Guillermo Capital Budgeting Guillermo Is Faced With

Guillermo Capital Budgeting Guillermo is faced with a difficult operating environment. Competition has intensified, and this is driving down his margins. At the same time, labor costs are rising. This is putting a squeeze on Guillermo. At present, it does not look like he can compete head to head against his new rival, as that rival is using a technological competitive advantage to outcompete Guillermo. As a result, Guillermo is now faced with three different options for revitalizing his business.

The first is to become a broker for a high-tech competitor based in Norway, a move that would take him out of the manufacturing business. The second is that he could add value to his existing product perhaps allowing him to improve his margins. Guillermo's third option is to adopt the Norwegian company's technology, as this would lower his cost of production significantly, restoring some of his net margin. In order to evaluate these three disparate alternatives, there are two major considerations.

The first is strategic -- which of these strategies offers the best potential for long-term growth. The second is financial. Making financial decisions such as this is termed capital budgeting -- specifically referring to decisions about where to invest the company's capital. There are three main capital budgeting techniques: net present value (NPV), internal rate of return (IRR) and payback period. This paper will analyze the merits of each of these three and then make recommendations to Guillermo. The first method is the payback period.

This method simply refers to the time it takes the company to earn back its initial investment in the project (Accounting for Management, 2011). This method is simple, but it is highly flawed. It only accounts for cash flows up until the point where the payback has been achieved. Future cash flows beyond that point, however, can contribute greatly to the profitability of the project. However, the further into the future the flows are, the riskier they are, so there is some merit to ignoring risky flows.

However, that payback period does not include all cash flows incremental to the project is a serious flaw, and this usually discourages modern managers from using this method to make capital budgeting decisions. The second method is the internal rate of return. The internal rate of return is the rate of return for the project that will result in an NPV of zero. A higher IRR therefore is ideal in the evaluation of a given project (Baker, 2000).

The downside to IRR, especially compared to NPV, is that the IRR does not take into account the size of the project. Thus, IRR is a poor method of making capital budgeting decisions between projects that for whatever reason are mutually exclusive. The project with the higher IRR might have a much lower NPV, and therefore contribute less to the company's wealth. However, the IRR is sometimes a valuable way to distinguish between projects. The net present value is the best method for making capital budgeting decisions.

The net present value is based on the time value of money. The NPV is the present day value of the future cash flows that are incremental to the project (Investopedia, 2012). Thus, the decision is being rendered on all of the future cash flows, and these are adjusted for the risk that is associated with either the project or the firm.

In theory, any project with a net present value over zero should be undertaken, because that project adds value to the firm In the case of Guillermo, each of the three alternatives is mutually exclusive, since each represents a distinctly different strategic direction for the company. In order for Guillermo to make a decision using NPV, however, he would need to have estimates for cash flows for each of his three options. Indeed, he has no financial estimates whatsoever for two of his options.

It is recommended, that because NPV is the most complete method of making capital budgeting decisions, that Guillermo use net present value as the basis for making his decision. However, for practical purposes, Guillermo is not going to be able to compare the three options. He can, however, derive an NPV for the high-tech brokerage option and the enhanced production option. In order to calculate the NPV, Guillermo must make assumptions about the future cash flows, and make assumptions about the risk inherent in this business.

The first will be challenging since this is an all-new business for Guillermo. He is going to have to rely on rough cash flow estimates based on his knowledge of the market and whatever market research he has done. The more market research that Guillermo does, the better information he will have -- the usefulness of his calculations rests on the strength of his assumptions. It is also important to remember that NPV only counts incremental cash flows. Thus, non-cash items like depreciation are not included.

Depreciation is only factored into the savings on the income tax that depreciation delivers. Expenses that are not incremental to the decision at hand are also not included in the calculation. In Guillermo's case, this includes pretty much every overhead line item, all of which will be incurred regardless of what option Guillermo chooses. The NPV of the high-tech brokerage option for Guillermo is as follows: Guillermo High-Tech Broker Year 0 1 2 3 Revenue 0 1770208 2392266 2392266 Direct Materials 0 0 0 0 Direct Labor 0 0 0 0 Direct Cost 1499300 1481560 1714240 Depreciation Tax Benefit 21000 196000.1 196000.1 Income Tax 92781.36 186496.4.