26 Incremental Analysis and Capital Budgeting Learning Objectives 1 2 Describe management’s decision-making process and incremental analysis. 1 Analyze the relevant costs in various decisions involving incremental analysis. 2 Contrast annual rate of return and cash payback in capital budgeting. 3 Distinguish between the net present value and internal rate of return methods. 4

1 Making decisions is an important management function. Describe management’s decision-making process and incremental analysis. LEARNING OBJECTIVE 1 Making decisions is an important management function. Does not always follow a set pattern. Decisions vary in scope, urgency, and importance. Steps usually involved in process include: Illustration 26-1 Management’s decision-making process LO 1

Decision-Making Process In making business decisions, Considers both financial and non-financial information. Financial information Revenues and costs, and Effect on overall profitability. Nonfinancial information Effect on employee turnover The environment Overall company image. LO 1

Incremental Analysis Approach Decisions involve a choice among alternative actions. Process used to identify the financial data that change under alternative courses of action. Both costs and revenues may vary or Only revenues may vary or Only costs may vary LO 1

How Incremental Analysis Works Illustration 26-2 Basic approach in incremental analysis Alternative B Incremental revenue is $15,000 less. Incremental cost savings of $20,000 is realized. Produces $5,000 more net income. LO 1

How Incremental Analysis Works Important concepts used in incremental analysis: Relevant cost Opportunity cost Sunk cost LO 1

How Incremental Analysis Works Sometimes involves changes that seem contrary to intuition. Variable costs sometimes do not change under alternatives. Fixed costs sometimes change between alternatives. LO 1

Service Company Insight American Express 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). LO 1

Types of Incremental Analysis Common types of decisions involving incremental analysis: Accept an order at a special price. Make or buy component parts or finished products. Sell or process further them further. Repair, retain, or replace equipment. Eliminate an unprofitable business segment or product. LO 1

Incremental Analysis Question Incremental analysis is the process of identifying the financial data that 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. None of the above. LO 1

DO IT! 1 Incremental Analysis Owen T Corporation is comparing two different options. The company currently follows Option 1, with revenues of $80,000 per year, maintenance expenses of $5,000 per year, and operating expenses of $38,000 per year. Option 2 provides revenues of $80,000 per year, maintenance expenses of $12,000 per year, and operating expenses of $32,000 per year. Option 1 employs a piece of equipment that was upgraded 2 years ago at a cost of $22,000. If Option 2 is chosen, it will free up resources that will increase revenues by $3,000. Complete the following table to show the change in income from choosing Option 2 versus Option 1. Designate any sunk costs with an “S.” LO 1

The company currently follows Option 1, with revenues of $80,000 per year, maintenance expenses of $5,000 per year, and operating expenses of $38,000 per year. Option 2 provides revenues of $80,000 per year, maintenance expenses of $12,000 per year, and operating expenses of $32,000 per year. Option 1 employs a piece of equipment that was upgraded 2 years ago at a cost of $22,000. If Option 2 is chosen, it will free up resources that will increase revenues by $3,000. LO 1

Analyze the relevant costs in various decisions involving incremental analysis. LEARNING OBJECTIVE 2 Special Price Order Obtain additional business by making a major price concession to a specific customer. Assumes that sales of products in other markets are not affected by special order. Assumes that company is not operating at full capacity. LO 2

Accept an Order at a Special Price Illustration: 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 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? LO 2

Accept an Order at a Special Price Illustration 26-4 Incremental analysis—accepting an order at a special price Fixed costs do not change since within existing capacity – thus fixed costs are not relevant. Variable manufacturing costs and expected revenues change – thus both are relevant to the decision. LO 2

DO IT! 2a 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? Accept or Reject? Accept or Reject? LO 2

Make or Buy Illustration: Baron Company incurs the following annual costs in producing 25,000 ignition switches for motor scooters. Illustration 26-5 Annual product cost data Instead of making its own switches, Baron Company might purchase the ignition switches at a price of $8 per unit. If purchased, $10,000 of the fixed costs will be eliminated. “What should management do?” LO 2

Make or Buy Illustration 26-6 Incremental analysis—make or buy Total manufacturing cost is $1 higher per unit than purchase price. Must absorb at least $50,000 of fixed costs under either option. LO 2

OPPORTUNITY COST The potential benefit that may be obtained from following an alternative course of action. LO 2

OPPORTUNITY COST Illustration: 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. Illustration 26-7 Incremental analysis—make or buy, with opportunity cost LO 2

Make or Buy Question 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 the above. LO 2

Service Company Insight Amazon.com 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). LO 2

DO IT! 2b 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 Variable overhead $32,000 Direct labor 20,000 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? LO 2

DO IT! 2b Make or Buy (a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. *$24,000 x .75 **166,000 units x $0.90 Juanita Company will incur $1,400 of additional costs if it buys the electrical cords rather than making them. LO 2

DO IT! 2b Make or Buy Will your answer be different if the released productive capacity will generate additional income of $5,000? Yes, net income will be increased by $3,600 if Juanita Company purchases the electrical cords rather than making them. LO 2

Sell or Process Further May have option to sell product at a given point in production or to process further and sell at a higher price. Decision Rule: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. LO 2

Sell or Process Further Illustration: Woodmasters Inc. makes tables. The cost to manufacture an unfinished table is $35. The selling price per unfinished unit is $50. Woodmasters has unused capacity that can 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. Illustration 26-8 Per unit cost of unfinished table LO 2

Sell or Process Further The incremental analysis on a per unit basis is as follows. Illustration 26-9 Incremental analysis—sell or process further Should Woodmasters sell or process further. Should Woodmasters sell or process further? LO 2

Sell or Process Further Question 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 2

DO IT! 2c Sell or Process Further Easy Does It manufactures unpainted furniture for the do-it-yourself (DIY) market. It currently sells a child’s rocking chair for $25. Production costs are $12 variable and $8 fixed. Easy Does It is considering painting the rocking chair and selling it for $35. Variable costs to paint each chair are expected to be $9, and fixed costs are expected to be $2.Prepare an analysis showing whether Easy Does It should sell unpainted or painted chairs. Solution LO 2

Repair, Retain, or Replace Equipment Illustration: Jeffcoat Company is considering replacing a factory machine with a new machine. 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 and the old unit could be sold for $5,000. The incremental analysis for the four-year period is as follows. LO 2

Repair, Retain, or Replace Equipment Prepare the incremental analysis for the four-year period. Illustration 26-10 Retain or Replace? Retain or Replace? LO 2

Repair, Retain, or Replace Equipment Additional Considerations The book value of old machine does not affect the decision. Book value is a sunk cost. Costs which cannot be changed by future decisions (sunk cost) are not relevant in incremental analysis. However, any trade-in allowance or cash disposal value of the existing asset is relevant. LO 2

DO IT! 2d Repair or Replace Equipment Rochester Roofing is faced with a decision. The company relies very heavily on the use of its 60-foot extension lift for work on large homes and commercial properties. Last year, the company spent $60,000 refurbishing the lift. It has just determined that another $40,000 of repair work is required. Alternatively, Rochester Roofing has found a newer used lift that is for sale for $170,000. The company estimates that both the old and new lifts would have useful lives of 6 years. However, the lift is more efficient and thus would reduce operating expenses by about $20,000 per year. The company could also rent out the new lift for about $2,000 per year. The old lift is not suitable for rental. The old lift could currently be sold for $25,000 if the new lift is purchased. Prepare an incremental analysis that shows whether the company should repair or replace the equipment. LO 2

DO IT! 2d Repair or Replace Equipment Solution The analysis indicates that purchasing the new machine would increase net income for the 6-year period by $27,000. LO 2

Eliminate an Unprofitable Segment or Product Key: Focus on Relevant Costs. Consider effect on related product lines. Fixed costs allocated to the unprofitable segment must be absorbed by the other segments. Net income may decrease when an unprofitable segment is eliminated. Decision Rule: Retain the segment unless fixed costs eliminated exceed contribution margin lost. LO 2

Should Champ be eliminated? Eliminate an Unprofitable Segment or Product Illustration: Venus Company manufactures three models of tennis rackets: Profitable lines: Pro and Master Unprofitable line: Champ Should Champ be eliminated? Illustration 26-11 Segment income data LO 2

Eliminate an Unprofitable Segment or Product Prepare income data after eliminating Champ product line. Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master. Illustration 26-12 Income data after eliminating unprofitable product line Total income is decreased by $10,000. LO 2

Eliminate an Unprofitable Segment or Product Incremental analysis of Champ provided the same results: Do Not Eliminate Champ Illustration 26-13 Incremental analysis—eliminating unprofitable segment with no reduction in fixed costs LO 2

Unprofitable Segments Question 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 2

DO IT! 2e Unprofitable Segments Lambert, Inc. manufactures several types of accessories. For the year, the knit hats and scarves line had sales 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. LO 2

Contrast annual rate of return and cash payback in capital budgeting. LEARNING OBJECTIVE 3 Capital Budgeting is the process of making capital expenditure decisions in business. Amount of possible capital expenditures usually exceeds the funds available for such expenditures. Involves choosing among various capital projects to find the one(s) that will maximize a company’s return on investment. LO 3

Evaluation Process Many companies follow a carefully prescribed process in capital budgeting. Illustration 26-14 Corporate capital budget authorization process LO 3

Evaluation Process Providing management with relevant data for capital budgeting decisions requires familiarity with quantitative techniques. Most common techniques are: Annual Rate of Return Cash Payback Discounted Cash Flow LO 3

Annual Rate of Return Indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment. Illustration 26-16 Annual rate of return formula LO 3

Annual Rate of Return Illustration: Reno Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years. It will 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 26-16 Annual rate of return formula LO 3

Annual Rate of Return Computing Average Investment 130,000 + 0 Illustration 26-20 Formula for computing average investment 130,000 + 0 = $65,000 2 Expected annual rate of return $13,000 = 20% $65,000 A project is acceptable if its rate of return is greater than management’s required rate of return. LO 3

Annual Rate of Return Principal advantages: Major limitation: Simplicity of calculation. Management’s familiarity with the accounting terms used in the computation. Major limitation: Does not consider the time value of money. LO 3

DO IT! 3a 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. Advance slide in presentation mode to reveal answer. LO 3

Cash Payback Cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment. Illustration 26-19 Computation of net annual cash flow Illustration 26-18 Cash payback formula $130,000 ÷ $39,000 = 3.3 years LO 3

Cash Payback The shorter the payback period, the more attractive the investment. 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. LO 3

Cash Payback Illustration: Chen Company proposes an investment in a new website that is estimated to cost $300,000. Illustration 26-20 Net annual cash flow schedule Cash payback should not be the only basis for capital budgeting decision as it ignores expected profitability of the project. LO 3

Management Insight Verizon 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 spent billions on upgrading its networks in the past few years, so it now offers 4G LTE service to 97% of the nation. 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. Sources: Martin Peers, “Investors: Beware Verizon’s Generation GAP,” Wall Street Journal Online (January 26, 2010); and Chad Fraser, “What Warren Buffett Sees in Verizon,” Investing Daily(May 30, 2014). LO 3

DO IT! 3b 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. LO 3

Cash Payback Question A $100,000 investment with a zero scrap value has an 8-year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. 8.00 years. 3.08 years. 5.00 years. 13.33 years. LO 3

Distinguish between the net present value and internal rate of return methods. LEARNING OBJECTIVE 4 Discounted Cash Flow Generally recognized as the best conceptual approach. Considers both the estimated total net cash flows from the investment and the time value of money. Two methods: Net present value. Internal rate of return. LO 4

Net Present Value Method Net cash flows are discounted to their present value and then compared with the capital outlay required by the investment. Interest rate used in discounting is the required minimum rate of return. Proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment. LO 4

Net Present Value Method Illustration 26-21 Net present value decision criteria A proposal is acceptable when net present value is zero or positive. LO 4

Net Present Value Method EQUAL NET ANNUAL CASH FLOWS Illustration: 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. Illustration 26-22 Calculate the net present value. LO 4

Net Present Value Method EQUAL NET ANNUAL CASH FLOWS Illustration: Calculate the net present value. Illustration 26-23 The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. LO 4

Net Present Value Method UNEQUAL NET ANNUAL CASH FLOWS Illustration: 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. LO 4

Net Present Value Method UNEQUAL NET ANNUAL CASH FLOWS Illustration 26-24 Computing present value of unequal annual cash flows LO 4

Net Present Value Method UNEQUAL NET ANNUAL CASH FLOWS Illustration: Calculate the net present value. Illustration 26-25 Analysis of proposal using net present value method The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. LO 4

Management Insight Sharp Wide-Screen Capacity Building a new factory to produce 60-inch TV screens can cost $4 billion. But for more than 10 years, manufacturers of these screens have continued to build new plants. By building so many plants, they have expanded productive capacity at a rate that has exceeded the demand for big-screen TVs. In fact, during one recent year, the supply of big-screen TVs was estimated to exceed demand by 12%, rising to 16% in the future. One state-of-the-art plant built by Sharp was estimated to be operating at only 50% of capacity. Experts say that the price of big-screen TVs will have to fall much further than they already have before demand may eventually catch up with productive capacity. Source: James Simms, “Sharp’s Payoff Delayed,” Wall Street Journal Online (September 14, 2010). LO 4

Internal Rate of Return Method IRR method finds the interest yield of the potential investment. IRR is the rate that will cause the PV of the proposed capital expenditure to equal the PV of the expected annual cash inflows. Two steps in method: Compute the internal rate of return factor. Use the factor and the PV of an annuity of 1 table to find the IRR. LO 4

Internal Rate of Return Method Step 1. Compute the internal rate of return factor. Illustration 26-26 For Reno Company: $130,000 ÷ $39,000 = 3.3333 LO 4

Internal Rate of Return Method Step 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Assume a required rate of return for Reno of 10%. Decision Rule: Accept the project when the IRR is equal to or greater than the required rate of return. LO 4

Internal Rate of Return Method Illustration 26-27 Internal rate of return decision criteria LO 4

Comparing Discounted Cash Flow Method Illustration 26-28 Comparison of discounted cash flow methods LO 4

Discounted Cash Flow Question 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. LO 4

DO IT! 4 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 revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. Management has a required rate of return of 9%. (a) Calculate the net present value on this project. (b) Calculate the internal rate of return on this project, and discuss whether it should be accepted. LO 4

DO IT! 4 Discounted Cash Flow Watertown should accept the project. (a) Calculate the net present value on this project. Watertown should accept the project. LO 4

DO IT! 4 Discounted Cash Flow (b) Calculate the internal rate of return on this project, and discuss whether it should be accepted. $900,000 ÷ 210,000 = 4.285714. 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. LO 4

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