P26-38, cont.
Requirement 1. cont.
Server A
Server B
Total net cash inflows during operating life of server
$ 78,000
$ 44,000
Less: Total depreciation during operating life of server
44,000
39,000
Total operating income during operating life
34,000
5,000
Divide by: Server’s operating life in years
÷ 3 years
÷ 3 years
Average annual operating income from server
$ 11,333
$ 1,667
(rounded)
(rounded)
Amount invested + Residual value
Average annual operating income
P26-38, cont.
Requirement 1. cont.
Microsoft Excel Results:
P26-38, cont.
Requirement 1. cont.
Microsoft Excel Formulas:
Requirement 2
Based on the calculated results in Requirement 1, Server A meets the payback, accounting rate of return
(ARR), net present value (NPV), and internal rate of return (IRR) criteria: The payback period is shorter
than the server’s operating life, NPV is positive, and the ARR and IRR are both greater than the required
rate of return.
Comprehensive Problem for Chapters 25–26
David Dennison, majority stockholder and president of Dennison, Inc., is working with his top managers
on future plans for the company. As the company’s managerial accountant, you’ve been asked to
analyze the following situations and make recommendations to the management team.
Requirements
1. Division A of Dennison, Inc. has $4,950,000 in assets. Its yearly fixed costs are $650,000, and the
variable costs of its product line are $1.40 per unit. The division’s volume is currently 480,000 units.
Competitors offer a similar product, at the same quality, to retailers for $3.75 each. Dennison’s
management team wants to earn a 10% return on investment on the division’s assets.
2. The division manager of Division B received the following operating income data for the past year:
The manager of the division is surprised that the T205 product line is not profitable. The division
accountant estimates that dropping the T205 product line will decrease fixed cost of goods sold by
$83,000 and decrease fixed selling and administrative expenses by $14,000.
a. Prepare a differential analysis to show whether Division B should drop the T205 product line.
b. What is your recommendation to the manager of Division B?
3. Division C also produces two product lines. Because the division can sell all of the product it can
produce, Dennison is expanding the plant and needs to decide which product line to emphasize. To
make this decision, the division accountant assembled the following data:
b. Prepare an analysis to show which product line to emphasize.
4. Division D is considering two possible expansion plans. Plan A would expand a current product line
at a cost of $8,500,000. Expected annual net cash inflows are $1,525,000, with zero residual value at
the end of 10 years. Under Plan B, Division D would begin producing a new product at a cost of
$8,300,000. This plan is expected to generate net cash inflows of $1,070,000 per year for 10 years,
the estimated useful life of the product line. Estimated residual value for Plan B is $990,000.
Division D uses straight-line depreciation and requires an annual return of 10%.
SOLUTION
Requirement 1(a)
Revenue at market price
(480,000 units × $3.75 per unit)
$ 1,800,000
Less: Desired profit
(10% × $4,950,000 assets)
495,000
Target full product cost
$ 1,305,000
Requirement 1(b)
Current variable costs
($1.40 per unit × 480,000 units)
$ 672,000
Plus: Current fixed costs
650,000
Current full product cost
$ 1,322,000
Requirement 1(c)
Target full product cost
(calculated above)
$ 1,305,000
Less: Variable cost
($1.25 per unit × 480,000 units)
600,000
Target fixed cost
$ 705,000
Requirement 1(d)
Current variable costs per unit
($1.25 per unit × 480,000 units)
$ 600,000
Plus: Fixed costs
($650,000 + $105,000 advertising)
755,000
Full product cost
1,355,000
Plus: Desired profit
(10% × $4,950,000 assets)
495,000
Cost-plus price
Divided by volume
Cost-plus price per unit
$3.85 per unit*
Comprehensive Problem for Chapters 25-26, cont.
Requirement 2(a)
Expected decrease in revenue
$ (300,000)
Expected decrease in total variable costs ($36,000 + $62,000)
$ 98,000
Expected decrease in fixed costs ($83,000 + $14,000)
Expected decrease in total costs
Expected decrease in operating income
$ (105,000)
Requirement 2(b)
Division B should not drop the T205 product line. If the T205 product line is dropped, operating income
will decrease by $105,000. Revenues will decline by $300,000, but expenses will only decline by
$195,000.
Requirement 3(a)
Requirement 3(b)
K707
G582
(1) Units produced per hour
26
50
(2) Contribution margin per unit
$ 57
Contribution margin per machine hour [(1) × (2)]
$ 1,482
$ 1,450
Requirement 4(a)
Payback
=
Amount invested
/
Expected annual
net cash inflow
Comprehensive Problem for Chapters 25-26, cont.
Requirement 4(a), cont.
Total net cash inflows during
operating life of property
=
Average annual
net cash inflow
×
Operating life
of property
Plan A:
=
$1,525,000
×
10 years
=
$15,250,000
Plan B:
=
$1,070,000
×
10 years
=
$10,700,000
Total depreciation during
=
$8,500,000
=
$8,500,000
=
$8,300,000
$990,000
=
$7,310,000
Total net cash inflows during operating life of property
$ 15,250,000
$ 10,700,000
Less: Total depreciation during operating life of property
Total operating income during operating life
Average annual operating income from plan
Amount invested + Residual value
Comprehensive Problem for Chapters 25-26, cont.
Requirement 4(a), cont.
ARR
=
Average annual operating income
Average amount invested
Plan A:
=
$675,000
=
15.88% (rounded)
$4,250,000
Plan B:
=
$339,000
=
7.30% (rounded)
$4,645,000
10
A
B
Comprehensive Problem for Chapters 25-26, cont.
Requirement 4(b)
=
/
=
5.574
Plan A: Because 5.574 is between 5.216 and 5.650, the IRR is between 12% and 14%.
Requirement 4(c)
Plan A’s internal rate of return (IRR) is 12.33%, which is greater than the company’s 10% required rate
of return. Plan B’s internal rate of return (IRR) is 6.30%, which is less than the company’s 10% required
rate of return.
Comprehensive Problem for Chapters 25-26, cont.
Requirement 4(d)
Based on the quantitative measures calculated in Requirements 4(a) and 4(b), Division D should choose
Plan A, rather than Plan B. Plan A has a positive net present value (NPV), whereas Plan B has a
Critical Thinking
Ethical Issue 26-1
Spencer Wilkes is the marketing manager at Darby Company. Last year, Spencer recommended the
company approve a capital investment project for the addition of a new product line. Spencer’s
recommendation included predicted cash inflows for five years from the sales of the new product line.
Darby Company has been selling the new products for almost one year. The company has a policy of
conducting annual post- audits on capital investments, and Spencer is concerned about the one-year
post-audit because sales in the first year have been lower than he estimated. However, sales have been
increasing for the last couple of months, and Spencer expects that by the end of the second year, actual
sales will exceed his estimates for the first two years combined.
Spencer wants to shift some sales from the second year of the project into the first year. Doing so will
make it appear that his cash flow predictions were accurate. With accurate estimates, he will be able to
avoid a poor performance evaluation. Spencer has discussed his plan with a couple of key sales
representatives, urging them to report sales in the current month that will not be shipped until a later
month. Spencer has justified this course of action by explaining that there will be no effect on the annual
financial statements because the project year does not coincide with the fiscal year––by the time the
accounting year ends, the sales will have actually occurred.
Requirements
1. What is the fundamental ethical issue? Who are the affected parties?
2. If you were a sales representative at Darby Company, how would you respond to Spencer’s request?
Why?
3. If you were Spencer’s manager and you discovered his plan, how would you respond?
4. Are there other courses of action Spencer could take?
SOLUTION
Requirement 1
The fundamental ethical issues are integrity, competence, and credibility. Part of management
accountability is managers’ responsibility to the various stakeholders of the company, including
customers, creditors, owners, employees, suppliers, governments, and the community—all parties who
have an interest in what the company does, and how it is done.
Requirement 2
Because the sales representatives are aware of Spencer’s plan, they would not be fulfilling their ethical
responsibilities (integrity, competence, and credibility) if they complied with Spencer’s request. They
Requirement 3
Spencer’s manager has the same ethical responsibilities as those discussed in Requirement 1, and must
Requirement 4
Spencer should consider the possibility that upper management will appreciate that developing estimates
is particularly challenging for capital investments, given the longer time frames and uncertainties
Fraud Case 26-1
John Johnson is the majority stockholder in Johnson’s Landscape Company, owning 52% of the
company’s stock. John asked his accountant to prepare a capital investment analysis for the purchase of
new mowers. John used the analysis to persuade a loan officer at the local bank to loan the company
$100,000. Once the loan was secured, John used the cash to remodel his home, updating the kitchen and
bathrooms, installing new flooring, and adding a pool.
Requirements
1. Are John’s actions fraudulent? Why or why not? Does John’s percentage of ownership affect your
answer?
2. What steps could the bank take to prevent this type of activity?
SOLUTION
Requirement 1
John’s actions are fraudulent. He intended to deceive and misappropriate company funds, and he
Requirement 2
The bank should make sure that effective internal control systems are in place requiring loan officers to
Team Project 26-1
Assume you are preparing to move into a new neighborhood. You are considering renting or buying.
Divide your team into two groups.
Requirements
1. Group 1 will analyze the renting option. A suitable rental is available for $500 per month, and you
expect rent to increase by $50 per month per year. Prepare a schedule showing rent payments for the
next 15 years. To simplify the problem, assume rent is paid annually. Using 5% as the discount rate,
determine the present value of the rent payments. Round present value amounts to the nearest dollar.
2. Group 2 will analyze the buying option. A suitable purchase will require financing $105,876 at 5%.
Annual payments for 15 years will be $10,200 (annual payments assumed to simplify the problem).
Calculate the present value of the payments. Additionally, using Excel with appropriate formulas,
prepare a payment schedule with the following columns (year 1 is completed as an example):
3. After each group has prepared its schedule, meet as a full team to discuss the analyses. What is the
total cash paid out for each option? What is the present value of the cash paid out for each option?
Explain the implications of the previous two answers. Are there other factors that should be
considered before deciding to rent or buy?
SOLUTION
Requirement 1
Schedule of Rent Payments:
Year
Monthly Rent Payment
Annual Rent Payment
1
$ 500
×
12
=
$ 6,000
2
550
×
12
=
6,600
3
600
×
12
=
7,200
4
650
×
12
=
7,800
5
700
×
12
=
8,400
6
750
×
12
=
9,000
7
800
×
12
=
9,600
8
850
×
12
=
9
900
×
12
=
10
950
×
12
=
11
×
12
=
12
×
12
=
13
×
12
=
14
×
12
=
15
×
12
=
Total
Year
Annual Rent
Payment
×
PV Factor
(i = 5 %)
=
Present Value
(rounded)
PV of each year’s rent payment
1
(n = 1)
$ 6,000
×
0.952
=
$ 5,712
2
(n = 2)
6,600
×
0.907
=
5,986
3
(n = 3)
7,200
×
0.864
=
6,221
4
(n = 4)
7,800
×
0.823
=
6,419
5
(n = 5)
8,400
×
0.784
=
6,586
6
(n = 6)
9,000
×
0.746
=
6,714
7
(n = 7)
9,600
×
0.711
=
6,826
8
(n = 8)
10,200
×
0.677
=
6,905
9
(n = 9)
10,800
×
0.645
=
6,966
10
11,400
×
0.614
=
7,000
11
12,000
×
0.585
=
7,020
12
12,600
×
0.557
=
7,018
13
13,200
×
0.530
=
6,996
14
13,800
×
0.505
=
6,969
15
14,400
×
0.481
=
6,926
$ 100,264
Team Project 26-1, cont.
Requirement 2
Present value
=
each payment
=
×
=
Amount of
×
Annuity PV Factor for i = 5%, n = 15
Microsoft Excel Results:
Team Project 26-1, cont.
Requirement 2, cont.
Microsoft Excel Formulas:
Team Project 26-1, cont.
Requirement 3
Option
Total cash
paid out
Present value of
cash paid out
Rent
$ 153,000
$ 100,264 (rounded)
Buy
$ 153,000
$ 105,876
Communication Activity 26-1
In 100 words or fewer, explain the difference between NPV and IRR.
SOLUTION
If NPV is positive, one knows only that the actual return on an investment is greater than the required