Guillermo Furniture Analysis

Guillermo Furniture Store Analysis

FIN 571

September 13, 2010

Abstract

* The purpose of this paper is to focus on the analysis of different alternatives available to Guillermo in no more than 750 words. The author must also determine the optimal weighted average cost of capital and discuss the use of multiple valuation techniques in reducing risks and calculate net present value of future cash flows of each of the alternatives

*

*

Guillermo Furniture Store Analysis

Guillermo's Furniture Store is experiencing unprecedented competition in what was once the sleepy town, Sonora, Mexico. The company was the largest furniture manufacturing company in the area well into the 1990's, when foreign competition began penetrating the market. Sonora, Mexico mild climate has attracted a lot of new comers and become a vacation destination. The new furniture competition has created an influx of jobs and people.

Guillermo's competition is especially taxing because its competitor uses innovative technology to produce their merchandise at lower costs and furthermore sell the furniture at lowers costs to consumer driving demand. This realization forces Guillermo to reevaluate his operation and seek alternatives for financial decisions and determine which of the three alternatives will place Guillermo in a better financial situation and provide competitive advantage.

Guillermo has three alternatives:

1. Maintain the business as is and change nothing (Current)

2. Guillermo can become a furniture broker for a foreign company (Broker)

3. Guillermo can invest in outfitting its existing plant with new technology (High-Tech)

The first option does not require any changes because the company would continue to operate as it always had in the past. The problem this presents is that it does not allow Guillermo to plan for the increasing competition that the company is experiencing. The second option would require analyzing the cost of capital of no longer producing mid-grade furniture as this would be in direct conflict with the Norwegian distributor. The third option would require a large initial investment to retrofit the existing furniture plant with equipment to automate the furniture producing process. The projects that Guillermo management has to select from are mutually exclusive, this means that management can only move forward on one project option.

Capital budgeting is the tool that assists management in determining the project that best meets the needs of the organization by being cost effective and the greatest rate of return. Capital budgeting is the process of choosing the firm's long-term capital investments (Emery, Finnerty, & Stowe, 2007). There are several techniques that manager can use to determine the best project alternative; Profitability Index, Net Present Value (NPV), and Weighted Average Cost of Capital. Profitability Index is a time-value-of-money adjusted method that can be used to evaluate capital budgeting, it is also referred to as the benefit-cost ratio. The formula for this technique is Profitability Index=PI=PV (future cash flows)/initial investment.

Currently, the initial investment to automate the furniture plant is unknown however,

Profitability Index = 1 + (NPV/initial investment)

thus allowing management to determine the best project choice. The benefit to using capital budgeting techniques is that it provides a guideline - decision rule - to assist managers in making the best options. Net Present Value is the difference between what something is worth...and what it costs (Emery, Finnerty, & Stowe, 2007). Net present value is often used however while NPV can be calculated in advance management will not know the truth value until the completion of the project. The decision rule for NPV is to move forward if NPV is positive. The NPV formula used for calculating a capitol budget projects

NPV= -222,705+42,577/1.12+... 42,577/ (1.12)11 = 222,705+225978 = $3, 2732)

Weighted Average Cost of Capitol is the calculation of a firm's cost of capitol in which each category (common stock, preferred stock, bonds and any other long-term debt) of capitol is proportionately weighted (Investopedia.com, 2010). The WACC theory is calculated as

If this theory is applied to Guillermo's scenario (numbers are in pesos):

Market Value of Debt = 300 million

Market Value of Equity = 400 million

Cost of Debt = 8%

Corporate Tax Rate = 35%

Cost of Equity = 18%

WACC = 12.5%

This information allows management to determine that any project selection should realize a minimum of 12.5% on return of investment.

Every decision that management makes has some inherent risk to the organization. The goal of the company is to minimize the impact of the risk or how much risk the company is willing to trade off for return. GF management can use various valuation techniques to reduce risks such as, Net Present Value of Future Cash Flows, Price-Earnings Ratio and Discounted Cash Flow Method. In addition to valuation techniques a sensitivity analysis this a technique used to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s) (Investopedia.com, 2010).

Guillermo Furniture must evaluate which of the three options presented will best suit the long term goals of the company and provide the highest rate of return based on investment. The WACC provides ways for management to level set the various options that are available.

References

Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate Financial Management (3rd ed.). New Jersey, NJ: Prentice Hall.

Investopedia.com. (2010). Sensitivity Analysis. Retrieved from http://www.investopedia.com/terms/s/sensitivityanalysis.asp

Investopedia.com. (2010). Weighted Average Cost Of Capital - WACC. Retrieved from http://www.investopedia.com/terms/w/wacc.asp

Guillermo