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CHAPTER 16 COST ANALYSIS FOR DECISION MAKING McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objectives 1. What are the meaning and application of the following “cost” terms: differential, allocated, sunk, and opportunity? 2. How are costs determined to be relevant for short-run decisions? 3. What is the special pricing decision when a firm is at full vs. idle capacity? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objectives 4. What are the attributes of capital budgeting that make it a significantly different activity from operational budgeting? 5. Why is present value analysis appropriate in capital budgeting? 6. What is the concept of the cost of capital, and why is it used in capital budgeting? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objectives 7. What are the uses of and differences between various capital budgeting techniques: net present value, present value ratio, and internal rate of return? 8. How are issues concerning estimates, income taxes, and the timing of cash flows and investments treated in the capital budgeting process? 9. How is the payback period of a capital expenditure project calculated? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objectives 10. How is the accounting rate of return of a project calculated, and how can it be used most appropriately? 11. Why are not all management decisions make strictly on the basis of quantitative analysis techniques? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 1 • What are the meaning and application of the following “cost” terms: differential, allocated, sunk, and opportunity? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Strategic, Operational, and Financial Planning Implement Plans Planning and Control Cycle Performance Analysis: Plans vs. Actual Results (Controlling) McGraw-Hill/Irwin Data Collection and Performance Feedback Executing Operational Activities (Managing) ©The McGraw-Hill Companies, Inc., 2002 Cost Classifications for Other Analytical Purposes • A differential cost is one that will differ according to the alternative activity selected • Allocated costs are those that have been assigned to a product or activity using some sort of arithmetic process – Do not arbitrarily allocate costs because costs may not behave the way assumed in the allocation method McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 2 • How are costs determined to be relevant for short-run decisions? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Relevant Costs • Short-run decisions may affect only a few days or weeks • Can involve: – The utilization of resources not otherwise active – The opportunity to reduce costs by adjusting the mix of resources – The ability to improve profits by further processing a product McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Decision Analysis Classifications • Relevant costs are: – Differential costs – Opportunity costs • Irrelevant costs are: – Allocated costs – Sunk costs McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 3 • What is the special pricing decision when a firm is at full vs. idle capacity? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Special Pricing Decision • Firm is presented with a special offer for their product below the normal selling price • Need to know where the firm is operating relative to capacity • Need to consider only relevant costs – not allocated fixed costs • Also must consider other factor such as affect on other customers McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 4 • What are the attributes of capital budgeting that make it a significantly different activity from operational budgeting? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Capital Budgeting • Capital budgeting is the process of analyzing proposed capital expenditures • Capital expenditures are investments in plant, equipment, new products, etc. • Want to determine if a large enough return on the investment can be generated over time McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Capital Budgeting vs. Operational Budgeting • The time frame being considered is different – longer – in capital budgeting • Capital budgeting provides an overall blueprint to help the firm meet its long-term growth objectives • Operational budget reflects firm’s strategic plans to achieve current period profitability McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 5 • Why is present value analysis appropriate in capital budgeting? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Investment Decision Special Considerations • Investment decisions involve committing financial resources now in anticipation of a return in the future • The time value of money must be considered due to the length of time involved • Most firms have more investment opportunities than resources available • Capital budgeting procedures help management identify favorable alternatives McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Qualitative Factors • Factors other than quantitative factors also must be considered • Must consider things such as competitive risk, managements’ personal goals, effects of selling additional stock if necessary • Usually large expenditures require the approval of the board of directors McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 6 • What is the concept of the cost of capital, and why is it used in capital budgeting? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Cost of Capital • The cost of capital is the rate of return on assets that must be earned to permit the firm to meet its interest obligations and provide the expected return to owners • Determining a firm’s cost of capital is a complex process • Cost of capital is a composite of borrowing costs and stockholder dividends and earnings’ growth potential McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Discount Rate • The cost of capital is the discount rate used to determine the present value of the investment proposal being analyzed • The discount rate is the interest rate at which future period cash flows are discounted • Ranges from 10 – 20% McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Capital Budgeting Techniques • Methods that use present value analysis: • Net present value (NPV) method • Internal rate of return (IRR) method • Methods that do not use present value analysis: • Payback method • Accounting rate of return method McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Variables Used in Capital Budgeting Methods • All methods use the amount to be invested • The amount of cash generated by the investment is used in the NPV, IRR, and payback methods • The accounting rate of return uses accrual accounting net income resulting from the investment McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 7 • What are the uses of and differences between various capital budgeting techniques: net present value, present value ratio, and internal rate of return? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Net Present Value • Net present value method involves calculating the present value of the expected cash flows from the project using the cost of capital as the discount rate • Then the net present value result is compared to the amount of investment required • NPV often referred to as the hurdle rate McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Internal Rate of Return • The IRR method solves for the actual rate of return that will be earned by the investment • The IRR is the discount rate at which the present value of the cash flows from the project will equal the investment in the project McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 8 • How are issues concerning estimates, income taxes, and the timing of cash flows and investments treated in the capital budgeting process? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Some Analytical Considerations • Estimates – the validity of the present value calculations will depend on the accuracy of the cash flow projections • Cash flows far in the future – due to uncertainty, usually do not consider cash flows more than ten years in the future • Timing of cash flows within the year – present value factors assume cash flows are received at the end of the year, but usually received throughout the year McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Some More Analytical Considerations • Investment made over a period of time – payments on the project may be made over a period of time, so interest on cash disbursements needs to be considered • Income tax effects of cash flows from the project – must include income tax expenditures in cash flow projections McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Still More Analytical Considerations • Working capital investment – working capital needs will increase due to increases in accounts receivables and inventories and is treated like an additional investment • Least cost projects – some expenditures are required by law, so need to choose the project with the lowest net cost McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 9 • How is the payback period of a capital expenditure project calculated? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Payback Method • The payback method is used to evaluate proposed capital expenditures by determining the length of time necessary to recover the amount of the investment • Add up the cash inflows until the total equals the investment • Then determine how many years it has taken to recover the investment • Very simple method, but does not consider the time value of money McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 10 • How is the accounting rate of return of a project calculated, and how can it be used most appropriately? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Accounting Rate of Return • Accounting rate of return focuses on the impact of the investment project on the financial statements • Done on a year-by-year basis • Drawback is time value of money is not considered • Often computed so stockholders will know the effect of the project on the financial statements McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Learning Objective 11 • Why are not all management decisions make strictly on the basis of quantitative analysis techniques? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 The Investment Decision • Both quantitative and qualitative factors are considered • Qualitative factors may include: – Commitment to a segment – Regulations that require an investment – Technological developments – Limited resources – Management’s judgments about the accuracy of the estimates used McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Integration of Capital Budget with Operating Budgets • Several aspects of the capital budget interact with the development of the operating budget: – Contribution margin increases and cost savings need to be included in the income statement budgets – Cash disbursements need to be included in the cash budget – Capital expenditures need to be included in the balance sheet budget McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002