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Running head: GUILLERMO FURNITURE STORE ANALYSIS

Guillermo Furniture Store Analysis Steven B Barry FIN/571 September 4, 2012 David Binder

GUILLERMO FURNITURE STORE ANALYSIS Guillermo Furniture Store Analysis Guillermo Navallez controlled a competitive advantage within the Sonora, Mexico location. When new competitors, started to move into the area bringing new high-tech practices, and the rising costs of labor Guillermo was starting to lose his advantage. Before these events, Guillermo held competitive strengths through the cost of the local labor market, branding techniques, and differentiating the organizations value above the competition.

Guillermo understood to reestablish a competitive advantage; he would have to develop a new strategy. Guillermo thought about three different types of strategies he could pursue to stay competitive against the new competition. Guillermo three ideas of strategy were to invest in new technology to add precision and reduce labor costs. Guillermo also considered becoming a broker for a company in Norway that was looking to distribute in North America. Guillermo even thought about maintaining his current strategy utilizing his patented technique for coating new furniture. Guillermo not knowing exactly which strategy idea would be best for him he decided to conduct analysis research to determine which option would be best for GFS. Capital Budgeting Techniques Guillermo will need to use capital budgeting techniques in order to determine which strategy will offer the best financial return. In capital budgeting there are many different types of techniques that can be used to compare the different strategies. The most appropriate capital budgeting techniques for Guillermo to use would include net present value (NPV), internal rate of return (IRR), discounted payback (Emery, Finnerty, & Stowe, 2007). NPV, being one of the best techniques for making decisions pertaining to capital budgeting (Emery, Finnerty, & Stowe, 2007). NPV, does not factor in cash flows after the

GUILLERMO FURNITURE STORE ANALYSIS discounted payback period. To effectively utilize NPV, it is necessary to determine the NPV of all of the cash inflows and outflows and then the discounted cash flows must be added. A positive NPV for any of Guillermos ideas will be mandatory for possible acceptance. A positive NPV indicates that the proposal will bring in more cash than what is required to pay back the debt expense and the extra cash would go to the stakeholders and shareholders. Conversely, a negative NPV for GFS options will lead to possible rejection. Since there are

multiple options, if two of them have a positive NPV, the option with the highest NPV will have precedence. A NPV of zero indicates that the cash flows of the option will be equal to pay back the capital invested (Emery, Finnerty, & Stowe, 2007). The IRR is the discount rate that equals the present value of a projects anticipated inflow of cash compared to the present value of a projects outflow. The IRR for any of Guillermos ideas is considered to be the rate of return that is expected (Emery, Finnerty, & Stowe, 2007). Generally, if the weighted average cost of capital (WACC) that would be used to finance one of GFS ideas is less than the IRR, there will be a surplus of cash after the capital is paid for. As with NPV, the surplus will be available for stockholders and shareholders. Conversely, if the WACC is more than the IRR, there will not be a profit for shareholders. The simple payback period is the anticipated number of years needed for Guillermo to recover the original investment. The payback period is typically the initial method utilized to evaluate projects for capital budgeting. On the other hand, the discounted payback period integrates a variant of the regular payback. It is comparable to the regular payback period with a discount pertaining to the cost of the project. This discount is the projects WACC. The discounted payback period utilizes the time value of money and factors in the number of years needed to recover the initial investment from discounted net cash flows in

GUILLERMO FURNITURE STORE ANALYSIS which the project generated. While the simple payback period does not factor in WACC, the discounted payback does consider capital costs. Guillermo will find a potential disadvantage for

both of these payback methods. These methods do not consider cash flows that are either paid or received following the payback period. Expected cash flows are typically at greater risk when compared to near-term cash flows. Thus the payback method is frequently utilized as an indicator of the amount of risk in a project. Projects with a greater risk have a longer payback period. Sensitivity Analysis It is essential for Guillermo to factor in the potential net income for each idea. If Guillermo opts to pursue the current process, the net income before taxes will be $42,577. If Guillermo pursues the high tech option, the net income before taxes will be $195,564. If Guillermo pursues the broker option, the net income before taxes will be $50,956. Another important factor for Guillermo is production. If Guillermo pursues either the high tech or broker option, the sales forecast will be $3,798 for mid-grade and $759 for high-end. For the current process, however, mid-grade production will be $2,532 and high-end will be $506. The reduction in prices for the high tech and broker options are attributed to increases in supply. Due to depreciation, the overhead will increase for the high tech and broker options. Currently, depreciation is $50,000, but the high tech and broker options will increase depreciation to $466,667. The high tech and broker options will cause an increase in salary of $45,000. The current scenario will not involve such an increase. Utility costs will also greatly increase if GFS pursues

GUILLERMO FURNITURE STORE ANALYSIS the high tech option. Utility costs will go from $9,000 to $27,000. If the broker option is selected this cost will decrease by 50%. Taxes will also vary based on which idea is selected and will affect the income. Currently, the income is at $24,695 after taxes. Income for the high tech option will be $29,554 after taxes. Income for the broker option would be $113,427 after taxes. Taxes are also a consideration, as taxes take 42% of the net income.

A sensitivity analysis of GFS operations shows an increase of $53,089 for current assets. Nonetheless, the most sizable increase is in cash. There is an increase of $56,179 in total assets. GFS total current liabilities increased by $53,069. Nonetheless, total liabilities decreased by $21,605 during those same years. Total equity increased by $24,695, largely due to an increase in retained earnings. Optimal WACC WACC is a determination of the cost of capital where every category of capital is weighted proportionately. An increase in WACC would entail a higher risk and a decrease in valuation. Guillermos cost of debt is 7.5% and the income tax expense rate is 42%. The weight of debt can be determined by dividing the total liability by the total equity. In 2006, this equates to $1,130,963 / ($1,130,963 + $211,111) or $1,130,963 / $1,342,074 = 84.3%. In 2007, this equates to $1,109,358 / ($225,805 + $1,109,358) or $1,109,358 / $1,335,163 = 83.1%. If we have a risk free rate of 4.36%, a market rate of 12.0, and a beta of 0.8, the weight of equity in 2006 would be $211,111 / ($211,111 + $1,130, 963) or $211,111 / $1,342,074 = 15.7%. In 2007, this equates to $225,805 / ($225,805 + $1,109,358) or $225,805 / $1,335,163 = 16.9%. So, in 2006, the WACC would equate to 7.5% x (1 42%) x 84.3% + 9.6% x 15.7% = 5.17. In 2007, the WACC would equate to 7.5% x (1 42%) x 83.1% + 9.6% x 16.9% = 5.23.

GUILLERMO FURNITURE STORE ANALYSIS NPV of Future Cash Flows The net present value is basically the total present value for a time series of cash flows (Emery, Finnerty, & Stowe, 2007). To calculate this, the discount rate and appropriate period of time are needed. For GFS, an appropriate period of time will demonstrate the property being fully depreciated in all scenarios. As such, a span of 20 years will be adequate. Income tax will

need to be subtracted from the net profit and then the depreciation charged will be added back. It will also be reasonable to assume the value of the equipment to be $1,000,000. A straight-line depreciation over 10 years is assumed. There will be a depreciation of $100,000 every year ($1,000,000 x 10%). After this period, the income before taxes of the high tech and broker options will go up by $100,000. Guillermo will need to pay taxes at a rate of 42%. This will directly reduce the cash flow. For the current scenario, the before-tax net income will increase by $50,000 after the building is fully depreciated. Guillermo will pay the tax rate of 42% on the $50,000 of extra income. Assuming that Guillermos net income does not change over the period of time and additional expenses stay the same over this period, the NPV over 20 years (10 percent) for the current option equates to $625,586, $4,839,169 for the high tech option, and $4,125,109 for the broker option. Conclusion Guillermo understanding that if he was going to stay in business he was going to have to come up with a different strategy. Guillermo had three ideas of a new strategy which were to invest in new equipment, becoming a broker for one of his competitors seeking to distribute throughout North America or to continue his current strategy of utilizing his patented technique for coating new furniture. The sensitivity analysis showed that by investing in new equipment

GUILLERMO FURNITURE STORE ANALYSIS over a 20 year NPV would be the best strategy for Guillermo, giving him the greatest return to achieve profitability and long-term sustainability for the business.

GUILLERMO FURNITURE STORE ANALYSIS Reference Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate Financial Management (3rd ed.). Upper Saddle River, NJ: Pearson Prentice Hall.