CAPITAL BUDGET

Capital Budget



Capital Budget

Introduction

There are three possible choices for Guillermo Furniture Store: a broker may be involved or go for high-tech. Their project can be categorized into current, broker and high-tech. Company required for opting the choice which is potentially good for the company and giving store a competitive advantage over others. It is commonly understood that managers of the company are responsible for applying techniques of capital budgeting for identifying the outstanding project. There are various type of techniques used in capital budgeting used in evaluation of project. Techniques used for capital budgeting are payback period, discounted payback period, net present value (NPV), and internal rate of return (IRR).



Payback period

Payback period is referred to the number of years taken by the project to repay its initial investment (Brown, et. al, (2006), that is the time required by the company to get back their initial investment. Therefore, the payback period evaluates the number of years taken by the project to repay the investment of the Guillermo's Furniture Store. That is, if the company decided to invest $ 0.3 million and the approved evaluation technique is payback period. The expected cash flow of the company is $ 42,573 per year. The cumulative cash flow of the company is - $ 300,000 which is investment of the company plus $ 42,573 cash inflow in time zero (t=0) gives total of -$ 257,427. Same process is done for Year 2 and cash inflow of $ 42,573 is added back to company account and the investment of the company regarding project is reduced to -$ 214,854. This process continues until it reaches the point where the cost is recovered and that period is the payback period of the company. In the given scenario, it is evaluated that total cash inflows at the end of year 8 exceeds the initial investment of the company. To find the exact payback period following formula is used:

After applying the payback period it is found that project will recover its initial investment in 7.05 years. The same tool is applied for other choices as broker and high tech proposals and found that payback period for high tech choice is 1.53 year and for broker it is 5.89 years. For the good project the payback period with short period is preferred and considered good project as compared with other proposals. In this it can be clearly found that proposal of high tech project is having shorter payback period and other project proposal will be rejected (Brigham, 2004).

Discounted Payback Period

The term discounted payback period refers to the number of period taken by a project to recover its cost by involving time value factor which is discounted net cash flows (Brigham, 2004). Despite payback period, in discounted payback period the cash flow is discounted with cost of capital of the firm and it gives better evaluation of the project as compared with payback period.

After applying the discounted payback period tool on the project of Guillermo Furniture Store it ...