CHAPTER 26
INCREMENTAL ANALYSIS AND CAPITAL
BUDGETING
Learning Objectives
1. DESCRIBE MANAGEMENT’S DECISION-MAKING
PROCESS AND INCREMENTAL ANALYSIS.
2. ANALYZE THE RELEVANT COSTS IN VARIOUS
DECISIONS INVOLVING INCREMENTAL ANALYSIS.
3. CONTRAST ANNUAL RATE OF RETURN AND CASH
PAYBACK IN CAPITAL BUDGETING.
4. DISTINGUISH BETWEEN THE NET PRESENT VALUE
AND INTERNAL RATE OF RETURN METHODS.
CHAPTER REVIEW
Incremental Analysis Approach
1. (L.O. 1) Management’s decision-making process frequently involves the following steps:
a. Identify the problem and assign responsibility.
b. Determine and evaluate possible courses of action.
c. Make a decision.
d. Review results of the decision.
2. (L.O. 2) Business decisions involve a choice among alternative courses of action. In making such
decisions, management ordinarily considers both financial and nonfinancial information. The process
used to identify the financial data that change under alternative courses of action is called incremental
analysis.
Accept an Order at a Special Price
4. An order at a special price should be accepted when the incremental revenue from the order
exceeds the incremental costs.
a. It is assumed that sales in other markets will not be affected by the special order.
b. If the units can be produced within existing plant capacity, generally only variable costs will
be affected.
Make or Buy
5. In a make or buy decision, management must determine the costs which are different under the
Sell or Process Further
6. The basic decision rule in a sell or process further decision is: Process further as long as the
incremental revenue from such processing exceeds the incremental processing costs.
Incremental revenue is the increase in sales which results from processing the product further.
Repair, Retain, or Replace Equipment
Eliminate an Unprofitable Segment or Product
8. In deciding whether to eliminate an unprofitable segment, management should choose the
alternative which results in the highest net income. Often fixed costs allocated to the unprofitable
segment must be absorbed by the other segments. It is possible, therefore, for net income to
decrease when an unprofitable segment is eliminated.
Allocate Limited Resources
Capital Budgeting
10. The process of making capital expenditure decisions is known as capital budgeting. The three
most commonly used capital budgeting techniques are (a) annual rate of return, (b) cash payback,
and (c) discounted cash flow.
Annual Rate of Return
11. (L. O. 3) The annual rate of return technique is based directly on accrual-accounting data. It
indicates the profitability of a capital expenditure. The formula is:
Expected Annual Net Income ÷ Average Investment = Annual Rate of Return
Average investment is based on the following:
Original Investment + Value at End of Useful Life
=
Average Investment
Cash Payback
13. The cash payback technique identifies the time period required to recover the cost of the capital
investment from the annual cash inflow produced by the investment. The formula for computing the
cash payback period is:
14. The evaluation of the payback period is often related to the expected useful life of the asset.
a. With this technique, the shorter the payback period, the more attractive the investment.
Discounted Cash Flow
15. (L.O. 4) The discounted cash flow technique is generally recognized as the best conceptual
approach to making capital budgeting decisions. This technique considers both the estimated total
Net cash flows and the time value of money. Two methods are used with the discounted cash flow
technique: net present value and internal rate of return.
Net Present Value Method
16. Under the net present value method, cash flows are discounted to their present value and then
compared with the capital outlay required by the investment. The difference between these two
amounts is the net present value (NPV).
Internal Rate of Return Method
18. The internal rate of return method results in finding the interest yield of the potential investment.
This is the interest rate that will cause the present value of the proposed capital expenditure to
equal the present value of the expected net annual cash flows. Determining the true interest rate
involves two steps:
LECTURE OUTLINE
A. Management’s Decision-Making Process.
1. The steps are:
a. Identify the problem and assign responsibility.
b. Determine and evaluate possible courses of action.
B. The Incremental Analysis Approach.
1. The process used to identify the financial data that change under alter-
native courses of action is called incremental analysis.
2. These data are relevant to the decision because they will vary in the future
among the possible alternatives.
SERVICE COMPANY INSIGHT
American Express decided to offer some of its customers $300 if they would give
back their credit card. Customers could receive the $300 even if they hadn’t paid
off their balance yet, as long as they agreed to give up their credit card.
What are the relevant costs and other information that American Express would
need to know in order to determine to whom to make this offer?
Answer: Clearly American Express would make this offer to those customers
that are most likely to default on their bills. The most important
4. Accept an order at a special price.
a. The relevant information is the difference between the variable manu-
facturing costs to produce the special order and expected revenues.
5. Make or buy.
a. In a make or buy decision, the relevant costs are:
(1) The variable manufacturing costs that will be saved.
b. Opportunity costs: The potential benefit that may be obtained by
following an alternative course of action.
ACCOUNTING ACROSS THE ORGANIZATION
Manufacturers in various industries have engaged in overseas off–shoring (outsourcing)
in recent years. Incremental analysis, comparing the relative labor costs in various
nations, often leads to outsourcing production to countries like China.
What are the disadvantages of outsourcing to a foreign country?
Answer: One issue relates to whether the quality of the product will suffer if the
car-makers outsource manufacture of aluminum wheels. In addition,
transportation costs will also increase.
7. Repair, retain, or replace equipment.
a. Management often has to decide whether to continue using an asset
or replace it.
b. The factors to consider are:
d. Any cash disposal value or trade-in allowance of the existing asset
is relevant to the decision.
8. Eliminate an unprofitable segment or product.
a. In deciding whether to eliminate an unprofitable segment, determine
the contribution margin, if any, produced by the segment and the
disposition of the segment’s fixed expenses.
9. Allocate limited resources.
a. When a company has limited resources, find the contribution margin
per unit of limited resource.
C. Capital Budgeting.
1. The process of making capital expenditure decisions in business is known
as capital budgeting.
2. Quantitative techniques that may be used for capital budgeting decisions
include:
a. Annual rate of return.
3. The annual rate of return technique is based directly on accounting data.
a. Annual rate of return is obtained from the following formula: Expected
Annual Net Income ÷ Average Investment.
b. The required rate of return is generally based on the company’s cost
of capital.
f. The principal advantages of the annual rate of return technique are
simplicity of calculation and management’s familiarity with the
accounting terms used in the computation.
g. A major limitation of this approach is that it does not consider the
time value of money.
4. The cash payback technique identifies the time period required to
recover the cost of the capital investment from the net annual cash flow
produced by the investment.
(2) The risk of loss from obsolescence and changed economic
conditions is less in a shorter payback period.
d. In the case of uneven cash flows, the company determines the
cash payback period when the cumulative cash flows from the
investment equal the cost of the investment.
5. The discounted cash flow technique is generally recognized as the best
conceptual approach to making capital budgeting decisions.
a. This technique considers both the estimated total net cash flows
from the investment and the time value of money.
b. Two methods are used with the discounted cash flow technique:
6. The net present value method involves discounting net cash flows to their
present value and then comparing the present value with the capital
outlay required by the investment. The difference between these two
amounts is referred to as net present value (NPV).
a. The interest rate to be used in discounting the future net cash flows
is the required rate of return.
7. The internal rate of return method finds the interest yield of the potential
investment.
b. The determination of the internal rate of return involves two steps:
(1) Compute the internal rate of return factor.
(2) Use the factor and the present value of an annuity of 1 table to
find the internal rate of return.
8. The two discounted cash flow methods differ as follows:
a. Objective:
(1) Net present value: compute net present value (a dollar
amount).
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Determining and evaluating possible courses of action is a step in management’s
decision-making process.
True False
2. In incremental analysis fixed costs may not change under alternative courses of action,
while variable costs may change.
True False
3. The relevant factors to consider in accepting an order at a special price are the additional
manufacturing costs incurred and expected revenues.
True False
4. The basic decision rule to sell or process further is: process further as long as the incre-
mental revenue from such processing exceeds the incremental processing costs.
True False
5. Book value is a sunk cost and is therefore relevant in incremental analysis of retain or
replace equipment.
True False
6. Contribution margin per unit of limited resource is obtained by dividing the contribution
margin per unit of each product by the number of units of the limited resource required
for each product.
True False
7. A major limitation of the annual rate of return approach is that it does not consider the
time value of money.
True False
8. The cash payback technique recognizes the time value of money plus expected profitability
of a project, and is therefore the most desirable approach to making capital budgeting
decisions.
True False
9. Net present value and internal rate or return are both methods used with the discounted
cash flow technique.
True False
10. The net present value method results in finding the interest yield of the potential investment.
True False
Multiple Choice
1. Which of the following is not a step in management’s decision-making process?
a. Identify the problem and assign responsibility.
b. Determine possible courses of action.
c. Review the results of the decision.
d. Prepare financial statements.
2. If revenues are $1,050,000 under alternative A and $1,080,000 under alternative B, and
costs are $950,000 for A and $1,020,000 for B, then using the basic approach in incre–
mental analysis, incremental revenues, costs, and net income, in comparing B to A are
respectively
a. $30,000, $70,000, $(40,000).
b. $(30,000), $70,000, $40,000.
c. $30,000, $70,000, $40,000.
d. $(30,000), $(70,000), $(40,000).
3. The cost to manufacture an unfinished unit is $160 ($120 variable, $40 fixed). The selling
price per unit is $200. The company has unused productive capacity and has determined
that units could be finished and sold for $260 with an increase in variable costs of 40%.
What is the additional net income per unit to be gained by finishing the unit?
a. $12.00.
b. $40.00.
c. $60.00.
d. $48.00.
4. Which of the following is generally recognized as the most informative and best conceptual
approach to making capital budgeting decisions?
a. Annual rate of return technique.
b. Cash payback technique.
c. Discounted cash flow technique.
d. None of the above.
5. If capital investment is $200,000 and equal annual cash inflows are $40,000, the internal
rate of return factor is
a. 20.0.
b. 5.0.
c. 4.0.
d. .25.
ANSWERS TO QUIZ
True/False
1. True 6. True
2. True 7. True
Multiple Choice
1. d.