Question

Riu Corporation has a Parts Division that does work for other Divisions in the company as well as for outside customers. The company's Repair Division has asked the Parts Division to provide it with 2,000 special parts each year. The special parts would require $17.00 per unit in variable production costs. The Repair Division has a bid from an outside supplier for the special parts at $28.00 per unit. In order to have time and space to produce the special part, the Parts Division would have to cut back production of another part-the B83 that it presently is producing. The B83 sells for $34.00 per unit, and requires $22.00 per unit in variable production costs. Packaging and shipping costs of the B83 are $4.00 per unit. Packaging and shipping costs for the new special part would be only $0.50 per unit. The Parts Division is now producing and selling 10,000 units of the B83 each year. Production and sales of the B83 would drop by 10% if the new special part is produced for the Repair Division.

Required:

a. What is the range of transfer prices within which both the Divisions' profits would increase as a result of agreeing to the transfer of 2,000 special parts per year from the Parts Division to the Repair Division?
b. Is it in the best interests of Riu Corporation for this transfer to take place? Explain.

c. What is capital budgeting? Why are capital budgeting decisions often difficult and risky?

d. In using a capital budgeting method that takes the time value of money into consideration, management must consider a hurdle rate in making its decisions. What is a hurdle rate? What factors does management have to consider in selecting a hurdle rate?

Answer 1

a) From the perspective of the Parts Division, profits would increase as a result of the transfer if and only if:

      Transfer price ≥ Variable cost + Opportunity cost

      The opportunity cost is the contribution margin on the lost sales, divided by the number         of units transferred:

    Opportunity cost = [($34.00- $ 22.00- $4.00) × 1000*] / 2,000 = $4.00

*10% × 10,000 = 1,000

Therefore, Transfer price ≥ ($17.00 + $0.50) + $4.00 = $21.5

From the viewpoint of the parts division , the transfer price must be less than the cost of buying the units from the outside supplier. Therefore, Transfer price < $28.00

Combining the two requirements, we get the following range of transfer prices:

$21.5≤ Transfer price ≤ $28.00

b) Yes, the transfer should take place. From the viewpoint of the entire company, the cost of transferring the units within the company is $21.5 but the cost of purchasing the special parts from the outside supplier is $28.00. Therefore, the company’s profits increase on average by $6.5 for each of the special parts that is transferred within the company, even though this would cut into production and sales of another product.

c) Capital budgeting is a method of analyzing and comparing substantial future investments and expenditures to determine which ones are most worthwhile. In other words, it’s a process that company management uses to identify what capital projects will create the biggest return compared with the funds invested in the project. Each project is ranked by its potential future return, so the company management can choose which one to invest in first.

capital budgeting decisions often difficult and risky because,

• Free cash flow is a scarce resource – there will never be enough to fund all proposals received
• Traditional capital budgeting orders the proposals according to the greatest potential return (highest Net Present Value (NPV) or Internal Rate of Return (IRR))
• Project cash requirements and estimated cash inflows are estimated for a foreseeable timeframe (5 – 10 years)
• A discount rate is applied to reduce all cash inflows and outlays into present value dollars. Another option reduces these flows to an effective Internal Rate of Return (IRR).
• All other things being equal, the highest NPV (or IRR) is the first to be funded, followed by the next, until investment funds are exhausted.

d)    Hurdle rate

A hurdle rate is the minimum rate of return on a project or investment required by   a manager or investor. The hurdle rate denotes appropriate compensation for the level of risk present; riskier projects generally have higher hurdle rates than those that are less risky.

Factors to consider when setting a hurdle rate

In analyzing a potential investment, a company must first hold a preliminary evaluation to test if a project has a positive net present value. Care must be exercised as setting a very high rate could be a hindrance to other profitable projects and could also favor short-term investments over the long-term ones. A low hurdle rate could also result in an unprofitable project.

Key considerations include:

• Risk premium – assigning a risk value for the anticipated risk involved with the project. Riskier investments generally have greater hurdle rates than less risky ones.
• Inflation rate – if the economy is experiencing a mild inflation, it may influence the final rate by 1-2 percent. There are instances when inflation may be the most significant factor to consider.
• Interest rate – interest rates represent an opportunity cost that could be earned on another investment, so any hurdle rate needs to be compared to real interest rates.