Guillermo Furniture Store Analysis - Essay Example

? Guillermo Furniture Store Analysis Guillermo Furniture Store Analysis Introduction Guillermo Furniture store is owned by Guillermo Navallez, located in Northern America. Guillermo has operated this business for several years successfully until late 20th century which saw him face the reality in a competitive global business environment (Brown, & Reilly, 2006). New players came up in the market that was able to produce quality furniture hence a heightened competition. Moreover, the economy grew feebly to an extent the owner might be forced becoming a mere distributor as opposed to a producer. There is a great desire by the company to find the best solution to increase its profitability in the intensely competitive environment. By use of the weighted average cost of capital (WACC), multiple valuation methods in minimizing the risks and calculation of Net Present Value (NPV) of future cash flows including sensitivity analysis, the company can find a solution to the impending problem. Weighted Average Cost of Capital The weighted average cost of capital (WACC) refers to the rate of return that the company or business anticipates acquiring on its optimal risk ventures in order to offer a considerable anticipated return to all its shareholders. It is applied in valuing new assets that possess similar risks as the existing assets and that hold a similar debt ratio. WACC is a relevant rate of discount specifically for projects that are similar to the current business operations (Brown, & Reilly, 2006). To determine WACC, one must first understand that a majority of firms use different forms of financing. Some of the financing techniques include use of bonds, ordinary shares, preferred shares and other form of securities. The securities have unique types of risks and thus owners seek to get various rates of return. Under such conditions, the firm’s cost of capital might not be equal to the anticipated return on common shares. It is dependent on the anticipated return from the entire portfolio of securities that the firm has given out. Besides, taxes are also included given the point that interest payments executed by the firm are expenses which are tax deductible. In this perspective Guillermo’s cost of capital will be established as the weighted average of post-tax interest cost of debt financing and the equity cost. This is to say that the anticipated rate of return on the company’s ordinary stock. The weights are the portions of debt and equity in the company’s capital structure.   The weighted average cost of capital is utilized to assess optimal risk on the capital ventures on projects. This is means that the risk on the projects coincides with the risks the company faces on the current operations and assets.  The average cost of capital is found by; WACC = Kd (1-T) Wd + Ke* We (Emery, Finnerty & Stowe, 2007). From the financial statements given the cost of debt before tax is 7.5%, the tax rate stands at 42%, the weight of debt in the capital structure in 2010 is 84.3% while that of 2011 is 82.4%, and the weight of equity in the capital structure is 15.7 in 2010 and 17.5 in 2011 while the cost of equity is 11.34% The above figures were derived as follows; Weight of debt: Information from assets, Liabilities & Equity Information    Wd 2010 = Total liability/ Total Equity=$1,130,963/ [$211,111+$1,130,963] = 84.3% Wd 2011 =Total liability /Total Equity=$1,109,358/ [$235,805+$1,109,358] = 82.4% Cost of equity is derived from the following steps: Risk free rate used is 4.36% while the market rate of return according to S & P rating is 13.08 %. It should be noted that the security’s contribution to the risk of a portfolio that is diversified is dependent on the market risk. However, some securities might not be affected by the ups and downs in the market. The sensitivity of securities to market movement is known as beta. Securities with a beta more than 1 are specifically sensitive to the market movement (Emery, Finnerty & Stowe, 2007). Guillermo has a beta of 0.8 which implies that the stock is less sensitive to the market. Thus the cost of equity is found by Ke = Rf + [Rm – Rf] ? Ke = 4.36% + [13.08 + 4.36]*0.8           Ke=4.36% + (8.72%) * 0.80                         Ke=4.36% + 6.976%                  Ke=11.34 % Weight of Equity: Wd 2010 =total liability total Equity + total liability=$211,111/$211,111 + $1,130,963=15.7% Wd 2011 =total liability total Equity + total liability=$235,805/$235,805 + $1,109,358=17.5% Therefore, Guillermo’s WACC is, WACC 2010=7.5%*1-42%*84.3%+11.34%*15.7%=5.54% WACC 2011=7.5%*1-42%*82.4%+11.34%*17.5%=5.57% The Use of Multiple Valuation Techniques in Risk Reduction In the process of reducing or minimizing risk various valuation methods can be used. One of the methods is known as the Discounted Cash flow valuation which is used to establish the viability of an investment option. Discounted cash flow assessment makes use of the future free cash estimates and marks them down to obtain a present value which is applied to gauge the feasibility of the project. In circumstances where the figure obtained through this method is more than the present cost of the venture, the project may be fit to be pursued (Brigham & Houston, 2004). If the figure obtained is less than the current cost of the investment then the project is not a good one to follow. This type of valuation is a significant tool for acquiring the asset value though it has its own flaws. For instance it is not actually probable to get the precise figure of a company’s cash flows in the future particularly in the modern times. Besides, it is time consuming to obtain the best discount rate through the method of trials and errors.      Another valuation technique that is worth of the discussion is the Relative valuation (Brigham & Houston, 2004). This is a standard concept that means the perception of putting to comparison the asset price and the market value of the same asset or group of assets. In the market of stocks or securities investment, the concept has resulted to critical tools which might be considered as spot pricing inconsistencies. These instruments have eventually transformed into significant tools to help financial analysts in making crucial decisions in connection to allocation of assets (Brealey, Myers & Marcus, 2001). The last technique is known as the Contingent Claim Valuation. Contingent valuation is found on the worth of stocks derived from the fact that the asset value may be higher than the current value of the anticipated cash flow in circumstances where the cash flow is dependent on the non-occurrence or occasion of a particular event or phenomenon (Emery, Finnerty & Stowe, 2007). The main demerit behind using this type of valuation lies behind the fact that the usage of discounted cash flow may underrate the actual of the asset or security. Discounted Payback Period: Discounted payback makes use of the time value of money in the decision making process (Fabozzi, 2003). Under this method the discounted payback period may be described as the number of years needed to recuperate the investment from the net cash flows generated from the investment. From the current project the discounted payback period from the discounted cash flows is 9.9 years while the High-tech has 1.4 years. The Broker has 8.1 years. Therefore High-tech project ranks higher than the current and Broker project. This is because it has the least discounted payback period to recover the invested cash flows (Brigham & Houston, 2004). Net Present Value (NPV) NPV is the most commonly used technique in capital budgeting decisions. NPV is a particular period is given by: Where CFt is the anticipated net cash flow at time t, k is the cost of capital for the project and n is the lifetime of the investment. The cash outflows is taken as negative cash flows for the investment since the cash position of the investor reduce with the level of investment (Fabozzi, 2003). In assessing the three projects, if the current project is taken the shareholder’s wealth will reduce by $ 26,755 and if the high-tech project is taken then shareholder’s wealth will rise by $ 955,065 and lastly if the Broker project is selected then the shareholder’s wealth will rise up by $ 27,014. Thus the conclusion is that the high-tech project ranks highest in relation to the value added on the shareholder’s wealth. It can also be noted that there is undeviating connection amidst NPV and economic value added (EVA) of an investment. The same way NPV is the investment’s future present value, so is EVA as accumulated annually. This is why if a project has a positive NPV its economic value added is also surplus of market value compared to the book value. Therefore NPV is the frequently applied technique by managers in the modern business management. Internal Rate of Return (IRR) The internal rate of return can be described as the rate of discount that compares the present value of an investment’s anticipated cash inflows to the present value of the investment’s cash outflows. The formula is given by: In this scenario trial and error method is used in finding the IRR. CFO represents the cash outflow while CFI represents the cash inflow. In case the IRR is higher WACC used to finance the investment then the project is fit to be pursued since it adds to the shareholder’s wealth. From the analysis through trial and error method, the current project has an IRR of 6.9%, high-tech project has 64.7% while the Broker project has 11%. The cost of capital is 5.57%, thus the best project that can be selected is High-tech project though all the projects qualify. Sensitivity Analysis By conducting sensitivity analysis of the current business operation for Guillermo the present assets of the firm go up by $ 53,069 amid the year 2010 and 2011. Nonetheless, majority of the hike is in terms of cash. The cumulative assets of the company went up by $ 56,179 amid the years 2010 and 2011. On the other hand the entire current liabilities for the firm rose by $ 53,069 for the year 2010 and 2011 but the total liabilities went down by $ 21,605 amid the years 2010 and 2011. Furthermore, the total equity rose by $ 24,695 in the stated financial period. This is because there was a considerable rise in the level of retained earnings. Putting in mind the flex budget the manufacture of mid-grade, the unit production reveal a favorable variance of 268 as opposed to the high-end units that possess an unfavorable variance of 106. Nonetheless, the time of labor for mid-grade is ranked at 1.50 which is favorable as opposed to the unfavorable 2.00 for the high-end. Conclusion From the evaluation above the results are more inclined towards the high-tech project tends to have an upper hand in terms of the payback period, the related internal rate of return and the net present value that will be realized from the project. Therefore the business stakeholders must consider taking on the High tech project compared to the current and Broker’s project. Notably, the net present value and internal rate of return which tend to give a more precise probable outcome for the intended investment has been essential in confirming that High tech project is more secure and beneficial to the shareholders. References Brigham, E. F., & Houston, J. F. (2004). Fundamental of Financial Management. South Western: Thomson. Brown, & Reilly. (2006). Investement Analysis and Portfolio Management. Thomson ONE Business School. Fabozzi, F. J. (2003). Financial management and analysis. New Jercy: John willy and sons. Brealey, R. A., Myers, S.C. & Marcus, A. J, (2001), Fundamental of Corporate Finance, 3rd  Edition, McGraw-Hill Primis CO, Inc Emery, D. R., Finnerty, J. D. & Stowe, J. D, (2007). Corporate Financial Management, Third  Edition, Prentice Hall: Pearson Education. Read More