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 (“Capital Budgeting Techniques”, n. d. ). 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 “today’s dollars” (“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 (“Capital Budgeting Techniques”, n. d. ). According to “Capital Budgeting Techniques” , (n. d. ) “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 (“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 (“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. This 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 (“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 (“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 (“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.
