Guillermo_Furniture_Store

Guillermo Furniture Store Analysis FIN 571 October 1, 2012 Gupreet Singh Guillermo Furniture Store Analysis Guillermo Navallez is facing challenges in his furniture store business. Guillermo has been a leader in the furniture store business in his area of Sonora, Mexico for years. This has changed as new competition has become a concern. Operating the furniture store as he has done in the past is no longer an option if Guillermo wishes to remain open and operating, and he must make a capital budget decision about the future. The choice will depend on financial factors and must continue to allow Guillermo to remain competitive in what is becoming a highly close and competitive global marketplace. This paper will provide an evaluation of the three alternative options available to Guillermo and the financial outcomes of these choices. The alternatives will be evaluated at current production levels and at a reduced production rate of 50% through a sensitivity analysis to ensure he could remain open if production declined. The weighted average cost of capital (WACC) and the net present value (NPV) will be calculated and various valuation techniques to reduce risk will be examined. Based on the data a recommendation in the concluding remarks will be made regarding which alternative will afford Guillermo the best return. Options The best capital budget option will be the alternative with the highest positive NPV as “a positive NPV increases wealth because the asset is worth more than it costs” (Emery, Finnerty, & Stowe, pg. 76, 2007). There are three alternative options available that Guillermo must consider. The first option is to continue to operate as he has in the past. Guillermo has good resources and relatively low labor costs remaining the same with increased competition is not the best alternative. The second option is to upgrade his operations and provide products through a high-tech automated solution, reducing labor costs, but costing more up front. The final solution is to become a high volume broker and distributor reducing the products he makes and selling the Norway companies products alongside his high-end and custom work. Calculations The calculations were computed using the information provided through the store data spreadsheet. The formulas were used within this document and Excel, some were modified that appeared incorrect. The resulting data is on the attached spreadsheets and will be referenced in the paper. The WACC was determined for alternatives from the formula on sheet Assets, Liabilities, and Equity tab cell B54. Formula represents the weighted required rates of return for each asset class (equity and liabilities). It was determined that a rate of return of 7.5% on liabilities was adequate because Guillermo’s mortgage rate is 7.5% and a 12% return on equity. The liabilities were multiplied 58% that is the difference after deducting 42% disclosed in tax expenses of net income. The NPV was calculated for each alternative by taking the total cash flow for that method (row 50), discounted by the WACC found for that particular method. It was assumed that the cash flows were to be discounted December 31, 2011 to December 31, 2010. To discount an amount by x% for two years, divide by (1 + x%)2. These values are highlighted in row 57. Alternative One In the first alternative choice, Guillermo will continue to operate and produce his furniture as normal. This current option is seeing shrinking profits and “an influx of people and jobs raised the cost of labor substantially” (University of Phoenix Student Portal, pg. 1, 2012). Alternative one is comfortable and familiar, costs are lower, but his competitors will continue to advance and his methods may become obsolete. This option assumes that Guillermo can continue to operate in an increasingly competitive and cost prohibitive environment. From the data on the attached spreadsheet, it has been determined that the WACC for alternative one in 2010 is at 5.61% and 5.74% for 2011. The NPV for this alternative is a positive $42,588, and although a positive NPV is considered good, this alternative assumes that Guillermo can progress on the current operations path and his competitors do not change. Given this perfect scenario Guillermo could remain in business. Alternative Two Guillermo’s second alternative is the high-tech option. This option requires the purchase of new equipment that will allow the furniture to be made with precise measurements and cuts. This alternative increases production by 50%, reduces labor costs, but has a high upfront capital investment. For this alternative and the following, assumptions are that this investment would be four million dollars raised through stock issuance. This alternative while offering some benefits could carry some concerns. Guillermo is known for the handcrafted products, and the machinery may not entice customers to continue to purchase if they were to see a discernible difference in quality. If this occurs the alternative costs will likely cause the company to go out of business. According to the data supplied even if the product sells as intended prices are reduced by 10% because supply increases with automation. The WACC for this alternative is 10.47% with a positive NPV of $469,014 in 2011. This alternative carries the highest positive NPV, but as mentioned carries risk as well. The amount of equity raised to finance this alternative carries for 30 years that increases liabilities over that period. Guillermo could see his best returns, or face bankruptcy if product does not sell. Alternative Three The third alternative is for Guillermo to become a distributor for a Norway company and sell their products along with his custom and high-end pieces. Based on the data, this alternative shows good reductions in labor and direct material costs and as the previous alternative, increases production by 50%. The risks are increased direct costs based on net FOB destination shipping and tariffs and that the Norway product would not sell as well as his line to his current clients. There is also the possibility that the Norway products would sell better, and he would eliminate his own products entirely. The WACC for this alternative is at 10.63% for 2011 with another positive, albeit less than alternative two, NPV of $239,804. This alternative could be a safe choice, but there are more unknowns with the different product lines sold together. Sensitivity Analysis A sensitivity analysis “varies key parameters in a process to determine the sensitivity of outcomes to the variation and addresses the question: “What if things do not go as predicted'”” (Emery, Finnerty, & Stowe, pg. 304, 2007). This type of analysis is useful to determine what may happen if production levels drop by 50%. To accomplish this, the production information in the second excel file on the Income tab (highlighted) was halved and the data flowed to the assets tab creating new NPVs. By performing this analysis Guillermo can see that net income after taxes all became negative and NPV declined for each alternative. The NPV moves dramatically from $42,588 to -$1,852 for current alternative, the High-Tech drops from $469,014 to $179,055, and the Broker method declined from $239,804 to $73,500. The largest decline is in the high-tech alternative but the only alternative that sees NPV move from positive to negative is in the current one. Given that the cash flow also declines in this alternative to a negative, this helps to show the weakness of the current plan if production declines, the current method becomes unsustainable. The other alternatives did decrease but remain positive in both cash flow and NPV allowing Guillermo to continue operations. Valuation Techniques Guillermo should employ various valuation techniques when determining his potential alternative capital investment. Capital Budgeting, NPV, and WACC mentioned above are some of these techniques, and there are others to help further reduce risk. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity (Discounted Cash Flow, 2012). NPV is a component of DCF, but DCF differs from NPV as DCF helps investors determine their returns and how long it would take for them to realize them. This technique coupled with the positive NPV results could help put investors at ease with the large equity offering from Guillermo. “The internal rate of return (IRR) is the project’s expected return” (Emery, Finnerty, & Stowe, pg. 223, 2007), the IRR is another capital budgeting technique that can help to reduce risk. Investors look for a high IRR that often must be met before they consider investing in a company and generally the higher the IRR the lower the risk of investment. Conclusion Guillermo Furniture Store is faced with a large decision that will shape the company’s future. Given the various alternatives considered there are some choices more appealing than others. Guillermo is aware that operating under the current model, although profitable, is not a long- term solution. Guillermo’s market is not going to become less competitive so a decision must be made. There are no guarantees with any of the alternatives, as business is inherently risky. Each alternative did result in positive NPV and cash flows, but there was one that stood out. The best alternative based on the data is to move forward with the high-tech choice. The initial capital outlay is much more, but the return is the largest even if production drops by half. References Discounted Cash Flow. (2012). Investopedia. Retrieved from http://www.investopedia.com/terms/d/dcf.asp#axzz27zSqmvBA Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate Financial Management (3rd ed.). Morristown, NJ: Wohl Publishing. University of Phoenix Student Portal. (2012). Guillermo Furniture Store Data. Retrieved from https://portal.phoenix.edu/classroom/coursematerials/fin_571/20120904/OSIRIS:42857960 University of Phoenix Student Portal. (2012). Guillermo Furniture Store Scenario. Retrieved from https://portal.phoenix.edu/classroom/coursematerials/fin_571/20120904/OSIRIS:42857960