June 3, 2012
The furniture business environment in Sonora, Mexico has drastically changed over the last decade. New, foreign competitors with high-tech equipment have entered the market driving down prices, and the number of jobs has significantly increased forcing the cost of labor to increase, as well. For Guillermo Furniture to survive this environment, the company must evaluate capital budget techniques and determine which technique is the most applicable for recommending if a capital investment will allow the company to maximize its profitability and survive. Capital Budget Evaluation Techniques
Guillermo has two alternatives to analyze capital investment opportunities; the company can either use the value of money concept or ignore the value of money. The time value of money concept indicates that the present value of a dollar received in the future will decrease over time, and as more time passes, the present value of the dollar will continue to decrease. Interest, risk, and inflation contribute to the decrease in the value of money over time. “When a company invests in capital assets, it sacrifices present dollars in exchange for the opportunity to receive future dollars” (Edmonds et al., 2007, p. 1151).
The value of money concept relies on the net present value method and the internal rate of return method. To determine if a capital investment is lucrative, a company must determine if the investment will provide a minimum rate of return. This process requires that a company determine the present value of cash flows, which leads to the net present value concept. The net present value concept calculates the present value of future cash inflows and reduces the inflows by the cost of the investment and any future cash outflows; a positive net present value indicates that a capital investment may be desirable, whereas, a...