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Guillermo Furniture Store is facing a difficult operating environment. The cost of labor -- a key input -- is increasing rapidly. The company is facing intense competition from a foreign competitor that has the ability to undercut Guillermo's low-end lines with better-quality goods. In order to save his business, Guillermo has sought out three different alternatives and is subjecting these alternatives to financial analysis. The results of the financial analysis will be combined with a strategic analysis in order to determine the best way forward for Guillermo.
Weighted Average Cost of Capital.
Since Guillermo is going to be using a net present value (NPV) analysis to help make his decision, the first step in this analysis is to determine the company's cost of capital. The three projects are substantially different from one another, and because they all have a different risk profile there is an argument to be made that they should each be evaluated with a project-specific discount rate. However, to simplify the process, Guillermo is going to use the company's weighted-average cost of capital as his discount rate. The formula for weighted average cost of capital is as follows:
Source: Investopedia...
The cost of debt is 7.5% and the weight was 47%, with a tax rate of 42%. The weighted average cost of capital therefore is as follows:
WACC = (.53)(10) + (.47)(7.5)(.58)
WACC = 5.3 + 2.0445 = 7.3445%
This can be rounded up to 8% in the interests of being conservative, which is always a recommended approach when performing capital budgeting analysis on major projects, because it ensures that the decision is not made on the basis of overly optimistic assumptions.
The first alternative is to invest in new technology. This investment would make Guillermo competitive with its foreign competitor, and allow the Guillermo to win back some of the market share it has lost. Based on the cash flows in Appendix A, this option has a net present value of $1.703 million. Strategically, this option addresses both of the major issues that are affecting the company's profitability. The new equipment will dramatically lower the labor costs of Guillermo, while the company will be able to lower its cost of production and increase its quality.
The second alternative is to become a broker for its high-tech competitor.…
Works Cited:
Investopedia (2012). Weighted average cost of capital (WACC). Retrieved March 20, 2012 from http://www.investopedia.com/terms/w/wacc.asp
Investopedia (2012). Sensitivity analysis. Investopedia. Retrieved March 20, 2012 from http://www.investopedia.com/terms/s/sensitivityanalysis.asp
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