and $50,000, respectively. Vilas has a 12% cost of capital rate, which is the required rate of return on the investment.
Instructions
(Round to two decimals.)
(a) Compute (1) the cash payback period and (2) the annual rate of return on the proposed capital expenditure.
(b) Using the discounted cash flow technique, compute the net present value.
Determine internal rate of return.
(LO 10)
E26-12 Ueker Company is considering three capital expenditure projects. Relevant data for the projects are as follows.
Annual income is constant over the life of the project. Each project is expected to have zero salvage value at the end of the project. Ueker Company uses the straight-line method of depreciation.
Instructions
(a) Determine the internal rate of return for each project. Round the internal rate of return factor to three decimals.
(b) If Ueker Company's required rate of return is 11%, which projects are acceptable?
E26-13 Leung Corporation is considering investing in two different projects. It could invest in both, neither, or just one of the projects. The forecasts for the projects are as follows.
Compute net present value and recommend project.
(LO 10)
The required rate of return acceptable to Leung is 9%.
Instructions
(a) Compute the net present value of the two projects.
(b) What capital budgeting decision should Leung make?
(c) Project A could be modified. By spending $25,000 more initially, the net annual cash flows could be increased by $10,000 per year. Would this change Leung's decision?
EXERCISES: SET B AND CHALLENGE EXERCISES
Visit the book's website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Exercise Set B.
PROBLEMS: SET A
Use incremental analysis for special order and identify nonfinancial factors in the decision.
(LO 3)
P26-1A ShurShot Sports Inc. manufactures basketballs for the National Basketball Association (NBA). For the first 6 months of 2014, the company reported the following operating results while operating at 80% of plant capacity and producing 120,000 units.
Fixed costs for the period were cost of goods sold $960,000, and selling and administrative expenses $225,000.
In July, normally a slack manufacturing month, ShurShot Sports receives a special order for 10,000 basketballs at $27 each from the Greek Basketball Association (GBA). Acceptance of the order would increase variable selling and administrative expenses $0.50 per unit because of shipping costs but would not increase fixed costs and expenses.
Instructions
(a) Prepare an incremental analysis for the special order.
(b) Should ShurShot Sports Inc. accept the special order? Explain your answer.
(c) What is the minimum selling price on the special order to produce net income of $4.00 per ball?
(d) What nonfinancial factors should management consider in making its decision?
Use incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors.
(LO 4)
P26-2A The management of Shatner Manufacturing Company is trying to decide whether to continue manufacturing a part or to buy it from an outside supplier. The part, called CISCO, is a component of the company's finished product.
The following information was collected from the accounting records and production data for the year ending December 31, 2014.
1. 8,000 units of CISCO were produced in the Machining Department.
2. Variable manufacturing costs applicable to the production of each CISCO unit were: direct materials $4.80, direct labor $4.30, indirect labor $0.43, utilities $0.40.
3. Fixed manufacturing costs applicable to the production of CISCO were:
All variable manufacturing and direct fixed costs will be eliminated if CISCO is purchased. Allocated costs will have to be absorbed by other production departments.
4. The lowest quotation for 8,000 CISCO units from a supplier is $80,000.
5. If CISCO units are purchased, freight and inspection costs would be $0.35 per unit, and receiving costs totaling $1,300 per year would be incurred by the Machining Department.
Instructions
(a) Prepare an incremental analysis for CISCO. Your analysis should have columns for (1) Make CISCO, (2) Buy CISCO, and (3) Net Income Increase/(Decrease).
(b) Based on your analysis, what decision should management make?
(c) Would the decision be different if Shatner Company has the opportunity to produce $3,000 of net income with the facilities currently being used to manufacture CISCO? Show computations.
(d) What nonfinancial factors should management consider in making its decision?
Compute gain or loss, and determine if equipment should be replaced.
(LO 6)
P26-3A Last year (2013), Richter Condos installed a mechanized elevator for its tenants. The owner of the company, Ron Richter, recently returned from an industry equipment exhibition where he watched a computerized elevator demonstrated. He was impressed with the elevator's speed, comfort of ride, and cost efficiency. Upon returning from the exhibition, he asked his purchasing agent to collect price and operating cost data on the new elevator. In addition, he asked the company's accountant to provide him with cost data on the company's elevator. This information is presented below.
Annual revenues are $240,000, and selling and administrative expenses are $29,000, regardless of which elevator is used. If the old elevator is replaced now, at the beginning of 2014, Richter Condos will be able to sell it for $25,000.
Instructions
(a) Determine any gain or loss if the old elevator is replaced.
(b) Prepare a 4-year summarized income statement for each of the following assumptions:
(1) The old elevator is retained.
(2) The old elevator is replaced.
(c) Using incremental analysis, determine if the old elevator should be replaced.
(d) Write a memo to Ron Richter explaining why any gain or loss should be ignored in the decision to replace the old elevator.
Prepare incremental analysis concerning elimination of divisions.
(LO 7)
P26-4A Gutierrez Company has four operating divisions. During the first quarter of 2014, the company reported aggregate income from operations of $213,000 and the following divisional results.
Discontinuance of any division would save 50% of the fixed costs and expenses for that division.
Top management is very concerned about the unprofitable divisions (I and II). Consensus is that one or both of the divisions should be discontinued.
Instructions
(a) Compute the contribution margin for Divisions I and II.
(b) Prepare an incremental analysis concerning the possible discontinuance of (1) Division I and (2) Division II. What course of action do you recommend for each division?
(c) Prepare a columnar condensed income statement for Gutierrez Company, assuming Division II is eliminated. (Use the CVP format.) Division II's unavoidable fixed costs are allocated equally to the continuing divisions.
(d) Reconcile the total income from operations ($213,000) with the total income from operations without Division II.
Compute annual rate of return, cash payback, and net present value.
(LO 9, 10)
P26-5A Henkel Company is considering three long-term capital investment proposals. Each investment has a useful life of 5 years. Relevant data on each project are as follows.
Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 15%. (Assume that cash flows occur evenly throughout the year.)
Instructions
(a) Compute the cash payback period for each project. (Round to two decimals.)
(b) Compute the net present value for each project. (Round to nearest dollar.)
(c) Compute the annual rate of return for each project. (Round to two decimals.) (Hint: Use average annual net income in your computation.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?
Compute annual rate of return, cash payback, and net present value.
(LO 9, 10)
P26-6A Lon Timur is an accounting major at a midwestern state university located approximately 60 miles from a major city. Many of the students attending the university are from the metropolitan area and visit their homes regularly on the weekends. Lon, an entrepreneur at heart, realizes that few good commuting alternatives are available for students doing weekend travel. He believes that a weekend commuting service could be organized and run profitably from several suburban and downtown shopping mall locations. Lon has gathered the following investment information.
1. Five used vans would cost a total of $75,000 to purchase and would have a 3-year useful life with negligible salvage value. Lon plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total annual payroll expense of $48,000.
3. Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $16,000, Maintenance $3,300, Repairs $4,000, Insurance $4,200, and Advertising $2,500.
4. Lon has visited several financial institutions to discuss funding. The best interest rate he has been able to negotiate is 15%. Use this rate for cost of capital.
5. Lon expects each van to make ten round trips weekly and carry an average of six students each trip. The service is expected to operate 30 weeks each year, and each student will be charged $12.00 for a round-trip ticket.
Instructions
(a) Determine the annual (1) net income and (2) net annual cash flows for the commuter service.
(b) Compute (1) the cash payback period and (2) the annual rate of return. (Round to two decimals.)
(c) Compute the net present value of the commuter service. (Round to the nearest dollar.)
(d) What should Lon conclude from these computations?
Compute net present value and internal rate of return.
(LO 10)
P26-7A Goltra Clinic is considering investing in new heart-monitoring equipment. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 4 years. Option B would require no rebuilding expenditure, but its maintenance costs would be higher. Since the Option B machine is of initial higher quality, it is expected to have a salvage value at the end of its useful life. The following estimates were made of the cash flows. The company's cost of capital is 8%.
Instructions
(a) Compute the (1) net present value and (2) internal rate of return for each option. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.)
(b) Which option should be accepted?
PROBLEMS: SET B
Use incremental analysis for special order and identify nonfinancial factors in decision.
(LO 3)
P26-1B Morello Inc. manufactures basketballs for the National Basketball Association (NBA). For the first 6 months of 2014, the company reported the following operating results while operating at 90% of plant capacity and producing 90,000 units.
Fixed costs for the period were cost of goods sold $900,000, and selling and administrative expenses $180,000.
In July, normally a slack manufacturing month, Morello receives a special order for 10,000 basketballs at $30 each from the Chinese Basketball Association (CBA). Acceptance of the order would increase variable selling and administrative expenses $0.50 per unit because of shipping costs but would not increase fixed costs and expenses.
Instructions
(a) Prepare an incremental analysis for the special order.
(b) Should Morello Inc. accept the special order?
(c) What is the minimum selling price on the special order to produce net income of $5.50 per ball?
(d) What nonfinancial factors should management consider in making its decision?
Use incremental analysis related to make or buy; consider opportunity cost and identify nonfinancial factors.
(LO 4)
P26-2B The management of Gill Corporation is trying to decide whether to continue manufacturing a part or to buy it from an outside supplier. The part, called FIZBE, is a component of the company's finished product.
The following information was collected from the accounting records and production data for the year ending December 31, 2014.
1. 5,000 units of FIZBE were produced in the Machining Department.
2. Variable manufacturing costs applicable to the production of each FIZBE unit were: direct materials $4.75, direct labor $4.60, indirect labor $0.45, utilities $0.35.
3. Fixed manufacturing costs applicable to the production of FIZBE were:
All variable manufacturing and direct fixed costs will be eliminated if FIZBE is purchased. Allocated costs will have to be absorbed by other production departments.
4. The lowest quotation for 5,000 FIZBE units from a supplier is $56,000.
5. If FIZBE units are purchased, freight and inspection costs would be $0.30 per unit, and receiving costs totaling $500 per year would be incurred by the Machining Department.
Instructions
(a) Prepare an incremental analysis for FIZBE. Your analysis should have columns for (1) Make FIZBE, (2) Buy FIZBE, and (3) Net Income Increase/(Decrease).
(b) Based on your analysis, what decision should management make?
(c) Would the decision be different if Gill Corporation has the opportunity to produce $6,000 of net income with the facilities currently being used to manufacture FIZBE? Show computations.
(d) What nonfinancial factors should management consider in making its decision?
Compute gain or loss, and determine if equipment should be replaced.
(LO 6)
P26-3B Last year (2013), Simmons Company installed new factory equipment. The owner of the company, Gene Simmons, recently returned from an industry equipment exhibition where he watched computerized equipment demonstrated. He was impressed with the equipment's speed and cost efficiency. Upon returning from the exhibition, he asked his purchasing agent to collect price and operating cost data on the new equipment. In addition, he asked the company's accountant to provide him with cost data on the company's equipment. This information is presented below.
Annual revenues are $360,000, and selling and administrative expenses are $45,000, regardless of which equipment is used. If the old equipment is replaced now, at the beginning of 2014, Simmons Company will be able to sell it for $58,000.
Instructions
(a) Determine any gain or loss if the old equipment is replaced.
(b) Prepare a 4-year summarized income statement for each of the following assumptions:
(1). The old equipment is retained.
(2). The old equipment is replaced.
(c) Using incremental analysis, determine if the old equipment should be replaced.
(d) Write a memo to Gene Simmons explaining why any gain or loss should be ignored in the decision to replace the old equipment.
Prepare incremental analysis concerning elimination of divisions.
(LO 7)
P26-4B Panda Corporation has four operating divisions. During the first quarter of 2014, the company reported aggregate income from operations of $129,000 and the divisional results shown below.
Discontinuance of any division would save 50% of the fixed costs and expenses for that division.
Top management is very concerned about the unprofitable divisions (III and IV). Consensus is that one or both of the divisions should be discontinued.
Instructions
(a) Compute the contribution margin for Divisions III and IV.
(b) Prepare an incremental analysis concerning the possible discontinuance of (1) Division III and (2) Division IV. What course of action do you recommend for each division?
(c) Prepare a columnar condensed income statement for Panda Corporation, assuming Division IV is eliminated. (Use the CVP format.) Division IV's unavoidable fixed costs are allocated equally to the continuing divisions.
(d) Reconcile the total income from operations ($129,000) with the total income from operations without Division IV.
Compute annual rate of return, cash payback, and net present value.
(LO 9, 10)
P26-5B The Borders and Noble partnership is considering three long-term capital investment proposals. Each investment has a useful life of 5 years. Relevant data on each project are as follows.
Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 12%. (Assume cash flows occur evenly throughout the year.)
Instructions
(a) Compute the cash payback period for each project. (Round to two decimals.)
(b) Compute the net present value for each project. (Round to nearest dollar.)
(c) Compute the annual rate of return for each project. (Round to two decimals.) (Hint: Use average annual net income in your computation.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?
Compute annual rate of return, cash payback, and net present value.
(LO 9, 10)
P26-6B Ben Paul is an accounting major at a western university located approximately 60 miles from a major city. Many of the students attending the university are from the metropolitan area and visit their homes regularly on the weekends. Ben, an entrepreneur at heart, realizes that few good commuting alternatives are available for students doing weekend travel. He believes that a weekend commuting service could be organized and run profitably from several suburban and downtown shopping mall locations. Ben has gathered the following investment information.
1. Five used vans would cost a total of $90,000 to purchase and would have a 3-year useful life with negligible salvage value. Ben plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total annual payroll expense of $43,000.
3. Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $26,000, Maintenance $4,000, Repairs $5,300, Insurance $4,500, and Advertising $2,200.
4. Ben desires to earn a return of 15% on his investment.
5. Ben expects each van to make ten round trips weekly and carry an average of six students each trip. The service is expected to operate 32 weeks each year, and each student will be charged $15 for a round-trip ticket.
Instructions
(a) Determine the annual (1) net income and (2) net annual cash flows for the commuter service.
(b) Compute (1) the cash payback period and (2) the annual rate of return. (Round to two decimals.)
(c) Compute the net present value of the commuter service. (Round to the nearest dollar.)
(d) What should Ben conclude from these computations?
Compute net present value and internal rate of return.
(LO 10)
P26-7B Platteville Eye Clinic is considering investing in new optical-scanning equipment. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 3 years. Option B would require no rebuilding expenditure, but its maintenance costs would be higher. Since the Option B machine is of initial higher quality, it is expected to have a salvage value at the end of its useful life. The following estimates were made of the cash flows. The company's cost of capital is 11%.
Instructions
(a) Compute the (1) net present value and (2) internal rate of return for each option. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.)
(b) Which option should be accepted?
PROBLEMS: SET C
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Problem Set C.
COMPREHENSIVE PROBLEM: Chapters 19 TO 26
CP26 You would like to start a business manufacturing a unique model of bicycle helmet. In preparation for an interview with the bank to discuss your financing needs, you need to provide the following information. A number of assumptions are required; clearly note all assumptions that you make.
Instructions
(a) Identify the types of costs that would likely be involved in making this product.
(b) Set up five columns as indicated.
Classify the costs you identified in (a) into the manufacturing cost classifications of product costs (direct materials, direct labor, and manufacturing overhead) and period costs.
(c) Assign hypothetical monthly dollar figures to the costs you identified in (a) and (b).
(d) Assume you have no raw materials or work in process beginning or ending inventories. Prepare a projected cost of goods manufactured schedule for the first month of operations.
(e) Project the number of helmets you expect to produce the first month of operations. Compute the cost to produce one bicycle helmet. Review the result to ensure it is reasonable; if not, return to part (c) and adjust the monthly dollar figures you assigned accordingly.
(f) What type of cost accounting system will you likely use—job order or process costing?
(g) Explain how you would assign costs in either the job order or process costing system you plan to use.
(h) Classify your costs as either variable or fixed costs. For simplicity, assign all costs to either variable or fixed, assuming there are no mixed costs, using the format shown.
(i) Compute the unit variable cost, using the production number you determined in (e).
(j) Project the number of helmets you anticipate selling the first month of operations. Set a unit selling price, and compute both the contribution margin per unit and the contribution margin ratio.
(k) Determine your break-even point in dollars and in units.
(l) Prepare projected operating budgets (sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative expense, and income statement). You will need to make assumptions for each of the following:
| Direct materials budget: | Quantity of direct materials required to produce one helmet; cost per unit of quantity; desired ending direct materials (assume none). |
| Direct labor budget: | Direct labor time required per helmet; direct labor cost per hour. |
| Budgeted income statement: | Income tax expense is 45% of income from operations. |
(m) Prepare a cash budget for the month. Assume the percentage of sales that will be collected from customers is 75%, and the percentage of direct materials that will be paid in the current month is 75%.
(n) Determine a relevant range of activity, using the number of helmets produced as your activity index. Recast your manufacturing overhead budget into a flexible monthly budget for two additional activity levels.
(o) Identify one potential cause of materials, direct labor, and manufacturing overhead variances for your product.
(p) Assume that you wish to purchase production equipment that costs $720,000. Determine the cash payback period, utilizing the monthly cash flow that you computed in part (m) multiplied by 12 months (for simplicity).
(q) Identify any nonfinancial factors that should be considered before commencing your business venture.
WATERWAYS CONTINUING PROBLEM
(This is a continuation of the Waterways Problem from Chapters 19 through 25.)
WCP26 Waterways Corporation puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 8% based on the rate of return it must pay its owners and creditors. Using that rate, Waterways then uses different methods to determine the best decisions for making capital outlays. Waterways is considering buying five new backhoes to replace the backhoes it now has. This problem asks you to evaluate that decision, using various capital budgeting techniques.
Go to the book's companion website, www.wiley.com/college/weygandt, to find the remainder of this problem.
Decision-Making Problems: Current Designs
BYP26-1 Recently, Mike Cichanowski, owner and CEO of Current Designs, received a phone call from the president of a brewing company. He was calling to inquire about the possibility of Current Designs producing “floating coolers” for a promotion his company was planning. These coolers resemble a kayak but are about one-third the size. They are used to float food and beverages while paddling down the river on a weekend leisure trip. The company would be interested in purchasing 100 coolers for the upcoming summer. It is willing to pay $250 per cooler. The brewing company would pick up the coolers upon completion of the order.
Mike met with Diane Buswell, controller, to identify how much it would cost Current Designs to produce the coolers. After careful analysis, the following costs were identified.
| Direct materials | $80/unit |
| Direct labor | $60/unit |
| Variable overhead | $20/unit |
| Fixed overhead | $1,000 |
Current Designs would be able to modify an existing mold to produce the coolers. The cost of these modifications would be approximately $2,000.
Instructions
(a) Prepare an incremental analysis to determine whether Current Designs should accept this special order to produce the coolers.
(b) Discuss additional factors that Mike and Diane should consider if Current Designs is currently operating at full capacity.
BYP26-2 A company that manufactures recreational pedal boats has approached Mike Cichanowski to ask if he would be interested in using Current Designs’ rotomold expertise and equipment to produce some of the pedal boat components. Mike is intrigued by the idea and thinks it would be an interesting way of complementing the present product line.
One of Mike's hesitations about the proposal is that the pedal boats are a different shape than the kayaks that Current Designs produces. As a result, the company would need to buy an additional rotomold oven in order to produce the pedal boat components. This project clearly involves risks, and Mike wants to make sure that the returns justify the risks. In this case, since this is a new venture, Mike thinks that a 15% discount rate is appropriate to use to evaluate the project.
As an intern at Current Designs, Mike has asked you to prepare an initial evaluation of this proposal. To aid in your analysis, he has provided the following information and assumptions.
1. The new rotomold oven will have a cost of $256,000, a salvage value of $0, and an 8-year useful life. Straight-line depreciation will be used.
2. The projected revenues, costs, and results for each of the 8 years of this project are as follows.
Instructions
(a) Compute the annual rate of return. (Round to two decimal places.)
(b) Compute the payback period. (Round to two decimal places.)
(c) Compute the NPV using a discount rate of 9%. (Round to nearest dollar.) Should the proposal be accepted using this discount rate?
(d) Compute the NPV using a discount rate of 15%. (Round to nearest dollar.) Should the proposal be accepted using this discount rate?
Decision-Making Across the Organization
BYP26-3 Aurora Company is considering the purchase of a new machine. The invoice price of the machine is $140,000, freight charges are estimated to be $4,000, and installation costs are expected to be $6,000. Salvage value of the new equipment is expected to be zero after a useful life of 5 years. Existing equipment could be retained and used for an additional 5 years if the new machine is not purchased. At that time, the salvage value of the equipment would be zero. If the new machine is purchased now, the existing machine would have to be scrapped. Aurora's accountant, Lisah Huang, has accumulated the following data regarding annual sales and expenses with and without the new machine.
1. Without the new machine, Aurora can sell 12,000 units of product annually at a per unit selling price of $100. If the new machine is purchased, the number of units produced and sold would increase by 10%, and the selling price would remain the same.
2. The new machine is faster than the old machine, and it is more efficient in its usage of materials. With the old machine the gross profit rate will be 25% of sales, whereas the rate will be 30% of sales with the new machine.
3. Annual selling expenses are $180,000 with the current equipment. Because the new equipment would produce a greater number of units to be sold, annual selling expenses are expected to increase by 10% if it is purchased.
4. Annual administrative expenses are expected to be $100,000 with the old machine, and $113,000 with the new machine.
5. The current book value of the existing machine is $36,000. Aurora uses straight-line depreciation.
Instructions
With the class divided into groups, prepare an incremental analysis for the 5 years showing whether Aurora should keep the existing machine or buy the new machine. (Ignore income tax effects.)
Managerial Analysis
BYP26-4 MiniTek manufactures private-label small electronic products, such as alarm clocks, calculators, kitchen timers, stopwatches, and automatic pencil sharpeners. Some of the products are sold as sets, and others are sold individually. Products are studied as to their sales potential, and then cost estimates are made. The Engineering Department develops production plans, and then production begins. The company has generally had very successful product introductions. Only two products introduced by the company have been discontinued.
One of the products currently sold is a multi-alarm clock. The clock has four alarms that can be programmed to sound at various times and for varying lengths of time. The company has experienced a great deal of difficulty in making the circuit boards for the clocks. The production process has never operated smoothly. The product is unprofitable at the present time, primarily because of warranty repairs and product recalls. Two models of the clocks were recalled, for example, because they sometimes caused an electric shock when the alarms were being shut off. The Engineering Department is attempting to revise the manufacturing process, but the revision will take another 6 months at least.
The clocks were very popular when they were introduced, and since they are private-label, the company has not suffered much from the recalls. Presently, the company has a very large order for several items from Kmart Stores. The order includes 5,000 of the multi-alarm clocks. When the company suggested that Kmart purchase the clocks from another manufacturer, Kmart threatened to rescind the entire order unless the clocks were included.
The company has therefore investigated the possibility of having another company make the clocks for them. The clocks were bid for the Kmart order based on an estimated $6.90 cost to manufacture:
| Circuit board, 1 each @ $2.00 | $2.00 |
| Plastic case, 1 each @ $0.80 | 0.80 |
| Alarms, 4 @ $0.15 each | 0.60 |
| Labor, 15 minutes @ $12/hour | 3.00 |
| Overhead, $2.00 per labor hour | 0.50 |
MiniTek could purchase clocks to fill the Kmart order for $10 from Trans-Tech Asia, a Korean manufacturer with a very good quality record. Trans-Tech has offered to reduce the price to $7.50 after MiniTek has been a customer for 6 months, placing an order of at least 1,000 units per month. If MiniTek becomes a “preferred customer” by purchasing 15,000 units per year, the price would be reduced still further to $4.50.
Omega Products, a local manufacturer, has also offered to make clocks for MiniTek. They have offered to sell 5,000 clocks for $5 each. However, Omega Products has been in business for only 6 months. They have experienced significant turnover in their labor force, and the local press has reported that the owners may face tax evasion charges soon. The owner of Omega Products is an electronic engineer, however, and the quality of the clocks is likely to be good.
If MiniTek decides to purchase the clocks from either Trans-Tech or Omega, all the costs to manufacture could be avoided, except a total of $5,000 in overhead costs for machine depreciation. The machinery is fairly new, and has no alternate use.
Instructions
(a) What is the difference in profit under each of the alternatives if the clocks are to be sold for $14.50 each to Kmart?
(b) What are the most important nonfinancial factors that MiniTek should consider when making this decision?
(c) What do you think MiniTek should do in regard to the Kmart order? What should it do in regard to continuing to manufacture the multi-alarm clocks? Be prepared to defend your answer.
Real-World Focus
BYP26-5 Founded in 1983, Beverly Hills Fan Company is located in Woodland Hills, California. With 23 employees and sales of less than $10 million, the company is relatively small. Management feels that there is potential for growth in the upscale market for ceiling fans and lighting. They are particularly optimistic about growth in Mexican and Canadian markets.
Presented below is information from the president's letter in the company's annual report.
BEVERLY HILLS FAN COMPANY
President's Letter
An aggressive product development program was initiated during the past year resulting in new ceiling fan models planned for introduction this year. Award winning industrial designer Ron Rezek created several new fan models for the Beverly Hills Fan and L.A. Fan lines, including a new Showroom Collection, designed specifically for the architectural and designer markets. Each of these models has received critical acclaim, and order commitments for this year have been outstanding. Additionally, our Custom Color and special order fans continued to enjoy increasing popularity and sales gains as more and more customers desire fans that match their specific interior decors. Currently, Beverly Hills Fan Company offers a product line of over 100 models of contemporary, traditional, and transitional ceiling fans.
Instructions
(a) What points did the company management need to consider before deciding to offer the special-order fans to customers?
(b) How would incremental analysis be employed to assist in this decision?
BYP26-6 Campbell Soup Company is an international provider of soup products. Management is very interested in continuing to grow the company in its core business, while “spinning off” those businesses that are not part of its core operation.
Address: www.campbellsoups.com, or go to www.wiley.com/college/weygandt
Steps
1. Go to the home page of Campbell Soup Company at the address shown above.
2. Choose the annual report dated July 29, 2012.
Instructions
Review the financial statements and management's discussion and analysis, and answer the following questions.
(a) What was the total amount of capital expenditures for the fiscal year ending July 29, 2012, and how does this amount compare with the previous year?
(b) What interest rate did the company pay on new borrowings for the fiscal year ending July 29, 2012?
(c) Assume that this year's capital expenditures are expected to increase cash flows by $42 million. What is the expected internal rate of return (IRR) for these capital expenditures? (Assume a 10-year period for the cash flows.)
BYP26-7 Refer back to E26-11 to address the following.
Instructions
Prepare a memo to Maria Fierro, your supervisor. Show your calculations from E26-11, (a) and (b). In one or two paragraphs, discuss important nonfinancial considerations. Make any assumptions you believe to be necessary. Make a recommendation based on your analysis.
Ethics Case
BYP26-8 NuComp Company operates in a state where corporate taxes and workers’ compensation insurance rates have recently doubled. NuComp's president has just assigned you the task of preparing an economic analysis and making a recommendation relative to moving the entire operation to Missouri. The president is slightly in favor of such a move because Missouri is his boyhood home and he also owns a fishing lodge there.
You have just completed building your dream house, moved in, and sodded the lawn. Your children are all doing well in school and sports and, along with your spouse, want no part of a move to Missouri. If the company does move, so will you because the town is a one-industry community and you and your spouse will have to move to have employment. Moving when everyone else does will cause you to take a big loss on the sale of your house. The same hardships will be suffered by your coworkers, and the town will be devastated.
In compiling the costs of moving versus not moving, you have latitude in the assumptions you make, the estimates you compute, and the discount rates and time periods you project. You are in a position to influence the decision singlehandedly.
Instructions
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues in this situation?
(c) What would you do in this situation?
All About You
BYP26-9 Managerial accounting techniques can be used in a wide variety of settings. As we have frequently pointed out, you can use them in many personal situations. They also can be useful in trying to find solutions for societal issues that appear to be hard to solve.
Instructions
Read the Fortune article, “The Toughest Customers: How Hardheaded Business Metrics Can Help the Hard-core Homeless,” by Cait Murphy, available at http://money.cnn.com/magazines/fortune/fortune_archive/2006/04/03/8373067/index.htm. Answer the following questions.
(a) How does the article define “chronic” homelessness?
(b) In what ways does homelessness cost a city money? What are the estimated costs of a chronic homeless person to various cities?
(c) What are the steps suggested to address the problem?
(d) What is the estimated cost of implementing this program in New York? What results have been seen?
(e) In terms of incremental analysis, frame the relevant costs in this situation.
Considering Your Costs and Benefits
BYP26-10 School costs money. Is this an expenditure that you should have avoided? A year of tuition at a public four-year college costs about $8,655, and a year of tuition at a public two-year college costs about $1,359. If you did not go to college, you might avoid mountains of school-related debt. In fact, each year, about 600,000 students decide to drop out of school. Many of them never return. Suppose that you are working two jobs and going to college, and that you are not making ends meet. Your grades are suffering due to your lack of available study time. You feel depressed. Should you drop out of school?
YES: You can always go back to school. If your grades are bad and you are depressed, what good is school doing you anyway?
NO: Once you drop out, it is very hard to get enough momentum to go back. Dropping out will dramatically reduce your long-term opportunities. It is better to stay in school, even if you take only one class per semester. While you cannot go back and redo your initial decision, you can look at some facts to evaluate the wisdom of your decision.
Instructions
Write a response indicating your position regarding this situation. Provide support for your view.
Answers to Chapter Questions
Answers to Insight and Accounting Across the Organization Questions
p. 1230 That Letter from AmEx Might Not Be a Bill Q: What are the relevant costs that American Express would need to know in order to determine to whom to make this offer? A: Clearly, American Express would make this offer to those customers that are most likely to default on their bills. The most important relevant cost would be the “expected loss” that an at-risk customer posed. If a customer has a high probability of defaulting, and if the expected loss exceeds the $300 cost, then American Express can probably save money by paying that customer to quit using its card so that the customer doesn't incur an even bigger bill.
p. 1231 Giving Away the Store? Q: What are the relevant revenues and costs that Amazon should consider relative to the decision whether to offer the Prime free-shipping subscription? A: The relevant revenues to consider would be the estimated change in revenue that would result from offering free shipping and the $79 annual fee for a Prime subscription. The relevant costs would be the estimated additional shipping costs that the company would incur.
p. 1238 Time to Move to a New Neighborhood? Q: What were some of the factors that complicated the company's decision to move? How should the company have incorporated such factors into its incremental analysis? A: The company received only $7.5 million for its California property, only 58 of 75 key employees were willing to move, construction was delayed by a year which caused the new plant to increase in price by $1.5 million, and wages surged in Idaho due to low unemployment. In performing incremental analysis of the decision to move, a company should perform sensitivity analysis. This would include evaluating the impact on the decision if all costs were, for example, 10% higher than expected or if cost savings were 10% lower than expected.
p. 1241 Investing for the Future Q: Why is it important for top management to constantly monitor the nature, amount, and success of a company's capital expenditures? A: In order to remain competitive and to grow, companies must continually invest in new opportunities. However, not all projects will be successful, so management must continually monitor projects to ensure that continuation of the investment is in the company's best interest.
p. 1244 Can You Hear Me—Better? Q: Based on the potentially slow initial adoption of 4G by customers, how might the conclusions of a cash payback analysis of Verizon's 4G investment differ from a present value analysis? A: If the initial adoption of 4G by customers is slow, then the amount of cash received in the early years will be low. This would lengthen the cash payback period, making it unlikely that the investment would get high marks with this test. However, the long-run potential of 4G is probably quite high as more people switch to smart phones and consequently increase their use of services that benefit from a high-speed connection. These later cash flows may well be large enough that they provide a positive net present value amount.
p. 1247 Seeing the Big Picture Q: How important is the choice of discount rate in making capital budgeting decisions? A: The point of this discussion is that errors in implementation, as well as the accuracy of the estimated future benefits and costs as measured by cash inflows and outflows, is what matters the most when making capital expenditure decisions. While the choice of discount rates will result in incremental differences in present value calculations, “missing the big picture” has the potential to cause much bigger decision errors. Underestimating potential future cash inflows can result in missed opportunities. Underestimating future costs can result in failed investments.
Answers to Self-Test Questions
1. d 2. b 3. c [($18 – $14) × 3,000] 4. b 5. d 6. a 7. d ($68 – $55) – $12 8. b 9. c 10. d ($200,000 – $140,000 – $50,000) 11. b ($15 ÷ 3) 12. d 13. b 14. c 15. b
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.
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