Capital Budget Recommendation Free Essays

As a dedicated furniture maker and businessman, a clear understanding of the techniques used to assist in capital budgeting is important. There are several techniques used, each having advantages and disadvantages. Within this recommendation, the advantages and disadvantages of each technique will be briefly discussed. We will write a custom essay sample on Capital Budget Recommendation or any similar topic only for you Order Now Additionally, discuss how each technique will assist in determining the desirable capital budget technique to recommend. Concluding with a course of action Mr. Navallez should take, along with calculation to support the recommended course of action. Capital budget techniques Several techniques can be used to analyze an opportunity to invest in capital. Net Present Value (NPV) allows decision makers to analyze the present value (cost) of a capital investment and determine if the investment will compensate the cash outflow used for capital investment by an excess of the desired rate of return. Management â€Å"wants to know the rate of return to expect from investing†, therefore, will â€Å"use the internal rate of return method. (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 1156) The internal rate of return produces the actual rate of return on an investment; where as, net present value allows management to select the desired rate of return on an investment. A simple and straightforward technique is the payback period; as the name suggests â€Å"payback† this technique â€Å"shows how long it will take to recover the initial cash outflow (the cost) of an investment. † (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 164) Although, the payback period furnishes the time period when the cost is likely to be recovered, the technique does not illustrate compensation in excess of the initial cash outflow or assist in evaluating different prospective capital investments. Additionally, modified internal rate of return technique shows the adjusted rate of return based on the expected return on investment after taxes, however, does not calculate compensation or assist in evaluation of alternatives. For the purpose of the recommendation further discussion o f net present value and internal rate of return assist in determining the desired course of action Mr. Navallez should acquire. The two techniques demonstrate the ability to compare the two prospective investments Mr. Navallez is considering. With reference to each prospective investment within this recommendation each will be referenced as Alternative 1 and Alternative 2. Alternative 1 is the purchase of automated high-tech machinery and Alternative 2 is becoming a representative. Net preset value vs. internal rate of return Net present value (NPV) is determined by â€Å"subtracting the cost of the investment from the present value of the future cash inflows. † (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 156) The future cash inflow is a calculation that is computed by taking the future annual cash inflow of the investment (payments), number of periods, and desired rate of return. Two outcomes are determined by the use of this technique, a high rate of return or a below rate of return. The most favorable outcome is a high rate of return; a high rate of return indicates the future cash inflow of an investment is worth the current cash outflow (cost of the investment). In use, the cost of the automated machinery subtracted from present value of the future cash inflows will show the net present value of the investment. Cash inflow consists of representative fees, working capital recovery due to the decrease in labor and manufacturing cost. Net present value will show whether the prospective investment will compensate in excess of the desired rate of return. Internal rate of return is a desire rate, also called hurdle rate, or cutoff rate, or minimum rate set by the organization as the expected return on the investment. â€Å"The rate of return is the rate at which the present value of cash inflows equals the cash outflows. † (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 1156) â€Å"The higher internal rate of return, the more profitable the investment. (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 1160) The internal rate of return is calculated by taking the total values (cash inflow and outflow) and â€Å"guess† (rate of return). This technique assist in the decision making process because once the internal rate of return is determined, the desired investment can easily be decid ed. Taking the cash outflow and inflow from each alternative and the desired rate of return will offer the best comparison as which investment will present a return favorable. Recommendation The recommendation Mr. Navallez should take is alternative 1. Alternative 1 offers the best return on investment. The use of the net present value techniques presents the desired return on investment. Net present value over internal rate of return presents the expected return on cash outflows for the cost of the investment, thus allowing management to â€Å"compute a present value index. † (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 1160) Assume the desired rate of return is 8% over 10 periods, alternative 1 cash inflow would be $421,834 with cash outflow being $323,091 and alternative 2 cash inflow of $314,057 with cash outflow being $283,930. The present value of alternative 1 is $98,743 and alternative 2 is $30,127. Alternative 1 yields a higher rate of return, however, taking it a step further to confirm alternative 1 is the best investment the present value index offers an additional comparison of the two investments. Present value index is calculated by dividing cash inflows from cash outflows, â€Å"the higher the ratio, the higher the rate of return per dollar invested into the proposed project. † (Edmonds, Edmonds, Olds, McNair, Schnieder, p. 1160) Alternative 1 ratio 1. 306 and alternative 2 ratio 1. 106; thus confirming alternative 1 the best investment and the most profitable for Mr. Navallez. How to cite Capital Budget Recommendation, Papers Capital Budget Recommendation Free Essays Capital Budget Recommendation ACC/543 November 19, 2012 Fred Johnston Capital budget evaluation techniques are used to determine if cash inflows are enough to repay the company for the cost of assets, cost of financing the asset, and a rate of return that would compensate the company for any errors made during the estimation of cash flows (â€Å"Capital Budgeting Techniques†, n. d. ). We will write a custom essay sample on Capital Budget Recommendation or any similar topic only for you Order Now When using evaluation techniques it is best to use more than one perspective so as not to produce biased results (Edmonds, Chapter 24, 2007). The time value of money assumes that the present value of a dollar in the future is less than a dollar today (Edmonds, Chapter 24, 2007). To make sure that cash outflows and cash inflows are comparable the present value of the future cash flows are restated to â€Å"today’s dollars† (â€Å"Capital Budgeting Techniques†, n. d. ). This in turn allows a company to determine if the investment will be beneficial considering the cost. The present value technique uses a discount rate and the present value of future cash inflows minus the present value of cash outflows to determine the net present value of the investment. If the net present value is determined to be positive, the investment is considered to yield a rate of return higher than the anticipated percent, thus, providing the company more than enough to repay the investment (Edmonds, Chapter 24, 2007). If the net present value is determined to be negative, the investment is less than the anticipated percentage. Therefore, the investment will not yield a rate of return, and would be a bad investment for the company. If the net present value is zero, the company would break even on the investment so it would then be at their discretion to determine whether they would invest or not (â€Å"Capital Budgeting Techniques†, n. d. ). According to â€Å"Capital Budgeting Techniques† , (n. d. ) â€Å"The internal rate of return method is the most commonly used method for evaluating capital budgeting proposals† (24). The internal rate of return method is the rate that the present value of cash inflows equals the cash outflows (Edmonds, Chapter 24, 2007). It is the rate of return that investors expect to earn on an investment (â€Å"Capital Budgeting Techniques†, n. . ). It is calculated using a trial and error technique as there is no formula to determine the internal rate of return (â€Å"Capital Budgeting Techniques†, n. d. ). Understanding the time value of money will allow Guillermo Furniture to properly calculate the present value of current and future cash flows. Th is is an important aspect as the value of a dollar to be received in the future is valued less than a dollar today. The present value technique will allow Guillermo Furniture to calculate what the value of the potential investment would be. He would need to determine what the discount rate (the minimum rate of return) would be, and then he could calculate the present value of the future cash inflows minus the present value of cash outflows to determine whether the investment would be beneficial for the company. The internal rate of return, when calculated, would let Guillermo Furniture know what the expected return on investment would be. As the internal rate of return is the same calculation used for other investments such as savings accounts and bonds, this method would be easier for Guillermo Furniture to use and understand. The method I would recommend for Guillermo Furniture to use would be the net present value method. The net present value method may be a little more involved than the Internal rate of return, but it provides a more accurate value for an investment. The net present value assumes that the cash inflows are reinvested to earn the discount rate (â€Å"Capital Budgeting Techniques†, n. d. ). Although the internal rate of return also assumes the cash inflows are reinvested, the net present value method is more realistic as the internal rate of return can potentially be very high on some projects (â€Å"Capital Budgeting Techniques†, n. d. ). Another reason the net present value would be more beneficial for Guillermo Furniture is that the internal rate of return can have more than one solution. This will happen if the cash flows change from positive one year to negative in the next year (â€Å"Capital Budgeting Techniques†, n. d. ). The net present value method will provide a much more reliable and accurate calculation for an investment. References: Capital Budgeting Techniques. (n. d. ). Retrieved from http://campus. murraystate. edu/academic/faculty/lguin/fin330/capbudtechniques. htm Edmonds, T. P. (2007). Fundamental Financial and Managerial Accounting Concepts. Retrieved from 24. How to cite Capital Budget Recommendation, Essay examples