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Capital Budgeting and Flexible Budgeting and Variances

Problem 1 - Flexible budget planning
Luke Chou, the president of Digitech Computer Services, needs your help. He wonders about the potential effects of the firm's net income if he changes the service rate that the firm charges its customers. The following basic data pertain to fiscal year 2012.
Standard rate and variable costs:
Service rate per hour $80.00
Labor $40.00
Overhead $7.20
General, selling, and administrative $4.30

Expected fixed costs:
Facility repair $525,000.00
General, selling, and administrative $150,000.00

a. Prepare the pro forma income statement that would appear in the master budget if the firm expects to provide 30,000 hours of services in 2012.
b. A marketing consultant suggests to Mr. Chou that the service rate may affect the number of service hours that the firm can achieve. According to the consultant's analysis, if Digitech charges customers $75 per hour, the firm can achieve 38,000 hours of services. Prepare a flexible budget using the consultant's assumption.
c. The same consultant also suggests that if the firm raises its rate to $85 per hour, the number of service hours will decline to $25,000. Prepare a flexible budget using the new assumption.
d. Evaluate the three possible outcomes you determined in Requirements a, b, and c and recommend a pricing strategy.

Problem 2 - Using net present value and payback period to evaluate investment opportunities
Bruce Graham saves $250,000 during the 25 years that he worked for a major corporation. Now he has retired at the age 50 and has begun to draw a comfortable pension check every month. He wants to ensure the financial security of his retirement by investing his savings wisely and is currently considering two investment opportunities. Both investments require an initial payment of $187,500. The following table presents the estimated cash inflows for the two alternatives.
Year 1 Year 2 Year 3 Year 4
Opportunity #1 $55,625 $58,750 $78,750 $101,250
Opportunity #2 $102,500 $108,750 $17,500 $15,000
Mr. Graham decides to use his past average return in mutual fund investments as the discount rate, it is 8 percent.

a. Compute the net present value of each opportunity. Which should Mr. Graham adopt based on the net present value approach?
b. Compute the payback period for each project. Which should Mr. Graham adopt based on the payback approach.
c. Compare the net present value approach with the payback approach. Which method is better in the given circumstances?

Solution Summary

Capital Budgeting and Flexible Budgets