chapter 8Responsibility Concepts and Sound Decision-Maki.docx

chapter 8
Responsibility Concepts and Sound
Decision-Making Analytics
Learning Objectives
• Understand concepts in responsibility accounting.
• Be able to provide a framework for rational business
decision making, and understand
how to apply these concepts for specific types of situations.
• Apply capital budgeting methods and discounted cash
flow concepts.
• Know how to make proper long-term investment
decisions.
istockphoto
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CHAPTER 8Section 8.1 Responsibility Accounting Concepts
Chapter Outline
8.1 Responsibility Accounting Concepts
Accumulation of Information to Match Centers
Management by Exception

Rational Decision Making
Sunk Costs
8.2 A General Framework for Making Sound Business Decisions
Applying the General Framework to an Example: Bulk Orders
Applying the General Framework to an Example: Offshoring
8.3 Capital Expenditures
Future Value
Annuity
Present Value
8.4 Making Decisions About Long-Term Investments
Net Present Value
Internal Rate of Return
Simpler Capital Budgeting Methods
Recap of Using Capital Budgeting Tools for Decision Making
8.1 Responsibility Accounting Concepts
In general, managers should be held accountable for the results
of their decisions and business execution. Without
accountability based on performance-related feedback, the
business will not perform at its best, and areas in need of
improvement may not be iden-
tified on a timely basis. Business feedback is often based on
financial results. You have
already seen how budgets and variances are used to help
identify areas for improvement.
Because managers are accountable for their decisions, actions,
and outcomes, their perfor-
mance measures should align around the department, product,
division, or other business
for which they are responsible. In other words, the attribution of
responsibility tends to
follow the organizational structure of the business.

Sometimes, a business has a highly dispersed design, with
decisions nested with lower
level managers. Other businesses generate decisions only at the
upper levels, and
lower level personnel are basically charged with execution of
defined actions. Proper
implementation of responsibility accounting concepts stipulates
that performance mea-
sures be aligned with the business organization structure. In
other words, accountability
should map to responsibility. Proper design of performance
measurement systems there-
fore requires that the management accountant carefully consider
the organizational struc-
ture. Sometimes performance measures are only appropriate on
an aggregated basis, such
as where the organization is structured as a top–down,
command-and-control, central-
ized decision-making entity. As lower level managers are given
increased authority, so
too should the accountability system be modified to provide
more disaggregated perfor-
mance measures. Although quite logical, this presents
measurement challenges.
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Different types of units must be evaluated using alternative
models. For example, some
units do not generate any revenue. They exist to provide support
services to other depart-

ments within the entity. Other business segments may have clear
cost and revenue func-
tions, and they might be evaluated on their profits. Given this
observation, it is common
for businesses to characterize areas of specific responsibility as
cost centers, profit centers,
or investment centers.
A cost center usually lacks clear revenue functions. Typical
departments that are
regarded as cost centers include accounting, human resources,
maintenance, and most
administrative groupings. Cost control is the key evaluative
element in assessing per-
formance for a cost center. Standard costs and variances are
useful tools for judging
performance. Of course, it is also important to not reduce costs
to the point of ineffec-
tiveness; cost control should not be confused with cost
minimization. Therefore, non-
financial measures of output should also be considered for a
cost center. Examples
include transactions processed, error rates, and results of
satisfaction surveys. Perhaps
you have heard of a balanced scorecard?
A balanced scorecard is a measurement system designed to track
all elements of perfor-
mance, whether related to financial outcomes, customer
satisfaction, innovation, or
internal execution. A balanced scorecard provides a holistic
approach because an array
of performance measurements is developed. Each element
evaluated is intended to align
with the overall entity objectives. The emphasis is on meeting
thresholds while concen-

trating on areas for continuous improvement. To find a balanced
scorecard in operation,
you need look no further than your next visit to a fast-food
restaurant. The time from
order entry to food deliver is constantly clocked, and the goal is
usually to deliver in
less than 2 minutes. Other important goals might relate to
cleanliness, staff turnover,
frequency of errors on order fulfillment, daily sales volume, and
so forth.
Balanced scorecard metrics provide a tool for assessing
fulfillment of key objectives.
Accountants often gather essential data and may become skilled
in developing graphical
presentations that show how well goals are being met. These
graphs are frequently posted
throughout the workplace to remind employees of their
importance.
A profit center manager is responsible for the control of both
costs and revenues. How-
ever, costs and revenues are not evaluated independently.
Instead, costs are considered in
relation to revenues. A cost overrun can be perfectly fine if it is
also met with increased
revenues and profit enhancements. Flexible budget tools
introduced in Chapter 6 are par-
ticularly well suited to the evaluation of a profit center.
At higher levels within an organization, managers may be
evaluated based on the notion
of investment centers. The manager of an investment center is
accountable not only for
its costs and revenues but also for the sufficiency of the return
on the amount of capital

invested within the business unit. One tool used to assess the
success or failure is the
return on investment (ROI). In its most elementary form, this
model is simply a ratio of
operating income to average assets deployed in the business
unit:
ROI 5 Operating Income / Average Assets
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However, it is sometimes useful to also assess operating income
in relation to sales and
sales in relation to average assets:
Margin on Sales 5 Operating Income / Sales
Turnover Rate 5 Sales / Average Assets
Algebraically, these ratios combine, as shown in Exhibit 8.1, to
produce the ROI calculation.
Exhibit 8.1
Accumulation of Information to Match Centers
When responsibility measurements are to be divided according
to cost, revenue, or invest-
ment centers, it also becomes necessary to develop the
accounting information system to
provide data in support of the assessment process. Useful
reports must be generated for

each unit of responsibility. Generalizing, these reports should
be sufficient to provide for
comparison of budget and actual data; align with the
organizational units of the firm; sup-
port variance calculations when applicable; and, it is hoped,
help identify areas/oppor-
tunities for targeted improvement. Aggregated data that are used
to measure results for
upper divisions may be disaggregated into reports applicable to
lower levels within the
business. For instance, a business may have two primary
segments, wholesale and retail.
The aggregate entity-wide performance report (in the leftmost
data column in Table 8.1) is
disaggregated into information applicable to each business unit:
RETURN ON
INVESTMENT
MARGIN
�
�
� TURNOVER
OPERATING
INCOME
SALES
SALES
AVERAGE
ASSETS

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Table 8.1: Aggregate performance
Combined Wholesale Retail
Sales $3,500,000 $2,000,000 $1,500,000
Variable expenses 2,250,000 1,500,000 750,000
Contribution margin $1,250,000 $ 500,000 $ 750,000
Traceable fixed costs 700,000 200,000 500,000
Controllable margin $550,000 $ 300,000 $250,000
Common fixed costs 250,000
Net margin $ 300,000
If applicable, the data column for retail could be further
disaggregated into information
for each retail store. Thus, aggregated data for the entire entity
can be used to judge the
performance of upper division corporate managers. The segment
data can be used to
judge the performance of midlevel managers. Also, if
applicable, individual store manag-
ers can be judged on the performance of their business unit.
In examining the preceding performance report, you likely

noticed that total fixed cost
was divided between traceable and common components.
Traceable fixed costs are
those that would no longer exist if a particular responsibility
center ceased to exist. Exam-
ples include the costs associated with real estate in use by the
retail unit, management
salaries, and so forth. In contrast, common fixed costs support
the operations of mul-
tiple units and would continue regardless of any decisions about
continuing or discon-
tinuing a responsibility center. Because effective performance
evaluation depends on a
proper alignment of responsibility and accountability, it is
important to separate fixed
costs between traceable and common components. It would be
inappropriate to evaluate
a manager’s performance based on an accounting model that
burdened the manager with
common costs for which there was no effective control.
Management by Exception
Management by exception is an often-used description of the
way in which responsibil-
ity reports are used. It means that reviews and corrective actions
should center around
areas of underperformance, as identified by data that do not
conform to expectations.
Thus, attention is focused on areas where corrections appear to
be needed. If the account-
ing information system does not support this objective, it is
arguably of little value for
management control. However, do not assume that every
exception requires change.
Sometimes performance can fall short of expectations because

of circumstances that are
beyond the control of a unit manager. Examples include
shutdowns due to storms, eco-
nomic recessions, and countless other disruptive events that are
externally or coinciden-
tally induced.
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Rational Decision Making
You can probably think of some things you would like to try
again. Perhaps you have
taken an exam and done poorly. The underperformance might
have been due to a lack of
preparation. Then again, maybe you just made a mathematical
error; or worse, maybe you
marked an answer sheet wrong by accident. Whatever the cause,
you probably think you
should have done better. If you reflect further, you will see that
there are really two differ-
ent types of explanations for the poor performance: a lack of
planning and poor execution.
The first type is clearly subject to your control.
It is easy to make an analogy to business. Management must be
diligent to control
against errors in both planning and execution. Our focus now is
on avoiding planning
errors. Remember, management has an ethical and fiduciary
duty to safeguard company
resources, and this includes application of proper planning and

decision-making prin-
ciples. Despite the best of plans, there is no guarantee of
success. However, there is no
excuse for engaging in a business action that has no chance of
success from the outset.
Sunk Costs
Perhaps the most frequent business mistake is to fail to
distinguish between sunk costs
and relevant costs. A sunk cost relates to the amount of a prior
expenditure or cost. You
may have invested in the stock of a particular company. If you
suspect the stock is going
to decline, you should consider selling it. It does not really
matter whether you paid more
or less than its current market value. Nevertheless, people
frequently tend to fixate on
sunk costs. Perhaps this is just human nature, but it has no place
in making sound busi-
ness decisions. Sunk costs are to be ignored in making business
decisions. This facet of
business decision making cannot be overemphasized; even when
people have a rational
comprehension of the concept, it is still difficult to set aside
emotion. The age-old expres-
sion that there is no use crying over spilt milk applies.
What matters is to base business decisions on relevant items.
Relevant items are those
that entail future costs and revenues that differ between
alternative decisions. The objec-
tive of business decision making is to identify decisions
yielding the best incremental out-
comes based on a comparison of just the relevant items. This
can be trickier than it seems.

To illustrate, assume that a corporation has a machine with an
original cost of $100,000,
a 5-year remaining life, no salvage value, and accumulated
depreciation equal to 40% of
cost. It produces 10,000 units per year, and operating costs are
$2 per unit. The company
can sell the unit for $20,000 and lease a new machine for
$22,000 per year for 5 years. No
additional operating costs would be incurred, and the leased
machine would also produce
10,000 units per year. Should the company sell its current
machine and enter into the lease
agreement? Immediately, you can see that the decision is not
obvious. Production is the
same under either option; only costs vary. Keeping and
operating the existing equipment
would result in incremental operating costs of $20,000 per year
(10,000 units 3 $2 per
unit). Leasing the machine would result in incremental
operating costs of $22,000 per year
but would be accompanied by a $20,000 upfront benefit from
selling the old machine. This
added $20,000 payment would more than offset the extra $2,000
per year of added costs
under the lease. Thus, it is better to sell the old machine and
enter into the lease agree-
ment. Of course, selling the old machine will produce an
immediate accounting loss of
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CHAPTER 8Section 8.2 A General Framework for Making
Sound Business Decisions

$40,000 ($20,000 sales price minus $60,000 net book value
($100,000 – $40,000)), but this is
irrelevant. Remember that sunk costs are to be ignored in
business decision making. This
is a difficult lesson to learn. Many managers would avoid taking
the accounting loss, even
though it is not the best option. Remember that the cost of the
old equipment would con-
tinue to be charged to depreciation expense if it is not sold.
8.2 A General Framework for Making Sound Business
Decisions
There are simply too many possibilities to catalog every type of
business decision you will confront. Thus, you must develop
critical thinking skills in support of a general
frame of reference for solving business problems. Perhaps you
will receive a bulk order
from a customer who is requesting a significant price reduction.
Perhaps you will need
to consider offshoring production to a country with less
expensive labor. There are many
such decisions that require thoughtful consideration. The
general approach to such deci-
sions begins by identifying all of the possibilities/outcomes,
noting the relevant costs and
benefits associated with each, and making a preliminary
determination of the option with
the best incremental impacts. However, the process does not end
there. You must also
weigh the seemingly best choice in the context of qualitative
variables. Qualitative factors
must include consideration of environmental, customer, and
employee impacts. Although
profit maximization is important, other facets also play a

significant role in defining a
business’s ability to achieve long-run success. Sound judgment
should not be replaced by
overreliance on quantitative models; they are complementary.
Applying the General Framework to an Example: Bulk Orders
It is quite common for customers to request reduced pricing on
bulk orders. A bulk order
involves a large quantity of units, perhaps even produced under
a unique brand name.
The beginning point for evaluating such orders is whether the
proposed price is at least
sufficient to cover all variable costs that it will generate. In
other words, will the order
have a positive contribution margin. As a general rule, such
orders will result in increased
profits. However, there are some notable exceptions.
One exception occurs when there are capacity constraints.
Acceptance of a bulk order will
consume productive capacity. If that either results in an
increase in fixed costs or displaces
other more profitable work, then simple reliance on the order’s
positive contribution mar-
gin can produce erroneous decisions. Thus, contribution margin
analysis should always
be weighted against the ability to generate margin, with the
objective of optimizing the
total firmwide contribution margin. This is decidedly different
than just looking at per-
unit contribution margin. These impacts are generally calculable
based on careful analy-
sis. However, it is trickier to evaluate market impacts. A
negative market consequence can
arise in at least two specific ways. First, other customers may

learn of the special pricing
and expect similar treatment. If that results, overall margin
deterioration might ensue.
Second, the overall increase in supply might dampen market
price to end consumers,
necessitating price reductions to clear the market.
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CHAPTER 8Section 8.2 A General Framework for Making
Sound Business Decisions
To illustrate, assume that Chip Country produces and sells a
specialty snack food for
$2 per bag. This price provides a gross profit of $0.75 per bag.
The manufacturing costs
consist of variable production costs of $1.00 per bag and
allocated fixed manufacturing
overhead of $0.25 per bag. The company’s factory only operates
one shift per day, and the
addition of an extra shift would generate no additional fixed
manufacturing overhead or
selling, general, and administrative (SG&A) costs. Big City
Markets has approached Chip
Country about producing a private-label snack that would not
compete with Chip Coun-
try’s existing market. Big City’s offer would require Chip
Country to double its output,
and it would fully consume capacity that can be generated via a
second shift. However,
Big City is only willing to pay $1.10 per bag. Should the offer
be accepted? At first glance,
it appears the offer is not good. After all, the gross profit is
only $0.75 per bag when the

selling price is $2. How can a $0.90 reduction in selling price
prove viable? The answer
to this question can be found in noting that gross profit is
calculated after deducting the
fixed manufacturing costs. Because the bulk order will not
trigger any additional nonvari-
able or SG&A costs, it is only necessary to recover the variable
manufacturing costs of $1
for this order to prove profitable. Thus, the bulk order appears
to be a viable opportunity.
It is only necessary to further consider the qualitative and
market-related facets before
deciding to go forward.
Applying the General Framework to an Example: Offshoring
You cannot help but notice that companies have increasingly
turned to offshore operations
to manufacture goods and provide other services such as tech
support and telemarketing.
This practice is often driven by a desire to obtain cheaper labor,
but tax and regulatory
issues have also played a significant role. A decision to
offshore should be based on care-
ful analysis of relevant costs and benefits, coupled with
appropriate weighting of qualita-
tive factors. In addition, a manager should attempt to judge the
risks associated with the
added prospect of political or logistical disruptions associated
with global dispersion.
Offshoring sometimes entails the abandonment of domestic
production facilities, in lieu
of contracting with a foreign supplier on a purely variable cost
basis. There is often very
little alternative use or market value for abandoned domestic

assets. The existence of
these resources may cloud the decision to offshore, but it should
not. As you know, sunk
costs must be ignored, and great care must be taken to identify
only the relevant items.
This becomes difficult when a facility that is no longer in use
will continue to generate
costs. Some of the fixed overhead is apt to continue even if a
service/product is no longer
produced. This unavoidable fixed overhead will not vary
between the alternatives and
is therefore ignored in the decision-making process. Conversely,
fixed factory overhead
that can be avoided via offshoring should be regarded as a
relevant item in any analysis.
Beyond these special considerations, offshoring via a variable
cost contract with a foreign
vendor should generally be driven by a comparison of
differences in the variable cost
components.
To illustrate, assume that Ballard Corporation has a
manufacturing plant in San Diego that
currently produces a component part used in its main product
line that is assembled in
Los Angeles. There is no alternative use for the San Diego
plant, and Ballard will retain it
for many years, whether closed or not. The following facts have
been identified:
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CHAPTER 8Section 8.3 Capital Expenditures

Annual fixedmanufacturing overhead at the San Diego
plant $1,000,000
Fixed manufacturing overhead that can be avoided by closing
the plant 40%
Variable costsof production $3.00 per unit
Annual parts production 2,500,000 units
Zhou Corporation has offered to produce and deliver to San
Diego an identical compo-
nent part for $3.20 per unit. The decision to offshore production
to Zhou would involve
no changes to SG&A. The rather obvious issue is whether or not
to offshore. Table 8.2
identifies the relevant costs:
Table 8.2: Relevant costs
Manufacture Offshore
Variable costs for 2,500,000 units ($3.00 vs. $3.20) $7,500,000
$8,000,000
Reduction in fixedcosts(40% of $1,000,000) (400,000)
Net of relevant items $7,500,000 $7,600,000
This fact set is relatively simple, but it is challenging to
identify just the relevant items and
draw the appropriate conclusion. The relevant items relate to
the differential in variable
and fixed costs. By comparing only relevant costs, it appears
that Ballard should con-
tinue to manufacture the component. The cost difference is

$100,000 less by continuing
to manufacture ($7,500,000 vs. $7,600,000). What is most
important for you to see within
this example is how easily an error could have been made in
this decision. The full cost of
manufacturing is $8,500,000 ($7,500,000 variable cost and
$1,000,000 fixed cost), which is
more than the $8,000,000 direct cost of offshoring. Yet
offshoring is not the right decision.
There is another $600,000 of fixed costs (the other 60% of the
$1,000,000 fixed overhead)
that will be incurred even if offshoring is selected.
Offshoring involves a number of qualitative issues. When
production is placed in the
hands of an outside supplier, added cost may arise from the
need to monitor the finan-
cial health and integrity of the vendor, the quality of
production, delivery schedules, and
similar issues. There are added costs associated with freight,
customs, taxes, and even
language barriers.
8.3 Capital Expenditures
Some business decisions relate to capital expenditures such as
the construction of a factory or purchase of equipment. These
activities can entail substantial initial cash
outlays, and it may be many years before the investment can be
recovered. Capital expen-
diture decisions often require the comparison of competing
alternatives. Furthermore,
options that appear best in the short run may not be best in the
long run, and vice versa.
You can probably relate to this issue in thinking about your own
education. You are

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currently investing time and money in an accounting class; you
could probably make
more money in the near term by working in your job and
skipping out on study time.
However, you understand that your long-term interests are
better served by investing in
your education. This is not much different than the challenge
faced by business manag-
ers. For instance, should an expensive robotic welder be
purchased to replace a manual
laborer? The near-term cash flow is better without the robot but
worse in the long run.
How are such decisions to be made intelligently?
This is the role of capital budgeting analysis. Mathematical
tools are brought to bear on
the evaluation process in a way that produces systematically
logical outcomes. At the
heart of many of these tools are concepts related to the time
value of money. You likely
have a sense that a dollar in the hand is worth more than a
dollar to be received in the
future. After all, a dollar in the hand can be reinvested to
generate additional returns and
grow to a greater sum than the dollar to be received in the
future. This notion is sometimes
referred to as the time value of money.
This fundamental principle is the starting point for

understanding key capital budgeting
tools. Although spreadsheet models and business analyst
calculators are readily available
to assist with all of the related calculations, they are all based
on basic mathematical equa-
tions that you should attempt to understand.
Future Value
The first of these is known as future value (or compound
interest). To illustrate, if you
invest $1,000 for 1 year, at 5% interest per year, your initial
investment will have grown
to $1,050 by the end of the year ($1,000 3 1.05). If you then
reinvest the $1,050 for another
year at 5%, your investment will grow to $1,102.50 ($1,050 3
1.05). The second year pro-
duces a greater amount of interest (than the first year) because
the accumulated interest
from the first year is also in the investment pool and generating
returns. An alternative
view of this calculation is to note that initial investment is to be
multiplied by 1.05 to the
second power (i.e., 1.052). The compounding of a greater
amount of interest each year
would continue through time. Indeed, if you wanted to know the
value to which the
investment would accumulate after 10 years at 5% per year, you
would multiply the initial
investment by 1.05 to the 10th power. This observation gives
rise to a general formulation
for the future value factor that can be multiplied times an initial
lump sum investment:
(1 1 i)n

where i is the interest rate per period, and n is the number of
periods.
Although it is a fairly simple matter to calculate the future
value factors via the previous
equation, they are also readily available by reference to a Future
Value of $1 table (see
Appendix A).
These tables provide predetermined values for a variety of such
computations. Examine
the table and satisfy yourself that a $10,000 investment will
grow to $25,937 by the end of
10 years at 10% per period. You should note the future value
factor of 2.5937 in the “10%
column/10-period row.” This factor is multiplied by the $10,000
initial investment.
waL80281_08_c08_189-212.indd 10 9/25/12 1:03 PM
Try It Yourself: Future Value of $1
Challenge: Find the future value of $1,000 if it is invested today
at 5% annual
interest for 15 years.
Calculation: The table in Appendix A indicates a factor of
2.07893 for 15 periods,
5% rate per period. This factor is multiplied by the $1,000
initial
investment.

Answer: The amount will grow to $2,078.93.
One important point is worth noting at the outset. The interest
rate from within the table is
in reference to the interest rate per period. In the preceding
example, we assumed annual
compounding. However, interest might be compounded monthly
or on some other basis.
For example, if a 12% annual interest rate were to be
compounded monthly, then the
interest rate would be 1% per month. A 3-year investment
would include 36 months.
Thus, to determine the future value of the investment would
entail reference to the “1%
column/36-period row.”
Annuity
Rather than investing a single lump-sum amount, investors will
sometimes make a regu-
lar stream of level payments into an account. For example, a
saver might deposit $10,000
per year at the beginning of each year into a savings account.
Streams of level payments
occurring on regular intervals are called annuities. You may be
wondering how you
would determine the amount that would accumulate after 5
years under such a process.
If you consider that such an annuity is really just a series of
lump-sum amounts, each
invested for a different number of years, you can discern that
the future value of annuity
can be determined by summing a series of individual lump-sum
investments. Consider
Exhibit 8.2.

Exhibit 8.2
$11,000
$12,100
$13,310
$14,642
$16,104
$67,156
X (1.10)1
X (1.10)2
X (1.10)3
X (1.10)4
X (1.10)5
=
=
=
=
=
=Accumulated Total

YEAR 1
$10,000
YEAR 2
$10,000
YEAR 3
$10,000
YEAR 4
$10,000
YEAR 5
$10,000
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The preceding illustration shows that the stream of investments
would grow to $67,156.
Because it is rather cumbersome to calculate the future value of
each investment and then
sum, tables are also available revealing individual factors for
the future value of such
annuities. The table in Appendix B reveals factors for the future
value of annuity, with the
first payment occurring at the beginning of the first period
(sometimes called an annuity

due or annuity in advance).
Examine that table and locate the value corresponding to 10%
and 5 periods. You should
locate a value of 6.71561. Multiplying the $10,000 annual
payment by this factor also yields
$67,156, but in a much quicker way.
Try It Yourself: Future Value of an Annuity
Challenge: Find the future value of beginning-of-month deposits
of $25 each for
24 months, if they are invested at 6% annual interest.
Calculation: The table in Appendix B indicates a factor of
0.5% rate per period (6% per year equals 0.5% per month). This
factor
is multiplied by the $25 periodic investment.
Answer: The deposits, with interest, will accumulate to
$638.98.
Present Value
Although future value calculations are quite useful for financial
planning, accounting and
capital budgeting decisions often depend on an opposite concept
called present value.
Present value reveals the current worth of cash to be received in
the future. As such, it is
sometimes called discounting of future cash flows. For example,
you may desire to know
today’s value associated with $1,000 to be received in 3 years.
Mathematically, this is sim-
ply the reciprocal logic to that applied in calculating future

value amounts. Thus, the fol-
lowing formula can be seen to apply:
1/(1 1 i)n
here i is the interest rate per period, and n is the number of
periods.
Thus, $1,000 to be received in 3 years, assuming a 5% interest
rate, is worth approximately
$863.84 today. In other words, it has a present value of
$863.84. Stated differently, that
amount invested today at 5% annual interest would grow to
approximately $1,000 after 3
years. You might calculate the present value factor of 0.86384
via the formula (1/1.053) and
then multiply that times the $1,000 future payment. However, as
you probably suspect,
there is a Present Value of $1 table (see Appendix C) that
includes appropriate factors for
a variety of scenarios.
You should take time to confirm that you can find the preceding
factor in the 5% column/
3-period row.
waL80281_08_c08_189-212.indd 12 9/25/12 1:03 PM
Try It Yourself: Present Value of $1
Challenge: Find the present value of $5,000, if it is to be
received in 5 years, and

the annual interest rate of 8% is compounded every 3 months.
Calculation: The table in Appendix C indicates a factor of
2% rate per period (8% per year equals 2% per quarter; there are
20 quarters in 5 years). This factor is multiplied by the $5,000
amount
to be received.
Answer: The present value of the $5,000 amount is $3,364.85.
Present value can also be calculated for annuities. As you will
soon see, this proves quite
useful in the evaluation of long-term capital investments. If the
uniform payments occur
at the end of each period, the annuity is termed an ordinary
annuity. One way to deter-
mine the present value of an ordinary annuity would be to sum
the present value of each
payment, as shown in Exhibit 8.3 for a 5-period, 10% annuity
stream of $10,000 cash flows:
However, tables such as the one in Appendix D already provide
summarized values asso-
ciated with the present value of an annuity.
Exhibit 8.3
Notice that the previous annuity has a present value of $37,908.
Examine the table, tak-
ing note that the factor corresponding to five periods and a 10%
rate is 3.7908. Thus, one
can simply multiply the $10,000 payment by that factor to
calculate the present value of
the annuity.
Try It Yourself: Present Value of an Annuity

Challenge: Assume that you have won a prize of $1,000 to be
received at the end
of each year for 20 years. The annual interest rate is 5%. How
much is
the present worth of this prize?
Calculation: The table in Appendix D indicates a factor of
5% rate per period. This factor is multiplied by the $1,000
annual
prize amount.
Answer: The present value of the prize is $12,462.21.
$9,090
$8,264
$7,514
$6,830
$6,210
$37,908
(1/(1.10)1) X
(1/(1.10)2) X
(1/(1.10)3) X
(1/(1.10)4) X
(1/(1.10)5) X

=
=
=
=
=
=Total Present Value
YEAR 1
$10,000
YEAR 2
$10,000
YEAR 3
$10,000
YEAR 4
$10,000
YEAR 5
$10,000
waL80281_08_c08_189-212.indd 13 9/25/12 1:03 PM

CHAPTER 8Section 8.4 Making Decisions About Long-Term
Investments
8.4 Making Decisions About Long-Term Investments
With the mathematical tools you have just learned, you should
be able to understand important concepts in making intelligent
decisions about long-term investments.
The application of these principles is termed capital budgeting.
To begin simply, assume
you are faced with two alternative investment choices, and the
going rate of interest is
7%. Investment A returns $1,000 at the end of each year for 10
years (a total of $10,000),
and Investment B returns $1,200 per year for 8 years (a total of
$9,600). Which is pre-
ferred? The answer to this question likely hinges on which
investment has the higher
present value. Investment A has a present value of $7,023.58
($1,000 3 7.02358), and
Investment B has a present value of $7,165.56 ($1,200 3
5.97130). Thus, Investment B is
preferred to A. It is important to note that this is true even
though Investment A returns
more in total than Investment B.
Now, this simple example left out one important variable. Can
you imagine what that is?
It is the cost of the investment initially. If Investment B cost
more than $7,165 up front,
it would be a bad investment indeed. Thus, accountants need to
consider not only the
present value of cash inflows but also the present value of cash
outflows associated with
an investment.

Net Present Value
The net present value of an investment is the difference between
the present value of
cash inflows and the present value of cash outflows. To make
this calculation requires
the selection of an interest rate, and that rate should reflect the
theoretical cost of capital
incurred by a firm. The cost of capital approximates the cost of
funds in use by an entity. If
a company borrows heavily, it can relate to the cost of interest
on debt. If a company relies
on shareholder investment, it can be meant to indicate the
expected rate of return that
shareholders expect to generate. Or, the cost of capital can
reflect a blending of both the
cost of debt and equity. In any event, if the net present value of
an investment is positive,
then an assumption is made that the investment is worthy of
further consideration. This
means that the present value of cash inflows exceeds the present
value of cash outflows,
and the investment at least generates returns in excess of the
firm’s cost of capital. The
opposite conclusion can be reached for investments with
negative net present values.
To illustrate net present value, assume that Impact Plastic
Corporation is considering the
purchase of a new mold that will have an initial cost of
$100,000. In addition, $25,000 will
need to be spent at the end of Year 2 and again at the end of
Year 4. These expenditures are
necessary to refurbish and polish the mold. The mold will be
leased to ski boot manufac-

turers that contract for plastic parts used in their products. The
mold will produce annual
lease payments to Impact amounting to $40,000 per year,
occurring at the end of each year,
for 5 consecutive years. Impact’s cost of capital is 8%. Table
8.3 shows that the discounted
cash flows produce a positive net present value of $19,899,
suggesting that the mold will
return well in excess of the cost of capital.
waL80281_08_c08_189-212.indd 14 9/25/12 1:03 PM
Investments
Table 8.3: Discounted cash flows
Cash outflow Cash inflow Net cash
flow
Present value
factor @ 8%
Present value
of net annual
cash flow
Initial cash
outlay
$100,000 ($100,000) 1.00000 ($100,000)
End of Year 1 $40,000 40,000 0.92593 37,037

End of Year 2 25,000 40,000 15,000 0.85734 12,860
End of Year 3 40,000 40,000 0.79383 31,753
End of Year 4 25,000 40,000 15,000 0.73503 11,025
End of Year 5 40,000 40,000 0.68058 27,223
Net present
value
$19,899
Try It Yourself: Net Present Value of an Investment That
Should Be Accepted
Challenge: Find the net present value of an investment requiring
a $200,000 initial
outlay and returning $30,000 at the end of each year for 10
years. The
company’s cost of capital is 5%. The investment has no residual
value.
Calculation: Using the present value factor from Appendix D,
note that present
value factor for the $30,000 annuity is 7.72173 (10 periods,
5%). Thus,
the present value of the inflows is $231,651.90 ($30,000 3
7.72173).
This is greater than the investment outflows of $200,000, all of
which
occurred immediately.
Answer: The net present value is positive $31,651.90, indicating
that the

investment returns more than the 5% cost of capital.
Try It Yourself: Net Present Value of an Investment That
Should Be Rejected
Challenge: Find the net present value of an investment requiring
a $200,000 initial
outlay and returning $30,000 at the end of each year for 10
years. The
company’s cost of capital is 9%. The investment has no residual
value.
Calculation: Using the present value factor from Appendix D,
note that present
value factor for the $30,000 annuity is 6.41766 (10 periods,
9%). Thus,
the present value of the inflows is $192,529.80 ($30,000 3
6.41766).
This is less than the investment outflows of $200,000, all of
which
occurred immediately.
Answer: The net present value is negative $7,470.20
($192,529.80 2 $200,000),
indicating that the investment returns less than the 9% cost of
capital.
waL80281_08_c08_189-212.indd 15 9/25/12 1:03 PM
Investments
Internal Rate of Return

Although net present value calculations are highly beneficial in
showing whether a par-
ticular rate of return is cleared, they fail to exactly identify the
full rate of return. This is
where the internal rate of return (IRR) comes into play. The
IRR essentially repeats
the previous calculations based on the actual rate of return that
causes the present value
of the inflows to equal the present value of the outflows. It is
the interest rate that causes
a zero net present value. Consider the revised Table 8.4, this
time using present value
factors at 15.38%:
Table 8.4: Internal rate of return
Cash outflow Cash inflow Net cash
flow
Present
value factor
@ 15.38%
Present value
of net annual
cash flow
Initial cash
outlay
$100,000 ($100,000) 1.00000 ($100,000)
End of Year 1 $40,000 40,000 0.86670 34,668
End of Year 2 25,000 40,000 15,000 0.75117 11,267

End of Year 3 40,000 40,000 0.65104 26,041
End of Year 4 25,000 40,000 15,000 0.56426 8,463
End of Year 5 40,000 40,000 0.48904 19,561
Net present
value
$0
The IRR for this project is more than 15%, as shown. The
process of evaluating invest-
ments using the IRR approach is to calculate the IRR for each
investment opportunity.
Projects offering the highest internal rates of return are deemed
best.
You may be wondering how the interest rate was found. It is
quite cumbersome to do
the calculations manually. Essentially, one is required to
repeatedly try rates, constantly
trying to close in on the rate that returns a zero net present
value. Fortunately, computer
programs simplify the process. The details of these calculations
are deferred to more
advanced-level accounting and finance classes.
You will also learn in advanced classes that the IRR has certain
limitations. First, IRR
mathematics can produce anomalous results. Where cash
inflows and outflow are highly
irregular over the span of the investment period, it is sometimes
possible to find two dif-
ferent rates, both of which will cause the present values of

inflows and outflows to be
equal. Also, bear in mind that IRR is useful for ranking all
investment options, but it does
not tell you which ones should be accepted. Should the business
only accept investments
with a greater than 10% rate, 15% rate, or 20% rate? There is no
answer to the question.
Presumably, the business should pick the best investments with
the available capital, but
the method does not signal at what point it is worthwhile to
obtain additional capital to
pursue added opportunities (or hold back capital for future
opportunities that have not
yet emerged).
waL80281_08_c08_189-212.indd 16 9/25/12 1:03 PM
Investments
Simpler Capital Budgeting Methods
Evaluation of long-term projects is not always based on
discounted cash flow concepts.
Alternative evaluation methods include consideration of the
accounting rate of return
and the payback method. The accounting rate of return examines
accounting income
rather than cash flows. It is calculated by dividing an
investment’s expected increase in
accounting income by the amount of the investment. If a project
costs $1,000,000 and is
expected to produce an ongoing average increase in accounting
income of $50,000, then

the accounting rate of return is 5%. Accounting income can
diverge significantly from
cash flows due to depreciation and other timing issues related to
cash flows that differ
from accrual-based income measurement. The payback method
is another simplistic tool
for evaluating capital expenditures. It results from dividing an
initial investment by the
expected annual cash inflow produced by the investment. If a
project costs $1,000,000
and is expected to produce an ongoing average increase in cash
flows of $100,000, then
the payback is 10 years. The method can be misleading in that it
fails to consider the time
value of money and what happens to cash flows beyond the
payback period.
Simple tools such as these can produce quick measures for
considering and ranking invest-
ment alternatives, but they probably should not be solely relied
on to produce consistently
high-quality investment decisions. They are but single
indicators, and management has
an ethical duty to consider more careful analysis in deciding
how to deploy firm resources
before making long-term capital allocation decisions.
Recap of Using Capital Budgeting Tools for Decision Making
Table 8.5 recaps the four fundamental capital budgeting tools
introduced in this chapter.
The middle column includes information about the general
decision-making rule. The last
column includes caveats about potential weaknesses for each
method.

Table 8.5: Four fundamental capital budgeting tools
Method Decision rule Caveat
Net present
value (NPV)
Select the investments with positive
NPV.
Outcomes are dynamic based on cost of
capital assumptions.
Internal rate of
return (IRR)
Rank order investments and select
those yielding the highest IRR.
Fails to consider duration of an
investment’s life and what options
will be available after an investment
matures.
Accounting rate
of return (ARR)
Rank order investments and select
those yielding the highest ARR.
Fails to consider timing of cash flows.
Payback Rank order investments and select those
with the shortest payback period.
Fails to consider returns after the

payback period, leaving the evaluator
blind as to the actual return on the
investment.
waL80281_08_c08_189-212.indd 17 9/25/12 1:03 PM
CHAPTER 8Concept Check
In no case should a manager resort to blind reliance on a single
method. Remember that
future inflows and all outflows, as well as assumptions about
interest rates, all require
some degree of prognostication about the future. Sound human
judgment must always
guide the final conclusion about the worthiness of a capital
expenditure.
Concept Check
The four questions that follow relate to several issues raised in
the chapter. Test
your knowledge of the issues by selecting the best answer. (The
correct answers can
be found at the end of your text.)
1. Which of the following is rarely a consideration when
analyzing a long-term project?
a. The cost of the investment
b. The lowest rate of return acceptable to management
c. The company’s current ratio
d. The investment’s cash inflows and cash outflows
2. The time value of money
a. is integrated in present value computations.

b. weights cash flows that occur in 5 years more heavily than
cash flows that occur
in 2 years.
c. is reflected by the accounting rate of return.
d. should not be considered when analyzing an investment.
3. Hughes Corporation is considering a $200,000 machine that
promises savings in
cash operating costs of $40,000 over each of the next 6 years.
The company requires
a 10% return on its investments. Appropriate present value
factors follow:
Present value of $1 Present value of a $1 annuity
0.56447 4.35526
Ignoring income taxes, the machine’s net present value is
a. $(5,790).
b. $(25,790).
c. $(177,421).
d. some amount other than those listed above.
4. The internal rate of return
a. ignores the time value of money.
b. is another name for the accounting rate of return.
c. results in a net present value of zero.
d. cannot be used when the payback period is less than 3 years.
waL80281_08_c08_189-212.indd 18 9/25/12 1:03 PM
CHAPTER 8Key Terms

accounting rate of return Examines
accounting income rather than cash flows.
It is calculated by dividing an investment’s
expected increase in accounting income by
the amount of the investment.
annuities Streams of level payments
occurring on regular intervals.
capital expenditures Activities that can
entail substantial initial cash outlays, and
it may be many years before the invest-
ment can be recovered.
common fixed cost Costs that support the
operations of multiple units.
cost center A department or product
group that lacks clear revenue functions
for a company.
future value Another term for compound
interest.
internal rate of return (IRR) The IRR
results from calculations based on the
actual rate of return that causes the present
value of the inflows to equal the present
value of the outflows.
investment center Accountable not only
for costs and revenues but also for the
sufficiency of the return on the amount of
capital invested within the business unit.

management by exception A method of
reporting in which reviews and correc-
tive actions should center around areas of
underperformance, as identified by data
that do not conform to expectations.
net present value The net present value
of an investment is the difference between
the present value of cash inflows and the
present value of the cash outflows.
payback method A tool for evaluating
capital expenditures. It results from divid-
ing an initial investment by the expected
annual cash inflow produced by the
investment.
profit center manager Responsible for the
control of both costs and revenues.
relevant items Those that entail future
costs and revenues that differ between
alternative decisions.
return on investment (ROI) A ratio
of operating income to average assets
deployed in the business unit.
sunk cost Refers to a prior expenditure or
cost.
time value of money A term referring to
the notion of money being reinvested to
generate additional returns and growing
to a greater sum than the amount to be
received in the future.

traceable fixed cost A cost that would no
longer exist if a particular responsibility
center ceased to exist.
Key Terms
waL80281_08_c08_189-212.indd 19 9/25/12 1:03 PM
CHAPTER 8Exercises
Critical Thinking Questions
1. Why must businesses exercise extreme care in the selection
of long-term investments?
2. Describe the screening and ranking processes related to
capital budgeting.
3. What three factors should be considered in the evaluation of
an investment
opportunity?
4. What is meant by an investment in working capital? Are
such investments ever
recovered? Briefly explain.
5. What is the lowest rate of return acceptable to a company?
6. Explain what is meant by the time value of money.
7. Explain the relationship, if any, between compound interest
and present value.
8. What is meant by the term “present value”?
9. Four methods are frequently used to evaluate capital
budgeting proposals. Are these
methods normally used by themselves or in conjunction with

each other? Why?
10. When examining a project’s cash inflows and outflows,
what present value rela-
tionship holds true at the internal rate of return?
Exercises
1. Basic present value calculations
Calculate the present value of the following cash flows,
rounding to the nearest dollar:
a. A single cash inflow of $12,000 in 5 years, discounted at a
12% rate of return.
b. An annual receipt of $16,000 over the next 12 years,
discounted at a 14% rate
of return.
c. A single receipt of $15,000 at the end of Year 1 followed
by a single receipt of
$10,000 at the end of Year 3. The company has a 10% rate of
return.
d. An annual receipt of $8,000 for 3 years followed by a
single receipt of $10,000 at
the end of Year 4. The company has a 16% rate of return.
2. Present value analysis: Working backward
The following information pertains to four independent
investments:
A B C D
Present value ? $19,646 $34,625 $50,852

Interest rate 10% ? 14% 12%
Investment period 4 years 5 years ? 10 years
Annual cash inflows $8,000 $ 6,000 $ 7,000 ?
Determine the unknown for each of the investments. (Note:
Amounts have been
rounded to the nearest dollar; please consider this procedure in
your calculations.
Do not interpolate.)
waL80281_08_c08_189-212.indd 20 9/25/12 1:03 PM
CHAPTER 8Exercises
3. Straightforward net present value calculations
Contempo Inc. is considering the acquisition of some new labor-
saving equipment.
Management estimates that the equipment will cost $42,000 and
will produce the
following savings in cash operating costs during the next 5
years: Year 1, $15,000;
Year 2, $13,000; Year 3, $10,000; Year 4, $10,000; and Year 5,
$6,000. The company
uses the net present value method to analyze investments and
desires a minimum
rate of return of 12%.
a. Compute the net present value of the proposed investment.
Ignore income taxes
and round to the nearest dollar.
b. Considering the time value of money, should Contempo

acquire the new equip-
ment? Why?
4. Cash flow calculations and net present value
On January 2, 20X1, Bruce Greene invested $10,000 in the
stock market and pur-
chased 500 shares of Heartland Development Inc. Heartland
paid cash dividends
of $2.60 per share in 20X1 and 20X2; the dividend was raised to
$3.10 per share in
20X3. On December 31, 20X3, Greene sold his holdings and
generated proceeds
of $13,000. Greene uses the net present value method and
desires a 16% return on
investments.
a. Prepare a chronological list of the investment’s cash flows.
Note: Greene is entitled
to the 20X3 dividend.
b. Compute the investment’s net present value, rounding
calculations to the nearest
dollar.
c. Given the results of part (b), should Greene have acquired
the Heartland stock?
Briefly explain.
5. Straightforward net present value and internal rate of return
The City of Bedford is studying a 600-acre site on Route 356
for a new landfill. The
startup cost has been calculated as follows:
Purchase cost: $450 per acre
Site preparation: $175,000

The site can be used for 20 years before it reaches capacity.
Bedford, which shares a
facility in Bath Township with other municipalities, estimates
that the new location
will save $40,000 in annual operating costs.
a. Should the landfill be acquired if Bedford desires an 8%
return on its investment?
Use the net present value method to determine your answer.
b. Compute the internal rate of return on this project.
waL80281_08_c08_189-212.indd 21 9/25/12 1:03 PM
CHAPTER 8Problems
Problems
1. Straightforward net present value and payback computations
STL Entertainment is considering the acquisition of a
sightseeing boat for summer
tours along the Mississippi River. The following information is
available:
Cost of boat $500,000
Service life 10 summer seasons
Disposal value at the end of 10 seasons $100,000
Capacity per trip 300 passengers
Fixed operating costs per season
(including straight-line depreciation)

$160,000
Variable operating costs per trip $1,000
Ticket price $5 per passenger
All operating costs, except depreciation, require cash outlays.
On the basis of
similar operations in other areas of the country, management
anticipates that each
trip will be sold out and that 120,000 passengers will be carried
each season. Ignore
income taxes.
Instructions
By using the net present value method, determine whether STL
Entertainment
should acquire the boat. Assume a 14% desired return on all
investments; round
calculations to the nearest dollar.
2. Basketball player decision
The Phoenix Kings of the United Basketball League have a
moody center by the
name of Orlando Dawkins. Dawkins is under contract with the
team and is sched-
uled to earn $650,000 in both 20X3 and 20X4. A $75,000 salary
increase will take
effect in 20X5.
Dawkins has not gotten along with several of his teammates
and, as a result,
management is exploring the possibility of a trade with the
Philadelphia Rock-
ets to acquire George Harper, a star player. The Kings would

pay the Rockets
$350,000 immediately for the trade to take place. Harper would
be paid a $270,000
signing bonus at the beginning of 20X3 that management plans
to expense over
the next 3 years by using straight-line amortization. Harper ’s
annual salary would
be $950,000 from 20X3 through 20X5, highest on the team
because of his ability
to attract fans. The Kings expect that increased attendance will
produce added
annual net cash inflows of $525,000.
waL80281_08_c08_189-212.indd 22 9/25/12 1:03 PM
CHAPTER 8Problems
Phoenix officials believe that both players would play 3 more
years for the Kings,
at which time they would become free agents and move along to
other clubs. The
Kings would receive $380,000 compensation from the other
club for Dawkins; for
Harper, the figure would increase to $500,000. Regardless of
whether the trade
takes place, the Kings are obligated to pay Dawkins $200,000 at
the end of 20X4
under the terms of his original contract.
The Kings desire a rate of return of 14% and use the net present
value method
to analyze investments. Round all calculations to the nearest
dollar, and ignore
income taxes.

Instructions
a. Determine whether the Kings should keep Dawkins or trade
for Harper. Assume
the trade would occur on January 1, 20X3.
b. Future cash flows are, in many cases, subject to change.
List several events that
could occur that might influence the cash flows in this situation.
3. Straightforward net present value and payback computations
The Calgary Eskimos play in the Canadian Hockey League.
Although the Eskimos
will soon be moving to a modern arena, management is studying
the possibility of
expanding the team’s present facility to accommodate increased
crowds. A $2.4 mil-
lion expansion is planned that has a $200,000 residual value and
will be depreciated
by the straight-line method over four seasons. Information about
the expansion
follows:
Number of seats Occupancy rate Ticket price
Class 1 seats 2,500 80% $6
Class 2 seats 2,000 60 4
The team will play 50 home games each season. Total added
operating costs per
game (ushers, cleanup, and depreciation) are expected to
average $11,800. All such
costs, except depreciation, require cash outlays.

Instructions
a. By using the net present value method and a 16% desired
rate of return, deter-
mine whether the expansion should be undertaken.
b. In addition to the cash flows presented here, what other
cash flows might change
if the Eskimos add on to the arena?
4. Equipment replacement decision
Columbia Enterprises is studying the replacement of some
equipment that originally
cost $74,000. The equipment is expected to provide 6 more
years of service if $8,700
of major repairs are performed in 2 years. Annual cash
operating costs total $27,200.
Columbia can sell the equipment now for $36,000; the estimated
residual value in
6 years is $5,000.
waL80281_08_c08_189-212.indd 23 9/25/12 1:03 PM
CHAPTER 8Problems
New equipment is available that will reduce annual cash
operating costs to $21,000.
The equipment costs $103,000, has a service life of 6 years, and
has an estimated
residual value of $13,000. Company sales will total $430,000
per year with either
the existing or the new equipment.
Columbia has a minimum desired return of 12% and depreciates

all equipment by
the straight-line method.
Instructions
a. By using the net present value method, determine whether
Columbia should
keep its present equipment or acquire the new equipment.
Round all calculations
to the nearest dollar, and ignore income taxes.
b. Columbia’s management believes that the time value of
money should be consid-
ered in all long-term decisions. Briefly discuss the rationale that
underlies man-
agement’s belief.
waL80281_08_c08_189-212.indd 24 9/25/12 1:03 PM

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