Guillermo’s Furniture Store Scenario
There are three alternatives available to the Guillermo’s Furniture Store. One is they can keep the current position or they can become broker or make it high-tech. Therefore, Guillermo’s furniture store can divide the project into current project, High tech project and the broker project.
Guillermo’s furniture store needs to select the option which is good for them and can provide competitive advantage to the store. It has been clear that managers are responsible for the use of capital budgeting techniques to find out exclusive project. We have different types of capital budgeting techniques. These capital budgeting techniques are:
1-Simple Payback, and/or Discounted Payback
2-Net Present Value (NPV)
3-Internal Rate Of Return (IRR)
The simple payback period:
“We can define the simple payback period as the expected number of years required to recover the original investment by Guillermo’s Furniture Store” (Brown, et. al, (2006), i.e. if the store has invested $300 millions in its project, then how much time it will take to recover its invested amount. Payback period is the first formal method used to evaluate capital budgeting projects. Here is the payback period for Guillermo’s Furniture Store. The cumulative cash flow of Guillermo’s Furniture store at t = 0 is just the initial cost of -$300,000. At Year 1 the cumulative cash flow is the previous cumulative of $300,000 plus the Year 1 cash flow of $500: -$300,000 + $42,573=-$257,427. Similarly, the cumulative for Year 2 is the previous cumulative of -$257,427 plus the Year 2 inflow of $42,573, resulting in –$214,854. We see that by the end of Year 7 the cumulative inflows have more than recovered the initial outflow. Thus, the payback occurred during the third year. If the $40,584 of inflows comes in evenly during Year 3, then the exact payback period can be found as follows:
Applying the same procedure to Project High-Tech and Broker, we find Payback period for them is 1.53 years and 5.89 years respectively. It is known that the shorter the payback period, the better. As the projects are mutually exclusive, Project High-tech would be accepted but Project current would be rejected. If the projects were mutually exclusive, High-tech would be ranked over Broker and Current because High-Tech has the shorter payback. Mutually exclusive project means that if one project is taken on, the other must be rejected (Brigham, 2004).
Discounted Payback Period:
In the real world firms use a variant of the regular payback, the discounted payback period, which is similar to the regular payback period except that the expected cash flows are discounted by the project’s cost of capital (WACC). So we can say that the discounted payback period uses the time value of money in its decision. Here, the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows generated from the project.
If we look at the values of discounted cash flows we can find that the discounted payback period for Current project is 9.9 years whereas High-Tech and Broker project 1.4 year and 8.1 years respectively
For Projects Current, High-Tech and Broker, project High-Tech ranked higher as compared to the others (Brigham, 2004).
Payback Vs Discounted Payback:
We can also says, that a payback is a type of “breakeven” calculation in the sense that if cash flows come in at the expected rate until the payback year, then the project will break even for that year. Here the simple payback period doesn’t consider the cost of capital whereas the discounted payback does consider capital costs it shows the breakeven year after covering debt and equity costs.
The biggest drawback of both the payback and discounted payback methods is that they ignore cash flows that are paid or received after the payback period of the...
Cited: Brigham, E. F., & Houston, J. F. (2004). Fundamental of Financial Management. South Western: Thomson.
Brown, & Reilly. (2006). Investement Analysis and Portfolio Management. Thomson ONE - Business School.
Fabozzi, F. J. (2003). Financial management and analysis. New Jercy: John willy and sons.
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