Guillermo’s furniture is a company that specialized in the production of furniture products whose location is in North America. Navallez Guillermo is the owner of this business. He was a recognized business man when his business was at its highest level this was up to around late 1990’s when reality checked in and things started going against his plans. Guillermo is being faced with a challenge of continuing with his work of production due to increased competition and the weakness of the economy. The alternative he has is shifting to being a distributor and quit manufacturing. The purpose of this paper is therefore to try and come up with a solution and advice Guillermo on how to make more profits. To help us come up with conclusive information on which direction Guillermo should take we are going to examine the weighted average cost of capital (WACC), multiple valuation techniques in risk reduction as well as compute net present value of future cash flows.
Weighted Average Cost of Capital
This can be defined as the rate that a given company or a business organisation is expected pay to all security holders in order to finance its assets. It can also be taken to mean an overall cost of capital that is used as an investment discount rate. Mostly WACC is used to find the value of new assets whose risk is regarded as the same to that of the old ones in a business.
Many companies get their finances from different sources which includes; common stock, bonds or preferred stock. It is clear that these different securities have different risks and therefore they are treated differently as far as rates of return are concerned. This therefore explains why the cost of capital of a company is different from the expected rate of return of the common stock. We can calculate the cost of capital of Guillermo as weighted average of the after tax interest and the expected rate of return on common stock.
Multiple valuation techniques
Discounted cash flow valuation is one of the valuation techniques that are used to reduce risk. It is used to estimate the level by which an investment opportunity is attractive. This analysis entails use future cash flow projections and discounting them to derive a present value which in turn is used evaluate the best and potential for investment. If through this computation discounted cash flow obtains a value greater than current cost of investment, then the opportunity is considered to be a good one.
Multiple valuation technique is computed as follows.
The other valuation technique is relative valuation which involves comparison of the price of an asset to similar assets as dictated by the market. Another technique we can mention is contingent claim valuation it involves valuation of stock on the assumption that, value of an asset may be greater compared to present value of the future cash flow.
In conclusion, it is right to say that one of the intentions of firms to compute weighted average costs of capital due to the need a standard discount rate for average risk projects. This average risk project has similar level of risk just like the old assets.
The best way for analyzing Guillermo’s alternatives is by calculating the return on investment that he makes in the two alternatives that is hi-tech and broker. Depreciation figures clearly shows that there is need to purchase additional buildings and equipment. The first step is to remove the depreciation figures for own business from the depreciation figures. From the computation the extra gain from hi-tech will be higher than extra gain from broker.
In both situations there is a negative return from investment and therefore the recommendations would be to continue with the current business. This is evident from the negative returns on the addition of equipments and buildings. Furthermore there are other assumptions made such as dividend withdrawal or drawings which are not necessarily made with any certainty. The idea of coating the furniture in order to increase a share in the market is going to work in the favour of Guillermo and should be incorporated.
Reference
Financial Accounting Standards Board. Statements of Financial Accounting Concepts. Irwin, 1987.
Chen, Richard C. "A Discounted Cash Flow Analysis for Financing Alternatives." National Public Accountant. July 1998.
Emery, D. R., Finnerty, J. D. & Stowe, J. D, (2007). Corporate Financial Management, Third Edition, Prentice Hall: Pearson Education.
