CHAPTER 26. Incremental Analysis and Capital Budgeting ASSIGNMENT CLASSIFICATION TABLE. B Problems. A Problems. Brief

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CHAPTER 26 Incremental Analysis and Capital Budgeting ASSIGNMENT CLASSIFICATION TABLE Study Objectives Questions Brief Exercises Exercises A Problems B Problems 1. Identify the steps in management s decision-making
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CHAPTER 26 Incremental Analysis and Capital Budgeting ASSIGNMENT CLASSIFICATION TABLE Study Objectives Questions Brief Exercises Exercises A Problems B Problems 1. Identify the steps in management s decision-making process. 2. Describe the concept of incremental analysis. 3. Identify the relevant costs in accepting an order at a special price. 4. Identify the relevant costs in a make-or-buy decision. 5. Give the decision rule for whether to sell or process materials further. 6. Identify the factors to consider in retaining or replacing equipment. 7. Explain the relevant factors in whether to eliminate an unprofitable segment. 8. Determine which products to make and sell when resources are limited. 1, , , 3 1A 1B 6, A 2B 8 5 5, , 9 3A 3B Contrast annual rate of return and cash payback in capital budgeting. 12, 13, 14, 15, 16 9, 1 11, 12, 13 4A, 5A 4B, 5B 26-1 ASSIGNMENT CLASSIFICATION TABLE (Continued) Study Objectives Questions Brief Exercises Exercises A Problems B Problems 1. Distinguish between the net present value and internal rate of return methods. 17, 18, 19, 2 11, 12, 13 12, 13, 14, 15 4A, 5A, 6A 4B, 5B, 6B 26-2 ASSIGNMENT CHARACTERISTICS TABLE Problem Number Description Difficulty Level Time Allotted (min.) 1A 2A 3A 4A 5A Make incremental analysis for special order, and identify nonfinancial factors in decision. Make incremental analysis related to make or buy; consider opportunity cost, and identify nonfinancial factors. Compute contribution margin, and prepare incremental analysis concerning elimination of divisions. Compute annual rate of return, cash payback, and net present value. Compute annual rate of return, cash payback, and net present value. Simple 2 3 Moderate 3 4 Moderate 3 4 Moderate 3 4 Complex 3 4 6A Compute net present value and internal rate of return. Moderate 2 3 1B 2B 3B 4B 5B Make incremental analysis for special order, and identify nonfinancial factors in decision. Make incremental analysis related to make or buy; consider opportunity cost, and identify nonfinancial factors. Compute contribution margin, and prepare incremental analysis concerning elimination of divisions. Compute annual rate of return, cash payback, and net present value. Compute annual rate of return, cash payback, and net Present value. Simple 2 3 Moderate 3 4 Moderate 3 4 Moderate 3 4 Complex 3 4 6B Compute net present value and internal rate of return. Moderate BLOOM S TAONOMY TABLE 26-4 Correlation Chart between Bloom s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems Study Objective Knowledge Comprehension Application Analysis Synthesis Evaluation 1. Identify the steps in management s decision-making process. BE26-1 Q26-1 Q26-2 E Describe the concept of incremental analysis. Q26-3 Q26-4 E26-1 BE Identify the relevant costs in accepting an order at a special price. Q26-5 BE26-3 E26-2 E26-3 P26-1A P26-1B 4. Identify the relevant costs in a makeor-buy decision. Q26-6 Q26-7 BE26-4 E26-4 P26-2A P26-2B 5. Give the decision rule for whether to sell or process materials further. Q26-8 BE26-5 E26-5 E Identify the factors to consider in retaining or replacing equipment. Q26-9 BE26-6 E Explain the relevant factors in whether to eliminate an unprofitable segment. Q26-1 BE26-7 E26-8 E26-9 P26-3A P26-3B 8. Determine which products to make and sell when resources are limited. Q26-11 BE26-8 E Contrast annual rate of return and cash payback in capital budgeting. Q26-13 Q26-12 Q26-14 Q26-15 Q26-16 BE26-9 BE26-1 E26-11 E26-13 E26-12 P26-4A P26-5A P26-4B P26-5B 1. Distinguish between the net present value and internal rate of return methods. Q26-18 Q26-19 Q26-2 Q26-17 BE26-12 E26-13 BE26-11 BE26-13 E26-12 E26-14 E26-15 P26-4A P26-5A P26-6A P26-4B P26-5B P26-6B Exploring the Web Organization Across the Decision Making Broadening Your Perspective Focus Real-World Organization Across the Decision Making Activity You All About Managerial Analysis Decision Making Across the Organization Communication Ethics Case ANSWERS TO QUESTIONS 1. The following steps are frequently involved in management s decision-making process: (a) Identify the problem and assign responsibility. (b) Determine and evaluate possible courses of action. (c) Make a decision. (d) Review results of the decision. 2. Your roommate is incorrect. Accounting contributes to the decision-making process at only two points: (1) prior to the decision, accounting provides relevant revenue and cost data for each course of action, and (2) following the decision, internal reports are prepared to show the actual effect of the decision on net income. 3. Disagree. Incremental analysis involves the identification of financial data that change under alternative courses of action. 4. In incremental analysis, the important point to consider is whether costs will differ (change) between the two alternatives. As a result, (1) variable costs may change under the alternative courses of action and (2) fixed costs may not change. 5. The relevant data in deciding whether to accept an order at a special price are the incremental revenues to be obtained compared to the incremental costs of filling the special order. 6. The manufacturing costs that are relevant in the make-or-buy decision are those that will change if the parts are purchased. 7. Opportunity cost may be defined as the potential benefit that may be obtained by following an alternative course of action. Opportunity cost is relevant in a make-or-buy decision when the facilities used to make the part can be used to generate additional income. 8. The decision rule in a decision to sell a product or to process it further is: Process further as long as the incremental revenue from the additional processing exceeds the incremental processing costs. 9. A sunk cost is a cost that cannot be changed by any present or future decision. Sunk costs, therefore, are not relevant in a decision to retain or replace equipment. 1. Net income will be lower if an unprofitable product line is eliminated when the product line is producing a positive contribution margin and its fixed costs cannot be avoided or reduced. 11. Contribution margin per unit of limited resource is determined by dividing the contribution margin per unit of the product by the number of units of the limited resource required to produce one unit of the product. 12. The screening of proposed capital expenditures may be done by a capital budgeting committee which submits its findings to the officers of the company. The officers, in turn, select the projects they believe to be the most worthy of funding and submit them to the board of directors. The directors ultimately approve the capital expenditure budget for the year. 26-5 Questions Chapter 26 (Continued) 13. The formula for the annual rate of return technique is: Annual net income average investment. 14. Cost of capital is the rate of return that management expects to pay on all borrowed and equity funds. The decision rule is: A project is acceptable if its rate of return is greater than or equal to management s minimum rate of return (which often is its cost of capital), and the project is unacceptable when the rate of return is less than the minimum rate of return. 15. Pete is not correct. The formula for the cash payback technique is: Cost of the capital investment net annual cash flows. The formula for the annual rate of return is: Expected annual net income average investment. 16. The cash payback technique is relatively easy to compute and understand. However, it should not ordinarily be the only basis for the capital budgeting decision because it ignores the profitability of the investment and the time value of money. 17. The two tables are: (1) Table 1 is the present value of a single future amount. This table is used when a project has uneven cash payments over its useful life. (2) Table 2 is the present value of a series of future cash flows. This table is used when a project has equal cash payments occurring at equal intervals of time over its useful life. 18. The decision rule is: Accept the project when net present value is zero or positive; reject the project when net present value is negative. 19. The steps are: (a) Compute the rate of return factor by dividing Capital Investment by Net Annual Cash Flows. (b) Use the factor and the present value of an annuity of 1 table to find the internal rate of return. 2. Under the internal rate of return method, the objective is to find the rate that will make the present value of the expected annual cash inflows equal the present value of the proposed capital expenditure. The decision rule under the internal rate of return method is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate. 26-6 SOLUTIONS TO BRIEF EERCISES BRIEF EERCISE 26-1 The correct order is: 1. Identify the problem and assign responsibility. 2. Determine and evaluate possible courses of action. 3. Make a decision. 4. Review results of the decision. BRIEF EERCISE 26-2 Alternative A Alternative B Net Income Increase (Decrease) Sales Costs Net income $15, 1, $ 5, $18, 12, $ 6, ($ 3, ( (2,) ($ 1, Alternative B is better than Alternative A. BRIEF EERCISE 26-3 Reject Order Accept Order Net Income Increase (Decrease) Revenues Costs Variable manufacturing Shipping Net income $ $ $92, 8, 4, $ 8, ($ 92, ((8,) ( (4,) ($ 8, The special order should be accepted. 26-7 BRIEF EERCISE 26-4 Make Buy Net Income Increase (Decrease) Variable manufacturing costs Fixed manufacturing costs Purchase price Total annual cost $5, 3, $8, $ 3, 53, $83, $(5,) ) (53,) $ (3,) The decision should be to continue to make the part. BRIEF EERCISE 26-5 Sell Process Further Net Income Increase (Decrease) Sales per unit Cost per unit Variable Fixed Total Net income per unit $ $2. $ $24. $ 12. (8.) ( (8.) $ 4. The bookcases should be processed further because the incremental revenues exceed incremental costs by $4. per unit. BRIEF EERCISE 26-6 Retain Equipment Replace Equipment Net 4-Year Income Increase (Decrease) Variable manufacturing costs New machine cost Total $2,4, $2,4, $1,76, 2, $1,96, ($ 64,* * (2,) $ 44, *$16, 4 The old factory machine should be replaced. 26-8 BRIEF EERCISE 26-7 Continue Eliminate Net Income Increase (Decrease) Sales Variable expenses Contribution margin Fixed expenses Net income $2, 18, 2, 4, ($ (2,) ( ) ) ($ 34,) ($(34,) $(2,) 18,) (2,) 6,) $ (14,) The Eagle product line should be continued because $2, of contribution margin will not be realized if the line is eliminated. This sum is greater than the $6, saving of fixed costs. BRIEF EERCISE 26-8 Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource [(a) (b)] Product A $11 2 $5.5 Product B $ $4.8 BRIEF EERCISE 26-9 $3, ($1, + $3,) = 7.5 years BRIEF EERCISE 26-1 The annual rate of return is calculated by dividing expected annual income by the average investment. The company s expected annual income is: $13, $8, = $5, Its average investment is: $49, + $1, 2 = $25, Therefore, its annual rate of return is: $5,/$25, = 2% 26-9 BRIEF EERCISE Project A Present value of net annual cash flows Capital investment Net present value Project B Present value of net annual cash flows Capital investment Net present value Cash 9% Discount Flows Factor = Present Value $7, = $449, , $ 54,236 Cash 9% Discount Flows Factor = Present Value $5, = $32,883 27, $ 5,883 Since Project A has a higher net present value than Project B, it should be selected. BRIEF EERCISE When net annual cash flows are expected to be equal, the internal rate of return can be approximated by dividing the capital investment by the net annual cash flows to determine the discount factor, and then locating this discount factor on the present value of an annuity table. $17,/$33,74 = By tracing across on the 7-year row we see that the discount factor for 9% is Thus, the internal rate of return on this project is approximately 9%. BRIEF EERCISE Net annual cash flows $34, 6.71 Capital investment $225, 1. Positive net present value Present Value $228,14 225, $ 3,14 The investment should be made because net present value is positive. 26-1 SOLUTIONS TO EERCISES EERCISE False. The first step in management s decision-making process is identify the problem and assign responsibility. 2. False. The final step in management s decision-making process is to review the results of the decision. 3. True. 4. False. In making business decisions, management ordinarily considers both financial and nonfinancial information. 5. True. 6. True. 7. False. Costs that are the same under all alternative courses of action do not affect the decision. 8. False. When using incremental analysis, either costs or revenues or both will change under alternative courses of action. 9. False. Sometimes variable costs will not change under alternative courses of action, but fixed costs will. EERCISE 26-2 (a) Reject Order Accept Order $24, 168, 62, $ 1, Net Income Increase (Decrease) Revenues (4, $6.) Cost of goods sold Operating expenses Net income $ $ (1) (2) $ 24, ((168,) ( (62,) $ 1, (1) Variable cost of goods sold = $2,4, 7% = $1,68,. Variable cost of goods sold per unit = $1,68, 4, = $4.2. Variable cost of goods sold for the special order = $4.2 4, = $168,. (2) Variable operating expenses = $9, 6% = $54,; $54, 4, = $1.35 per unit; 4, $1.35 = $54,; $54, + $8, = $62,. (b) As shown in the incremental analysis, Wyco Company should accept the special order because incremental revenues exceed incremental expenses by $1, EERCISE 26-3 (a) Reject Order Accept Order Net Income Effect Revenues Materials ($.5) Labor ($1.5) Variable overhead ($1.) Fixed overhead Sales commissions Net income $ $ -- $23,75 (2,5) (7,5) (5,) (5,) -- $ 3,75 $23,75 (2,5) (7,5) (5,) (5,) -- $ 3,75 (b) (c) As shown in the incremental analysis, Innova should accept the special order because incremental revenue exceeds incremental expenses by $3,75. It is assumed that sales of the golf disc in other markets would not be affected by this special order. If other sales were affected. Innova would have to consider the lost sales in making the decision. Second, if Innova is operating at full capacity, it is likely that the special order would be rejected. EERCISE 26-4 (a) Make Buy Net Income Increase (Decrease) Direct materials (4, $4.) Direct labor (4, $6.) Variable manufacturing costs ($24, 5%) Fixed manufacturing costs Purchase price (4, $13.5) Total annual cost $16, 24, 12, 4, $56, $ 4, 54, $58, $ 16, 24, 12, ( (54,) ($ (2,) 26-12 EERCISE 26-4 (Continued) (b) (c) No, Shannon Inc. should not purchase the lamps. As indicated by the incremental analysis, it would cost the company $2, more to purchase the lamps. Yes, by purchasing the lamp shades, a total cost saving of $15, will result as shown below. Make Buy Net Income Increase (Decrease) Total annual cost (above) Opportunity cost Total cost $56, 35, $595, $58, $58, $(2,) 35,) $ 15,) EERCISE 26-5 Sell (Basic Kit) Process Further (Stage 2 Kit) Net Income Increase (Decrease) Sales per unit Costs per unit Direct materials Direct labor Total $27. $12. $12. ($33. ( ) $ 6. (1) ( ) 9. (2) ( ) $15.) $ 6.) $(6.) (9.) $(3.) Net income per unit $15. ($18.) $ 3.) (1) The cost of materials decreases because Stacy can make two Stage 2 Kits from the materials for a basic kit. (2) The total time to make the two kits is one hour at $18 per hour or $9 per unit. Stacy should carry the Stage 2 Kits. The incremental revenue, $6., exceeds the incremental processing costs, $3.. Thus, net income will increase by processing the kits further EERCISE 26-6 (a) Sales per unit Costs per unit Materials Labor Variable overhead (7%) Fixed overhead Total Net income per unit Sell $ $29 $11 Process Further ($45 (155 ( $121 Net Income Increase (Decrease) $ 5 (5) (2) (14) -- (39) $ 11 (b) As shown in the incremental analysis, Donkey Bikes should process further (rather than sell unassembled) because incremental revenue exceeds incremental expenses by $11 per unit. EERCISE 26-7 Operating costs New machine cost (Depr.) Salvage value (old) Total Retain Machine Replace Machine Net Income Increase (Decrease) $12, (1) ($1,)(2) ($ 2,) ( 21,) ( (21,) ( (5,) ( 5,) $12, ($116, ($ 4,) (1) $24, 5. (2) $2, 5. The current machine should be replaced. The incremental analysis shows that net income for the five-year period will be $4, higher by replacing the current machine EERCISE 26-8 Continue Eliminate Net Income Increase (Decrease) Sales Variable expenses Cost of goods sold Operating expenses Total variable Contribution margin Fixed expenses Cost of goods sold Operating expenses Total fixed Net income (loss) $ 98,2) (56,) 12,) 68,) 3,2) (2,47) 26,6) 47,7) $(16,87) $ ( (2,47 26,6 47,7 $(47,7) $(98,2) (56,) 12,) 68, (3,2) ( ) ) $(3,2) Judy is incorrect. The incremental analysis shows that net income will be $3,2 less if the Ketchum Division is eliminated. This amount equals the contribution margin that would be lost by discontinuing the division. EERCISE 26-9 (a) $3, + $75, $3, = $75, (b) Stunner Double-Set Total Sales Variable expenses Gross profit Fixed expenses Net income $3, 15, 15, 142,5* $ 7,5 *$3, + [($3, $8,) $3,] **$75, + [($5, $8,) $3,] $5, 2, 3, 262,5** $ 37,5 $8, 35, 45, 45, $ 45, (c) As shown in the analysis above, Shatner should not eliminate the Mega-Power product line. Elimination of the line would cause net income to drop from $75, to $45,. The reason for this decrease in net income is that elimination of the product line would result in the loss of $6, of contribution margin while saving only $3, of fixed expenses EERCISE 26-1 (a) Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource (a) (b) Product A B C $7 2 $3.5 $4 1 $4 $6 2 $3 (b) Product B should be manufactured because it results in the highest contribution margin per machine hour. (c) (1) Machine hours (a) (3, 3) Contribution margin per unit of limited resource (b) Total contribution margin [(a) (b)] Product A B C 1, 1, 1, $ 3.5 $3,5 $ 4 $4, $ 3 $3, The total contribution margin is $1,5 ($3,5 + $4, + $3,). (2) Product B Machine hours (a) Contribution margin per unit of limited resource (b) Total contribution margin [(a) (b)] 3, $ 4 $12, EERCISE (a) Cost of hoist: $15, + $2,9 + $82 = $18,72. Net annual cash flow: Number of extra mufflers: 4 52 weeks (a) 28 Contribution margin per muffler ($65 $35 $1) (b) $ 2 Total net annual cash flow (a) (b) $4,16 Cash payback = $18,72 $4,16 = 4.5 years EERCISE (Continued) (b) Average investment: ($18,72 + $1,8) 2 = $9,9. Annual depreciation: ($18,72 $1,8) 5 = $3,528. Annual net income: $4,16 $3,528 = $632. Average annual rate of return = $632 $9,9 = 6.4% (rounded). EERCISE (a) Year AA Annual Net Cash Flow $ 7, 9, 15, Cumulative Net Cash Flow $ 7, 16, 31, Cash payback 2.4 years $22, $16, = $6, $6, $15, =.4 BB 22, (28,5 3) = 2.32 years CC Year 1 $13, $13, 2 1, 23, 3 9, 32, Cash payback 1.9 years $22, 13, = $9, $9, $1, =.9 The most desirable project is CC because it has the shortest payback period. The least desirable project is AA because it has the longest payback period. As indicated, only CC is acceptable because its cash payback is 1.9 years EERCISE (Continued) (b) AA BB CC Net Net Annual Annual Discount Cash Present Cash Present Net Cash Factor Flow Value Flow Value flow Year Total present value Investment Net present value $ 7, 9, 15, $ 6,25 7,175 1,677 24,12 22, $ 2,12 $9,5 9,5 9,5 $ 8,482 7,573 6,762 22,817 22, $ 817 $13, 1, 9, Present Value $ 11,67 7,972 6,46 (1) 25,985 22, $ 3,985 (1) This total may also be obtained from Table 2: $9, = $22,817. Project CC is still the most desirable project. Also, on the basis of net present values, all of the projects are acceptable. Project BB is the least desirable. EERCISE (a) (1) Annual rate of return: $18, [($15, + $) 2] = 24%. (2) Cash payback: $15, $48, = 3.13 years. (b) Item Amoun
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