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Running Head: Financial Analysis in Guillermo Furniture Store Scenario

Financial Analysis in Guillermo Furniture Store Scenario:

Discussion and Explanation

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Course Name, Semester No, Class Level

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September 14, 2009

Abstract

Guillermo's Furniture Store Scenario provides the expedient case study for studying the concept of financial principle in the competitive economic environment. The current paper discusses the approach of financial management with correct application of ideas to create value and economic efficiency through analysis of financial transactions to establish the position of Guillermo in market.

Cost Relationships and Behaviors to Supplement Decision-Making Prerogatives for the Manager

Financial principles, financial markets, and business ethics form a foundation for the financial decisions that managers routinely make. Guillermo’s case study shows that the arrival of new competitor from oversees have put unexpected challenges on the financial condition of the company. The principles of finance describe typical behavior in financial transactions and provide guidance for decision making in the case of Guillermo. Competitors have advantage of applying the new technology to produce customized product with precise measurement to meet the demands of customer. Guillermo is also seeing the issue of rise in labor cost due to economic prosperity of the city. Since financial self-interest guides rational decision making, Guillermo has to reestablish its position to meet the challenges from foreign competitors in Sonora. Many financial decisions must consider the time value of money. The availability of local labor on cheap price, market condition and brand value has given economic advantage to the Guillermo from the competitors till the sudden change happened as mention in the discussion. Guillermo has three alternatives to approach the business with new insight and action. Incremental costs and benefits are the basis for choices among alternatives where transactions have at least two sides, with each party considering their self-interest. Concept of an opportunity cost can be applied to differentiate between the value of one action and the value of the best alternative. He can invest in new technology and make furniture automatically, accurately and with almost no labor costs. So, developing expertise can create value. Other option is to become a broker for a Norway firm and coordinate the distribution channels for that firm. Also, he can apply third alternative of continuing with his current business and use the new patented technique of coating furniture. In this way, diversification can reduce risk and extraordinary returns are possible with new ideas (R. Emery, Douglas; D. Finnerty, John & John D. Stowe., 2007)).

The firm value is total of its liabilities and equity. Firm value of Guillermo is $1,298,275 for year 2007 and $1,287,064 for year 2008 as reflected in Assets, Liabilities and Equity information for Guillermo’s financial statement. It assesses the company values of its assets. Equity is measure of current price of the all outstanding share of firm’s stock. Even if financing decision does not affect the firm’s value, it is helpful in estimating the cost of capital which is necessary for providing the value of minimum return investors can expect from their decision of investment in Guillermo.

Capital Budgeting provides the decision parameter to check whether firm’s decision to invest in any project is worth pursuing or not. The classifications of investment project are determined by project size and the type of benefit to the company. Since project is over 1 million dollar, it is considered as large project. The company can plan to invest in expanding the business, acquisition, renovation or replacement of assets. Sales strategy is also involved in investment decision.

The economic evaluations of investment proposal determine the right strategy for going ahead with any strategy like sales distribution, advertisement or R&D program. The time value of money is critical in any making important decision regarding accepting or rejecting the project. Some evaluation parameter is better than other parameter depending on the nature and projection of investment.

Let us consider the evaluation based on NPV vs. IRR for project.

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NPV vs. IRR Independent projects

(Source: )

Decision Rule:

If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project

If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project.

The IRR is the break-even discount rate which makes the inflow of cash equals to outflow of cash. It brings the net present value (NPV) of investment as 0. It is general assumption that internal rate of return (IRR) are the rate of re-investment for cash flows. But modified internal rate of return assumes that cash flows are re-invested at the company’s cost of capital or the rate mentioned of re-investment. Hence, MIRR is better representative of the profitability of the project. MIRR also balances the error of multiple IRR and provides better accuracy for rate of return. NPV evaluates the excess of cash flows at defined period of time in market. It gives the value of investment in market from the initial costs occurred for setting the project. NPV analysis is the best indicator for checking the progress of project on financial performance. NPV value of Hi-Tech project is $337,898 and IRR is also 40.5% which reflects positive return on investment in project. These parameters help managers in making better decision.

Guillermo can utilize the labor time, labor cost, material requirement and sales forecast from budget to project the revenue of the company for future financial performance. Managers can assess all the three available options to decide the most profitable choice. But sometimes the profitability is not the sole factor for selecting the option as associated risk and investment cost can mitigate the factors of profit. Income information assists in calculating the financial ratio of the company’s performance in the market. The profit before tax (PBT) turns out to be $19,798 for the sales revenue with current analysis. Net Income before taxes is $83,815 in the case of using the latest technology of computer controlled laser lathe. If Guillermo takes the broker service Norway’s manufacturer, PBT is -$37,918 which is negative. Considering these factors computer controlled laser lathe option looks most profitable. Still the investment cost of purchasing the new manufacturing equipment is huge which requires extra payment of interest on the loan amount. Broker service does not require any investment cost as there is no production cost involved. But it is not profitable with demand of current production. Top management has to weigh the three options to choose the best option depending on the long term market vision of the firm.

Earnings before taxes (EBT) provide valuable insight in checking the pros and cons of all the options. If Guillermo selects computer controlled lathe, investment cost will also reduce the amount of taxes due to factor of depreciation on equipment in the coming years. This will positively affect the profit. The option of membership in Norway’s manufacturer will also require fees which can be used to reduce the taxes. Hence, these two options can increase the profit.

The weighted-average cost of capital (WACC) is other important cost factor which can help in evaluating the actual cost of investment. WACC is the expected rate of return considering average risk investments for organizations so that they can ensure the fair amount of return to its stakeholders (Fabozzi, F. J., 2003). It is applicable for assessing the value of new equipment on the basis of risk factors and ratio of debt from previous years. WACC measurement involves the risk factor from all the associated securities from common stock, bonds and other forms of securities. It also includes the expected return from theses security and tax deduction on interest from the stocks issued by the company.

Let us calculate the WACC for 2008:

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Where L = D/(D+E) = $965,866/($965,866+$203,876) = $936,628/$1169742= 0.826 = 82.6%

T = Corporate tax rate = 42% = 0.42

rd = Cost of debt before tax = 7.5% = 0.075

|Capital Asset Pricing Model | |

|Rf |4.0% |

|Rm |12.0% |

|ß |1.5 |

|re = Rf + ß (Rm - Rf) = .04+ 1.5(.12 - .04) = .04+ 1.5(.08) = .04+ .12 |16.0% |

Hence, WACC = (1-0.826)*0.16+0.826*(1-0.42)*0.075 = 0.02784+0.03593 = 0.06377 = 6.38%

WACC can be used for estimating cost of capital but question remains whether it is viable financial index if future project operations are totally different from current operations of the project.

Control System to Achieve Guillermo’ Organizational Goals

The ways of creating value and economic efficiency in the market happens through increasing the customer service and launching better products to satisfy the need of customer at lowest cost. In the present case study related to Guillermo, foreign competitors are able to create the products according to the requirement of customer at prices which is much lower in comparison to Guillermo furniture store’s product. Customer is getting greater value for money in Sonora. Market prices in an efficient market reflect publicly available information. Guillermo is trying to match competitor’ market presence by increasing the customer value through their patented process of creating a coating for his furniture. Still competitors have advantage in the form of efficiently using the resources to create greater value. Economic efficiency can also be evaluated through the cumulative assessment of consumer surplus and producer surplus which reflects in the favor of foreign company. Guillermo can follow the competitor’s strategy as in the case of the free-rider problem mentioned the corporate finance where followers adopt the successful strategies of leader which is corollary of behavioral principle (R. Emery, Douglas; D. Finnerty, John & John D. Stowe., 2007).

Analysis of financial transaction is important aspect of business decision to choose the best alternative and its impact on the market with respect to competitors. Guillermo has focused on the effect of low selling price from competitors as well as influence of developmental activities in Sonora. They have also evaluated the scenario of acquisition by larger corporate or acquiring other companies to mitigate the effect of competitors in the market. Adopting the high-technology to create better furniture items and providing the 24/7 service is also considered. The concept of financial transaction creates the foundation for preparing business strategy on the basis of sound assumption and logical factors to choose the right alternatives. Also, Business ethics, standards of conduct, and moral judgment are central to the operations and profitability of many businesses.

A Break-even Analysis on the Current Situation

| |Mid grade |High end |Total |

|Sales |$1,112,165.00 |$384,123.00 |$1,496,288.00 |

|Variable cost | | | |

|Direct Material |$305,900.00 |$109,250.00 |$415,150.00 |

|Direct Labor |$655,500.00 |$196,650.00 |$852,150.00 |

|Benefits |$65,550.00 |$19,665.00 |$85,215.00 |

|Contribution Margin |$85,215.00 |$58,558.00 |$143,773.00 |

|Fixed cost | | | |

|Salaried | | |$50,000.00 |

|Benefits | | |$5,000.00 |

|Utilities | | |$9,000.00 |

|Insurance | | |$3,000.00 |

|Property tax | | |$975.00 |

|Depreciation | | |$50,000.00 |

|Supplies | | |$6,000.00 |

|Total fixed cost | | |$123,975.00 |

|Net income before tax | | |$19,798.00 |

| | | | |

| | | | |

|CM Ratio |0.076620825 |0.152445961 |0.096086449 |

| | | | |

|Beak even point = Fixed cost / CM Ratio | |123975/0.096086449 |$1,290,244.37 |

| | |Amount |Units |

|Mid grade | |$959,016.33 |1884 |

|High end | |$331,228.04 |377 |

| | |$1,290,244.37 | |

The break-even point provides the amount at which total contribution margin becomes equal to total fixed cost applied in the production unit. It is the different between revenue and variable cost. When Guillermo achieves present value of $1,290,244.37, its investment and production cost is recovered. But it is not always true reflection of company’s financial status as firm can sell the project and earn the money through investment which can bring the net cash flow equivalent without actually making profit from the project.

Compute the ROI, RI, and EVA for the Current Situation.

Calculation Table for ROI,RI and EVA

| |Budgeted |Actual |

|Residual Income RI(=Net Earnings – Debt |$11,483-$29,328 = -$17845 |-$19013-$29328 = -$48341 |

|payments) | | |

|Return on investment ROI (=Earnings Before |$19,798/$1,011,340 = 0.0195 = 1.95% |-$32,781/$1,261,745 = -0.025 = -2.5% |

|Taxes/ Total Operating Expenses) | | |

|Economic Value Added EVA = Net Operating |$11,483 - $936,628*7.85/100 |-$19013-$936,628*7.85/100 |

|Profit after Taxes (NOPAT) - (Capital * Cost|= $11,483 - $73525.29 |= -$19013 - $73525.29 |

|of Capital(WACC)) |= -$62042.298 |= -$92538.298 |

The residual income is the amount company is left with paying its debt from earning. The negative value of RI shows that company is not able to meet its obligations. The return on investment is calculated as the ratio of operating expenses of for production and EBIT. This is also negative for actual result of 2008 which reflects the Guillermo’s inability to generate operating profit. The projection of budget is positive but actual performance shows different result.

EVA is a concept which is utilized in organization to check the proper usage of the resources in achieving financial performance. It can be calculated as difference between net operating profit after taxes (NOPAT) and capital invested. So it becomes obvious to see the pattern between EVA and financial result, the better the EVA of company, the better it performs in terms of profits and resource optimization. But EVA turns out to be negative in the case of Guillermo’s furniture store which evaluates the measurement of investment as loss below the cost of capital. The company has to take precautionary measure to bring the financial future of company on positive track to make its employee and shareholders happy (Brown, & Reilly, 2006).

Results show that new competitor is giving nightmare to the established business of Guillermo.

Conclusion

The financial concepts with wealth of experience in dealing with business process provides the managers sufficient insight to incorporate the different elements of competitive environment for preparing the combat strategy to encounter the challenges of reviving the financial condition of Guillermo Furniture Store. Firms, value, NPV,IRR, MIRR, Payback period, and WACC are key financial metrics in assessing the imapct of financial decision in Guillermo. Break-even analysis, ROI, RI, and EVA are important in measuring the financial performance of the organization to apply control system to naviagte the future of company in positive direction. The current evauation reflects the application of latest technology of computer controlled laser lathe is best option for changing the fortune wheel of company.

References

R. Emery, Douglas; D. Finnerty, John & John D. Stowe. (2007). Corporate Financial Management (3rd ed.). Prentice Hall, Inc: A Pearson Education Company:

Brigham, E. F., & Houston, J. F. (2004). Fundamental of Financial Management. South Western: Thomson.

Brown, & Reilly. (2006). Investement Analysis and Portfolio Management. Thomson ONE - Business School.

Fabozzi, F. J. (2003). Financial management and analysis. New Jercy: John willy and sons.

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