## Chapter 26: Incremental Analysis and Capital Budgeting

Chapter 26: Incremental Analysis and Capital Budgeting DO IT! 1 Incremental Analysis Owen T Corporation is comparing two different options. The com...
Author: Randall Wilcox
Chapter 26: Incremental Analysis and Capital Budgeting DO IT!

1

Incremental Analysis

Owen T Corporation is comparing two different options. The company currently follows Option 1, with revenues of \$80,000 per year, maintenance expenses of \$5,000 per year, and operating expenses of \$38,000 per year. Option 2 provides revenues of \$80,000 per year, maintenance expenses of \$12,000 per year, and operating expenses of \$32,000 per year. Option 1 employs a piece of equipment that was upgraded 2 years ago at a cost of \$22,000. If Option 2 is chosen, it will free up resources that will increase revenues by \$3,000. Complete the following table to show the change in income from choosing Option 2 versus Option 1. Designate any sunk costs with an “S.”

Option 1

Option 2

Net Income Increase (Decrease)

Sunk (S)

Revenues Maintenance expenses Operating expenses Equipment upgrade Opportunity cost

Solution

Revenues Maintenance expenses Operating expenses Equipment upgrade Opportunity cost

Option 1

Option 2

Net Income Increase (Decrease)

\$80,000 5,000 38,000 22,000 3,000

\$80,000 12,000 32,000 0 0

\$ 0 (7,000) 6,000 0 3,000

Action Plan

✔ Past costs that cannot Sunk (S)

S

be changed are sunk costs. ✔ Benefits lost by choosing one option over another are opportunity costs.

\$ 2,000 Related exercise material: BE26-1, BE26-2, E26-1, and

DO IT!

26-1.

D-1

D-2

DO IT!

DO IT! 2a

Special Orders 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. The special order results in additional shipping costs of \$1 per unit. Compute the increase or decrease in net income Cobb realizes by accepting the special order, assuming Cobb has excess operating capacity. Should Cobb Company accept the special order?

Solution Action Plan Reject

Accept

Net Income Increase (Decrease)

Revenues Costs

\$–0– –0–

\$125,000* 95,000**

\$125,000 (95,000)

Net income

\$–0–

\$ 30,000

\$ 30,000

✔ Identify all revenues

that change as a result of accepting the order. ✔ Identify all costs that change as a result of accepting the order, and net this amount against the change in revenues.

*5,000 3 \$25 **(5,000 3 \$18) 1 (5,000 3 \$1)

The analysis indicates net income increases by \$30,000; therefore, Cobb Company should accept the special order. Related exercise material: BE26-3, E26-2, E26-3, and

DO IT!

26-2a.

DO IT!

DO IT! 2b

D-3

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 Direct labor \$20,000

Instead of making the electrical cords at an average cost per unit of \$1.00 (\$166,000 4 166,000), 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 are 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?

Solution Action Plan

Net Income Increase (Decrease)

–0– –0– –0– 18,000* 149,400**

\$ 90,000 20,000 32,000 6,000 (149,400)

Make Direct materials Direct labor Variable manufacturing costs Fixed manufacturing costs Purchase price Total cost

\$ 90,000 20,000 32,000 24,000 –0–

\$

\$166,000

\$167,400

\$

(1,400)

*\$24,000 3 0.75 **\$166,000 3 \$0.90

This analysis indicates that Juanita Company will incur \$1,400 of additional costs if it buys the electrical cords rather than making them. (b)

Total cost Opportunity cost Total cost

Make

Net Income Increase (Decrease)

\$166,000 5,000

\$167,400 –0–

\$(1,400) 5,000

\$171,000

\$167,400

\$ 3,600

Yes, the answer is different. The analysis shows that net income increases by \$3,600 if Juanita Company purchases the electrical cords rather than making them. Related exercise material: BE26-4, E26-4, and

DO IT!

26-2b.

✔ Look for the costs that change.

✔ Ignore the costs that do not change.

✔ Use the format in

the chapter for your answer. ✔ Recognize that opportunity cost can make a difference.

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DO IT!

DO IT! 2c

Sell or Process Further Easy Does It manufactures unpainted furniture for the do-it-yourself (DIY) market. It currently sells a child’s rocking chair for \$25. Production costs are \$12 variable and \$8 fixed. Easy Does It is considering painting the rocking chair and selling it for \$35. Variable costs to paint each chair are expected to be \$9, and fixed costs are expected to be \$2. Prepare an analysis showing whether Easy Does It should sell unpainted or painted chairs.

Solution Action Plan Sell

Process Further

Net Income Increase (Decrease)

Revenues Variable costs Fixed costs

\$25 12 8

\$35 21a 10b

\$10 (9) (2)

Net income

\$ 5

\$ 4

\$ (1)

✔ Identify the revenues

that change as a result of painting the rocking chair. ✔ Identify all costs that change as a result of painting the rocking chair, and net the amount against the revenues.

a

\$12 1 \$9

b

\$8 1 \$2

The analysis indicates that the rocking chair should be sold unpainted because net income per chair will be \$1 greater. Related exercise material: BE26-5, E26-5, and

DO IT! 2d

DO IT!

26-2c.

Repair or Replace Equipment Rochester Roofing is faced with a decision. The company relies very heavily on the use of its 60-foot extension lift for work on large homes and commercial properties. Last year, the company spent \$60,000 refurbishing the lift. It has just determined that another \$40,000 of repair work is required. Alternatively, Rochester Roofing has found a newer used lift that is for sale for \$170,000. The company estimates that both the old and new lifts would have useful lives of 6 years. However, the new lift is more efficient and thus would reduce operating expenses by about \$20,000 per year. The company could also rent out the new lift for about \$2,000 per year. The old lift is not suitable for rental. The old lift could currently be sold for \$25,000 if the new lift is purchased. Prepare an incremental analysis that shows whether the company should repair or replace the equipment.

Solution Action Plan

Retain Equipment

✔ Those costs and

revenues that differ across the alternatives are relevant to the decision. ✔ Past costs that cannot be changed are sunk costs.

Operating expenses Repair costs Rental revenue New machine cost Sale of old machine

\$120,000* 40,000

Total cost

\$160,000

Replace Equipment

Net Income Increase (Decrease)

\$ (12,000)** 170,000 (25,000)

\$120,000 40,000 12,000 (170,000) 25,000

\$133,000

\$ 27,000

*(6 years 3 \$20,000) **(6 years 3 \$2,000)

The analysis indicates that purchasing the new machine would increase net income for the 6-year period by \$27,000. Related exercise material: BE26-6, E26-6, and

DO IT!

26-2d.

DO IT!

DO IT! 2e

D-5

Unprofitable Segments

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.

Solution Net Income Increase (Decrease)

Continue

Eliminate

Sales Variable costs Contribution margin Fixed costs

\$400,000 310,000 90,000 120,000

\$

0 0 0 20,000

\$(400,000) 310,000 (90,000) 100,000

Net income

\$ (30,000)

\$(20,000)

\$ 10,000

The analysis indicates that Lambert should eliminate the knit hats and scarves line because net income will increase \$10,000. Related exercise material: BE26-7, E26-7, E26-8, and

DO IT! 3a

DO IT!

Action Plan

✔ Identify the revenues

that change as a result of eliminating a product line. ✔ Identify all costs that change as a result of eliminating a product line, and net the amount against the revenues.

26-2e.

Annual Rate of Return

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.

Solution Action Plan Revenues Less: Expenses (excluding depreciation) Depreciation (\$900,000/6 years)

\$400,000 \$190,000 150,000

Annual net income

340,000 \$ 60,000

Average investment 5 (\$900,000 1 0)/2 5 \$450,000. Annual rate of return 5 \$60,000/\$450,000 5 13.3%. Since the annual rate of return (13.33%) is greater than Watertown’s required rate of return (9%), the proposed project is acceptable. Related exercise material: BE26-9, E26-10, and

DO IT!

26-3a.

✔ Expected annual net

income 5 Annual revenues 2 Annual expenses (including depreciation expense). ✔ Annual rate of return 5 Expected annual net income/Average investment. ✔ Average investment 5 (Original investment 1 Value at end of useful life)/2.

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DO IT!

DO IT! 3b

Cash Payback Period 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.

Solution Action Plan

✔ Annual cash inflows 2

Annual cash outflows 5 Net annual cash flow. ✔ Cash payback period 5 Cost of capital investment/Net annual cash flow.

DO IT!

4

Estimated annual cash inflows Estimated annual cash outflows

\$400,000 190,000

Net annual cash flow

\$210,000

Cash payback period 5 \$900,000/\$210,000 5 4.3 years. Related exercise material: BE26-8, E26-9, E26-10, and

DO IT!

26-3b.

Discounted Cash Flow 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. Management has a required rate of return of 9%.

Action Plan

✔ Compute net annual

✔ ✔

cash flow: Estimated annual cash inflows 2 Estimated annual cash outflows. Use the NPV technique to calculate the difference between net cash flows and the initial investment. Accept the project if the net present value is positive. Compute the IRR factor: Capital investment 4 Net annual cash flows. Look up the factor in the present value of an annuity table to find the internal rate of return. Accept the project if the internal rate of return is equal to or greater than the required rate of return.

(a) Calculate the net present value on this project, and discuss whether it should be accepted. (b) Calculate the internal rate of return on this project, and discuss whether it should be accepted.

Solution (a) Estimated annual cash inflows Estimated annual cash outflows Net annual cash flow

\$210,000 Cash Flow

Present value of net annual cash flows Capital investment

\$400,000 190,000

\$210,000

9% Discount Factor

Present Value

4.48592*

\$942,043 900,000

Net present value

\$ 42,043

*Table 2, Appendix G

Since the net present value is greater than zero, Watertown should accept the project. (b) \$900,000 4 210,000 5 4.285714. Using Table 2 of Appendix G and the factors that correspond with the six-period row, 4.285714 is between the factors for 10% and 11%. 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. Related exercise material: BE26-11, BE26-12, E26-10, E26-11, E26-12, and

DO IT!

26-4.

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DO IT!

D-7

Exercises

Nathan T Corporation is comparing two different options. Nathan T curDO IT! 26-1 rently uses Option 1, with revenues of \$65,000 per year, maintenance expenses of \$5,000 per year, and operating expenses of \$26,000 per year. Option 2 provides revenues of \$60,000 per year, maintenance expenses of \$5,000 per year, and operating expenses of \$22,000 per year. Option 1 employs a piece of equipment which was upgraded 2 years ago at a cost of \$17,000. If Option 2 is chosen, it will free up resources that will bring in an additional \$4,000 of revenue. Complete the following table to show the change in income from choosing Option 2 versus Option 1. Designate Sunk costs with an “S.”

Option 1

Option 2

Net Income Increase (Decrease)

Determine incremental costs.

(LO 1)

Sunk (S)

Revenues Maintenance expenses Operating expenses Equipment upgrade Opportunity cost DO IT! 26-2a Maize Company incurs a cost of \$35 per unit, of which \$20 is variable, to make a product that normally sells for \$58. A foreign wholesaler offers to buy 6,000 units at \$30 each. Maize will incur additional costs of \$4 per unit to imprint a logo and to pay for shipping. Compute the increase or decrease in net income Maize will realize by accepting the special order, assuming Maize has sufficient excess operating capacity. Should Maize Company accept the special order?

Evaluate special order.

DO IT! 26-2b Wilma Company must decide whether to make or buy some of its components. The costs of producing 60,000 switches for its generators are as follows.

Direct materials Direct labor

\$30,000 \$42,000

\$45,000 \$60,000

(LO 2)

(LO 2)

Instead of making the switches at an average cost of \$2.95 (\$177,000 4 60,000), the company has an opportunity to buy the switches at \$2.70 per unit. If the company purchases the switches, all the 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 switches. (b) Would your answer be different if the released productive capacity will generate additional income of \$34,000? DO IT! 26-2c Mesa Verde manufactures unpainted furniture for the do-it-yourself (DIY) market. It currently sells a table for \$75. Production costs are \$40 variable and \$10 fixed. Mesa Verde is considering staining and sealing the table to sell it for \$100. Variable costs to finish each table are expected to be \$19, and fixed costs are expected to be \$3. Prepare an analysis showing whether Mesa Verde should sell unpainted or finished tables.

Sell or process further.

DO IT! 26-2d Darcy Roofing is faced with a decision. The company relies very heavily on the use of its 60-foot extension lift for work on large homes and commercial properties. Last year, Darcy Roofing spent \$60,000 refurbishing the lift. It has just determined that another \$40,000 of repair work is required. Alternatively, it has found a newer used lift that is for sale for \$170,000. The company estimates that both lifts would have useful lives of 6 years. The new lift is more efficient and thus would reduce operating expenses by about \$20,000 per year. Darcy Roofing could also rent out the new lift for about \$10,000 per year. The old lift is not suitable for rental. The old lift could currently be sold for \$25,000 if the new lift is purchased. Prepare an incremental analysis showing whether the company should repair or replace the equipment.

Repair or replace equipment.

DO IT! 26-2e Gator Corporation manufactures several types of accessories. For the year, the gloves and mittens line had sales of \$500,000, variable expenses of \$370,000, and fixed expenses of \$150,000. Therefore, the gloves and mittens line had a net loss of \$20,000. If Gator eliminates the line, \$38,000 of fixed costs will remain. Prepare an analysis showing whether the company should eliminate the gloves and mittens line.

Analyze whether to eliminate unprofitable segment.

DO IT! 26-3a Wayne Company is considering a long-term investment project called ZIP. ZIP will require an investment of \$120,000. It will have a useful life of 4 years and no salvage value.

Calculate annual rate of return.

(LO 2)

(LO 2)

(LO 2)

(LO 3)

D-8

DO IT!

Annual revenues would increase by \$80,000, and annual expenses (excluding depreciation) would increase by \$41,000. Wayne uses the straight-line method to compute depreciation expense. The company’s required rate of return is 12%. Compute the annual rate of return. Compute the cash payback period for an investment.

(LO 3) Calculate net present value and internal rate of return of an investment.

(LO 4)

DO IT! 26-3b Wayne Company is considering a long-term investment project called ZIP. ZIP will require an investment of \$140,000. It will have a useful life of 4 years and no salvage value. Annual cash inflows would increase by \$80,000, and annual cash outflows would increase by \$40,000. Compute the cash payback period. DO IT! 26-4 Wayne Company is considering a long-term investment project called ZIP. ZIP will require an investment of \$120,000. It will have a useful life of 4 years and no salvage value. Annual cash inflows would increase by \$80,000, and annual cash outflows would increase by \$40,000. The company’s required rate of return is 12%. (a) Calculate the net present value on this project and discuss whether it should be accepted. (b) Calculate the internal rate of return on this project and discuss whether it should be accepted.

CONTINUING PROBLEMS EXCEL TUTORIAL

CURRENT DESIGNS CD26-1 Recently, Mike Cichanowski, owner and CEO of Current Designs, received a phone call from the president of a brewing company. He was calling to inquire about the possibility of Current Designs producing “floating coolers” for a promotion his company was planning. These coolers resemble a kayak but are about one-third the size. They are used to float food and beverages while paddling down the river on a weekend leisure trip. The company would be interested in purchasing 100 coolers for the upcoming summer. It is willing to pay \$250 per cooler. The brewing company would pick up the coolers upon completion of the order. Mike met with Diane Buswell, controller, to identify how much it would cost Current Designs to produce the coolers. After careful analysis, the following costs were identified. Direct materials Direct labor

\$80/unit \$60/unit

\$20/unit \$1,000

Current Designs would be able to modify an existing mold to produce the coolers. The cost of these modifications would be approximately \$2,000. Instructions (a) Prepare an incremental analysis to determine whether Current Designs should accept this special order to produce the coolers. (b) Discuss additional factors that Mike and Diane should consider if Current Designs is currently operating at full capacity. CD26-2 A company that manufactures recreational pedal boats has approached Mike Cichanowski to ask if he would be interested in using Current Designs’ rotomold expertise and equipment to produce some of the pedal boat components. Mike is intrigued by the idea and thinks it would be an interesting way of complementing the present product line. One of Mike’s hesitations about the proposal is that the pedal boats are a different shape than the kayaks that Current Designs produces. As a result, the company would need to buy an additional rotomold oven in order to produce the pedal boat components. This project clearly involves risks, and Mike wants to make sure that the returns justify the risks. In this case, since this is a new venture, Mike thinks that a 15% discount rate is appropriate to use to evaluate the project. As an intern at Current Designs, Mike has asked you to prepare an initial evaluation of this proposal. To aid in your analysis, he has provided the following information and assumptions. 1. The new rotomold oven will have a cost of \$256,000, a salvage value of \$0, and an 8-year useful life. Straight-line depreciation will be used.

DO IT!

2. The projected revenues, costs, and results for each of the 8 years of this project are as follows. Sales Less: Manufacturing costs Depreciation Shipping and administrative costs Income before income taxes Income tax expense Net income

\$220,000 \$140,000 32,000 22,000

194,000 26,000 10,800 \$ 15,200

Instructions (a) Compute the annual rate of return. (Round to two decimal places.) (b) Compute the payback period. (Round to two decimal places.) (c) Compute the net present value using a discount rate of 9%. (Round to nearest dollar.) Should the proposal be accepted using this discount rate? (d) Compute the net present value using a discount rate of 15%. (Round to nearest dollar.) Should the proposal be accepted using this discount rate?

WATERWAYS (Note: This is a continuation of the Waterways problem from Chapters 19–25.) WP26 Waterways Corporation puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 8% based on the rate of return it must pay its owners and creditors. Using that rate, Waterways then uses different methods to determine the best decisions for making capital outlays. Waterways is considering buying five new backhoes to replace the backhoes it now has. This problem asks you to evaluate that decision, using various capital budgeting techniques. Go to the book’s companion website, www.wiley.com/college/weygandt, to find the remainder of this problem.

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