Guillermo Furniture Store is facing a challenging operating environment. He is facing strong new competition that is threatening the company's margins and market share. The competitor is able to do this by utilizing state-of-the-art technology that allows the company to undercut Guillermo considerably on price, with a fairly low perception of quality drop-off in the eyes of the consumer. The second environmental challenge that Guillermo faces is that the cost of labor has increased significantly in recent years. The company's low cost of labor had been a source of competitive advantage for a long period of time. With these two changes in the environment, Guillermo Furniture is no longer competitive. The company needs to examine its options.
There are a number of options that Guillermo is analyzing in order to keep the company alive. It has generally been determined that the company cannot survive for much longer using the current business model. As a result, Guillermo will need to find a new business model. This paper will analyze some of the different business models available to Guillermo.
Analyzing the different alternatives involves the consideration of the different expected future cash flows. There are two main steps to this process. The first step is to determine the company's cost of capital. This figure is arbitrary to some degree, but can reflect elements such as the rate at which the company can acquire capital (the weighted-average cost of capital) and the risk associated with the company's ongoing business. In this situation, the WACC is probably a starting point, because Guillermo is considering making dramatic changes to its business model. As such, the rate at which the company can borrow capital would be expected to change as the risk of the business changes. That adjustment, if deemed necessary, would be the final step in determining the weighted-average cost of capital.
The second step is to estimate the future cash flows associated with each alternative. In this case, Guillermo is faced with a number of alternatives that the company has yet to explore. The first alternative is investing in technology to allow the company to match the technology of its main competitor. The second alternative is to become a distributor to his main rival. The third option is to leverage the company's patented process for coating. These three options are all distinctly different from each other, and from the current Guillermo business model. The expected future cash flows in this situation are very difficult to estimate, but through a combination of benchmarking, research and educated guesses, Guillermo can make some cash flow determinations to use in the calculations.
Once this is done, the project is typically evaluated in terms of its net present value, which is the expected future cash flows discounted to present-day dollars using a discount rate. The discount rate is typically the weighted-average cost of capital, and will be in this situation as well.
Weighted-Average Cost of Capital
The formula for the weighted-average cost of capital (WACC) is as follows:
Wd (Cd) + We (Ce) = WACC, where the Wd is the weight of debt in the company's capital structure, Cd is the cost at which Guillermo can borrow, We is the weight of equity in the company's capital structure and Ce is the cost of equity of the company. The first step, therefore, is to determine the company's capital structure. This is done using the balance sheet. For Guillermo, the total liabilities are $1,109,358 and the total equity is $235,805. This gives the company a capital structure of 82.4% debt and 17.6% equity.
The next step is to determine the company's cost of debt and cost of equity. The debt is mostly a mortgage that was signed twelve years ago, so that rate is not especially relevant today. However, as it is the best piece of information about the company's cost of debt, that number will be used. The cost of equity would normally be determined by using the capital-asset pricing model. However, Guillermo Furniture does not trade on a public market and as a result it has no beta with which to calculate the CAPM. The cost of equity therefore is very difficult to estimate. Under normal conditions, a corollary company would be chosen to use as a rough estimate of Guillermo's business-specific risk. It is worth considering, however, that Guillermo's risk profile in the future will be significantly different than it has been in the past if the company completely changes its business model. The traditional market risk premium over the risk-free rate is 7%. The current risk free rate is around 0.25%. The approximate beta for Guillermo, given the current risk conditions of the company, the impact of future changes to the business model and the small size of Guillermo can be set at 1.5. Using CAPM, the cost of equity would be:
0.25 + (1.5)(7) = 10.75%
This gives Guillermo a weighted-average cost of capital as follows:
Guillermo needs to calculate the net present value of the expected future cash flows for each of the alternatives. It is important to use multiple methods of analysis because each method relies on assumptions and guesswork. Thus, the use of multiple methods provides a better opportunity for Guillermo to have a stronger understanding of the alternatives, from multiple perspectives.
The first alternative is to maintain the status quo. At present, Guillermo has a net income of $42, 577. The variance analysis shows that the market is shifting towards the mid-grade product. This hurts the margins, because the cost of goods sold is 25.6% on the high-end product and 27.9% on the mid-grade. Thus, the company earns less contribution margin for the mid-grade so a shift towards mid-grade threatens profits. The current option is already the lowest-profit option according to Guillermo's assumptions, and with expected reductions in profits in the future, it will remain a risky proposition for the company. Assuming that profits decrease 3% each year -- a conservative assumption, the net present value for the next ten years of Guillermo's current business model is $218,316.50 (see Appendix A for NPV calculations).
For the second option, going high tech, has a very high initial cost. However, this option allows Guillermo to meet to strategic objectives that address the changes in the company's operating environment. The company will be able to meet the same precision cutting as its main competitor, and at the same cost. This will make Guillermo cost-competitive. Guillermo can also reduce its workforce, alleviating another of the company's major concerns, the rising cost of labor in Sonora. The net present value of going high-tech is $1.24 million. This calculation is slightly skewed because the initial investment is discounted as depreciation expense instead of taken out at the beginning of the project. It is unknown what the cost of the equipment will truly be. However, this net present value is so much higher than the status quo, assuming a 3% increase in revenue each year, that the gaps in the information available to complete the calculation are not particularly relevant.
The third option is to become a distributor. Strategically, this is a weak option because it insists that Guillermo go into business with the one main competitor in the market. As a tied distributor, Guillermo estimates that the sales may increase significantly -- up to 50% - but it is worth noting that the depreciation expense for this option is grossly overstated by Guillermo. The depreciation expense noted matches that associate with the high-end machinery option, when all becoming a distributor entails is building out warehouse space. The net present value of this option is $324,244. This option is clearly not as lucrative as the high-tech manufacturing option. However, the impact of the depreciation might lead to higher net income that would yield a better NPV.
The shortest payback is the status quo, because there is essentially no initial investment. The high-tech option has by far the highest net present value of the three options present for Guillermo. The fourth option, the coating option, has not had cash flows estimated for it by Guillermo. Therefore, it will not factor in this discussion. The patent can be licensed no matter what other option Guillermo pursues.
Strategically, the first option seems unviable. Although Guillermo is profitably today, revenues are expected to decrease as the company comes under increasingly heavy price competition. This will decrease margins, in turn decreasing profits. If margins are decreasing at the same time as volumes are decreasing, the company will start losing money much more quickly than is currently estimated. The third option is also weak strategically for two reasons. The first is that it forces Guillermo to rely almost solely on a single company to partner with. That puts the fate of Guillermo on that one company -- if its marketing or product falters, Guillermo would be left with no viable fallback option. The second option, which sees Guillermo take advantage…