Kế toán tài chính 2 - Chapter 27: Analysis for decision making

Analysis forDecision MakingMultimedia Slides by: Gail A. Mestas, MAcc, New Mexico State UniversityChapter 27Learning ObjectivesExplain how managers make short-run decisions in the management cycle.Define incremental analysis and describe how it applies to short-run decision analysis.Perform incremental analysis for outsourcing decisions, special order decisions, segment profitability decisions, sales mix decisions involving constrained resources, and sell or process-further decisions.Copyright © Houghton Mifflin Company. All rights reserved.Learning Objectives (cont’d)Identify types of projected costs and revenues used to evaluate alternatives for capital investment.Apply the concept of the time value of money.Analyze capital investment proposals using the net present value method.Analyze capital investment proposals using the payback period method and the accounting rate-of-return method.Copyright © Houghton Mifflin Company. All rights reserved.Short-Run Decision Analysis and the Management CycleObjective 1Explain how managers make short-run decisions in the management cycleCopyright © Houghton Mifflin Company. All rights reserved.Short-Run Decision Analysis and the Management CycleReaders of financial reports are interested in knowing what happened to produce those particular resultsAnswer this question using the historical information in these reportsProvides financial and nonfinancial quantitative informationShould be relevant, timely, and presented in a format that is easy to use in decision makingCopyright © Houghton Mifflin Company. All rights reserved.Short-Run Decision Analysis and the Management Cycle (cont’d)Short-run decision analysisThe systematic examination of any decision whose effects will be felt over the course of the next yearManagers frequently take five predictable actions when deciding what to doFirst four actionsDuring the planning stageLast actionDuring the reviewing stageCopyright © Houghton Mifflin Company. All rights reserved.PlanningManagers take the following four actions during the planning stage when performing short-run decision analysisDiscover a problem or needIdentify all reasonable courses of actionPrepare a thorough analysis of each possible solutionIdentify total costs, savings, and other financial effectsSelect the best course of actionCopyright © Houghton Mifflin Company. All rights reserved.Planning (cont’d)The following qualitative factors will influence a bank manager’s decision to keep or eliminate a branch locationCompetitionDo competitors have a branch office located here?Economic conditionsDoes this branch location benefit the community we serve?Product or service qualityCan we attract more business because of the service quality of this branch?TimelinessDoes the branch promote customer service?Copyright © Houghton Mifflin Company. All rights reserved.ExecutingStage in which managersMust adapt to changing environmentsTake advantage of opportunities that will improve the organization’s profitability and liquidity in the short-runDuring this stage a bank manager may choose toEliminate a branch officeBecause costs exceed revenuesKeep a branch officeBecause the community expects the organization to provide this serviceCopyright © Houghton Mifflin Company. All rights reserved.ReviewingManagers evaluate each decision to determine whether it produced the forecasted resultsThis is the fifth predictable action when performing short-run decision analysisIf results fell short, managers identify and prescribe corrective actionIf the solution is not satisfactory or the problem remains, the management cycle begins againCopyright © Houghton Mifflin Company. All rights reserved.ReportingManagers prepare reports related to short-run decisions throughout the management cycleDevelop budgets that show estimated costs and revenues related to alternative courses of actionCompile analyses of data that support their decisionsCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat are the five predictable actions frequently taken by managers during short-run decision analysis?Discover a problem or needIdentify all reasonable courses of actionPrepare a thorough analysis of each possible solutionIdentify total costs, savings, and other financial effectsSelect the best course of actionEvaluate each decision to determine whether it produced the forecasted resultsCopyright © Houghton Mifflin Company. All rights reserved.Objective 2Define incremental analysis and describe how it applies to short-run decision analysisIncremental Analysis for Short-Run DecisionsCopyright © Houghton Mifflin Company. All rights reserved. is a method of comparing alternatives by focusing on the differences in their projected revenues and costsAlso called differential analysis if it ignores revenues or costs that stay the same or do not differ among alternativesIncremental AnalysisCopyright © Houghton Mifflin Company. All rights reserved.Irrelevant Costs and RevenuesDifferential costA cost that changes between alternativesAlso referred to as an incremental costIrrelevant revenueRevenues that will not differ between alternativesIrrelevant costA cost that does not differ between alternativesIncludes sunk costsCosts that were incurred because of a previous decision and cannot be recovered through the current decisionCopyright © Houghton Mifflin Company. All rights reserved.Irrelevant Costs and Revenues (cont’d)Home State Bank managers must decide to buy one of two ATM machines—C or W. The machines have the same purchase price but different revenues and cost characteristics. The company currently owns ATM B, which it bought 3 years ago for $15,000 and which has accumulated depreciation of $9,000. It is now obsolete and cannot be sold or traded inThe accountant has collected the following annual revenue and operating cost estimates for the two new machinesCopyright © Houghton Mifflin Company. All rights reserved.The first step in incremental analysis is to eliminate any irrelevant revenues and costsSunk costsThe book value of ATM BRepresents money that was spent in the past and does not affect the decision about whether to replace the old ATM with a new oneIrrelevant Costs and Revenues (cont’d)Home State Bank managers must decide to buy one of two ATM machines—C or W. The machines have the same purchase price but different revenues and cost characteristics. The company currently owns ATM B, which it bought 3 years ago for $15,000 and which has accumulated depreciation of $9,000. It is now obsolete and cannot be sold or traded inATM B would be of interest only if it could be sold or traded inCopyright © Houghton Mifflin Company. All rights reserved.Irrelevant Costs and Revenues (cont’d)Recall the annual revenue and operating cost estimates for the two new machinesThe costs of direct materials and fixed overhead are the same under both alternativesThese are irrelevant costs and can also be eliminated from the analysisCopyright © Houghton Mifflin Company. All rights reserved.Irrelevant Costs and Revenues (cont’d)The incremental analysis is prepared using only the differential revenues and costs that will change between the alternative ATMsCopyright © Houghton Mifflin Company. All rights reserved.Incremental AnalysisCopyright © Houghton Mifflin Company. All rights reserved.Opportunity Costs are the benefits that are forfeited or lost when one alternative is chosen over anotherCopyright © Houghton Mifflin Company. All rights reserved.Opportunity Costs (cont’d)When deciding between alternatives, managersUse incremental analysisSimplifies management’s evaluation of a decisionReduces time needed to choose the best course of actionDetermine opportunity costsMust consider other issues, such as quality and reputationCopyright © Houghton Mifflin Company. All rights reserved.Opportunity Costs (cont’d)The interest that could be earned from the proceeds of the sale is an opportunity cost for the nursery ownerIt is revenue the owner has chosen to forego to continue operating the nursery in that locationA plant nursery has been in operation for many years at the intersection of two highways. A bank has offered the owner a high price for the landCopyright © Houghton Mifflin Company. All rights reserved.Opportunity Costs (cont’d)The salary the teller would lose by returning to school is an opportunity costThe total cost of school includes not only tuition, books, supplies, and living expenses, but also the amount of salary foregone while the teller is a full-time studentA bank teller is deciding whether to go back to school full time to earn a degree in financeCopyright © Houghton Mifflin Company. All rights reserved.Opportunity Costs (cont’d)Opportunity costs often come into play when a company is operating at or near full capacity and must choose what products or services to offerCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is an opportunity cost?A benefit that is given up because one course of action is taken instead of anotherCopyright © Houghton Mifflin Company. All rights reserved.Application of Incremental Analysis and Short-Run DecisionsObjective 3Perform incremental analysis for outsourcing decisions, special order decisions, segment profitability decisions, sales mix decisions involving constrained resources, and sell or process-further decisionsCopyright © Houghton Mifflin Company. All rights reserved.Application of Incremental Analysis and Short-Run DecisionsIncremental analysis can be applied to the following common situationsOutsourcing decisionsSpecial order decisionsSegment profitability decisionsSales mix decisions involving constrained resourcesSell or process-further decisionsCopyright © Houghton Mifflin Company. All rights reserved.OutsourcingThe use of suppliers outside the organization to perform services or produce goods that could be performed or produced internallyMake-or-buy decisionsDecisions about whether to make a part internally or buy it from an external supplierMay lead to outsourcingIncremental Analysis for Outsourcing DecisionsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)Core competenciesThe activities an organization performs bestMany companies focus their resources on their core competencies toImprove operating incomeCompete effectively in global marketsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)Organizations may outsource expensive, nonvalue-adding activitiesPayroll processingTrainingManaging fleets of vehiclesSales and marketingCustodial servicesInformation managementMany areas that are outsourced involve either relatively low skill areas or highly specialized knowledge that can be better acquired from experts outside the companyCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)Outsourcing production or operating activities can reduce a company’sInvestment in physical assets and human resourcesImproves cash flowOperating costsImproves operating incomeCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)A common decision facing managers is whether to make or buy a partGoalSelect the most profitable alternativeMust identify the costs of each alternative and their effects on revenues and existing costsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)Managers need the following information for analysisCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)For the past five years, Box Company has purchased packing cartons from an outside supplier at a cost of $1.25 per carton. The supplier has just informed Box Company that it will be raising the price to $1.50 per carton, effective immediatelyBox Company has idle machinery that could be adjusted and used to produce packing cartonsAnnual production and usage would be 20,000 cartonsEstimated cost of direct materials is $.84 per cartonWorkers earn $8.00 per hour and can produce 20 cartons per hour ($.40 per carton)Cost of variable manufacturing OH will be $4 per direct labor hour and 1,000 direct labor hours will be requiredFixed overhead per year includes $4,000 of depreciation and $6,000 of other fixed costsThere is space to produce the cartons and the machines will remain idle if the part is purchasedCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Outsourcing Decisions (cont’d)Irrelevant costsDepreciation costs and other fixed manufacturing OH costsMachinery and factory space have no other useCosts are the same for both alternativesRelevant costs and revenuesCompared for each alternative in an incremental analysisCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis: Outsourcing DecisionThe company will save $1,200 if it decides to make the cartonsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order DecisionsSpecial order decisionsDecisions about whether to accept or reject special orders at prices below normal market pricesUsually involve large numbers of similar items that are sold in bulkAre not expected and so are not included in annual cost or sales estimatesAre one-time events and should not be included in revenue or cost estimates for subsequent yearsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)Before accepting a special product orderEnsure that the products involved are sufficiently different from the regular product line to avoidViolating federal price discrimination laws Reducing unit sales from the full-priced regular product lineCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)A special product order should be accepted only if it maximizes operating incomeBased onThe organization’s strategic plan and objectivesRelevant costs of the special orderQualitative factorsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)Approaches to determining whether a special order should be acceptedCompare special order price to relevant costs to produce, package, and ship the orderRelevant costs includeVariable costsVariable selling costs, if anyOther costs directly associated with the special order (e.g., freight, insurance, packaging, and labeling the product)Prepare a special order bid priceCalculate a minimum selling priceEquals relevant costs plus an estimated profitCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)Costs that may be excluded from a special order decision analysisSales commission expensesCustomer may have contacted the company directlyFixed costs of existing facilityDo not change if the company accepts the special orderCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)Costs relevant to the decisionFixed costs that must be incurred to fill the special orderPurchase of additional machineryIncrease in supervisory helpIncrease in insurance premiumsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)Home State Bank has been approved to provide and service four ATMs at a special event. The event sponsors want the fee per ATM transaction to be $.50. Past ATM usage at special events has averaged 2,000 transactions per machine. The bank has located four idle ATMs for the eventBased on the following cost data, should Home State Bank accept the special event offer?Copyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Special Order Decisions (cont’d)Irrelevant costsFixed costsThe only costs affected by the order are Direct materialsDirect laborVariable overheadCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis: Special Order DecisionAccepting the special offer will increase contribution margin, and therefore operating income, by $1,200Copyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability DecisionsManagers must decide whether to keep or drop unprofitable segmentsProduct linesServicesSales territoriesDivisionsDepartmentsStoresOutletsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability Decisions (cont’d)Management must select the alternative that maximizes operating income based onThe organization’s strategic plan and objectivesRelevant revenues and costsQualitative factorsObjective of this analysisIdentify the segments that have a negative segment marginCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability Decisions (cont’d)Segment marginA segment’s sales revenue minus its direct costs (direct variable costs and direct fixed costs traceable to the segment)Such costs are assumed to be avoidable costsCan be eliminated if the segment were droppedCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability Decisions (cont’d)If a segment has a positive segment margin, it should be keptIt is able to cover its own direct costsCan contribute a portion of its revenue to cover common costs and add to operating incomeIf a segment has a negative segment margin, it should be eliminatedHowever, the remaining segments must be able to cover the unavoidable costsCommon cost that will be incurred regardless of the decisionCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability Decisions (cont’d)To analyze segment profitabilityPrepare a segmented income statementUse variable costing to identify variable and fixed costsDirect fixed costsThe fixed costs that are traceable to the segmentsCommon costsThe remaining fixed costsAre not assigned to segmentsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability Decisions (cont’d)Incremental analysis shows that operating income will increase by $9,000 if the Safe Deposit Division is droppedOnce the segmented income statement has been completed, an incremental analysis can be preparedCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Segment Profitability Decisions (cont’d)Incremental analysis now shows that operating income will decrease by $7,500 if the Safe Deposit Division is droppedAssume that Bank Operation’s sales will decrease 20 percent if management eliminates the Safe Deposit DivisionCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix DecisionsResource constraintsLimits on resources may restrict types or quantities of products or services a company can provideMachine timeAvailable laborOther activitiesInspectionEquipment setupCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Organizations must decide which products or services contribute the most to company profitability in relation to the amount of capital assets or other constrained resources needed to offer these itemsIdentify by calculating the contribution margin per constrained resource for each product or serviceCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Sales mix decisionTo select the alternative that maximizes the contribution margin per constrained resourceBased on the organization’sStrategic plan and objectivesRelevant revenues and costsQualitative factorsUse incremental analysisCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Decision analysis uses two stepsCalculate contribution margin per unit for each product or service affected by the constrained resourceEquals selling price per unit less variable costs per unitCalculate contribution margin per unit of the constrained resourceEquals contribution margin per unit divided by the quantity of the constrained resource required per unitCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Home State Bank offers three types of loans: commercial loans, auto loans, and home loans. Current loan application capacity is 100,000 processing hoursThe product line data are as followsQuestion 1Which product line should be advertised and promoted initially because it is the most profitable for the bank? Which should be second? Which should be last?Copyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis: Sales Mix Decision Involving Constrained ResourcesIncremental Analysis for Sales Mix Decisions (cont’d)Loans that provide the highest contribution margin per processing hour should be sold firstThe analysis indicates that the loans should be sold in the following orderAuto loansHome loansCommercial loansCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Home State Bank offers three types of loans: commercial loans, auto loans, and home loans. Current loan application capacity is 100,000 processing hoursThe product line data are as followsQuestion 2How many of each type of loan should be sold to maximize the company’s contribution margin based on current loan activity of 100,000 processing hours? What is the total contribution margin for that combination?Copyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Compare current loan application activity to the required loan activity to meet the current loan demandThe current demand exceeds the current capacity by 15,000 processing hoursCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sales Mix Decisions (cont’d)Management must determine the sales mix that maximizes the company’s contribution marginWill also maximize its operating incomeCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis: Sales Mix Decision Involving Constrained ResourcesIncremental Analysis for Sales Mix Decisions (cont’d)Copyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further DecisionsSome companies offer products or services that can either be sold in a basic form or be processed further and sold as a more refined product or service to a different marketExampleMeatpacking companyCan sell sides of beef and pounds of bones to other companies for further processingCan decide to cut and package meet, process bone into fertilizer, and tan hides into leatherCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)Sell or process-further decisionA decision about whether to sell a joint product at the split-off point or sell it after further processingJoint productsTwo or more products, made from a common material or process, that cannot be identified as separate products or services during some or all of the processingSplit-off pointA specific point where joint products or services become separate and identifiablePoint at which a company may choose to sell or process furtherCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)ObjectiveSelect the alternative that maximizes operating incomeBased on Organization’s strategic plan and objectivesRelevant revenues and costsQualitative factorsCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)Steps in incremental analysis processCalculate incremental revenueDifference between total revenue if sold at split-off point and total revenue if sold after processing furtherCompare incremental revenue to incremental costs of processing furtherChoose to process further if incremental revenue exceeds incremental costsIf incremental costs exceed incremental revenue, choose to sell at the split-off pointCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)Joint costs, or common costs, are ignored in the analysisThey are incurred before the split-off point and do not change if further processing occursEven though joint costs are assigned to products or services when valuing inventories and calculating cost of goods sold, they are not relevant to a sell or process further decisionCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)Basic CheckingOnline checking account, debit card, and online bill payment with a required minimum average balance (RMAB) of $500Premier CheckingPaper and online checking account, debit card, a credit card, and a small life insurance policy equal to the maximum credit limit on the credit card. RMAB $1,000Personal BankerAll the features of Premier Checking plus a safe deposit box, $5,000 personal line of credit at prime, financial investment advice, and a toaster on opening the account. RMAB $5,000Home State Bank’s management is looking for new markets for banking services. They are considering adding two levels of service beyond the Basic Checking account services, Premier Checking and Personal BankerCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)The bank can earn sales revenue of 5 percent on its checking account balancesThe total cost of Basic Checking is currently $50,000The bank’s accountant provided the following data per accountCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis: Sell or Process-Further DecisionCopyright © Houghton Mifflin Company. All rights reserved.Incremental Analysis for Sell or Process-Further Decisions (cont’d)The analysis indicates that the bank should offer personal banking services in addition to Basic Checking accountsNotice that the $50,000 joint costs of Basic Checking were ignored because they are sunk costs that will not influence the decisionCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat should all decisions based on incremental analysis take into account?Final decisions should always take into account the organization’s strategic plan and objectives, relevant revenues and costs, and qualitative factorsCopyright © Houghton Mifflin Company. All rights reserved.Capital Investment DecisionsObjective 4Identify types of projected costs and revenues used to evaluate alternatives for capital investmentCopyright © Houghton Mifflin Company. All rights reserved.Capital Investment Decisions are decisions about when and how much to spend on capital facilities and other long-term projectsMay includeMachinery, systems, or processesBuilding additions, renovations, or new structuresEntire new divisions or product linesDistribution and software systemsCapital investments are expensive and decisions about them must be made carefullyCopyright © Houghton Mifflin Company. All rights reserved.Capital Investment Analysis is the process of making decisions about capital invesmentsAlso called capital budgetingConsists ofIdentifying the need for a capital investmentAnalyzing courses of action to meet that needPreparing reports for managersChoosing the best alternativeAllocating funds among competing needsCopyright © Houghton Mifflin Company. All rights reserved.Capital Investment Analysis (cont’d)Every part of the organization participates in the processFinancial analystsSupply a target cost of capital or desired rate of return and an estimate of how much money can be spent annually on capital facilitiesMarketing specialistsPredict trends and new product demandsHelps in determining which operations need expansion or new equipmentManagers at all levelsHelp identify facility needsPrepare preliminary cost estimates for the desired capital investmentCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment AnalysisManagers must predict how the new asset will perform and how it will benefit the companyUse various measures to estimate the benefits to be derived from a capital investmentCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Two methods of measuring the expected benefit from an investment projectNet incomeManagers determine increases in net income resulting from the capital investment for each alternativeNet cash inflowsBalance of increases in projected cash receipts over increases in projected cash payments resulting from a capital investmentMore widely used measureCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Equipment replacement decisions may involve alternatives for which revenues are the same among alternativesBenefits are measured in cost savingsCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Either net cash inflows or cost savings can be used as the basis for evaluationIf analysis involvesCash receiptsUse net cash inflowsCash outlaysUse cost savingsCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Equal cash flowsProjected cash flows are the same from year to yearUnequal cash flowsProjected cash flows vary from year to yearAre commonRequire a more detailed analysisCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Carrying value of an assetIs the undepreciated portion of the original cost of a fixed assetCost of the asset less its accumulated depreciationIs irrelevant in capital investment analysis It is a past, or historical, cost and will not be altered by the decisionNet proceeds from the sale or disposal of an assetAre relevantAffect cash flow and may differ for each alternativeCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Income taxes alter the amount and timing of cash flows of projects under consideration by for-profit companiesThe effects of taxes must be included in capital investment analysesDepreciation expense is tax-deductibleStrongly influences the amount of income taxes a company paysCan lead to significant tax savingsCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Assume a company has a tax rate of 30 percent on taxable incomeIt is considering a capital project that will make the following annual contribution to operating incomeCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Net cash flows for this project can be determined in two waysNet cash inflows—receipts and disbursementsNet cash inflows—income adjustment procedureCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Net cash inflows—receipts and disbursementsCopyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Net cash inflows—income adjustment procedureIn both computations, net cash inflows are $170,000, and the total effect of income taxes is to lower the net cash inflows by $30,000Copyright © Houghton Mifflin Company. All rights reserved.Measures Used in Capital Investment Analysis (cont’d)Other cash inflows relevant to evaluating a proposed capital investmentDisposal of an assetProceeds from the sale of an old asset are current cash inflowsProjected disposal or residual values of replacement equipmentRepresent future cash inflows and usually differ among alternativesSometimes called disposal or salvage valueCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is the carrying value of an asset, and is it relevant to a capital investment analysis?Carrying value of an asset is the undepreciated portion of the original cost of a fixed asset. It is equal to the cost of the asset less its accumulated depreciation It is irrelevant in capital investment analysis because it is a past, or historical, cost and will not be altered by the decisionCopyright © Houghton Mifflin Company. All rights reserved.The Time Value of MoneyObjective 5Apply the concept of the time value of moneyCopyright © Houghton Mifflin Company. All rights reserved.The Time Value of Money is the concept that cash flows of equal dollar amounts separated by an interval of time have different present values because of the effect of compound interestThe notions of interest, present value, and future value are all related to the time value of moneyCopyright © Houghton Mifflin Company. All rights reserved.Interest is the cost associated with the use of money for a specific period of timeIs an important consideration in any business decisionCopyright © Houghton Mifflin Company. All rights reserved.Interest (cont’d)Simple interestThe interest cost for one or more periods when the amount on which the interest is computed stays the same from period to periodCompound interestThe interest cost for two periods or more when the amount on which interest is computed changes in each period to include all interest paid in previous periodsCopyright © Houghton Mifflin Company. All rights reserved.Example: Simple InterestJo Sanka accepts an 8 percent, $30,000 note due in 90 days How much will Sanka receive in total when the note comes due?The total Sanka will receive is computed as followsThe formula for calculating simple interest is as followsIf the interest is paid and the note is renewed for an additional 90 days, the interest calculation will remain the sameCopyright © Houghton Mifflin Company. All rights reserved.Example: Compound InterestAndy Clayburn deposits $5,000 in an account that pays6 percent interest. The interest is paid at the end of the year, and that interest is added to the principal at that time. This total in turn earns interest. He expects to leave the principal and accumulated interest in the account for 3 yearsWhat will be his account total at the end of three years?Note that the annual amount of interest increases each year by the interest rate times the interest of the previous yearCopyright © Houghton Mifflin Company. All rights reserved.Present ValueWhat is the difference between receiving $100 today or one year from now?If received todayCan invest the amount and earn interest on itIf received one year from nowThe opportunity to earn interest over the year is foregoneAn amount to be received in the future (future value) is not worth as much today as the same amount to be received today (present value) because of the cost associated with the passage of timeCopyright © Houghton Mifflin Company. All rights reserved.Present Value (cont’d)Present ValueThe amount that must be invested now at a given rate of interest to produce a given future valueFuture valueThe amount an investment will be worth at a future date if it is invested at compound interestPresent value and future value are closely relatedCopyright © Houghton Mifflin Company. All rights reserved.Present Value (cont’d)Daschel Company needs $1,000 one year from now. How much should the company invest today to achieve the goal if the interest rate is 5 percent?Interest of 5 percent on $952.38 for one year equals $47.62, and the two amounts added together equal $1,000.00Copyright © Houghton Mifflin Company. All rights reserved.Present Value of a Single Sum Due in the FutureThe preceding equation can be adapted to compute this amountReza Company must invest $3,455.34 today to have $4,000.00 in three yearsReza Company wants to be sure of having $4,000 at the end of 3 years. How much should the company invest today to achieve the goal if the interest rate is 5 percent?Copyright © Houghton Mifflin Company. All rights reserved. Use Table 3 to compute the amount Reza Company must invest todayLook down the 5 percent column and across the row for 3 periods to find the factor 0.864Except for a difference of $0.66, the answer is the same as the earlier onePresent Value of a Single Sum Due in the Future (cont’d)Reza Company wants to be sure of having $4,000 at the end of 3 years. How much should the company invest today to achieve the goal if the interest rate is 5 percent?Copyright © Houghton Mifflin Company. All rights reserved.Present Value of an Ordinary AnnuityOrdinary annuityA series of equal payments or receipts that will begin one time period from the current datePresent value of an ordinary annuityThe present value of amounts equally spaced over a period of timeCopyright © Houghton Mifflin Company. All rights reserved.The present value of each payment to Foder Company can be calculated separately using Table 3 and then summed for the total present valueThe present value of this sale is $13,615Present Value of an Ordinary Annuity (cont’d)What is the present value of this sale?Foder Company has sold a piece of property and is to receive $15,000 in three equal annual payments of $5,000, beginning one year from today. The current interest rate is 5%Copyright © Houghton Mifflin Company. All rights reserved. Use Table 4 to compute the present value of the payments Foder will receiveLook down the 5 percent column and across the row for 3 periods to find the factor 2.723The answer is the same as the earlier onePresent Value of an Ordinary Annuity (cont’d)Foder Company has sold a piece of property and is to receive $15,000 in three equal annual payments of $5,000, beginning one year from today. The current interest rate is 5%Copyright © Houghton Mifflin Company. All rights reserved.Present Value of an Ordinary Annuity (cont’d)If Foder Company is willing to accept a 5 percent rate of return, management will be equally satisfied to receiveA single cash payment of $13,615 todayThree equal annual cash payments of $5,000 spread over the next three yearsCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is the difference between simple and compound interest?For simple interest calculations, the amount on which interest is calculated stays the same from period to period When calculating compound interest, the amount on which interest is calculated increases at the end of each period by the amount of interest for that periodCopyright © Houghton Mifflin Company. All rights reserved.The Net Present Value Methods of Evaluating Proposed Capital InvestmentsObjective 6Analyze capital investment proposals using the net present value methodCopyright © Houghton Mifflin Company. All rights reserved.The Net Present Value Methods of Evaluating Proposed Capital InvestmentsWhen evaluating a proposed capital investment, managers must predict how the new asset will PerformBenefit the companyNet present value methodMost important measure used to estimate the benefits to be derived from a capital investmentCopyright © Houghton Mifflin Company. All rights reserved.Net Present Value evaluates a capital investment by discounting its future cash flows to their present values and subtracting the amount of the initial investment from their sumThe net present values for all proposed projects are comparedThose with net present values that exceed the initial investment are selected for implementationCopyright © Houghton Mifflin Company. All rights reserved.Advantages of the Net Present Value MethodIncorporates the time value of money into the analysisFuture cash inflows and outflows are discounted by the company’s minimum rate of return to determine their present valuesThe minimum rate of return should be greater than or equal to the company’s cost of capitalCopyright © Houghton Mifflin Company. All rights reserved.Advantages of the Net Present Value Method (cont’d)Cost of capitalWeighted-average rate of return a company must pay to its long-term creditors and shareholders for the use of their fundsCopyright © Houghton Mifflin Company. All rights reserved.Advantages of the Net Present Value Method (cont’d)Each future cash inflow and outflow over the life of the assets is discounted to the presentSingle amountUse Table 3 Series of equal periodic amountsUse Table 4Copyright © Houghton Mifflin Company. All rights reserved.Advantages of the Net Present Value Method (cont’d)Positive net present valueTotal of the discounted net cash inflows exceeds the cash investment at the beginningRate of return on investment exceeds company's’ minimum rate of return (also called the hurdle rate)Project can be acceptedCopyright © Houghton Mifflin Company. All rights reserved.Advantages of the Net Present Value Method (cont’d)Negative net present valueCash investment at the beginning exceeds the total of the discounted net cash inflows Rate of return on investment is less than the company's’ minimum rate of return Project should be rejectedIf the net present value is zero, the project meets the minimum rate of return and can be acceptedCopyright © Houghton Mifflin Company. All rights reserved.Net Present Value Method IllustratedOpen Imaging Company is considering the purchase of a magnetic resonance imaging (MRI) machine to improve the efficiency of its Radiology Department. Management must decide between Model M and Model NModel MCost of $17,500Estimated residual value of $2,000 after 5 yearsProjected cash inflows of $6,000, $5,500, $5,000, $4,500, and $4,000 during its five-year lifeModel NCost of $21,000Estimated residual value of $2,000 after 5 yearsProjected cash inflows of $6,000 per year for 5 yearsCopyright © Houghton Mifflin Company. All rights reserved.Net Present Value Method IllustratedDetermine the net present value for Model MMust use Table 3 because of unequal cash flowsThe cash outflow for the purchase is not discounted because it occurs at time zeroThe residual value is discounted because it represents a cash inflow that will take place at the end of year 5Copyright © Houghton Mifflin Company. All rights reserved.Net Present Value Method Illustrated (cont’d)Determine the net present value for Model NTable 4 is used because the cash inflows are expected to be equal amounts in each yearHowever, Table 3 must still be used to determined the present value of the machine’s residual valueCopyright © Houghton Mifflin Company. All rights reserved.Net Present Value Method Illustrated (cont’d)Results of the two analysesNet present value of Model M is $303.50Net present value of Model N is ($404.00)Model M should be chosen because it Has a positive net present valueIs expected to exceed the company’s minimum rate of returnModel N should be rejected because it has a negative net present valueCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat does a negative net present value indicate?It indicates that a proposed capital project’s expected rate of return is less than the company's’ minimum rate of return. The project should be rejectedCopyright © Houghton Mifflin Company. All rights reserved.Other Methods of Capital Investment AnalysisObjective 7Analyze capital investment proposals using the payback period method and the accounting rate-of-return methodCopyright © Houghton Mifflin Company. All rights reserved.Other Methods of Capital Investment AnalysisTwo other commonly used methods for capital investment analysisPayback period methodAccounting rate-of-return methodProvide rough guides to evaluating capital investmentsNet present value method is bestCopyright © Houghton Mifflin Company. All rights reserved.The Payback Period Method bases the decision to invest in a capital project on the minimum length of time it will take to recover the amount of the initial investmentCopyright © Houghton Mifflin Company. All rights reserved.The Payback Period MethodGordon Company is interested in purchasing a new bottling machine that costs $51,000 and has a residual value of $3,000. The machine is expected to increase revenues by $17,900 per year and increase operating costs by $11,696 per year (including depreciation and taxes). The company uses the straight-line method of depreciation and the machine is expected to have a ten-year service lifeThe only noncash expense or revenue is depreciation, which must be removed from the operating costsCopyright © Houghton Mifflin Company. All rights reserved.The Payback Period Method (cont’d)Gordon Company is interested in purchasing a new bottling machine that costs $51,000 and has a residual value of $3,000. The machine is expected to increase revenues by $17,900 per year and increase operating costs by $11,696 per year (including depreciation and taxes). The company uses the straight-line method of depreciation and the machine is expected to have a ten-year service lifeThe payback period is computed as followsIf the company’s payback period is 5 years or less, this proposal would be approvedCopyright © Houghton Mifflin Company. All rights reserved.The Payback Period Method (cont’d)Calculating payback period for capital investment proposals with unequal annual net cash inflowsSubtract each annual amount, in chronological order, from the cost of the capital facilityWhen a zero balance is reached, the payback period has been determinedMay occur in the middle of a year Compute portion of the final year by dividing amount needed to reach zero by the entire year’s estimated cash inflowCopyright © Houghton Mifflin Company. All rights reserved.The Payback Period Method (cont’d)Widely usedIs easy to compute and understandUseful in areas where technology changes rapidlyDisadvantagesDoes not measure profitabilityDoes not adjust cash flows for the time value of moneyEmphasize the time it takes to recover the investment rather than the long-term return on the investmentIgnores all future cash flows after the payback periodDisadvantages of the payback period method significantly outweigh its advantages Copyright © Houghton Mifflin Company. All rights reserved.The Accounting Rate-of-Return Method is a method of evaluating capital investment proposals by dividing the project’s annual after-tax net income by the average cost of the investmentIs imprecise, but easyUses financial statement informationCopyright © Houghton Mifflin Company. All rights reserved.The Accounting Rate-of-Return Method (cont’d)The following formula is used to calculate accounting rate of returnTo compute average annual net income, use the cost and revenue data prepared for evaluating the projectThe following formula is used to calculate average investment costCopyright © Houghton Mifflin Company. All rights reserved.The Accounting Rate-of-Return Method (cont’d)Gordon Company is interested in purchasing a new bottling machine that costs $51,000 and has a residual value of $3,000. The machine is expected to increase revenues by $17,900 per year and increase operating costs by $11,696 per year (including depreciation and taxes). The company uses the straight-line method of depreciation and the machine is expected to have a ten-year service life. Only projects that are expected to yield more than 16% return are acceptedThe projected rate of return is higher than the minimum 16%, so management should seriously consider making this investmentCopyright © Houghton Mifflin Company. All rights reserved.The Accounting Rate-of-Return Method (cont’d)Widely usedEasy to understand and applyDisadvantagesNot a reliable figureNet income is averaged over the life of the investmentUnreliable if estimated annual income differs from year to yearCash flows are ignoredDoes not consider the time value of moneyCopyright © Houghton Mifflin Company. All rights reserved.DiscussionA machine costs $10,000, has an expected life of 4 years, and a residual value of $2,000. If purchased, it is expected to increase revenues by $5,000 per year and expenses by $3,500 per year. What is the payback period? Copyright © Houghton Mifflin Company. All rights reserved.Time for ReviewExplain how managers make short-run decisions in the management cycleDefine incremental analysis and describe how it applies to short-run decision analysisPerform incremental analysis for outsourcing decisions, special order decisions, segment profitability decisions, sales mix decisions involving constrained resources, and sell or process-further decisionsCopyright © Houghton Mifflin Company. All rights reserved.And FinallyIdentify types of projected costs and revenues used to evaluate alternatives for capital investmentApply the concept of the time value of moneyAnalyze capital investment proposals using the net present value methodAnalyze capital investment proposals using the payback period method and the accounting rate-of-return methodCopyright © Houghton Mifflin Company. All rights reserved.