Guillermo Furniture Store Financial Analysis & NPV Options

Introduction

Guillermo Furniture Store is facing a challenging operating environment. The company faces strong new competition that threatens its margins and market share. The competitor is able to undercut Guillermo considerably on price by utilizing state-of-the-art technology, with only a modest perceived drop in quality in the eyes of consumers. The second environmental challenge Guillermo faces is that the cost of labor has increased significantly in recent years. The company's low cost of labor had been a source of competitive advantage for a long period of time. With these two changes in the environment, Guillermo Furniture is no longer competitive, and the company needs to examine its options.

There are a number of options that Guillermo is analyzing in order to keep the company viable. It has generally been determined that the company cannot survive for much longer using the current business model. As a result, Guillermo will need to find a new direction. This paper analyzes some of the different business models available to Guillermo.

Analyzing the different alternatives involves consideration of the different expected future cash flows. There are two main steps to this process. The first step is to determine the company's cost of capital. This figure is somewhat arbitrary, but it can reflect elements such as the rate at which the company can acquire capital (the weighted-average cost of capital, or WACC) and the risk associated with the company's ongoing business. In this situation, the WACC is probably the best starting point, because Guillermo is considering making dramatic changes to its business model. As such, the rate at which the company can borrow capital would be expected to change as the business risk changes. That adjustment, if deemed necessary, would be the final step in determining the weighted-average cost of capital.

The second step is to estimate the future cash flows associated with each alternative. Guillermo is faced with several alternatives the company has yet to fully explore: investing in technology to match its main competitor, becoming a distributor for that rival, and leveraging the company's patented coating process. These three options are all distinctly different from each other and from the current Guillermo business model. The expected future cash flows are very difficult to estimate, but through a combination of benchmarking, research, and educated assumptions, Guillermo can make the cash flow determinations needed for the calculations.

Financial Modeling

Once this is done, each alternative is typically evaluated in terms of its net present value (NPV) — the expected future cash flows discounted to present-day dollars using a discount rate. The discount rate used here is the weighted-average cost of capital.

The formula for the weighted-average cost of capital (WACC) is:

W_d(C_d) + W_e(C_e) = WACC

where W_d is the weight of debt in the company's capital structure, C_d is the cost at which Guillermo can borrow, W_e is the weight of equity in the capital structure, and C_e is the company's cost of equity. The first step is to determine the company's capital structure using the balance sheet. For Guillermo, total liabilities are $1,109,358 and total equity is $235,805. This gives the company a capital structure of 82.4% debt and 17.6% equity.

Weighted-Average Cost of Capital

The next step is to determine the cost of debt and cost of equity. The debt is mostly a mortgage signed twelve years ago, so that rate is not especially current. However, as it is the best available information about the company's cost of debt, that figure will be used. The cost of equity would normally be determined using the capital asset pricing model (CAPM). However, Guillermo Furniture does not trade on a public market and therefore has no beta with which to calculate CAPM. The cost of equity is thus very difficult to estimate. Under normal conditions, a comparable company would be selected to provide a rough estimate of Guillermo's business-specific risk.

It is also worth noting that Guillermo's risk profile in the future will differ significantly from its past if the company completely changes its business model. The traditional market risk premium over the risk-free rate is 7%. The current risk-free rate is approximately 0.25%. Given the current risk conditions of the company, the expected impact of future changes to the business model, and the small size of the firm, a beta of 1.5 is a reasonable estimate. Using CAPM, the cost of equity is:

0.25 + (1.5)(7) = 10.75%

This gives Guillermo a weighted-average cost of capital as follows:

(.824)(12) + (.176)(10.75) = 9.888 + 1.892 = 11.78%

Conclusion

Guillermo should pursue the high-technology investment option. It has the highest net present value, and it leaves Guillermo with a high level of control over its own strategy. The company would still be able to compete effectively and retain strong market share with the high-technology investment. At this point, Guillermo has better North American distribution than its new competitor. This means that if it can produce at the same price, it would hold a competitive advantage through easier and lower-cost access to market. The high-tech option is therefore the best choice strategically. That it is also the best option financially only reinforces why the investment in high-tech production equipment is the right path for Guillermo at the present time.