Guillermo_Capital_Budget_Recommendation

Guillermo Capital Budget Recommendation Judy Blackman ACC/543 October 31, 2011 Linda Miller Guillermo Capital Budget Recommendation Guillermo Furniture located in Sonora, Mexico produces mid-grade and high-end sofas. Until the late 1990s the company had increasing profit, but profits began to shrink because of recent changes in the business environment and economy (University of Phoenix, 2009). After researching Guillermo determined that he had to make changes to stay in business. I have been asked by Guillermo to study the different opportunities available, which are a high-technology solution and a broker solution and to determine which would produce the greatest return on his investment. To determine which alternative solution would be the best for the company it is necessary to differentiate between the different capital budget evaluations techniques. Capital budget evaluation techniques When analyzing the cash flow associated with capital investment there are several techniques, which can be divided into two categories. The first category uses techniques using time value of money concepts is the first category. Included in the first category are techniques such as the payback method and the unadjusted rate of return method, which are easier to understand but less accurate. The second category includes techniques, which ignore the time value of money. Include here are techniques such as the net present value method and the internal rate of return method. They offer major improvements in accuracy but are more difficult to understand (Edmonds, 2007). One method, which is simple to apply and easily understood, is the payback method, which shows the amount of time necessary to recover the initial cost or cash outflow of the investment. If an investment has a shorter payback period it is usually considered better. Profitability is not measured by the payback method but instead only investment recovery is measured. Measured in years the payback method uses the following formula to calculate the payback period: Payback Period equals net cost of investment divided by annual net cash inflow (Edmonds, 2007). A second method is the present value index method. This method is used to compare different size investment opportunities. It can be computed by dividing the present value of cash inflows by the present value of cash outflows, and if there is a high ratio there will be a high rate of return per dollar invested. The present value of the future cash flows generated by the project is calculated by the net present value method. This present value of the cash inflow is compared to the present value of any outflows. If the present value of the cash inflow is greater than the present value of the cash outflow it will result in a positive net value for the project. The present value of the future cash inflows must be compared by management to the current cash out flow required to purchases them. The net present value of the investment opportunity is determined by subtracting the cost of the investment from the present value of the future cash inflows (Edmonds, 2007). A third method is the unadjusted rate of return method. With this method there is no adjustment of investment cash flows to reflect the time value of money. This is sometimes called the simple rate of return. Because of the failure to recognize the recovery of capital, which had been invested the accuracy of the unadjusted rate of return suffers. The capital investment is usually recovered through revenue over the life of the asset with respect to a depreciable asset. To calculate the unadjusted rate of return the average incremental increase in annual net income cost is divided by the net cost of original investment (Edmonds, 2007). The final method is the internal rate of return. The internal rate of return is the rate at which the present value of cash inflows equals the cash outflows. If the internal rate of return is below the desired rate of return the project should be rejected by management. The desired rate of return is sometimes called the cut off rate or the hurdle rate. In other words to be acceptable the internal rate of return must be higher than the desired rate of return from the investment. These terms are just alternative for the cost of capital and to be accepted an investment must provide an internal rate of return higher than the company’s cost of capital (Edmonds, 2007). How present value index method can help make recommendation In regard to Guillermo’s case the use of the present value index method would be the best method to use. It would be best because of the ability to compare the different capital investment opportunities because the opportunities vary in size and duration. Guillermo identified two main investment opportunities, which are the high technology solution and the broker or distribution opportunity. First the present value of each investment opportunity must be calculated to draw a valid conclusion about the value of each opportunity. Recommendation As previously mentioned the present value index method is calculated by dividing the present value of cash inflows by the present value of cash outflows. The overhead cost is 697,899 pesos and the net income before taxes is 217,344 pesos for the high-technology opportunity. By dividing the 697,899 pesos by 217,344 pesos the rate of return for the high technology opportunity is 3.2011. In the broker solution the overhead cost is 196,383 pesos and the net income before taxes is 485,040 pesos and when the 196,383 is divided by the 485,040 the rate of return is 0.40488. Also to compute the present value index for the high technology opportunity and the broker opportunity an estimate of expected cash flows from the two opportunities is necessary. After considering the circumstances facing Guillermo, evaluating the company’s data sheets, and using the present value index method to compare the different capital investment opportunities the recommendation for Guillermo is that the high technology opportunity should be chosen because it has a higher rate of return at 3.2011 than the broker opportunity at a rate of 0.40488. Reference Page Edmonds, T.P. et al. (2007). Fundamental financial & managerial accounting concepts. New York: McGraw - Hill University of Phoenix. (2009). Guillermo Furniture [Multimedia]. Retrieved from University of Phoenix, ACC543-Managerial accounting and legal aspects of business website.