What is more, the competitors were producing these pieces at an alarming rate, and using high-tech equipment and absolutely no labor costs. Over the years, Navallez noticed that his profit margins shirked as prices decreased and costs increased. Navallez decided to do his own research on some of his competitors and discovered that to keep up, many of the local competitors was either consolidating by merger or acquisition. Navallez, being proud of his accomplishments did not want to industrialize his company and contacted Wells Accounting firm to help him with alternatives to match the competitors.
Wells Accounting Firm plan of action is to assist Navallez by helping him understand the difference between the various capital budget techniques, and then providing Navallez a recommendation on the best-fit project to bring Guillermo’s Furniture and Manufacturing Company back to excellent financial health. Capital Budget Recommendation: Guillermo Furniture Wells accounting firm was contacted by Guillermo Navallez, business owner after realizing that his company faced considerable profit loss with the onset of competitors producing like quality pieces for a fraction of the cost.
Wells accounting firm was challenged to help Guillermo Navallez understand the various capital budgeting techniques and to present a recommendation to restore Guillermo’s Furniture and Manufacturing Company to excellent financial health. Wells accounting firm immediately went to work, employing various budgeting techniques such as the payback technique, break even analysis, and net present value, internal rate of return, and cash flow expected based on a variety of alternatives. Each technique provides essential information for Guillermo Navallez, and helps the firm best determine how to move forward.
To best determine which approach would be most beneficial, the firm must first determine Navallez Company’s current financial position. The figures below represent Guillermo’s Furniture and Manufacturing Company current financial position for previous and current year, respectively. TOTAL ASSETS $1,350,627 USD $1,356,534 USD According to Guillermo Navallez, his company produces two grades of products to service a wide-range of customer: Mid-Grade, and High-End. Navallez believes that his prices are reasonable.
The first capital budgeting technique, the payback technique, or the cash payback technique is used to identify time periods needed to recover the cost of capital investments from the net annual cash flow produced by the investment. For example if Navallez decides to purchase equipment and continue manufacturing High-End products at faster rates, employing less human capital also deciding to purchase as opposed to leasing the new equipment, we will calculate his payback as following: Payback Technique
Initial Investment1,200,000. 00 Estimated Useful Life10Years Estimated Salvage0 Estimated Annual Cash flows Cash Inflow from Customer $ 217,630. 33 Cash outflow for Operating $ 77,298. 28 Net Annual Cash Flow $ 140,332. 05 Cash Payback Period $ 8. 55 The payback period is associated with the useful life of the equipment (asset). In this case the payback period is unacceptable seeing that the period is longer than 60% of the life of the equipment (asset), yielding 86%.
Another technique is the break even analysis. This technique helps the firm understand the lower ranges of profit where margins are concerned. The firm will be able to determine when Guillermo’s Furniture and Manufacturing Company will begin to make a profit after all expenses are considered. For example, at current Guillermo’s Furniture and Manufacturing Company produces the following: Break even analysis makes the following assumptions: 1. Fixed costs are constant 2.
Quantity of goods are constant per output 3. Variable cost are constant per output unit Because Break even is a variation of payback technique, the firm is able to further determine the monthly current or projected sales before Guillermo’s Furniture and Manufacturing Company yields a profit. Net present value is another technique taken into consideration. This technique uses time value of money, and determines the difference between costs and market values of projects. NPV :
Investment (150% of book value of assets) $(2,023,244. 07) Year 1 after tax cash flow $ 362,496. 81 Year 2 after tax cash flow $ 362,496. 81 Year 3 after tax cash flow $ 362,496. 81 Year 4 after tax cash flow $ 362,496. 81 Year 5 after tax cash flow $ 362,496. 81 When the net present value of the Guillermo’s Furniture and Manufacturing Company net present value is a positive number, the general rule is to approve the project because this means that the project will add value to the company.
The intent of reviewing these techniques is to determine which project will yield positive profits for the company and how much profit can be expected. Similar to net present value is the internal rate of return, which is used to measure an acceptable investment opportunity. The internal rate of return is equivalent to the net present value rate of zero for an investment. When looking at a variety of alternatives, the firm determined that Guillermo’s Furniture and Manufacturing Company could be profitable using a variety of alternatives, thus the recommendation.
Wells Accounting Firm determined that Guillermo’s Furniture and Manufacturing Company should market and push the flame retardant product, while also coordinating the company’s existing distributor network and essentially becoming a representative for the other manufacturer. Reference(s): Edmonds, T. P. et al. (2007). Fundamental financial & managerial accounting concepts. New York: McGraw-Hill. Retrieved from the University of Phoenix eBook Collection. Fast4Cast. (2007). Retrieved from http://fast4cast. com/break-even-calculator. aspx