Ongko_Furniture_Recommendation

Ongko Furniture Store Scenario II Bali, Indonesia, a beautiful vacation spot, is also a large furniture manufacturing location in Southeast Asia. Bali’s supply of timber and inexpensive labor has made it easy for Jaya Ongko to make furniture for years near his Bali home (UOP, 2011). As global competition enters the market with high-tech equipment that produces high quality furniture for a lower cost, Ongko begins to feel the pressure. The nearby opening of one of the largest retailers in the nation’s headquarters, along with community development that results in increased labor costs, create a larger issue for Ongko’s company. Ongko is currently experiencing a lower profit margin, and it is time to follow one of three alternatives: maintain its current position; implement a new high-tech system; or become a broker for a furniture manufacturer overseas. Ongko’s managers will use capital budgeting techniques to choose the best alternative that enables the company’s competitive advantage. This proposal presents an analysis of the optimal weighted average cost of capital (WACC), the use of multiple valuation techniques in reducing risks, and the net present value (NPV) of future cash flows for each of the alternatives. In determining the optimal approach for the company, Ongko must assess alternatives for financial decisions and determine the best course of action. One solution is to maintain the current business status. This option allows foreign and larger companies to enter the market with newer technology. Another solution is to expand and remodel the plant with new technology and robotic automation. In the long run, this will allow the company to lean out its manufacturing labor costs. By evaluating the opportunity costs against the initial capital expense of installing the high-tech line, management will determine if automation will offer the greatest savings and benefits over time. Decreasing cost of production and increasing revenues can only be realized if the product maintains its quality standards. The third alternative is to become a furniture distributor. Coordinating the existing distribution network and becoming a representative for a separate manufacturer may prove to be beneficial to the business. Optimal Weighted Average Cost of Capital (WACC) There are various forms of capital budgeting techniques that should be applied to these alternative projects in order to choose the most successful of the three, and predict as well as reduce future risks. When making capital budgeting decisions “The objective is to find investment projects that will add value to the firm. These are projects that are worth more to the firm than they cost—projects that have a positive NPV” (Emery, 2007, p. 216). This proposal illustrates the optimal Weighted Average Cost of Capital (WACC) associated with Ongko’s alternatives and the use of multiple valuation techniques in reducing risk. According to Emery et al., “the cost of capital is the weighted average of the current required returns on debt and equity, where the weights are the market-value proportions of debt and equity in the firm’s capital structure” (2007, p. 209). The weighted average cost of capital (WACC) is the weighted average of the cost of equity and the after tax cost of debt, and is used to determine if proposed investments or purchases are a beneficial endeavor. Ongko's current assets consist of cash, accounts receivables, inventory and pre-paid insurance for a total worth of $1,357,250. The total amount of debt the company has is $1,114,816, the cost of debt = 8%, corporate tax rate = 42%, cost of equity = 18%. The Ongko budget sheet was used to calculate the current WACC of 7.86 percent (UOP, 2011). Need to show how the WACC was calculated by plaguing in the numbers See below: The Optimal Weighted Average Cost of Capital (WACC) The optimal weighted average cost of capital (WACC) is the average cost that a company is expected to pay to finance its assets (Emery et al., 2007). The formula is as follows: WACC= [pic] re + [pic] (1-T)rd= (1- L) re + L(1-T)rd With the above formula, Onkgo’s WACC can be calculated (refer to table 1): Cost of debt= 7.5% Market rate = 12.0 Income tax expense rate= 42% beta= .8 Risk free rate= 4.36% Table 1 |Year |2009 |2010 | |Weight of debt = total liability / total equity|$1,130,963 / ($1,130,963 + $211,111)= 84.3% |$1,109,358 / ($225,805 + $1,109,358)= 83.1% | |Weight of equity |$211,111 / ($211,111 + $1,130, 963)= 15.7% |$235,805 / ($235,805 + $1,109,358)= 18% | |WACC |7.5% x (1 – 42%) x 84.3% + 9.6% x 15.7% = 5.17 |7.5% x (1 – 42%) x 83.1% + 9.6% x 18% = 5.34 | Multiple Valuation Techniques in Reducing Risks A risk analysis should be conducted in the standard decision-making process for any company. Ongko’s management must decide on the appropriate techniques to identify risks in each project, as well as determine the amount of risk the company is prepared to accept. There are several valuation techniques to apply to Ongko’s scenario. While this proposal discusses NPV and WACC methods to ensure profitability of the project, other capital budgeting criteria can also be used along with the NPV and WACC to ensure the project is profitable. Capital budgeting techniques such as the payback and discounted payback methods are a prime example. These concepts provide a means to calculate the expected number of years required to recover the original investment (Emery, et al., 2007). For instance, calculating the simple payback period provides the expected number of years required to recover the original investment. If Ongko invested $500 million in the High-Tech line, the company should see payback within the given time period. By applying these valuation techniques, the company will understand the estimated time it will take to recover the initial cash flow. Monitoring WACC and Internal Rate of Return (IRR) also helps calculate risk. If the IRR is higher than the WACC, the project will be considered viable. Sensitivity Analysis is another method that will support decision-making. This technique is used to determine how different values of an independent variable impact the dependent variable, illustrating which assumptions have the most and least influence on the company’s financial forecast. According to Emery et al., it helps “determine the sensitivity of outcomes to the variation” (2007, p. 304). A sensitivity analysis report accomplishes this by addressing the lack of predictability of an outcome. Applying this report to each project will help determine the most profitable and practical solution. Net Present Value (NPV) The Net Present Value (NPV) is one of the most used and reliable methods for capital budgeting decisions. It is defined as “the difference between what something is worth (the present value of its expected future cash flows—its market value) and what it costs” (Emery, 2007, p. 221). NPV also uses discounted cash flow techniques to find the value of the project’s cash flow in the present and future. If the initial investment for the High-tech line is $500,000, the NPV results show that in five years, this is the best option. Table One displays the before-tax NPV after five years. Table 1: NPV |Current |High-tech |Broker | |$189,079 |$412,296 |$279,049 | OK Conclusion Jaya Ongko has made furniture near his home in Bali for years. The influx of development and direct competition has changed his business environment, and using capital budgeting techniques that follow solid financial principles is the best way to enter into the decision-making process for the future of his business. Gaining a competitive edge is important to success, and Ongko’s decision to implement the High-tech production line will provide a course of action that will be economically advantageous. Understanding the use of WACC and NPV to conduct a sensitivity analysis provides Ongko with the risks inherent to each project. The company can make a knowledgeable decision based on the amount of risk to accept and the methods to be used minimize these risks. References Emery, Douglas R., Finnerty, John D., & Stowe, John D. (2007). Corporate Financial Management (3rd ed.). Prentice Hall, Inc. Retrieved from https://ecampus.phoenix.edu/content/eBookLibrary2 University of Phoenix. (n.d.). Ongko's Furniture Scenario. Retrieved from University of Phoenix, FIN/GM571 - International Corporate Finance website. Retrieved from https://portal.phoenix.edu/classroom/coursematerials/ University of Phoenix. (n.d.). Ongko's Furniture Budget. Retrieved from University of Phoenix, FIN/GM571 - International Corporate Finance website. Retrieved from https://portal.phoenix.edu/classroom/coursematerials/