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Guillermo Furniture Sensitivity Analysis

Essay by   •  September 5, 2011  •  Case Study  •  1,634 Words (7 Pages)  •  2,647 Views

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Guillermo Furniture Sensitivity Analysis

Guillermo Furniture

Guillermo Navallez a fine furniture producer of high-end and mid-grade furniture in Sonora, Mexico is challenged with foreign competition that produces the same quality of furniture at a lower cost and an influx of people in the community creating economic instability. As a result of the new competition and a drastic population growth, Guillermo's profit margin has decreased as prices began to fall and cost began to rise (Guillermo's Furniture Store Scenario, 2011). Guillermo must analyze various methods that will prove profitable creating an economical advantage. Guillermo must decide whether to remain as an independent producer, become a distributor for another organization, or Guillermo become a representative for another manufacturer. The objective of this paper is to provide adequate information to support the alternatives available to Guillermo, including a sensitivity analysis. This paper will provide an optimal weighted average cost of capital, multiple valuation techniques in reducing risks, and the net present value of prospective cash flow for all options.

Guillermo must use capital budgeting to determine which alternative is most beneficial to Guillermo Furniture. When a company plans to invest in new facilities, equipment, or products, it may engage in capital budgeting. "Capital budgeting is the process of choosing a firm's long-term investments" (Emery, 2007, p. 873). Capital budgeting is essential because a firm is identified by its assets and the assets the firm produces. Capital budgeting is essential a shareholders wealth. According to Emery, Finnerty, & Stowe (2007), "the more successful a firms capital budgeting decisions, the higher the value of the firm's stock. "Capital budgeting is a process a firm can use to propose future investment projects" (Connaughton, 2008, p. 1) A company employs capital budgeting to establish whether a project's benefits will outweigh the costs of investing in the project Guillermo Furniture can use capital budgeting to determine the most financially profitable option for the future of the organization. The most common techniques used in capital budgeting are the internal rate of return, the net present value, the discounted cash flow analysis, and payback period method. Guillermo Furniture must consider the organizations accessible funds, the need for cash flow throughout an optimal timeline, and the responsibility to future shareholders.

An organization can use net present value to establish a financial decision. The net present value is the most commonly used technique in capital budgeting. "Net present value (NPV) is the difference between what something is worth and what it costs" (Emery, 2007, p. 74). The calculation for NPV is: NPV = the present value of expected future cash flows minus the cost. This formula can be analyzed by Guillermo to calculate the market value of the organization. A positive NPV increases the wealth of the organization because the organization is more than the market value. A negative NPV decreases the wealth of the organization because the assets cost more than the market value. A zero NPV is the result of the organization earning its required return. A zero NPV is fair and acceptable to the market. When determining the NPV of an organization, one must realize there are risks associated with each decision that are supported by special knowledge of the situation. The three alternatives for Guillermo Furniture (current, high-end, and broker) can be determined by taking the present value of each alternatives expected future cash flow minus the cost.

Table 1: Net Present Value

Current High-end Broker

Rate 10 10 10

Interest 12% 12% 12%

One- year 100000 150000 180000

Two- years 120000 175000 196000

Three- years 144000 210000 235200

Four- years 172800 252000 282240

NPV $10,202.64 $15,257.63 $18,179.46

The net present value for the current situation is $10,202.64, the high-end is $15,257.63, and the broker is $18,179.46. The information is based upon a rate of 10 years, an interest rate of 12%, and the current value per year. The information returned a positive NPV that proves Guillermo Furniture is slightly above the market value.

The internal rate of return is an organizations expected return. "If the cost of capital

(required return) equals the IRR (expected return), the NPV equals zero" (Emery, 2007, p. 223). The internal rate of return is comparable to a bond yield maturity. The objective of the internal rate of return is to determine if the project will create value. The formula to determine the internal rate of return is: ∑ = CF(t)/(1 + IRR)(t)= 0. The NPV and the IRR are considered the same. However, the IRR must be calculated by using experimental factors. The IRR and NPV are the same when the project is an independent and conventional project. An independent project is a venture that is elected autonomously of other projects. A conventional project is a venture that has an original cash depletion preceded by one or more future income. The internal rate of return for Guillermo Furniture for the current situation is 35%, for the high-end situation is 32%, and for the broker situation is 35%. The internal rate of return for Guillermo Furniture provides information to determine to undertake the project because the IRR is more than the capital cost of 10%.

Table 2: Internal

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