Guillermo Furniture Store is a furniture manufacturer in the city of Sonora, Mexico. Until the late 90’s, Guillermo Navallez had been a very successful business owner. Sonora provided a good supply of timber, the labor was considerably inexpensive, and Guillermo could sell his handcrafted products at a slight premium because of their quality. During the late 90’s two events occurred causing a dent in Guillermo’s business and profits. The first event was a new foreign competitor entering the market. The new competitor used a new high-tech approach to produce customized furniture at rock bottom prices.
The second event was one of the largest retailers located a few miles from Guillermo began to have a major impact on the communities in Sonora. “With inexpensive housing, mild weather, beautiful scenery, un-congested roads, a new International Airport, and plenty of development, an influx of people and jobs raised the cost of labor substantially. Guillermo watched his profit margin shrink as prices fell and cost rose” (University of Phoenix, 2010). Alternatives Guillermo must find a solution to deal with the new changing market.
He must research alternatives to make a profitable decision; the alternatives are categorized as different investment projects. Project one, the first alternative, Guillermo maintains his current position and continues operating the same way. Project two, the second alternative, Guillermo begins using the high-tech approach like his competitor; he produces customized furniture at a lower cost. The third alternative, he becomes a furniture broker for another company. Guillermo must decide on the best alternative that would help increase his profits and take back his competitive advantage in the furniture market.
This paper will explore and analyze the different alternatives available to him. Based on the analysis Guillermo can decide which alternative would be best to help him rebuild his business, re-grow his profits, and reduce his costs. Capital budgeting techniques should be applied to the different alternatives to determine the most successful and predict and reduce future risks. When making capital budgeting decisions “The objective is to find investment projects that will add value to the firm”, “These are projects that are worth more to the firm than they cost—projects that have a positive NPV” (Emery, 2007, p. 216).
The first technique is the net present value. The Net Present Value (NPV) is one of the most used and reliable methods when managing capital budgeting decisions. NPV is defined as “the difference between what something is worth (the present value of its expected future cash flows—its market value) and what it costs” (Emery, 2007, p. 221). NPV also uses discounted cash flow techniques to find the value of the project’s cash flow in the present and future. Calculating the NPV will help Guillermo determine which project to choose. If the result of a particular project’s NPV is positive then the company should take on that project.
The formula for NPV is: NPV= Total PV of future cashflows – initial cashflow (CF0). Weighted average cost of capital (WACC) is another widely used method. WACC is the required return on the firm as a whole; often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. By calculating a weighted average, the company can determine the interest for every dollar that is financed. Techniques in Reducing Risks Every decision made consists of pros, cons, and risks. It is necessary to implement methods to minimize risk.
For each project, techniques are needed to identify risk. Each project is associated with certain risks; Guillermo must determine the amount of risks the company can afford. There are several valuation techniques that can be applied to this scenario. Other capital budgeting criteria can be used with NPV and WACC to ensure the project is profitable. For example, the payback and discounted payback methods take on the investment concept of “getting your money back” “the expected number of years required to recover the original investment” (Emery, 2007). Shorter time means lower risk. Another technique is monitoring WACC and IRR.
Indicating whether the IRR is higher than the WACC will show the riskiness of the project; once the company has monitored each rate against one another the riskiness of each project can be identified. The higher the IRR is to the WACC, the lower the risk. If Guillermo applies this report to each project, it would help determine which projects are most practical as well as profitable based on the outcome. Evaluation of the Alternatives: Before evaluating each individual alternative, the companies weighted average cost of capital, (shown in the excel spreadsheet) must be first calculated.
The company’s WACC is 9. 17. The first alternative was to remain the same and make no changes to the current operation. The net present value calculated to -26,755. The IRR was 6. 9% which was less than our WACC and the payback period was 9. 9%. The second project was to utilize the high-tech approach. The NPV was 955,065. The IRR was 64. 7% and the payback period was 1. 4 years. The third alternative, the company moves toward primarily broker versus manufacturing. The NPV was 27,014. The IRR was 11. 0% and the payback period was 8. 1 years.
Recommendation. In analyzing alternatives, the best choice is to start using the high-tech approach. Project one would not work because the NPV is a negative number; it means it would not be a good project for the company. The payback period is 9. 9 years which was the highest out of the three alternatives. Also the IRR is lower than WACC, indicating a higher risk. Project three would not work because while NPV is positive, the payback period is higher than the high-tech approach; the IRR is not as high as with the high-tech approach. The high-tech approach has a very high NPV; the IRR was the highest at 64. % – meaning very little risk when compared to WACC. Also the payback period was only 1. 4 years, the lowest out of the three alternatives. The high tech approach allows Guillermo to become independent and self sufficient; at the same time, increases his competitive advantage. Guillermo would be able to diminish costs while performing more work with less labor. New technology reduces waste and material costs. He needs to invest in new high-tech equipment because even with increase costs, utility costs to support new technology, will be able to realize an increase in assets after initial costs.
The other alternatives required many capital investments, investment knowledge of the market, and other investments Guillermo cannot afford at this time. As a team, we believe he should move forward with the purchase of high-tech equipment. Guillermo has a history of success and can maintain success but they need to update their process and create a buzz to attract customers. Every organization goes through a change; organizations that remain on top are ones that are creative and develop an atmosphere where the employees are motivated to succeed.
After analyzing Guillermo’s Furniture Store, it has been determined implementing high-tech equipment will result in a decrease in labor costs, salaries for the workers, and production costs. Negatives are the equipment will depreciate over the years and insurance on the equipment may be expensive, property taxes and income tax may increase as well. However, by making the conversion to a high-tech facility it will result in decreased labor time, direct costs, price per unit, and employee costs or benefits.
The high-tech technology approach would serve as the most cost effective way for Guillermo to conduct a successful business. Recommendation Justification Our recommendation justification is if Guillermo implements a high tech upgrade to his facility, it will allow his business to create profits all while maintaining his core competencies. Guillermo already has a good reputation; if he is able to increase production, he would be able to offer his customers lower costs on furniture. Doing so will allow Guillermo to compete with the competition.
His new specialized coating also helps his company stand out from other companies. With the new upgrades in technology, he will be competitive with his prices; giving him the competitive advantage in market competition. Financial Justification Guillermo will increase production with new high tech equipment. He will be able to reduce costs in labor and production, enabling him to see an increase in revenues and assets. With increased revenues, Guillermo can invest his profits into long term bonds or other business investments. These bonds and investments must be low risk which will bring down the cost of his debts.
Also the consumer market is continually evolving and by trending towards new high tech innovative technologies, Guillermo will increase the worth of his company; in addition to attracting new potential investors. By making his company more appealing to potential investors, he creates opportunities to create more advertising for his business. Guillermo’s downfall has been the company’s lack of adapting to the times. By committing to innovative technical manufacturing Guillermo will be able to run a successful furniture company while still maintaining time to spend with his family.