Executive Summary: Guillermo Furniture
Capital Budget Recommendation
Guillermo Furniture is located in Sonora, Mexico. It was founded by Guillermo Navallez. The company manufactures midgrade and high-end sofas and the company and its owner is being pressured by the increased competition that is moving its way into Sonora, Mexico. Guillermo has hired an accounting firm to explain which option would be the best move for the company financially. The options presented to Guillermo are; consolidating into a larger organization by merger of acquisition, going with a high-tech solution like his foreign competition and decreasing production cost, moving his company from primarily manufacturing to primarily distribution or continue to work on creating the …show more content…
flame retardant coating for furniture.
Capital Budget Evaluation Techniques A capital budget is a process where an organization considers whether certain projects, enhancements or investments are worth pursuing. We are going to look into the Net Present Value, Internal Rate of Return, Payback Method and the Unadjusted Rate of Return. All of these processes are in place to assist business owners with making wise financial decisions for investments or budgeting. Below I will differentiate between the different methods.
The Net Present Value (NPV) technique compares the present values of future cash inflows against the initial cost and cash outflows of a capital investment ("Investopedia", 2014).
For Guillermo Furniture the future inflows of cash must be compared with the interest rate that Guillermo could receive on the investment somewhere else.
Internal Rate of Return is another part of capital budgeting. It is a discount rate used to make the net present value of cash flows for a project zero. The higher the internal rate of return the more desirable the project is ("Investopedia", 2014). The greater the IRR is than the required rate of return on either opportunity, the more advantageous it is for Guillermo to embark on that project. Quite often, the company 's cost of capital is used as the required rate of return to assist in determining profitability of the project.
Payback Method is one of the lower methods to use. Its meaning is the same as its name pay back. Many companies use this method because it is simple its gaining back your initial investment cost ("Investopedia", 2014). This method would provide Guillermo with enough time to recover its initial investment cost. The shorter payback periods will benefit Guillermo better because it will allow the company to next focus on making larger …show more content…
profits.
Unadjusted Rate of Return does not take into account time value of money. Provide approximations for the revenues that will be produced by an anticipated venture and then subtract all related expenses from these revenues. Once this figure is calculated, it is divided by the net cost of the original investment this process provides you with the figure for the unadjusted rate of return. However, it should be noted that due to many situations the rate of return could alter from year to year ("Investopedia", 2014).
How Capital Budget Techniques Will Help Make the Recommendation for Guillermo
Out of all of the Capital Budget Techniques the Net Present Value technique will prove very useful in determining the recommendation for Guillermo.
If Guillermo decides to purchase the new equipment in order to compete with his foreign competitor this will prove to be more beneficial for the company because the increases in production will result in lower prices per unit, labor cost will also drastically decrease because most manufacturing of parts will be done electronically. The Net Present Value technique will show whether purchasing the equipment in order to decrease production and labor cost is worth it. Out of the other scenarios being weighed by Guillermo the net present value will help with those as well. The Payback option is also a useful option for Guillermo because with purchasing if the product is not purchased in full you are given a timeline to have the purchased paid for so Guillermo will be able to have an outline of the payback period. Also, because short payback periods are looked upon more heavily a lot of the investments being made by the company will likely have short payback period. The options that don’t seem to fair to well for Guillermos scenarios are Internal Rate of Return, and the unadjusted rate of return. These two capital budget techniques do not work well with the scenario for Guillermo to have new technology or equipment added to the shop in order to decrease labor and production cost and to increase the profits that will be seen with the
new upgrades a few years down the line.
Recommended Course of Action
The recommended course of action is to upgrade the store to include the new equipment that will cut down on the labor and production cost. However, just like with anything we must factor in the cost of the equipment being used for the stores upgrade. Using the NPV method if the purchase price of the machine needed is less than the NPV for the year than Guillermo should purchase the new equipment. To determine this figure, the cash inflow per year should be determined. The total cash inflow for mid-grade and high-end is figured below.
Mid-grade = (2,585 X 509) – (3,878 X 459) = 1,315,765 – 1,780,002 = -464,237
High-end = (517 X 879) – (776 X 789) = 454,443 – 612,264 = -157,821
The total cash inflow/year = -622,058
Total cash inflows = 43,690
Cash outflows = 45,000 + 18,000 + 12,000 + 2925 – 21,865 = 56,060
Cash inflows – cash outflows = -12,370
NPV = 12,370 X 6.144567 = 76,008
Conclusion
Guillermo must stay within 76,008 when purchasing the new equipment. I think believe that this is still an excellent investment for the company. It will be a short payoff and the amount of money that is saved on labor and production cost will increase over the years. Even though there are some risk with having the new equipment that should be factored in the expenses this is still the best choice for Guillermo and what he believes in regards to running the company while still having enough time for his family.
References
Investopedia. (2014). Retrieved from http://www.investopedia.com/search/default.aspx?q=unadjusted%20rate%20of%20return
Guillermo Furniture is located in Sonora, Mexico. It was founded by Guillermo Navallez. The company manufactures midgrade and high-end sofas and the company and its owner is being pressured by the increased competition that is moving its way into Sonora, Mexico. Guillermo has hired an accounting firm to explain which option would be the best move for the company financially. The options presented to Guillermo are; consolidating into a larger organization by merger of acquisition, going with a high-tech solution like his foreign competition and decreasing production cost, moving his company from primarily manufacturing to primarily distribution or continue to work on creating the …show more content…
flame retardant coating for furniture.
Capital Budget Evaluation Techniques A capital budget is a process where an organization considers whether certain projects, enhancements or investments are worth pursuing. We are going to look into the Net Present Value, Internal Rate of Return, Payback Method and the Unadjusted Rate of Return. All of these processes are in place to assist business owners with making wise financial decisions for investments or budgeting. Below I will differentiate between the different methods.
The Net Present Value (NPV) technique compares the present values of future cash inflows against the initial cost and cash outflows of a capital investment ("Investopedia", 2014).
For Guillermo Furniture the future inflows of cash must be compared with the interest rate that Guillermo could receive on the investment somewhere else.
Internal Rate of Return is another part of capital budgeting. It is a discount rate used to make the net present value of cash flows for a project zero. The higher the internal rate of return the more desirable the project is ("Investopedia", 2014). The greater the IRR is than the required rate of return on either opportunity, the more advantageous it is for Guillermo to embark on that project. Quite often, the company 's cost of capital is used as the required rate of return to assist in determining profitability of the project.
Payback Method is one of the lower methods to use. Its meaning is the same as its name pay back. Many companies use this method because it is simple its gaining back your initial investment cost ("Investopedia", 2014). This method would provide Guillermo with enough time to recover its initial investment cost. The shorter payback periods will benefit Guillermo better because it will allow the company to next focus on making larger …show more content…
profits.
Unadjusted Rate of Return does not take into account time value of money. Provide approximations for the revenues that will be produced by an anticipated venture and then subtract all related expenses from these revenues. Once this figure is calculated, it is divided by the net cost of the original investment this process provides you with the figure for the unadjusted rate of return. However, it should be noted that due to many situations the rate of return could alter from year to year ("Investopedia", 2014).
How Capital Budget Techniques Will Help Make the Recommendation for Guillermo
Out of all of the Capital Budget Techniques the Net Present Value technique will prove very useful in determining the recommendation for Guillermo.
If Guillermo decides to purchase the new equipment in order to compete with his foreign competitor this will prove to be more beneficial for the company because the increases in production will result in lower prices per unit, labor cost will also drastically decrease because most manufacturing of parts will be done electronically. The Net Present Value technique will show whether purchasing the equipment in order to decrease production and labor cost is worth it. Out of the other scenarios being weighed by Guillermo the net present value will help with those as well. The Payback option is also a useful option for Guillermo because with purchasing if the product is not purchased in full you are given a timeline to have the purchased paid for so Guillermo will be able to have an outline of the payback period. Also, because short payback periods are looked upon more heavily a lot of the investments being made by the company will likely have short payback period. The options that don’t seem to fair to well for Guillermos scenarios are Internal Rate of Return, and the unadjusted rate of return. These two capital budget techniques do not work well with the scenario for Guillermo to have new technology or equipment added to the shop in order to decrease labor and production cost and to increase the profits that will be seen with the
new upgrades a few years down the line.
Recommended Course of Action
The recommended course of action is to upgrade the store to include the new equipment that will cut down on the labor and production cost. However, just like with anything we must factor in the cost of the equipment being used for the stores upgrade. Using the NPV method if the purchase price of the machine needed is less than the NPV for the year than Guillermo should purchase the new equipment. To determine this figure, the cash inflow per year should be determined. The total cash inflow for mid-grade and high-end is figured below.
Mid-grade = (2,585 X 509) – (3,878 X 459) = 1,315,765 – 1,780,002 = -464,237
High-end = (517 X 879) – (776 X 789) = 454,443 – 612,264 = -157,821
The total cash inflow/year = -622,058
Total cash inflows = 43,690
Cash outflows = 45,000 + 18,000 + 12,000 + 2925 – 21,865 = 56,060
Cash inflows – cash outflows = -12,370
NPV = 12,370 X 6.144567 = 76,008
Conclusion
Guillermo must stay within 76,008 when purchasing the new equipment. I think believe that this is still an excellent investment for the company. It will be a short payoff and the amount of money that is saved on labor and production cost will increase over the years. Even though there are some risk with having the new equipment that should be factored in the expenses this is still the best choice for Guillermo and what he believes in regards to running the company while still having enough time for his family.
References
Investopedia. (2014). Retrieved from http://www.investopedia.com/search/default.aspx?q=unadjusted%20rate%20of%20return