Guillermo_Furniture_Store_Recommendation

Guillermo Furniture Store is in financial trouble. Overseas competition has eroded the company’s profit margins causing the business to underperform. To remain competitive, Guillermo must evaluate other options that will enable his company to be a going concern. The current option is failing the business and must be replaced by either an automated, high-tech facility or Guillermo must become a broker. Using data on the pro forma statements, Team C will analyze the feasibility of the two options; then, calculate and compare the Weighted Average Cost of Capital (WACC), Net Present Value (NPV), and Internal Rate of Return (IRR). The result will be from a financial decision aligning the data results and calculations with the best alternative. Alternatives Guillermo is evaluating three alternatives to decide on the best investment for the company to grow the business. The alternatives divided into three buckets are: Project A - the Status Quo Project: Significantly reduce production of high-end furniture and increase production of middle-end furniture with a slight adjustment to price-setting. With an increase of $0.02 over the current price optimizing its price setting based on current production capacity, the result is increase to net income with a lower cost of capital (Emery et al., 2007, p. 280). The sales history shows that middle-end furniture sells the best. This is the most conservative alternative, as it does not require any additional investments, just change of the product mix and price. Project B - the High-Tech Project: Adopt the technology that the competition currently uses and purchase new high-tech equipment, thus increasing the fixed costs but also decreasing the variable costs (that are high due to the high cost of labor). For example, in 1983, a UK retailer, Burton Reproductions, invested in furniture manufacturing with highly mechanized methods at a cost of £1m or approximately $1.5 million (CM Archives, 2007). The company was able to increase the quantity and quality of production in a single location. Project C - the Broker Project: Become a product distributor/broker for another company, and sell the current equipment thus generating cash from residual income. For example, in April 2009, British Home Stores Limited joined ventures with Kuehne & Nagel Group investing storage, delivery, and customer service for apparel, furniture, and houseware (The Week, 2009). A distributor facilitated with handling volume allocations and nationwide service. Although British Home merged with Arcadia Group in July 2009, Arcadia financials indicated sales were up 2.3% that fiscal year (BusinessWeek, 2009). Capital Budgeting Capital expenditures can have significant impact on the selection of Guillermo’s recommendation because the decision will directly affect the financial performance of the company. Several alternatives are proposed and Capital Budgeting will be used to measure the best rate of return: “A company that manufactures furniture is considering whether or not to also start manufacturing its own fabric for the furniture. The furniture manufacturer can use capital budgeting to determine the most financially profitable option for manufacturing fabric among the four investment projects” (Connaughton, 2008). Calculating the NPV is the most popular method of this process. The projects’ results are calculated and analyzed to determine the best method for Guillermo to implement. In addition to NPV, WACC and IRR are used to aid in determining the best alternative. Using capital budgeting techniques will help in determining the best financial decision for Guillermo to gain back the leverage he once had in the furniture industry. Guillermo must focus on short term and long terms goals of the company’s future to ensure strategic alignment. Another method of the Capital Budget process is the use of pro forma cash flow statements. Drafting a one to five year cash flow plan can provide a forecast of possible outcomes of each alternative. The five year cash flow hypothetical projects are attached to this report as Exhibits. Exhibit 1 Status Quo Project indicates the increase in sales year over year projection because of a slight adjustment to price setting option. Exhibit 2 High-Tech Project indicates that after a large initial investment sales and operational expenses increased, too, followed by a drastic increase in the cash balance. Exhibit 3 Broker Project shows a superior increase in sales as well as expenses with a significant cash balance after the initial investment. Income statements and balance sheets will be analyzed with the focus on the company’s current cash flow that will result in the implementation of a financial plan to align with the growth of the company. Using capital budgeting techniques is the best method to select the optimum project investment that is mutually exclusive from the other projects. WACC, NPV, and IRR are a few of the techniques Guillermo can use to help him decided which project is worth undertaking. Table A Weighted Average Cost of Capital (WACC) Net Present Value (NPV) Internal Rate of Return (IRR) Project A Status Quo 10% $942,530 IRR should be higher than 10% to make NPV positive Project B High Tech 8.42% $475,198,025 IRR should be higher than 8.42% to make NPV positive Project C Broker 8.29% $334,433,031 IRR should be more than 8.29% to make NPV positive. Weighted Average Cost of Capital Companies raise capital in two ways: bonds (debt) and issuing common and preferred stocks. “It is very important to note that L [leverage] that is used in calculating the weighted average cost of capital, does not depend on the initial cost of the project; it depends on the total value of the project” (Emery et al., 2007, p. 198). That is why a five year cash flow will be the deciding factor in the initial High-Tech $20 million investment option that seems to be too high. Using Project B as an example, the market value of debt is $20 million. The company has 10,000 shares outstanding that will sharply increase in value after the company announces the long-term investment and growth opportunities. The total market value of the company’s equity will be worth approximately $24.5 million. The firm’s capital structure is the proportion of debt and equity (Emery et al., 2007, p. 193). So the firm value equals “the total market value of its liabilities plus the total market value of its owners’ equity” (Emery et al., 2007, p. 190). The goal is to add the value and maximize the stockholders’ wealth. WACC can help decide which projects or investment should be undertaken. The formula for WACC is: WACC = (E/(D + E)) * re + (D/(D + E)) * (1 – T) * rd Project B: D (market value of debt) = $20,000,000 E (market value of equity) = $24,500,000 T (marginal corporate tax rate) = 42% re (required return for equity) = 12% rd (required return for debt) = 7% WACC = (24.5/44.5) * 12% + (20/44.5) * (.58) * 7% = 0.066 + 0.0182 = 0.0842 = 8.42% The minimum required rate of return of the project that Guillermo decides to undertake in the future should be at least 8.42%. This rate will satisfy the investors and creditors and signal that the company should realize growth of revenue. “The firm’s value depends only on the size of its expected future cash flows and the required return of those expected future cash flows” (Emery et al., 2007, p. 189). WACC is the way to make sure that the company can handle additional financial undertakings and not lose value. Net Present Value Net Present Value (NPV) is a technique used in capital budgeting to assess the profitability of a proposed investment or project. It is, “the difference between what something is worth (the present value of its expected future cash flows - its market value) and what it costs” (Emery et al., 2007, p. 221). NPV is “an indicator of how much value an investment or project adds to the firm” (Net Present Value, 2010). The discount rate, the interest rate used in determining the present value of future cash flows, “is a key variable in the process” (Net Present Value, 2010). NPV could result in one of three outcomes: positive, negative, or zero. If the projects NPV is zero, the project is neutral; it would neither gain nor lose money for the firm. The decision to accept the project “should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation” (Net Present Value, 2010). If NPV is negative, then it is rejected as the project will return less than it cost. However, if NPV is positive, then it should be accepted because it will “add value to the firm” (Net Present Value, 2010). All of the Guillermo’s potential projects have a positive NPV. When firms face with several choices, it should select the project that “yields the higher NPV” (Net Present Value, 2010). “When making capital budgeting decisions, a firm evaluates the expected future cash flows in relation to the required initial investment” (Emery et al., 2007, p. 216). The investment projects should add more value to the firm and have a positive NPV. To calculate NPV, one should know the cost of capital, which is, basically, the required return. The required return “is the minimum rate of return that you need to earn to be willing to make an investment and is the rate of return that exactly reflects the riskiness of the expected future cash flows” (Emery et al., 2007, p. 220). As calculated in Table A, above, Guillermo store’s minimum required return should be at least 8.4%. NPV Project B The project guarantees the following net cash inflows: 1 year: +5,033,365 2 year: +60,296,241 3 year: +113,540,457 4 year: +193,774,137 5 year: +314,510,741 Using formula NPV (Emery et al., 2007, p. 235) NPV = -20,000,000 + 5,033,365* (1/1.0842)1 + 60,296,241* (1/1.0842)2 + 113,540,457* (1/1.0842)3 + 193,774,137* (1/1.0842)4+ 314,510,741* (1/1.0842)5 NPV = -20,000,000 + 4,642,468 + 51,294,574 + 89,088,660 + 140,235,575 + 209,936,748 NPV = 475,198,025 One can see that the NPV from Project B is actually good, so Guillermo can undertake this investment. However, simply calculating the project’s NPV will not reduce the risk. But if Guillermo realizes the estimates, the company will add value to its stock and maximize the stockholders’ wealth. Internal Rate of Return Another method of evaluating a capital budgeting project is calculating the internal-rate-of-return (IRR), which is “the project’s expected return” (Emery et al., 2007, p. 223). If the required return equals IRR, then NPV is zero. So the company should undertake the projects only if IRR exceeds r (the cost of capital). IRR is the discount rate that forces the present value of the project’s expected cash inflows to equal the present value of the project’s expected costs. IRR is another method to assess the profitability of a project. “The IRR is essentially the “flipside” of NPV and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desires rate of return. IRR computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV (and should be made) and above which an investment results in a positive NPV (and should be avoided). It is the break-even discount rate, the rate at which the value of cash outflows equals the value of cash inflows” (Internal Rate of Return, 2009). The decision to undertake a project depends upon the relationship between the project’s Cost of Capital, the minimum return an investor will accept on an investment, and the IRR. The decision rule explains that a firm should undertake a project if the IRR exceeds the project’s cost of capital. For Projects A, B, and C, if the IRR exceeds 10%, 8.42%, and 8.29%, respectively, Guillermo should undertake the project. A note of caution: IRR is not the most reliable method and should be used with caution. Profitability Index Profitability Index (PI) is another time-value-of-money adjusted technique that can be used by Guillermo to evaluate the capital budgeting project. Project B PI = PV (future cash flows) / Initial investment PI = 1+ (NPV / initial investment) PI = 1+ (475,198,025/20,000,000) PI = 24.75 Because PI is greater than 1, Guillermo may undertake the project. The idea underlying the PI is to measure the capital budgeting project’s “bang for the buck” (Emery et al., 2007, p. 229). This way one can see how much return is realized per invested dollar. Calculations: Projects A and C Project A WACC D (market value of debt) = $170,737 E (market value of equity) = $233,361 T (marginal corporate tax rate) = 42% re (required return for equity) = 12% rd (required return for debt) = 7% WACC = (233,361/404,098) * 12% + (170,737/404,098) * (.58) * 7% = 0.5775 + 0.4225 WACC = .10 = 10% NPV The project guarantees the following net cash inflows: 1 year: -86,161 2 year: +129,300 3 year: +336,711 4 year: +541,713 5 year: +743,676 NPV = -170,737 + (-86,161) * (1/1.1)1 + 129,300 * (1/1.1)2 + 336,711 * (1/1.1)3 + 541,713 * (1/1.1)4 + 743,676 (1/1.1)5 = -170,737 + (-78,328) + 106,859 + 252,975 + 369,997 + 461,764 NPV = 942,530 IRR should be higher than 10% to have NPV positive, PI = 1 + (NPV/initial investment) PI = 1 + (942,530/170,737) PI = 6.52 Project C WACC D (market value of debt) = $10,000,000 E (market value of equity) = $11,500,000 T (marginal corporate tax rate) = 42% re (required return for equity) = 12% rd (required return for debt) = 7% WACC = (11,500/21,500) * 12% + (10,000/21,500) * (.58) * 7% = 0.064 + 0.0189 WACC = 0.0829 = 8.29% NPV The cash flows are: 1 year: +860,780 2 year: +37,141,626 3 year: +76,819,675 4 year: + 136,603,196 5 year: +226,555,085 NPV = -10,000 + 860,780 * (1/1.0829)1 + 37,141,626 * (1/1.0829)2 + 76,819,675 * (1/1.0829)3 + 136,603,196 * (1/1.0829)4 + 226,555,085 * (1/1.0829)5 NPV = -10,000,000 + 794,884 + 31,672,635 + 60,493,317 + 99,336,177 + 152,136,018 NPV = 334,433,031 IRR should be more than 8.29% to make NPV positive. PI = 1 + (NPV/initial investment) PI = 1 + (334,433,031/10,000,000) PI = 34.44 Recommendation: Future Investment Opportunities Guillermo also has a chance to increase his future revenues by using future investment opportunities and the “options to identify additional more-valuable investment possibilities in the future that result from a current investment” (Emery et al., 2007, p. 281). Currently, Guillermo has “a patented process for creating a coating for his furniture” (University of Phoenix, 2010). Flame-retardant and stain resistant coating, a valuable idea that has a strong comparative advantage, increases chances to sell additional pieces of furniture and serve a bigger market share, thus increasing the revenues. It is interesting to notice that Guillermo can apply his patented furniture coating process to all the three projects. Both Project A (Status Quo) and Project B (High-Tech) will benefit because even if there exists a market for the flame retardant, there is “not as much of a market for the finished coating” (University of Phoenix, 2010). Even working with the broker (Project C), the special coating can be applied to the furniture, distributed from Norway to USA. The foreign company, of course, will pay for the right to use this special process. Conclusion After reviewing Guillermo Furniture Store’s three alternatives using pro forma cash budget calculations and capital budgeting, Team C has decided to recommend Project B the High-Tech Project. Although this decision will incur an initial increase in fixed costs, variable costs will decrease. Project A, the Status Quo Project, is too conservative and less risky, allowing room for competitors to have an advantage over the company, as versatility in offering high and middle – end furniture is a plus. Project C, the Broker Project, would not give Guillermo the opportunity to offer unique and exclusive furniture pieces. Project C would have the company act as a distributor/broker for other companies. In comparison to Project A and C, Project B revealed a drastic cash balance increase and an approximate total market value of the company’s worth being $24.5 million. Implementing Project B will assist Guillermo in remaining competitive in the furniture industry, while taming excellent working capital management.