Finance

Guillermo Furniture Store Analysis and Recommendation Taraswa Lance, Swanzetta Maxwell, Kiera Peoples, and Johnnique Harris FIN/571 May 3, 2010 Dr. Kofi Guillermo Furniture Store Analysis and Recommendation The purpose of this paper is to analyze Guillermo Furniture Store’s alternatives, make a recommendation for their financial decision, and make justifications based on the recommendation. A pro-forma cash flow budget will also be created for Guillermo’s next five years. This in depth analysis will help Guillermo Furniture Store handle the possible challenges of the future. By hiring a team of financial experts, Guillermo must examine the sound financial analysis presented to him and look to pursue the final recommendation. This presentation will provide analysis of three potential alternatives and make a final recommendation for Guillermo to move his business forward. Included in this presentation will be a listing of the key assumptions for each alternative, in addition to credible, mechanically correct and properly justified NPV calculations for each alternative. A final recommendation based on the analysis is presented, including logical rationale and justification for the final recommendation, a sensitivity analysis of the NPV calculations for the recommended alternative, and a five year pro forma cash flow budget for the recommended alternative. At the conclusion of this presentation, it will be clear the way Guillermo needs to move to keep his business thriving within this competitive market. (This yellow highlighted portion may be reintroduced if extra words are needed, and the red highlighted sections have been reworded. Key Assumptions The three alternatives for Guillermo to consider are to current and continue doing business as normal, to invest in new high-tech equipment, or to become a broker. Each alternative uses certain key assumptions. These assumptions help to provide an estimate, or forecast, of how Guillermo will perform with each alternative. Current Situation Key Assumptions For Guillermo Furniture Store, the key assumptions for the current situation alternative include estimating the market value of equity at seven times earnings before interest, taxes, depreciation, and amortization (EBITDA). This calculation computes as follows: 47,763 + 50,000*7 = $684 (I can't figure out were these numbers are in the spreadsheet). In this situation, Guillermo will keep the basic capital structure, despite the need for financing. The riskless rate of 3% will increase at the rate of inflation. The risk premium is 9% and since the beta is unknown, it assumes the value of 1. 7.5% is the interest rate on current debt so it can be assumed that Guillermo has the option to obtain more debt at this rate. The Assets and Liabilities income statement lists that the sales growth rate is 1% per year, assuming that the quantity listed in the Budget statement stays the same. Changes in costs and prices will remain constant with the inflation rate. (Section reworded) High-Tech Situation Key Assumptions The high-tech alternative has a 1% per year growth rate, as displayed in the Income Information sheet. Changes in costs will grow to 3% and prices are 10% lower than in the current situation because of the increases in supply. The Income Information sheet shows an increase in property taxes of 6.5% due to the introduction of new capital and equipment costing $4,500,000. The straight-line depreciation method is used meaning that buildings depreciate at 30 years and equipment at 10 years. After these calculations, the cost for high-tech equipment will amount to $4,000,000. will need to put up It would be best for Guillermo Furniture Store use $2 million in cash and then finance $2 million. The total amount of new capital will increase the market value of equity to $4,684. The book value of debt is the market value of debt, which is $2937. The risk premium is 9% and since the beta is unknown, it assumes the value of 1. Broker Situation Key Assumptions The broker situation will include a sales growth of 1% per year. Guillermo will serve as the intermediary in facilitating deals between furniture stores and distributors. As indicated on the Income statement, production will increase by 50%. Costs for materials are $360 (mid-grade) and $410 (high-end). Costs will remain constant with the inflation rate while prices will decrease by 10% from the current situation due to the increase in supply. The labor rate remains the same as specified in the current situation because technical labor is not needed. No changes will be made in the exchange rate. The tax rate will remain the same despite annual productivity improvements of 1%. No new capital is added so the market value of equity remains at $684 and the book value of debt (market value of debt) is $937. The weighted average cost of capital or (WACC) will not change from the current situation because no changes will occur in their capital structure even when financing is needed. The risk premium is 9% and since the beta is unknown, it assumes the value of 1. Net Present Value (NPV) Refer to the attached spreadsheet for a 10-year forecast of the net present value (NPV). A brief summary of the results are as follows: Current Situation High-tech Situation Broker Situation 10 Year NPV: $1,006,550 10 Year NPV $602,321 10 Year NPV: $1,525,053 IRR: N/A IRR: 12% IRR: N/A Payback N/A Payback: 5.10 years Payback: N/A WACC calculation: 7.6% WACC calculation: 9.1% WACC calculation: 7.6% The current situation has no initial investment; therefore, payback and interest rate return (IRR) are not applicable. The high-tech situation will involve a large initial investment to purchase new equipment. The broker situation has no initial investment and is similar to the current alternative because it does not have a payback or interest rate return (IRR). Recommendation Net present value (NPV) is a key tool used to calculate the most beneficial alternative by determining the difference between a projects market value versus its cost. The role of risk is best measured by comparing cash outflows to expected cash inflows (Emery, Finnerty, & Stowe, 2007). The present value of all cash flows of each alternative is necessary to determine the value of each. If a project has positive NPV, it is usually the best alternative to choose. The alternative that yields the highest NPV, when compared to the NPV of other alternatives will provide the most favorable results. The analysis shows that the current situation has an NPV of $1,006,550, the high-tech NPV is $602,321, and the broker NPV is $1,525,050. As a result, the broker situation is the recommendation for Guillermo Furniture Store. Rationale and Justification We have taken all three alternatives into consideration. The Broker alternative seems to be the best approach for Guillermo. When we calculated all three alternatives, the Broker approach provides the most value for Guillermo. To review, the Current alternative NPV returned the value of $1,006,550. This is if Guillermo continues to run his operation the same way without any changes. The WACC calculation is 6.9%. The Hi-Tech alternative calculations were as follows. The initial investment is -$4,500,000. The 10 year NPV is $756,588 IRR 64%, and the payback 5.10 years. The WACC calculation is 6.9%. Costs are assumed to grow at the rate of inflation provided. Prices will reduce by 10% because the supply increases. The Broker alternative calculations are as follows. The 10 year NPV calculation is $5,506,984 IRR is 57%, and payback is -0.152508689 years. The WACC is 6.9%. The market value of equity remains at $937 because there is no new capital added. The payback occurs faster than the other two alternatives. However, the analysis indicates that Broker alternative has the highest NPV and will bring the most value to Guillermo. Sensitivity Analysis After making the recommendation to become a broker, there are three key areas to analyze to observe how changes in either of them could affect NPV. The three areas of concern for Guillermo are volume, price, and costs. As these values fluctuate, the NPV of the broker scenario fluctuates. The purpose of the sensitivity analysis is to help make better decisions on how sensitive the result will be to unforeseen changes in volume, price, and costs. Of equal importance will be an analysis of how changes to the initial investment can impact the NPV of the recommended alternative. The sensitivity analysis assists in identifying the most critical areas of concern and allows opportunity to identify potential areas of the organization that may be vulnerable. It emphasizes the validity of the NPV analysis and helps Guillermo to make a more informed decision on how to move forward. According to the sensitivity analysis provided, becoming a broker is a sound business move. In analyzing fluctuations in volume, price, and cost, it is determined that the NPV of this project will remain positive. This indicates that the broker alternative would be a good direction for Guillermo to pursue. The sensitivity analysis resulted in numerous negative NPV scenarios, which impacted the working capital and expose some potential areas of concern and perhaps guide Guillermo toward another more viable alternative. Five Year Pro Forma Cash Flow Budget The five year pro forma cash flow budget shows the forecast of the operating results of the Broker alternative. Below is a snapshot of the ending cash balance for years 1-5. |  |Year 1 |Year 2 |Year 3 |Year 4 |Year 5 | |Ending Cash Balance |639,615 |488,325 |524,394 |604,251 |648,385 | The financial statements provided will assist in the planning process to assess the effect of the Broker alternative on schedules of financial activity, such as a sales budget, a capital budget, or marketing budget (Emery, Finnerty, & Stowe, 2007. The results of the pro forma cash budget are on the attached spreadsheet in detail. Conclusion As the market conditions change, an organization must change its operations to maintain profitability during times of change. To accomplish this, they must develop ideas for capital budgeting, examine their current operations, analyze alternative opportunities, and make the right decision to move forward. Careful capital budgeting analysis has resulted in the broker alternative as the recommended solution that will lead Guillermo Furniture Store into the next phase of its operations. The data presented shows that the broker scenario has the highest NPV of the three potential alternatives. When conducting a capital budgeting process, the alternative that has the highest NPV is the one that will provide the most value to a firm. Therefore, the broker alternative is the way to go for Guillermo. This will allow Guillermo to better position his company to move forward in an ever-changing competitive market. Reference Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate financial management (3rd ed.). Upper Saddle River, NJ: Pearson Prentice Hall.