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Chapter 26: Q2RQ (page 1463)
Describe the capital budgeting process.
Answer
The capital budgeting process is linked with the allocation of funds into the capital assets for the growth of the business.
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What is the decision rule for ARR?
Darren Dillard, majority stockholder and president of Dillard, Inc., is working with his top managers on future plans for the company. As the company鈥檚 managerial accountant, you鈥檝e been asked to analyze the following situations and make recommendations to the management team.
Requirements
1. Division A of Dillard, Inc. has \(5,250,000 in assets. Its yearly fixed costs are \)557,000, and the variable costs of its product line are \(1.90 per unit. The division鈥檚 volume is currently 500,000 units. Competitors offer a similar product, at the same quality, to retailers for \)4.25 each. Dillard鈥檚 management team wants to earn a 12% return on investment on the division鈥檚 assets.
a. What is Division A鈥檚 target full product cost?
b. Given the division鈥檚 current costs, will Division A be able to achieve its target profit?
c. Assume Division A has identified ways to cut its variable costs to \(1.75 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the division to achieve its target profit?
d. Division A is considering an aggressive advertising campaign strategy to differentiate its product from its competitors. The division does not expect volume to be affected, but it hopes to gain more control over pricing. If Division A has to spend \)120,000 next year to advertise and its variable costs continue to be \(1.75 per unit, what will its cost-plus price be? Do you think Division A will be able to sell its product at the cost-plus price? Why or why not?
2. The division manager of Division B received the following operating income data for the past year:
| DIVISION B OF DILLARD, INC. Income Statement For the Year Ended December 31, 2018 | |||
| Product Line | Total | ||
| T205 | B179 | ||
Net sales revenue | \)310,000 | \(360,000 | \)670,000 |
Cost of goods sold: | |||
Variable | 31,000 | 44,000 | 75,000 |
Fixed | 275,000 | 67,000 | 342,000 |
The total cost of goods sold | 306,000 | 111,000 | 417,000 |
Gross profit | 4,000 | 249,000 | 253,000 |
Selling and administrative expenses: | |||
Variable | 68,000 | 80,000 | 148,000 |
Fixed | 47,000 | 27,000 | 74,000 |
Total selling and administrative expenses | 115,000 | 107,000 | 222,000 |
Operating income (loss) | \((111,000) | \)142,000 | \(31,000 |
The manager of the division is surprised that the T205 product line is not profitable. The division accountant estimates that dropping the T205 product line will decrease fixed cost of goods sold by \)75,000 and decrease fixed selling and administrative expenses by \(10,000.
a. Prepare a differential analysis to show whether Division B should drop the T205 product line.
b. What is your recommendation to the manager of Division B?
3. Division C also produces two product lines. Because the division can sell all of the product it can produce, Dillard is expanding the plant and needs to decide which product line to emphasize. To make this decision, the division accountant assembled the following data:
| Per unit | ||
K707 | G582 | |
Sales price | \)84 | \(50 |
Variable cost | 24 | 21 |
Contribution margin | \)60 | \(29 |
Contribution margin ratio | 71.4% | 58.0% |
After expansion, the factory will have a production capacity of 4,700 machine hours per month. The plant can manufacture either 40 units of K707s or 62 units of G582s per machine hour.
a. Identify the constraining factor for Division C.
b. Prepare an analysis to show which product line to emphasize.
4. Division D is considering two possible expansion plans. Plan A would expand a current product line at a cost of \)8,600,000. Expected annual net cash inflows are \(1,525,000, with zero residual value at the end of 10 years. Under Plan B, Division D would begin producing a new product at a cost of \)8,000,000. This plan is expected to generate net cash inflows of \(1,100,000 per year for 10 years, the estimated useful life of the product line. Estimated residual value for Plan B is \)980,000. Division D uses straight-line depreciation and requires an annual return of 10%.
a. Compute the payback, the ARR, the NPV, and the profitability index for both plans.
b. Compute the estimated IRR of Plan A.
c. Use Excel to verify the NPV calculations in Requirement 4(a) and the actual IRR for the two plans. How does the IRR of each plan compare with the company鈥檚 required rate of return?
d. Division D must rank the plans and make a recommendation to Dillard鈥檚 top management team for the best plan. Which expansion plan should Division D choose? Why?
List some common cash inflows from capital investments.
What is the internal rate of return?
Using ARR to make capital investment decisions Refer to the Henry Hardware information in Exercise E26-20. Assume the project has no residual value. Compute the ARR for the investment. Round to two places.
Henry Hardware is adding a new product line that will require an investment of \(1,512,000. Managers estimate that this investment will have a 10-year life and generate net cash inflows of \)310,000 the first year, \(270,000 the second year, and \)240,000 each year thereafter for eight years.
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