Guillermo_Capital_Budget

Guillermo Capital Budgeting Methodologies Guillermo Navallez has been making furniture for many years in Sonora, Mexico and now is facing challenging times as foreign competition has entered the area. The competitor is using technological advancement that can produce customized furniture at a lower price. As a result, ”Guillermo watched his profit margins shrink and , as prices fell and costs rose” (University of Phoenix. (2011, ). Guillermo needs to determine how to make his business profitable, maintain his market share and keep a competitive advantage. There are a few alternatives (projects) for Guillermo to consider so he can achieve his goal. The first alternative (project) is for Guillermo to manage the store in its current state and keep operations as it has always been. The second alternative (project) is to apply high-tech advancements to produce custom furniture at a lower cost but faster rate. The third alternative (project) is to become a furniture broker for another company. “The objective is to find investment projects that will add value to the firm. These are projects that are worth more to the firm than they cost—projects that have a positive NPV” (Emery, Finnerty, & Stowe, 2007, p. 216). Once the proper Capital budgeting methodologies are reviewed, the Optimal Weighted Cost of Capital (WACC) will be determined and a sensitivity analysis can performed so Guillermo may consider all the information he has to make the best project choice for his business. Capital Budgeting Methodologies Guillermo must consider proper capital budgeting methodologies to find out which project will best fit his goal. The following capital budgeting methodologies should be utilized: 1. Net Present Value ( NPV) 2. Internal rate of Return ( IRR) 3. Simple payback and discounted payback. The Net Present Value is ( NPV) defined as “ the difference between what something is worth ( the present value of its expected future cash flow-its market value) and what it costs” (Emery et al., 2007, p. 221. NPV uses discounted cash flow methods to reflect on the present and future projects cash flow. NPV, however does not consider cash flows after the payback discounted payback period. An effective use of NPV is to determine the all of the cash in and cash out and then add the discounted cash flows. A positive NPV means a project is making enough cash to service the debt and to offer the required return to shareholders, therefore the firm (Guillermo) should accept that project. Conversely, A negative NPV would entail a possible rejection to the firm (Guillermo). There are several projects for Guillermo to consider, therefore the option with the highest NPV should have precedence. The Internal Rate of Return (IRR) is the projects expected return. For this particular scenario, the IRR is asking if the firms (Guillermo) capital budgeting projects return exceeds its required return and therefore create value. (Emery et al., 2007, p.223). This method is very valuable to Guillermo in deciding which project will be best to move forward. Generally, if the WACC that finances Guillermo’s project is less than the IRR that is an indication that there is surplus after the capital is paid. Conversely, if the WACC is more than the IRR, there is not a lot of profit. In the scenario, if you consider the NPV, the surplus , as mentioned before, would find its way back to its shareholders. The simple payback period for Guillermo is the time period or number of years it will take for Guillermo to recover his original investment. For Guillermo, this decision should be considered if the payback is less than a present amount of time (Emery et al., 2007, p.230). Conversely, the discounted payback period is “superior to payback method because it includes the effect of the time value of money” (Emery et al., 2007, p.232) as it integrates a variant on regular payback. While the discounted payback considers capital costs, the regular payback period does not factor in the WACC. All in all, the payback period is more frequently used as a indicator of the amount of risk a project may have. The longer the payback period for a project, the greater the risk is for that particular project. Optimal Weighted Cost of Capital (WACC) The WACC is “represented as the weighted average cost of the components of any financing package that will allow the project to be undertaken” (Emery et al., 2007, p.197) “The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate” ("Investopedia," 2011) For this scenario, we can use the information from appendix 1 and we will use the cost of debt is equal 7.5% and the income tax expense rate is 42%. The weight of debt can be determined by dividing the total liability by the total equity. In 2009, this equates to $1,130,963 / ($1,130,963 + $211,111) or $1,130,963 / $1,342,074 = 84.3%. In 2010, this equates to $1,109,358 / ($225,805 + $1,109,358) or $1,109,358 / $1,335,163 = 83.1%. If we have a risk free rate of 4.36%, a market rate of 12.0, and a beta of 0.8, the weight of equity in 2009 would be $211,111 / ($211,111 + $1,130, 963) or $211,111 / $1,342,074 = 15.7%. In 2010, this equates to $225,805 / ($225,805 + $1,109,358) or $225,805 / $1,335,163 = 16.9%. So, in 2009, the WACC would equate to 7.5% x (1 – 42%) x 84.3% + 9.6% x 15.7% = 5.17. In 2010, the WACC would equate to 7.5% x (1 – 42%) x 83.1% + 9.6% x 16.9% = 5.23. Sensitivity Analysis For each possible project, Guillermo needs to consider his potential net income for each option. If Guillermo opts to pursue his current process, the net income before taxes will be $42,577. If Guillermo pursues the hi-tech option, the net income before taxes will be $195,564. If Guillermo pursues the broker option, the net income before taxes will be $50,955. Another important factor for Guillermo is production. If Guillermo pursues either the hi-tech or broker option, the sales forecast will be $3,798 for mid-grade and $759 for high-end. For the current process, however, mid-grade production would be $2,532 and high-end would be $506. The reduction in prices for the hi-tech and broker options can be attributed to increases in supply. Additionally, due to depreciation, the overhead would increase for the hi-tech and broker options. Currently, depreciation is $50,000, but the hi-tech and broker options would cause it to be $466,667. Additionally, the high-tech and broker options would cause an increase in salary ($45,000); however, the current scenario would not involve such an increase. Utility costs would also greatly increase if Guillermo pursues the hi-tech option; it would go from $9,000 to $27,000. If the broker option is selected it would be $4,497. Taxes would additionally vary based on which option is selected and would affect the income as such. Currently, the income is at $24,695 after taxes. Income for the hi-tech option would be $29,554 after taxes. Income for the broker option would be $113,427 after taxes. A sensitivity analysis of Guillermo’s operations shows an increase of $53,089 pertaining to current assets between 2009 and 2010. Nonetheless, the most sizable increase is in regard to cash. There was an increase of $56,179 in total assets between 2009 and 2010. Guillermo’s total current liabilities also increase by $53,069 between 2009 and 2010. Nonetheless, total liabilities decreases by $21,605 during those same years. Total equity increased by $24,695, largely due to an increase in retained earnings. NPV of Future Cash Flows The net present value is the total present value pertaining to a time series of cash flows and to calculate this, the discount rate and appropriate period of time is needed. (Emery et al., 2007). In this scenario, an appropriate period of time would demonstrate the property being fully depreciated in all scenarios As such, a span of 20 years would be appropriate. Income tax would need to be subtracted from the net profit and then the depreciation charged would be added back. Let us assume the value of the equipment to be $1,000,000 and that there is a straight-line depreciation over 10 years and there will be depreciation of $100,000 every year ($1,000,000 x 10%). Once this period is up, the income before taxes of the hi-tech and broker options would go up by $100,000. Guillermo would need to pay taxes at a rate of 42%; this would directly affect the cash flow (reduction). When it comes to the current scenario, the before-tax net income would increase by $50,000 once the building has fully depreciated. Guillermo would have to pay the tax rate of 42% on the $50,000 of extra income. Assuming that Guillermo’s net income does not change over the period of time and additional expenses stay the same over this period, the NPV over 20 years (10 percent) for the current option equates to $625,585.53, $4,839,169.20 for the hi-tech option, and $4,125,109.02 for the broker option. Guillermo’s success is dependent on deciding which project is best suited for him while employing the capital budgeting techniques previously discussed. Capital budgeting techniques such as net present value ( NPV), internal rate of return ( IRR), simple payback and discounted payback are the leading factors to help Guillermo with his final decisions to either: maintain his current strategies, invest in new “high-tech” technologies or to become a broker with a firm in Norway. Final review of the sensitivity analysis and NPV of future cash flow should make the decision easy for Guillermo.   Appendix 1. Assets, Liabilities & Equity Information 12/31/2009 12/31/2010 Cash $ 120,872 USD $ 165,933 USD Accounts Receivable 201,266 205,374 Sales growth has slowed to 1% Inventory 118,686 122,357 Inflation is running at 3% Pre-paid Insurance 1,250 1,500 TOTAL CURRENT ASSETS $ 442,074 USD $ 495,163 USD Buildings 1,500,000 1,500,000 Less: Accumulated Depreciation (600,000) (650,000) Equipment 50,000 50,000 Less: Accumulated Depreciation (50,000) (50,000) TOTAL ASSETS $1,342,074 USD $1,345,163 USD Accounts Payable $ 79,917 USD $ 82,388 USD Income Taxes Payable 16,988 17,882 Wages Payable 41,060 43,221 Current Portion of Notes Payable 27,132 29,238 TOTAL CURRENT LIABILITIES $ 165,097 USD $ 172,730 USD Mortgage Note Payable 965,867 936,628 TOTAL LIABILITIES $1,130,963 USD $1,109,358 USD Common Stock $ 10,000 USD $ 10,000 USD Retained Earnings 201,111 225,805 TOTAL EQUITY $ 211,111 USD $ 235,805 USD TOTAL LIABILITIES & EQUITY $1,342,074 USD $1,345,163 USD (University of Phoenix. (2011, ).   Appendix 2 Income Information-Current Standards Current Hi-Tech Broker Production Current Production = Sales Forecast Mid-Grade 2,532.00 3,798.00 3,798.00 High-End 506.00 759.00 759.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,497 Benefits 103,730 82,412 21,644 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 82,137 21,401 Taxes are 42% of Net Income 265,282 891,543 663,663 Net Margins 222,705 695,979 612,708 Overhead 42,577 195,564 50,955 Net Income before taxes (University of Phoenix. (2011, ).   References Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate financial management (3rd ed.). Upper Saddle River, NJ: Pearson Prentice Hall. University of Phoenix. (2011, ). Guillermo Furniture Store Simulation [FIN 571 comment]. Retrieved from https://portal.phoenix.edu/classroom/coursematerials/fin_571/20110621/ WAAC. (2011). Retrieved July 16, 2011, from www.investopedia.com