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Furniture requiring sensitivity analysis. The optimal WACC and the use of multiple valuation techniques will be used to reduce risk and the NPV of future cash flows will be calculated for each of the alternatives discussed. Guillermo’s Furniture store in Sonora, Mexico is a large furniture manufacturing store in North America. The area has a large supply of timber used in production and inexpensive labor allowing Guillermo’s to produce quality handcrafted products at a slight premium. In the 1990s a new competitor marketing furniture to exact specifications using a high-tech approach enter the furniture manufacturing business. In addition, the location of the new company offered amenities that could not be found in Sonora. Guillermo used sensitivity analysis to learn how the competition were adapting to change in the market and evaluated merging with or being acquired by a larger company, converting to the high-tech solution to manufacture furniture, or coordinating his existing network to become a distributor for another manufacturer, while marketing his patented process for furniture coating. Sensitivity analysis is a calculation of the interest coverage ratio, fixed charged coverage ration and debt service coverage ratio for each capital structure scenario. There are many different methods used to determine the value of undertaking and investing in projects that require a capital budget investment. Owners must choose between proposed projects and use different capital budget techniques in their decision making process. The following methods are more commonly used strategies to determine the value of a capital budget project. Simple payback, discounted payback or weighted average capital cost (WACC), Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI),
Guillermo’s payback period for the three projects will be the initial investment divided by the net income before taxes. . the quality of the investment increases.55 years and the Broker project payback is $612. NPV. he should expect to recoup the original money invested. The Discounted Payback Period also known as the Weighted Average Capital Cost (WACC) takes time value of money into consideration.797/$195.564=3. Payback is computed by summing all the expected cash flows without discounting them in sequential order until the sum equals the initial outflow. and Payback discounted. meaning one project is taken on. An appealing investment concept is that of getting your money back ( ). If Guillermo invested $250 million in one of its projects.02 years.577=5.708/$50. Assuming the projects are mutually exclusive. Investor’s often want an estimate of the time it will take to recover the initial cash investment. All are methods to evaluate capital budgeting projects. so the payback would occur the third year. The current project is the least risky using this method of valuation and the others are rejected. The payback for the HighTech project is $695. To determine the best option. All things being equal the investment with the shorter payback period is considered to have the least risk. As the payback period decreases. IRR. This means that the current project is the better choice because it has the shortest payback. Guillermo will use alternative analysis that is the evaluation of different choices available for achieving an objective ( Guillermo will use the Payback Made Simple. The discounted Payback Period is the number of years required to recover the ). however. The payback period is the expected number of years required to recover the original investment ( ). the others must be rejected ( ). The payback for the current project is $222. In comparison the cumulative for the second year is the previous cumulative plus the cash inflow from the second year.705/$42.23 years. The payback period is popular because it is easy to calculate and understand. the High-Tech project should be considered closer using different valuation techniques because it is a close second.995=12.and Modified Internal Rate of Return (MIRR).
2007). With the drawbacks of the simple payback method and the discounted payback method being in future cash flows beyond . The discounted payback period incorporates time value of money in recouping the initial investment. (Put calculations here) All of these methods have disadvantages. The discounted payback is an estimate of how long it takes a projects discounted cash flows to equal the initial out flow. The WACC is a more difficult calculation because the investor’s equity and required return on investment is considered after tax and the debt return is viewed as pretaxed data. . a project with high cash flow is less valuable than a project with no cash flow after the payback period. The Weighted Average Cost of Capital (WACC) is expressed as the weighted average of the required return for equity and the required return of debt. Discounted payback is similar to the Payback Period except that the use of expected cash flows are discounted by the projects cost of capital or (WACC). Net Present Value (NPV) is one of the most widely used techniques for making capital budgeting decisions. more cash flows received after the payback period would be more valuable than no cash flow. and T represents the marginal corporate tax rate on income from the project. L is the market value proportion of debt financing. The optimal WACC supports the High-Tech project in this scenario. The weights are based on the market values of the organizations debt and equity. The Payback Made Simple and Discounted Payback Method ignore cash transactions after the project period because expected cash flow is considered riskier than near-term cash flows.investment from discounted net cash flows generated from the Project (Emery. 2007). The formula adjusts for this by multiplying (1-T) by the required return for debt only because it is considered a pretax figure. the higher the associated risk (Emery. Discounted payback is considered superior to the simple payback method because it includes the effects generated by the time value of money. The payback period is often used an indicator of a project’s risk because the longer the payback period. Realistically.
Although the cash flow out is negative for the three projects.12)/30=-612. The Current project has a positive NPV using the cost of capital rate of 12% over 11 years NPV=$222. the High-Tech project would be eliminated using the payback period valuation technique but the project can be explored using the NPV that considers the present value of each cash flow to include inflow and outflow of cash. If the NPV is zero it indicates that the projects cash flows are equal or sufficient to repay the initial investment. Project High-Tech shows the highest return for the shareholders. discounted at the project’s cost of capital.the payback period year.311=9535.564/ (1. it can remain uneven in other projects ( ). Project current managers would probably use this technique.577/ (1. 2003). The High-Tech project using a cost of capital rate of 12% over 5 years provides a positive NPV=-695. The NPV helps avoid rejecting a project that appears risky through valuation of cash flows. Initial investments and expenses like buying equipment or building factories are considered negative cash flows because the investor’s cash balance decreased with the investment. . There is a relationship between the NPV and the Economic Value-Added (EVA) for determining the value of a project. the NPV considers this payments and evaluates the value of the project though out its life. and making a decision based on the NPV results. Shareholders wealth would increase by _______________.705+$42. NPV=612708+50. For example. If the project has a positive NPV.708+350535=-262173.979+777.12)11=$3273 but at a payback period of 10years the NPV is negative. Projects with positive NPV will generate more cash than is needed to repay the initial investment.12)5=695. When the net cash in investment increases the NPV for the project is positive because the wealth of the stockholders increases. The Broker project using a cost of capital rate of 12% over a 30 year period provides a negative NPV and should be rejected. either its EVA and Market Value Added (MVA) or the excess of the firm’s book value will remain positive (Fabuzzi.955/ (1. summing the discounted cash flows.979+195.
An organization should consider the decrease in the cost of capital and penalties to the stockholders.The Internal Rate of Return (IRR) determines the value of the Project High-Tech. ________for High-Tech. The IRR is similar to calculating the bond yield to its maturity. . The IRR for Project Current is________. and ____for Project Broker. It is the discount rate that equals the present value of the projects expected inflow of cash to the present value of the projects outflows.
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