wiley chapter 26 slides
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Transcript of wiley chapter 26 slides
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26-1
Prepared byCoby Harmon
University of California, Santa BarbaraWestmont College
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26 Incremental Analysis and Capital Budgeting
Learning Objectives
After studying this chapter, you should be able to:
[1] Identify the steps in management’s decision-making process.
[2] Describe the concept of incremental analysis.
[3] Identify the relevant costs in accepting an order at a special price.
[4] Identify the relevant costs in a make-or-buy decision.
[5] Identify the relevant costs in determining whether to sell or process materials further.
[6] Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
[7] Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
[8] Determine which products to make and sell when resources are limited.
[9] Contrast annual rate of return and cash payback in capital budgeting.
[10] Distinguish between the net present value and internal rate of return methods.
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Preview of Chapter 26
Accounting PrinciplesEleventh Edition
Weygandt Kimmel Kieso
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Making decisions is an important management function.
Does not always follow a set pattern.
Decisions vary in scope, urgency, and importance.
Steps usually involved in process include:
LO 1 Identify the steps in management’s decision-making process.
Illustration 26-1
Incremental Analysis
Management’s Decision-Making Process
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In making business decisions,
Considers both financial and non-financial information.
Financial information
► Revenues and costs, and
► Effect on overall profitability.
Non-financial information
► Effect on employee turnover
► The environment
► Overall company image.
LO 1 Identify the steps in management’s decision-making process.
Incremental Analysis
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Decisions involve a choice among alternative actions.
Process used to identify the financial data that change
under alternative courses of action.
► Both costs and revenues may vary or
► Only revenues may vary or
► Only costs may vary
LO 2 Describe the concept of incremental analysis.
Incremental Analysis Approach
Incremental Analysis
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26-7 LO 2 Describe the concept of incremental analysis.
How Incremental Analysis Works
Incremental revenue is $15,000 less under Alternative B.
Incremental cost savings of $20,000 is realized.
Alternative B produces $5,000 more net income.
Illustration 26-2
Incremental Analysis
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Important concepts used in incremental analysis:
Relevant cost.
Opportunity cost.
Sunk cost.
LO 2 Describe the concept of incremental analysis.
How Incremental Analysis Works
Incremental Analysis
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Sometimes involves changes that seem contrary to
intuition.
Variable costs sometimes do not change under
alternatives.
Fixed costs sometimes change between alternatives.
LO 2 Describe the concept of incremental analysis.
How Incremental Analysis Works
Incremental Analysis
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Common types of decisions involving incremental analysis:
1. Accept an order at a special price.
2. Make or buy component parts or finished products.
3. Sell or process further them further
4. Repair, retain, or replace equipment.
5. Eliminate an unprofitable business segment or product.
Incremental Analysis
LO 2 Describe the concept of incremental analysis.
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Incremental analysis is the process of identifying the financial
data that
a. Do not change under alternative courses of action.
b. Change under alternative courses of action.
c. Are mixed under alternative courses of action.
d. None of the above.
LO 2 Describe the concept of incremental analysis.
Incremental Analysis
Question
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Obtain additional business by making a major price
concession to a specific customer.
Assumes that sales of products in other markets are
not affected by special order.
Assumes that company is not operating at full capacity.
LO 3 Identify the relevant costs in accepting an order at a special price.
Accept an Order at a Special Price
Incremental Analysis
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Illustration: Sunbelt Company produces 100,000 Smoothie blenders
per month, which is 80% of plant capacity. Variable manufacturing
costs are $8 per unit. Fixed manufacturing costs are $400,000, or $4
per unit. The blenders are normally sold directly to retailers at $20
each. Sunbelt has an offer from Kensington Co. (a foreign wholesaler)
to purchase an additional 2,000 blenders at $11 per unit. Acceptance
of the offer would not affect normal sales of the product, and the
additional units can be manufactured without increasing plant
capacity. What should management do?
LO 3 Identify the relevant costs in accepting an order at a special price.
Accept an Order at a Special Price
Incremental Analysis
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26-15 LO 3
Fixed costs do not change since within existing capacity – thus
fixed costs are not relevant.
Variable manufacturing costs and expected revenues change –
thus both are relevant to the decision.
Illustration 26-4
Accept an Order at a Special Price
Advance slide in presentation mode to reveal answer.
Incremental Analysis
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Accept or
Reject?
Cobb Company incurs costs of $28 per unit ($18 variable and $10
fixed) to make a product that normally sells for $42. A foreign
wholesaler offers to buy 5,000 units at $25 each. Cobb will incur
additional shipping costs of $1 per unit. Compute the increase or
decrease in net income Cobb will realize by accepting the special
order, assuming Cobb has excess operating capacity. Should Cobb
Company accept the special order?
LO 3
Accept or
Reject?
DO IT!>
Advance slide in presentation mode to reveal answer.
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Illustration: Baron Company incurs the following annual costs in
producing 25,000 ignition switches for motor scooters.
Make or Buy
LO 4 Identify the relevant costs in a make-or-buy decision.
Instead of making its own switches, Baron Company might purchase the ignition switches at a price of $8 per unit. “What should management do?”
Illustration 26-5
Incremental Analysis
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Total manufacturing cost is $1 higher per unit than purchase price.
Must absorb at least $50,000 of fixed costs under either option.
Illustration 26-6
LO 4 Identify the relevant costs in a make-or-buy decision.
Make or Buy
Incremental Analysis
Advance slide in presentation mode to
reveal answer.
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26-20 LO 4 Identify the relevant costs in a make-or-buy decision.
The potential benefit that
may be obtained from
following an alternative
course of action.
Make or Buy – Opportunity Cost
Incremental Analysis
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26-21 LO 4 Identify the relevant costs in a make-or-buy decision.
Illustration 26-7
Make or Buy – Opportunity Cost
Illustration: Assume that through buying the switches, Baron
Company can use the released productive capacity to generate
additional income of $38,000 from producing a different product.
This lost income is an additional cost of continuing to make the
switches in the make-or-buy decision.
Incremental Analysis
Advance slide in presentation mode to
reveal answer.
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In a make-or-buy decision, relevant costs are:
a. Manufacturing costs that will be saved.
b. The purchase price of the units.
c. Opportunity costs.
d. All of the above.
LO 4 Identify the relevant costs in a make-or-buy decision.
Question
Incremental Analysis
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Juanita Company must decide whether to make or buy some of its
components for the appliances it produces. The costs of producing
166,000 electrical cords for its appliances are as follows.
Direct materials $90,000 Variable overhead $32,000
Direct labor 20,000 Fixed overhead 24,000
Instead of making the electrical cords at an average cost per unit of
$1.00 ($166,000 ÷ 166,000), the company has an opportunity to buy the
cords at $0.90 per unit. If the company purchases the cords, all variable
costs and one-fourth of the fixed costs will be eliminated.
(a) Prepare an incremental analysis showing whether the company
should make or buy the electrical cords. (b) Will your answer be different
if the released productive capacity will generate additional income of
$5,000?
LO 4 Identify the relevant costs in a make-or-buy decision.
DO IT!>
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(a) Prepare an incremental analysis showing whether the company
should make or buy the electrical cords.
Juanita Company will incur $1,400 of additional costs if it buys the
electrical cords rather than making them.
LO 4 Identify the relevant costs in a make-or-buy decision.
DO IT!>
Advance slide in presentation mode to
reveal answer.
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(b) Will your answer be different if the released productive capacity
will generate additional income of $5,000?
Yes, net income will be increased by $3,600 if Juanita Company
purchases the electrical cords rather than making them.
LO 4 Identify the relevant costs in a make-or-buy decision.
DO IT!>
Advance slide in presentation mode to
reveal answer.
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May have option to sell product at a given point in
production or to process further and sell at a higher
price.
Decision Rule:
Process further as long as the incremental revenue from
such processing exceeds the incremental processing
costs.
LO 5 Identify the relevant costs in determining whether to sell or process materials further.
Sell or Process Further
Incremental Analysis
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Sell or Process Further
Illustration: Woodmasters Inc. makes tables. The cost to
manufacture an unfinished table is $35. The selling price per
unfinished unit is $50. Woodmasters has
unused capacity that can be used to finish
the tables and sell them at $60 per unit. For a finished table, direct
materials will increase $2 and direct labor costs will increase $4.
Variable manufacturing overhead costs will increase by $2.40 (60%
of direct labor). No increase is anticipated in fixed manufacturing
overhead.
Illustration 26-8
LO 5 Identify the relevant costs in determining whether to sell or process materials further.
Incremental Analysis
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Should Woodmasters sell or process further.Should Woodmasters sell or process further?
The incremental analysis on a per unit basis is as follows.Illustration 26-9
Sell or Process Further
LO 5
Incremental Analysis
Advance slide in presentation mode to reveal answer.
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The decision rule is a sell-or-process-further decision:
Process further as long as the incremental revenue from
processing exceeds:
a. Incremental processing costs.
b. Variable processing costs.
c. Fixed processing costs.
d. No correct answer is given.
LO 5 Identify the relevant costs in determining whether to sell or process materials further.
Question
Incremental Analysis
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Illustration: Jeffcoat Company is considering replacing a factory machine with a new machine. Jeffcoat Company has a factory machine that originally cost $110,000. It has a balance in Accumulated Depreciation of $70,000, so its book value is $40,000. It has a remaining useful life of four years. The company is considering replacing this machine with a new machine. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four-year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160,000 to $125,000 and the old unit could be sold for $5,000. The incremental analysis for the four-year period is as follows.
LO 6 Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
Repair, Retain, or Replace Equipment
Incremental Analysis
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Retain or Replace?Retain or Replace?
Prepare the incremental analysis for the four-year period.
Illustration 26-10
Repair, Retain, or Replace Equipment
LO 6 Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
Incremental Analysis
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Additional Considerations
The book value of old machine does not affect the decision.
► Book value is a sunk cost.
► Costs which cannot be changed by future decisions (sunk
cost) are not relevant in incremental analysis.
However, any trade-in allowance or cash disposal value of
the existing asset is relevant.
LO 6 Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
Repair, Retain, or Replace Equipment
Incremental Analysis
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Key: Focus on Relevant Costs.
Consider effect on related product lines.
Fixed costs allocated to the unprofitable segment must be absorbed by the other segments.
Net income may decrease when an unprofitable segment is eliminated.
Decision Rule: Retain the segment unless fixed costs eliminated exceed contribution margin lost.
LO 7 Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
Eliminate an Unprofitable Segment or Product
Incremental Analysis
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Illustration: Venus Company manufactures three models of tennis
rackets:
Profitable lines: Pro and Master
Unprofitable line: Champ
Illustration 26-11
Should Champ be eliminated?
LO 7 Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
Eliminate an Unprofitable Segment or Product
Incremental Analysis
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Prepare income data after eliminating Champ product line. Assume
fixed costs are allocated 2/3 to Pro and 1/3 to Master.
Illustration 26-12
Total income is decreased by $10,000.
LO 7
Incremental Analysis
Eliminate an Unprofitable Segment or Product
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Incremental analysis of Champ provided the same results:
Do Not Eliminate Champ
Illustration 26-13
LO 7 Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
Incremental Analysis
Eliminate an Unprofitable Segment or Product
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If an unprofitable segment is eliminated:
a. Net income will always increase.
b. Variable expenses of the eliminated segment will have to be absorbed by other segments.
c. Fixed expenses allocated to the eliminated segment will have to be absorbed by other segments.
d. Net income will always decrease.
LO 7 Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
Question
Incremental Analysis
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26-38
Lambert, Inc. manufactures several types of accessories. For the
year, the knit hats and scarves line had sales of $400,000, variable
expenses of $310,000, and fixed expenses of $120,000. Therefore,
the knit hats and scarves line had a net loss of $30,000. If Lambert
eliminates the knit hats and scarves line, $20,000 of fixed costs will
remain. Prepare an analysis showing whether the company should
eliminate the knit hats and scarves line.
LO 7
DO IT!>
Advance slide in presentation mode to reveal answer.
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Resources are always limited.
► Floor space for a retail firm.
► Raw materials, direct labor hours, or machine capacity
for a manufacturing firm.
Management must decide which products to make and
sell to maximize net income.
LO 8 Determine which products to make and sell when resources are limited.
Allocate Limited Resources
Incremental Analysis
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Allocate Limited Resources
Illustration: Collins Company manufactures deluxe and standard
pen and pencil sets. The limiting resource is machine capacity,
which is 3,600 hours per month. Relevant data consist of the
following.Illustration 26-14Contribution margin and machine hours
Compute contribution margin per unit of limited resource.
LO 8 Determine which products to make and sell when resources are limited.
Incremental Analysis
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26-42
Allocate Limited Resources
Compute contribution margin per unit of limited resource.
Company should shift the sales mix to standard sets or should
increase machine capacity.
Illustration 26-15
LO 8 Determine which products to make and sell when resources are limited.
Incremental Analysis
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Allocate Limited Resources
Illustration: Assume Collins is able to increase machine capacity
from 3,600 hours to 4,200 hours, the additional 600 hours could be
used to produce either the standard or deluxe pen and pencil sets.
Determine the total contribution margin under each alternative.
Illustration 26-16
LO 8 Determine which products to make and sell when resources are limited.
Incremental Analysis
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26-44
Capital Budgeting is the process of making capital
expenditure decisions in business.
Amount of possible capital expenditures usually exceeds
the funds available for such expenditures.
Involves choosing among various capital projects to find
the one(s) that will maximize a company’s return on
investment.
Capital Budgeting
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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Many companies follow a carefully prescribed process in
capital budgeting. Illustration 26-17Corporate capital budgetauthorization process
Evaluation Process
Capital Budgeting
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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Providing management with relevant data for capital
budgeting decisions requires familiarity with quantitative
techniques.
Most common techniques are:
1. Annual Rate of Return
2. Cash Payback
3. Discounted Cash Flow
Evaluation Process
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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26-48
Indicates the profitability of a capital expenditure by dividing
expected annual net income by the average investment.
Illustration 26-19
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Capital Budgeting
Annual Rate of Return
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Illustration: Reno Company is considering an investment of
$130,000 in new equipment. The new equipment is expected to
last 5 years. It will have zero salvage value at the end of its useful
life. Reno uses the straight-line method of depreciation for
accounting purposes. The expected annual revenues and costs of
the new product that will be produced from the investment are:
Illustration 26-18
Annual Rate of Return
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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26-50
Expected annual
rate of return
Illustration 26-20
Formula for computingaverage investment
= $65,000 130,000 + 0
2
$13,000
$65,000= 20%
A project is acceptable if its rate of return is greater than
management’s required rate of return.
Annual Rate of Return
Computing Average Investment
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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Annual Rate of Return
Principal advantages:
Simplicity of calculation.
Management’s familiarity with the accounting terms used in
the computation.
Major limitation:
Does not consider the
time value of money.
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenue would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. It uses the straight-line method to compute depreciation expense. Management has a required rate of return of 9%. Compute the annual rate of return.
LO 9LO 9
DO IT!>
Advance slide in presentation mode to reveal answer.
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$130,000 ÷ $39,000 = 3.3 years
Cash payback technique identifies the time period required
to recover the cost of the capital investment from the net
annual cash inflow produced by the investment.
Cash Payback
Illustration 26-22Computation of net annualcash flow
Illustration 26-21Cash payback formula
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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The shorter the payback period, the more attractive the
investment.
In the case of uneven net annual cash flows, the company
determines the cash payback period when the cumulative net
cash flows from the investment equal the cost of the
investment.
Cash Payback
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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Illustration: Chen Company proposes an investment in a new
website that is estimated to cost $300,000.
Cash payback should not be the only basis for capital budgeting
decision as it ignores expected profitability of the project.
Cash Payback
Illustration 26-23Net annual cash flowschedule
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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26-57 LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Compute the cash payback period.
DO IT!>
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A $100,000 investment with a zero scrap value has an 8-year
life. Compute the payback period if straight-line depreciation
is used and net income is determined to be $20,000.
a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.
Cash Payback
Question
LO 9 Contrast annual rate of return and cash payback in capital budgeting. LO 9 Contrast annual rate of return and cash payback in capital budgeting.
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Generally recognized as the best conceptual approach.
Considers both the estimated total net cash flows from
the investment and the time value of money.
Two methods:
► Net present value.
► Internal rate of return.
Discounted Cash Flow
Discounted Cash Flow
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Net cash flows are discounted to their present value and
then compared with the capital outlay required by the
investment.
Interest rate used in discounting is the required minimum
rate of return.
Proposal is acceptable when NPV is zero or positive.
The higher the positive NPV, the more attractive the
investment.
Discounted Cash Flow
Net Present Value Method
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Illustration 26-24
Net present value decision
criteriaA proposal is acceptable when net present value is zero or positive.
Discounted Cash Flow
LO 10 LO 10
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Illustration: Reno Company’s net annual cash flows are $39,000.
If we assume this amount is uniform over the asset’s useful life,
we can compute the present value of the net annual cash flows.
Equal Net Annual Cash Flows
Illustration 26-25
Discounted Cash Flow
Calculate the net present value.
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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The proposed capital expenditure is acceptable at a required rate
of return of 12% because the net present value is positive.
Illustration: Calculate the net present value.
Discounted Cash Flow
Equal Net Annual Cash Flows
Illustration 26-26
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Illustration: Reno Company management expects the same
aggregate net annual cash flow ($195,000) over the life of the
investment. But because of a declining market demand for the
new product over the life of the equipment, the net annual cash
flows are higher in the early years and lower in the later years.
Discounted Cash Flow
Unequal Net Annual Cash Flows
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Illustration 26-27
Computing present value of unequal annual cash flows
Discounted Cash Flow
Unequal Net Annual Cash Flows
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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The proposed capital expenditure is acceptable at a required rate
of return of 12% because the net present value is positive.
Illustration: Calculate the net present value.
Discounted Cash Flow
Unequal Net Annual Cash Flows
Illustration 26-28Analysis of proposal using netpresent value method
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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IRR method finds the interest yield of the potential
investment.
IRR is the rate that will cause the PV of the proposed
capital expenditure to equal the PV of the expected
annual cash inflows.
Two steps in method:
► Compute the interval rate of return factor.
► Use the factor and the PV of an annuity of 1 table to find
the IRR.
Discounted Cash Flow
Internal Rate of Return Method
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Step 1. Compute the internal rate of return factor.
Discounted Cash Flow
Internal Rate of Return Method
Illustration 26-29
For Reno Company:
$130,000 ÷ $39,000 = 3.3333
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Step 2. Use the factor and the present value of an annuity
of 1 table to find the internal rate of return.
Discounted Cash Flow
Internal Rate of Return Method
Assume a required rate of return for Reno of 10%.
Decision Rule: Accept the project when the IRR is equal to or
greater than the required rate of return.
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Illustration 26-30
Internal Rate of Return Method
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Illustration 26-31
Discounted Cash Flow
Comparing Discounted Cash Flow Methods
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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A positive net present value means that the:
a. Project’s rate of return is less than the cutoff rate.
b. Project’s rate of return exceeds the required rate of
return.
c. Project’s rate of return equals the required rate of
return.
d. Project is unacceptable.
Discounted Cash Flow
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
Question
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Watertown Paper Corporation is considering adding another machine
for the manufacture of corrugated cardboard. The machine would
cost $900,000. It would have an estimated life of 6 years and no
salvage value. The company estimates that annual revenues would
increase by $400,000 and that annual expenses excluding
depreciation would increase by $190,000. Management has a
required rate of return of 9%.
(a) Calculate the net present value on this project.
(b) Calculate the internal rate of return on this project, and
discuss whether it should be accepted.
DO IT!>
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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Watertown should accept the project.
(a) Calculate the net present value on this project.
DO IT!>
LO 10 Distinguish between the net present value and internal rate of return methods.
LO 10 Distinguish between the net present value and internal rate of return methods.
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(b) Calculate the internal rate of return on this project, and discuss
whether it should be accepted.
DO IT!>
LO 10LO 10
$900,000 ÷ 210,000 = 4.285714.
Since the project has an internal rate that is greater than 10% and the
required rate of return is only 9%, Watertown should accept the project.
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