McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved CHAPTER 16 Cost Analysis for Decision Making McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Decision Making Strategic, Operational, and Financial (Planning) Planning and Control Cycle Executing operational activities (Managing) Data collection and Performance Feedback Performance analysis: Plans vs. actual results (Controlling) L O 1 Implement Plans Revisit Plans

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved relevant cost A relevant cost is a future cost that differs between alternatives. 1 2 Relevant Cost Information L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Relevant Cost Information L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000. Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice. Opportunity Cost L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved  Will you drive or fly to Colorado for a spring break ski trip?  You have gathered the following information to help you with the decision. Motel cost is $90 per night. Meal cost is $25 per day. Your car insurance is $75 per month. Kennel cost for your dog is $7 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $700.  Driving requires two days, with an overnight stay, cutting your time in Colorado by two days.  Will you drive or fly to Colorado for a spring break ski trip?  You have gathered the following information to help you with the decision. Motel cost is $90 per night. Meal cost is $25 per day. Your car insurance is $75 per month. Kennel cost for your dog is $7 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $700.  Driving requires two days, with an overnight stay, cutting your time in Colorado by two days. Relevant Cost Information L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved $90 8 $25 8 $7 Relevant Cost Information L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Costs do not differ, so they are not relevant to decision. Also, car insurance is not relevant to the decision as it is a sunk cost. Relevant Cost Information L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Transportation costs differ between the two alternatives, so they are relevant to your decision. Are the two extra days in Colorado worth the $500 extra cost to fly? Relevant Cost Information L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those amounts that occur if the company decides to accept the new business. The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those amounts that occur if the company decides to accept the new business. The Special Pricing Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved MicroTech currently sells 4,400 laptop computers. The company has revenue and expenses as shown below: The Special Pricing Decision Based on capacity of 5,000 units: $2,500,000 ÷ 5,000 units = $500 per unit. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved MicroTech receives an offer to purchase 500 of its laptop computers for $1,800 each. If MicroTech accepts the offer, total fixed overhead will not increase and a selling commission will not be paid on the computers in the special order. Should MicroTech accept the offer? The Special Pricing Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved First let’s look at incorrect reasoning that leads to an incorrect decision. Our manufacturing cost is $2,000 per unit. I can’t sell for $1,800 per unit. The Special Pricing Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved This analysis leads to the correct decision. The Special Pricing Decision 000’s omitted from all numbers. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The Special Pricing Decision 500 new units × $800 = $400, new units × $1,800 selling price = $900,000 L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved new units × $450 = $225,000 The Special Pricing Decision 500 new units × $250 = $125,000 L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Even though the $1,800 selling price is less than the normal $2,400 selling price, MicroTech should accept the offer because net income will increase by $150,000. The Special Pricing Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved If MicroTech accepts the offer, net income will increase by $150,000. We can reach the same results more quickly like this: Special order contribution margin = $1,800 – $1,500 = $300 Change in income = $300 × 500 units = $150,000. The Special Pricing Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Should I continue to make the part, or should I buy it? What will I do with my idle facilities if I buy the part? The Make or Buy Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The Make or Buy Decision  The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier.  Decision rule: Costs avoided must be greater than outside supplier’s price to consider buying the component. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved MicroTech currently makes the motherboards used in its laptop computers. Unit costs for manufacturing the motherboards are: The Make or Buy Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved An outside supplier has offered to provide the motherboards at a cost of $300 each plus a $5 shipping charge per motherboard. Twenty percent of the fixed overhead will be avoided if the motherboards are purchased. MicroTech has no alternative use for the facilities. Should MicroTech accept the offer? The Make or Buy Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Differential costs of making (costs avoided if bought from outside supplier): The Make or Buy Decision MicroTech should not pay $305 per unit to an outside supplier to avoid the $270 per unit differential cost of making the part ($35 disadvantage). L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved If MicroTech buys the motherboards from the outside supplier, the idle facilities could be used to expand production of flat screen monitors that have a contribution margin of $50 each. Does this information change MicroTech’s decision? The Make or Buy Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The real question to answer is: “What is the best use of MicroTech’s facilities?” The opportunity cost of facilities changes the decision. The Make or Buy Decision L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Continue or Discontinue a Segment CRUISERS, INC. Segmented Income Statement For the Year Ended December 31st Discontinue the Repair Parts Division and increase operating income by $24,000 L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Continue or Discontinue a Segment L O 3 What about fixed expenses?

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Continue or Discontinue a Segment We must eliminate more in fixed expenses than the amount of contribution margin we are losing. amount of contribution margin we are losing. L O 3 Closing the Repair Parts Division will eliminate: Sales$320,000 Variable Expenses 160,000 Contribution Margin 160,000

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Continue or Discontinue a Segment L O 3 Operating Income Decreases by $40,000 if we discontinue the Repair Parts Division. Operating Income with Repair Parts Division$152, 000 Operating Income without Repair Parts Division (112,000) Decrease in Operating Income $ 40,000

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Short-Term Allocation of Scarce Resources L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Integrated Technologies produces two products and selected data are shown below: Short-Term Allocation of Scarce Resources If 120 hours of processing time are available, which product should be produced? L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Let’s calculate the contribution margin per hour of processing time. Short-Term Allocation of Scarce Resources L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Let’s calculate the contribution margin per hour of processing time. Short-Term Allocation of Scarce Resources Product 2 should be emphasized. It is the more valuable use of processing time, yielding a contribution margin of $100 per hour as opposed to $75 per hour for Product 1. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Let’s calculate the contribution margin per hour of processing time. Short-Term Allocation of Scarce Resources If there are no other considerations, the best plan would be to produce enough products to meet current demand for Product 2 and then use of any remaining time to make Product 1. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Let’s change topics. Long-Run Investment Decisions L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Capital Budgeting Managers must plan significant outlays for projects that have long-term implications such as the purchase of new equipment and introduction of new products. L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Ê Outcome is uncertain. Ë Large amounts of money are usually involved. Ì Investment involves a long-term commitment. Í Decision may be difficult or impossible to reverse. Capital Budgeting L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved ? ? ? Limited Investment Funds Plant Expansion New Equipment Office Renovation I will choose the project with the most profitable return on available funds. Investment Decision Special Considerations L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Business investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time. Investment Decision Special Considerations L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate used to calculate the present value of the investment proposal being analyzed. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. Cost of Capital L O 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Capital Budgeting Techniques Methods that use present value analysis: Net present value (NPV). Internal rate of return (IRR). Methods that use present value analysis: Net present value (NPV). Internal rate of return (IRR). Methods that do not use present value analysis: Payback. Accounting rate of return. Methods that do not use present value analysis: Payback. Accounting rate of return. L O 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved A comparison of the present value of cash inflows with the present value of cash outflows Net Present Value (NPV) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved  Chose a discount rate – the minimum required rate of return.  Calculate the present value of cash inflows.  Calculate the present value of cash outflows. NPV = Ë – Ì Net Present Value (NPV) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved General decision rule... Net Present Value (NPV) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved BoxMover, Inc. is considering the purchase of a conveyor costing $16,000 with a 7-year useful life and a $5,000 salvage value. Annual net cash flows are shown in the following table. BoxMover’s cost of capital is 12 percent. Ignoring taxes, compute the NPV for this investment. Net Present Value L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Net Present Value L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Present value factors for 12 percent Net Present Value L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved A positive net present value indicates that this project earns more than 12 percent, so the investment should be made. Net Present Value L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Brown’s cost of capital return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,004 Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Brown’s cost of capital return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,004 Net Present Value (NPV) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Brown’s cost of capital return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,004 Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Brown’s cost of capital return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,004 Using the present value of an annuity PV of inflows = $20,000 × = $113,004 NPV = $113,004 - $96,000 = $17,004 Net Present Value (NPV) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Calculate the NPV if Brown Company’s cost of capital is 14 percent instead of 12 percent. Note that the NPV is smaller using the larger interest rate. Using the present value of an annuity PV of inflows = $20,000 × = $104,322 NPV = $104,322 - $96,000 = $8,322 Net Present Value (NPV) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Ranking Investment Projects Profitability Present value of cash inflows index Investment required = The higher the profitability index, the more desirable the project. The higher the profitability index, the more desirable the project. L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved  The actual rate of return that will be earned by a proposed investment.  The interest rate that equates the present value of inflows and outflows from an investment project – the discount rate at which NPV = 0. Internal Rate of Return (IRR) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved  Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs.  The machine has a 10-year life. Internal Rate of Return (IRR) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Net annual cash flows PV factor for the internal rate of return = $104, 322 $20,000 = Internal Rate of Return (IRR) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved % Find the 10-period row, move across until you find the factor Look at the top of the column and you find a rate of 14%. Using the present value of an annuity of $1 table... Internal Rate of Return (IRR) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved  Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs.  The machine has a 10-year life. Internal Rate of Return (IRR) internal rate of return The internal rate of return on this project is 14%. If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable. L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved If annual cash inflows are unequal, trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. If annual cash inflows are unequal, trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. Internal Rate of Return (IRR) L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Some Analytical Considerations  Sensitivity analysis and post audits are helpful in dealing with estimates.  Cash flows far into the future are often not considered because of uncertainty and a small impact on present values.  Cash flows are assumed to occur at the end of the year.  Some projects will require additional investments over time.  Sensitivity analysis and post audits are helpful in dealing with estimates.  Cash flows far into the future are often not considered because of uncertainty and a small impact on present values.  Cash flows are assumed to occur at the end of the year.  Some projects will require additional investments over time. L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Some Analytical Considerations  Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income.  Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life.  Least cost projects, often required by law, will have negative NPV’s.  Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income.  Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life.  Least cost projects, often required by law, will have negative NPV’s. L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Jones Company is considering purchasing a machine that costs $55,000 with a 5-year life and $5,000 salvage value. ($55,000 - $5,000) ÷ 5 years Some Analytical Considerations L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Some Analytical Considerations L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Payback Period The payback period of an investment is the number of years it will take to recover the amount of the investment. Managers prefer investing in projects with shorter payback periods. L O 9

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved TexCo wants to install a machine that costs $17,000 and has an 8-year useful life with $1,000 salvage value. Annual net cash flows are: Payback Period Includes salvage L O 9

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved TexCo recovers the $17,000 purchase price between years 4 and 5, about 4.7 years for the payback period. Payback Period L O 9 2,500/3,500 =.7 years + 4 years

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Ignores the time value of money. Ignores cash flows after the payback period. Payback Period L O 9

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period? Payback Period L O 9 Yes... Payback Period ignores all future cash flows after the payback period

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The accounting rate of return focuses on accounting income instead of cash flows. Accounting Rate of Return Accounting Operating income rate of return Average investment = L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Reconsider the $17,000 investment being considered by TexCo. The annual operating income is $2,000. Compute the accounting rate of return. Accounting Rate of Return Accounting Operating income rate of return Average investment = L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Reconsider the $17,000 investment being considered by TexCo. The annual operating income is $2,000. Compute the accounting rate of return. Accounting Rate of Return Accounting Operating income rate of return Average investment = Beginning book value + Ending book value 2 L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Accounting Rate of Return Accounting $ 2,000 rate of return $16,000 = $17,000 + $15,000 2 Reconsider the $17,000 investment being considered by TexCo. The annual operating income is $2,000. Compute the accounting rate of return. = 12.5% L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved  Depreciation may be calculated several ways.  Income may vary from year to year.  Time value of money is ignored. So why would I ever want to use this method anyway? Accounting Rate of Return L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved In addition to the consequences of various quantitative models, management’s investment decisions are influenced by such qualitative factors as: 1. A business segment requiring special consideration; 2. Mandatory regulations and goals; 3. Technological developments within the industry; and 4. Limited resources and capital rationing. Investment Decisions L O

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved End of Chapter 16