Guillermo Financial Analysis

Guillermo Financial Analysis

FIN571/University of Phoenix

June 11, 2012

Beatrice Jones

Guillermo Financial Analysis

Mr. Navallez, the owner of Guillermo Furniture is faced with the task of making changes in an attempt to bring the business back to a profitable position. Currently the store is in a difficult position financially. The arrival of the new competitor from oversees has caused a negative shift in the financial condition of Guillermo Furniture Store. To properly assess which option the owner should pursue, Mr. Navallez would need to research the; sensitivity analysis, net present value and weighted average cost of capital for each option. This paper will briefly discuss capital budgeting and the three possible options; keep current set up, become a broker or evolve to high-tech. It is essential that Guillermo Furniture Store choose the best option to gain a competitive advantage in the industry.

To decide if a project is worth pursuing or investing in, the firm uses capital budgeting. According to the text, "Capital budgeting is fundamental because a firm is essentially defined by its assets and the products and services those assets produce." (Emery, Finnerty, & Stowe, 2007, p.187). The investment of the project is classified by the type of benefit to company and the size of the project. This project requires the firm to evaluate the current project, broker and high tech investment according to the NPV and sensitivity to investment.

Net present value of future cash flows

There are different types of capital budgeting techniques which include: simple payback, discounted payback, NPV (net present value), and IRR (internal rate of return). The expected number of years required to recover the original investment by Guillermo Furniture Store is considers the simple pay back period. This would mean how much time the company would need to compensate the initial investment should they choose to pursue the broker or high tech project options.

A break-even discount rate is when the IRR has a inflow of cash equal to the outflow of cash and makes the NPV of the investment = 0. The rate of reinvestment for cash flows is the internal rate of return (IRR), while the excess of cash flows at a defined period of time in the industry is the NPV.

The cumulative cash flow of Guillermo Furniture Store is currently at t = 0 and the initial cost is -$7,000,000. At Year one the cumulative cash flow includes the previous cumulative cash flow of that year plus $500. In years two, four and five the cash outlay increases by $700,000. The decision rule for the NPV versus the IRR is: if the cash flows are discounted and k1 and the NPV is positive then the firm should accept the project. However if the cash flows are discounted and the NPV is negative this means that IRR<k2; then Guillermo should reject that project option.

Sensitivity Analysis

The current, broker and high tech investment can be put at $300,000 for the first year to evaluate the sensitivity analysis. This would make the cumulative cash flow -$300,000 + 39,061 = $-260,939 which results in a PV of $42,577. The discount return rate is equal to the weighted-average cost of capital (WACC). Using the WACC is important to assess the expect rate of return in relation of the risks associated with common stock or associated securities. According to the payback of discounted cash flow the initial investment is recovered after nine years. Therefore the Hi-tech option would take the least amount of time to recover from the invested amount making the recovery period around 5.89 to 7.05 years. When considering the options on the hi-tech option would be worth investing in if all of the options are mutually exclusive. The stockholders confidence will be increased when there is a positive value of NPV projected during the payback period. This can produce more investment capital for Guillermo by reviving or engaging new vendor and supplier confidence and support. If the company chooses the current option the increase in shareholders' wealth would be $7,798; the increase would be $68,366 if they choose the broker option. However the largest increase is $1,133,775 if Guillermo Furniture Store chooses the High-tech option.

Optimal weighted average cost of capital

Another important factor of the capital budgeting is the