Guillermo_Analysis

Guillermo Furniture Store Analysis Brian Murphy University of Phoenix October 11, 2010 Guillermo Furniture is located in Sonora, Mexico. The founder and creator is Guillermo Navallez. The company grew to become a large furniture manufacturer for North America. Guillermo furniture remained successful until the late 1990’s when two forces combined to decrease his profitability. The first factor that affected his business was a new competitor that used high-tech equipment to develop the customized furniture. The second factor was the increase in cost of labor in Sonora, Mexico. The cheap labor was always a benefit of having the factory in this city. Guillermo was faced with three alternatives to increase his profitability. Guillermo will need to evaluate all three alternatives to determine which option would be the best option for the future of the company. Alternatives The first of the three available alternatives would be to maintain its current position. The second alternative is the high-tech option. This option would involve a high initial investment to purchase the high-tech equipment needed to compete with the new competitor. The third alternative would be to become a broker for another company. Guillermo will need to use the capital budgeting techniques to determine which of the three alternatives is best. “When making capital budgeting decisions, a firm evaluates the expected future cash flows in relation to the required initial investment” (Emery, 2007, pg216). Three criteria for capital budgeting are Net Present Value (NPV), Weighted Average Cost of Capital (WACC), and Internal Rate of Return (IRR). Net Present Value Net Present Value (NPV) is the difference between what something is worth (the present value of its expected future cash flows – its market value) and what it costs. “Another way to determine value is to use discounted-cash-flow (DCF) analysis and compute the present value of all the cash flows connected with ownership” (Emery, 2007, pg 222). The NPV of a capital budgeting project is the present value of all the cash flows connected with the project now and in the future. Calculating the NPV will assist Guillermo in determining which alternative to select. If the NPV is positive then Guillermo should pursue that alternative. The calculation for finding the NPV is: [pic] If Guillermo chooses the high-tech option and inputs the numbers into the formula and the NPV is positive, then this option should be chosen. Choosing this option will require Guillermo to purchase the high-tech equipment. He then would need to determine a budget over a certain number of years and predict the company’s cash flow for that number of years to determine if the NPV is positive. Internal Rate of Return Another method Guillermo should use in evaluating their capital budgeting project is the internal-rate-of-return method (IRR). The IRR is the project’s expected return. If the cost of capital equals the IRR, the NPV equals zero. “So, one way of viewing the IRR is to say that it is the discount rate that makes the total present value of all of a project’s cash flows sum to zero” (Emery, 2007, pg 223). The formula to use to calculate the IRR is: [pic] If the IRR exceeds the cost of capital, then Guillermo should pursue the project. The IRR takes a lot of trial and error to calculate. Guillermo will need to adjust the discount rate to until they find a percent that creates a positive outcome. Weighted Average Cost of Capital Along with the NPV and IRR the weighted average cost of capital (WACC) is another method Guillermo can use to evaluate the capital budgeting project. The WACC can be described in terms of financing rates. “Therefore, it can always be represented as the weighted average cost of the components of any financing package that will allow the project to be undertaken” (Emery, 2007, pg 197). The cost of capital is the return required for Guillermo to take on the project. The WACC can be expressed as the weighted average of the required return for equity, and the required return for debt. The formula to calculate the WACC is: [pic] L is the market value proportion of debt financing, and T represents the marginal corporate tax rate on income from the project. The WACC will show the minimum percentage that would satisfy Guillermo. Techniques in Reducing Risks Guillermo realizes that there are risks in whatever alternative he chooses. There are methods he can use to minimize the risk. Along with the NPV, IRR, and WACC, there are other methods he can use to best determine the alternative to choose for the future of his business. Two additional methods he can use are the payback and discounted payback methods. The payback methods are concepts used in getting your money back. The payback methods will provide an estimate of the time it will take to recover the initial cash outflow. “Payback is computed by simply summing all the expected cash flows (without discounting them) in sequential order until the sum equals the initial outflow” (Emery, 2007, pg 230). If the payback is less than a preset amount of time, then Guillermo can undertake the project. The payback method provides a control on liquidity, offers a different type of risk control, is easy to compute, and is simple to understand. “The discounted payback is the amount of time it takes for the project’s discounted cash flows to equal the project’s initial cost” (Emery, 2007, pg 231). The discounted payback period incorporates the time value of money into the basic notion of getting your money back. Like the regular payback method, Guillermo will want to pursue a project if the discounted payback is less than a preset amount of time. Discounted payback is superior to the payback method because it includes the effects of the time value of money. Sensitivity Analysis Sensitivity analysis is “a technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions” (Sensitivity Analysis, 2010). Guillermo will want to perform a sensitivity analysis to assist with determining which alternative to pursue. This will give Guillermo the necessary information to make a decision. Guillermo should rank all the assumptions in order from most important to least important. “Sensitivity analysis is very useful when attempting to determine the impact the actual outcome of a particular situation will have if it differs from what was previously assumed” (Sensitivity Analysis, 2010). Due to the amount of risk involved in pursuing a capital budgeting project, it is important to take the necessary steps to minimize that risk. Guillermo is faced with three different alternatives for the future of his business. Guillermo will want to determine the NPV, IRR, and WACC of each alternative to get a good idea as to which alternative is most likely to succeed. The payback methods will also help in determining the length of time for Guillermo to get his money back from the initial investment. After the necessary evaluations are complete Guillermo will have enough information to make a decision with the least amount of risk. Reference: Emery, Douglas. Et al. (2007). Corporate Financial Management, 3rd ed. New Jersey: Pearson-Prentice Hall. Sensitivity Analysis. (2010). Investopedia. Retrieved on October 9, 2010 from http://www.investopedia.com/terms/s/sensitivityanalysis.asp.