Guillermo Must Decide Which Option

Guillermo must decide which option he is to choose for the future direction of Guillermo Furniture. The company needs to choose between three main courses of action. The first of these is that the company would focus its energies on a coating for which it has a competitive advantage. The second is that the company would focus on a high tech automation technology and take his company mainstream. The third is to quit manufacturing furniture altogether and go into the brokerage business.

Each of these choices represents a new strategic direction for the company and for the most part Guillermo has no preference between these different options. The decision will largely be made on financial considerations. Analysis of the Alternatives Because three of the main capital budgeting techniques involve a discount rate, this must be derived for Guillermo. This will come from the company's weighted average cost of capital, a common tool used in capital budgeting (Llano-Ferro, 2009).

The current balance sheet for Guillermo shows a capital structure of 80.4% bank loans and 19.6% shareholders' equity. The cost of loans is 7.5%, and the cost of equity is 16%. Thus, the WACC is calculated as follows: (.075)(.804)+(.16)(.196) = 6.03 + 3.136 = 9.166% This can be simplified to 9%, to aid in the calculations. It is not essential that the WACC be used explicitly, it is merely a guidepost for the firm's cost of capital. There are a number of different ways in which the alternatives can be analyzed. The first is the choice to focus on the patent coating.

There are a number of techniques by which this option can be analyzed. The first is the payback period. For this option, the payback period is as follows: for the patent coating, the initial investment is $300,000. The revenues expected are $42,577 per year. Thus, simple payback is: $300,000 / $42,577 = 7.04 years The discounted payback method operates on the same principle, but uses discounted cash flows as a means of determining the payback period. This is because cash flows in the future are not worth as much as cash flows today, because of inflation.

The discount rate for Guillermo is the weighted-average cost of capital (WACC), which in this case is 9%. Thus, the discounted payback is as follows around 11 1/2 years. The IRR for the patent coating option is -1.9%, and the NPV of this option over ten years is -$26,755. This is because the option does not pay for itself until after year 11, meaning that ten years out the project is still under water.

The IRR is lower than the discount rate, which also indicates that the project simply does not generate enough revenue to justify the up-front cost of the patent coating option. The second alternative is the investment in high-tech automation. The conventional payback period for this alternative is 1.53 years for this option; the discounted payback period is 1.4 years. Both of these are superior to the first alternative. The IRR for this option is 64.7%, and the net present value of this option is $955,065.

The high-tech automation option is highly profitable, but it has a drawback in that it represents a major shift in strategic direction. Also, the revenue forecasts are highly speculative at this point, so that must also be taken into consideration. The third option is the cease manufacturing and become a broker. This alternative carries with it a conventional payback period of 5.89 years and a discounted payback period of 8.1 years. This places this option in between the other two options.

The IRR for the brokerage option is 11%; and the net present value for this option is $27,014. The brokerage option is profitable, but just barely, and not nearly as profitable as the high-tech automation option. A sensitivity analysis would normally also be carried out. In this situation, the assumptions built into the calculations are fairly basic, and the disparity between the three different options is substantial. There is little that could occur to change the order of ranking between these three options on a financial basis.

In particular, the number one option of high-tech automation is hugely profitable, while the others would be lucky to be profitable. However, if the decision was not so obvious, a sensitivity analysis would be conducted on the basis of changing multiple assumptions, to see which of the options was most robust to a "worst-case" scenario (Breierova & Choudhari, 1996). Recommendation When faced with a choice between three mutually exclusive options, managers must develop a set of evaluation criteria.

Guillermo needs to set strategic goals for his company that will serve as the basis of his evaluation. In this case, Guillermo has two main potential goal types -- strategic and financial. The capital budgeting analysis above focuses on the financial aspects of these recommendations. The decision-making criteria should include a standard of measurement -- in this case net present value is a good standard of measurement (Harris, 1998).

Given that Guillermo does not appear to have a preference among the three options, the finances of the different options will be the primary consideration of note. The financial implications of all three are diverse. The first option, to focus on the patent coating, has a negative net present value. Typically, an alternative with a negative net present value would not be given consideration, as undertaking such an investment would be worse for the company than doing nothing (Baker, 2000).

In short, the patent coating option does not make enough money to justify the investment. Pursuing this option would hurt Guillermo Furniture, so it is rejected. The third option, to become a furniture broker, has a positive net present value. Thus, this alternative can remain under consideration. The IRR is 11%, which is higher than the company's weighted average cost of capital. This option, however, only barely has a positive net present value.

Given that it represents the most significant strategic departure, the cash flow estimates of this option must be treated with some degree of skepticism. As a result, the slightly positive NPV does not make a convincing case for the adoption of this option. The second option, investing in high tech automation equipment, has a substantially positive net present value. Guillermo's calculations have this option producing a net present value of $955,065.

Even when treated to a sensitivity analysis, this figure withstands scrutiny and delivers a high net present value and internal rate of return. Therefore, this option is the only one of the three that makes financial sense for Guillermo. Indeed, its payback period is very short, allowing Guillermo to profit within two years from this decision. It is recommended, therefore, that Guillermo adopt the second option, to invest in the high-tech automation equipment. This option will have significant impacts on the firm's financial picture.

The pro forma for Guillermo at present is as follows: GUILLERMO'S FURNITURE STORE Pro Forma Cash Budget Year 1 Year 2 Year 3 Year 4 Year 5 Cash Inflows Beginning cash balance 168,801 140,150 171,130 208,156 248,984 Net Revenue 1,342,911 1,410,057 1,480,560 1,554,588 1,632,317 Total receivables 211,458 215,773 220,177 224,670 229,256 Total 1,723,170 1,765,980 1,871,867 1,987,413 2,110,556 Cash Outflows Personal expenses 0 8,000 10,000 10,200 10,200 Employee compensation/benefits 1 1,210,646 1,234,859 1,259,556 1,284,747 1,310,442 Non-personnel operating expenses 2.