Chap 025

Chapter 25
Capital Budgeting and Managerial

Decisions
QUESTIONS
1.
Capital budgeting is the process of planning the acquisition or sale of plant assets.
2.
Capital budgeting decisions are risky because: (1) the outcomes are uncertain, (2)
large amounts of money are usually involved, (3) the investment involves a longterm commitment, and (4) the decisions may be difficult or impossible to reverse.
3.
Capital budgeting decisions require careful analysis because they are generally the
most difficult and risky decisions that management faces.
4.
The payback period ignores both the present value of cash flows and all cash flows
after the payback period.
5.
A shorter payback period is desirable because management prefers to reduce the

risk that the investment might not be profitable over the long run. As a result of
acquiring assets with shorter payback periods, a company is both less vulnerable to
inaccurate long-term predictions of future cash flows and is less subject to changes
in external factors that might adversely affect the investment project.
6.
If net income is earned evenly throughout each year and straight-line depreciation is
used, the average investment is the original cost plus the salvage value, divided by
2. For this machine, the average investment equals $110,000, computed as
($200,000 + $20,000)/ 2.
7.
When the present value of expected net cash flows, discounted at 10%, exceeds the
amount invested it indicates that the expected rate of return on the investment is
greater than 10 percent. On the other hand, when the present value of expected net
cash flows, discounted at 10%, is less than the amount invested it indicates that the
expected rate of return on the investment is less than 10 percent.
8.
Receiving $100 one year from today is worth less than $100 today because a return
can be earned on a $100 investment during the year. If $100 to be received one year
from today is discounted at 12%, the present value is $100 x 0.8929 = $89.29 (the
present value factor is taken from Table B.1). This means that if $89.29 is invested at
12% for one year, it will be worth $100 at the end of that year. This amount also can
be found by dividing $100 by 1.12.
McGraw-Hill Companies, Inc., 2005

Solutions Manual, Chapter 25
95
9.
The return on an investment must cover the interest and provide an additional profit
to reward the company for risk. For example, if money can be borrowed at 10%, a
required after-tax return of about 15% is usually acceptable for companies with
average risk projects.
10. Accelerated depreciation produces larger tax deductions and lower tax payments in
the early years of an assets life compared with straight-line depreciation. This is
because the larger depreciation expense for accelerated methods in earlier years
reduces both taxable income and taxes paid in the short run (in the long run there is
no difference except for the time value of money). Therefore, net cash inflows will
be larger in earlier years, which will increase the present value of future cash flows.
11. An out-of-pocket cost requires a current outlay of cash. An opportunity cost is the
potential benefit that is lost by choosing an alternative course of action.
Opportunity costs are not recorded in the accounting records.
12. Sunk costs are irrelevant because they remain the same whether the product is sold
in its present condition or processed further.
13. There are virtually no incremental costs associated with shipping the additional
dozen donuts. The companys employees would not receive any additional
compensation for handling one additional dozen, no ground transportation costs
would be incurred for picking it up at the senders location, additional fuel costs for
transportation would be minuscule, and no additional transportation costs would be
incurred at the destination.
14. Tastykake management could use one of the following common methods to evaluate
the potential oven investment: payback period, accounting rate of return, net
present value, or internal rate of return.
15. The company might be willing to sell the units internationally if (a) the company has
excess capacity, (b) the incremental costs of manufacturing and selling the units are
less than $15 each, which it appears to be at $13 variable cost per unit (c) the
international sales wont reduce domestic sales, and (d) the international buyer is
unwilling to pay more than $15.

96
Fundamental Accounting Principles, 17th Edition
QUICK STUDIES
Quick Study 25-1 (10 minutes)
1. If all else is equal, Investment A would be preferred over Investment B
because of As shorter payback period.
2. However, if the investments are different, then there are at least four
reasons why Investment B might be preferred over Investment A:
i. The present value of cash flows from Investment B might greatly exceed
the present value of cash flows from Investment A.
ii. Investment B might be expected to have total cash flows significantly in
excess of the total cash flows returned by Investment A.
iii. Risk of Investment B might be much less than the risk of Investment A.
iv. The growth potential of Investment B might be much greater than that
for Investment A.

Payback period of Investment = $18,000 / $6,000 = 3.0 years
Net present value of investment*
Present value of seven $20,000 cash inflows (20,000 x 4.8684)...............
$ 97,368
Present value of $12,000 at end of seven years (12,000 x 0.5132)........... 6,158
Present value of cash inflows.....................................................................103,526
Less immediate cash outflow......................................................................100,000
Net present value..........................................................................................
$ 3,526
*Present value factors from tables at the end of Appendix B:
4.8684 = Present value of an annuity of 1, where n = 7, i = 10% (from Table B.3)
0.5132 = Present value of 1, where n = 7, i = 10% (from Table B.1)

Accounting rate of return = $1,300 / [($30,000 + 4,000)/2] = 7.65%

97

X
Contribution margin per unit...................................................
$10.00
Production hours per unit....................................................... 1/2
Contribution margin per production hour..............................
$20.00
Y
$ 8.00
1/3
$24.00
Sales Mix Analysis: Since Memory Lane can sell all it can produce of both
products, it should allocate all of its production capacity to Product Y. This is
because Y yields a $24 contribution margin per production hour (versus $20 for X).

Incremental cost analysis
Costs of purchasing
Cost to purchase Product B....................................................$5.00
Revenue loss from reduced price ($9 - $8)............................ 1.00
Total cost................................................................................... 6.00
Savings of purchasing
Costs eliminated if Product B purchased ($5 of $6)............. 5.00
Net incremental cost of purchasing Product B.....................$1.00
Analysis: Mo-Kan Co. should continue to manufacture and sell Product A.
Year
Cash flows
Present value
of 1 at 10%
Present value of
cash flows
Cumulative
present value of
cash flows
$(100,000)
1.0000
$(100,000)
$(100,000)
35,000
0.9091
31,819
(68,181)
35,000
0.8264
28,924
( 39,257)
35,000
0.7513
26,296
( 12,961)
35.000
0.6830
23,905
10,944
35,000
0.6209
21,732
32,676
The break-even time point occurs in the 7th month of the 4th year [computed
as ($12,961 / $23,905) x 12 = 6.5 months]. Therefore, a reasonable estimate
would be approximately 3.5 years (or 3 7/12 years) for break-even time.
98
EXERCISES
Exercise 25-1 (20 minutes)
a.
Payback period =
Cost of investment
Annual net cash flow
$260,000
= $125,000 = 2.08 years
where
Annual after-tax income.............................................
$ 75,000
Plus depreciation*.......................................................
50,000
Annual net cash flow..................................................
$125,000
*Annual depreciation =
$260,000 - $10,000
5
= $50,000
b.
Payback period =
Cost of investment
$190,000
Annual net cash flow = $50,000
= 3.8 years
where
Annual after-tax income.............................................
$ 30,000
Plus depreciation*.......................................................
20,000
Annual net cash flow..................................................
$ 50,000
$190,000 - $10,000
9
= $20,000

Annual Net
Cash Flows
Year 1.............................
$30,000
Year 2.............................
20,000
Year 3.............................
30,000
Year 4.............................
60,000
Year 5.............................
19,000
Cumulative
Cash Flows
$ 30,000
50,000
80,000
140,000
159,000
Cost of investment........................... $90,000

Paid back in years 1-3...................... 80,000
Paid back in year 4........................... $10,000
Continued on next page.

99
Exercise 25-2 (Continued)

Part of year =
Amount paid back in year 4

Net cash flow in year 4
$10,000
= $60,000
= 0.167
Payback period = 3 + 0.167 = 3.167 years, or 3 years and 2 months

COMPUTATION OF ANNUAL DEPRECIATION EXPENSE
Double-declining balance rate = (100% / 5) x 2 = 40%

Annual Depr.
Beginning
(40% of
Accum. Depr.
Year
Book Value
Book Value)
at Year-End
1
$300,000
$120,000
$ 120,000
2
180,000
72,000
192,000
3
108,000
43,200
235,200
4
64,800
14,800
250,000
5
50,000
0
250,000
Ending
Book Value
$180,000
108,000
64,800
50,000
50,000
ANNUAL CASH FLOWS

Year 1
Year 2
Year 3
Year 4
Year 5
Net
Income
$ 20,000
50,000
100,000
75,000
200,000
Net Cash
Flow
$ 140,000
122,000
143,200
89,800
200,000
Depreciation
$120,000
72,000
43,200
14,800
0
Cost of machine.....................................
Paid back in years 1 and 2....................
Paid back in year 3................................
Amount paid back in year 3

Net cash flows in year 3
Cumulative
Cash Flow
$ 140,000
262,000
405,200
495,000
695,000
$300,000
262,000
$ 38,000
$38,000
$143,200
= 0.265
Payback period = 2 + 0.265 = 2.265 years

100

$500,000 + $100,000
Average investment =
= $300,000
2
Accounting rate of return = $15,000 / $300,000 = 5%

COMPUTING NET CASH FLOWS FROM NET INCOME
Net income
Sales.............................................................$150,000
Cash flows
$150,000
Materials, labor & overhead........................ 80,000
80,000
Depreciation................................................. 20,000
Selling and administrative.......................... 15,000
15,000
Pretax income.............................................. 35,000

Income taxes (30%)..................................... 10,500
10,500
Net income...................................................$ 24,500

Net cash flows.............................................
1. Payback period =
$240,000
$44,500
2. Accounting rate of return =
$ 44,500
= 5.39 years
$24,500
$120,000*
= 20.42%
*Average investment
Cost................................... $240,000
Salvage.............................
0
Sum................................... $240,000
Average (Sum/2)............... $120,000

101

Annual
Net Cash
Flows
Years 1 through 12...............................................

$ 44,500
Present
Value of
Annuity
at 8%
7.5361
Present
Value of
Net Cash
Flows
$ 335,356
Amount to be invested.........................................
(240,000)
Net present value of investment.........................
$ 95,356)
Based on this net present value analysis, the investment is acceptable.

1.
PROJECT C1
Net Cash
Flows
Present
Value of 1
at 12%
Year 1.................................................
$ 10,000
0.8929
Year 2.................................................
90,000
0.7972
Year 3.................................................
140,000
0.7118
Totals.................................................
$240,000
Amount invested...................................................
Net present value..................................................
Present
Value of
Net Cash
Flows
8,929
71,748
99,652
$180,329
(190,000)
$ (9,671)
PROJECT C2
Net Cash
Flows
Present
Value of 1
at 12%
Year 1.................................................
$ 80,000
0.8929
Year 2.................................................
80,000
0.7972
Year 3.................................................
80,000
0.7118
Totals.................................................
$240,000
Amount invested...................................................
Present
Value of
Net Cash
Flows
$ 71,432
63,776
56,944
$192,152
(190,000)
$ 2,152
Continued on next page.

102
Exercise 25-7 (Continued)

PROJECT C3
Net Cash
Flows
Present
Value of 1
at 12%
Year 1.................................................
$150,000
0.8929
Year 2.................................................
50,000
0.7972
Year 3.................................................
40,000
0.7118
Totals.................................................
$240,000
Amount invested...................................................
Present
Value of
Net Cash
Flows
$133,935
39,860
28,472
$202,267
(190,000)
$ 12,267
Analysis and Interpretation: Both Project C2 and Project C3 yield a positive

net present value. Accordingly, both C2 and C3 are acceptable investments.
2.
INTERNAL RATE OF RETURN VS. NET PRESENT VALUE FOR C2
Project C2 will have an internal rate of return higher than 12%. We know
this because Project C2 has a positive net present value using a 12% rate of
return.
3.
INTERNAL RATE OF RETURN FOR PROJECT C2
(i) Present value factor
= Amount invested / Net cash flows

= $190,000 / $80,000 = 2.375
(ii) Factor is approximately equal to the 13% discount factor of 2.375 for 3
years (see Table B.3*).
Answer: IRR = 13%
*Instructor note: There is not a 13% column in the PV tables; students will need to
interpolate 12% + [ (15%-12%) x ({2.4018 2.3750}/ 0.1186) ] = 12.68%.

103

Normal
Volume
Sales.................................................. $3,000,000
Additional
Volume*
$240,000
Combined
Total
$3,240,000
Costs and expenses

Direct materials...............................
400,000
40,0001
440,000
Direct labor......................................
800,000
80,0002
880,000
Overhead.........................................
200,000
30,000
230,000
Selling expenses............................
300,000
Administrative expenses...............
514,000
86,000
600,000
Total costs and expenses.............. $2,214,000
$236,000
$2,450,000
$ 790,000
Net income........................................ $ 786,000
300,000
4,000
2
(20,000 x $2)
(20,000 x $4)
*ADDITIONAL VOLUME COMPUTATIONS
Additional sales revenue = 20,000 units @ $12 = $240,000
Materials cost per unit = $400,000/200,000 units = $2 per unit
Labor cost per unit = $800,000/200,000 units = $4 per unit
Incremental overhead = $200,000 x 15% = $30,000
Incremental administrative = $86,000 (given)
RECOMMENDATION: The company should accept the offer because the

additional sales would yield an incremental net income of $4,000.

104

INCREMENTAL COST OF MAKING THE PART
Variable costs (50,000 units @ $1.50).....................................
$ 75,000
Incremental fixed costs............................................................50,000
Total incremental cost of making 50,000 units......................
$125,000
INCREMENTAL COST OF BUYING THE PART

Cost per unit to buy..................................................................
$
2.70
Total incremental cost of buying 50,000 units.......................
$135,000
RECOMMENDATION: Note that the allocated fixed costs of $45,000 are not
relevant to this managerial decision because they will continue whether the
part is made or bought. Therefore, the incremental costs of making the part
are $10,000 less per year than buying it. This implies that the company
should continue to make this part.
Note: We should recognize that this decision depends on the alternative uses for the
productive facilities dedicated to making the part. If they can be used to produce a profit
greater than the $10,000 annual savings that the company attains by making this part,
the part should probably be purchased and the facilities used for the other more
profitable activities.

105

INCREMENTAL REVENUE AND COST OF ADDITIONAL PROCESSING
Revenue if processed further*................................................
$ 700,000
Revenue if sold as is................................................................
500,000
Incremental revenue.................................................................
200,000
Less incremental cost of processing.....................................
300,000
Incremental net income (or loss)............................................
$(100,000)
*Revenuefromprocessedproducts
Units
Product B.....................................................................
4,000
Product C.....................................................................
8,000
Total revenue from processed products..................
Price
$75
50
Total
$300,000
400,000
$700,000
ALTERNATE SOLUTION FORMAT

Net income (loss) from processed products
Revenue if processed further.................................................
Less: Additional costs of processing..................................$(300,000)
Opportunity cost (lost sales of Product A)................. (500,000)
Net benefit to processing.......................................................
$ 700,000
(800,000)
$(100,000)
RECOMMENDATION: This analysis shows that the company will be worse off
by $100,000 if it chooses to process Product A into the two products of B
and C. (Note that the $20 per unit cost of manufacturing Product A is sunk
and irrelevant to this decision.)

106

Instructor note: In all three cases, the total unavoidable expenses of $53,900 remain the same
because they cannot be avoided by eliminating departments.
1. NO DEPARTMENTS ELIMINATED
Total
M
Sales..................................
$112,000 $31,500
Expenses
Avoidable........................
60,200
4,900
Unavoidable...................
53,900
25,900
Total expenses...............
114,100
30,800
Net income (loss).............
$ (2,100) $ 700
N
$17,500
O
$28,000
P
$21,000
T
$14,000
18,200
6,300
24,500
$ (7,000)
11,200
2,100
13,300
$14,700
7,000
14,700
21,700
$ (700)
18,900
4,900
23,800
$ (9,800)
2. DEPARTMENTS WITH EXPECTED NET LOSSES ELIMINATED

Total
M
Sales.......................................................
$ 59,500 $31,500
Expenses
Avoidable..............................................
16,100
4,900
Unavoidable.........................................
53,900
25,900
Total expenses.....................................
70,000
30,800
Net income (loss)..................................
$(10,500) $ 700
N
$
0
6,300
$ 6,300
$(6,300)
O
$28,000
P
$
T
0
11,200
0
2,100
14,700
13,300 $ 14,700
$14,700 $(14,700)
0
4,900
4,900
$(4,900)
Explanation: This income statement reflects elimination of Departments N,

P, and T. The sales and avoidable expenses are the combined amounts for
Departments M and O. The net loss has actually increased because the
excess of sales dollars over avoidable expenses has declined and less
remains to cover unavoidable expenses.
3. DEPARTMENTS WITH LESS SALES THAN AVOIDABLE EXPENSES ELIMINATED
Total
M
Sales.......................................................
$80,500 $31,500
Expenses
Avoidable..............................................
23,100
4,900
Unavoidable.........................................
53,900 25,900
Total expenses.....................................
77,000 30,800
Net income (loss)..................................
$ 3,500 $ 700
N
$
O
$28,000
0
11,200
6,300
2,100
6,300
13,300
$(6,300) $14,700
P
$21,000
T
$
7,000
14,700
21,700
$ (700)
0
4,900
4,900
$(4,900)
Explanation: This income statement reflects the Departments M, O, and P.

Departments N and T are eliminated because their sales dollars do not
cover their avoidable costs.

107

Preliminary computations
Contribution margin per hour
Product TLX
Selling price per unit...................................................
$12.50
Variable costs per unit................................................ 3.75
Contribution per unit...................................................
$ 8.75
Product MTV
$ 7.50
4.50
$ 3.00
Machine-hours to produce 1 unit.............................. 0.50

Contribution margin per machine-hour
(or contribution/hours per unit)...............................
$17.50
1.
0.20
$15.00
FOR PRODUCT TLX

Maximum sales.....................................................
Hours needed per unit.........................................
Total hours used (3,750 x 0.50)...........................
3,750 units
0.50
1,875 hours
FOR PRODUCT MTV

Remaining hours (2,200 1,875).........................
Hours needed per unit.........................................
Maximum production* (325/0.20)........................
325 hours
0.20
1,625 units
*Still below market maximum production.
SALES MIX RECOMMENDATION: These results suggest the company

should manufacture as many units of Product TLX as it can produce
and sell until reaching a (market or production) constraint. Thereafter,
any remaining capacity should be devoted to Product MTV, up to the
maximum that can be produced and/or sold.
2.
CONTRIBUTION MARGIN FROM THE RECOMMENDED SALES MIX

Un
its
Product TLX.................. 3,750
Product MTV................. 1,625
Total...............................
Contribution
per Unit
$8.75
3.00
Total
$32,813*
4,875
$37,688
*Rounded

108

1. Recovery time computation
Payback Period
Break-Even Time
$100,000 / $35,000 = 2.86 years
3.5 years (see answer for QS 25-7)
2. The advantage of break-even time is that it considers the time value of

money. This means break-even time should provide a superior estimate
of the recovery time relative to the payback period method.
3. When (1) the interest rate is very low, 1% for example, and (2) the
payback period is very short, then payback period and break-even time
will yield similar results.

109
PROBLEM SET A
Problem 25-1A (50 minutes)
Part 1
Annual straight-line depreciation =
$300,000 - $20,000
4 years
= $70,000
Part 2
Net
Income
Expected annual sales of new product...................$1,150,000
Net Cash
Flow
$1,150,000
Expected costs of new product

Direct materials.......................................................
(300,000)
(300,000)
Direct labor..............................................................
(420,000)
(420,000)
Overhead excluding depr. on new asset..............
(210,000)
(210,000)
Depreciation on new asset....................................
(70,000)
Selling and administrative expenses....................
(100,000)
Income before taxes..................................................
50,000
Income taxes (30%)...................................................
(15,000)
Net income................................................................. $
Net cash flow*............................................................
(100,000)
(15,000)
35,000
$ 105,000
* Alternatively, annual net cash flow can be computed as

Net income + Depreciation = $35,000 + $70,000 = $105,000
Part 3
Payback Period =
$300,000
$105,000
= 2.86 years

110
Problem 25-1A (Continued)

Part 4
Accounting rate of return =
$35,000
$160,000*
= 21.88%
* Average investment
Asset cost................................................
$300,000
Final years book value...........................
20,000
Sum...........................................................
$320,000
Average (Sum /2).....................................
$160,000
Part 5
Present Value of Net Cash Flows
Net Cash
Flows
Year 1.............................
$105,000
Year 2.............................
105,000
Year 3.............................
105,000
Year 4*............................
125,000
Totals.............................
$440,000
Present
Value of
1 at 7%
0.9346
0.8734
0.8163
0.7629
Present
Value of Net
Cash Flows
$ 98,133
91,707
85,712
95,363
370,915
Amount invested...............................
(300,000)
Net present value..............................
$ 70,915
* Year 4s cash flow includes the $20,000 salvage value.

111

Part 1
PROJECT Y
Net income........................................
$112,000
Depreciation expense*.....................
175,000
Net cash flow....................................
$287,000
$700,000 - $0
4 years
= $175,000
PROJECT Z
Net income........................................
$ 72,800
Depreciation expense*.....................
233,333
Net cash flow....................................
$306,133
$700,000 - $0
3 years
= $233,333
Part 2
PROJECT Y
Payback Period =
$700,000
$287,000
= 2.44 years
$700,000
$306,133
= 2.29 years
PROJECT Z
Payback Period =

112

Part 3
PROJECT Y
$112,000
$350,000*
= 32%
*Average investment
Asset cost.................................................
$700,000
Average (Cost/2).......................................
$350,000
PROJECT Z
$72,800
$350,000*
= 20.8%
*Average investment
Asset cost.................................................
$700,000
Average (Cost/2).......................................
$350,000

113

Part 4
PROJECT Y
Net Cash
Flows
Years 1-4........................
$287,000
Present
Value of
1 at 8%
Annuity
Present
Value of
Net Cash
Flows
3.3121
$950,573
Amount invested...................................................
(700,000)
$250,573
PROJECT Z
Net Cash
Flows
Years 1-3........................
$306,133
Present
Value of
1 at 8% Annuity
Present
Value of
Net Cash
Flows
2.5771
$788,935
Amount invested...................................................
(700,000)
$ 88,935
Part 5
Recommendation to management is to pursue Project Y. This is because
Project Y has a positive net present value, which means that we expect it to
earn at least 8% on our cash investment in the machine. Project Z also has
a positive net present value, but its present value is less than that of Project
Y. We also note that the accounting rate of return is higher for Project Y
compared with Project Z.

114

Part 1
RESULTS USING STRAIGHT-LINE DEPRECIATION
(a)
Income
Before
Deprec.
Year 1.............................
$12,000
(b)
StraightLine
Deprec.
$ 3,000
(c)
Taxable
Income
(a) - (b)
$9,000
(d)
40%
Income
Taxes
$3,600
(e)
Net Cash
Flows
(a) - (d)
$8,400
Year 2.............................
12,000
6,000
6,000
2,400
9,600
Year 3.............................
12,000
6,000
6,000
2,400
9,600
Year 4.............................
12,000
6,000
6,000
2,400
9,600
Year 5.............................
12,000
6,000
6,000
2,400
9,600
Year 6.............................
12,000
3,000
9,000
3,600
8,400
(d)
40%
Income
Taxes
$2,400
(e)
Net Cash
Flows
(a) - (d)
$9,600
Part 2
RESULTS USING MACRS DEPRECIATION
(a)
Income
Before
Deprec.
Year 1.............................
$12,000
(b)
MACRS
Deprec.
$6,000
(c)
Taxable
Income
(a) - (b)
$6,000
Year 2.............................
12,000
9,600
2,400
960
11,040
Year 3.............................
12,000
5,760
6,240
2,496
9,504
Year 4.............................
12,000
3,456
8,544
3,418
8,582
Year 5.............................
12,000
3,456
8,544
3,418
8,582
Year 6.............................
12,000
1,728
10,272
4,109
7,891

115

Part 3
NET PRESENT VALUE OF ASSET USING STRAIGHT-LINE DEPRECIATION
Present
Value of
1 at 10%
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
Present
Net Cash
Value of Net
Flows
Cash Flows
Year 1.............................
$ 8,400
$ 7,636
Year 2.............................
9,600
7,933
Year 3.............................
9,600
7,212
Year 4.............................
9,600
6,557
Year 5.............................
9,600
5,961
Year 6.............................
8,400
4,742
Totals.............................
$55,200
40,041
Amount invested.......................................................................
(30,000)
Net present value......................................................................
$10,041
Part 4
NET PRESENT VALUE OF ASSET USING MACRS DEPRECIATION
Present
Net Cash
Value of
Flows
1 at 10%
Year 1.............................
$ 9,600
0.9091
Year 2.............................
11,040
0.8264
Year 3.............................
9,504
0.7513
Year 4.............................
8,582
0.6830
Year 5.............................
8,582
0.6209
Year 6.............................
7,891
0.5645
Totals.............................
$55,199
Amount invested...............................
Present
Value of Net
Cash Flows
$ 8,727
9,123
7,140
5,862
5,329
4,454
40,635
(30,000)
$10,635
Part 5
Analysis: The net present value using MACRS depreciation is greater than the
net present value using straight-line depreciation because the cash flows are
larger in the earlier years of the assets life under MACRS depreciation. They
are larger because the depreciation deductions are larger, resulting in less
income taxes paid in the earlier years.

116

CAYMAN PRODUCTS
COMPARATIVE INCOME STATEMENTS
(1)
(2)
(3)
Normal
Volume
New
Business
Combined
Sales..................................................
$1,200,000
$172,000
$1,372,000
Direct materials............................... 384,000
64,000
448,000
Direct labor...................................... 96,000
24,000
120,000
Overhead......................................... 288,000
36,000
324,000
Costs and expenses
Selling expenses............................ 120,000
120,000
Administrative expenses............... 80,000
4,000
84,000
Total costs & expenses.................... 968,000
128,000
1,096,000
Operating income.............................
$ 232,000
$ 44,000
$ 276,000
Supporting computations
Normal direct materials cost.........................................
$384,000
Units of output................................................................
300,000
Cost per unit...................................................................
$
1.28
New business volume....................................................50,000
New business direct materials cost.............................
$ 64,000
Normal direct labor cost................................................
$ 96,000
Units of output................................................................
300,000
Cost per unit...................................................................
$
0.32
Overtime per unit (50%)................................................. 0.16
New business direct labor cost per unit......................
$
0.48
New business direct labor cost....................................
$ 24,000
Total overhead................................................................
$288,000
Fixed overhead (25%)..................................................... 72,000
Variable overhead...........................................................
$216,000
Units of output................................................................
300,000
Cost per unit...................................................................
$
0.72
New business variable overhead cost.........................
$ 36,000

117

Part 1
Product G
Product B
Selling price per unit............................................

$120
$160
Variable costs per unit.........................................40
90
Contribution margin per unit...............................

$ 80
$ 70
Machine hours to produce 1 unit........................0.8
2.0
Contribution per machine hour

(or contribution/[hours per unit]).....................
$100
$ 35
Part 2
Sales Mix Recommendation. To the extent allowed by production and
market constraints, the company should produce as much of Product G as
possible. With a single shift yielding 176 hours per month (8 x 22), the
company can produce these units of Product G:
Maximum output of G =
176 hrs. per mo.

0.8 hrs. per unit
= 220 units per month
Contribution Margin at Recommended Sales Mix

Contribution margin = 220 units x $80 per unit = $17,600 per month

118

Part 3
Sales Mix Recommendation with Second Shift. If the second shift is
added, the maximum possible output of G will double
352 hrs. per mo.
= 440 units per mo.
0.8 hrs. per unit
However, this level of output exceeds the companys market constraint of
400 units of G per month. This means the company should produce 400
units of Product G, and commit the remainder of the productive capacity to
Product B. This is computed as follows
Maximum possible output of G =
Units of Product G.....................................................

Hours per unit............................................................ 0.8
Hours used for Product G.........................................320 hours
Hours available for Product B (352 hrs - 320 hrs)......... 32 hours
The output of Product B with 32 production hours is

Units of Product B
32 hrs. per mo.

2 hr. per unit
Contribution Margin at This Sales Mix

Units
From G...............................................
400
From B...............................................
16
Less extra shift costs.......................
Total contribution margin................
Contr./unit
$80
70
Total
$32,000
1,120
(6,500)
$26,620
Management decision. The contribution margin of $26,620 exceeds the

contribution margin of $17,600 generated by one shift alone (see part 2).
Therefore, management should add the second shift.

119

Part 4
Sales Mix Recommendation. By incurring additional marketing cost, the
company can relax the market constraint for sales of Product G up to the
point where 440 units can be sold. This means the company can produce
440 units of Product G, and commit the remainder of its productive
capacity, if any, to Product B. These computations are
Units of Product G...................................................
Hours per unit........................................................... 0.8
Hours used for Product G....................................... 352 hours
Hours available for Product B (352 hrs - 352 hrs)......
0 hours
The output of Product B with 0 production hours is
Units of Product B
0 hrs. per mo.

2 hr. per unit
Contribution Margin with This Sales Mix

Units
From G............................................... 440
From B............................................... 0
Less extra marketing costs.............
= 0 units per month
Contr./unit
$80
70
Total
$35,200
0
(6,500)
(2,000)
$26,700
Management decision. This contribution margin of $26,700 is only slightly

better than the contribution margin of $26,620 generated under the existing
market constraint (see part 3). Therefore, management may decide to
undertake this marketing strategy or decide that the marginal benefits
generated do not warrant the marketing efforts.

120

Part 1
HOME DECOR COMPANY
Analysis of Expenses under Elimination of Department 200
Total
Expenses
Eliminated
Expenses
Continuing
Expenses
Cost of goods sold...............................................

$ 938,000
$414,000
$524,000
Direct expenses
Advertising..........................................................
58,000
24,000
34,000
Store supplies used...........................................

15,600
7,600
8,000
DepreciationStore equipment........................
16,600
Allocated expenses
Sales salaries*....................................................
208,000
16,600
104,000
Rent expense......................................................
28,320
Bad debts expense.............................................
36,000
104,000
28,320
16,200
Office salary*.......................................................
62,400
19,800
62,400
Insurance expense*............................................
6,200
1,540
4,660
Miscellaneous office expenses*........................

8,000
800
7,200
Total expenses......................................................
$1,377,120
$568,140
$808,980
*Computation notes. Closing Department 200 will eliminate 70% of its insurance
expense and 25% of its miscellaneous office expense. Sales salaries will be
reduced by the amounts paid to the two clerks who will not be replaced. The
office salary will not be eliminated, but it will be reclassified so that one-half will
be reported as sales salary and one-half as office salary.

121

Part 2
HOME DECOR COMPANY
Forecasted Annual Income Statement
Under Plan to Eliminate Department 200
Sales......................................................................
$872,000
524,000
Gross profit from sales........................................
348,000
Operating expenses
Advertising..........................................................
34,000
8,000
Depreciation of store equipment......................
16,600
Sales salaries.....................................................
135,200*
Rent expense......................................................
28,320
Bad debts expense............................................
19,800
Office salary........................................................
31,200*
Insurance expense.............................................
4,660
Miscellaneous office expenses.........................
7,200
Total operating expenses....................................
284,980
Net income............................................................
$ 63,020
* Administrative salary reassignment

Total
Sales
Salaries
Salaries
Salesclerks.........................................................................
$104,000
$104,000
Administrative worker.......................................................
62,400
Reassign adm. worker to sales.........................................
0
31,200
Revised salaries.................................................................
$166,400
$135,200
Office
Salary
$62,400
(31,200)
$31,200

122

Part 3
HOME DCOR COMPANY
Reconciliation of Combined Income with Forecasted Income
Combined net income ......................................................... $ 74,880
Less Dept. 200's lost sales..................................................
(580,000)
Plus Dept. 200s eliminated expenses................................
568,140
Forecasted net income........................................................
$ 63,020
ANALYSIS
Department 200's avoidable expenses of $568,140 are $11,860 less than its
revenues of $580,000. This means the company's annual net income would
be $11,860 less from eliminating Department 200. This analysis suggests
the department should probably not be eliminated.

123
PROBLEM SET B
Problem 25-1B (50 minutes)
Part 1
Annual straight-line depreciation =
$100,000 - $25,000
= $15,000
5 years
Part 2
Net
Income
Expected annual sales of new product........................
$ 350,000
Net Cash
Flow
$ 350,000
Expected annual costs of new product

Direct materials............................................................ 150,000
150,000
Direct labor................................................................... 50,000
50,000
Overhead excluding depr. on new asset................... 100,000
100,000
Depreciation on new asset......................................... 15,000

Selling and administrative expenses......................... 23,000
23,000
Income before taxes....................................................... 12,000

Income taxes (20%)........................................................
2,400
Net income......................................................................$
9,600
Net cash flow*.................................................................
2,400
$ 24,600
*Alternatively, annual net cash flow can be computed as:

Net income + Depreciation = $9,600 + $15,000 = $24,600

124
Problem 25-1B (Continued)

Part 3
Payback Period =
$100,000
$24,600
= 4.07 years
Part 4
$9,600
$62,500*
= 15.36%
*Average investment
Asset cost..................................................
$100,000
Final years book value.............................
25,000
Sum............................................................
$125,000
Average (Sum /2).......................................
$ 62,500
Part 5
Net Cash
Flows
Year 1.............................
$ 24,600
Year 2.............................
24,600
Year 3.............................
24,600
Year 4.
24,600
Year 5*............................
49,600
Present
Value of
1 at 12%
0.8929
0.7972
0.7118
0.6355
0.5674
Present
Value of Net
Cash Flows
$ 21,965
19,611
17,510
15,633
28,143
Totals.............................
$148,000
$102,862
Amount invested...............................
(100,000)
2,862
* Year 5s cash flow includes the $25,000 salvage value.

125

Part 1
PROJECT A
Net income...............................................$ 31,500
Depreciation expense*............................ 160,000
Net cash flow...........................................$191,500
$480,000 - $0
3 years
= $160,000
PROJECT B
Net income............................................ $ 51,800
Depreciation expense*........................
120,000
Net cash flow........................................ $171,800

$480,000 - $0
4 years
= $120,000
Part 2
PROJECT A
Payback Period =
$480,000
$191,500
= 2.5 years
$480,000
$171,800
= 2.8 years
PROJECT B
Payback Period =

126

Part 3
PROJECT A
$31,500
$240,000*
= 13.1%
*Average investment
Asset cost..................................................
$480,000
Average (Cost/2)........................................
$240,000
PROJECT B
$51,800
$240,000*
= 21.6%
*Average investment
Asset cost..................................................
$480,000
Average (Cost/2)........................................
$240,000

127

Part 4
PROJECT A
Net Cash
Flows
Years 1-3........................
$191,500
Present
Value of
1 at 10%
Annuity
Present
Value of
Net Cash
Flows
2.4869
$ 476,241
Amount invested...................................................
(480,000)
Net present value.................................................. $ (3,759)

PROJECT B
Net Cash
Flows
Present
Value of
1 at 10%
Annuity
Present
Value of
Net Cash
Flows
Years 1-4........................
$171,800
3.1699
$544,589
Amount invested...................................................
(480,000)
Net present value.................................................. $ 64,589

Part 5
Recommendation to management is to pursue Project B. This is because
Project B has a positive net present value, which means that we expect it to
earn at least 10% on our cash investment in the machine. Project A has a
negative net present value, meaning that it is not expected to earn the
required rate of return. We might also note that the accounting rate of
return is also higher for Project B compared with Project A.

128

Part 1
RESULTS USING STRAIGHT-LINE DEPRECIATION
(a)
Income
Before
Deprec.
Year 1.............................
$15,000
(b)
StraightLine
Deprec.
$2,500
(c)
Taxable
Income
(a) - (b)
$12,500
(d)
30%
Income
Taxes
$3,750
(e)
Net Cash
Flows
(a) - (d)
$11,250
Year 2.............................
15,000
5,000
10,000
3,000
12,000
Year 3.............................
15,000
5,000
10,000
3,000
12,000
Year 4.............................
15,000
5,000
10,000
3,000
12,000
Year 5.............................
15,000
5,000
10,000
3,000
12,000
Year 6.............................
15,000
2,500
12,500
3,750
11,250
(d)
30%
Income
Taxes
$3,000
(e)
Net Cash
Flows
(a) - (d)
$12,000
Part 2
RESULTS USING MACRS DEPRECIATION
(a)
Income
Before
Deprec.
Year 1.............................
$15,000
(b)
MACRS
Deprec.
$5,000
(c)
Taxable
Income
(a) - (b)
$10,000
Year 2.............................
15,000
8,000
7,000
2,100
12,900
Year 3.............................
15,000
4,800
10,200
3,060
11,940
Year 4.............................
15,000
2,880
12,120
3,636
11,364
Year 5.............................
15,000
2,880
12,120
3,636
11,364
Year 6.............................
15,000
1,440
13,560
4,068
10,932

129

Part 3
NET PRESENT VALUE OF ASSET USING STRAIGHT-LINE DEPRECIATION
Net Cash
Flows
Present
Value of
1 at 15%
Present
Value of Net
Cash Flows
Year 1.............................
$11,250
0.8696
$ 9,783
Year 2.............................
12,000
0.7561
9,073
Year 3.............................
12,000
0.6575
7,890
Year 4.............................
12,000
0.5718
6,862
Year 5.............................
12,000
0.4972
5,966
Year 6.............................
11,250
0.4323
4,863
Totals.............................
$70,500
$44,437
Amount invested.......................................................................
(25,000)
Net present value......................................................................
$19,437
Part 4
NET PRESENT VALUE OF ASSET USING MACRS DEPRECIATION
Present
Value of
1 at 15%
Present
Value of Net
Cash Flows
Year 1.............................
$12,000
0.8696
Year 2.............................
12,900
0.7561
Year 3.............................
11,940
0.6575
Year 4.............................
11,364
0.5718
Year 5.............................
11,364
0.4972
Year 6.............................
10,932
0.4323
Totals.............................
$70,500
Amount invested...............................
$10,435
9,754
7,851
6,498
5,650
4,726
$44,914
(25,000)
$19,914
Net Cash
Flows
Part 5
Analysis: The net present value using MACRS depreciation is greater than the
net present value using straight-line depreciation because the cash flows are
larger in the earlier years of the assets life under MACRS depreciation. They
are larger because the depreciation deductions are larger, resulting in less
income taxes paid in the earlier years.

130

WINDTRAX COMPANY
COMPARATIVE INCOME STATEMENTS
(1)
(2)
(3)
Normal
Volume
New
Business
Combined
Sales..................................................$200,000
$16,000
$216,000
Costs and expenses

Direct materials............................... 30,000
3,000
33,000
Direct labor...................................... 12,000
2,400
14,400
Overhead......................................... 50,000
1,000
51,000
Selling expenses............................
7,500
7,500
Administrative expenses............... 31,500
750
32,250
Total costs and expenses................ 131,000
7,150
138,150
Operating income.............................$ 69,000
$ 8,850
$ 77,850
Supporting computations
Normal direct material cost...........................................
$ 30,000
Units of output................................................................
200,000
Cost per unit...................................................................
$ 0.15
New business volume....................................................
20,000
New business direct material cost...............................
$ 3,000
Normal direct labor cost................................................
$ 12,000
Units of output................................................................
200,000
Cost per unit...................................................................
$ 0.06
Overtime per unit (100%)............................................... 0.06
New business direct labor cost per unit......................
$ 0.12
20,000
New business direct labor cost....................................
$ 2,400
Total overhead................................................................
$ 50,000
Fixed overhead (80%).....................................................
40,000
Variable overhead...........................................................
$ 10,000
Units of output................................................................
200,000
Cost per unit...................................................................
$ 0.05
20,000
New business variable overhead cost.........................
$ 1,000

131

Part 1
Product 22
Selling price per unit............................................ $ 175
Variable costs per unit.........................................
100
Contribution margin per unit............................... $ 75
Machine hours to produce 1 unit........................
0.8
Contribution per machine hour
(or contribution/[hours per unit])..................... $93.75
Product 44
$ 200
150
$ 50
0.5
$ 100
Part 2
Sales Mix Recommendation To the extent allowed by production and
market constraints, the company should produce as much of Product 44 as
possible. With a single shift yielding 184 hours per month (8 x 23), the
company can produce these units of Product 44:
Maximum output of 44 =
184 hrs. per mo.

0.5 hrs. per unit
Contribution Margin at Recommended Sales Mix

Contribution margin = 368 units x $50 per unit = $18,400 per month

132

Part 3
Sales Mix Recommendation with Second Shift If the second shift is added,
the maximum possible output of 44 will double:
368 hrs. per mo.
= 736 units per mo.
0.5 hrs. per unit
However, this level of output exceeds the companys market constraint of
450 units of Product 44 per month. This means the company should
produce 450 units of Product 44, and commit the remainder of the
productive capacity to Product 22. This is computed as follows:
Maximum possible output of 44 =
Units of Product 44..................................................= 450 units per month

Hours per unit........................................................... 0.5
Hours used for Product 44...................................... 225 hours
Hours available for Product 22 (368 hrs - 225 hrs)...... 143 hours
The output of Product 22 with 143 production hours is

Units of Product 22
143 hrs. per mo.

0.8 hrs. per unit
Contribution Margin at This Sales Mix

Units
From 44.............................................. 450
From 22.............................................. 178
(rounded down to whole units)
Contr./unit
$50
75
Total
$22,500
13,350
(5,000)
$30,850
Management decision This amount of $30,850 exceeds the contribution

margin of $18,400 generated by one shift alone (see part 2). Therefore,
management should add the second shift.

133

Part 4
Sales Mix Recommendation By incurring additional marketing cost, the
company can relax the market constraint for sales of Product 44 up to the
point where 500 units can be sold. This means the company can produce
500 units of Product 44, and commit the remainder of its productive
capacity to Product 22. These computations are:
Units of Product 44................................................= 500 units per month
Hours per unit........................................................ 0.5
Hours used for Product 44.................................... 250 hours
Hours available for Product 22
(368 hrs less 250 hrs)......................................... 118 hours
The output of Product 22 with 118 production hours is

Units of Product 22
118 hrs. per mo.

0.8 hr. per unit
Contribution Margin with This Sales Mix

Units
From 44.............................................. 500
From 22.............................................. 147
Less extra marketing costs.............
(rounded down to whole units)
Contr./unit
$50
75
Total
$25,000
11,025
(5,000)
(500)
$30,525
Management decision This amount of $30,525 is less than the contribution

margin of $30,850 generated under the existing market constraint (see part
3). Therefore, management should not undertake this marketing strategy.

134

Part 1
TURFTIME COMPANY
Analysis of Expenses under Elimination of Department Z
Total
Expenses

$293,200
Eliminated
Expenses
Continuing
Expenses
$62,550
$230,650
1,500
700
13,500
2,800
10,500
Sales salaries*....................................................
46,800
Rent expense......................................................
13,800
Bad debts expense.............................................
12,500
Office salary*.......................................................
13,000
Insurance expense*............................................
2,800
Miscellaneous office expenses*........................
2,100
23,400
455
375
23,400
13,800
10,500
13,000
2,345
1,725
Total expenses......................................................
$413,200
$90,980
$322,220
Direct expenses
Advertising..........................................................
15,000
3,500
Depreciation of store equip...............................
10,500
Allocated expenses
2,000
Computation Notes Closing Department Z will eliminate 65% of its insurance

expense and 30% of its miscellaneous office expense. Sales salaries will be
reduced by the amounts paid to the two clerks who will not be replaced. The
office salary will not be eliminated, but it will be reclassified so that one-half will
be reported as sales salary and one-half as office salary.

135

Part 2
TURFTIME COMPANY
Forecasted Annual Income Statement
Under Plan to Eliminate Department Z
Sales......................................................................
$350,000
230,650
Gross profit from sales........................................
119,350
Operating expenses
Advertising..........................................................
13,500
2,800
Depreciation of store equipment......................
10,500
Sales salaries.....................................................
29,900*
Rent expense......................................................
13,800
Bad debts expense............................................
10,500
Office salary........................................................
6,500*
Insurance expense.............................................
2,345
Miscellaneous office expenses.........................
1,725
Total operating expenses....................................
91,570
Net income............................................................
$ 27,780
* Office salary reassignment

Total
Sales
Office
Salaries Salaries Salary
Salesclerks.........................................................................
$23,400 $23,400
Office clerk.........................................................................
13,000
$13,000
Reassign office clerk to sales...........................................
0
6,500
(6,500)
Revised salaries.................................................................
$36,400 $29,900 $ 6,500

136

Part 3
TURFTIME COMPANY
Reconciliation of Combined Income with Forecasted Income
Combined net income ...................................................... $ 24,300
Less Dept. Z's lost sales.................................................. (87,500)
Plus Dept. Zs eliminated expenses................................
90,980
Forecasted net income..................................................... $ 27,780
ANALYSIS
Department Z's avoidable expenses of $90,980 are $3,480 greater than its
revenues of $87,500. This means the company's annual net income would
be $3,480 higher from eliminating Department Z. This analysis suggests
management should probably go ahead with the elimination of the
department as planned.

137
SERIAL PROBLEM
Serial Problem, Success Systems (50 minutes)
COMPUTING NET CASH FLOWS FROM NET INCOME
Net income
Sales.............................................................$150,000
Cash flows
$150,000
Materials, labor & overhead........................ (80,000)
(80,000)
Depreciation................................................. (20,000)
Selling and administrative.......................... (15,000)
(15,000)
Pretax income.............................................. 35,000

Income taxes (30%)..................................... (10,500)
(10,500)
Net income...................................................$ 24,500

Net cash flows.............................................
1. Payback period =
$120,000
$44,500
2. Accounting rate of return =
$ 44,500
= 2.7 years
$24,500
$60,000*
= 40.8%
*Average investment
Cost................................... $120,000
Salvage..............................
0
Sum................................... $120,000
Average (Sum/2)............... $ 60,000

138
Reporting in Action
BTN 25-1
1. We cannot determine the incremental product cost because we do not

know how many times the promotion will be successful and how many
patrons will redeem ticket stubs.
If the Royals rarely achieve 12 hits then Krispy Kreme has a tremendous
advertising campaign at very low cost. However, the Royals might
surprise marketing managers at Krispy Kreme and achieve the 12 hits
much more frequently than expected.
2. 20,000 fans x .05 redemption rate = 1,000 dozen donuts.
3. 15 games x 20,000 fans x .05 redemption rate = 15,000 dozen donuts x $2
cost per dozen = $30,000.
4. Krispy Kreme gains low cost exposure (Krispy Kreme may have been
charged an upfront flat fee to be allowed to run the promotion) as the

Royals TV and radio announcers frequently mention the promotion on
air. The fans love the promotion and cheer wildly for MORE HITS and
DONUTS as the Royals approach 12 hits in a game. The excitement
added by Krispy Kreme to the ballgames can only be positive for its
reputation with customers.
Krispy Kreme hopes that customers redeeming ticket stubs for free
donuts will also purchase coffee, additional donuts, or memorabilia
while they are in the store.
5. Answer depends on the information collected. However, if Krispy Kreme
continued the promotion it would be because it viewed the promotion

benefits as greater than the promotion costs. If it discontinued the
promotion the potential reasons would likely be that it viewed the
promotion costs as greater than the promotion benefits or that its
marketing executives wanted to keep their promotions fresh and everchanging.

139
Comparative Analysis
BTN 25-2
1. Answer depends on the newspaper selected and its price for advertising
space. The cost of a one-quarter page advertisement in a medium-sized
U.S. city newspaper is probably near $2,000.
2. If we assume that the average product of Krispy Kreme and Tastykake
sells for around $5, then the contribution margin per product is about $1
(using the 20% stated assumption in the problem). This would mean that
the company would need to sell at least 2,000 additional products
(computed by dividing the $2,000 advertisement by the $1 contribution
margin per product) to recover the price of the advertisement.
Incremental sales of more than 2,000 products from this advertisement
would support the profitability of this marketing strategy.
3.
TO:
FROM:
DATE:
SUBJECT:
MEMORANDUM
Primary points for discussion of the importance of effective advertising:

(a) Students need to recognize that advertising is very expensive and
crucial to most merchandisers.
(b) The students should also recognize that an advertisement must be
effective to justify its cost and the related product mix decision of
managers.
(c) In most cases the advertisement must generate several thousand
dollars in sales to pay for the advertisement.

140
Ethics Challenge
BTN 25-3
1. Present value of $100 to be received in 10 years assuming a 12%

discount rate is approximately $32. This is computed as $100 x 0.322.
2. We need to be concerned about any project with expected long-term
cash inflows. This is especially the case if the larger cash inflows are
expected later rather than sooner in the assets life. This concern is tied
to the riskiness of long-term predictions and the likely biases of
individuals proposing the project.
The answer to part 1 shows that long-term cash inflows are small when
factoring in their present values. Also, since the long-term predictions
are inherently more risky, the discount factor should probably increase
as the cash inflow gets further into the future.
Communicating in Practice
BTN 25-4
Instructor note: Answers will vary, but responses should address the questions asked and
include some discussion of the following points for each method.
Payback
Period
Cash flows
Accounting
Rate of Return
Accrual
income
Net Present
Value
Cash flows
Internal Rate of
Return
Cash flows
Profitability
Profitability
Measurement
basis
Measurement
unit
Periods
Percent
Dollars
Percent
Strengths
Easy to
understand
Easy to
understand
Allows
comparison
of projects
Allows
comparison
of projects
Reflects time
value of
money
Reflects
different risk
levels over
projects life
Reflects time
value of
money
Allows
comparisons
of dissimilar
projects
Ignores
time value
of money
Ignores
time value
of money
Ignores
cash flows
after
payback
period
Ignores
annual
rates over
life of
project
Difficult to
compare
dissimilar
projects
Limitations
Ignores
varying risk
levels over
life of
project

141
Taking It to the Net
BTN 25-5
1. The notion of capital appears to be similar in both the government and

private sector in the sense that the commissions report also defines
capital as having future value.
2. The investment analysis techniques (for example, payback period, NPV,
and IRR) may be useful depending on the nature of the investment. This
is because many of the capital investments that the federal government
makes have social/societal benefits, which are hard to quantify. For
example, it is hard to quantify investments in highways or education or
health care. For investments whose benefits are quantifiable, it would
be helpful to use the techniques explained in the chapter.
Teamwork in Action
BTN 25-6
Instructor note: Answers will vary across students. Yet the examples, while different, should
capture similar qualitative factors.
SAMPLE SOLUTION
Project
Investment in an improved baggage handling system. The new, improved
baggage handling system is expected to increase both customer
satisfaction and likelihood of repeat business.
Qualitative Factors
Competition has a new, more efficient and effective system.
Need to replace old system.
Increased customer demand for a new system because of special
baggage handling needs, for example, golf clubs to vacation destination.
Eases the workload of baggage handlers.
Improves employee morale.
Safety concerns with the older system--both employees and customers.

142
Business Week Activity
BTN 25-7
1. An investment in graduate education can increase an individuals future

cash flows. It is possible to measure the cost of the education against
the possible future benefits (increased cash flows) using the capital
budgeting techniques discussed in this chapter.
2. To calculate the payback, Stephan first figures out the students'
opportunity cost of attendingboth the tuition payments and the
forgone salary. He assumes a student in a two-year program loses 18
months of income (allowing for a summer internship). Then he projects
the graduates' earnings over the next eight years, folding bonuses and
other compensation into the post-MBA salary. Stephan assumes a 10%
raise each year after graduationwhich smoothes out differences in
occupations as well as economic ups and downs over the course of 10
years.
3. The average 2002 graduate will break even on the investment in an MBA
education after 5.6 years.
4. The European payback period is shorter at 5.1 years versus 5.6 years for
Americans.
5. A 35.5% annual return.
Entrepreneurial Decision
BTN 25-8
Since AnthroTronix can sell all it can produce of both products, it should
allocate all of its production capacity to the home model of the CosmoBot.
This is because the home model yields a $1,600 contribution margin per
production hour (versus $1,000 for the enhanced model).
Enhanced
Model
Contribution margin per unit............................... $ 500
Production hours per unit...................................
Home
Model
$ 400
1/2
1/4
Contribution margin per production hour.......... $1,000
$1,600

143
Hitting the Road
BTN 25-9
1. Answers will vary among students.

Sample Example
For illustrative purposes, one sample solution would appear as
follows:
Lease terms$400 per month for 35 months; plus $10,000 final
payment at the end of 35 months; 12% annual interest rate.
To compute the present value of the lease payments
PV of 35 payments of $400 per month discounted
at 1% (12%/12 months).......................................................
$11,763*
PV of $10,000 final payment at end of 35 months
discounted at 1%................................................................
7,059**
Total PV of lease....................................................................
$18,822
* $400 x 29.4086 (from Table B.3)
** $10,000 x 0.7059 (from Table B.1)
Purchase terms$16,500
2. In most cases the students will find it more costly to lease an

automobile than to purchase it outright. Also, getting the salesperson
to negotiate the outright purchase of the automobile is sometimes
challenging once youve shown interest in leasing. This is because of
the usually higher profit margin associated with leasing.
Using the sample numbers from part 1, the PV of the lease is $18,822,
which is $2,322 more than the outright purchase price of $16,500.

144
Global Decision
BTN 25-10
1. Grupo Bimbo distributed 15,200 hand-held computers to its sales force

(70%) in 2002. The plan is to further this distribution in 2003.
2. Yes. Grupo Bimbo closed plants in Dallas, Vienna, and Mexico City.
3. Mrs. Bairds Honey 7 Grain and Sugar Free Breads, and Oroweats
Country Wheat Bread.
4. Grupo Bimbo increased sales volume for 2002 in Brazil, Chile, Colombia,
Peru, and Central America.
5. The most outstanding activity was the support of the junior soccer
tournament held throughout Latin America.

145

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Chapter 25

Capital Budgeting and Managerial

A shorter payback period is desirable because management prefers to reduce the

McGraw-Hill Companies, Inc., 2005

McGraw-Hill Companies, Inc., 2005

Fundamental Accounting Principles, 17th Edition

Quick Study 25-2 (10 minutes)

Quick Study 25-4 (10 minutes)

McGraw-Hill Companies, Inc., 2005

Quick Study 25-5 (15 minutes)

Quick Study 25-6 (15 minutes)

Fundamental Accounting Principles, 17th Edition

Exercise 25-2 (20 minutes)

Cost of investment........................... $90,000

McGraw-Hill Companies, Inc., 2005

Exercise 25-2 (Continued)

Amount paid back in year 4

Payback period = 3 + 0.167 = 3.167 years, or 3 years and 2 months

Double-declining balance rate = (100% / 5) x 2 = 40%

ANNUAL CASH FLOWS

Amount paid back in year 3

Payback period = 2 + 0.265 = 2.265 years

McGraw-Hill Companies, Inc., 2005

Fundamental Accounting Principles, 17th Edition

Exercise 25-4 (15 minutes)

Exercise 25-5 (20 minutes)

Materials, labor & overhead........................ 80,000

Pretax income.............................................. 35,000

Net income...................................................$ 24,500

2. Accounting rate of return =

McGraw-Hill Companies, Inc., 2005

Exercise 25-6 (20 minutes)

Years 1 through 12...............................................

Net present value of investment.........................

Based on this net present value analysis, the investment is acceptable.

Exercise 25-7 (35 minutes)

Continued on next page.

McGraw-Hill Companies, Inc., 2005

Fundamental Accounting Principles, 17th Edition

Exercise 25-7 (Continued)

Analysis and Interpretation: Both Project C2 and Project C3 yield a positive

INTERNAL RATE OF RETURN VS. NET PRESENT VALUE FOR C2

INTERNAL RATE OF RETURN FOR PROJECT C2

(i) Present value factor

= Amount invested / Net cash flows

McGraw-Hill Companies, Inc., 2005

Exercise 25-8 (25 minutes)

Costs and expenses

Total costs and expenses.............. $2,214,000

Net income........................................ $ 786,000

RECOMMENDATION: The company should accept the offer because the

McGraw-Hill Companies, Inc., 2005

Fundamental Accounting Principles, 17th Edition

Exercise 25-9 (20 minutes)

INCREMENTAL COST OF BUYING THE PART

McGraw-Hill Companies, Inc., 2005

Exercise 25-10 (25 minutes)

ALTERNATE SOLUTION FORMAT

McGraw-Hill Companies, Inc., 2005

Fundamental Accounting Principles, 17th Edition

Exercise 25-11 (30 minutes)

2. DEPARTMENTS WITH EXPECTED NET LOSSES ELIMINATED

Explanation: This income statement reflects elimination of Departments N,

Explanation: This income statement reflects the Departments M, O, and P.