Guillermo Furniture Guillermo Has Three

Guillermo Furniture

Guillermo has three options from which to choose with respect to his furniture business. He can invest in automation technology that will allow his factory to be more productive; he can leave the manufacturing business and become a broker; or he can focus on leveraging the business potential of his patent coating technique. A net present value calculation has been conducted with respect to these options, but Guillermo must subject this raw numbers to greater scrutiny before making a final decision. Because these numbers are based on rough estimates of future cash flows, they must be subjected to sensitivity analysis. As well, Guillermo must analyze whether or not he has utilized the most appropriate discount rate when calculating the net present value of these cash flows.

Discount Rate -- WACC

In order for Guillermo to subject his calculations to scrutiny, he must determine the most appropriate discount rate for his firm. This can be done by utilizing the weighted average cost of capital (WACC). The inputs to the WACC calculation are simple -- the cost of equity, the cost of debt and the relative weight of each in the firm's capital structure. Guillermo's current capital structure consists of $965,866 in debt and $235,805 in equity. This gives a firm value of $1,201,671. The cost of debt is 7.5% and the cost of equity is 16%. The weighted-average cost of capital at Guillermo can therefore be rendered as follows:

Cost

% Total

Capital Structure

(Rate)

Capital

WACC

Bank Loans

965,866

7.5%

80.4%

6.03%

Equity

235,805

16.0%

19.6%

3.14%

9.17%

Given the WACC of 9.17%, the discount rate used in calculating the NPV of the different options was 9%. With this discount rate, the future cash flows can be discounted back to the present day.

Techniques

There are four main capital budgeting techniques that can be utilized by Guillermo to help analyze these three options -- net present value is the best one, but he can also utilize internal rate of return (IRR), payback period and discounted payback. These latter two will be discussed first. Both payback and discounted payback relate the initial investment in terms of how long it will take to earn that initial investment back. These techniques are informative only, as they do not take into account the complete set of cash flows relating to the investment. Calculating the simple payback period for the patent coating strategy begins with the initial investment of $300,000. The cash flows from this option are $42,577 per year, so the calculation is $300,000 / $42,577 = 7.04 years. For the automation technology, the simple payback is 1.53 years and for the brokerage option the simple payback is 5.89 years.

The discounted payback is a slightly more sophisticated variant of simple payback in that it utilizes the discounted cash flows in this calculation. The discount rate is derived from the WACC, so will be 9% for this calculation. For the patent coating strategy, the $42,577 annual cash flows become $39,601 in year one; $35,836 in year two, etc. Using these cash flows, the payback period calculation is used, yielding a payback period of 9.9 years for the patent coating option. For the automation technology option, the discounted payback period is 1.4 years and for the brokerage option the discounted payback is 8.1 years.

The internal rate of return is a similar calculation to the net present value. The basic premise of IRR is that if the IRR is higher than the discount rate, the project will be profitable over its life, whereas if the IRR is lower, the project will not be profitable. The IRR calculation is normally done in Excel, but can be rendered as

The IRR for the patent coating option is 6.9%; for the automation technology it is 64.7%; for the brokerage option it is 11%.

The net present value (NPV) discounts the cash flows using the discount rate derived from the weighted-average cost of capital. This calculation utilizes all of the cash flows that are specific to the decision at hand, including the initial outlay, salvage value and all cash flows beyond the payback period. This makes the NPV the most complete of the capital budgeting techniques available to Guillermo. Although normally this calculation is completed in Excel, the formula is as follows:

For the patent coating scenario, the NPV is -$26,755; for the automation technology it is $955,065; and for the brokerage option it is $27,014. These results are consistent with the results for the IRR and the two payback period calculations.

Sensitivity Analysis

Before Guillermo proceeds, he will need to subject these calculations to a sensitivity analysis. By adjusting some of the key variables, Guillermo can better understand the degree to which the final numbers are sensitive to real world deviations from the expected figures. For example, if the discount rate increases as a result of these investments, it may change the NPV ranking of the different options, depending on the timing of certain cash flows. Taking a discount rate of 12%, the patent coating option would now have an NPV of -$59,430; the automation technology would now have an NPV of $804,982; and the brokerage option would now have an NPV of -$12,091. The sensitivity analysis reveals therefore that the brokerage option's positive NPV is sensitive to changes in the discount rate. Should taking this option increase the cost of borrowing such that it raises the WACC or if the company issues equity to pay for the initial investment, thereby raising the cost of capital, this option would no longer be profitable.

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