1044 words - 5 pages

Capital Budget Recommendation for Guillermo

Lynda D. Keller

ACC543

June 23, 2014

Richard Collins

Capital Budget Recommendation for Guillermo

The first and most necessary goal of any organization is to maximize shareholder wealth. Maximizing shareholder wealth includes identifying and analyzing future projects that can provide value. Typically in a risk-return trade off the greater the risk, the higher the return. According to Krenz and Miller, “organizations undertake risky directions when the outcomes are so desirable that the probability of failure makes it worthwhile,” (Krenz & Miller, 2011, p. 18). Guillermo’s Furniture Store is facing increased competition, especially ...view middle of the document...

Projects with positive net present value will likely provide benefit to the company, and projects with a negative net present value could not cover the cost of the project.

An important factor in the net present value is the discount rate. The present value of the project’s expected cash flows inversely relates to the discount rate. When one goes up the other goes down.

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the weighted average of the required return for equity and the required return for debt. The WACC is the overall required return an organization uses to determine the feasibility of capital projects. WACC is important as a measurement of the bottom line an investment must return to add value for shareholders. Companies with a lower WACC have a competitive advantage over companies with a higher WACC as these companies with a lower WACC have a lower hurdle for projects to meet and, therefore, more opportunities. According to Stephen Kincheloe, “a principal advantage of employing the WACC is that it separates the investment and financing decisions,” (Kincheloe, 1990, p. 95).

Internal Rate of Return

“The internal rate of return (IRR) is the discount rate necessary to achieve a net present value of zero,” (Krentz & Miller, 2011, p. 17). The higher the internal rate of return the greater the potential reward. Comparison of internal rates of returns between multiple projects allows a company to rank projects for potential profitability. Other factors aside managers should give strong consideration to the opportunity with the highest IRR.

According to Emery, Finnerty, and Stowe, “the IRR is the discount rate that makes the total present value of all the project’s cash flows sum to zero,” (Emery, Finnerty, & Stowe, 2007, p. 223). Typically, a financial analyst computes the IRR by trial and error. Financial managers compute the IRR as the point when the present value amount of cash inflows are the same as the present value of cost outflows.

Capital Budgeting Analysis for Guillermo Furniture

Net present value calculations are an appropriate tool to use in determining the best approach for Guillermo Furniture. A comparison between net present values will require determining the net present value of each option. Next a comparison of the net present value between each...

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