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Capital budgeting techniques for Guillermo Furniture

Read Guillermo's Furniture Scenario. Explain the finance concepts and how they relate to the context of the scenario.

Guillermo's Furniture Store Scenario

While many people know that Sonora, Mexico is a beautiful vacation spot, it is also a large furniture manufacturing location in North America. Guillermo Navallez made furniture for years near his Sonoran home. The area had a good supply of timber for the variety of tables and chairs produced by his company. Labor was also relatively inexpensive. In addition, he priced his handcrafted products at a slight premium for the quality they represented. Overall, life was good for Guillermo.

All of that was true until late in the 1990s when two forces combined to cause a large dent in his business. First, a new competitor from overseas entered the furniture market. Using a high-tech approach, this foreign competition provided furniture to exact specifications and did so with rock-bottom prices. Second, the sleepy communities in Sonora woke up. One of the largest retailers in the nation's headquarters was just a few miles down the road, and its influence had expanded considerably. With inexpensive housing, mild weather, beautiful scenery, un-congested roads, a new International Airport, and plenty of development, an influx of people and jobs raised the cost of labor substantially. Guillermo watched his profit margins shrink as prices fell and costs rose.

After doing some research on his competition to see how they are handling these changes, it is clear that many of them are consolidating into larger organizations by merger or acquisition. Being independent, Guillermo does not relish the idea of being acquired by a larger competitor and then retired as the new company squeezes every peso it could out of the overhead costs. Guillermo also is not looking to expand his management responsibilities by acquiring another organization either; that could affect his time with his family in ways that he will not enjoy.

Guillermo then spent some time looking at the foreign competition and their high-tech solution. Essentially, their production utilizes a computer controlled laser lathe to produce exact cuts in the wood. Highly automated, the plant in Norway uses very little labor as robots even perform the precise movement and assembly functions. The cost of the technology is immense, as is the reduction in the labor needed for production. In addition, the production can move between products quickly, and it runs on a 24-hour basis, as the shift-differentials are more than offset by the reduction in labor. Converting his production to this model would be expensive, but he saw how he could also decrease dramatically his production costs.

When talking to some of his distributors about their wants, he had another idea that appealed to him. A second competitor, currently operating only in Norway, has been looking for channels to distribute in North America. This second potential rival, however, did not operate furniture outlets favoring instead to rely on chain distributors. Perhaps Guillermo could coordinate his existing distributor network and essentially become a representative for this other manufacturer. While he may retain some of the high end custom work, he could move his company from primarily manufacturing to primarily distribution.

Guillermo also has a patented process for creating a coating for his furniture. In producing this product, the process first creates a common flame-retardant, and upon further processing, the coating is complete and stain resistant. There is market for the flame retardant, but not as much of a market for the finished coating. There is another product that Guillermo could buy to apply to his furniture as well that would add the same amount of value for the furniture.

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For this problem we could do the following:

- Analyse different alternatives available to Guillermo
- Determine the optimal WACC and discuss the use of multiple valuation techniques in reducing risks.
- Calculate NPV of future cash flows for each of the alternatives

Let us consider 3 alternatives for Guillermo's Furniture: Do nothing; Convert their production to a high-tech system; and Convert from primarily manufacturing to primarily distribution. These projects are called in short as: Current, Hi-tech, Broker and their data are provided in the original Excel file.

In order to make a quantitative analysis of these project alternatives, one could use capital budgeting techniques to evaluate and find the most profitable/feasible project. The following quantities should be considered:

1. Payback Period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)

1. Payback period:

Payback period refers to the period of time required for the return on an investment to "repay" the sum of the original investment. As there is no specific information on a reasonable value for investment, we should choose one. Say Guillermo's furniture invested $200 million for the project, we need to find the payback ...

$2.19