Guillermo Furniture Store Analysis: Different Alternatives Available - Case Study Example

Guillermo Furniture Store Analysis Different Alternatives Available of Phoenix Different Alternatives Available Hi-Tech One of the options available to Guillermo in order to deal with the competition is to go high tech. This will involve using robots to make furniture. However, one will have to consider whether there is a demand for these furniture that will make the use of robots feasible. As indicated in the case investing in robots and expanding the production facility is a very capital intensive exercise and therefore the volume required to make the project feasible is very important. Guillermo is currently producing 2,532 units of the Mid-Grade furniture and 506 units of the High-End furniture. If he goes hi-tech he can increase both by 50% to 3798 units of Mid-Grade and 759 units of High-End. Producing is one challenge but getting the items sold is another challenge. In order to determine whether this project is feasible a sensitivity analysis and an evaluation using net present value will be carried out. Sensitivity Analysis Sensitivity analysis performed using the information in the spreadsheet indicates that this project will not yield any positive returns (when combined with the current high-End operations) if production levels are not at least 14.2% above current levels. At 14.2% above current levels Guillermo would be producing 2892 units of Mid-Grade and 578 units of High-End furniture. See Appendix 1 for results. Broker Another option open to Guillermo is to become a distributor in North America for a Norwegian company. This project will involve an expansion in the facility to accommodate the increased production. It will also involve the use of robots. Sensitivity Analysis Sensitivity analysis using the information given in the excel spreadsheet indicates that Guillermo would not be able to yield any profits on being a Broker if the level of sales is not at least 38.3% above current production levels. See Appendix 1 for details. Therefore, this project will not be able to withstand any large fluctuations in demand. The Weighted Average Cost of Capital (WACC) The formula for 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 is shareholders’ equity D is debt T is the tax rate L is leverage re is the cost of shareholders funds, for which ROE is used in this question ROE = (profit after tax/shareholders’ funds) x100% = 24,695/235805 x 100% = 10.5% rd is the cost of debt, for which the interest rate on the building financed 12 years ago is adjusted for a 3% per annum rate of inflation = 10..4% Leverage = D/(D + E) Leverage = 936,628/1,172,433 = 0.8 Therefore, L = 0.8 and (1-L) = 0.2 WACC = 0.2 x 10.5 + 0.8 + (1 – 0.42)10.4 = 2% + 5% = 7% This is the current WACC and is the lowest return expected. Therefore, it will be used to calculate the NPV Evaluation Techniques Emery et al (2007) states that: “when making capital budgeting decisions, a firm evaluates the expected future cash flows in relation to the required initial investment. The objective is to find investment projects that will add value to the firm.” The role of management is to analyze each option to determine which method would result in more profits and therefore yield more benefits for the company. There are a number of techniques available to determine which project is more feasible. These techniques include payback period, accounting rate of return (ARR), net present values (NPV) and internal rate of return (IRR). The two options available to Guillermo can be assessed using these techniques. Payback Period The payback period indicates the length of time that the project takes to recover the initial investment (Brigham and Ehrhardt, 2005). This method is biased towards short term projects. “Investments with longer payback periods are often more risky than those with shorter payback periods. This is because the shorter the payback period, the lower the risk that market conditions can render the initial investments obsolete/useless” (Benzinga.com). This technique is one of the preliminary techniques used to decide whether a project is feasible. It does not take into consideration inflation and the time value of money nor can it facilitate decision making in relation to projects with the same payback period. Additionally, it does not take into account the fact that the cash flows are variable. Furthermore, the choice of cut off period is not justifiable. It is arbitrarily chosen. Accounting Rate of Return (ARR) The accounting rate of return is “an unsophisticated technique of project appraisal (Gitman, 1997). It shows the return on capital employed (ROCE) or the return on investment (ROI). Several formulae are used in its calculation. The most popular formula is dividing the estimated average profits over the life of the project by the estimated average investment and multiplying the results by 100 to get a percentage. Other formulae used divide the estimated total profits by the estimated initial investment or the estimated average profits by the estimated initial investment. This method has a number of drawbacks in that it does not take into consideration the timing of the cash flows. Additionally, it focuses on accounting profits rather than cash flows and ignores the size of the investment. Internal Rate of Return (IRR) “The internal rate of return (IRR) is a widely used tool for evaluating deterministic cash flow streams … When used appropriately, it can be a valuable aid in project acceptance and selection” (Hazen, 2003). The IRR is defined as that discount rate which equates the present value of a project’s expected cash flows to the present value of the projected cost (Brigham and Ehrhardt 2005). That is, where NPV is equal to zero. It is calculated using the following formula: NPV = CF0 + ((CF1/(1 + IRR)1)1 + ((CF2/(1 + IRR)2) + (CF3/(1 + IRR)3) + (CF4/(1 + IRR)4) + (CF5/(1 + IRR)5) = 0. The present value tables may also be used in a trial and error fashion. Net Present Value The net present value takes into account the time value of money as it discounts the cash flows over the period. An NPV of zero means that the cash flow from the project would not be sufficient to repay the initial investment and provide the required rate of return on the project. A negative NPV suggests that the project cannot generate sufficient funds to repay the initial investment and therefore should not be undertaken. A positive NPV suggests that the project can repay the initial investment as well as allow some returns to shareholders (Brigham and Ehrhardt 2005). A positive NPV therefore means that a project can be undertaken. Evaluation of Options Using NPV Technique The WACC of 7% was used as the discount factor to calculate the NPV on both options. A 12 year period was chosen to recover the funds. See Appendix 2. After that period only the Hi-Tech option had a positive NPV of $43,337 as shown in Appendix 2. The Broker option had a negative NPV of ($622,783) as shown in Appendix 2, and this would require about another 10 to 15 years to become positive. The Hi-Tech option is the most promising and should earn positive returns even if the sales fall to current levels. The net income figures in Appendix 1 reflect a downward adjustment in price to facilitate a 10% increase in sales. This was not readjusted in our sensitivity analysis. If price and volume is adjusted to current levels then the net income would be as reflected in Appendix 3 and the cash flows would be higher resulting in the project yielding a positive NPV earlier than shown in the calculations in Appendix 2. Flame Retardant and Coating Process It currently cost Guillermo $10 per liter to produce the flame retardant. There is a market for the flame retardant but the market price is $10 which is the same price that it cost Guillermo to produce. This will not add to the value of the business unless increased production will result in a lower cost per unit. Guillermo should not produce the product for sale, even though there is a market for it as he would not realize any profit on the sale. Guillermo could either choose to buy or make the product for use on the furniture that he sells. However, it would not make any economic sense for him to produce more than he requires. The reason is that if the price falls later, he will not be able to recover his costs. In the event that price falls he may choose to buy the product rather than produce it for the use of the business. Guillermo should therefore watch the market closely to see if the price falls so that he could take advantage of such an event. We are also not sure how he arrived at the $10 per liter since the materials cost only $2. The company only requires $61 liters per year and this would cost only $610. The difference of $8 per unit that is not accounted for on the spread sheet approximates to $488. It would possibly cost more than that in cost administer the purchase and storage of the chemicals as well as its production. It may therefore be economically feasible for Guillermo to buy the product. If Guillermo chooses to produce the coating the product would cost $25 as per the spreadsheet. On the other hand, if Guillermo chooses to buy the product it would cost $27.5. The difference between producing the product and buying the product yields a gross margin $2.50 which is a 10% return. However, there is not much of a market for the finished coating and so Guillermo should not produce more than is required for his business operations. Furthermore, the cost included in the spreadsheet only includes the cost of the chemicals and so there is no certainty that the business benefit from producing it. Based on the incomplete information in the spreadsheet and the fact that we do not know how Guillermo arrived at the $10 per liter for the cost of the flame retardant we cannot definitely give an advice but the quantity involved is rather small and may not be worth the effort. However, if the costing is correct then he should only produce it for his own use. In terms of the coating the cost per liter for just the chemicals is very high. We are not certain how much additional cost would have to be incurred in its production. However, with the small amount required its production, even at a profit of $2.5 per liter does not appear economically feasible as it will only result in a profit of $2.5 as 304 = $760. It may cost Guillermo much more than $760 to produce the item and in such an event he may consider buying the product since it adds the same value as the one he produces. References Benzinga.com. (2010) Quicker Paybacks. Accretive Capital LLC dba Benzinga.com. HighBeam Available: http://www.highbeam.com. Last accessed on 4th Apr 2011. Brigham, E.F. & Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western Emery, D.R., Finnerty, J.D. & Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall Gitman, L.J. (1997). Principles of Managerial Finance. 8th ed. USA: Addison Wesley Hazen, G.B (2003). A new perspective on multiple internal rates of return. Engineering Economist. Institute of Industrial Engineers, Inc. (IIE). Available: http://www.highbeam.com/doc/1P3-322982301.html. Last accessed 4th Apr 2011 Appendix 1 Production 10% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 2,785.00 2,785.00 High-End 506.00 557.00 557.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,500 Benefits 103,730 62,972 18,412 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 (9,501) (51,517) Net Margins 265,282 653,918 486,818 Overhead 222,705 676,539 609,479 Net Income before tax 42,577 (22,621) (122,661) Production 14.2% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 2,892.00 2,892.00 High-End 506.00 578.00 578.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,497 Benefits 103,730 65,020 18,748 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 127 (43,866) Net Margin 265,282 678,890 505,370 Overheads 222,705 678,587 609,812 Net Income before taxes 42,577 303 (104,442) Production 20% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,038.00 3,038.00 High-End 506.00 607.00 607.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,496 Benefits 103,730 67,820 19,212 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 13,318 (33,373) Net Margin 265,282 713,095 530,815 Overheads 222,705 681,387 610,275 Net Margin before tax 42,577 31,708 (79,460) Production 30% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,292.00 3,292.00 High-End 506.00 658.00 658.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,498 Benefits 103,730 72,700 20,028 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 36,348 (15,037) Net Margin 265,282 772,810 575,290 Overheads 222,705 686,267 611,092 Net Income before taxes 42,577 86,543 (35,802) Production 38.3% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,502.00 3,502.00 High-End 506.00 700.00 700.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,498 Benefits 103,730 76,732 20,700 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 55,364 98 Net Margins 265,282 822,118 611,998 Overheads 222,705 690,299 611,765 Net Income before taxes 42,577 131,819 233 Production 40% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,545.00 3,545.00 High-End 506.00 708.00 708.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,495 Benefits 103,730 77,548 20,828 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 59,166 3,107 Net Margins 265,282 831,987 619,287 Overheads 222,705 691,115 611,889 Net Income before tax 42,577 140,872 7,398 Appendix 2 Calculation of Net Present Values (NPV) Hi-Tech Option Year Cash Flow PV Factor 7% PV of Cash Flow 0 (4166670) 1 (4166670) 1 530094 0.935 495638 2 530094 0.873 462772 3 530094 0.816 432557 4 530094 0.763 404462 5 530094 0.713 377957 6 530094 0.666 353043 7 530094 0.623 330249 8 530094 0.582 308515 9 530094 0.544 288371 10 530094 0.508 269288 11 530094 0.475 251795 12 530094 0.444 235362 NPV     43337   Broker Option Year Cash Flow PV Factor 7% PV of Cash Flow 0 (4166670) 1 (4166670) 1 446221 0.935 417217 2 446221 0.873 389551 3 446221 0.816 364116 4 446221 0.763 340467 5 446221 0.713 318156 6 446221 0.666 297183 7 446221 0.623 277996 8 446221 0.582 259701 9 446221 0.544 242744 10 446221 0.508 226680 11 446221 0.475 211955 12 446221 0.444 198122 NPV     (622783) Appendix 3 Production at current levels with no change in price Current Hi-Tech Broker Production Mid-Grade 2,585.00 2,585.00 2,585.00 High-End 517.00 776.00 776.00 Direct Materials ($)/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 509.00 509.00 509.00 High-End 879.00 879.00 879.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 6,234 Benefits 105,815 63,276 21,916 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 19,370 95,494 56,445 Net Income 270,908 904,209 749,109 Overheads 224,790 676,843 614,717 Net Income before taxes 46,118 227,366 134,392 Read More