Fin_4k_4

Guillermo Furniture Store Analysis: Capital Budgeting Techniques Decide Optimal Alternative The principles of finance exist to determine the monetary worth and health of an organization. These principles are designed to provide as objective an outlook as is possible such that courses of action and subsequent operations are transparent and accurate lest poor decisions be made with transient accountability. In the case scenario of Guillermo’s Furniture Store, the entitled owner understands the fundamental need for change to ensure continued business prosperity in the face of intensified competition and increasing costs. Indeed, Guillermo’s agenda is founded upon his desire to maintain his current standard of life; maintain income without increasing stress or need to commit more time to work (i.e. away from his family). Thus, he wishes to solidify his financial future by shifting the nature of his business in order to remain relevant in a market where increased labour costs and competition are prevalent. As an astute owner, Guillermo recognizes several potential avenues, each mutually exclusive to the others, to shift the primary nature of his business. The three alternatives under consideration are entitled: Current Project, High-Tech Project and Broker Project. In order to decide between the proposed alternative paradigms, thorough examination of principle financial metrics shall be generated to provide the basis for informed decision-making; capital budgeting techniques shall be employed. Specifically, the capital budgeting techniques to be employed are: Simple payback, Discounted payback, Net Present Value (NPV) and internal rate of return (IRR). Additionally, weighted average cost of capital (WACC), net present value (NPV) of future cash flows, a sensitivity analysis and discussion of risk mitigation shall be discussed as they pertain to each alternative. Simple Payback Period Emery, Finnerty and Stowe (2007) define simple payback as "the expected number of years required to recover the original investment". Thus, the shorter the payback period, the more profitable the operation and the more advisable it would be to adopt as a paradigm shift in operations. Payback is "... computed by simply summing all the expected cash flows (...) in sequential order until the sum equals the initial outflow "(Emery, Finnerty & Stowe. 2007. p. 230). As only one business alternative may be chosen (the alternatives are mutually exclusive), the project with the shortest payback period. The author postulates that the High-Tech Project is preferable in this case. Discounted Payback Period Emery, Finnerty and Stowe (2007) describe discounted payback as: "... the amount of time it takes for the project’s discounted cash flows to equal the project’s initial cost " (p. 231). Therefore, the discounted payback period takes into account the time value of money (Emery, Finnerty & Stowe. 2007. p.231). Thus, for the purpose of the alternatives presented, discounted payback represents the period of time required to recover the initial investment from discounted net cash flows. If, the High-Tech Project proves to have the shortest discounted payback period it would be favourable over the other alternatives. However, the "discounted payback is superior to the payback method because it includes the effects of the time value of money. However, it too is arbitrary and suffers from the weakness of ignoring all cash flows beyond the cutoff" (Emery, Finnerty & Stowe. 2007. p.232). Net Present Value (NPV) NPV is widely regarded as the benchmark capital budgeting technique: "NPV measures the value the project will create, which is the difference between what the project is worth and what it will cost to undertake. The NPV method recommends that all independent projects with a positive NPV be undertaken" (Emery, Finnerty & Stowe. 2007. p.234). Thus, the project having the greatest NPV ought to be selected as most advantageous; it will return the greatest amount of wealth from the initial investment. NPV may be calculated as follows: CFt is the expected net cash flow at period t, k is the cost of capital for the project and n signifies the life of the project (number of cash flows). Thus, in order to conduct a sensitivity analysis, each of the latter parameters could be varied to determine their respective effect upon NPV: "Sensitivity analysis measures the sensitivity of NPV by varying one variable at a time" (Emery, Finnerty & Stowe. 2007. p.305). In order to complete this equation, the time period and the discount rate must be stipulated. None are given in the case study and are thus entirely dependent on assumptions. If, the High-Tech Project proves to have the highest NPV it would be the favoured alternative. Internal Rate of Return (IRR) Simply put, the IRR is: "The expected return of a capital budgeting project" (Emery, Finnerty & Stowe. 2007. p.876). Below is the equation to calculate IRR provided the discount rate of the cash inflows is equal to the cash outflows: The higher the IRR (if IRR is greater than WACC), the more profitable the project. If the High- Tech Project provides the highest IRR, it ought to be selected. Weighted Average Cost of Capital (WACC) Emery, Finnerty & Stowe (2007) define the formula for WACC as follows (p.446): WACC = (1 − L)re + L(1 − T )rd Where: re (required return for equity), and rd (required return for debt) as hypothetical functions of L (the leverage ratio = quotient of debt and (debt+equity)). Note that L presents proportional risk to the shareholders and debtholders of the firm: "required returns on equity and debt (re and rd, respectively) depend on L" (Emery, Finnerty & Stowe. 2007. p.445). In order to calculate the WACC precisely, exact values need to be provided within the case study. Without such information for each scenario, the calculations would be entirely dependent on assumptions. Sensitivity Analysis According to the assigned readings, a sensitivity analysis "... entails varying the maximum expenditure limit. ... a firm may find that a small increase in the total expenditure would allow it to undertake the next most desirable project, which may be a worthwhile trade-off" (Emery, Finnerty & Stowe. 2007. p.289). Further, a "Sensitivity analysis varies key parameters in a process to determine the sensitivity of outcomes to the variation" (Emery, Finnerty & Stowe. 2007. p.304). However, therein lies the drawback to a sensitivity analysis; it allows for the effect of only one parameter to be examined at one time. Unfortunately, rarely are real-world variables entirely independent of one another. Therefore, scenario analysis is a superior method: "scenario analysis constructs scenarios in which several variables change in each scenario. A project is evaluated by looking at its NPVs in all of the constructed scenarios" (Emery, Finnerty & Stowe. 2007. p.305). Conclusion In the case scenario of Guillermo’s Furniture Store, the entitled owner understood the fundamental need for change to ensure continued business prosperity. The owner considered three mutually exclusive courses of action to shift the nature of this business. Ultimately, the author postulates that the option High-Tech Project will prove to be the most profitable through capital budgeting technique calculations. Specifically, the High-Tech Project would be selected if it presented the shortest payback period, shortest discounted payback period, the greatest NPV and the highest internal rate of return. The use of multiple valuation techniques lends credibility and the agreement between the collective results is preferable than reliance on any one of them individually. In so doing, the risk of the assessments being inaccurate is drastically reduced. Thus, Guillermo is most likely to select the High-Tech Project option correctly to remain most competitive within the market, increase his personal wealth and ensure optimal work-life balance.