Chapter 25 – Capital Budgeting and Managerial Decisions
Exercise 25-14 (continued)
PROJECT C2
Net Cash
Flows
Present
Value of
1 at 12%
Present
Value of Net
Cash Flows
Year 1……………………………………………………………$ 96,000 0.8929 $ 85,718
Year 2……………………………………………………………96,000 0.7972 76,531
Year 3…………………………………………………………… 96,000 0.7118 68,333
PROJECT C3
Net Cash
Flows
Present
Value of
1 at 12%
Present
Value of
Net Cash
Flows
Year 1……………………………………………………………$180,000 0.8929 $160,722
Year 2……………………………………………………………60,000 0.7972 47,832
Year 3…………………………………………………………… 48,000 0.7118 34,166
Analysis and Interpretation: Both Project C2 and C3 yield a positive net
present value. Accordingly, both C2 and C3 are acceptable investments.
Project C1 has a negative net present value, so it should be rejected.
2. INTERNAL RATE OF RETURN VS. NET PRESENT VALUE FOR C2
Project C2 will have an internal rate of return higher than 12%.
25-1481
Chapter 25 – Capital Budgeting and Managerial Decisions
Exercise 25-15A (20 minutes)
Using Excel, Project A (B) has an internal rate of return of 26.96 (35.00%).
Project A Project B
A B C D
1 Initial investment -160000 -105000
2Annual cash flows,
end of period
3 1 40000 32000
4 2 56000 50000
Exercise 25-16 (10 minutes)
1. Sunk cost
2. Relevant benefits
25-1482
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
Exercise 25-17 (25 minutes)
Normal Additional Combined
Volume Volume* Total
Sales………………………………..………... $2,250,000 $180,000 $2,430,000
Costs and expenses
Direct materials…………..………....... 300,000 30,0001330,000
Direct labor………………………………. 600,000 60,0002660,000
The company should accept the offer as it increases income by $3,000.
1(15,000 x $2) 2 (15,000 x $4)
*ADDITIONAL VOLUME COMPUTATIONS
Additional sales revenue = 15,000 units @ $12 = $180,000
Exercise 25-18 (20 minutes)
Part 1
Normal Additional Combined
Volume Volume Total
Sales………………………………..………... $8,000,000 $1,500,000 $9,500,000
Costs and expenses
Direct materials…………..………....... 1,000,000 250,000 1,250,000
25-1483
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
Fixed overhead…………………..…….. 1,400,000 0 1,400,000
Variable selling and admin. exp.... 1,120,000 380,000 1,500,000
Fixed selling and admin. exp........ 1,040,000 0 1,040,000
Calculations:
Normal volume sales: 80,000 units x $100 per unit = $8,000,000
Additional revenue from new order: 20,000 units x $75 per unit = $1,500,000
Additional direct materials: 20,000 units x $12.50 per unit = $250,000
Additional direct labor: 20,000 units x $15.00 per unit = $300,000
Additional variable overhead: 20,000 units x $10.00 per unit = $200,000
Additional selling and administrative expense: 20,000 units x ($14 + $5) per unit = $380,000
Based on this analysis, Goshford should accept the new business.
Part 2
Other factors that Goshford should consider before deciding whether to
accept the new business are:
Will regular customers demand a reduction in their selling price if they
hear of the sale to the new customer?
Will the new customer expect to receive the special price for future
sales?
If Goshford accepts the new business, it will be operating at full
capacity. Can they maintain that full capacity without any defects?
What will happen to regular sales if they cannot meet current customers’
expectations because of this order?
Exercise 25-19 (20 minutes)
Make Buy
Variable costs (65,000 @ $1.95)……………..……… $126,750 —-
Incremental fixed costs……………….……..…………
75,000
RECOMMENDATION : Note that the allocated fixed costs of $62,000 are not
relevant to this managerial decision because they will continue whether the
part is made or bought. Therefore, the incremental costs of making the
part are $9,500 less per year than buying it. This implies that the company
should continue to make this part.
25-1484
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
Note: We should recognize that this decision depends on the alternative uses for the
productive facilities dedicated to making the part. If they can be used to produce a profit
greater than the $9,500 annual savings that the company attains by making this part, the
part should probably be purchased and the facilities used for the other more profitable
activities.
Exercise 25-20 (20 minutes)
Make Buy
Variable costs (40,000 @ $1.95)……………..……… $78,000 —-
Incremental fixed costs……………….……..…………
Cost to buy (40,000 @ $3.50) ..………..…………....
65,000
— $140,000
Total…………………………………………………..………... $143,000 $140,000
RECOMMENDATION : Note that the allocated fixed costs of $58,500 are not
relevant to this managerial decision because they will continue whether the
25-1485
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
Exercise 25-21 (15 minutes)
Scrap Rework
Sale of scrapped/reworked units……………….….. $55,000 $187,000
Less out-of-pocket costs to rework..……...........
—-
(99,000)
(1) The incremental income from selling as scrap is $55,000 (22,000 x $2.50).
Exercise 25-22 (15 minutes)
INCREMENTAL REVENUE AND COST OF ADDITIONAL PROCESSING
Revenue if processed further (7,000 x $25)……………………….………..……..$175,000
Revenue if sold as is (7,000 x $8)…………………………….………..…………..…. 56,000
Incremental revenue………………………………………………..…………..…………..119,000
RECOMMENDATION : Varto should not process these units further, as they will
Exercise 25-23 (25 minutes)
Sell as is
Process
further
Incremental revenue………………………..…………... $700,000 $1,372,000*
Incremental costs…………………………………………. —- (420,000)
25-1486
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
*Revenue from processed products
Units Price Total
Product B……..………..……….………..………..……………….….…...5,600 $105 $ 588,000
RECOMMENDATION : This analysis shows that the company will be better off
by $252,000 if it chooses to process Product A into the two products of B
and C. (Note that the $28 per unit cost of manufacturing Product A is sunk
and irrelevant to this decision.)
Exercise 25-24 (30 minutes)
Preliminary computations
Contribution margin per hour Product TLX Product MTV
Selling price per unit…………..………..………..……….….. $15.00 $ 9.50
Exercise 25-24 (continued)
1. FOR PRODUCT TLX
Maximum sales……………………………………………………………….4,700 units
Hours needed per unit………………………………………..………..… 0.50
Total hours used (4,700 x 0.50)……………………………...………..2,350 hours
FOR PRODUCT MTV
25-1487
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
SALES MIX RECOMMENDATION : These results suggest the company
should manufacture as many units of Product TLX as it can produce
and sell until reaching a (market or production) constraint. Thereafter,
any remaining capacity should be devoted to Product MTV, up to the
maximum that can be produced and/or sold.
2. CONTRIBUTION MARGIN FROM THE RECOMMENDED SALES MIX
Un
its
Contribution
per Unit Total
Product TLX……………………………….. 4,700 $10.20 $47,940
Exercise 25-25 (30 minutes)
Instructor note: In all cases, the total unavoidable expenses of $107,800 remain the same
because they cannot be avoided by eliminating departments.
1. DEPARTMENTS WITH EXPECTED NET LOSSES ELIMINATED
Total M N O P T
Sales……….……….…….…..….….….…..…...$119,000 $63,000 $ 0 $56,000 $ 0 $ 0
Expenses
Avoidable…..………..………..……………….32,200 9,800 0 22,400 0 0
2. DEPARTMENTS WITH LESS SALES THAN AVOIDABLE EXPENSES ELIMINATED
Total M N O P T
Sales……….……….…….…..….….….…..…...$161,000 $63,000 $ 0 $56,000 $42,000 $ 0
25-1488
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
Unavoidable………………….….….….….... 107,800 51,800 12,600 4,200 29,400 9,800
25-1489
Education.
Chapter 25 – Capital Budgeting and Managerial Decisions
Exercise 25-26 (20 minutes)
ALTERNATIVE A: INCREASE OR (DECREASE) IN NET INCOME
Cost to buy new machine…………………………………………………………….……$(115,000)
Cash received to trade in old machine……………………….…………..………… 52,000
The company should replace the machine with alternative machine B. This
will increase net income by $32,000.
Exercise 25-27 (15 minutes)
1. Recovery time computation
2. The advantage of break-even time is that it considers the time value of
3. When (1) the interest rate is very low, 1% for example, and (2) the
25-1490
25-1491