Guillermo owns the Guillermo Furniture store, which is specialized in making high and mid-end grade furniture. The company faces foreign competition from a company that makes use of advanced technology to produce quality products at low process. This has necessitated Guillermo to study various approaches of making his enterprise profitable and have a competitive advantage, as well as maintain his market share. The store will either be managed through high-tech or become a broker, to achieve the aforementioned goal. The paper analyzes the various alternatives, which are available to Guillermo that includes sensitivity analysis.
The case presented is demonstrative of a typical business environment and sheds more light on the various challenges entrepreneurs face. A concept of competition is evident in the furniture business following the entry of a competitor. Earlier, the sector was under monopoly since Guillermo was the only player and he independently determined the prices of the products he produced. The company’s entry led to increased costs of production, a situation that was so challenging, considering Guillermo was just a sole proprietor of an extremely small firm. The other concept in the case is business expansion. While Guillermo was operating a considerably small business, it was inevitable to expand its production either through mergers or amalgamations. This is a critical concept instrument in ensuring firms enjoy economies of scale, adopt modern technology and increase their profit margin regardless of the level of competition. Large purchases of raw materials will results to large discounts, which can substantially have positive effects on the prices. Besides, expanding its operations will definitely put it in a better position to adopt a modern technology. As a result, it will manufacture quality products and emerge as the best supplier, not only in Mexico, but also internationally. Lastly, there is the concept of flexibility. The situation in which Guillermo has found himself in can be best addressed by a dynamic approach of the business. He can diversify his business rather concentrating on a single line of production. Diversification is critical in spreading risk and in reducing the probability of loses. Therefore, it is essential for it to collaborate with other companies to ensure that any gap is bridged.
The furniture store, which has been manufacturing quality furniture for years, is situated at Sonora, Mexico with Guillermo Navallez as the founder. The products that it produces are of high quality although its competitor is producing the same at extremely reduced prices. These low prices have attracted Guillermo customers, and it is a threat to sustainable business. The company was able to sell its handmade furniture at a higher premium because of the top quality brand. Guillermo made use of the self-interested behavior concept, which ensures that when all aspect in the market is equal, all customers will tend to choice an offer that is financially beneficial to them. In the Sonora area, timber was at a premium, and this enabled the firm to produce a variety of furniture. This monopolistic market came to an end following the entry of a competitor and a major retailer (Brealey et al, 2001).
It was the decision of Guillermo to incorporate research to analyze the competition factor in the market and establish how it could manage change following the entries. The research was meant to review the activities of the two firms and their impact to the entire market. It was established that the two firms had previously either merged or acquired other firms to take advantage of the economies of scale. This was the exact opposite of Guillermo firm, which was independent and was not in favor for the idea of amalgamation. With respect to behavior principle, the sole proprietor thought that acquisitions or merger could lead to neglect of family, intricate management structure and loss of power.
Using a multiple of assessment techniques, the optimal WACC will be determined to analyze the risks. Each alternative’s NPV (net present value) of projected cash flows will be considered. Since a firm is defined by the products and services its assets produce, capital budgeting is a fundamental tool of assessing its viability. Therefore, Guillermo can make use of capital budgeting to make a decision regarding the best alternative for his firm’s long-term capital investment. Capital budgeting provides a direct link between the firm and the shareholder’s wealth. It highly correlates with the value of the firm’s stock and Guillermo can easily link the firm’s profitability to his decision. Internal Rate of Return, Net Present Vale, Discounted Payback, and Simple Payback Period are the capital budgeting techniques, which will be used to determine the best alternative.
Weighted Average Cost of Capital (WACC)
WACC is a firm’s rate of return which should is expected to be earned on its risk investment for it to offer a good return to shareholders. This parameter is used in valuing new assets with the same level of risks to those that support similar ratio of debt. The WACC is a rate for discounting a project since it is a carbon copy a company’s existing business. Most firms are funded through securities, such as bonds, common stock, as well as preferred stocks. Since each of these securities has varying level of risks, it is the duty of investors to look for different rates of returns in them. In that case, the capital’s cost for companies is no longer similar to the expected gain on stock. The rate of return is dependent on the expected profits from all the company’s stocks. Apart from expected returns on securities issued, it is also dependent on taxes since tax on interest payments can be deducted. Therefore, the capital’s cost for Guillermo will be estimated as the average of cost of equity and after cost of financing tax interest, which is the rate of gain of common stock of Guillermo firm. The weights are components of a firm’s equity and debt capital structure. The WACC (weighted average cost of capital) is instrumental in evaluating a project’s average risk. This implies that the risk of existing firms operations and assets matches the projects risk (Kieso & Weygandt, 1998).
WACC (Working Average Cost of Capital) = (Kd *1) - (T*Wd) + (We*Ke)
Where:
Kd: Cost of debt before tax
T: Tax rate
Wd: debt’s weight in the capital structure
Ke: Cost of equity
We: Equity’s weight in the capital structure
Assumptions:
Kd: 7.5%
T: 42%
Wd: 84.3%, 82.4%
Ke:11.34
We: 15.7, 17.5
Weight of Debt
Wd 2011=Total liability Total Equity = 1,130,963211,111+130,963= 84.3%
Wd 2012=Total liability Total Equity = 1,109,358235,805+1,109,358 = 84.3%
Cost of equity
Market rate of return =13.08%
Risk free rate=4.36%
The effect of a security to the risk of an expanded portfolio is dependent on the market risk. However, not all stocks are evenly affected by the market behavior. Beta is the parameter for measuring the sensitivity of a stock to movement.
Cost of equity
Ke= (13.08% - 4.36%) + 4.36%*8 10
Ke= 11.34 %
Weight of Equity
Wd 2011=Total liability Total Equity = 211,111211,111+ 130,963= 15.7%
Wd 2012=Total liability Total Equity = 235,805235,805+ 1,109,358 = 17.5%
Guillermo’s WACCWACC 2011= (7.5%)* (1-42%) *(84.3%+11.34%) * 15.7% = 5.54% WACC 20112 = (7.5%) *(1-42%) *(82.4%+11.34%)*17.5% = 5.57%
Risk Reduction Using Multiple Valuation Techniques
There are various techniques of valuation used in reducing risks and Discounted Cash Flow valuation is one of them. This approach is used in estimating the attractiveness of an investment opportunity. DCF analyses make use of future discounts and free cash flow projections to calculate NPV, which is critical in evaluating the potentials of an investment. When the value calculated by analysis of DCF is greater that the current project’s cost, then the investments opportunity is feasible and presumed to be worth the investment. This valuation is can be used in calculating the worth of an asset despite it having its drawbacks. For many, it is not feasible to estimate the exact amount a firm’s cash flow since it takes many trial and error to come with an appropriate discounting rate.
Relative Valuation is a valuation technique of comparing market prices of an asset’s price with than of a firm’s asset. The notion, in terms of stocks, has resulted to pertinent practical mechanism for spotting price anomalies. Subsequently, these mechanisms have become influential in aiding investors and analysts as well, to make critical pronouncements regarding allotment of assets.
Lastly, Contingent Claim Valuation is a technique used in valuing a firm’s stock. This is on the basis of the idea that the asset’s value is greater that its expected cash flow when the cash flow’s present value is a contingent on the probability of an event taking place. The fact that this technique uses discounted cash implies that the technique can underestimate the value of an asset, and this is a huge drawback.
Net Present Value
This is the difference between the present value of an item and its expected future value. Net Present Value is typically used to provide investors with an easy and quick way of determining whether a price is likely to yield a desired rate of return. Net Present Value will appear in three ways as a dollar amount: less than zero, zero or greater than zero.
NPV for Each Alternative
Hi-Tech Broker
Extra Depreciation 416,667 416,666.67
Equipments (Depreciation) 100,000.00 100,000.00
Building (Depreciation) 316,667 316,667
Investment on Equipments 1,000,000 1,000,000
Investment on Buildings 9,500,010 9,500,010
Total Additional Investment 10,500,010 10,500,010
Cost of investment (At ten percent) 1,050,001 1,050,001
Gain on Investment 88,732.65 4,859.41
Returns on Investment (0.92) (1.00)
The Guillermo’s alternatives can be analyzed through calculation of the Returns on Investment (ROI). From the figures of depreciation, it is apparent that additional equipment and buildings should be acquired. The business’ depreciation figures are first subtracted from the overall depreciation figures. With respect the overall depreciation figures, $416,667, $100,000 is assumed to be the depreciation value of equipments. This implies that the cost for equipment will be the value multiplied by ten, which is one million dollars. The same formula is applied to the cost of buildings. Ten percent is presumed to be the cost of investment. $88,732 is the extra gain accrued from the use of high technology to produce goods while additional return from a broker being $4,858. In all scenarios, the Return on Investment (ROI) is negative. Therefore, it is wise for Mr. Guillermo Navallez to pursue with his previous strategies. He may seek other ways of reducing cost while still maintaining his customer base (Emery et al., 2007).
References
Brealey, R. A., Myers, S.C. & Marcus, A. J, (2001). Fundamental of Corporate Finance, 3rd
Edition, McGraw-Hill Primis CO, Inc Kieso, D. E., & Weygandt, J.J. (1998). Intermediate Accounting, Volume 1, 9th Edition John
Weiley & Sons, Inc, Emery, D. R., Finnerty, J. D. & Stowe, J. D, (2007). Corporate Financial Management, Third
Edition, Prentice Hall: Pearson Education.
