Guillermo_Essay_Wk_4

Running Head: GUILLERMO FURNITURE STORE Guillermo Furniture Store Analysis Guillermo Navallez owes a furniture store in Sonora, Mexico. Lately, he has seen a turn in the area where he does business, which has affected his sales and his costs to do business. Guillermo has three alternatives in order to keep the company in the current position: Project Current, Project High-tech, and Project Broker. After Guillermo has insight into which alternative would suit his store best, he can determine the weighted average cost of capital (WACC) and he can calculate the Net Profit Value (NPV). To find the best option, there are various options that can be used from capital budgeting techniques; including: simple payback, discounted payback, and net present value. In the Simple payback capital budgeting technique refers to the amount of time it will take Guillermo to recover his original investment. The cumulative cash flow of Guillermo’s Furniture store at t = 0 is just the initial cost of -$300,000. At Year 1 the cumulative cash flow is the previous cumulative of $300,000 plus the Year 1 cash flow of $500: -$300,000 + $42,573 = -$257,427. Similarly, the cumulative for Year 2 is the previous cumulative of -$257,427 plus the Year 2 inflow of $42,573, resulting in –$214,854. We see that by the end of Year 7 the cumulative inflows have more than recovered the initial outflow. Thus, the payback occurred during the third year. If the $40,584 of inflows comes in evenly during Year 3, then the exact payback period can be found as follows: Payback Period = 7 + ($1,989 / $42,573) = 7.05 years. Applying the same procedure to Project High-Tech and Project Broker, we find the payback period for them is 1.53 years and 5.89 years respectively. It is known that the shorter the payback period, the better. As the projects are mutually exclusive, meaning if a project is taken on, the other is rejected, Project High-tech would be accepted but Project Current would be rejected. If the projects were mutually exclusive, Project High-tech would be ranked over Project Broker and Project Current because Project High-Tech has the shorter payback. The discounted payback period uses the time value of money. Here the weighted average cost of capital (WACC) is used to determine the discounted payback period. If we look at the values of discounted cash flows (see Excel file) we can find that the discounted payback period for Project Current is 9.9 years whereas Project High-Tech and Project Broker are 1.4 year and 8.1 years respectively. Net Present Value (NPV) is known as the best technique in the capital budgeting decisions. There are flaws in the simple payback as well as discounted pay back periods because it does not consider the cash flow. The NPV method relies on discounted cash flow (DCF) techniques is used to find the value of the project by considering the cash flow of the project until its life. To calculate the NPV, the following occurs: a) Find the present value of each cash flow, including all inflows and outflows, discounted at the project’s cost of capital, b) Sum these discounted cash flows; this sum is defined as the project’s NPV, and c) If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen. The following is the formula to calculate NPV: NPV = ∑ (CFt / (1 + k)t). Here CFt is the expected net cash flow at Period t, k is the project’s cost of capital, and n is the life of the project. Cash outflows are treated as negative cash flows for the project because the investor’s cash position decreased with the investment. In evaluating Projects Current, High-Tech and Broker, only CF0 is negative (see Excel file). By calculating the different alternatives, Guillermo can determine which Project would be the best suit for his company. By determining which Projects are mutually exclusive, he can decide on the Project that produces the most profit. After computing all the information, it is determined that Project High-tech would be the most beneficial Project for Guillermo Furniture Store. Reference Brigham, E. F., & Houston, J. F. (2004). Fundamental of Financial Management. South Western: Thomson.