Guillermo Risk Capital Budgeting for Guillermo Furniture

Guillermo Risk Capital Budgeting for Guillermo Furniture Guillermo Furniture has an uncertain road ahead, with several options that its owner can select from in an attempt to bring his company into the twenty-first century as a profitable and productive entity. Industry changes and changes in the regional economy have made it impossible for Guillermo to continue running his high-end hand-made furniture with the same laborious and highly skilled process while remaining competitive with more automated companies and those with wider and more efficient distribution networks.

The options facing Guillermo and Guillermo Furniture are not ideal from the owner's perspective, but considering them in an objective light should allow him to select the best alternative for his company in the changing economic environment.

The first alternative is that he could automate the manufacturing process, which would come at the cost of substantial capital but would allow him to remain in his primary business as a furniture manufacturer; second, he can effectively cease operations as a furniture manufacturer and become a distributor instead, with contracts from European companies seeking entrance into the North American market already a possibility for him; finally, Guillermo could choose to begin manufacturing and selling the flame retardant chemical that he originally developed as a part of his furniture finishing product for use in manufacturing, but that has other broader applications as well.

Each of these choices carries with it different risks and different opportunities, with some expense necessarily incurred in changing the business over to a new mode and model and with different amounts of expected revenue, as well. All of this needs to be considered along with market factors in a sensitivity analysis that will help guide Guillermo towards the right decision and Guillermo Furniture to a profitable future.

Sensitivity Analysis A sensitivity analysis is a quantitative tool that contains certain qualitative elements in its framework and that essentially allows for an investigation of how a certain variable or certain variables can influence a future situation given a certain set of circumstances (Investopedia, 2012).

Using this sensitivity analysis and some predicted values for each of Guillermo's choices and Guillermo Furniture's potential future, it will be possible to come to a more informed and a more objective determination about the path Guillermo should pursue and the risks and rewards of each scenario.

Establishing some baselines form which to make predictions about Guillermo Furniture requires a basic understanding of the current macroeconomic environment and the changes that might be in store over the next five years, which can be hypothesized from a brief review of current analyses.

Unfortunately, the picture painted by current forecasts does not give a very certain prediction for the future of the world's economy and for the economy of North America and the developed world -- the market for Guillermo Furniture's current products and its products if it continues to either manufacture and/or distribute furniture.

If anything, "uncertainty" could be said to be the watchword of the coming years, with analysts predicting growth in some sectors but persistent unemployment as well, and with the developing and the developed world potentially growing farther and farther apart with very different economic outlooks (El-Erian, 2012; Elliott, 2010). This means that any numbers selected as the basis for a sensitivity analysis of Guillermo Furniture's future prospects will necessarily be somewhat specious.

Selecting numbers that are within established averages and long-term trends, however, and skewing towards the lower end of such trends and figures will provide a reasonable estimate of future risks and rewards facing Guillermo and Guillermo Furniture in each of the three identified modes of continuing business in the twenty-first century. The figures established can also be manipulated on the accompanying spreadsheet as a means of conducting a more thorough sensitivity analysis by assessing each of the three described scenarios under different cost, borrowing, and revenue bases.

As initial baseline estimates it is assumed that the cost of borrowing will be five percent, as ongoing uncertainty will keep prime interest rates low and thus cheapen the cost of borrowing on the open market, though actual availability of funding might tighten due to bank and investor weariness. Given the strong track record of Guillermo Furniture's performance, it is likely that Guillermo and his company will be able to secure financing at a reasonable rate, thus affirming this estimate as a useful starting place.

The cost of equity, meanwhile, is estimated at a much higher ten percent, as direct investors will want substantially more rewards for what is a substantially risky venture. The initial ten percent estimate for Guillermo Furniture's cost of equity also takes into account the likelihood that Guillermo and his family will be bearing all equity costs themselves, thus representing a direct and material risk to the family and not simply gains demanded by stockholders or other investors less interested in Guillermo's stability or personal profitability.

An estimate of an ongoing three percent inflation rate is also assumed, as is a twenty percent corporate tax rate -- tax rates in Mexico are likely to fluctuate considerably and are difficulty to fix in any meaningful way without knowing a great deal about Guillermo's current position.

Twenty percent is a reasonable estimate given current trends in Mexico and the world at large when it comes to tax rates, and three percent is a fairly standard figure to use for estimating inflation; these estimates will help the sensitivity analysis by making it more accurate and relevant to the real world situation that is likely to be faced over the next five years.

Finally, estimates as to Guillermo Furniture's potential costs and future revenues in each of its ventures are made based on current sales revenue and what would be expected in terms of sales volume and in terms of price-per-unit that Guillermo would be able to command as a manufacturer of furniture, as a distributor of furniture, and as a manufacturer of the flame retardant.

No extensive data analysis was employed to develop these figures, as again the specific of Guillermo Furniture's current position would need to be known in much greater detail if this was to have an efficacy. Instead, it is assumed that Guillermo has a medium-sized factory and can exhaust his production supply through sales either as a manufacturer or as a distributor.

With these figures, it is possible to carry out the sensitivity analysis though a calculation and manipulation of the weighted average cost of capital (WACC) and the net present value (NPV) of Guillermo's future. The accompanying spreadsheet provides the calculations of the WACC and the NPVs for each project using the figures mentioned above; the figures can all be adjusted and the calculated numbers will automatically adjust as appropriate, and in this way it is possible to perform a sensitivity analysis that examines many different scenarios and potentials.

With the assumption that debt is far cheaper than equity the optimal weighted average cost of capital from a strictly numeric standpoint would be to fund the transition, regardless of which one.