Horngren'S Financial And Managerial Accounting

Darren Dillard, majority stockholder and president of Dillard, 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 Dillard, Inc. has \(5,250,000 in assets. Its yearly fixed costs are \)557,000, and the variable costs of its product line are \(1.90 per unit. The division’s volume is currently 500,000 units. Competitors offer a similar product, at the same quality, to retailers for \)4.25 each. Dillard’s management team wants to earn a 12% return on investment on the division’s assets. 

a. What is Division A’s target full product cost? 

b. Given the division’s 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:

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:

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’s required rate of return? 

d. Division D must rank the plans and make a recommendation to Dillard’s top management team for the best plan. Which expansion plan should Division D choose? Why?

Match the following business activities to the steps in capital budgeting process.

Steps in the capital budgeting process:

a. Develop strategies

b. Plan

c. Direct

d. Control

Business activities:

1. A manager evaluates progress one year into the project.

2. Employees submit suggestions for new investments.

3. The company builds a new factory.

4. Top management attends a retreat to set long-term goals.

5. Proposed investments are analyzed.

6. Proposed investments are ranked.

7. New equipment is purchased.

Lockwood Company is considering a capital investment in machinery:

Initial investment $ 600,000

Residual value 50,000

Expected annual net cash inflows 100,000

Expected useful life 8 years

Required rate of return 12%

8. Calculate the payback.

9. Calculate the ARR. Round the percentage to two decimal places.

10. Based on your answers to the above questions, should Lockwood invest in the machinery?

Calculate the present value of the following future cash flows, rounding all calculations to the nearest dollar.

11. \(5,000 received in three years with interest of 10%

12. \)5,000 received in each of the following three years with interest of 10%

13. Payments of \(2,000, \)3,000, and $4,000 received in years 1, 2, and 3, respectively, with interest of 7%

David is entering high school and is determined to save money for college. David feels he can save $6,000 each year for the next four years from his part-time job. If David is able to invest at 7%, how much will he have when he starts college?

Cornell Company is considering a project with an initial investment of \(596,500 that is expected to produce cash inflows of \)125,000 for nine years. Cornell’s required rate of return is 12%.

14. What is the NPV of the project?

15. What is the IRR of the project?

16. Is this an acceptable project for Cornell?

Explain the difference between capital assets, capital investments, and capital budgeting.

Explain the difference between capital assets, capital investments, and capital budgeting.

Describe the capital budgeting process.

Describe the capital budgeting process.

What is capital rationing?

What are post-audits? When are they conducted?

List some common cash inflows from capital investments.

List some common cash outflows from capital investments.

What is the payback method of analyzing capital investments?

How is payback calculated with equal net cash inflows?

How is payback calculated with unequal net cash inflows?

What is the decision rule for payback?

What are some criticisms of the payback method?

Outlining the capital budgeting process Review the following activities of the capital budgeting process: a. Budget capital investments. b. Project investments’ cash flows. c. Perform post-audits. d. Make investments. e. Use feedback to reassess investments already made. f. Identify potential capital investments. g. Screen/analyze investments using one or more of the methods discussed. Place the activities in sequential order as they occur in the capital budgeting process.

 What is the accounting rate of return?

How is ARR calculated?

 What is the decision rule for ARR?

 Why is it preferable to receive cash sooner rather than later?

Question: What is an annuity? How does it differ from a lump sum payment?

 How does compound interest differ from simple interest?

Explain the difference between the present value factor tables—Present Value of \(1 and Present Value of Ordinary Annuity of \)1.

How is the present value of a lump sum determined?

How is the present value of an annuity determined?

Why are net present value and internal rate of return considered discounted cash flow methods?

What is net present value?

What is the decision rule for NPV?

What is the profitability index? When is it used?

What is the internal rate of return?

How is IRR calculated with equal net cash inflows?

How is IRR calculated with unequal net cash inflows?

What is the decision rule for IRR?

How can spreadsheet software, such as Excel, help with sensitivity analysis?

Why should both quantitative and qualitative factors be considered in capital investment decisions?

S26-2 Using payback to make capital investment decisions 

Carter Company is considering three investment opportunities with the following payback periods:

Use the decision rule for payback to rank the projects from most desirable to least desirable, all else being equal.

Using accounting rate of return to make capital investment decisions

Carter Company is considering three investment opportunities with the following accounting rates of return:

Use the decision rule for ARR to rank the projects from most desirable to least desirable. Carter Company’s required rate of return is 8%.

Question: Using the payback and accounting rate of return methods to make capital investment decisions 

Consider how Hunter Valley Snow Park Lodge could use capital budgeting to decide whether the \(11,000,000 Snow Park Lodge expansion would be a good investment. Assume Hunter Valley’s managers developed the following estimates concerning the expansion:

Assume that Hunter Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $600,000 at the end of its seven-year life.

Requirements 

1. Compute the average annual net cash inflow from the expansion. 
2. Compute the average annual operating income from the expansion.

Using the payback method to make capital investment decisions

Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26-4. Compute the payback for the expansion project. Round to one decimal place.

S26-6 Using the ARR method to make capital investment decisions Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26-4. Calculate the ARR. Round to two decimal places.

Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26-4 and your calculations in Short Exercises S26-5 and S26-6. Assume the expansion has zero residual value.

Requirements 

1. Will the payback change? Explain your answer. Recalculate the payback if it changes. Round to one decimal place. 

2. Will the project’s ARR change? Explain your answer. Recalculate ARR if it changes. Round to two decimal places. 

3. Assume Hunter Valley screens its potential capital investments using the following decision criteria:

Suppose Hunter Valley is deciding whether to purchase new accounting software. The payback for the $30,050 software package is two years, and the software’s expected life is three years. Hunter Valley’s required rate of return for this type of project is 10.0%. Assuming equal yearly cash flows, what are the expected annual net cash savings from the new software?

Use the Present Value of \(1 table (Appendix A, Table A-1) to determine the present value of \)1 received one year from now. Assume a 8% interest rate. Use the same table to find the present value of \(1 received two years from now. Continue this process for a total of five years. Round to three decimal places.

Requirements 

1. What is the total present value of the cash flows received over the five-year period? 

2. Could you characterize this stream of cash flows as an annuity? Why or why not? 

3. Use the Present Value of Ordinary Annuity of \)1 table (Appendix A, Table A-2) to determine the present value of the same stream of cash flows. Compare your results to your answer to Requirement 1. 

4. Explain your findings.

Your grandfather would like to share some of his fortune with you. He offers to give you money under one of the following scenarios (you get to choose): 

1. \(7,250 per year at the end of each of the next eight years 

2. \)49,650 (lump sum) now 

3. $98,650 (lump sum) eight years from now

Requirements 

1. Calculate the present value of each scenario using an 8% discount rate. Which scenario yields the highest present value? Round to nearest whole dollar. 

2. Would your preference change if you used a 10% discount rate?

Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26- 4. What is the project’s NPV (round to nearest dollar)? Is the investment attractive? Why or why not?

Refer to Short Exercise S26-4. Assume the expansion has no residual value. What is the project’s NPV (round to nearest dollar)? Is the investment attractive? Why or why not?