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CMA Part 2
Financial Decision Making
Objectives
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Use Marginal Analysis for decision making
Calculate effect on operating income of a decision
Identify and describe qualitative factors
Identify the effects of changes in capacity
Impact of income taxes on Marginal Analysis
Recommend a course of action
Relation between pricing and supply/demand
Target costing and target pricing
Define elastic and inelastic demand
Evaluate and recommend pricing strategies
Risk Assessment: financial/operational/strategic risks
Identify and explain the benefits of Risk Management
2
• Relevancy
SU 9.1 – Decision Making:
Applying Marginal Analysis
– Be made in the future (not SUNK costs)
– Differ among the possible alternative courses of action
– Avoidable costs (controllable = subject to Management decision /
strategy)
– Incremental (marginal or differential)  Relevant Range = incremental
cost of an additional unit of output is the same. Outside range
incremental cost change.
• Committed costs are not part of the decision making process
• Be careful using UNIT revenue and cost
 Emphasis to be on TOTAL relevant revenues and costs
3
SU 9.1 – Decision Making:
Applying Marginal Analysis
• Marginal / Differential / Incremental Analysis
– Problem in CMA will be an evaluation of choices among courses
of action
– What are the relevant and irrelevant costs?
– Quantitative analysis = ways in which revenues and costs vary
with the option chosen
– Focus on incremental revenue & costs, not total revenue & cost
 See example page 266  idle capacity (incremental impact)
– Compare marginal revenue and marginal cost (contribution
margin)
– Fixed costs have already been “absorbed”
4
SU 9.1 – Decision Making:
Applying Marginal Analysis
– Qualitative Factors to consider
- Pricing rules
- Government regulation
- Cannibalization between products (stealing market share from
yourself)
- Outsourcing
- Employee morale
5
SU 9.1 – Decision Making:
Applying Marginal Analysis
• Add-or-drop-a-segment decisions
– Disinvestment / capital budgeting decisions
– Marginal cost > Marginal revenue = Firm should disinvest
• Four steps to be taken
1.
2.
3.
4.
Identify fixed costs that will be eliminated if disinvesting
Determine the revenue needed to justify continuing operations
Establish the opportunity cost of funds that will be received
Determine whether the carrying amount of the asset = economic value. If
not revalue use market fair value and not carrying amount. Cost of idle
capacity is relevant cost.
• Special Orders when excess capacity
– No opportunity costs
– Accept order = Variable costs (Contribution Margin)
6
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 1
The cost incurred by Gleason for the market study is a(n)
A
Incremental cost.
B
Prime cost.
C
Opportunity cost.
D
Sunk cost.
7
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 1 Answer
Correct Answer: D
A sunk cost is a previously incurred cost that is the result of a past irrevocable
management decision. Nothing can be done in the future about sunk costs.
The market study cost is an example.
8
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 2
Assuming that Gleason elects to produce the frozen dessert, the profit
that would have been earned on the breakfast rolls is a(n)
A
Deferrable cost.
B
Sunk cost.
C
Avoidable cost.
D
Opportunity cost.
9
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 2 Answer
Correct Answer: D
An opportunity cost is the maximum return that could have been earned on
the next best alternative use of a resource. In this case, the lost profit on the
rolls is an opportunity cost.
10
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 3
If Hermo decides to supply power to Quigley, it wants to be compensated for the
decrease in the life of the plant and the appropriate variable costs. Hermo has
decided that the charge for the decreased life should be based on the original cost of
the plant calculated on a straight-line basis. The minimum annual amount that
Hermo would charge Quigley would be
A
$450,000
B
$630,000
C
$990,000
D
Some amount other than those given.
11
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 3 Answer
Correct Answer: B
The minimum charge would include any variable costs incurred plus
depreciation on a straight-line basis. Currently, variable costs are $360,000 at
60% of capacity ($1,800,000 × 20%). If Quigley purchases energy equal to an
additional 30% of capacity, it can be assumed that the increase in total
variable costs will be half of the variable costs for 60% of capacity, or
$180,000. Also, allocating $21,000,000 over 14 years results in an annual
depreciation of $1,500,000. Of this amount, 30% will relate to the capacity
sold. Thus, the depreciation charge to Quigley is $450,000 ($1,500,000 ×
30%). The total charge is $630,000 ($450,000 depreciation + $180,000 VC).
12
SU 9.2 – Decision Making:
Special Orders
• Special Orders when excess capacity exists
– Differential (marginal or incremental) cost must be considered.
 Example on page 268
• Special Orders when no excess capacity exists
– Differential (marginal or incremental) cost must be considered.
 Example on page 268
13
SU 9.2 – Decision Making: Special Orders
Practice Question 1
Production of a special order will increase gross profit when the
additional revenue from the special order is greater than
A
The direct materials and labor costs in producing the order.
B
The fixed costs incurred in producing the order.
C
The indirect costs of producing the order.
D
The marginal cost of producing the order.
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SU 9.2 – Decision Making: Special Orders
Practice Question 1 Answer
Correct Answer: D
Gross profit will increase if the incremental or marginal cost of producing the
order is less than the marginal revenue. Marginal cost equals the relevant
variable costs assuming fixed costs are not affected by the special order.
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SU 9.2 – Decision Making: Special Orders
Practice Question 2
When considering a special order that will enable a company to make use
of currently idle capacity, which of the following costs is irrelevant?
A
Materials.
B
Depreciation.
C
Direct labor.
D
Variable overhead.
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SU 9.2 – Decision Making: Special Orders
Practice Question 2 Answer
Correct Answer: B
Because depreciation will be expensed whether or not the company accepts
the special order, it is irrelevant to the decision. Only the variable costs are
relevant.
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SU 9.2 – Decision Making: Special Orders
Practice Question 3
Which of the following cost allocation methods is used to determine the
lowest price that can be quoted for a special order that will use idle
capacity within a production area?
A
Job order.
B
Process.
C
Variable.
D
Standard.
18
SU 9.2 – Decision Making: Special Orders
Practice Question 3 Answer
Correct Answer: C
If idle capacity exists, the lowest feasible price for a special order is one
covering the variable cost. Variable costing considers fixed cost to be a period
cost, not a product cost. Fixed costs are not relevant to short-term inventory
costing with idle capacity because the fixed costs will be incurred whether or
not any production occurs. Any additional revenue in excess of the variable
costs will decrease losses or increase profits.
19
SU 9.3 – Decision Making: Make or Buy
• Make or Buy = insourcing or outsourcing (critical mass)
– Not enough capacity outsource least efficient product
– Support services can be outsourced
• Consider relevant costs to the investment decision
– Key variable is total relevant costs, not all total costs.
– Sunk cost and costs that do not change between choices are
irrelevant
– Opportunity costs are considered when at full capacity
20
SU 9.3 – Decision Making: Make or Buy
• Capacity constraint
– Use marginal analysis
– Maximize CM
– Product mix
• Sell or process further decisions
– Sell at split off point or process
– Joint cost of product is irrelevant
– Based on relationship between incremental cost and revenue
21
SU 9.3 – Decision Making: Make or Buy
Practice Question 1
A company’s approach to an insourcing vs. outsourcing decision
A
Depends on whether the company is operating at or below normal
volume.
B
Involves an analysis of avoidable costs.
C
Should use absorption (full) costing.
D
Should use activity-based costing.
22
SU 9.3 – Decision Making: Make or Buy
Practice Question 1 Answer
Correct Answer: B
Available resources should be used as efficiently as possible before
outsourcing. If the total relevant costs of production are less than the cost to
buy the item, it should be produced in-house. The relevant costs are those
that can be avoided.
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SU 9.3 – Decision Making: Make or Buy
Practice Question 2
In a make-versus-buy decision, the relevant costs include variable
manufacturing costs as well as
A
Factory management costs.
B
General office costs.
C
Avoidable fixed costs.
D
Depreciation costs.
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SU 9.3 – Decision Making: Make or Buy
Practice Question 2 Answer
Correct Answer: C
The relevant costs in a make-versus-buy decision are those that differ
between the two decision choices. These costs include any variable costs plus
any avoidable fixed costs. Avoidable fixed costs will not be incurred if the
“buy” decision is selected.
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SU 9.4 – Decision Making:
Other Situations
• Capacity Constraints and Product Mix
– Maximize the contribution margin per unit of the
constrained resource.
– Can be difficult with multiple constraints and requires
linear programing to solve.
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SU 9.4 – Decision Making:
Other Situations
• Sell-or-Process-Further Decisions
– Determine whether to sell product at the split-off
point or process further
– Decision is based on difference between
incremental cost and incremental revenue
27
SU 9.4 – Decision Making: Other Situations
Practice Question 1
When a multiproduct plant operates at full capacity, quite often decisions must
be made as to which products to emphasize. These decisions are frequently
made with a short-run focus. In making such decisions, managers should select
products with the highest
A
Sales price per unit.
B
Individual unit contribution margin.
C
Sales volume potential.
D
Contribution margin per unit of the constraining resource.
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SU 9.4 – Decision Making: Other Situations
Practice Question 1 Answer
Correct Answer: D
In the short run, many costs are fixed. Hence, contribution margin (revenues
– all variable costs) becomes the best measure of profitability. Moreover,
certain resources are also fixed. Accordingly, when deciding which products to
produce at full capacity, the criterion should be the contribution margin per
unit of the most constrained resource. This approach maximizes total
contribution margin.
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SU 9.4 – Decision Making: Other Situations
Practice Question 2
In joint-product costing and analysis, which one of the following costs is relevant
when deciding the point at which a product should be sold to maximize profits?
A
Separable costs after the split-off point.
B
Joint costs to the split-off point.
C
Sales salaries for the period when the units were produced.
D
Purchase costs of the materials required for the joint products.
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SU 9.4 – Decision Making: Other Situations
Practice Question 2 Answer
Correct Answer: A
Joint products are created from processing a common input. Joint costs are
incurred prior to the split-off point and cannot be identified with a particular
joint product. As a result, joint costs are irrelevant to the timing of sale.
However, separable costs incurred after the split-off point are relevant
because, if incremental revenues exceed the separable costs, products should
be processed further, not sold at the split-off point.
31
SU 9.5 – Price Elasticity of Demand
• Demand increases when price goes down in theory
• Price of product and quantity demanded are inversely
related
• Price Elasticity of Demand = Sensitivity
% change in Q
% change in P
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SU 9.5 – Price Elasticity of Demand
• Price elasticity of demand
Percent change in quantity demanded
Percent change in price
• Most accurate way to calculate elasticity = ARC
method
%ΔQ
%ΔP
=
[(Q1 – Q2) / (Q1+Q2) ]
[(P1 – P2) / (P1+P2)]
 See example page 297, #19
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SU 9.5 – Price Elasticity of Demand
• Elasticity > 1 relatively elastic
– Small change in price = large change in quantity
• Elasticity = 1 unitary elastic
– Single-unit change in price = single-unit change in quantity
• Elasticity < 1 perfectly inelastic
– Large change in price = small change in quantity
• Infinite perfectly elastic
– Horizontal line
– Firm has no influence on market price
– Pure competition
• Elasticity = 0 perfectly inelastic
– Vertical line
– Consumer will pay
34
SU 9.5 – Price Elasticity of Demand
Practice Question 1
If the coefficient of elasticity is zero, then the consumer demand
for the product is said to be
A
Perfectly inelastic.
B
Perfectly elastic.
C
Unit inelastic.
D
Unit elastic.
35
SU 9.5 – Price Elasticity of Demand
Practice Question 1 Answer
Correct Answer: A
When the coefficient of elasticity (percentage change in demand/change in
price) is less than one, demand is inelastic. When the coefficient is zero, the
demand is perfectly inelastic.
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SU 9.6 – Pricing Theory
• Pricing Objectives: profit maximization / target margin / forecasted
volume / image (segmentation – positioning) / stabilization
• Price-setting factors
– Supply & Demand = Economic (external factors)
•
•
•
•
Type of market
Customer perceptions
Elasticity
Competition
– Internal Factors
•
•
•
•
Marketing & Mix
Relevant cost
Strategy
Capacity
37
SU 9.6 – Pricing Theory
• External Factors
– Type of market (pure competition, monopolistic,
oligopolistic or monopoly)
– Customer perceptions of price and value
– Price / demand relationship
– Competitors’ products, costs, prices and amount
supplied.
• Timing of demand
38
SU 9.6 – Pricing Theory
• Cartels
– Illegal practice except in international markets
– Collusive oligopoly
– Restrict output & charge higher $$
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SU 9.6 – Pricing Theory
• Cost-based pricing differs from target pricing
– Four basic formulas
– Target pricing
– Life cycle costing
 See example page 358
•
•
•
•
Market-based pricing - what the consumer will pay
Competition-based pricing - going rate & sealed bids
New product pricing - skimming & penetration pricing
Pricing by intermediaries - markups & downs
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SU 9.6 – Pricing Theory
• Price adjustments
–
–
–
–
–
–
–
Geographical pricing
Discounts & Allowances
Discriminatory pricing
Psychological pricing
Promotional pricing
Value Pricing
International pricing
41
SU 9.6 – Pricing Theory
• Product-mix pricing
–
–
–
–
–
Product line
Optional product
Captive product
By-product
Product bundle
42
SU 9.6 – Pricing Theory
• Illegal pricing
–
–
–
–
Pricing products below cost
Price discrimination among customers
Collusive pricing
Dumping
43
SU 9.6 – Pricing Theory Practice Question 1
Several surveys point out that most managers use full product costs,
including unit fixed costs and unit variable costs, in developing cost-based
pricing. Which one of the following is associated with cost-based pricing?
A
Price stability.
B
Price justification.
C
Target pricing.
D
Fixed-cost recovery.
44
SU 9.6 – Pricing Theory Practice Question 1 Answer
Correct Answer: C
A target price is the expected market price of a product, given the company’s
knowledge of its customers and competitors. Hence, under target pricing, the
sales price is known before the product is developed. Subtracting the unit
target profit margin determines the long-term unit target cost. If cost-cutting
measures do not permit the product to be made at or below the target cost,
it will be abandoned.
45
SU 9.6 – Pricing Theory Practice Question 2
If a U.S. manufacturer’s price in the U.S. market is below an appropriate
measure of costs and the seller has a reasonable prospect of recovering the
resulting loss in the future through higher prices or a greater market share,
the seller has engaged in
A
Collusive pricing.
B
Dumping.
C
Predatory pricing.
D
Price discrimination.
46
SU 9.6 – Pricing Theory Practice Question 2 Answer
Correct Answer: C
Predatory pricing is intentionally pricing below cost to eliminate competition
and reduce supply. Federal statutes and many state laws prohibit the practice.
The U.S. Supreme Court has held that pricing is predatory when two
conditions are met: (1) The seller’s price is below “an appropriate measure of
its costs,” and (2) it has a reasonable prospect of recovering the resulting loss
through higher prices or greater market share.
47
SU 9.6 – Pricing Theory Practice Question 3
Which one of the following will occur in an organization that gives managers
throughout the organization maximum freedom to make decisions?
A
Individual managers regarding the managers of other segments as they do
external parties.
B
Two divisions of the organization having competing models that aim for the
same market segments.
C
Delays in securing approval for the introduction of new products.
D
Greater knowledge of the marketplace and improved service to customers.
48
SU 9.6 – Pricing Theory Practice Question 3 Answer
Correct Answer: C
Decentralization is beneficial because it creates greater responsiveness to the
needs of local customers, suppliers, and employees. Managers at lower levels
are more knowledgeable about local markets and the needs of customers,
etc. A decentralized organization is also more likely to respond flexibly and
quickly to changing conditions, for example, by expediting the introduction of
new products. Furthermore, greater authority enhances managerial morale
and development. Disadvantages of decentralization include duplication of
effort and lack of goal congruence.
49
SU 9.6 – Pricing Theory Practice Question 4
A proposed transfer price may be based upon the outlay cost. Outlay cost
plus opportunity cost is the
A
Retail price.
B
Price representing the cash outflows of the supplying division plus the
contribution to the supplying division from an outside sale.
C
Price usually set by an absorption-costing calculation.
D
Price set by charging for variable costs plus a lump sum or an additional
markup, but less than full markup.
50
SU 9.6 – Pricing Theory Practice Question 4 Answer
Correct Answer: B
At this price, the supplying division is indifferent as to whether it sells
internally or externally. Outlay cost plus opportunity cost therefore represents
a minimum acceptable price for a seller. However, no transfer price formula is
appropriate in all circumstances.
51
SU 9.7 – Practice Question 1
Finn Products, a start-up company, wants to use cost-based pricing for its only
product, a unique new video game. Finn expects to sell 10,000 units in the
upcoming year. Variable costs will be $65 per unit and annual fixed operating costs
(including depreciation) amount to $80,000. Finn’s balance sheet is as follows: If
Finn wants to earn a 20% return on equity, at what price should it sell the new
product?
A
$75.00
B
$78.60
C
$79.00
D
$81.00
52
SU 9.7 – Practice Question 1 Answer
Correct Answer: C
The net income Finn will require is calculated as follows:
Return on equity
Net income
=
=
=
=
Net income ÷ Equity
Equity × Return on equity
$300,000 × 20%
$60,000
The necessary selling price can then be derived:
Net income
=
[(Selling price – Variable costs) × Units sold] – Fixed costs
Selling price
=
(Net income + Fixed costs + Variable costs) ÷ Units sold
=
($60,000 + $80,000 + $650,000) ÷ 10,000
=
=
$790,000 ÷ 10,000
$79 per unit
53
SU 9.7 – Practice Question 2
Leader Industries is planning to introduce a new product, DMA. It is expected that
10,000 units of DMA will be sold. The full product cost per unit is $300. Invested
capital for this product amounts to $20 million. Leader’s target rate of return on
investment is 20%. The markup percentage for this product, based on operating
income as a percentage of full product cost, will be
A
42.9%
B
57.1%
C
133.3%
D
233.3%
54
SU 9.7 – Practice Question 2 Answer
Correct Answer: C
Leader’s required return is $4,000,000 ($20,000,000 invested capital × 20%).
Full product costs amount to $3,000,000 (10,000 units × $300). The markup
percentage on DMA is therefore 133.3% ($4,000,000 ÷ $3,000,000).
55
SU 9.8 – Risk Management
• Four types of risk
1.
2.
3.
4.
Hazard risks - insurable
Financial risks - interest rates
Operational risks - procedural failure
Strategic risks - global, political and regulatory
• Volatility and time
56
SU 9.8 – Risk Management
• Capital adequacy =
Solvency (cash flows)
Liquidity (reserves)
• Risk =
Severity of consequences
+ Likelihood of occurrence
57
SU 9.8 – Risk Management
• Five strategies for risk response
1. Risk avoidance - end the activity that establishes
the risk
2. Risk retention - acceptance of risk, self insurance
3. Risk reduction - mitigation
4. Risk sharing - move risk to third party. Insurance,
hedging, JV
5. Risk exploitation - deliberately entering to pursue
high return
58
SU 9.8 – Risk Management
• Residual risk is the risk that remains after the effects
of avoidance, sharing, or mitigation efforts.
• Inherent risk is the risk that arises for the activity itself.
• Risk appetite
• Benefits
- Efficient use of resources
- Fewer surprises
- Reassuring investors
59
SU 9.8 – Risk Management
• 5 Key Steps in Risk Management process
1. Identify risks
2. Assess risks
3. Prioritize risks
4. Formulate risk responses
5. Monitor risk responses
60
SU 9.8 – Risk Management
• Hazard risk management
– Insurance
• Financial risk management
– Hedging
– Sinking funds
– Rigid policies (maturity matching)
61
SU 9.8 – Risk Management
• Qualitative risk assessment tools
– Identification
– Ranking
– Mapping
• Quantitative risk assessment tools
– Value at risk (VaR)
See example page 284
62
SU 9.8 – Risk Management
63
SU 9.8 – Risk Management Practice Question 1
The risk associated with a project will increase in direct proportion to
all of the following the:
A
Duration of the project.
B
Volatility of the cash flows associated with the project.
C
Uncertainty surrounding the impact of Federal regulation on the
project.
D
Capital adequacy of the organization.
64
SU 9.8 – Risk Management Practice
Question 1 Answer
Correct Answer: D
Capital adequacy is a term normally used in connection with financial
institutions. A bank must be able to pay those depositors that demand their
money on a given day and still be able to make new loans. Capital adequacy
can be discussed in terms of solvency (the ability to pay long-term obligations
as they mature), liquidity (the ability to pay for day-to-day ongoing
operations), reserves (the specific amount a bank must have on hand to pay
depositors), or sufficient capital.
65
SU 9.8 – Risk Management Practice Question 2
All of the following are potential benefits of risk management
A
Lower cost of capital.
B
Efficient allocation of resources.
C
Flexibility in responding to unforeseen circumstances.
D
Reduced inherent risk.
66
SU 9.8 – Risk Management Practice
Question 2 Answer
Correct Answer: D
Inherent risk is the risk of an activity that arises from the activity itself. For
example, uranium prospecting is inherently riskier than retailing.
67
SU 9.8 – Risk Management Practice Question 3
Which one of the following calculations does employ statistical
techniques such as the normal distribution?
A
Cash flow at risk.
B
Earnings distribution.
C
Value at risk.
D
Capital adequacy.
68
SU 9.8 – Risk Management Practice
Question 3 Answer
Correct Answer: D
Capital adequacy is a term normally used in connection with financial
institutions. A bank must be able to pay those depositors that demand their
money on a given day and still be able to make new loans. Capital adequacy
can be discussed in terms of solvency (the ability to pay long-term obligations
as they mature), liquidity (the ability to pay for day-to-day ongoing
operations), reserves (the specific amount a bank must have on hand to pay
depositors), or sufficient capital.
69
CMA Part 2
Financial Decision Making
SU 10.1 – The Capital Budgeting Process
• Capital budgeting is the process of planning
and controlling investment for long-term
projects.
– Will affect the company for many accounting
periods going forward
– Relatively inflexible once made
71
SU 10.1 – The Capital Budgeting Process
– Predicting the need for future capital assets is one
of the more challenging tasks
• Affected by
–
–
–
–
Inflation
Interest rates
Cash availability
Market demands
– Production capacity is a key driver
72
SU 10.1 – The Capital Budgeting Process
• Applications for capital budgeting
– Buying equipment
– Building facilities
– Acquiring a business
– Developing a product of product line
– Expanding into new markets
73
SU 10.1 – The Capital Budgeting Process
• Important to correctly forecast future changes in
demand in order to have the correct capacity.
• Planning is crucial to anticipate changes in
capital markets, inflation, interest rates and
money supply.
• Consider the tax consequences.
– All decisions should be done on an after tax basis
74
SU 10.1 – The Capital Budgeting Process
• Costs considered in capital budgeting
– Avoidable cost
• May be eliminated by ceasing or improving an activity.
– Common cost
• Shared by all options and is not clearly allocable.
– Deferrable cost
• May be shifted to the future.
– Fixed cost
• Does not very within relevant range.
– Imputed cost
• May not have a specific cash outlay in accounting
continued
– Incremental cost
• Difference in cost of two options.
75
SU 10.1 – The Capital Budgeting Process
– Opportunity cost
• Maximum benefit forgone based on next alternative, including that of the
stockholders (which also establishes the firms hurdle rate).
– Relevant cost
• Vary with action.
• Constant cost don’t affect decision.
– Sunk cost
• Cannot be avoided.
– Weighted-average Cost of Capital
• Weighted average of the interest cost of debt (net of tax) and the costs
(implicit or explicit) of the components of equity capital to be invested in longterm assets. It is also the “hurdle rate”.
76
SU 10.1 – The Capital Budgeting Process
• Stages in Capital Budgeting
1. Identification and definition
• Identify the strategy
• Define the projects
– Revenue, costs, and cash flow
– Most difficult stage
2. Search
• Each investment to be evaluated be each function
of the firms value chain.
77
SU 10.1 – The Capital Budgeting Process
3. Information-acquisition
• Costs and benefits of the projects are enumerated
• Quantitative financial factors have highest priority
• Nonfinancial measures (quantitative and qualitative)
4. Selection
• Increase shareholder value. NPV, IRR..
5. Financing
• Debt or equity
6. Implementation and monitoring
• Feedback and reporting
78
SU 10.1 – The Capital Budgeting Process
• Investment Ranking Steps
– Determine Net Investment Costs
• Gross cash requirement less cash recovered from trade or sale of existing
assets, adjusted for taxes
• Investment required includes funds to provide for increases in working capital,
i.e. additional receivables and inventories.
– Calculating estimated cash flows
•
•
•
•
Capture increase in revenue, decrease costs
Net cash-flow period by period from investment
Economic life of the investment
Depreciable life
– Comparing cash-flows to Net Investment Costs
• Evaluate the benefit
– Ranking investments
• NPV, IRR, Payback
79
SU 10.1 – The Capital Budgeting Process
• Book Rate of Return =
GAAP NI from Investment
Book Value of Investment
– Also called accrual accounting rate of return
– Don’t use accrual accounting numbers, instead use cash flow
• Net Income is affected by company’s choices of accounting methods
– Also, do not compare project book rate to company’s book rate
of return for investments which could be distorted
80
SU 10.1 – The Capital Budgeting Process
• Relevant Cash Flows
– Net initial investment
• New equipment cost
• Working capital requirements,
• After tax disposals proceeds
– Annual net cash flows
• After tax cash collections for operations
• Depreciation tax savings
– Project termination cash flows
• After tax disposal
• Working capital recovery
 See example on page 309
81
SU 10.1 – The Capital Budgeting Process
• Other Considerations
– Inflation
• Raises hurdle rate
– Post-audits – Deterrent of bad projects.
•
•
•
•
Actual to expected cash flow
Identify sources of unrealistic estimates
Avoid premature evaluations of projects
Non-quantitative benefits
82
SU 10.1 – The Capital Budgeting Process
Practice Question 1
The relevance of a particular cost to a decision is determined by
A
Riskiness of the decision.
B
Number of decision variables.
C
Amount of the cost.
D
Potential effect on the decision.
83
SU 10.1 – The Capital Budgeting Process
Practice Question 1 Answer
Correct Answer: D
Relevance is the capacity of information to make a difference in a decision by
helping users of that information to predict the outcomes of events or to
confirm or correct prior expectations. Thus, relevant costs are those expected
future costs that vary with the action taken. All other costs are constant and
therefore have no effect on the decision.
84
SU 10.1 – The Capital Budgeting Process
Practice Question 2
Lawson, Inc., is expanding its manufacturing plant, which requires an investment of
$4 million in new equipment and plant modifications. Lawson’s sales are expected to
increase by $3 million per year as a result of the expansion. Cash investment in
current assets averages 30% of sales; accounts payable and other current liabilities
are 10% of sales. What is the estimated total investment for this expansion?
A
$3.4 million.
B
$4.3 million.
C
$4.6 million.
D
$5.2 million.
85
SU 10.1 – The Capital Budgeting Process
Practice Question 2 Answer
Correct Answer: C
The investment required includes increases in working capital (e.g., additional
receivables and inventories resulting from the acquisition of a new
manufacturing plant). The additional working capital is an initial cost of the
investment, but one that will be recovered (i.e., it has a salvage value equal to
its initial cost). Lawson can use current liabilities to fund assets to the extent
of 10% of sales. Thus, the total initial cash outlay will be $4.6 million {$4
million + [(30% – 10%) × $3 million sales]}.
86
SU 10.1 – The Capital Budgeting Process
Practice Question 3
What is the net cash outflow at the beginning of the first year that
Dickins should use in a capital budgeting analysis?
A
$(170,000)
B
$(180,000)
C
$(192,000)
D
$(210,000)
87
SU 10.1 – The Capital Budgeting Process
Practice Question 3 Answer
Correct Answer: D
Delivery and installation costs are essential to preparing the machine for its
intended use. Thus, the company must initially pay $210,000 for the machine,
consisting of the invoice price of $180,000, the delivery costs of $12,000, and
the $18,000 of installation costs.
88
SU 10.2 – Discounted Cash Flow Analysis
• Time Value of Money
–
–
–
–
Concept: A dollar received in the future is worth less than today.
Present Value (PV) – Value today of future payment
Future Value (FV) – Future value of an investment today.
Annuities – equal payments at equal intervals
• Ordinary annuity (in arrears)
• Annuity due (in advance) – PV & FV is always greater than ordinary
annuity
 See examples on page 310 through 312
89
SU 10.2 – Discounted Cash Flow Analysis
– Hurdle rate
• Goal is for companies discount rate to be as low as
possible.
• WACC or Shareholder’s opportunity cost of capital.
• The lower the firm’s discount rate, the lower the
“hurdle” the company must clear to achieve
profitability
90
SU 10.2 – Discounted Cash Flow Analysis
• Net Present Value (NPV)
– Project return in $$
– Positive NPV indicates a higher rate of return than
the company’s desired rate
 See example on 313
91
SU 10.2 – Discounted Cash Flow Analysis
• Internal Rate of Return (IRR)
– Project return in %
– IRR shortcomings •
•
•
•
Directional changes of cash flows
Mutually exclusive projects
Varying rates of return
Multiple investments
92
SU 10.2 – Discounted Cash Flow Analysis
• Cash flows and discounting
NPV = Cash flow0 + Cash flow1 + Cash flow2
(1 + r)0
(1 + r)1
(1 + r)2
Comparing Cash Flow Patterns – Page 315
93
SU 10.2 – Discounted Cash Flow Analysis
• NPV vs IRR comparison
– Reinvestment rate NPV assumes the cash flow can be reinvested at projects
discount rate.
– Independent projects:
• NPV and IRR give same accept/reject decision if projects are independent.
• All acceptable independent projects can be undertaken.
– Mutually exclusive projects.
•
•
•
•
•
•
•
•
Cost of one greater than other
Timing, amounts, and direction of cash flow are different
Different useful lives
IRR provides 1 rate, NPV can be used with multiple rates.
Multiple investments. NPV is adaptable, IRR is not.
IRR assumes cash flow is reinvested at IRR rate.
NPV assumes reinvestment in the desired rate of return.
– NPV and IRR are most sound decision making tools for wealth maximization.
 NPV profile – Page 317
Select greatest NPV over greatest IRR
94
SU 10.2 – Discounted Cash Flow Analysis
Question 1
The net present value (NPV) method of investment project analysis assumes
that the project’s cash flows are reinvested at the
A
Computed internal rate of return.
B
Risk-free interest rate.
C
Discount rate used in the NPV calculation.
D
Firm’s accounting rate of return.
95
SU 10.2 – Discounted Cash Flow Analysis
Question 1 Answer
Correct Answer: C
The NPV method is used when the discount rate is specified. It assumes that
cash flows from the investment can be reinvested at the particular project’s
discount rate.
96
SU 10.2 – Discounted Cash Flow Analysis
Question 2
The net present value of a proposed investment is negative; therefore, the
discount rate used must be
A
Greater than the project’s internal rate of return.
B
Less than the project’s internal rate of return.
C
Greater than the firm’s cost of equity.
D
Less than the risk-free rate.
97
SU 10.2 – Discounted Cash Flow Analysis
Question 2 Answer
Correct Answer: A
The higher the discount rate, the lower the NPV. The IRR is the discount rate
at which the NPV is zero. Consequently, if the NPV is negative, the discount
rate used must exceed the IRR.
98
SU 10.2 – Discounted Cash Flow Analysis
Question 3
Dr. G invested $10,000 in a lifetime annuity for his granddaughter Emily. The
annuity is expected to yield $400 annually forever. What is the anticipated
internal rate of return for the annuity?
A
Cannot be determined without additional information.
B
4.0%
C
2.5%
D
8.0%
99
SU 10.2 – Discounted Cash Flow Analysis
Question 3 Answer
Correct Answer: B
The correct answer is 4.0%.
$10,000 = $400 ÷ IRR; IRR = 0.040 = 4.0%.
100
SU 10.3 – Payback and Discounted Payback
• Payback period is the number of years it take
for an asset to pay for itself
– Pro
• Simple
– Cons
• No consideration for time value of money
• Does not consider cash flow after payback period
101
SU 10.3 – Payback and Discounted Payback
• Constant cash flows
Payback =
Initial net investment
Annual expected cash flow
• Variable cash flows
– Cumulative calculation
See example on page 318
102
SU 10.3 – Payback and Discounted Payback
• Discounted payback method
– Used to overcome the payback methods disregard for
time value of money
– Pro
• More conservative yet still simple
– Con
• Does not consider cash flow after payback period.
 See example on page 318
103
SU 10.3 – Payback and Discounted Payback
• Other payback methods
– Bailout payback
• Considers salvage value
– Payback reciprocal
• 1 / payback
• Estimate of IRR
continued
104
SU 10.3 – Payback and Discounted Payback
– Breakeven time
• Time require for discounted cash flows to equal 0
• Alternative is to consider the time required for the
present value of the cumulative cash inflows to equal
the present value of all the expected future cash flows
105
SU 10.3 – Payback and Discounted Payback
Question 1
Which one of the following methods for evaluating capital projects is the
useful from an investment analysis point of view?
A
Accounting rate of return.
B
Internal rate of return.
C
Net present value.
D
Payback.
106
SU 10.3 – Payback and Discounted Payback
Question 1 Answer
Correct Answer: A
The accounting, or book, rate of return is an unsatisfactory means of
evaluating capital projects for two major reasons. Because the accounting
rate of return uses accrual-basis numbers, the calculation is subject to such
accounting judgments as how quickly to depreciate capitalized assets. Also,
the accounting rate of return is an average of all of a firm’s capital projects; it
reveals nothing about the performance of individual investment choices.
107
SU 10.3 – Payback and Discounted Payback
Question 2
The payback reciprocal can be used to approximate a project’s
A
Profitability index.
B
Net present value.
C
Accounting rate of return if the cash flow pattern is relatively stable.
D
Internal rate of return if the cash flow pattern is relatively stable.
108
SU 10.3 – Payback and Discounted Payback
Question 2 Answer
Correct Answer: D
The payback reciprocal (1 ÷ payback) has been shown to approximate the
internal rate of return (IRR) when the periodic cash flows are equal and the
life of the project is at least twice the payback period.
109
SU 10.4 – Ranking Investment Projects
• Why should we rank investment projects?
– Capital rationing
• Reasons
– Lack of financial resources
– Control estimation bias
– Unwillingness to issue new equity (to raise new capital)
110
SU 10.4 – Ranking Investment Projects
• Methods
– Profitability index =
NPV
Net Investment
 See example on page 320
– Internal capital markets – Internal funding
– Linear programming – Technique for optimizing
resource allocation.
111
SU 10.4 – Ranking Investment Projects
Question 1
The profitability index approach to investment analysis
A
Fails to consider the timing of project cash flows.
B
Considers only the project’s contribution to net income and does not
consider cash flow effects.
C
Always yields the same accept/reject decisions for independent projects
as the net present value method.
D
Always yields the same accept/reject decisions for mutually exclusive
projects as the net present value method.
112
SU 10.4 – Ranking Investment Projects
Question 1 Answer
Correct Answer: C
The profitability index (excess present value index) of an investment is the
ratio of the present value of the future net cash flows (or only cash inflows) to
the net initial investment. It is a variation of the net present value (NPV)
method and facilitates the comparison of different-sized investments.
Because it is based on the NPV method, the profitability index will yield the
same decision as the NPV for independent projects. However, decisions may
differ for mutually exclusive projects of different sizes.
113
SU 10.4 – Ranking Investment Projects
Question 2
The method that divides a project’s annual after-tax net income by the
average investment cost to measure the estimated performance of a capital
investment is the
A
Internal rate of return method.
B
Accounting rate of return method.
C
Payback method.
D
Net present value (NPV) method.
114
SU 10.4 – Ranking Investment Projects
Question 2 Answer
Correct Answer: B
The accounting rate of return uses undiscounted net income (not cash flows)
to determine a rate of profitability. Annual after-tax net income is divided by
the average carrying amount (or the initial value) of the investment in assets.
115
SU 10.4 – Ranking Investment Projects
Question 3
The technique that measures the estimated performance of a capital
investment by dividing the project’s annual after-tax net income by the
average investment cost is called the
A
Bail-out payback method.
B
Internal rate of return method.
C
Profitability index method.
D
Accounting rate of return method.
116
SU 10.4 – Ranking Investment Projects
Question 3 Answer
Correct Answer: D
The accounting rate of return (also called the unadjusted rate of return or
book value rate of return) measures investment performance by dividing the
accounting net income by the average investment in the project. This method
ignores the time value of money.
117
SU 10.5 – Comprehensive Examples
Page 320
118
SU 10.6 – Risk Analysis and Real Options
In Capital Investments
• Risk analysis – Attempt to measure the variability of future returns from
proposed investment.
– Informal method – NPV is calculated and reviewed.
– Risk-adjusted discount rates – Adjust rate of return upwards as project
becomes more risky.
– Certainty equivalent adjustments- from Utility theory – the point where you
are indifferent to a choice between a certain sum of money and the expected
value of a risky sum.
– Simulation analysis – Computer is used to generate many results based upon
various assumptions.
• Pilot plants
– Sensitivity analysis – An iterative process of recalculated returns based on
changing assumptions.
119
SU 10.6 – Risk Analysis and Real Options
In Capital Investments
• Real (managerial or strategic) options
– Value of a real option – The difference between the projects NPV with
the option vs. without the option.
• Usually more valuable the later it is exercised.
– Types of real options:
•
•
•
•
•
•
•
Abandonment (Put option)
Follow-up investment
Wait and Learn (call option)
Flexibility option – vary an input
Capacity option – vary an output
New geographical markets
New product option – follow on products
120
SU 10.6 – Risk Analysis and Real Options
In Capital Investments Question 1
Sensitivity analysis, if used with capital projects,
A
Is used extensively when cash flows are known with certainty.
B
Measures the change in the discounted cash flows when using the
discounted payback method rather than the net present value
method.
C
Is a “what-if” technique that asks how a given outcome will change if
the original estimates of the capital budgeting model are changed.
D
Is a technique used to rank capital expenditure requests.
121
SU 10.6 – Risk Analysis and Real Options
In Capital Investments Question 1 Answer
Correct Answer: C
After a problem has been formulated into any mathematical model, it may be
subjected to sensitivity analysis, which is a trial-and-error method used to
determine the sensitivity of the estimates used. For example, forecasts of
many calculated NPVs under various assumptions may be compared to
determine how sensitive the NPV is to changing conditions. Changing the
assumptions about a certain variable or group of variables may drastically
alter the NPV, suggesting that the risk of the investment may be excessive.
122
SU 10.6 – Risk Analysis and Real Options
In Capital Investments Question 2
When the risks of the individual components of a project’s cash flows are
different, an acceptable procedure to evaluate these cash flows is to
A
Divide each cash flow by the payback period.
B
Compute the net present value of each cash flow using the firm’s cost of
capital.
C
Compare the internal rate of return from each cash flow to its risk.
D
Discount each cash flow using a discount rate that reflects the degree of
risk.
123
SU 10.6 – Risk Analysis and Real Options
In Capital Investments Question 2 Answer
Correct Answer: D
Risk-adjusted discount rates can be used to evaluate capital investment
options. If risks differ among various elements of the cash flows, then
different discount rates can be used for different flows.
124
SU 10.6 – Risk Analysis and Real Options
In Capital Investments Question 3
Sensitivity analysis is used in capital budgeting to
A
Estimate a project’s internal rate of return.
B
Determine the amount that a variable can change without generating
unacceptable results.
C
Simulate probabilistic customer reactions to a new product.
D
Identify the required market share to make a new product viable and
produce acceptable results.
125
SU 10.6 – Risk Analysis and Real Options
In Capital Investments Question 3 Answer
Correct Answer: B
After a problem has been formulated into any mathematical model, it may be
subjected to sensitivity analysis, which is a trial-and-error method used to
determine the sensitivity of the estimates used. For example, forecasts of
many calculated NPVs under various assumptions may be compared to
determine how sensitive the NPV is to changing conditions. Changing the
assumptions about a certain variable or group of variables may drastically
alter the NPV, suggesting that the risk of the investment may be excessive.
126