Short Run Decision Analysis

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Chapter 23
Analysis for
Decision Making
Short-Run Decision Analysis
Objective 1
Explain how managers make
short-run decisions.
Copyright HoughtonMifflinCompany. All rights reserved. 5| 2
Short-Run Decision Analysis
The systematic examination of any decision
whose effects will be felt over the course of
the next year
Managers frequently take five predictable
actions when deciding what to do
First four actions happen during the planning stage
Last action happens during the evaluating stage
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Planning
Managers take the following four actions
during the planning stage when performing
short-run decision analysis:
1 Discover aproblemor need
1. Discover a problemor need
2. Identify all reasonable courses of action
3. Prepare a thorough analysis of each possible
solution (identify total costs, savings, and
other financial effects)
4. Select the best course of action
Performing
Managers must adapt to
changing environments
Take advantage of opportunities that will
improve the organizations profitability and
liquidity in the short-run
Evaluating
Managers evaluate each decision to
determine whether it produced the
forecasted results
If resultsfell short managersidentifyand
If results fell short, managers identify and
prescribe corrective action
If the solution is not
satisfactory or the
problemremains, the
management process
begins again.
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Communicating
Managers prepare reports related to short-run
decisions throughout the management process
Develop budgets that show estimated costs
and revenues related to alternative courses
of action
Compile analyses of data that support their
decisions
Stop & Review
Q. What are the five predictable actions frequently
taken by managers during short-run decision
analysis?
1. Discover a problemor need
p
2. Identify all reasonable courses of action
3. Prepare a thorough analysis of each possible
solution
Identify total costs, savings, and other financial effects
4. Select the best course of action
5. Evaluate each decision to determine whether it
produced the forecasted results
Incremental
Analysis for Short-Run Decisions
Objective 2
Define incremental analysis, and
describe how it applies to short-run
decision analysis.
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Incremental Analysis
A method of comparing alternatives by
focusing on the differences in their
projected revenues and costs
Also called differential analysis if it ignores
revenues or costs that stay the same or do not
differ among alternatives
Irrelevant Costs and Revenues
Irrelevant cost
A cost that
does not differ
between
Differential cost
A cost that
changes
between
Irrelevant revenue
Revenues that
will not differ
between
alternatives
Includessunk
costs
alternatives
Also referred
to as an
incremental
cost
alternatives
Irrelevant
Costs and Revenues Illustrated
Home State Bank managers must decide to buy one of two ATM
machinesC 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
ld t d d i
sold or traded in.

ATM C ATM W
Increaseinrevenue $16,200 $19,800
Increaseinannual operatingcosts
Direct materials 4,800 4,800
Direct labor 2,200 4,100
Variableoverhead 2,100 3,050
Fixedoverhead(depreciationincluded) 5,000 5,000

The manager has collected the following annual revenue and
operating cost estimates for the two new machines.
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Sunk costs
Thebookvalueof ATM B
Irrelevant Costs
and Revenues Illustrated (contd)
Step 1 in incremental analysis: Eliminate
any irrelevant revenues and costs.
The book value of ATM B
Represents money that was spent in the past and
does not affect the decision about whether to
replace the old ATM with a new one
ATM B would be of interest only if it
could be sold or traded in
Irrelevant Costs
Recall the annual revenue and operating cost
estimates for the two new machines

ATM C ATM W
Increaseinrevenue $16,200 $19,800
Increaseinannual operatingcosts
Direct materials 4,800 4,800
Direct labor 2,200 4,100
Variableoverhead 2,100 3,050
Fixedoverhead(depreciationincluded) 5,000 5,000

The costs of direct materials and fixed overhead are the
same under both alternatives
Theseareirrelevant costs and can also beeliminated fromthe
analysis
Irrelevant Costs
The incremental analysis is prepared
using only the differential revenues and
costs that will change between the
alternativeATMs
alternative ATMs
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Theincremental analysis
ispreparedusingonly
thedifferential revenues
andcoststhat will
changebetweenthe
alternativeATMs.
Opportunity Costs
The benefits that are forfeited or lost when one
alternative is chosen over another
Using incremental analysis simplifies
managementsevaluationof adecision
management s evaluation of a decision
and reduces time needed to choose the
best action
Determine opportunity costs
Must consider other issues, such as quality
and reputation
Opportunity Costs Illustrated
h i h ldb df h d f h
A plant nursery has been in business for many years at
the intersection of two highways. A bank has offered the
owner a high price for the land.
The interest that could be earned fromthe proceeds of the
sale is an opportunity cost for the nursery owner
It is revenue the owner has chosen to forego to continue
operating the nursery in that location
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Opportunity Costs Illustrated
The salary the teller would lose by returning to school is an
opportunity cost
A bank teller is deciding whether to go back to school
full time to earn a degree in finance.
opportunity cost
The 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 student
Stop & Review
Q. What are opportunity costs?
A. Benefits that are given up because one course
of action is taken instead of another.
Application of Incremental
Analysis to Short-Run Decisions
Objective 3
Apply incremental analysis to
outsourcing decisions, special order
decisions, segment profitability
decisions, sales mix decisions
involving constrained resources, and
sell or process-further decisions.
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Make-or-buy decisions
Decisions about whether
to make a part internally
or buyit fromanexternal
Incremental
Analysis for Outsourcing Decisions
Outsourcing
The use of suppliers
outside the
organizationto
or buy it froman external
supplier
May lead to
outsourcing
organization to
performservices or
produce goods that
could be performed
or produced
internally
for Outsourcing Decisions (contd)
Many companies focus
their resourcesontheir
Core competencies
Activities an
organization
their resources on their
core competencies to
Improve operating
income
Compete effectively in
global markets
g
performs best
for Outsourcing Decisions (contd)
Organizations may outsource expensive, nonvalue-
adding activities
Payroll processing
Training
Managing fleets of vehicles
Sales and marketing
Custodial services
Information management
Many areas that areoutsourced involveeither relatively low skill
areas or highly specialized knowledgethat can bebetter acquired
fromexperts outsidethecompany
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Incremental Analysis for
Outsourcing Decisions (contd)
Outsourcing
production or
operating activities
canreducea
Improves cash
flow
can reduce a
companys
investment in
physical assets and
human resources
and operating costs
Improves
operating
income
Make or Buy Decisions
A common decision facing managers is
whether to make or buy a part
Select the most profitable alternative
Must identify the costs of each alternative and their
effects on revenues and existing costs
Goal
Make or Buy Decisions (contd)
Managers need the following
information for analysis:
Information About Making Information About Outsourcing
Need for additional machinery Purchasepriceof item
Rent or net cashflow to begenerated Variablecosts of making item
fromvacated spaceinfactory
Incremental fixed costs Salvagevalueof unused machinery
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Make or Buy Decision Illustrated
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 immediately.
Should Box Company continue to outsource the cartons?
Box Company has idle machinery that could be adjusted and
used to produce packing cartons
Should Box Company continue to outsource the cartons?
Annual production and usage would be 20,000 cartons
Estimated cost of direct materials is $.84 per carton
Workers earn $8.00 per hour and can produce 20 cartons per
hour ($.40 per carton)
Make or Buy
Decision Illustrated (contd)
Cost of variableOHwill be$4per direct labor hour and
Cost of variable OH will be $4 per direct labor hour and
1,000 direct labor hours will be required
Fixed overhead per year includes $4,000 of
depreciation and $6,000 of other fixed costs
There is space to produce the cartons and the machines
will remain idle if the part is purchased
Make or Buy
Decision Illustrated (contd)
I l
Irrelevant costs
Depreciation costs and other fixed OH costs
Machinery and factory space have no other use
Costs arethesamefor both alternatives
Relevant costs and revenues
Compared for each alternative in an
incremental analysis
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Incremental
Analysis: Outsourcing Decision
Thecompany should makethecartons becauseit will save$1,200.
for Special Order Decisions
Decisions about whether to accept or reject special orders
at prices below normal market prices
ll i l l b f i il i h
Special Order Decisions
Usually involve large numbers of similar items that are
sold in bulk
Are not expected and so are not included in annual cost
or sales estimates
Are one-time events and should not be included in
revenue or cost estimates for subsequent years
A special product order shouldbe accepted only if it
maximizes operating income
Approaches for
Special Order Decisions (contd)
Compare special order price to relevant costs to
produce, package, and ship the order
Relevant costs include
Variablecosts
Variableselling costs, if any
Other costs directly associated with thespecial order (e.g.,
freight, insurance, packaging, and labeling theproduct)
Prepare a special order bid price
Calculate a minimumselling price
Equals relevant costs plus an estimated profit
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Costs to Exclude from
Special Order Decision Analysis
Fixed costs of
existing facilities
Do not change if the
company accepts the
Sales commission
expenses
Customer may have
contactedthe
special order
contacted the
company directly
Costs Relevant to
Special Order Decisions (contd)
Fixed costs that must be incurred to fill the
special order would be relevant to the
decision
Purchaseof additional machinery
Purchase of additional machinery
Increase in supervisory help
Increase in insurance premiums
Special Order Decision Illustrated
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 event.
Based on the following cost data, should Home State Bank accept
the special event offer?
ATMCost Data for 400,000 Transactions
(Annual Use for One Machine)
Direct materials $.10
Direct labor .05
Overhead
Variable .20
Fixed($100,000400,000) .25
Advertising($60,000400,000) .15
Other fixedsellingandadministrative
expenses($120,000400,000) .30
Cost per transaction $1.05
Feeper transaction $1.50

Performingaspecial
order incremental
analysis will assist in
thedecision process
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Incremental Analysis for Special
Order Decision Illustrated (contd)
Irrelevant costs:
Fixed costs
The only costs affected by the order are
direct materials direct labor and
direct materials, direct labor, and
variable overhead
Incremental
Analysis: Special Order Decision
Accepting thespecial offer will increasecontribution
margin, and thereforeoperating income, by $1,200
Segment Profitability Decisions
Managers must decide whether to keep or
drop unprofitable segments
Product lines
Services
Sales territories
Divisions
Departments
Stores
Outlets
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Incremental Analysis for Segment
Profitability Decisions (contd)
Management must select the alternative that
maximizes operating income based on
The organizations strategic plan and objectives
Relevantrevenuesandcosts
Objective of this analysis
Identify the segments that have a negative
segment margin
Relevant revenues and costs
Qualitative factors
Segment Margin
A segments sales revenue minus its direct costs
(direct variable costs and direct fixed costs
traceable to the segment)
Such costs are assumed to be avoidable costs
(Can be eliminated if the segment were dropped)
Segment Margin (contd)
Drop the segment
However, the remaining
segments must be able to
Positive Segment Margin Negative Segment Margin
Keep the segment
It is able to cover its
own direct costs
cover the unavoidable costs
Common cost that will
be incurred regardless of
the decision
Can contribute a
portion of its revenue
to cover common costs
and add to operating
income
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for Segment Profitability Decisions
To analyze segment profitability:
Prepare a segmented income statement (Use
variable costing to identify variable and fixed
costs)
Direct fixed costs
The fixed costs that are traceable to the segments
Common costs
The remaining fixed costs
Are not assigned to segments
)
Home State Bank
Segmented Income Statement
For the Year Ended December 31, 20xx

Bank
Operations
Safe
Deposit
Total
Company

Sales $135,000 $15,000 $150,000
Lessvariablecosts 52,500 7,500 60,000
Contributionmargin $ 82,500 $ 7,500 $ 90,000
Lessdirect fixedcosts 55,500 16,500 72,000
Segment margin $ 27,000 ($9,000) $ 18,000
Oncethe
segmented income
statement has been
completed, an
incremental
anal siscanbe
Segment margin $ 27,000 ($9,000) $ 18,000
Lesscommonfixedcosts 12,000
Operatingincome $ 6,000

Home State Bank
Segmented Profitability Decision
Incremental AnalysisSituation 1

Keep Safe
Deposit
Drop Safe
Deposit
Difference in
Favor of Dropping
Safe Deposit

Sales $150,000 $135,000 ($15,000)
Contributionmargin $ 90,000 $ 82,500 ($ 7,500)
Segment margin $ 18,000 $ 27,000 $ 9,000
Lesscommonfixedcosts 12,000 12,000 0
Operatingincome $ 6,000 $ 15,000 $ 9,000

Incremental
analysis shows that
operatingincome
will increaseby
$9,000 if theSafe
Deposit Division is
dropped
analysis can be
prepared
Home State Bank
Segmented Income Statement
For the Year Ended December 31, 20xx

Bank
Operations
Safe
Deposit
Total
Company

Sales $135,000 $15,000 $150,000
Contributionmargin $ 82,500 $ 7,500 $ 90,000
Segment margin $ 27,000 ($9,000) $ 18,000
L fi d 12000
Assumethat Bank
Operations sales will
decrease20 percent if
management eliminates
theSafeDeposit
Di i i
Lesscommonfixedcosts 12,000

Incremental analysis
now shows that
operatingincomewill
decreaseby $7,500 if
theSafeDeposit
Division is dropped
Home State Bank
Segmented Profitability Decision
Incremental AnalysisSituation 2

Keep Safe
Deposit
Drop Safe
Deposit
Difference in
Opposition to
Dropping Safe
Deposit

Sales $150,000 $108,000 ($42,000)
Contributionmargin $ 90,000 $ 66,000 ($24,000)
Segment margin $ 18,000 $ 10,500 ($ 7,500)
Lesscommonfixedcosts 12,000 12,000 0
Operatingincome $ 6,000 ($ 1,500) ($ 7,500)

Division
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Incremental
Analysis for Sales Mix Decisions
Resource constraints (machine time,
available labor, other activities) may cause
companies to consider which products are
best to offer
Identify by calculating the
contribution margin per
constrained resource for
each product or service
Sales Mix Decision
Select the alternative that maximizes
the contribution margin per constrained
resource
Basedontheorganizations
Based on the organization s
Strategic plan and objectives
Qualitative factors
Use incremental analysis
Incremental
Analysis for Sales Mix Decisions
Two Steps:
1. Calculate contribution margin per unit for
each product or service affected by the
constrained resource
Equals selling price per unit less variable costs
per unit
2. Calculate contribution margin per unit of the
constrained resource
Equals contribution margin per unit divided by
the quantity of the constrained resource required
per unit
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for Sales Mix Decisions Illustrated
Home State Bank offers three types of loans: commercial loans, auto
loans, and home loans. Current loan application capacity is 100,000
processing hours.
The product line data are as follows:

C i l A t H
Commercial
Loans
Auto
Loans
Home
Loans
Current loanapplicationdemand 20,000 30,000 18,000
Processinghoursper loanapplication 2 1 2.5
Loanoriginationfee $24.00 $18.00 $32.00
Variableprocessingcosts $12.50 $10.00 $18.75
Variablesellingcosts $6.50 $5.00 $6.25

Question 1
Which 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?
Incremental
Analysis:
Sales Mix
Decision
Decision
Involving
Constrained
Resources
Incremental Analysis for Sales
Mix Decisions Illustrated (contd)
Th l i i di t th t th l h ld
Loans that provide the highest contribution
margin per processing hour should be sold first
The analysis indicates that the loans should
be sold in the following order
1. Auto loans
2. Home loans
3. Commercial loans
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for Sales Mix Decisions (contd)
Home State Bank offers three types of loans: commercial loans, auto
loans, and home loans. Current loan application capacity is 100,000
processing hours.
The product line data are as follows:

Commercial
Loans
Auto
Loans
Home
Loans
Current loanapplicationdemand 20,000 30,000 18,000
Processinghoursper loanapplication 2 1 2.5
Loanoriginationfee $24.00 $18.00 $32.00
Variableprocessingcosts $12.50 $10.00 $18.75
Variablesellingcosts $6.50 $5.00 $6.25

Question 2
How many of each type of loan should be sold to maximize the banks
contribution margin based on current loan activity of 100,000 processing
hours? What is the total contribution margin for that combination?
Compare current loan application activity to
the required loan activity to meet the current
loan demand
L T C t D d
Loan Type Current Demand
Commercial 40,000 processinghours(20,000loansx2processinghours)
Auto 30,000 processinghours(30,000loansx1processinghour)
Home 45,000 processinghours(18,000loansx2.5processinghours)
115,000 total processinghours

Thecurrent demand exceeds thecurrent
capacity by 15,000 processing hours
Management must determine the sales mix that
maximizes the companys contribution margin
Will also maximize its operating income
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Contribution
Margin
Autoloans(30000loansx$300per loan) $ 90000
Auto loans (30,000 loans x $3.00 per loan) $ 90,000
Homeloans (18,000 loans x $7.00 per loan) 126,000
Commercial loans (12,500 loans x $5.00 per loan) 62,500
Total contribution margin $278,500

Sell or Process-Further Decisions
Meatpacking company
Can sell sides of beef and
pounds of bones to other
companies for further
i
Some companies offer
products or services that
can either be sold in a
basic formor be
processing
Can decide to cut and
package meat, process bone
into fertilizer, and tan hides
into leather
processed further and
sold as a more refined
product or service to a
different market
Incremental Analysis for Sell or
Process-Further Decisions (contd)
Sell or process-further decision
A decision about whether to sell ajoint product at thesplit-off
point or sell it after further processing
J oint products
Two or moreproducts, madefromacommon material or process,
that cannot beidentified as separateproducts or services during
p p g
someor all of theprocessing
Split-off point
A specific point wherejoint products or services becomeseparate
and identifiable
Point at which acompany may chooseto sell or process further
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Select the alternative that maximizes operating
Objective of incremental analysis for sell or
process-further decisions
p g
income based on:
Organizations strategic plan and objectives
Qualitative factors
Steps in incremental analysis process
Calculate incremental revenue
Difference between total revenue if sold at split-off
point and total revenue if sold after processing
further
further
Compare incremental revenue to incremental
costs of processing further
Chooseto process further if incremental revenueexceeds
incremental costs
If incremental costs exceed incremental revenue, chooseto sell
at thesplit-off point
J oint costs, or common costs, are ignored in
the analysis
They are incurred before the split-off point and
donot changeif further processingoccurs
do not change if further processing occurs
Even though joint costs areassigned to products or services
when valuing inventories and calculating cost of goods sold,
they arenot relevant to asell or process further decision
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Basic Checking
Home State Banks 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 Banker.
g
Onlinecheckingaccount, debit card, and onlinebill payment with a
required minimumaveragebalance(RMAB) of $500
Premier Checking
Paper and onlinecheckingaccount, adebit card, acredit card, and asmall
lifeinsurancepolicy equal to themaximumcredit limit on thecredit card.
RMAB $1,000
Personal Banker
All thefeatures of Premier Checkingplus asafedeposit box, $5,000
personal lineof credit at primeinterest rate, financial investment advice,
and atoaster on openingtheaccount. RMAB $5,000
The bank can earn sales revenue of 5 percent on its checking
account balances
The total cost of Basic Checking is currently $50,000
The banks accountant provided the following data per
account

Product Sales Revenue Additional Costs

Basic Checking $ 25 $ 0

Premier Checking 50 30

Personal Banker 250 200

Incremental Analysis:
Sell or Process-Further Decision
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The analysis indicates that the bank
should offer personal banking services in
addition to Basic Checking accounts
Notice that the $50,000 joint costs of Basic Checking
were ignored because they are sunk costs that will not
influence the decision
Stop & Review
Q. What is the object of incremental analysis for
segment profitability decisions?
A. The object of this analysis is to identify the
segmentsof abusinessthat haveanegative
segments of a business that have a negative
segment margin. Segment margin is equal to the
segments sales revenue minus its direct costs. A
positive segment margin means the segment is
able to cover its own direct costs and contribute
a portion of its revenue to cover common costs
and add to operating income.
Stop & Review
Q. Why are sales mix decisions important?
A. Sales mix decisions are important because of
limited resources. Incremental analysis for
salesmixdecisionshelpsmanagers
sales mix decisions helps managers
determine 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
those items.
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Stop & Review
Q. What are core competencies?
A. Core competencies are the activities an
organization performs best. In other words, the
companyishighlycompetent at performing
company is highly competent at performing
these activities. Many companies focus their
resources on their core competencies to improve
operating income and compete effectively in
global markets. Other activities may be
outsourced.
Stop & Review
Q. Is the decision to accept or reject a special order
based solely on the orders effects on
contribution margin?
A. No. Qualitativefactorsmust betakeninto
A. No. Qualitative factors must be taken into
consideration in the decision-making process,
such as the impact of the special order on regular
customers, the potential of the special order to
lead into new sales, and the customers ability to
maintain an ongoing relationship regarding good
ordering and paying practices.
Stop & Review
Q. What is the objective of a sell or process-
further decision?
A. The objective is to select the alternative that
maximizes operating income, based on the
organizations strategic plan and objectives,
the relevant revenues and costs, and
qualitative factors.
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Capital Investment Decisions
Objective 4
Identify the types of projected costs and
revenues used to evaluate alternatives for
it l i t t
capital investment.
Capital Investment Analysis
The process of making decisions about
capital invesments
Alsocalledcapital budgeting
Also called capital budgeting
Consists of
Identifying theneed for acapital investment
Analyzing courses of action to meet that need
Preparing reports for managers
Choosing thebest alternative
Allocating funds among competing needs
Capital Investment Analysis (contd)
Financial analysts
Supply atarget cost of capital or desired rateof return and an
estimateof howmuchmoneycanbespentannuallyoncapital
Every part of the organization participates in the process
estimateof how much money can bespent annually on capital
facilities
Marketing specialists
Predict trends and new product demands
Managers at all levels
Help identify facility needs
Preparepreliminary cost estimates for thedesired capital
investment
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Measures Used in
Net cash inflows
Balanceof increases in
j d h i
Two methods of measuring the expected benefit froman
investment project:
Net income
Managers determine
i i i
projected cash receipts over
increases in projected cash
payments resulting froma
capital investment
Morewidely used measure
increases in net income
resulting fromthe capital
investment for each
alternative
Measures Used in
Either net cash inflows or cost savings can be
used as the basis for evaluation
If analysis involves
y
cash receipts
If analysis involves
cash outlays
use net cash inflows.
use cost savings.
Measures Used in
Equal cash flows
Projected cash flows are the same fromyear
to year
Unequal cash flows
q
Projected cash flows vary fromyear to year
Are common
Require a more detailed analysis
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Measures Used in
Carrying value of an asset
Is the undepreciated portion of the original cost
of a plant asset
Is irrelevant in capital investment analysis
Net proceeds fromthe sale or disposal of an asset
Are relevant
Affect cash flow and may differ for each
alternative
Measures Used in
Income taxes alter the amount and timing of cash
flows of projects under consideration by for-profit
companies
The effects of income taxes must be included in
it l i t t l
capital investment analyses
Depreciation expense is tax-deductible
Strongly influences the amount of income taxes a
company pays
Can lead to significant income tax savings
Measures Used in
Assume a company has a tax rate of 30 percent on
taxable income
It is considering a capital project that will make the
following annual contribution to operating income
g p g

Cash revenues $ 400,000
Cash expenses (200,000)
Depreciation (100,000)
Incometaxes at 30% (30,000)
Operatingincomeafter incometaxes $ 70,000

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Measures Used in
Net cash flows for this project can be
determined in two ways
1. Net cash inflowsreceipts and
disbursements
disbursements
2. Net cash inflowsincome adjustment
procedure
Measures Used in
Net cash inflowsreceipts and
disbursements

Revenues (cash inflows) $ 400,000
( ) ,
Cash expenses (outflows) (200,000)
Incometaxes (outflows) (30,000)
Net cash inflows $ 170,000

Measures Used in
Net cash inflowsincome adjustment
procedure

Operatingincomeafter incometaxes $ 70000
Operating incomeafter incometaxes $ 70,000
Add back noncash expenses (depreciation) 100,000
Less noncash revenues
Net cash inflows $ 170,000

In both computations, net cash inflows are $170,000, and the total
effect of income taxes is to lower the net cash inflows by $30,000
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Other Cash Inflows Relevant
to a Proposed Capital Investment
Disposal of an asset
Proceeds fromthe sale of an old asset are current
cash inflows
Projected disposal or residual values of
replacement equipment
Represent futurecash inflows and usually differ
among alternatives
Sometimes called disposal or salvage value
Stop & Review
Q. What is the carrying value of an asset, and is
it relevant to a capital investment analysis?
A. Carrying value of an asset is the
d i t d ti f th i i l t f
undepreciated portion of the original cost of
a plant 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 decision.
The Time Value of Money
Objective 5
Apply the concept of the time value
of money.
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The Time Value of Money
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 interest
Thenotions of interest,
present value, and future
valueareall related to
thetimevalueof money
Interest: The cost associated with the use of money for
a specific period of time
Interest (contd)
The interest cost
for one or more
periods when the
Simple Interest Compound Interest
The interest cost for
two periods or more
whentheamount on
pe odsw e t e
amount on which
the interest is
computed stays
the same from
period to period
when the amount on
which interest is
computed changes in
each period to include
all interest paid in
previous periods
Simple Interest Illustrated
J o Sanka accepts an 8 percent, $30,000 note due in 90 days.
How much will Sanka receive in total when the note comes due?
Time Rate Principal Expense Interest =
p p
$591.78 90/365 8/100 $30,000 = =
Interest Principal Total + =
$30,591.78 $591.78 $30,000.oo = + =
If theinterest is paid and thenoteis renewed for an additional 90
days, theinterest calculation will remain thesame
5/20/2009
30
Compound Interest Illustrated
Andy Clayburn deposits $5,000 in a savings account that pays
6 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 years.
What will be his account total at the end of three years?
(1) (2) (3) (4)

Year
Principal Amount
at Beginning of
Year
Annual Amount
of Interest
(col. 2 x .06)
Accumulated Amount
at End of Year
(col. 2 + col. 3)
1 $5,000.00 $300.00 $5,300.00
2 5,300.00 318.00 5,618.00
3 5,618.00 337.08 5,955.08

Notethat theannual amount of interest increases each year by
theinterest ratetimes theinterest of theprevious year
Present Value
If receivedtoday youwill beabletoinvest theamount and
What is the difference between receiving
$100 today or one year fromnow?
If received today, you will be able to invest the amount and
earn interest on it
If received one year fromnow, you have missed the
opportunity to earn interest over the year
An 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 time
Present Value & Future Value
Present Value
The amount that must
be invested now at a
givenrateof interest to
Future Value
The amount an
investment will be
worthat afuturedate
Present valueand futurevalueareclosely related
given rate of interest to
produce a given future
value
worth at a future date
if it is invested at
compound interest
5/20/2009
31
Present Value Illustrated
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?
V l F t R t ) I t t (10 V l P t +
Value Future Rate) Interest (1.0 Value Present = +
$1,000.00 1.05 Value Present =
1.05 $1,000.00 Value Present =
$952.38 Value Present =
Interest of 5 percent on $952.38 for oneyear equals $47.62,
and thetwo amounts added together equal $1,000.00
Present Value
of a Single Sum Due in the Future
The preceding equation can be adapted to compute this amount

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?

Year
Amount at
End of Year Divided by
Present Value at
Beginning of Year
3 $4,000.00 1.05 = $3,809.52
2 3,809.52 1.05 = 3,628.11
2 3,628.11 1.05 = 3,455.34

RezaCompany must invest $3,455.34
today to have$4,000.00 in threeyears
Use Table 3 to compute the amount Reza Company must invest today
Present Value of a
Single Sum Due in the Future (contd)
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?
Table 3. Present Val ue of $1 to be Recei ved at the End of Gi ven Number of Time Periods
Periods 1% 2% 3% 4% 5% 6% 7%
Look down the5 percent column and across therow for 3 periods to find the
factor 0.864
Value Present Factor Value - Present Value Future =
$3,456 0.864 000 , 4 $ =
Except for adifferenceof $0.66, theanswer is thesameas theearlier one
Periods 1% 2% 3% 4% 5% 6% 7%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713
5/20/2009
32
Present
Value of an Ordinary Annuity
Ordinary Annuity
A series of equal payments or receipts that
will begin one time period fromthe current
d
Present value of an ordinary annuity
The present value of amounts equally spaced
over a period of time
date
Future Cash Receipts Present-Value Factor
Present Value
of an Ordinary Annuity Illustrated
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%.
p
(Annuity)
Year 1 Year 2 Year 3
at 5 Percent
(from Table 3)

Present Val ue
$5,000 x .952 = $ 4,760
$5,000 x .907 = 4,535
$5,000 x .864 = 4,320
Total Present Value $13,615

Thepresent valueof each payment to Foder Company can becalculated
separately using Table3 and then summed for thetotal present value.
Thepresent valueof this saleis $13,615
UseTable4tocomputethepresent valueof thepayments Foder will receive
Table 4. Present Value of an Ordinary Annuity of $1 to be Recei ved Each Peri od for a
Given Number of Time Periods
Periods 1% 2% 3% 4% 5% 6% 7%
1 0 990 0 980 0 971 0 962 0 952 0 943 0 935
Present Value of an
Ordinary Annuity Illustrated (contd)
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%.
Look down the5 percent column and across therow for 3 periods to find the
factor 2.723
Value Present Factor Value - Present Payment Periodic =
$13,615 2.723 000 , 5 $ =
Theanswer is thesameas theearlier one
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100
5/20/2009
33
Present Value of
an Ordinary Annuity (contd)
If Foder Company is willing to accept a 5
percent rate of return, management will be
equally satisfied to receive
A singlecashpayment of $13615today
A single cash payment of $13,615 today
Three equal annual cash payments of $5,000
spread over the next three years
Stop & Review
Q. What is the difference between simple and
compound interest?
A. For simple interest calculations, the
amo nt on hichinterest iscalc lated
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 period.
The Net Present Value Method
Objective 6
Use the net present value method to
analyze capital investment proposals.
5/20/2009
34
The Net Present Value Method
Net present value method
Most important measure
usedtoestimatethe
When evaluating
proposed
investments,
used to estimatethe
benefits to bederived
fromacapital investment
managers must
predict how the
new asset will
performand benefit
thecompany
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
fromtheir sum
The net present values for all proposed projects
are compared
Those with net present values that exceed the
initial investment are selected for
implementation
Advantages of the
Net Present Value Method
Incorporates the time value of money into the
analysis
Future cash inflows and outflows are
discounted by the companys minimumrate
of return to determine their present values
The minimumrate of
return should be greater
than or equal to the
companys cost of capital
5/20/2009
35
Advantages of the
Net Present Value Method (contd)
Cost of capital
Weighted-average rate of return a company
must pay to its long-termcreditors and
shareholders for the use of their funds
Advantages of the
Each future cash inflow and outflow over the
life of the assets is discounted to the present
Single amount
UseTable3
Use Table 3
Series of equal periodic amounts
Use Table 4
Advantages of the
Positive net present value
Total of the discounted net cash inflows
exceeds the cash investment at the beginning
Rateof returnoninvestment exceeds
Rate of return on investment exceeds
company's minimumrate of return (also called
the hurdle rate)
Project can be accepted
5/20/2009
36
Advantages of the
Negative net present value
Cash investment at the beginning exceeds the
total of the discounted net cash inflows
Rateof returnoninvestment islessthanthe
Rate of return on investment is less than the
company's minimumrate of return
Project should be rejected
If thenet present valueis zero, theproject meets
theminimumrateof return and can beaccepted
Net Present
Value Method Illustrated
Open Imaging Company is considering the purchase of an ultrasound
machine to improve the efficiency of its Radiology Department.
Management must decide between Model M and Model N. The
companys minimum rate of return is 16 percent.
Model M
Model M
Cost of $17,500
Estimated residual valueof $2,000 after 5 years
Projected cash inflows of $6,000, $5,500, $5,000, $4,500, and
$4,000 during its five-year life
Model N
Cost of $21,000
Estimated residual valueof $2,000 after 5 years
Projected cash inflows of $6,000 per year for 5 years
Net Present
Value Method Illustrated
Determinethenet present valuefor Model M
Must useTable3 becauseof unequal cash flows
Model M

Year
Net Cash
Inflows
16%
Factor
Present
Value

1 $6,000 .862 $ 5,172.00
2 5,500 .743 4,086.50
3 5,000 .641 3,205.00
4 4,500 .552 2,484.00
5 4,000 .476 1,904.00
Residual value, year 5 2,000 .476 952.00
Total present valueof cashinflows $17,803.50
Lesspurchasepriceof Model M 17,500.00
Net present value $ 303.50

Thecash outflow for the
purchaseis not discounted
becauseit occurs at timezero.
Theresidual valueis discounted because
it represents acash inflow that will take
placeat theend of year 5.
5/20/2009
37
Net Present
Value Method Illustrated (contd)
Determine the net present value for Model N
Table 4 is used because the cash inflows are expected to be
equal amounts in each year
However, Table 3 must still be used to determine the
t l f th hi id l l
present value of the machines residual value
Model N

Year
Net Cash
Inflows
16%
Factor
Present
Value

1-5 $6,000 3.274 $19,644.00
Residual value, year 5 2,000 .476 952.00
Total present valueof cashinflows $20,596.00
Lesspurchasepriceof Model N 21,000.00
Net present value ( $ 404.00 )

Net Present
Value Method Illustrated (contd)
Results of the two analyses
Net present valueof Model M is $303.50
Net present valueof Model N is ($404.00)
M d l M h ldb h b it
Model M should be chosen because it
Has apositivenet present value
Is expected to exceed thecompanys minimumrateof return
Model N should be rejected because it has a negative net
present value
Stop & Review
Q. What does a negative net present value
indicate?
A. It indicates that a proposed capital projects
expected rate of return is less than the
company's minimum rate of return. The
project should be rejected.
5/20/2009
38
Other Methods
of Capital Investment Analysis
Objective 7
Use the payback period method and the
accounting rate-of-return method to
l it l i t t l
analyze capital investment proposals.
Other Methods
of Capital Investment Analysis
Payback period method
Accounting rate-of-return method
Provide rough guides to evaluating capital
investments
Net present value method is best
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 investment
initial investment
Inflows Cash Net Annual
Investment of Cost
Period Payback =
5/20/2009
39
The Payback
Period Method Illustrated
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
d th hi i t d t h t i lif
and the machine is expected to have a ten-year service life.
The only noncash expense or revenue is depreciation, which must be
removed from the operating costs.
Asset the of Life
Value Residual Cost
on Depreciati Annual

=
year per $4,800
years 10
$3,000 $51,000
=
=
The Payback
Period Method Illustrated (contd)
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.
y
Thepayback period is computed as follows:
Expenses Cash Revenue Cash
Machine of Cost
Period Payback
=
$4,800) ($11,696 $17,900
$51,000

=
years 4.6
$11,004
$51,000
= =
If thecompanys payback
period is 5 years or less,
this proposal would be
approved
The Payback Period Method
1. Subtract each annual amount, in
h l i l d f th t f th
Calculating payback period for proposals with unequal
annual net cash inflows
chronological order, fromthe cost of the
capital facility
2. When a zero balance is reached, the payback
period has been determined
(May occur in themiddleof ayear; computeportion of the
final year by dividing amount needed to reach zero by the
entireyears estimated cash inflow)
5/20/2009
40
Disadvantages
to the Payback Period Method
Does not measure profitability
Does not adjust cash flows for the time value
of money
Emphasizes the time it takes to recover the
investment rather thanthelong-termreturn
investment rather than the long-termreturn
on the investment
Ignores all future cash flows after the
payback period
The Accounting
Rate-of-Return Method
Method of evaluating capital investment
proposals by dividing the projects average
annual net income by the average cost of
theinvestment
the investment
Is imprecise, but easy
Uses financial statement information
The Accounting
Rate-of-Return Formula
Cost Investment Average
Income Net Annual Average s Project'
Return of Rate Accounting =
To computeaverageannual net income, usethecost and revenuedata
Value Residual
2
Value Residual Investment Total
Cost Investment Average +
(

=
prepared for evaluating theproject.
Thefollowing formulais used to calculateaverageinvestment cost.
5/20/2009
41
The Accounting
Rate-of-Return Method Illustrated
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
machine is expected to have a ten year service life. Only projects that
are expected to yield more than 16% return are accepted.
$3,000
2
$3,000 $51,000
$11,696 $17,900
Return of Rate Accounting
+
(

=
% 23
$27,000
$6,204
= =
Theprojected rateof return is
higher than theminimum16%, so
management should seriously
consider making this investment
Disadvantages to the
Accounting Rate-of-Return Method
Not a reliable figure
Net income is averaged over the life of the
investment
Unreliable if estimated annual income
differs from year to year
Cash flows are ignored
Does not consider the time value of money
Stop & Review
Q. A 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?
year per $2,000
years 4
$2,000 $10,000
on Depreciati Annual =
=
( )
years 2.86
$2,000 $3,500 $5,000
$10,000
Period Payback =

=
A.
5/20/2009
42
Chapter Review
1. Explain how managers make short-run decisions.
2. Define incremental analysis, and describe how it
applies to short-run decision analysis.
3. Apply incremental analysis to outsourcing
decisions, special order decisions, segment
profitability decisions, sales mix decisions
involving constrained resources, and sell or
process-further decisions.
4. Identify the types of projected costs and revenues
used to evaluate alternatives for capital
investment.
Chapter Review (contd)
5. Apply the concept of the time value of money.
6. Use the net present value method to analyze
capital investment proposals.
7. Usethepaybackperiodmethodandthe
7. Use the payback period method and the
accounting rate-of-return method to analyze
capital investment proposals.

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