Guillermo Furniture Capital Budget Recommendation
As a new hire accountant for employer Guillermo Furniture, I have analyzed and differentiate capital budge techniques and recommended best suited course of action. Capital Budget Recommendation Guillermo Navallez is a handcrafted midgrade and high-end sofas manufacturer, and owns of Guillermo Furniture Company.As a newly hired accountant in this company, I have been asked to differentiate among the various capital budget evaluations techniques, and explain how these different techniques will help make the appropriate recommendation. Capital budgeting is the processes most organizations use to permit authorize capital spending on long-term projects and other projects requiring significant investment of capital. Typically capital budgeting analysis compares cash inflows and cash outflows instead of net income calculated using the accrual basis.
Capital projects are typically evaluated using quantitative analysis and qualitative information. There are two capital budget evaluation processes that take into consideration the time value of money Net Present Value (NPV) and the Internal Rate of Return (IRR) (Edmonds, 2007). Time value of money is necessary when comparing possible business investments that have different costs, cash flows, and service lives.Processing a discounted cash flow technique such as the net present value method allows a business to consider the possible cash inflows, cash outflows and the necessary rate of return on the investment before it is considered feasible. When the required rate of return is calculated it changes the discount rate that is used when calculating the net present value of the investment (Edmonds, 2007). When an organization selects to implement the internal rate of return method, they are assuming the higher internal rate of return will be more profitable in the end (Edmonds, 2007).
The internal rate of return uses the present value concepts as well as establishing the interest yield of proposed capital budget inflows is the equivalent of the investment project that has a net present value of zero and the present value of net cash The payback method and the unadjusted rate of return are methods that overlook the time value of money but are quick and easy to calculate but prove to be less accurate. These types of methods are typically used for small investment.The payback method itself shows how long it will take the company to recover the initial investment cost. When using the payback method, it is recommended to apply for a shorter payback period. The formula for computing the payback period is as follows: Payback period = Net cost of investment ? Annual net cash inflow Another technique for capital budgeting that doesn’t compute discounted cash flow is the unadjusted rate of return method or the simple rate of return.
Investment cash flows are not adjusted to show the time value of money.This method is also called simple rate of return and computed as follows: Unadjusted rate of return = Average incremental increase in annual net Income ? Net cost of original investment Explanation of capital budget techniques The difference between present value of cash flows and the cost of the project investment provide the net present value of the investment. In case the net present value is in negative amount, it means the present value of value of expected cash flows is lower than the cost of project investment.Cash flows can be computed at lower amount by placing investment at the required rate if the investment return is below the required rate; in this case it is recommended to reject that investment. When dealing with positive net present value, it is better to generate cash flow by implementing the projected investment plan rather than to invest at the standard rate of return.
To compute net present value, we need to find the cash inflows and the cash out flows, and the organizations required rate of return on projected investment (Edmonds, 2007).The Internal rate of return technique is required to recreate the cash flow from an investment equal to the cost of the investment project in process. In case the project is implemented than the internal rate of return is the rate that is provided. Normally, the higher the internal rate of return, the more profitable the investment would be. The IRR consist two step processes, first the internal rate of return factor is calculated by dividing the proposed capital investment amount by the net annual cash flow.Then the factor is found in the present value of an annuity of 1 table using the service life of the project for the number of periods.
The discount rate that the factor is the closest to is the internal rate of return (Edmonds, 2007). The pay back technique measures the length of time it takes a company to recover in cash its initial investment. The major disadvantage of payback period is that it does not take into account any cash flows after the payback period and therefore ignores the salvage value of any asset bought as a part of project.The discounted payback period technique of capital budgeting is similar to payback period and based on the time taken to recover the investment on discounted cash flows discounted to their present value.
Currently Guillermo Furniture is challenged by other competitors and required to change productions options. I have reviewed the financial data to compare Hi- Tech and Distribution options and come to conclusion that we must accept Hi- Tech furniture production. In this option our company can increase profit by 353%, revenue increase is same in both options but net profit in hi-tech is higher in hi-tech.In attached excel worksheet I have shown that calculation (CliffsNotes.
com). The net present value is positive in hi tech and internal rate of return is also impressive of 0. 998. I will highly recommend accepting hi tech option to invest for Guillermo furniture.
Conclusion Guillermo Furniture is given a choice of hi tech and distribution options to choose in order to survive in tough competition. After reviewing and analyzing financial data and applied main capital budgeting techniques. It is recommended to make investment in hi tech furniture manufacturing.