Guillermo Corporate Finance Examining Guillermo Furniture: The Principles of Corporate Finance

Guillermo Furniture, a furniture manufacturer, wholesaler, and retailer located in Sonora, Mexico is faced with a choice. The company is facing increasing competition from overseas competitors that employ newer technologies in the manufacturing process that allow them to reduce labor costs without significantly sacrificing the quality of their products. With a rather substantial initial investment, Guillermo Furniture can purchase the equipment necessary for them to also move to a more automated manufacturing process, which would solve the problem of increasing labor costs in Sonora but which would also drastically change the company and its relationship with the people of the region. Guillermo could also shift from manufacturing to distribution, again drastically changing his company and his workforce relationship yet employing more individuals with lower initial costs. An application of the principles of corporate finance to this case can help a decision to emerge.

Applying the Principles

The first primary principle that must be examined in this case is the investment principle, which is itself made up of several smaller principles. First and foremost is the concept of the "hurdle rate" -- however Guillermo proceeds, the expected return must be at this rate or higher, and the riskier a project is the higher the bar of the hurdle should be raised. The major monetary investment to move to robotic/automated manufacturing increases the risk of this decision significantly, meaning there would need to be a high expected return to justify the expenditure.

The hurdle rate and the overall...

There are essentially two sources of funding -- increased equity from the owners and borrowing from outside lenders (revenue from operations that goes to fund these projects is essentially owner's equity, as it would be going to the owner if it wasn't going back into the company). The cash flows that will be generated from each project as well as the timing of these cash flows and the potential positive and negative side effects of the each choice must also be used to gauge the risk and hurdle rate for each project, and will help any company to invest wisely. For Guillermo Furniture, the difference in expected cash flows from a move to distribution or a move to automated manufacturing must be examined; automating the manufacturing process requires a major outgoing cash flow though potentially more immediate revenue results, while distribution requires little initial investment but could take longer to pay off. Automation will also almost certainly require incurring major debt from an outside lender, while this could likely be avoided with a move to distribution.
The next "grand principle" in corporate finance is known as the financing principle, and it is closely related to some aspects of the investment principle. This principle states that projects should be funded in a way that maximizes the value of returns and matches the financing to the nature of the asset being financed. Borrowing is not always a bad thing, for instance; the fact that it will defer direct costs to the business for some time could be good for Guillermo's transitional period.

On the other…