Guillermo Furniture Store: Available Alternatives to Guillermo - Research Paper Example

Guillermo Furniture Store Analysis: Alternatives Available to Guillermo Introduction Guillermo Furniture Store is a sole proprietorshipthat is owned and operated by Guillermo Navallez. The firm has been operating as a profitable business for a number of years. Sales and profits were high until the later part of the 1990s when Guillermo encountered competition from manufacturing businesses that were based overseas as well as a large local manufacturer. This competition had a negative effect on Guillermo’s operations leading to a reduction in profits. As a result of this, Guillermo realizes that he needs to act quickly or go out of business. The benefits of operating as a sole proprietorship include the fact that Guillermo is able to make decisions without consulting anyone. With this in mind, Guillermo has decided not to merge with other organizations or even to acquire another organization. This led to the consideration of three options – continue as usual; purchase a hi-tech machine; and operate as a broker. However, before any decision can be taken, an analysis of the three options is required. Continuing as usual does not require Guillermo to do anything but to do business in the same manner as before. It is best that Guillermo makes some changes to his current operations. If sales and profits continue to fall then the end result is that the firm would have cease operations. However, with Guillermo’s reluctance to go the way of merger or acquisition closure of the business may be inevitable if the other options are not feasible. Purchasing a hi-tech machine is a very costly option as it requires an outlay of capital. Therefore, Guillermo’s ability to obtain funds as well as the cost of capital has to be a prime consideration. However, there are benefits that can be achieved from going this route. In order to break even, a certain level of sales would have to be achieved. The break-even point is achieved at the minimum level of sales which ensures that the firm neither makes a loss nor a profit. It is a measure of risk that is and s frequently used in making entrepreneurial decisions (Prakash and Deshpande 1982). This is only possible if Guillermo is able to produce furniture at a cost which is lower than the competition. This option of operating as a broker would require Guillermo to become a local distributor for an overseas firm while continuing to manufacture some of the items currently produced. This option will therefore require some changes in the way it has been operating as the main emphasis will be on distribution. This option does not require any capital outlay. An evaluation of the three options will be the focus of this paper. Capital budgeting techniques will be discussed and the very familiar and useful net present value technique will be utilized in order to arrive at a decision. Capital budgeting is the process by which long term capital investments are evaluated (Titman et al., 2011). The value that capital budgeting projects create is its NPV and this is dependent on the cost of capital (Emery et al., 2007). If the cost of capital is high, then the NPV will be relatively low, and if the cost of capital is low, the NPV will be relatively high. Project Evaluation Techniques The main objective of this evaluation is to determine which of the three options available to Guillermo will provide the best return. Some of the techniques that can be used to evaluate projects include the NPV, simple payback, and the internal rate of return (IRR). In making a decision on the feasibility of any project, the cash flows that will arise in future in relation to the initial investment would have to be evaluated (Emory et al., 2007). In the same manner, Titman et al. (2011) indicate that an investment opportunity is valued by evaluating its cash flows. Net Present Value The NPV is the technique that will be used to evaluate the three alternatives available to Guillermo. It is the most preferred capital budgeting technique (Ryan and Ryan, 2002). The primary focus of NPV technique is how time affects the value of money. Therefore, cash flows have to be discounted at the firm’s cost of capital. The difference between cash inflows and cash outflows which in most cases represents an initial investment is the NPV (Titman et al., 2011). A positive NPV suggests that the firm can recover its initial investment from future cash flows. The project chosen is the one that yields the highest NPV. Simple payback The payback period is the number of years that it takes an organization to recover its investment (Titman et al., 2011). This is a technique that is widely used because of its simplicity. It was also considered to be preferred by organizations in the past (Ryan and Ryan, 2002). However, it is not treated as the final technique in deciding whether a project is viable but as a preliminary tool. This is due to the fact that it does not take into consideration the time value of money which is very critical in evaluating investment options and in reducing the risks associated with investments. Additionally, it does not pay attention to cash flows generated after the payback period. It is also considered to have a bias for short-term projects, and so if the project is lengthy, a level of uncertainty exists. The criterion that this technique uses to make a decision is to accept the project if the payback period is less than the maximum number of years initially specified (Titman et al., 2011). Internal rate of return The internal rate of return (IRR) is the discount rate that results in an NPV of zero (Titman et al., 2011). Along with NPV it is considered to be superior to other capital budgeting techniques (Ryan and Ryan, 2002). In fact, a survey indicates that IRR followed by NPV and simple payback in that order was used more than 50% of the time by over 392 CFO’s of large US companies (Graham and Harvey, 2002). The formula for calculating the IRR is: NPV = CF0 + ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) = 0 This calculation involves the use of NPV as the subject of the formula as shown above. Cost of Capital In making any investment decision the cost of capital is a prime consideration. Most firms use several types of capital and the return required on each is necessary in making capital budgeting decisions). Therefore, a weighted average of the different capital used in financing a project is required. This average is described as the weighted average cost of capital (WACC). The formula that is used in calculating WACC is as follows: WACC = E/(D + E)re + D/(D + E) (1 – T)rd = (1 - L)re + L(1 – T)rd Where, E represents shareholders’ equity; D is the debt; T is the tax rate; L represents leverage; rd is the cost of debt; and re the cost of equity (shareholders funds). The cost of capital has to be assumed as insufficient information is available to facilitate its calculation. A discount rate of 15% is therefore used in this paper. This discount rate takes into consideration the risks involved and the ease with which fixed assets and certain receivables can be liquidated in case the company is no longer a going concern. Sensitivity Analysis Sensitivity analysis allows for changes to be made to certain variables in order to determine how these changes will impact the final decision. The use of Microsoft excel to compute the NPV allows for different production levels to be used in order to determine the level of production at which a 15% cost of capital will feasible. Additionally, sensitivity analysis can also facilitate changes to the cost of capital in the same way. Evaluating the Alternatives The three alternatives available to Guillermo, as previously mentioned, are: continue as usual, purchase the hi-tech machine, and operate as a broker. The cash flows which are based on the current level of operation are shown in the table below. Description Hi-tech Broker Continue Net Income before taxes 195,564 50955 42,577 Tax at 42% 82137 21401 17882 Net Income after tax 113,427 29554 24,695 Add back Dep 416,667 416,667 50,000 Cash InFlow 530,094 446,221 74,695 Table 1. Calculation of Cash Inflow The cash inflows based on the three alternatives are shown in Table 1. The hi-tech option has the highest inflow. However, the initial cash outlay as well as the time value of money have not yet been taken into consideration. Continue as usual Continuing as usual will result in a profit of $42,577 as shown in Appendix 1. Table 2 shows the working capital ratios which indicate that Guillermo Furniture Store will be able to pay its debts as they fall due. Ratios Formula 2010 2009 Current ratio Current assets to current liabilities 3:1 3:1 Acid test ratio (Current assets less inventory) to current liabilities 2 2 Table 2. Working Capital/Liquidity Ratios Guillermo is not expected to default on its debts if the trend based on the last two years continues. However, if sales fall drastically a different picture emerges. Sales would need to fall 73 in order for losses to occur. This kind of reduction is not anticipated. Additionally, Guillermo has sufficient room to cut expenses by as much as 20%. Purchase hi-tech machine The purchase of a hi-tech machine represents a substantial investment. The cost of the hi-tech machine can be found by manipulating information in the financial statements. This is calculated in Table 3. Total Depreciation Charges 466,667 Less: Depreciation on Building 50,000 Depreciation on Hi-Tech Equipment 416,667 Multiplied by: Estimated Economic Life 10 Cost of Hi-Tech Equipment (416,667 x 10) 4,166,670 Table 3 – Calculation of the Cost of Hi-tech Machine The cost of the hi-tech machine is $4,166,670 and Guillermo does not have the money. This means that a substantial amount of funds will have to be borrowed in order to facilitate the purchase. The information in Appendix 2 suggests that this option will not be feasible if the cost of capital is 15% as the project will generate negative returns over the next ten years. Machines are normally deprecated over a period of 10 years. Operating as a broker This option will require the same capital outlay as the option involving the purchase of the hi-tech machine. The information in Table 1 and Appendix 1 indicate that the returns from this alternative are less than the hi-tech machine option and involve a much higher negative return over the expected useful life of the equipment acquired for use in this option. Conclusion The most and the only favorable option is to continue as usual. The other two alternatives are not feasible based on the cost of capital and the time period in which the investment would have to be recovered. Guillermo should continue as usual until a more favorable opportunity has been found. Appendix 1 Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,798.00 3,798.00 High-End 506.00 759.00 759.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,497 Benefits 103,730 82,412 21,644 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 82,137 21,401 265,282 891,543 663,663 222,705 695,979 612,708 42,577 195,564 50,955 Sales at 27% below Current levels Production Mid-Grade 1,884.00 High-End 377.00 Direct Materials ($)/Unit Mid-Grade 140.00 High-End 250.00 Direct Labor ($/HR)/Unit 15.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 High-End 30.00 Direct Cost/Unit Mid-Grade 440.00 High-End 700.00 Price/Unit Mid-Grade 509.00 High-End 879.00 Plant Overhead/Yr Salaries 50,000 Utilities 9,000 Benefits 78,485 Insurance 3,000 Property Taxes 975 Depreciation 50,000 Supplies 6,000 Income Tax Expense 8 197,479 197,460 19 Appendix 2 Continue as Usual   Year Cash Flow PV Factor 15% PV of Cash Flow NPV at 5 and 10 yrs 0 0 1 0   1 74695 0.8696 64955   2 74695 0.7561 56477   3 74695 0.6575 49112   4 74695 0.5718 42711   5 74695 0.4972 37138 250,393 6 74695 0.4323 32291   7 74695 0.3759 28078   8 74695 0.3269 24418   9 74695 0.2843 21236   10 74695 0.2472 18465   NPV     374879 374,879 Option 2 - Purchase of Hi-Tech Machine   Year Cash Flow PV Factor 15% PV of Cash Flow NPV at 5 yrs 0 (4166670) 1 (4166670)   1 530094 0.8696 460970   2 530094 0.7561 400804   3 530094 0.6575 348537   4 530094 0.5718 303108   5 530094 0.4972 263563 (2,389,689) 6 530094 0.4323 229160   7 530094 0.3759 199262   8 530094 0.3269 173288   9 530094 0.2843 150706   10 530094 0.2472 131039   NPV     (1506234)  (1506234)   Option 3 - Operating as Broker   Year Cash Flow PV Factor 15% PV of Cash Flow NPV at 5 and 10 yrs 0 (4166670) 1 (4166670)   1 446221 0.8696 388034   2 446221 0.7561 337388   3 446221 0.6575 293390   4 446221 0.5718 255149   5 446221 0.4972 221861 (2,670,848) 6 446221 0.4323 192901   7 446221 0.3759 167734   8 446221 0.3269 145870   9 446221 0.2843 126861   10 446221 0.2472 110306   NPV     (1,927,176)  (1,927,176) References Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate Financial Management (3rd ed.). USA: Prentice Hall. Graham, J., & Harvey, C. (2002). How do CFO’s make capital budgeting and capital structure decisions? Journal of Applied Corporate Finance, 15(1), 8 – 23. Ryan, P., & Ryan, G. (2002). Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, 8(4), 355-364. Singh, S. P., & Deshpande, J. V. (1982). Break-Even Point. Economic and Political Weekly, 17(48), 123 - 128 Titman, S., Martin, J. A., & Keown, A. (2011). Financial Management: Principles and Application (11th ed.). USA: Prentice Hall. Read More