Guillermo Furniture Store Analysis

Guillermo Furniture Store Analysis

When a firm is considering a project, certain capital budgeting decisions need to be made. Assumptions such as the amount of sales, duration of the project, and the amount of capital needed to fund a project all need to be deliberated to determine if the project is worth the risk of investing valuable resources. New projects are huge undertakings, and managers must analyze the potential risks and uncertainties to make both important and difficult capital investment decisions. Business managers must use financial principles, financial markets, and ethics when making financial decisions that will affect the condition of the company. Techniques such as weighted average cost of capital (WACC), net present value (NPV) and enhancing valuation help to reduce risks associated with projects of this magnitude.

In the case study, of the Guillermo Furniture store analysis, Guillermo has three financial options to consider to develop economic efficiency and value. These options will help to establish the furniture store's position within the market. Financial principles assume that an individual will act in an economically rational way and will act in their own self-interest (Emery, Finnerty & Stowe, 2007, p. 20). Guillermo will analyze the incremental costs and benefits to decide the best choice among the transactions that will have the greatest benefit for his company.

Guillermo is faced with rising labor costs, and foreign competition is encroaching on the company's profit margin and economic growth. Guillermo must reassess the financial position of the company to address the challenges or may be forced to close its doors.

The first option considered is a result of Guillermo's examination of a high-tech foreign competitor. The competition uses a computerized laser lathe to cut wood with high efficiency. The investment would reduce the cost of labor for production and could be run on 24-hours a day. The precision of the technology can meet more individualized needs of customers, thus creating value. Another option to consider is to become a broker for a Norwegian company and become a distributer to different channels within the United States. A third alternative is to continue operations and diversify his business by patenting his coating technique for furniture. This technique is both fire resistant and stain resistant. "In this way, diversification can reduce risk and extraordinary returns are possible with new ideas" (R. Emery, Douglas; D. Finnerty, John & John D. Stowe., 2007, p. 193).

Forecasting is a tool that all managers must use to make proper business decisions. Forecasting determines if there is sufficient cash flow to fund projects, the amounts of products that need to be made and sold as well as the amount of overhead that is required for the company to continue to do business. The current financial status of the company will help determine which option will be the most lucrative for Guillermo.

Many types of capital budgeting techniques are available to assist managers in making financial decisions. Payback, Discounted Payback, Net present Value (NPV), Internal Rate of Return (IRR) and Discounted Cash Flow are among the techniques available

Payback Method

The payback method determines how much time, in number of years that it will take to recover the initial capital for an investment. Payback method does not take into consideration the time value of money and are the sums of all of the cash flows until the sum is equal to the first outflow of profit.

Discounted Payback

The discounted payback is very similar to the payback method, in that it determines how many years it will take before the invest starts to turn a profit. The difference between the two methods is that discounted payback method incorporates the effects of the time value of money.

Net Present Value (NPV)

Net present value is comparing the value of a dollar today compared to how much the dollar will be worth in the future. A dollar is worth more today because inflation eats into the purchasing power of future money. The net present value (NPV) method discounts all cash flows at the project's required return, its cost of capital. The NPV measures the value the project will create, which is the difference between what the project is worth and what it will cost to undertake (Emery, Finnerty, & Stowe, 2007, p. 197). The NPV helps to establish the rate of return to determine if the project is worth investing in.

Internal Rate of Return

The internal rate of return is the discounted rate that makes all cash flows, (both positive and negative) for a particular investment equal to zero. The IRR is the interest rate where Net present values of costs is equal to the net present value of the benefits of an investment. The IRR method recommends that every conventional capital budgeting project with project an IRR greater than its cost of capital be undertaken (Emery, Finnerty, & Stowe, 2007, p. 196).

Discounted Cash Flow Method

Discounted cash flow is a method of assessing a company asset by determining the value of the asset today based on what the projections of all the revenue that could become available to future investors. "The purpose of discounted cash flow method is just to estimate the money received from an investment and to adjust for the time value of money" (Emery, Finnerty, & Stowe, 2007, 196).

Weighted Average Cost of Capital

Present Value (PV) is the value today of a specific amount of money in the future. PV is found by multiplying the cash flow by a discounted rate. The discount rate that is used most often is the (WACC) Weighted Average Cost of Capital. This method is used most often because considers the time value of money and the risk of investment. Guillermo needs to determine the WACC to reveal the amount of minimum return on the investment. WACC is the, "weighted average cost of the components of any financing package that will allow the project to be undertaken," (Emery, Finnerty, & Stowe, 2007, p. 197). The WACC for Guillermo is calculated as follows:

Capital:

Bank loans: $936,628 + $29,238 = $965,866 at 7.5% = 80.4% of Capital and 6.03%

WACC

Equity: $235,805 at 16% = 19.6% of Capital and 3.14% WACC

Total WACC: 9.17%

Financial decisions are measured by their net present value (NPV). NPV is the difference between what something