Chapter 25: Differential Analysis, Profitability Analysis and Capital Budgeting Please note: GST versions of the end-of chapter questions are not appropriate for this chapter. Discussion question 1. Accountants may provide much of the quantitative information in the decision-making process outlined in this chapter. What quantitative and non-quantitative information could people working in marketing, human resource management, tourism and hospitality, and sports and recreation contribute to the decision-making process of an organisation such as a hotel chain? Marketing would provide quantitative information such as market share and could be involved in setting different prices for different packages and the costings for marketing campaigns. Non-quantitative information could include the overall corporate image that the hotel chain wanted to project, the attributes of the different sites in which the hotels are located and marketing campaigns. Human resource management would provide quantitative information such as the costings of the different staff levels and the requirements of any award rates, penalty rates and over time. Non-quantitative information would include the type of skills that are likely to be required by a hotel chain and what duties can be expected by various levels of employees. They would also provide advice on what types of staff need to be employed. Tourism and hospitality would provide quantitative information about costs of providing various services that the hotel chain provides. They may also be able to provide costs on such things as laundry, food and cleaning. Non-quantitative information would include expertise about what would attract customers and the appropriate way of organising the hotel. Sports and recreation would provide quantitative information on costs of recreation facilities within the hotel chain and quantities of supplies required for the varying types of sport and recreation available. Non-quantitative information may include information about what type or sports and recreation are currently popular, what facilities are needed and what expertise is needed in staffing to support the facilities offered. 2. This text indicates that one of the roles of managers is to make decisions about organising resources. How can a human resource manager use differential analysis in deciding the appropriate number and levels of staff in a large professional office such as a marketing, law or accounting firm? Human resource managers could use differential analysis to compare what happens to profitability when the mix of professional staff is altered within a firm. For example, if a firm replaces one high level professional with two graduates how would this affect the income generated and the costs involved in staffing. A high-level professional can usually be charged out to clients at a much higher rate than graduates but there are is only one senior employee compared to two graduates. The salary cost of two graduates is likely to be different from a senior staff member’s salary. 3. A business manager was heard to remark: ‘Quantitative analysis may be all right for some businesses but I’d rather make decisions based on my intuition and years of experience’. Do you agree? Explain. Qualitative factors often play an important role in the decision-making process. Management’s intuition and experience can be very useful in seeking effective ways of making decisions. Comments such as these usually reflect a lack of understanding of particular quantitative techniques, and their uses. This defensive attitude is a typical reaction to the suggestion that such techniques be used. However, most business decisions involve some measure of profitability or cost savings as the ultimate payoff. Consequently, as much relevant quantitative information as can be gathered within the time available also should be used to ensure that all aspects of the situation are considered. Effective decision making should be based on as many qualitative and quantitative factors as can be used by the manager. Therefore, it is difficult to agree with the manager. 4. How can the ideas of `evaluation of a make-or-buy decision’ be used in deciding whether to use existing staff expertise and existing resources in a new marketing campaign for a clothing brand name or whether to use an external professional marketing firms expertise? Other than costs, what factors should be taken into account in such a decision? If existing staff expertise and existing resources are to be used in a new marketing campaign for a clothing brand name then the fact that they cannot work on other campaigns needs to be taken into account as well. How much spare capacity the firm has needs to be considered. If the new marketing campaign can be covered from existing resources then this may bias the decision towards producing the campaign in house. If there is not much spare capacity than any reduction in work on other clients’ needs to be considered. The costs of getting consultants from outside the firm to cover the campaign need to be weighed up against whether there is existing spare capacity within the firm or what has to be given up in terms of other campaigns to cover the clothing brand name job. Other than costs the existing expertise of staff versus what can be bought in from a consultant would need to be taken into consideration. If the firm doesn’t currently have expertise in promoting new brand names then it could consider employing a consultant and getting some of its existing staff to work alongside them so that they can develop skills in this area. 5. You are responsible for managing a large department store. Explain how the section on ‘product mix decisions’ in this chapter could be relevant to deciding what departments you would include in the department store and where you might position such departments within the store. The limiting factor in a large department store is the amount of floor space available. You would firstly need to determine the contribution margin ratio per department within the store Next the contribution margin ratio per metre of floor space required by each department needs to be determined Those departments with the highest contribution margin per square metre of floor space should be positioned where they are likely to get more customers. Other factors to consider would include the fact that some products are not likely to be bought on impulse by customers but sought out by them and so these types of products, like bedding and furniture, will not need to be positioned in as prominent a position as things like cosmetics where impulse buying is possible and the contribution margin per metre of floor space is high. 6. On presenting your manager with the differential analysis of two possible uses for a piece of land that cost the company $2million your manager believes you have made a major error as you omitted the cost of the land. Explain the term ‘sunk costs‘ and why you have not made an error. Sunk costs are costs that have already been incurred and that won’t change regardless of the decision being made. As the business has paid for the land in the past it doesn’t matter what it decides to do with it in the future because this will not change the $2million that has been spent on it. Even if one of the options is to sell the land for less than $2million this does not change how much was paid for the land. 7. An accounting student said, ‘In making capital budgeting decisions it is necessary to determine the relevant cash flows from the proposal rather than the revenues and expenses based on normal accrual accounting’. Do you agree? Explain. Capital budgeting involves the evaluation of a single project, or a number of competing projects. Evaluation is based on a number of factors including profitability, return on investment, return of cash invested, timing of cash flows, etc. Techniques involving the use of cash flows are usually preferred. Capital projects usually cover a long-time span, and therefore the need for an accrual accounting approach is not necessary. Over the life of the project, cash flows are more important, and the accountant is correct. A coverage of the advantages and disadvantages of the various capital budgeting techniques could be undertaken. Timing of the cash flows is also important, and the payback method, while based on cash flows, does not consider the time value of money. Generally, the statement made is correct. While techniques other than discounted cash flow techniques may be used, they are not as appropriate. 8. Calculation of present value and determining discounted cash flows are two techniques which are the same. Do you agree. Explain your stance. Discounted cash flow techniques are used to determine the present monetary value of a future sum of money, based on an interest or discount rate. This recognises that money has a value influenced by time. Present value techniques are methods of analysing capital investment projects. The method relies on discounted cash flow techniques in arriving at the discounted cash flow figures used in the analysis. The present value method allows decisions to be made on the acceptability or otherwise of capital projects based on the present values of cash inflows and outflows. Common usage of the terms could imply that both techniques are the same thing used in evaluating capital projects. However, as indicated above, they are not strictly the same. 9. The method of depreciation used has no effect on the capital budgeting decision. Discuss. In capital budgeting decision making based on accounting techniques, such as return on investment, the depreciation method used is relevant as it is included in determining profit. In capital budgeting decisions based on cash flow analysis, depreciation could be regarded as irrelevant, since depreciation is a non-cash item. In this sense, it would not matter which method of depreciation is used. However, since depreciation is a tax deduction if entities have earned a taxable income, the amount of depreciation does influence the cash paid for tax. It therefore affects the cash flows from the capital project. Gains and losses resulting from the disposal of depreciable assets also affect the level of taxable income, and therefore cash flows, relevant to capital investment decisions, are affected. Since different depreciation methods will have different tax consequences, the cash flows will be affected by the depreciation method used for tax purposes. Therefore, the depreciation method used may or may not affect the capital decision process. 10. Comment on the following statement: ‘Cost of capital is the cost of the capital raised to pay for a particular project. If the money is borrowed from the bank, then the interest rate charged on the loan by the bank is the cost of capital.’ Cost of capital is a concept which refers to the cost of a business entity in obtaining funds in the form of debt and/or equity to fund operations and capital investment. Every source of capital, whether it be from ordinary shares, preference shares, debentures and other long term loans, or retained profits, will have a different cost to the entity – dividend and interest. Entities have different mixes of the components of capital mentioned above. The cost of capital is usually determined by finding the average cost of all sources of capital. The final figure is a weighted average cost of the capital mix. While the statement is true for a single project funded from a single source, this is not the way most entities operate. The cost of capital in this sense is extremely simplistic. Exercises Exercise 25.1 Decision-making process Mixon Marketing is considering employing another marketing consultant to help with managing its clients. The human resources manager of the firm is weighing up whether to employ a marketing graduate or a marketing manager with at least 5 years’ experience. Required (a) Using the decision-making process outlined at the beginning of this chapter describe the process the human resource manager would follow, including possible goals of employing someone, the type of information they may require on the alternatives, how they could evaluate the outcomes and make a decision. (LO1) (a) 1. Establish goals and strategies, and then define the problems. • The aim is to employ a marketing consultant to help with managing clients. • As a business maximising profit is likely to be part of the goals. • Two strategies being considered are to either employ a graduate or a manager with 5 years’ experience. • The problem is a lack of staff to manage clients. 2. Gather information on alternative courses of action. • Need costs of employing graduates and managers. • If a graduate is to be employed they need to know what work could be passed onto someone at this level to free up existing managers to manage clients’ accounts. 3. Evaluate the outcomes of each of the alternatives. • Work out which alternative is the most cost efficient. • Also need to consider which alternative is most effective for the marketing firm. 4. Make a decision, i.e. choose a course of action • Based on the above analysis decide whether to employ a graduate or an experienced manager. Exercise 25.2 Differential analysis David Booth operates Booth Bootcamp Pty Ltd. David is a graduate of a sports and a recreation course, offers customised adventures for business groups wanting to develop their staff. Two clients have approached Booth Bootcamp Pty Ltd to run an adventure in the first week of April but David can run only one adventure at a time and has to choose which alternative will maximise profit. Both adventures will require a week of David’s time at a cost of $1100 and the use of the company’s specially fitted-out SUV at a cost of $2800. One client wants a rock climbing adventure for 10 people and will pay up to $860 per person. The cost per person for food and equipment is $180 and fixed setup costs are $2500. The other client wants a white water rafting adventure for 8 people and will pay up to $900 per person. David estimates the cost per person for food and equipment is $170 and the fixed setup costs are $2500. Required (a) Using only the differential income and expenses determine which adventure David should provide. (LO2) (a) The cost of ’David’s time, $1100, and the cost of the SUV, $2800, and the fixed setup costs, $2500, do not vary between the alternatives and so can be ignored when using differential analysis as they will not influence which alternative is preferred. The total of these costs is $6400 per week. Rock climbing: 10 people ($860 – $180) = $6800. White water rafting: 8 ($900 – $170) = $5840. Rock climbing will provide a higher contribution margin and should therefore be accepted. This question highlights the importance of properly costing and pricing sport and recreation services if a business is to succeed. Exercise 25.3 Special order McKenzie Music Ltd manufactures hand held game players at a per-unit cost of the following. The company sells each player for $240 and is presently operating at 80% of its capacity of 200 000 units per year. The company has received a special order at a price of $199 per unit from an e-retailer for 1000 units per month for 1 year only. The units sold to the e-retailer would have a different cover from the company’s regular players that would add an extra $5 per unit to direct materials. McKenzie Ltd would have to purchase a new machine for $120 000 to produce the new covers. The machine will have no alternative use or residual value at the end of the year. The sales by the e-retailer would have no impact on the company’s regular sales, because of the different cover and markets involved. Required (a) Should the company accept the special order? Explain. (b) What would be the impact on profits of accepting the order. (LO2) (a) and (b) Idle capacity 0.2 (200 000) = 40 000 units per year. Special order 1 000 units per month = 12 000 units a year. Assuming fixed factory overhead costs are unavoidable. Special order: CM = $199 – (6 + 18 + 36 + 5) = $134.00 per unit Net gain = $134.00 (12 000) – $120 000 = $1 488 000 Therefore, accept the special order. Profit would be increased by $1 488 000. Exercise 25.4 Make-or-buy decision Blagojevic Ltd manufactures hard disk recorders for television and makes all parts for the machines, including the outside casing. The cost per unit of the casings at a production level of 150 000 units is as follows. The fixed factory overhead cost is direct, and half of the direct fixed overhead cost could be eliminated if the casings are purchased rather than produced. An outside supplier has offered to produce and sell to Blagojevic Ltd 150 000 casings at a price of $40 per unit. Required (a) Should the offer be accepted if there are no alternative uses for the manufacturing capacity currently being used to produce the casings? Why? (LO2) (a) Avoidable costs per unit Make Buy Difference Direct materials $ 6.00 Direct labour 8.00 Variable factory o/h 24.00 Fixed factory o/h 4.00 Difference in favour of making $42.00 $40.00 $2.00 per unit Total difference in favour of buying $2.00 (150 000) = $300 000. Exercise 25.5 Employ full time or casual staff Fo University Ltd is a private provider of diplomas in human resource management and is trying to decide whether to employ a new full-time staff member or whether to use casual staff paid by the hour to cover the increased demand for its courses. The costs of employing a new staff member to teach five classes for 3 hours each per week for 40 weeks per year and to perform associated assessment and administration tasks are shown below. For each hour of teaching, the casual staff are also paid an hour of marking and an hour of administration at a rate of $24 per hour. Required (a) Calculate whether it is more cost effective to employ a new permanent staff member or to employ casual staff on an hourly basis. What factors, other than costs, should be taken into consideration in making the final decision? (LO2) (a) Full time staff: • Avoidable costs of employing a full-time staff member are $112 000. • The $24 000 fixed costs of office space will be incurred regardless of whether full time staff are employed or not. Casual staff: • Number of teaching hours per year = 5 classes 3 hours 40 weeks = 600 hours per year. • ($48 + $24 + $24) 600 hours = $57 600. The cost of employing casual staff is more than half the cost of a full-time staff member. Factors other than costs that need to be considered are that full-time staff are: • carry out research • available to answer student queries throughout the whole week • needed to carry out course administration and organisational functions • required to develop course material and assessment • provide leadership to casual staff. Exercise 25.6 Differential analysis and joint products Gazzola Ltd produces four joint products — A, B, C and D — at a total cost of $325 000. The company can sell the products immediately at the split-off point for $100 000, $40 000, $90 000 and $85 000 respectively. Alternatively, the products also can be processed further and sold as shown below. Assume that all costs after the split-off point can be avoided for any product that is not processed beyond the split-off point. Required (a) Which products should be processed further and which should be sold at the split-off point? Show calculations to justify the decisions. (LO2) (a) Further processing (Joint costs are irrelevant): Product A B C D Revenue Cost to further process Net gain Sell at split-off Gain (Loss) from further processing $200 000 94 000 106 000 100 000 6 000 $240 000 200 000 40 000 40 000 0 $290 000 215 000 75 000 90 000 (15 000) $140 000 50 000 90 000 85 000 5 000 Sell C at split-off. Further process A and D. B doesn’t make any difference. Exercise 25.7 Product mix decisions Tscharke Ltd manufactures and sells four products — A, B, C and D. The selling prices, variable costs, and number of machine hours required to produce each product are as follows. Each of the four products is produced using a single machine. The machine has a maximum production capacity of 10 000 hours per year. Required (a) How many units of each of the four products can be produced in a year if the company produces only that product? (b) Assuming that the company can sell all units produced, which product or mix of products should be produced? (c) Assuming that the company must produce 1 000 units of Product B, what additional products should be produced? (LO2) (a) Product Units A 10 000/4 = 2 500 B 10 000/3 = 3 333 C 10 000/2 = 5 000 D 10 000/5.5 = 1 818 (b) Product CM/unit CM/machine hour Total CM A $26 $26/4 = $6.50 $16 250 B 38 38/3 = 12.67 42 229 C 27 27/2 = 13.50 67 500 D 28 28/5.5 = 5.09 9 254 Produce 5 000 units of product B for a contribution margin of $67 500. (c) Product Machine hours consumed B 1 000 3 = 3 000 machine hours C 3 500 2 = 7 000 = 10 000 The company should produce 3 500 units of C, which has the greatest CM per machine hour. Exercise 25.8 Profitability performance Violante Ltd operates four departments, and data relevant to each are as follows. Required (a) Rank the four departments based on return on assets. (b) What is the residual profit of each department, assuming that the company requires a minimum return on the average investment in assets of 14%? (LO3) (a) ROA analysis Department ’Electrical ’Furniture Kitchen Decorating Profit Av assets ROA Ranking $56 000 400 000 14% 4 $135 150 795 000 17% 3 $21 560 98 000 22% 1 $19 760 104 000 19% 2 (b) Profit Minimum return @ 14% Residual profit (loss) Ranking $56 000 56 000 0 4 $135 150 111 300 $ 23 850 1 $21 560 13 720 $7 840 2 $19 760 14 560 $5 200 3 Exercise 25.9 Return on investment analysis Phone Screens and Computer Screens are two divisions operated as investment centres of Siciliano Ltd. Management wants to know which of the two earned the highest return on investment for the year ended 30 June 2020. The details for each division for the year ended 30 June 2020 were as follows. Required (a) Calculate the return on investment for each division. (LO3) (a) Phone Screens Computer Screens Profit before tax $ 240 000 $360 000 Interest expense 40 000 80 000 Profit before interest and tax 280 000 440 000 Sales revenue 2 000 000 2 500 000 Average total assets 1 250 000 1 700 000 Profit margin 14% 17.6% Asset turnover 1.6 1.47 Return on Investment 22.4% 25.9% Exercise 25.10 Residual profit analysis Siciliano Ltd, from exercise 25.9, requires a minimum return on investment of 16%. Required (a) Calculate the residual profit for the Phone Screen and the Computer Screen divisions of Siciliano Ltd using the data from Exercise 25.9 (LO3) (a) Phone Screens Computer Screens Average assets $1 250 000 $1 700 000 Minimum return at 16% 200 000 272 000 Profit before tax and interest 280 000 440 000 Residual profit $ 80 000 $168 000 Exercise 25.11 Capital budgeting methods Chocolate Daydreams Ltd produces chocolates and is evaluating the purchase of a new machine that will cost $1 060 000 and have no residual value. Annual net cash inflows (including tax payments) for each of the next 10 years are expected to be $190 000. The average annual profit is expected to be $95 250. The company has a cost of capital of 12%. Required (a) Calculate the payback period. (b) Calculate the net present value. (c) Calculate the return on average investment. (LO3, LO6 and LO7) (a) Payback period: $1 060 000/$190 000 = 5.58 years (b) Net present value: NPV = $190 000 (5.6502) – $1 060 000 (see Table 25.2) = $1 073 538 – $1 060 000 = $13 538 (c) Return on average investment $95 250/($1 060 000/2) = 18% Exercise 25.12 Cost of capital Qin Ltd wants to determine its cost of capital to use in future capital budgeting decisions. The company’s capital structure is as follows. Required (a) Calculate the company’s cost of capital based on the information available. (LO6) (a) Source of capital Source of capital Percentage of total capital Borrowings 20% Percentage of total capital Borrowings 100 % 33.33% Preference shares Ordinary shareholders’ equity 15% (0.70) = 10.5% 11.11% Ordinary shareholders’ equity 55.55% 100.00% Cost of capital Borrowings 9% (0.3333) = 3.00% Preference shares 7% (0.1111) 12% (0.10) 12% (0.10) = 0.78% Ordinary shareholders’ equity 10% (0.5555) = 5.56% Cost of capital 9.34% Exercise 25.13 Discounted cash flows and payback period Home whitegoods manufacturer, Mozzi Ltd, is evaluating the purchase of a new machine that will cost $580 000 and be paid for in cash. The machine will be depreciated over 10 years with a resale value at the end of $60 000. Annual before-tax cash savings from better productivity are expected to be $60 000. The company has a cost of capital of 10%. Assume an income tax rate of 30%. Required (a) Determine the annual after-tax cash savings from the machine. (b) What is the payback period for the investment? (c) What is the net present value of the investment? (LO5 and LO7) (a) Annual after-tax cash savings: Net cash savings before tax $60 000 Tax adjusted cash savings ($60 000(1 – 0.30)) $42 000 Add: Depreciation tax shield (52 000 0.30) 15 600 After tax cash savings $57 600 (b) Payback period: $580 000/$57 600 = 10.1 years This is longer than the life of the machine. (c) Net present value: NPV = $57 600 (6.1446) + 60 000 (0.3855) – $580 000 = $(202 941.04) Hence this is not a good investment. Exercise 25.14 Capital budgeting decision Fizulic Filters is considering the purchase of equipment that will produce net after-tax cash savings over the useful life of the equipment of 5 years as follows. Required (a) What is the maximum price the business should pay for the equipment, assuming a discount rate of 10%? (LO6) (a) PV = 14 300 (0.9091) + 13 800 (0.8264) + 13 300 (0.7513) + 12 800 (0.6830) + 12 400 (0.6209) = $50 838.30 The maximum price the business should pay for the equipment is $50 838.30. Exercise 25.15 Capital budgeting evaluations Bradshaw Bakeries Ltd is evaluating investment alternatives for three machines and has compiled the following relevant information. The company requires a 10% minimum return on new investments. Required (a) Calculate the payback period for each investment. (b) Calculate the net present value for each investment. (c) Determine the net present value index for each investment. (d) Based on your analysis in requirements A, B and C above, which machine (if any) should be purchased? (LO6 and LO7) (a) Payback period: Machine M1: $600 000/$140 000 = 4.29 years Machine M2: $860 000/$240 000 = 3.6 years Machine M3: $560 000/$180 000 = 3.11 years (b) Net present value: Machine M1: $140 000 (4.3553) – $600 000 = $9 742 Machine M2: $240 000 (3.7908) – $860 000 = $49 792 Machine M3: $180 000 (3.1699) – $560 000 = $10 582 (c) Present value index: Machine M1: $609 472/$600 000 = 1.02 Machine M2: $909 792/$860 000 = 1.06 Machine M3: $570 582/$560 000 = 1.02 (d) Machine M3 ranks first on payback period but M2 ranks higher on net present value and present value index. Problems Problem 25.16 Make or buy decision The screens for mobile phones are currently purchased from an outside supplier at a cost of $40 each by Futuristic Phones Ltd. The company is concerned about the quality of the screens it is buying as one in a 500 is found to be faulty within a year of using them to make mobile phones. If the company decides to manufacture the screens, it would have to purchase new machines at a cost of $9 000 000. The new machinery would enable the company to produce its annual requirement of 600 000 screens and would have to be scrapped at the end of a 5-year useful life. The following costs per unit would be required to produce the screens (excluding the cost of the new machinery). The allocated fixed factory overhead would be a reassignment of existing costs based on estimated sales volume. Required (a) Should the company make or buy the screens for the mobile phones? Explain why. (LO2) (a) Relevant costs to manufacture: Direct materials $10 Direct labour 6 Variable factory overhead 12 Depreciation (1) 3 $31 Cost of purchasing is $40 per screen so the company should consider making the screens particularly if it believes that it can achieve a higher level of reliability by manufacturing them itself. (1) Depreciation: ($9 000 000/5)/600 000 = $3 Problem 25.17 Make or buy decision Butterworth Boats Ltd produces boats for water skiing. The motors for the boats are currently purchased from an outside supplier at a cost of $4000 each. Some factory space that Butterworth Boats Ltd currently rents to another company for storage purposes could be used to produce the motors. The annual rental revenue from the factory space is now $1 500 000. If the company decides to manufacture the motors, it will have to purchase new machines at a cost of $60 000 000. The new machinery will enable the company to produce its annual requirement of 60 000 motors and will have to be scrapped at the end of a 5-year useful life. The following costs per unit will be required to produce the motors (excluding the cost of the new machinery). The direct fixed factory overhead will be required to start producing the motors, and the allocated fixed factory overhead will be a reassignment of existing costs based on estimated sales volume. Required (a) Should the company make or buy the motors for the boats? Explain why. (LO2) (a) Relevant costs to manufacture: Direct labour $500 Direct materials 1 600 Variable factory overhead 800 Fixed factory overhead 500 Depreciation (1) 200 $3 600 Number of units 60 000 $216 000 000 Opportunity cost-rental 1 500 000 Cost to manufacture $217 500 000 Cost outside purchase ($4 000 60 000) 240 000 000 Cost in favour of manufacture $22 500 000 (1) Depreciation: ($60 000 000/5)/60 000 = $200 The company should make the motors at a cost of $217 500 000. To purchase outside at $240 000 000 would cost $22 500 000 more. Problem 25.18 Differential analysis and joint products Hentschke Ltd produces two products, X and Y, at a joint cost of $480 000. The company can sell 620 000 units of product X for $30 per unit, or the units can be processed further at a cost of $160 000 to produce 16 000 units of product A, 20 000 units of product B, and 25 000 units of product C. The unit selling prices for products A, B and C are $45, $30 and $40 respectively. The company can sell 24 000 units of product Y or they can be processed further to produce 10 000 units of product D and 15 000 units of product E. The additional processing to produce products D and E will cost $120 000. The per-unit selling prices are product Y $60, product D $100, and product E $60. Required (a) Which of the products should be sold at the split-off point and which should be processed further? (LO2) (a) Product Sales value at split-off Separable cost Sales value after further processing Net gain (loss) X $18 600 000 $160 000 A $720 000 (1) B 600 000 (2) C 1 000 000 (3) $2 320 000 $(164 440 000) (6) Y $1 440 000 $120 000 D $600 000 (4) E 900 000 (5) $1 500 000 $(60 000) (7) Product x and product y should be sold at split-off point. Note: Joint costs are irrelevant in making this decision. 1. 16 000 units @ $45 = $720 000 2. 20 000 units @ $30 = $600 000 3. 25 000 units @ $40 = $1 000 000 4. 10 000 units @ $100 = $600 000 5. 15 000 units @ $60 = $900 000 6 X net loss $2 320 000 – $18 600 000 – $160 000 = $ (16440000) 7 Y net loss $1 500 000 – $1 440 000 – $120 000 = $(60 000) Problem 25.19 Cash flows in a capital budgeting decision Kellaway Ltd is considering installing a computer controlled production line to significantly reduce its manufacturing costs. The annual after-tax cost savings are expected to be $460 000, and the production line will cost $1 800 000. Its useful life will be 5 years and its resale value at that time is estimated at $200 000, net of tax effects. However, a major upgrade costing $80 000 will be required at the end of the third year. The company’s cost of capital is 12%. Required (a) Using the net present value method, determine whether the computer controlled system should be purchased. Justify your conclusion. (LO5) (a) Year Expected net cash inflow Present value factor Present value cash flows 1 $460 000 0.8929 (Table 25.1) $410 734 2 460 000 0.7972 (Table 25.1) 366 712 3 380 000 0.7118 (Table 25.1) 270 484 4 460 000 0.6355 (Table 25.1) 292 330 5 660 000 0.5674 (Table 25.1) 374 484 Present value of cash flows 1 714 744 Initial investment $1 800 000 Net present value $(85 256) With a negative NPV of $(85 256) the computer controlled system should not be purchased. Problem 25.20 Special order Abeer Kalaba is the owner of a Champion Chips Pty Ltd, which produces communication chips for mobile phones. The company has two production lines, one for a standard communication chip that is also produced by several competitors and one for custom communication chips built to customer specifications. Financial results of the company for the previous year are as shown below. The building has been leased for 10 years at $22 000 per year. The rent, electricity, and other fixed manufacturing costs are allocated based on the amount of floor space occupied by each production line. Depreciation is specifically allocated to the machines used on each line. Abeer recently received an order from one of his best customers to produce 5000 custom-built communication chips and is trying to decide whether he should accept the order. His company is currently working at full capacity and is required by contract to produce all specialty orders already received. He could reduce the production of standard chips by a third for the next year to accept the new special order. The customer has offered to pay $24.00 per chip with the new order. The direct costs will be $16 per chip, and Abeer will have to buy a new tool costing $20 000 to produce the custom-built chips. The tool will be scrapped when this order has been delivered. Required (a) Should Abeer accept the order? In your answer, identify the unavoidable costs, differential revenues and costs, and opportunity costs. (LO2) (a) CM special order ($24.00 – $16.00) $8.00 Number of units special order 5 000 Total CM special order $40 000 Less cost of new tool 20 000 Net contribution special order 20 000 Less opportunity cost: CM foregone standard communication chips ($110 000 – 28 800 – 32 500)/3 16 233 Net gain on special order $3 767 Unavoidable costs which must still be paid include: rent, depreciation, electricity, other fixed manufacturing costs. Abeer should accept the order. Problem 25.21 Make or buy decision SpeedBurn Ltd manufactures DVD burners and is considering expanding production. A distributor has asked the company to produce a special order of 3000 DVD burners. The burners will be sold using a different brand name and will not influence SpeedBurn Ltd’s current sales. The plant is currently producing 28 000 units per year. Total capacity is 30 000 units per year, so the company will have to reduce the production of units sold under its own brand name by 1000 units if the special order is accepted. The company’s income statement for the previous financial year ended 30 June 2020 is summarised below. The company’s variable factory overhead is $30 per unit, and the variable selling and distribution expenses are $10 per unit. The administrative expenses are completely fixed and will increase by $10 000 if the special order is accepted. There will be no variable selling and distribution expenses associated with the special order, and variable factory overhead per unit will remain constant. The company’s direct labour cost per unit for the special order will increase 5%, and direct materials cost per unit for the special order will decrease 5%. Fixed factory overhead and fixed selling and distribution expenses will not change. Required (a) If the distributor has offered to pay $110 per unit for the special order, should the company accept the offer? Show calculations to support your conclusion. (LO2) (a) CM special order: Selling price $110.00 Variable costs: Direct materials $45 – 2.25 = 42.75 Direct labour 20 + 1 = 21 Variable overhead 30 = 30 93.75 CM per unit $16.25 Units in special order 3 000 Total CM special order $48 750 Less: Increased admin expense 10 000 $38 750 Less: Opportunity cost CM foregone 1 000 ($140 – 45 – 20 – 30 – 10) 35 000 Increase in profit if the order is accepted $3 750 Since overall profits will be increased by $3 750, the special order should be accepted. Problem 25.22 Make or buy decision Retelsdorf Ltd manufactures tablet screens. Recently, the company has been producing slightly below 75% of capacity and management is considering how to use currently unused plant capacity. One proposal is to produce a component used in several of the company’s products that is currently being purchased from a supplier for $80 per unit. The company uses 20 000 of these components per year. The estimated cost of producing each component is as follows. Factory overhead is applied to all products on the basis of direct labour hours. The expected capacity for the year is 300 000 direct labour hours. Fixed factory overhead for the year is budgeted at $3 600 000. Required (a) Should the company continue to purchase the component or produce it internally? What is the total cost differential involved? (LO2) (a) Relevant costs to manufacture: Direct materials $28.00 Direct labour ($30 1) 30.00 Variable overhead (1) ($18.00 1) 18.00 $76.00 Cost to purchase 80.00 Differential against manufacturing $4.00 (1) Overhead allocation rate is $30/1 = $30 per DLH Total estimated overhead $30 300 000 = $9 000 000 Budgeted fixed overhead 3 600 000 Budgeted variable overhead $5 400 000 Variable overhead per direct labour hour ($5 400 000/300 000) = $18 per direct labour hour. The company should manufacture the component as the savings will be (20 000 $4.00) $80 000 Plant capacity 300 000 DLH Spare capacity = 300 000 DLH 25% = 75 000 hrs DLHs to manufacture 20 000 components at 1 DLH’ per component = 20 000 DLH. Problem 25.23 Joint product costs Green Gnome Ltd produces garden fertilisers. The fertilisers are made into pellets which are sold in 5-kilogram packets. The fertilisers are based on a basic mix of minerals and nutrients that make up 80% of each packet. To this basic mix are added special nutrients and minerals for special purpose fertilisers such as the lawn mix, the rose mix, the Australian native plant mix as well as a general mix, which is made up entirely of the basic mix. Green Gnome Ltd can make up to 100 tonnes of the basic mix each year at a cost of $200 000 and it needs to decide how to divide this between its four product lines. To some extent this is determined by how many 5-kilogram packets the company can sell of each product line. The following data is relevant. Required (a) Determine the most profitable mix of products given the amount of basic mix that can be produced each year and the estimated market for each product. (LO2) (a) Product Cost per 5kg packet Selling price per 5kg packet Contribution margin/packet General Mix 5kg $2 = $10 $20 $10 Lawn Mix 4kg $2 + $3 = $11 $26 $15 Rose Mix 4kg $2 + $4 = $12 $30 $18 Australian Native Mix 4kg $2 + $3 = $11 $20 $9 Cost of Basic Mix = $200 000 / 200 000kg = $2/kg The order of profitability of products is: Rose Mix, Lawn Mix, General Mix and Australian Native Mix. The most profitable use of the basic mix is to maximise the sales of products in the above order. Rose Mix 8 000 packets 4kg = 32 000 kgs Lawn Mix 12 000 packets 4kg = 48 000 kgs General Mix 15 000 packets 5kg = 75 000 kgs 155 000kgs Australian Native Mix (200 000 – 155 000)/4 = 11 250 packets Contribution margin: Rose Mix 8 000 packets $18 = 144 000 Lawn Mix 12 000 packets $15 = 180 000 General Mix 15 000 packets $10 = 150 000 Australian Mix 11 250 packets $9 = 101 250 Total Contribution Margin $575 250 Problem 25.24 Profitability analysis Truong Trucking Co. Ltd operates a freight service and is planning the next year’s operation. The company’s assets are estimated to be $30 400 000 at the beginning of the financial year and $30 700 000 at the 30 June end of financial year. The company expects that it will deliver 25 000 000 kilograms of freight during the year. The variable costs per kilogram averages $2, and total fixed costs are budgeted at $8 000 000. Required (a) What price should the company charge to deliver a kilogram of freight to earn an 18% before-tax return on the estimated investment in assets? (b) Calculate the approximate profit margin earned and turnover of assets expected for the company’s next financial year. The company will not have any interest expense. Use the price from requirement A. (c) If the company can reduce the variable costs needed to deliver a package by $0.20, what will be the effect on the return on the estimated investment in operating assets? (d) If the company actually delivers 27 500 000 kilograms of freight at the price determined in requirement A, what is the company’s rate of return on its budgeted average investment in assets? (e) Refer to requirement A. If the company requires a return on investment of 14%, how much residual profit can be expected for the next financial year? (LO3) (a) Average investment: ($30 400 000 + $30 700 000)/2 = $30 550 000 ROI = Profit before income tax and interest/total assets ROI * Total Assets= Income (Price * Qty sold) – Variable costs-Fixed costs Rearrange to: Price * Qty sold= Variable costs + Fixed costs + ROI*Total Assets Let x = Delivery charge per kilogram 25 000 000 x = 2(25 000 000) + 8 000 000 + 0.18 (30 550 000) 25 000 000 x = 50 000 000 + 8 000 000 + 5 499 000 x = $2.54 (b) Profit margin = = = 8.7% Asset turnover = (208%) (c) ROI (from B) ROI (C) = (rounded) There would be an increase of 16% in ROI (d) ROI = (rounded) (e) Operating profit (from B) $5 500 000 Minimum acceptable return (1) 4 270 000 Residual profit $1 230 000 (1) 0.14 ($30 500 000) Problem 25.25 Return on investment Pierre Ltd is a catering business owned by well-known chef Pierre Boudin. It is organised as two divisions, each with its own manager. There is the Shop Division, managed by Louise Lane, that runs retail outlets in a number of shopping centres throughout the city, and the Catering Division, managed by Brett Spark, that provides food for corporate functions, parties and public events. Pierre is considering going into semi-retirement and wants one of the managers to run the overall business. Pierre has decided to assess the return on investment of the two divisions and to hand over the management of Pierre Ltd to whichever manager runs the division with the higher return on investment. Relevant information for the divisions is as follows. Required (a) Which manager should Pierre appoint to take over management of the company? (LO3) (a) Shop Division Catering Division Sales revenue $2 400 000 $1 800 000 Selling & administrative expenses 1 600 000 1 200 000 Interest expense 60 000 80 000 Profit before tax 740 000 520 000 Tax expense 220 000 160 000 Profit $520 000 $360 000 Average total assets $2 200 000 $1 600 000 Profit before tax and interest 800 000 600 000 Profit margin 33% 33% Asset turnover 1.1 1.125 ROI 36.7% 37.5% As the manager of the Catering Division Brett Spark would be given the job of managing the overall company for Pierre based on his division achieving the higher ROI. Problem 25.26 Capital budgeting evaluations Wilde Marketing Partnership, marketing consultants, is considering a project requiring considerable expansion of its current operations. This will require the purchase of equipment at a cost of $600 000. The new equipment will have a 10-year life and then have no resale value. The new project would produce a net increase in cash inflows of $120 000 each year. The company has a cost of capital of 12%. Required (a) What is the payback period for the equipment? (b) Calculate the net present value of the equipment. (c) What is the net present value index for the equipment? (d) Should the firm purchase the equipment? Why or why not? (LO6) (a) Payback period: $600 000/$120 000 = 5 years (b) Net present value: NPV = 5.6502 ($120 000) – $600 000 = $78 024 (c) Net present value index: (d) Yes, the firm should purchase the machine as all measures are adequate. 1. The payback period of 5 years appear to be satisfactory given the 10 year life of the project. 2. The net present value is greater than zero. 3. The net present value index is greater than one. Problem 25.27 Capital budgeting evaluations Medrano Ltd is a furniture manufacturer. The company is looking at three alternative specialised machines to replace its existing production line. Data for each of the machines are as follows. The company’s cost of capital is 12%. Required (a) Rank the three machines using each of the following methods: i. net present value method ii. net present value index iii. payback period iv. return on average investment. (b) Comment on the rankings under the four methods of evaluating the machines and explain which method would provide the best result for the firm and why payback period or return on average investment might be preferred by Medrano Ltd. (LO6 and LO7) (a) i. Net present value method: Furniture Fixer = 400 000 5.6502 – 1 500 000 = $760 080 2 Framing Furniture = 320 000 6.1944 – 1 200 000 = $782 208 1 Carpenter’s Mate = 320 000 4.9676 – 1 100 000 = $489 632 3 ii. Net present value index: Furniture Fixer = 400 000 5.6502 / 1 500 000 = 1.51 2 Framing Furniture = 320 000 6.1944 / 1 200 000 = 1.65 1 Carpenter’s Mate = 320 000 4.9676 / 1 100 000 = 1.45 3 iii. Payback period: Furniture Fixer = 1 500 000 / 400 000 = 3.75 years 2 Framing Furniture = 1 200 000 / 320 000 = 3.75 years 2 Carpenter’s Mate = 1 100 000 / 320 000 = 3.44 years 1 iv. Return on average investment: Furniture Fixer = 590 000 / 1 500 000 = 39.3% 3 Framing Furniture = 510 000 / 1 200 000 = 42.5% 2 Carpenter’s Mate = 520 000 / 1 100 000 = 47.3% 1 (b) The net present value method and the net present value index both favour the Framing Furniture machine. Since these methods both take into account all the cash flows and also take into account the time value of money they are regarded as providing the best information for decision making. Both payback period and return on average investment favour the Carpenter’s Mate machine as this costs the least and gives the same estimated annual net cash inflow increase as the Framing Furniture. A quick payback may be preferred by management that has a more short term view of the company. Problem 25.28 Capital expenditure decision Evans Engineering is an engineering consulting firm specialising in the installation of electronic communications systems. The company is considering the purchase of testing equipment that will be used on jobs. The equipment will cost $1 740 000 and will have no residual value at the end of its 6-year life. The firm’s accountant projects revenue and expenses with the operation of the equipment that are equal to the cash inflows and cash outflows associated with it, except for depreciation. A summary of the cash flows expected from the equipment (without considering taxes) is as follows. Assume the company’s cost of capital is 12% and its expected tax rate is 30%. Required (a) Calculate the return on average investment for the equipment. (b) Determine the annual net cash inflows (after tax) expected from the operation of the equipment. (c) Calculate the net present value for the investment. (d) Determine the net present value index for the investment. (e) Should the testing equipment be purchased? Explain why. (LO6 and LO7) (a) Year Net cash Profit Tax Profit inflow before Depreciation before tax @ 30% after tax depreciation 1 $400 000 $290 000 $110 000 $33 000 $ 77 000 2 410 000 290 000 120 000 36 000 84 000 3 370 000 290 000 80 000 24 000 56 000 4 410 000 290 000 120 000 36 000 84 000 5 430 000 290 000 140 000 42 000 98 000 6 390 000 290 000 100 000 30 000 70 000 Total profit after tax 469 000 Average profit after tax $ 78 167 Return on average investment = (b) Year Profit after tax Add back depreciation Net cash flows after tax 1 $77 000 $290 000 $367 000 2 84 000 290 000 374 000 3 56 000 290 000 346 000 4 84 000 290 000 374 000 5 98 000 290 000 388 000 6 70 000 290 000 360 000 (c) Year Expected net cash inflows PV factor @ 12% PV cash flows (rounded) 1 $367 000 0.8929 $327 694 2 374 000 0.7972 298 153 3 346 000 0.7118 246 283 4 374 000 0.6355 237 677 5 388 000 0.5674 220 151 6 360 000 0.5066 182 376 Present value cash flows 1 512 334 Initial investment (1 740 000) Net present value $(227 666) (d) Net present value index (e) No. NPV is negative. Net present value index greater less than one. Problem 25.29 Alternative capital budgeting methods Flasher Freight Ltd is considering three investments for the new year. The company has a cost of capital of 12%. Summary information concerning the net cash inflows of the investments and their initial costs is shown below. Required (a) Calculate the payback period for each investment. (b) What is the net present value for each investment? (c) What is the net present value index for each investment? (d) Should any of these investments be accepted? If so, in what order should they be accepted, given limited available funds? (LO6 and LO7) (a) Payback period: Investment A B C = 4.14 years = 3.36 years = 5.20 years (b) NPV: Project: A: 4.9676 ($48 000) – $198 493 = $39 951.80 B: 3.6048 ($36 000) – $120 875 = $8 897.80 C: 6.1944 ($24 000) – $124 730 = $23 935.60 (c) Present Value Index: Project: A: $238 444.80/$198 493 = 1.20 B: $129 772.80/$120 875 = 1.07 C: $148 665.60/$124 730 = 1.19 (d) Project A should be accepted, since it has the highest positive NPV and marginally the highest PV Index. If more than one investment is affordable then they would be accepted in the order Project A, Project C then Project B. Problem 25.30 Comprehensive example Ben’s Big BBQs Pty Ltd makes large barbecues and sells them through specialist barbecue stores and outdoor furniture stores. Ben’s Big BBQs Pty Ltd has been approached by a national department store, DMart, to produce 2000 barbecues per year for the next 3 years on their behalf. Ben’s Big BBQs Pty Ltd has the capacity to produce 20 000 barbecues per year but is currently making and selling only 15 000 under its own brand name at a wholesale price of $300 per barbecue. DMart wants the barbecues made for them to have Dmart’s brand name on them and to have special features not on the standard model produced by Ben’s Big BBQs Pty Ltd. DMart is prepared to pay only $200 per barbecue. If Ben’s Big BBQs Pty Ltd takes the order it will need a special machine that will cost $200 000 and last only the 3 years of the deal with DMart — it will then be scrapped for $20 000. This machine will be depreciated using straight-line depreciation. Currently the variable cost per barbecue is $150, and this will be the same variable cost for the DMart barbecues. Fixed costs for Ben’s Big BBQs Pty Ltd are $1 200 000 per year and this will not change if the special order is accepted, except for the depreciation costs of the new machine. Ben’s Big BBQs Pty Ltd is taxed at the company rate of 30%. The capital structure of Ben’s Big BBQs Pty Ltd is as follows. Required (a) Calculate the annual increase in cash flows if the special order for DMart is accepted. Assume all sales and variable expenses are eventually received and paid in cash. (b) Calculate the weighted average cost of capital for Ben’s Big BBQs. (c) Calculate the net present value of the new machine that Ben’s Big BBQs will have to purchase if the special order for DMart is accepted. (d) Calculate the net present value index for the new machine. (e) Calculate the payback period for the new machine. (f) Calculate the return on average investment for the new machine. (g) Comment on whether the Ben’s Big BBQs should purchase the new machine based on your calculations above and suggest factors other than financial ones that should be taken into consideration when making the final decision about whether to accept the special order from DMart or not. (LO6 and LO7) (a) Annual increase in cash flows if the special order for DMart is accepted. Without order With DMart order Differential Analysis Sales 15 000 @ $300 $4 500 000 $4 500 000 2 000 @ $200 400 000 $400 000 Variable expenses 15 000 @ $150 (2 250 000) (2 250 000) 2 000 @ $150 (300 000) (300 000) Fixed expenses – Regular (1 200 000) (1 200 000) – Depreciation ________ (60 000) (60 000) Profit before tax 1 050 000 1 090 000 40 000 Tax (12 000) Profit $ 28 000 New machine depreciated using straight line over 3 years with a scrap value of $20 000. ($200 000 – 20 000)/3 = $60 000 depreciation per year. Over the next 3 years all sales and variable expenses are eventually received and paid in cash. $400 000 – $300 000 – ($40 000 30%) = $88 000 annual increase in cash flows if the special order for DMart is accepted. (b) Borrowings 40% 12% 4.8% Preference shares 20% 18% 3.6% Ordinary shares 40% 19% 7.6% Weighted average cost of capital 16%.0 (c) $88 000 2.2459 197 639.20 $20 000 0.6407 12 814.00 210 453.20 Initial outlay 200 000.00 NPV $ 10 453.20 (d) NPV Index = 210 453.20/200 000 = 1.05 (e) Payback period = $200 000/88 000 = 2.27 years (f) Return on average investment: Average investment = ($200 000 + 20 000)/2 = $110 000 Average profit = $28 000 (from A. above) Return on average investment = $28 000/110 000 = 25.5% (g) The above calculations would suggest that on quantitative grounds the special order for DMart should be accepted and the new machine purchased. Qualitative factors that need to be taken into account would be whether Ben’s Big BBQs branded products’ sales are likely to be affected by DMart selling a similar product. If it becomes known that DMart are effectively selling the same product at a lower price, then this may affect the reputation of Ben’s Big BBQs. Case studies Decision analysis Make or buy plastic casings Fonus Ltd produces mobile phones. The machine used to manufacture the plastic casings for the phones is increasingly producing twisted and deformed casings and is in urgent need of replacement. You are the accountant for Fonus Ltd, and have investigated the possibility of either replacing the machine with an updated version or buying in the casings from an outside supplier that produces plastic parts for other manufacturers. You have summarised your findings thus far. Make the plastic casings. The new machine required to manufacture the plastic casings costs $720 000 and has a useful life of 3 years. The equipment will have no final resale value. The machine can manufacture all the different-shaped casings needed for Fonus Ltd’s range of mobile phones by simply changing the mould that is used. The cost of the various plastic casings is estimated to be the same regardless of the shape or size. Each year, Fonus Ltd makes 300 000 mobile phones that all require one plastic casing each. The company’s costs incurred in producing a plastic casing with the old machine were as follows. Included in the fixed factory overhead costs is depreciation of the old plastic casings moulding machine of $0.75 per unit. The new equipment will be more efficient and will reduce direct labour costs and variable overhead cost by 30%. The direct materials cost will be reduced by $0.20 per unit but fixed factory overhead will not change, except for the depreciation, if the new equipment is purchased. The new plastic casings moulding machine has a capacity of 500 000 casings per year and Fonus Ltd has no other use for the space involved. Buy the plastic casings. You have found a supplier who is prepared to produce the plastic casings for the company for $7.60 each. The supplier will sign a contract fixing that price for the next 3 years. Required (a) Assuming that Fonus Ltd will continue to produce 300 000 phones each year, should the plastic casings be made by Fonus or bought? (b) If Fonus Ltd produces 500 000 phones each year, would your decision be different? If so, why? (c) If the space involved in the production of the plastic casings can be leased for 3 years at an annual rent of $100 000, how would this affect your decision? (d) What non-financial considerations should be taken into account in the decision to make or buy the plastic casings? (a) Using differential analysis: Relevant costs of making a casing: Direct materials (4.20 – 0.20) $4.00 Direct labour (3.00 0.7) 2.10 Variable overhead (1.20 0.7) 0.84 Depreciation (720 000/3) / 300 000 0.80 Total $7.74 Cost of buying a casing $7.60 Casings required 300 000 Annual cost if purchased $2 280 000 Cost of savings – buying (300 000 0.14) $42 000 With a cost saving of buying of only $0.14 per casing (or less than 2%), it could be argued that it may be better to continue to make the casings so as to maintain control of the quality of production and to ensure a reliable supply. (b) Relevant costs of making a casing: Variable costs (4.00 + 2.10 + 0.84) $6.94 Depreciation (720 000/3) / 500 000 0.48 Total $7.42 Casings required 500 000 Annual cost – making $3 710 000 Annual cost – buying, $7.60 (500 000) $3 800 000 Cost of savings – making $90 000 As well as the benefits mentioned in part A of producing the casings in-house, if 500 000 casings were required there would also be a cost advantage to producing them in house. (c) As the possible rent income of $100 000 which will be available if the casings are bought is $10 000 p.a. more than the extra cost of buying them, if a maximum number of 500 000 casings are needed, then it may be worth buying them. Again the $10 000 p.a. extra may not be enough to lose control of production quality and reliability of supply. If Fonus Ltd only needed 300 000 casings, then the advantage would be $142 000 and it would be worth buying the casings from the external supplier. (d) Non-financial factors that should be considered are: quality control, reliability of deliveries from the outside source, and alternative uses of production space and facilities. Communication and leadership Capital budgeting decisions The Hyupp Group runs five-star hotels in most major cities. The group is looking to build a six-star luxury resort in South-East Asia on a remote island. The chief financial officer prefers to use the payback method to evaluate the new investment. The senior accountant believes the return on average investment would be a better approach as it uses the accounting records of the firm. The assistant accountant paid attention in her lectures on discounted cash flow during her recent time at university and believes that is the superior method for analysing capital budgeting decisions. The three agree to make notes on their preferred method and then compare the three approaches. Required (a) In groups of three, each person takes on the role of one of the friends and writes a page on the pros and cons of the method chosen by that character. Try to convince the other two people in the group that your method would be the most appropriate in this instance. (a) Students should be encouraged to undertake more extensive research than just the text. Some of the advantages and disadvantages that students could list for each of the three capital budgeting methods include: Payback period method: the payback period for the new 6 star luxury hotel will be the cost of the hotel divided by estimates of increased sales less any reductions in costs. The advantages are that this method has been used in the past so it will be generally understood, it is simple to calculate and easy to understand. It encourages investment in assets that have a shorter payback and therefore frees up cash flow for other investments and also reduces the risk of an investment. The disadvantages are that it ignores the time value of money and the total life of the asset, only focussing on the earlier years of the payback period. This may lead to investments that are actually less profitable over their entire life. Return on average investment: this is calculated by dividing the average increase in profit from the new luxury hotel by the average investment or cost of the hotel over its useful life. The advantage, as stated by the accountant, is that is uses the accounting records of the business as a basis for the decision. It uses a measure of profit rather than of cash flow. This method is easy to use and to understand. The advantage of this method over the payback method is that it does consider the profitability of the new asset over its whole life and not just the payback period. The disadvantage is that it does not consider the time value of money. This means that it treats profit received at the end of the asset’s life as being equal to profit received in the first year. It also ignores how the asset is financed. Discounted cash flow: under this method the net cash flows from investing in the new luxury hotel are estimated over its useful life. This is then discounted back to the present value and compared to the cost of the hotel. If the present value of the cash flows exceed the outlay cost, then the investment is considered worthwhile. The advantage of this method is that it does consider the time value of money. The disadvantage is that many people find it difficult to understand. A difficulty common to all of these methods is estimating the increase in income and reductions in expenses and the changes in cash flows that could occur as a result of the investment in a six star luxury resort in South-East Asia. Ethics and governance Conflict of interests Creekside Cement Ltd is considering purchasing a new cement-mixing truck. The supplier of trucks, Sea Meant Trucks Ltd, sells its trucks for $350 000 cash or customers can purchase them by paying annual instalments of $60 000 per year over 10 years at a discount rate of 10%. Di Shonest is the chief financial officer for Creekside Cement Ltd and her husband, Barry, works for the Loans & Savings Bank. Barry earns a 0.1% commission on any loans he makes. Barry has told Di that he can organise a loan for Creekside Cement Ltd to purchase the cement mixing truck with repayments of only $52 000 per year. This loan will be over 15 years with a discount rate of 12%. Creekside Cement Ltd is experiencing some cash flow problems at the moment so it cannot afford to pay cash for a new cement truck, though it could afford annual payments of $60 000. Di has done all the relevant calculations and recommends to the board that Creekside Cement Ltd should borrow the $350 000 from the Loans & Savings Bank on the terms Barry suggested. Required (a) Calculate the present value of the three finance options available to Creekside Cement Ltd. (b) Who are the stakeholders involved in the machine purchase decision? (c) What are the ethical issues, if any, involved? (a) PV of purchasing the truck now is $350 000. PV of finance from truck company $60 000 6.1446 = $368 676 PV of Loans & Savings Bank loan $52 000 6.8109 = $354 166.80 (b) The stakeholders involved in the machine purchase decision are Creekside Cement Ltd, Di Shonest and her husband, Barry. (c) The ethical issue is that Di’s husband will earn a commission based on her decision and she should declare this. As it turns outs the Loans & Savings Bank loan is the best option for Creekside Cement Ltd given that it can’t afford the $350 000 now. However, Di should still declare Barry’s financial interest in the decision so that she cannot be accused later on of choosing this option for personal gain. Financial analysis Refer to the latest financial report of JB Hi-Fi Limited on its website, www.jbhifi.com.au, and answer the following questions. 1. A perusal of the report clearly indicates that JB Hi-Fi Ltd does make capital budgeting decisions of some magnitude. What evidence is there of these activities? 2. What method of capital budgeting would you expect JB Hi-Fi Ltd to use? Explain your answer. 3. Does JB Hi-Fi Ltd fund capital projects through special borrowings or through equity? Explain your answer. 4. What does the investing activity section of the cash flow statement tell us about capital budgeting for the previous 12 months? 1. There is evidence of capital budgeting decisions in the notes and in the cash flow statement (cash flows from investing activities). There is evidence of both purchase of property, plant and equipment and sale of property Note 9 to the accounts gives more details. 2. In the notes a reference is made to ‘cost of capital’. This would suggest the use of discounted cash flow techniques of capital budgeting. From note 10 ‘The discount rate is derived from the Group’s weighted average cost of capital, adjusted for varying risk profiles.‘ From the Chairman and Chief Executive Officer’s report, ‘This considered approach to new store locations, means new stores should continue to deliver comfortably in excess of their cost of capital.‘ 3. Students will need to analyse the debt and equity sections of the balance sheet and the cash flows from financing. For example, in 2016 JB Hi-Fi Ltd reduced its borrowings significantly and issued more shares (equity) and appears to have finance property, plant and equipment purchases using cash flows from operations and issuing shares. 4. The investing section of the cash flow statement will give some indication of investments that met JB Hi-Fi Ltd’s capital budgeting requirements for the previous 12 months. Solution Manual for Accounting John Hoggett, John Medlin, Claire Beattie, Keryn Chalmers, Andreas Hellmann, Jodie Maxfield 9780730344568
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