Capital Budgeting for Guillermo Furniture Guillermo Navallez,

Capital Budgeting for Guillermo Furniture

Guillermo Navallez, owner of the relatively small yet highly successful furniture manufacturer Guillermo Furniture, is faced with a tough decision. Due to changes in the industry an in his operating atmosphere, Guillermo is unable to continue competitively running his company as he has for the past decades, with a crew of skilled laborers building furniture and with distribution handled essentially by the company itself. He must either automate his manufacturing process with a very high initial cost for equipment but allowing him to continue as a furniture manufacturer, he can shift to distribution for foreign competitors with cheaper products seeking entry into the North American market, or he can begin manufacturing and selling his patented flame retardant instead. Each choice will require an initial outlay of capital and will also have varying returns over the years. Assessing these options from a budgetary standpoint requires the application of a capital budgeting technique.

Capital Budgeting Techniques

There are several different methods of capital budget evaluation that can be used to help make a decision in the Guillermo Furniture case. By evaluating the current budget and accounting figures of Guillermo Furniture and provided an understanding of the capital requirements of each of Guillermo's options, these methods of evaluation can help predict which avenue will be the most effective, at least in terms of capital requirements and how long it would take to recover costs. This leads to the first method of capital budgeting analysis, the payback period method, which is the simplest yet the least accurate (Guin, 2011). This involves examining the amount of time it will take for a capital expenditure to produce as much cash inflow as it cost to purchase -- in Guillermo's case, the cost of automation might be very high, but if the revenue generated would quickly "payback" the cost of the equipment it might be seen as a better choice than a low-cost choice with a long payback period, such as might be the case if Guillermo were to retool in order to focus on his patented coating procedures and processes (Case, n.d.; Guin, 2011; Cross, 2012).

The second method of capital budgeting evaluation is the internal rate of return, which is essentially a predictor of how much investors would eventually stand to gain (or potentially lose) from a project or capital acquisition (Guin, 2011; Cross, 2012). By comparing the minimum rate of return for a set of given capital expenditures and determining their internal rate of return through a series of calculations, the most profitable option (assuming estimates of costs and cash flows are made correctly) can be determined (Guin, 2011; Cross, 2012). To begin with, there must be an estimate of the "hurdle rate," which is essentially the rate at which future dollars are expected to depreciate against current dollars over the life of the project, so that the present value of benefits can be calculated and compared to the present value of costs (Guin, 2011). If the present value of benefits is higher than the present value of costs, the project is expected to earn more than the hurdle rate and further analysis is warranted (Guin, 2011). Through a series of rough estimates of the actual rate of depreciation, the degree to which the rate of return on the project outstrips the hurdle rate can be calculated and used as a measure of the project's profitability (Guin, 2011).

Finally, the relatively simple yet accurate and telling net present value method -- also called the discounted cash flow method -- can be used to evaluate a capital budget allocation (Guin, 2011; Cross, 2012). This method is similar to the internal rate of return method in that it also accounts for the depreciation of future dollars compared to present dollars, establishing a similar "hurdle rate" and then simply subtracting the present value of costs from the projected present value of benefits; the resulting number is the net present value of the project or capital acquisition (Guin, 2011; Cross, 2012). Rather than delivering a percentage or ratio, this method delivers a dollar amount for each project. Both the internal rate of return method and the net present value method can be applied to all of the potential ways forward Guillermo has identified, and their relative costs and profits can be weighed in order to make a decision about which way forward will carry the largest cost/benefit ratio or be the most profitable.

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