Capital Budgeting

c. In the budget process, you learned that we start with the master (overall) budget or forecast. What role does the flexible budget play in the budgeting process? Why should we have flexible budgets at all? Isn’t the master (overall) budget enough?

d. What distinguishes an investment center from a cost center or a profit center?

e. What is the impact on net present value of any project resulting from an increase in the discount rate (cost of capital) from 10% to 16%? Why is this so?

Problem 2 – Standard Costs & Variance Analysis (18 total points, 3 points each):

Brussels Chocolates of Belgium uses standard costs and a flexible budget to control its manufacture of its chocolates. Operating data for the last week have been summarized. A total of 4,000 boxes of chocolates were produced. A total of 4,300 pounds of chocolate costing €15.5 (Euros) were purchased and used. The standard, or forecast, price was €16.0. One pound of chocolate is the standard allowed quantity per box of chocolate made. Direct labor actually cost €195,200, based on 6,400 actual hours at a rate of €30.50 per hour, compared to the standard rate of €30.00 per direct labor hour. The labor standard is 1.50 direct labor hours per box. Variable manufacturing overhead cost €69,500. The flexible budget is based on €10.00 per standard direct labor hour.

Required: You are to compute the following variances:

a. Materials price.

b. Materials quantity (usage).

c. Direct labor rate.

d. Direct labor efficiency (usage).

e. Variable overhead spending.

f. Variable overhead efficiency (usage).

Problem 3 – Capital Budgeting, Net Present Value, Internal Rate of Return (24 total points, 3 points each):

The Adams County Board of Representatives is considering the construction of a longer runway at the county airport. Currently, the airport can handle only private aircraft and small commuter jets. A new longer runway would enable the airport to handle the midsize commuter jets used on many domestic flights. Data pertinent to the Board’s decision appear below:

Cost of acquiring additional land for runway: $70,000

Cost of runway construction: $200,000

Cost of extending perimeter fence: $29,840

Cost of runway lights: $39,600

Annual cost of maintaining new runway: $28,000

Annual incremental revenue from landing fees: $40,000

All costs will be paid at the inception of the project and will not be financed over time. In addition to the above data, two other facts have surfaced recently. First, a new snowplow will be required at a cost of $100,000. The old snowplow can be sold for $10,000. The new, larger plow will cost $12,000 more in annual operating costs than the old plow. Second, the Board believes that the proposed long runway, and the major jet service it will bring to the county, will increase economic activity in the community, which will result in $64,000 of additional tax revenue annually to the county. For purposes of their financial analysis, the Board has decided to use a 10-year time horizon, and the county has established a 12% hurdle rate for capital projects. Since this project involves a county government (and in a moment of weak-minded compassion on my part), taxes are not involved.

Required:

a. Compute the net initial total outlay for the long runway.

b. Compute the annual net cost or benefit of the runway.

c. Prepare a net present value analysis of the proposed new long runway.

d. Determine the internal rate of return (IRR) for the runway.

e. Should the Board approve the new runway? Why or why not?

f. Which of the financial data are most certain in your opinion? Which are least certain? Why?

g. What qualitative factors might you consider as a Board member that might impact your decision?

h. What does the annual net benefit of the runway need to be in order for the project to have a return equal to the county’s 12% hurdle rate?

Problem 4 – Analysis and Significance of Various Ratios (18 total points, 6 points each):

Sheeler, Inc, is a manufacturer of construction equipment and is considering the purchase of one of its suppliers, Puritan Industries. The purchase has been given the preliminary approval by Sheeler’s Board of Directors, and several discussions have taken place between the executive management of both companies. Puritan has submitted financial data for the last few years and Sheeler’s controller has analyzed it and prepared the following table of some of Puritan’s ratios, along with comparable industry ratios. Below is a sample of some of them:

Year 3 Year 2 Year 1 Industry

Return on stockholder equity 13.03 13.02 12.98 12.96

Inventory turnover

(average sale period) 51.16 47.29 42.15 38.63

Times interest earned 3.87 3.46 3.28 3.56

Price-earnings ratio 10.96 11.23 11.39 11.54

Debt-to-equity ratio 0.50 0.46 0.48 0.57

Accounts receivable turnover 6.98 7.25 7.83 7.78

Current ratio 1.65 1.95 1.70 2.30

Dividend yield ratio 2.08 2.06 2.12 2.25

Required:

a. Identify 2 ratios that would be of interest to short-term creditors. What do they measure? What do they tell you about Puritan?

b. Identify 3 ratios that would be of interest to stockholders. What do they measure? What do they tell you about Puritan?

c. Identify 2 ratios that would be of interest to long-term creditors. What do they measure? What do they tell you about Puritan?

Problem 5 – Outside Suppliers, Contribution Margin, Break-Even Point, Relevant Range, Investment Centers, Return on Investment (ROI), and Transfer Prices (24 total points, 3 points each):

The Canadian Instruments Company (CIC) uses a decentralized form of organizational structure and considers each of its divisions as an investment center. The Toronto Division (TD) is currently selling 15,000 air filters annually, although it has sufficient productive capacity to produce 21,000 units per year. Variable manufacturing costs amount to $21 per unit, while the total fixed costs are $90,000. The 15,000 air filters are sold to outside customers at $40 per unit.

The Montreal Division (MD), also a part of CIC, has indicated that it would like to buy 1,500 air filters from TD, but only at a price of $37, since this is the price MD is currently paying to an outside supplier for a similar air filter. The company has a cost of capital of 7%.

Required:

a. What is the unit contribution margin for TD’s sales to outsiders? What is the break-even point in units and sales dollars?

b. Will the new order push TD outside its relevant range? Why or why not?

c. What is the pre-tax effect on CIC’s income if MD buys the 1,500 air filters internally from TD?

d. What is the minimum price that TD should be willing to accept for these 1,500 air filters?

e. What is the maximum price that MD should be willing to pay for these 1,500 air filters?

f. What qualitative factors should be considered in this type of decision, above and beyond any transfer price considerations?

g. Suppose that TD is currently producing and selling 21,000 air filters annually to outside customers. What would be the effect on overall CIC income if TD was required by executive management to sell 1,500 air filters to MD at the $37 per unit price?

h. For this part only, assume that TD is currently earning annual operating income of $36,000, and TD’s average invested capital is $300,000. The division manager has an opportunity to invest in a proposal that will require an additional investment of $20,000 and will increase annual operating income by $2,000. What is the impact of this project on TD’s overall ROI?

Problem 6 - Statement of Cash Flow (10 points):

Davis Corp’s comparative balance sheet and income statement for the last year appear below:

Balance Sheet

For the Year Ended December 31

2009 2008

Assets Cash 57,000 23,000

Accounts receivable 90,000 69,000

Inventory 30,000 49,000

Prepaid expenses 9,000 15,000

Long-term investments 270,000 190,000

Plant and equipment 450,000 450,000

Less accumulated depreciation 273,000 231,000

Total assets 633,000 565,000

Liabilities Accounts Payable 22,000 45,000

Accrued liabilities 31,000 24,000

Taxes payable 18,000 25,000

Bonds payable 60,000 100,000

Deferred taxes 39,000 24,000

Owners Equity Common stock 140,000 110,000

Retained earnings 323,000 237,000

Total liabilities and owners equity 633,000 565,000

Income Statement

For the year 2009

Sales 850,000

Cost of goods sold 410,000

Gross margin 440,000

Selling & admin expenses 280,000

Net operating income 160,000

Income taxes 48,000

Net income 112,000

Davis declared and paid a cash dividend of $26,000 during 2009, and has another cash dividend planned for 2010 in the amount of $40,000. Davis has also planned to spend $150,000 in new capital equipment in 2010.

Required:

Prepare a statement of cash flows for Davis Corp. for the year ended December 31, 2009. Use the indirect method.