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Guillermo Furniture Scenario: Capital Budget Recommendations

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Guillermo Furniture, a company that manufactures mid-grade and high-end sofas, has just hired you as an accountant. The owner, Guillermo Navallez, has assigned you the tasks of determining which decisions provide the greatest returns. Review the Guillermo Furniture data sheets (attached).

The Guillermo Furniture Store Scenario:
Guillermo Navallaz is the proud owner of Guillermo?s Furniture Store located in Sonora, Mexico. He chose this area because of its excellent supply of timber for the variety of tables and chairs produced by his company. Business was going well until the late 1990s? when two events caused a decline in Guillermo?s business. First, a new overseas competitor entered the Sonora furniture market with their high-tech approach that provided furniture to exact customer specifications at low prices. The second event was that the community of Sonora began to grow. The increase of people and jobs raised the cost of labor significantly and Guillermo experienced shrinking profit margins as prices fell and costs rose (University of Phoenix, 2011).

In order for Guillermo to increase his profits, maintain his market share, and have an advantage over his competitors, he must look at alternative projects to improve business. The object of this paper is to make a recommendation for Guillermo to follow based on the financial analysis of the data presented and to evaluate three alternatives for Guillermo to consider. Once a course of action for Guillermo to follow is agreed upon, the team will analyze the financial data to support their recommendation, which will address the issue of foreign competition and labor cost.

The analysis will focus on how the alternative chosen will help Guillermo increase profits over the next five years and lower all the costs involved in producing or distributing the furniture. The paper includes a Cash Flow Budget, including assumptions, which will be based on the projected sales and expense budget for the year and any capital investments the company projects over the next five years.

- Obtain the number that is shown as a result for total assets on the assets, liabilities, and equity.
- Differentiate among the various capital budget evaluation techniques.
- Explain how these different techniques would help you make your recommendation to Guillermo.
- The cost of the asset is in the depreciation and please use 10% as the return rate. Recommend a course of action based on a capital budget evaluation technique and include present value calculations as part of your recommendation.

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Capital Budgeting Recommendations:
Capital budgeting is one of the most important financial tools that are used by an organization. Capital budgeting analyzes the investments available to a company, and assists them in determining which investments to undertake. There are several methods through which the capital decision is analyzed, one of the best methods for evaluating the net present value.

Net Present Value Method:
Net Present Value (NPV) is a technique that analyzes the value of an investment option. NPV works with the Time Value of Money concepts, and realizes that a dollar today isn't worth the same as a dollar tomorrow. Each of the cash flows have a different present value, as they take place in different years. The NPV calculations are determined by using the cost of capital for the organization.

Forecasted cash flows need to be made with realistic assumptions. Once you have the cash flow during each period and discounted correctly, the sum of the net present value of future cash flows is compared to the initial investment required. If you subtract the initial investment from the net present value and the amount is positive, the investment should be accepted. If it's negative, the company needs to reject the investment as planned and look for ways to increase the cash flows or reduce the initial investment.

Internal Rate of Return:
Another method of evaluating investments is the Internal Rate of Return (IRR). This is the rate at which the net present value (NPV) of a project is equal to zero. If the IRR is greater than the cost of capital, then the company should accept the project; if the IRR is less than the cost of capital the project should be rejected.

Many business experts caution at using IRR as the primary means of evaluating an investment. Instead, NPV gives management a better view of the reality of the project, as it deals directly with the 'big picture' of the project. In reality, IRR is only useful when the company can invest idle cash at the IRR rate. The IRR is difficult to use because the cost of capital is determined by market conditions. The assumptions of IRR reinvestment also lead to distortions of the economic reality of the situation. It is also very difficult to make a mutually exclusive investment decision simply based on IRR alone. If the cost of capital is used, the IRR of the project can fall considerably. It is always advisable to use Net Present value in evaluating a project and IRR should not be used as it can be misleading at times.

Profitable Index:
The profitability index is the ratio of the present value of cash inflows at the required rate of return, to the initial cash outflow. It is accepted if the PI is greater than one. It's also worthwhile to note that this is directly related to the net present value.

The net present value calculation is the total present value of a time series of cash flows. For this we require the time period and a discount rate. In this problem, I have selected twenty years because it helps us capture the effect of the building being fully depreciated for the current business. The span of 20 years also captures the effect of the equipment being fully depreciated in case of hi-tech and broker business.

First, we subtract the income tax from the net profit. Then we add back the depreciation charged. In case of current business, the problem mentions that the building has been depreciated for 13 years, in other words it must be depreciated for 17 years more. Further, since we have not been given the value of equipment in case of hi-tech and broker business, we have assumed the total value of the equipment to be $1,000,000. if this is depreciated straight line over a period of ten ...

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Capital budgeting techniques for Guillermo Furniture

Read Guillermo's Furniture Scenario. Explain the finance concepts and how they relate to the context of the scenario.

Guillermo's Furniture Store Scenario

While many people know that Sonora, Mexico is a beautiful vacation spot, it is also a large furniture manufacturing location in North America. Guillermo Navallez made furniture for years near his Sonoran home. The area had a good supply of timber for the variety of tables and chairs produced by his company. Labor was also relatively inexpensive. In addition, he priced his handcrafted products at a slight premium for the quality they represented. Overall, life was good for Guillermo.

All of that was true until late in the 1990s when two forces combined to cause a large dent in his business. First, a new competitor from overseas entered the furniture market. Using a high-tech approach, this foreign competition provided furniture to exact specifications and did so with rock-bottom prices. Second, the sleepy communities in Sonora woke up. One of the largest retailers in the nation's headquarters was just a few miles down the road, and its influence had expanded considerably. With inexpensive housing, mild weather, beautiful scenery, un-congested roads, a new International Airport, and plenty of development, an influx of people and jobs raised the cost of labor substantially. Guillermo watched his profit margins shrink as prices fell and costs rose.

After doing some research on his competition to see how they are handling these changes, it is clear that many of them are consolidating into larger organizations by merger or acquisition. Being independent, Guillermo does not relish the idea of being acquired by a larger competitor and then retired as the new company squeezes every peso it could out of the overhead costs. Guillermo also is not looking to expand his management responsibilities by acquiring another organization either; that could affect his time with his family in ways that he will not enjoy.

Guillermo then spent some time looking at the foreign competition and their high-tech solution. Essentially, their production utilizes a computer controlled laser lathe to produce exact cuts in the wood. Highly automated, the plant in Norway uses very little labor as robots even perform the precise movement and assembly functions. The cost of the technology is immense, as is the reduction in the labor needed for production. In addition, the production can move between products quickly, and it runs on a 24-hour basis, as the shift-differentials are more than offset by the reduction in labor. Converting his production to this model would be expensive, but he saw how he could also decrease dramatically his production costs.

When talking to some of his distributors about their wants, he had another idea that appealed to him. A second competitor, currently operating only in Norway, has been looking for channels to distribute in North America. This second potential rival, however, did not operate furniture outlets favoring instead to rely on chain distributors. Perhaps Guillermo could coordinate his existing distributor network and essentially become a representative for this other manufacturer. While he may retain some of the high end custom work, he could move his company from primarily manufacturing to primarily distribution.

Guillermo also has a patented process for creating a coating for his furniture. In producing this product, the process first creates a common flame-retardant, and upon further processing, the coating is complete and stain resistant. There is market for the flame retardant, but not as much of a market for the finished coating. There is another product that Guillermo could buy to apply to his furniture as well that would add the same amount of value for the furniture.

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