Guillermo Furniture Store Is Facing a Difficult

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 (2012)

The cost of equity is 10% and the weight is 53%. 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. This option, again with the figures in Appendix A, has a net present value of $1.596 million. This is something of a "if you can't beat 'em, join 'em" option, where Guillermo admits that it would be difficult to match the competitor and decides to help the competitor gain access to the North American market. The net present value, however, is a little bit lower than that of the new technology option.

The third option is the "do-nothing" alternative. Because the business is declining, however, and the external environment is challenging on multiple levels, this option is by far the least attractive, and the least likely to be profitable.

When performing capital budgeting activities, it is important to perform a sensitivity analysis. This analysis allows the company to test its conclusions by changing some of the key variables, to see how much the conclusions change. What happens is that the more sensitive a project is, the more the NPV will change with a change in a key variable. Neither calculation is affected much by a change to the discount rate -- both remain profitable and the changes are minimal. The revenue calculations are not a major factor either. The biggest difference between the two best scenarios is in the slightly higher costs associated with being a broker. Given that the company has less cost control if it undertakes the broker option, and this option is already the lesser of the two, this indicates that the broker option is not as attractive.