Case Study: Guillermo Furniture Company
Capital Budget Recommendation
Kelly Garner
ACC/543
November 3, 2014
Mr. Thomas Frank
Capital Budget Recommendation
Guillermo Navallez is the owner of the Guillermo Furniture Company; a furniture manufacturing company located near Sonora, Mexico. He has been able to offer customers products at a premium price for years. However, recent economic and environmental factors have threatened the future success of the company. I have been hired as an accountant to make capital budget recommendations that would provide the greatest return for the company. The proposal will consider different capital budgeting evaluation techniques and will recommend a course of action. The net present value will support the proposal.
Background and Researched …show more content…
Options
Profits have decreased as costs continue to rise. Guillermo has no desire to take part of a merger or acquisition by a larger competitor. He does not consider this to be a viable option. Neither does he wish to add to “his management responsibilities by acquiring another organization” (Guillermo Furniture Scenario, University of Phoenix, ACC/543 – Week 1). Guillermo has considered making a capital investment. He is willing “to exchange current cash outflows for the expectation of receiving future cash inflows” (Edmonds, et. al., 2007, p. 1150).
Guillermo researched to see what options were available to him. He discovered that most of the foreign competitors used a high-tech solution for production; an automated laser lathe. This technology was rather expensive, but it would decrease overall production costs. Guillermo would be able to reduce labor significantly and could run production activities around the clock. A second option would warrant Guillermo the opportunity of becoming a distributor for another competitor. Lastly, Guillermo could revamp his patented furniture coating process. Currently, the process consists of two steps. The flame-retardant process has a market and can be profitable for the company. However, there is not a market for the finished coating process.
Differentiating Among the Various Capital Budget Evaluation Techniques Companies use the planning process of capital budgeting to evaluate whether or not a potential investment is worth the required amount of funding. At the end of calendar year 2013, Guillermo Furniture Company had $506,902 USD in total assets. There are several analytical techniques Guillermo may use to help him in selecting a wise capital investment project. All of the capital budget evaluation techniques offers advantage and disadvantages.
Every technique may not fit Guillermo’s situation. He may however apply multiple techniques when evaluating options. “Limiting analysis to only one tool could produce biased results” (Edmonds, et. al., 2007, p. 1155).
Net Present Value
“Net present value is an evaluation technique” that considers the initial cost of an investment and the desired rate of return to calculate the present value of future cash inflows (Edmonds, et. al., 2007, p. 1155). The focus of this technique is to increase the value of the business. There are three steps to make this determination. First, all cash inflows must be identified. Thereafter, “appropriate conversion factors are identified, and the cash inflows are converted to their equivalent present values” (Edmonds, et. al., 2007, p. 1158). Secondly, the cash outflows would be determined by the same method. Lastly, the present value of the outflows are subtracted from the present value of the inflows.
Payback Period The payback period technique calculates the length of time it would take to recover the initial cost of the investment. The sooner the recovery of investment costs, the better it is for the company. This method does not measure how profitable the investment may be for the company. “The formula for computing the payback period is the net cost of investment divided by the annual net cash inflow” (Edmonds, et. al., 2007, p. 1165).
Internal Rate of Return
“The internal rate of return is the rate at which the present value of cash inflows equals the cash outflows” (Edmonds, et. al., 2007, p. 1156). When selecting an investment proposal, the “internal rate of return” should be “higher than the” desired rate of return. Therefore, the investment must provide “a return higher than the cost of capital” (Varol, et. al., 2012).
Recommendation
Guillermo’s projected income information provides two options, hi-tech and broker. Both options could have an increase in production by 50%, and the direct material cost would remain constant. However, the broker option would have a slight advantage as there would be no material cost for the mid-grade units. Labor costs would increase from fifteen dollars an hour to forty dollar for both options. The increase is due to the technical skills required of the workers. The labor hours would decrease drastically, which would be a huge cost savings for the company.
Both options would allow Guillermo to reduce prices by 10%. The reason for this decrease is because of an increase in supply. The equipment has a useful life of ten years and has a straight-line depreciation. Calculation for net present value are:
Options
Annual Net Income (pretax)
Depreciation
Income Taxes
Annual Cash Flow
Current
47,183
+
50,000
-
19,817
$ 77,366
High-Tech
218,202
+
466,667
-
91,645
$ 593,224
Broker
68,973
+
466,667
-
28,969
$ 506,671
After considering Guillermo’s options, the datasheets were reviewed and evaluated.
The present value method was used to compare the profitability of the options. The overhead cost for the high-tech option is $697,995. The net income before taxes is $218,202. The rate of return equaled 0.3126. The broker option has overhead costs in the amount of $613,044 and the net income before taxes resulting in $68,973. The rate of return equaled 0.1125. Guillermo is recommended to select the high technology investment solution because of its higher return rate. When conducting the analysis using the net present value technique, the calculations equaling zero or higher would be favorable. The results would deem the high-tech investment to be the most desirable. Such a transaction would yield an acceptable rate of return.
References
Edmonds, T. P., Edmonds, C. D., Olds, P. R., McNair, F.M., Tsay, B.-Y., Schneider, N. W., et al. (2007). Chapter 24: Planning for Capital Investment. In Fundamental Financial and Managerial Accounting Concepts (1st ed.). New York, NY: McGraw-Hill. Retrieved October 28, 2014 from The University of Phoenix eBook Collection database.
Varol, N., Costa-Font, J., and McGuire, A. (2012). Does Adoption of Pharmaceutical Innovation Respond to Changes in the Regulatory Environment? In Applied Economic Perspectives and Policy. Retrieved November 3,
2014.
Kelly Garner
ACC/543
November 3, 2014
Mr. Thomas Frank
Capital Budget Recommendation
Guillermo Navallez is the owner of the Guillermo Furniture Company; a furniture manufacturing company located near Sonora, Mexico. He has been able to offer customers products at a premium price for years. However, recent economic and environmental factors have threatened the future success of the company. I have been hired as an accountant to make capital budget recommendations that would provide the greatest return for the company. The proposal will consider different capital budgeting evaluation techniques and will recommend a course of action. The net present value will support the proposal.
Background and Researched …show more content…
Options
Profits have decreased as costs continue to rise. Guillermo has no desire to take part of a merger or acquisition by a larger competitor. He does not consider this to be a viable option. Neither does he wish to add to “his management responsibilities by acquiring another organization” (Guillermo Furniture Scenario, University of Phoenix, ACC/543 – Week 1). Guillermo has considered making a capital investment. He is willing “to exchange current cash outflows for the expectation of receiving future cash inflows” (Edmonds, et. al., 2007, p. 1150).
Guillermo researched to see what options were available to him. He discovered that most of the foreign competitors used a high-tech solution for production; an automated laser lathe. This technology was rather expensive, but it would decrease overall production costs. Guillermo would be able to reduce labor significantly and could run production activities around the clock. A second option would warrant Guillermo the opportunity of becoming a distributor for another competitor. Lastly, Guillermo could revamp his patented furniture coating process. Currently, the process consists of two steps. The flame-retardant process has a market and can be profitable for the company. However, there is not a market for the finished coating process.
Differentiating Among the Various Capital Budget Evaluation Techniques Companies use the planning process of capital budgeting to evaluate whether or not a potential investment is worth the required amount of funding. At the end of calendar year 2013, Guillermo Furniture Company had $506,902 USD in total assets. There are several analytical techniques Guillermo may use to help him in selecting a wise capital investment project. All of the capital budget evaluation techniques offers advantage and disadvantages.
Every technique may not fit Guillermo’s situation. He may however apply multiple techniques when evaluating options. “Limiting analysis to only one tool could produce biased results” (Edmonds, et. al., 2007, p. 1155).
Net Present Value
“Net present value is an evaluation technique” that considers the initial cost of an investment and the desired rate of return to calculate the present value of future cash inflows (Edmonds, et. al., 2007, p. 1155). The focus of this technique is to increase the value of the business. There are three steps to make this determination. First, all cash inflows must be identified. Thereafter, “appropriate conversion factors are identified, and the cash inflows are converted to their equivalent present values” (Edmonds, et. al., 2007, p. 1158). Secondly, the cash outflows would be determined by the same method. Lastly, the present value of the outflows are subtracted from the present value of the inflows.
Payback Period The payback period technique calculates the length of time it would take to recover the initial cost of the investment. The sooner the recovery of investment costs, the better it is for the company. This method does not measure how profitable the investment may be for the company. “The formula for computing the payback period is the net cost of investment divided by the annual net cash inflow” (Edmonds, et. al., 2007, p. 1165).
Internal Rate of Return
“The internal rate of return is the rate at which the present value of cash inflows equals the cash outflows” (Edmonds, et. al., 2007, p. 1156). When selecting an investment proposal, the “internal rate of return” should be “higher than the” desired rate of return. Therefore, the investment must provide “a return higher than the cost of capital” (Varol, et. al., 2012).
Recommendation
Guillermo’s projected income information provides two options, hi-tech and broker. Both options could have an increase in production by 50%, and the direct material cost would remain constant. However, the broker option would have a slight advantage as there would be no material cost for the mid-grade units. Labor costs would increase from fifteen dollars an hour to forty dollar for both options. The increase is due to the technical skills required of the workers. The labor hours would decrease drastically, which would be a huge cost savings for the company.
Both options would allow Guillermo to reduce prices by 10%. The reason for this decrease is because of an increase in supply. The equipment has a useful life of ten years and has a straight-line depreciation. Calculation for net present value are:
Options
Annual Net Income (pretax)
Depreciation
Income Taxes
Annual Cash Flow
Current
47,183
+
50,000
-
19,817
$ 77,366
High-Tech
218,202
+
466,667
-
91,645
$ 593,224
Broker
68,973
+
466,667
-
28,969
$ 506,671
After considering Guillermo’s options, the datasheets were reviewed and evaluated.
The present value method was used to compare the profitability of the options. The overhead cost for the high-tech option is $697,995. The net income before taxes is $218,202. The rate of return equaled 0.3126. The broker option has overhead costs in the amount of $613,044 and the net income before taxes resulting in $68,973. The rate of return equaled 0.1125. Guillermo is recommended to select the high technology investment solution because of its higher return rate. When conducting the analysis using the net present value technique, the calculations equaling zero or higher would be favorable. The results would deem the high-tech investment to be the most desirable. Such a transaction would yield an acceptable rate of return.
References
Edmonds, T. P., Edmonds, C. D., Olds, P. R., McNair, F.M., Tsay, B.-Y., Schneider, N. W., et al. (2007). Chapter 24: Planning for Capital Investment. In Fundamental Financial and Managerial Accounting Concepts (1st ed.). New York, NY: McGraw-Hill. Retrieved October 28, 2014 from The University of Phoenix eBook Collection database.
Varol, N., Costa-Font, J., and McGuire, A. (2012). Does Adoption of Pharmaceutical Innovation Respond to Changes in the Regulatory Environment? In Applied Economic Perspectives and Policy. Retrieved November 3,
2014.