Guillermo Furniture Store Analysis - Case Study Example

Guillermo Furniture Store Analysis: Alternatives Options Introduction There are two additional options available to Guillermo. In order to make an informed decision, each option needs to be evaluated. This will be done using what if/sensitivity analysis The Hi-Tech Option The high-tech option involves using robots to make furniture. The level of demand for these furniture items is very important as this will determine the feasibility of this option. Investing in robots and expanding the production facility is a capital intensive exercise and therefore the volume that will be required to make the project feasible is of major important. Current production and forecasted levels of production are as follows: Product Current Number of Units Number of Units Projected Mid-Grade Furniture 2.532 3798 High-End Furniture 506 739 The table above shows current production and projected levels if production is increased by 50%. What if/Sensitivity Analysis –Hi-Tech Project The spreadsheet was used to carry out a “what if” /sensitivity analysis. Indications are 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% above current levels. If production is 14 above current levels Guillermo would be producing 2892 units and 578 units of Mid Grade and High-End furniture respectively.. The results are shown in Appendix 1. The Broker Option Guillermo could also become a distributor in North America for a Norwegian company. Expansion of the facility to accommodate the increased production would be required. What If/Sensitivity Analysis – Broker Option Calculations done in excel suggest that Guillermo would not be able to earn any profits from this option if the level of sales is not at least 38% above current production levels. Additional information can be found in the Appendix. The project will not be able to accommodate any large changes 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 E represents shareholders’ equity; D – debt; T - the tax rate; L – leverage; re is the cost of shareholders funds; Based on Brigham and Ehrhardt (2005) this requires the calculation of a number of components such as β representing the systematic risk, risk free rate of return which is the ten year bond rate, and the market return, The calculation of β requires a calculation of the regression of the market index return on Guillermo’s stock. None of these information are available so Guillermo’s return on equity (ROE) will be used : 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%. This is done to account for the time value of money. Leverage = D/(D + E) Leverage = 936,628/1,172,433 = 0.8 Reults: L = 0.8 and (1-L) = 0.2 WACC = 0.2 x 10.5% + 0.8 + (1 – 0.42)10.4% = 2% + 5% = 7% The current WACC is 7% - the lowest return expected and so it will be used to calculate the NPV Evaluation Techniques According to Emery et al (2007), a firm should undertake an evaluation of the expected future cash flows in relation to the required initial investment when making capital budgeting decisions. The objective here is to find profitable projects that will increase the economic value added (EVA) for the shareholders. Each option is assessed to determine which is best. There are a number of techniques available to determine which project is more feasible. These techniques include payback period net present values (NPV) which represents the two options which will be used for this evaluation. Simple Payback Period The simple payback period tells how long it takes to recover the initial investment (Brigham and Ehrhardt, 2005). This method has a bias for short term projects. The longer the time period the more risky the project since uncertainty is increased.. This technique is one of the preliminary techniques used to decide whether a project is feasible. Its described as simple because it does not take the time value of money into consideration. Another drawback is that it does not take into consideration the fact that cash flows are variable. Accounting Rate of Return (ARR) The accounting rate of return is another project evaluation technique. Several formulae are used in its calculation, of which is . the most widely used is dividing the estimated average profits over the project’s life by the estimated average investment and then multiplying the result by 100%. Internal Rate of Return (IRR) The internal rate of return (IRR) is a widely used tool. The IRR is the 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).Where NPV is equal to zero. The formula is: NPV = CF0 + ((CF1/(1 + IRR)1)1 + ((CF2/(1 + IRR)2) + (CF3/(1 + IRR)3) + (CF4/(1 + IRR)4) + (CF5/(1 + IRR)5) = 0. Net Present Value Net present value is widely used. It takes the time value of money into account in discounting the cash flows over the period. An NPV of zero indicates insufficient cash flow from the project to repay initial investment as well as provide the required rate of return. If NPV is negative then the initial investment cannot be repaid from cash flows and so it should not be carried out. When NPV is positive cash flows will be able to cover the initial investment as well as allow some returns to shareholders (Brigham and Ehrhardt 2005). 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 investment in the projects. Only the Hi-Tech option resulted in positive NPV of $43,337. The Broker option had a negative NPV of ($622,783).. This would require more time to become positive. See Appendix 2 for further information. The most profitable option is Hi-Tech option with positive returns. If both the price and the volume is adjusted to the current level then the net income what is shown in Appendix 3 and the cash flows would therefore be higher resulting in the project yielding a positive NPV much earlier than suggested in Appendix 2. The Flame Retardant and the Coating Process The current cost to produce the flame retardant is $10 per liter. A market exist for the flame retardant, however, the market price is $10. This is the same price it cost Guillermo to produce. Guillermo should not produce the product for sale. Guillermo could either make or buy the product for use on the furniture that he sells. However, the pros and cons need to be carefully assessed. Produce the coating would cost $25 as per the spreadsheet. However, if Guillermo buys the product it would cost $27.5. The difference between producing the product and buying the product is $2.50, a return of 10%. There is no market for the finished coating and so Guillermo should not produce in excess of requirements. Based the information in the spreadsheet, there are some gaps to be filled to allow further evaluation. if the cost is accurate then produce only for own use. In terms the coating process the cost per liter of the chemicals is very high. There should some additional costs involved. Only a small amount is required and so it should be purchased. References Brigham, E.F. & Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western Emery, D.R., Finnerty, J.D. & Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall Appendix 1 Produce 10% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 2,785.00 2,785.00 High-End 506.00 557.00 557.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,500 Benefits 103,730 62,972 18,412 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 (9,501) (51,517) Net Margins 265,282 653,918 486,818 Overhead 222,705 676,539 609,479 Net Income before tax 42,577 (22,621) (122,661) Produce 14.% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 2,892.00 2,892.00 High-End 506.00 578.00 578.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,497 Benefits 103,730 65,020 18,748 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 127 (43,866) Net Margin 265,282 678,890 505,370 Overheads 222,705 678,587 609,812 Net Income before taxes 42,577 303 (104,442) Produce 20% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,038.00 3,038.00 High-End 506.00 607.00 607.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,496 Benefits 103,730 67,820 19,212 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 13,318 (33,373) Net Margin 265,282 713,095 530,815 Overheads 222,705 681,387 610,275 Net Margin before tax 42,577 31,708 (79,460) Produce 30% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,292.00 3,292.00 High-End 506.00 658.00 658.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,498 Benefits 103,730 72,700 20,028 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 36,348 (15,037) Net Margin 265,282 772,810 575,290 Overheads 222,705 686,267 611,092 Net Income before taxes 42,577 86,543 (35,802) Produce 38% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,502.00 3,502.00 High-End 506.00 700.00 700.00 Direct Materials ($)/Unit Mid-Grade 140.00 140.00 High-End 250.00 250.00 250.00 Direct Labor ($/HR)/Unit 15.00 40.00 40.00 Labor Time (Hrs)/Unit Mid-Grade 20.00 4.00 High-End 30.00 4.00 4.00 Direct Cost/Unit Mid-Grade 440.00 300.00 360.00 High-End 700.00 410.00 410.00 Price/Unit Mid-Grade 509.00 459.00 459.00 High-End 879.00 789.00 789.00 Plant Overhead/Yr Salaries 50,000 95,000 95,000 Utilities 9,000 27,000 4,498 Benefits 103,730 76,732 20,700 Insurance 3,000 15,000 15,000 Property Taxes 975 3,900 3,900 Depreciation 50,000 466,667 466,667 Supplies 6,000 6,000 6,000 Income Tax Expense 17,882 55,364 98 Net Margins 265,282 822,118 611,998 Overheads 222,705 690,299 611,765 Net Income before taxes 42,577 131,819 233 Produce 40% above current levels Current Hi-Tech Broker Production Mid-Grade 2,532.00 3,545.00 3,545.00 High-End 506.00 708.00 708.00 Direct Materials ($)/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 Read More