CHAPTER 26
Incremental Analysis and Capital Budgeting
ASSIGNMENT CLASSIFICATION TABLE
Learning Objectives
Questions
Brief
Exercises
Do It!
Exercises
A
Problems
1. Describe management’s
decision-making process and
incremental analysis.
1, 2, 3, 4
1, 2
1
1
2. Analyze the relevant costs in
various decisions involving
incremental analysis.
5, 6, 7, 8, 9,
10
3, 4, 5, 6, 7
2a, 2b, 2c,
2d, 2e
2, 3, 4, 5, 6,
7, 8
1A, 2A, 3A,
4A
3. Contrast annual rate of return
and cash payback in capital
budgeting.
11, 12, 13,
14, 15
8, 9
3a, 3b
9, 10
5A, 6A, 7A
4. Distinguish between the net
present value and internal
rate of return methods.
16, 17, 18,
19
10, 11, 12
4
10, 11, 12
5A, 6A, 7A
ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
1A
Use incremental analysis for special order and identify
nonfinancial factors in the decision.
Simple
20–30
2A
Compute gain or loss, and determine if equipment should
30–40
5A
Compute annual rate of return, cash payback, and net
6A
Compute annual rate of return, cash payback, and net
30–40
Use incremental analysis related to make or buy,
consider opportunity cost, and identify nonfinancial
Moderate
30–40
BLOOM’ S TAXONOMY TABLE
Correlation Chart between Bloom’s Taxonomy, Learning Objectives and End–of-Chapter Exercises and Problems
Learning Objective
Knowledge
Comprehension
Application
Analysis
Synthesis
Evaluation
*1. Describe management’s decision–
making process and incremental
analysis.
Q26-1
Q26-2
Q26-3
Q26-4
E26-1
BE26-1
BE26-2
DI26-1
*2. Analyze the relevant costs in
various decisions involving
incremental analysis.
Q26-8
Q26-5
Q26-6
Q26-7
Q26-9
Q26-10
BE26-3 DI26-2c
BE26-4 DI26-2d
BE26-5 DI26-2e
BE26-6
BE26-7
DI26-2a
DI26-2b
E26-2
E26-3
E26-4
E26-5
E26-6
E26-7
E26-8
P26-3A
P26-4A
P26-1A
P26-2A
*3. Contrast annual rate of return and
cash payback in capital
budgeting.
Q26-12
Q26-11
Q26-13
Q26-14
Q26-15
BE26-8 DI26-3b
BE26-9 E26-10
DI26-3a E26-11
E26-9
P26-5A
P26-6A
P26-7A
*4. Distinguish between the net
present value and internal rate of
return methods.
Q26-17
Q26-18
Q26-19
Q26-16
BE26-11
E26-10
BE26-10
BE26-12
DI26-4
E26-11
E26-12
P26-5A
P26-6A
P26-7A
Broadening Your Perspective
BYP26-1
BYP26-4
BYP26-2
BYP26-3
BYP26-5
BYP26-6
BYP26-7
ANSWERS TO QUESTIONS
1. The following steps are frequently involved in management’s decision-making process:
(1) Identify the problem and assign responsibility.
(2) Determine and evaluate possible courses of action.
(3) Make a decision.
(4) Review results of the decision.
4. In incremental analysis, the important point to consider is whether costs will differ (change)
between the two alternatives. As a result, sometimes (1) variable costs do not change under the
alternative courses of action and (2) fixed costs do change.
5. The relevant data in deciding whether to accept an order at a special price are the incremental
revenues to be obtained compared to the incremental costs of filling the special order.
8. The decision rule in a decision to sell a product or to process it further is: Process further as
long as the incremental revenue from the additional processing exceeds the incremental
processing costs.
9. A sunk cost is a cost that cannot be changed by any present or future decision. Sunk costs, such
as the book value of an old piece of equipment, therefore, are not relevant in a decision to retain
or replace equipment.
Questions Chapter 26 (Continued)
13. Cost of capital is the average rate of return that the company must pay to obtain borrowed and
equity funds. The decision rule is: Accept the project when the internal rate of return is equal to or
greater than the required rate of return (which often is its cost of capital). Reject the project when
the internal rate of return is less than the required rate of return.
14. Tom is not correct. The formula for the cash payback technique is: Cost of the capital investment ÷
Net annual cash flow. The formula for the annual rate of return is: Expected annual net income ÷
average investment.
17. The decision rule is: Accept the project when net present value is zero or positive; reject the
project when net present value is negative.
18. When the net annual cash flows are equal each year, the steps are:
(1) Compute the internal rate of return factor by dividing Capital Investment by Net Annual Cash
Flows.
(2) Use the factor and the present value of an annuity of 1 table to find the internal rate of
return.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 26-1
The correct order is:
1. Identify the problem and assign responsibility.
BRIEF EXERCISE 26-2
Alternative
A
Alternative
B
Net Income
Increase
(Decrease)
Revenues
BRIEF EXERCISE 26-3
Reject
Order
Accept
Order
Net Income
Increase
(Decrease)
Revenues
$0
$75,000
*
($ 75,000)
BRIEF EXERCISE 26-4
Make
Buy
Net Income
Increase
(Decrease)
BRIEF EXERCISE 26-5
Sell
Process
Further
Net Income
Increase (Decrease)
46.00
Sales price per unit
Cost per unit
$62.00
$70.00
$8.00
BRIEF EXERCISE 26-6
Retain
Equipment
Replace
Equipment
Net 5-Year
Income
Increase
(Decrease)
Variable manufacturing costs
Continue
Eliminate
Net Income
Increase (Decrease)
Sales
Variable costs
$200,000
180,000
$ –0–
–0–
$(200,000)
(180,000)
BRIEF EXERCISE 26-8
$450,000 ÷ $60,000 = 7.5 years
BRIEF EXERCISE 26-9
The annual rate of return is calculated by dividing expected annual income
by the average investment. The company’s expected annual income is:
Its average investment is:
$490,000 + $10,000
=
$250,000
2
BRIEF EXERCISE 26-10
Project A
Cash
Flows
X
9% Discount
Factor
=
Present
Value
Present value of net annual cash flows
Present value of salvage value
$70,000
0
X
X
6.41766
.42241
=
=
$449,236
0
Project B
Cash
Flows
X
9% Discount
Factor
=
Present
Value
Present value of net annual cash flows
$55,000
X
6.41766
=
$352,971
Project A has a higher net present value than Project B, and it should be
accepted.
BRIEF EXERCISE 26-11
When net annual cash flows are expected to be equal, the internal rate of
return can be approximated by dividing the capital investment by the net
BRIEF EXERCISE 26–12
Present Value
Net annual cash flows – $40,000 X 5.65
$226,000
SOLUTIONS FOR DO IT! REVIEW EXERCISES
DO IT! 26-1
Alternative
1
Alternative
2
Net Income
Increase
(Decrease)
Sunk (s)
Revenues
$65,000
$60,000
$(5,000)
Maintenance expense
5,000
5,000
0
Operating expenses
Equipment upgrade
17,000
Opportunity cost
$3,000
DO IT! 26-2a
Reject
Accept
Net Income
Increase (Decrease)
Revenues
$ –0–
$180,000
$180,000
Costs
Net income
$ –0–
$ 36,000
$ 36,000
DO IT! 26–2b
(a)
Make
Buy
Net Income
Increase (Decrease)
Direct materials
$ 30,000
$ –0–
$ 30,000
Direct labor
42,000
–0–
42,000
Variable manufacturing
costs
45,000
–0–
45,000
(b)
Make
Buy
Net Income
Increase (Decrease)
Total cost
$177,000
$207,000
$(30,000)
Total cost
$211,000
Purchase price
–0–
(162,000)
Total cost
DO IT! 26–2c
Sell
Process
Further
Net Income Increase
(Decrease)
Sales per unit
Cost per unit
$75
$100
$25
DO IT! 26–2d
Retain
Equipment
Replace
Equipment
Net Income
Increase (Decrease)
Operating expenses
$120,000
$120,000
Repair costs
40,000
40,000
Rental revenue
New machine cost
Sale of old machine
Total cost
$ 75,000
DO IT! 26–2e
Continue
Eliminate
Net Income
Increase (Decrease)
Sales
$500,000
$ 0
$(500,000)
Variable costs
370,000
0
370,000
Contribution margin
Fixed costs
38,000
Net income
$(38,000)
DO IT! 26-3a
Revenues ………………………………………………………….. $80,000
Less:
Expenses (excluding depreciation) ……………….. $41,000
Since the annual rate of return, 15%, is greater than Wayne’s required rate
of return, 12%, the proposed project is acceptable.
DO IT! 26-3b
DO IT! 26-4
(a)
Estimated annual cash inflows…………………………... $80,000
Estimated annual cash outflows ………………………… 40,000
Net annual cash flow …………………………………………. $40,000
(b)
Estimated annual cash inflows…………………………... $80,000
SOLUTIONS TO EXERCISES
EXERCISE 26-1
1. False. The first step in management’s decision–making process is “identify
the problem and assign responsibility”.
2. False. The final step in management’s decision-making process is to
review the results of the decision.
EXERCISE 26-2
(a)
Reject
Order
Accept
Order
Net Income
Increase
(Decrease)
Revenues ($4.80)
Materials ($0.50)
$ –0–
–0–
$24,000
(2,500)
$24,000
(2,500)
EXERCISE 26-3
(a)
Reject
Order
Accept
Order
Net Income
Increase
(Decrease)
Revenues (15,000 X $7.60)
Cost of goods sold
$0
0
$114,000
78,000
(1)
($114,000)
( (78,000)
(1) Variable cost of goods sold = $2,600,000 X 70% = $1,820,000.
(b) As shown in the incremental analysis, Moonbeam Company should
accept the special order because incremental revenues exceed
incremental expenses by $4,200.
EXERCISE 26-4
(a)
Make
Buy
Net Income
Increase
(Decrease)
Direct materials (30,000 X $4.00)
Direct labor (30,000 X $5.00)
$120,000
150,000
$ 0
0
$ 120,000
150,000
EXERCISE 26-4 (Continued)
(c) Yes, by purchasing the finials, a total cost saving of $6,500 will result
as shown below.
Make
Buy
Net Income
Increase
(Decrease)
Total annual cost (above)
$420,000
$433,500
$(13,500)
EXERCISE 26-5
Sell
(Basic Kit)
Process Further
(Stage 2 Kit)
Net Income
Increase
(Decrease)
Sales per unit
Costs per unit
Direct materials
$30
$16
( )$36( )
( ) $ 8 (1)
$(6)
$(8)
(1) The cost of materials decreases because Anna can make two Stage
2 Kits from the materials for a basic kit.
(2) The total time to make the two kits is one hour at $18 per hour or
$9 per unit.
EXERCISE 26-6
Retain
Machine
Replace
Machine
Net Income
Increase
(Decrease)
Operating costs
New machine cost
$125,000
0
(1)
($100,000)
( 25,000)
(2)
($ 25,000
( (25,000)
The current machine should be replaced. The incremental analysis shows
that net income for the five-year period will be $6,000 higher by replacing the
current machine.
EXERCISE 26-7
Continue
Eliminate
Net Income
Increase
(Decrease)
Sales
Variable costs
Cost of goods sold
Operating expenses
$100,000)
( 61,000)
(30,000)
$( 0)
( 0)
( 0)
$(100,000)
(61,000)
(30,000)
EXERCISE 26-8
(a) $30,000 + $70,000 – $40,000 = $60,000
(b)
Tingler
Shocker
Total
Sales
Variable expenses
$300,000
150,000
$500,000
200,000
$800,000
350,000
EXERCISE 26-9
(a)
AA
Year
Net Annual Cash Flow
Cumulative Net Cash Flow
1
2
$ 7,000
9,000
$ 7,000
16,000
EXERCISE 26-9 (Continued)
BB
CC
Year
Net Annual Cash Flow
Cumulative Net Cash Flow
1
2
3
$13,000
12,000
11,000
$13,000
25,000
36,000
(b)
AA
BB
CC
Year
Discount
Factor
Cash
Flow
Present
Value
Cash
Flow
Present
Value
Cash
Flow
Present
Value
Total present value
Less: Investment
21,966
(22,000
24,019
(22,000
(1)
(22,000
1
2
.89286
.79719
$ 7,000
9,000
$ 6,250
7,175
$10,000
10,000
$ 8,929
7,972
$13,000
12,000
$11,607
9,566