The scenario for this week??™s assignment centers once again around Guillermo Furniture, a manufacturing company owned and operated by Guillermo Navallez. Guillermo??™s Furniture Store is located near his home of Sonora, Mexico. Sonora is a place that is considered to be a beautiful vacation spot with mild weather, traffic free roads, and an atmosphere of pictorial scenic beauty; it is also the largest manufacturing ???spot??? of furniture in North America. Currently, Guillermo is experiencing growth and economic expansion in his market, coupled with challenges that are affecting his business sustainability and profits. Emergence of competition, economic growth, and enhanced developments in technology has affected Guillermo??™s production and profitability; profit margins have shrunk as prices fell and cost rose (University of Phoenix, 2010). To remain a pillar and profitable in his current markets he must analyze his financial position, embrace change, and employ aggressive financial strategies.
For a number of years Guillermo Navallez enjoyed being the owner of the only furniture manufacturing business in the town of Sonora, Mexico. The town was not only a beautiful vacation destination; it supplied Guillermo with a generous supply of timber for his furniture production, a relatively inexpensive labor force, and the ability to charge premium prices for his products. As the cliche goes, ???Anything that seems too good to be true usually is.??? Competition moved into Sonora making it impossible for Guillermo to continue operating his business in the same fashion and sustain the benefits of large profit margins. The influx of change presented numerous challenges to Guillermo??™s existing operation. The first was an overseas company who used a hi-tech approach to the furniture manufacturing process, allowing for furniture to be made to exact specifications and the ability to charge customers extremely low prices. Second, an emergence of people and jobs raised labor cost considerably. Unfortunately, Guillermo did not foresee nor prepare for the possibility of competition infiltrating and impeding his market share. He finds himself in a situation in which he has to react by making sound business decisions on the best method to keep his company out of the ???red??? and restore his profits which have shrunk considerably. He has alternatives to consider in making prudent business decisions of the direction in which he desires his business to progress. Previously, alternatives were analyzed
by conducting a sensitivity analysis, determining the optimal weighted average cost of capital, discussing the use of multiple valuation techniques in reducing risks, and calculating the net present value (NPV) of future cash flows for each of these alternatives.
This paper will define these alternatives and give a final recommendation based on the analysis previously presented, a justification regarding the decision made and a five year pro forma cash flow budget for the recommended alternative. At the conclusion of this presentation, it will be clear regarding the direction that Guillermo should take to achieve a thriving business within a competitive market.
Guillermo is facing challenges within his industry and he is being forced to seek alternatives that will allow him to adapt while remaining competitive force. As owner operator, it is imperative with the decline of his profits that Guillermo??™s decisions be geared toward total profitability. Whether he decides to continue with manufacturing his furniture, as he has done for years (basically remain status quo), by doing nothing and risk the misfortune of being ???left behind??? in an ever-changing environment. Guillermo??™s other choice is to embrace change and technology by becoming hi-tech and investing in the latest high tech equipment (thus increasing his output capacity for a greater propensity of profits). He could choose to step into the furniture broker world and become a distributor and capitalize on his flame retardant patent.
However, with each scenario, Guillermo must analyze the expected cost of capital (project??™s required return) prior to making a definitive decision. According to Emery, Finnerty, and Stowe (2007), this ???required return??? is the minimum return investors must expect to earn to finance the project today. On the other hand, Guillermo may consider the opportunity cost. Whichever decision, he will be giving up something, in other words with an opportunity cost he evaluates and decides the value of one action and the best valued alternative.
Although sensitive to the needs of the general population and concerned about the market??™s expectancy regarding continuance of his fine, handcrafted, and exquisite furniture; Guillermo possesses self-directed interests. This includes his strong desire not to be ???squeezed??? out by mergers, acquisitions, or the competition. He wants anatomy that he may keep his identity and brand. He also wants control of his inflow and outflow of cash, and the flexibility to spend more quality and vacating time with his family. Therefore, the ???best-fit??? alternative for Guillermo??™s business world is the combination of somewhat status quo and becoming a distributor. In other words, he should retain some of the high end custom work, but move the primarily focus on his business from manufacture to distributor. Maintaining part of his existing business would allow him to sustain his brand, control, and a sense of anatomy. Undoubtedly, he is employing the ???Principle of Risk-Return Trade-Off??? because he is willing to take less return in exchange for less risk. This embraces the conservative approach to financing working capital by focusing on locking long-term financing with lower rates thus providing him with lower financing cost signaling lower risk. Branching out as a distributor would allow Guillermo to avoid set up cost, management, overhead, and eliminate the cost of manufacturing as a mass producer.
Guillermo primarily is a businessman and it is imperative that he realize that with any change in the direction of his business choosing, his operation has to continue to be profitable. Along with selecting to go with one of the three alternatives he has to consider the effects that it can cause. Whether he decides to consolidate into a larger organization by merger or acquisition, to expand his management responsibilities and purchase another organization, or even elect to employ hi-tech robotics for the manufacturing of his furniture; the greatest factor to consider is the cost. The initial cost of technology would be substantial; it affords Guillermo the ability to reduce drastically his labor force. In addition, production moves between products rapidly and runs on a 24-hour basis. This would increase productivity and efficiency and decrease production cost. A third opportunity would be to take advantage of his established distribution network, shut down the majority of his production and become a distribution channel for other furniture manufacturers. This alternative allows for him to continue some of his high-end custom work. Last, because Guillermo has patented his process for creating furniture coating; he could market and sell it. A demand and sales market exist for the flame retardant but not as much for the finished coating product.
It was realized that Guillermo quickly decided that he did not want to entertain the idea of merger or acquisition. Merger would result in the larger company retiring him and acquisition would take too much time away from his family. In a similar sense, there is not much demand for his finished coating product. He would have to revise his patent and begin producing, marketing, and distributing the flame retardant. He would also have to downsize greatly his production to only fill high end custom orders that can often have significant inconsistency in
sales. Guillermo believes that process would be too much like starting over and the return would not be worth the risk.
Two different classifications of investment projects exist. One is classified by the size of the project, whereas the other is classified by the type of benefit it adds to the company; whether or not there is an increase in cash flow, a decrease in risk, or whether or not there is an indirect benefit to the company. According to the information provide on Guillermo??™s financial background his current assets have increased each year whereas his total assets have remained much the same or stable. His current liabilities have increased while his liabilities have remained low. It would seem that Guillermo should consider becoming a partner with a competitor to increase his profits.
When making the decision whether to invest in another venture or production model, it is important to consider the risk-return tradeoff. Guillermo must understand the risk associated with that investment; the expected return on that investment, the cost, and how sensitive profit margins are to a change in sales. An analysis of Guillermo??™s second and third alternatives set against his current business model will be performed to assist with his investment decision. All three alternatives mentioned focuses on a decision of whether to change Guillermo??™s operating model or modify his status quo position. The operating risks are a result of the operating leverage. Operating leverage has an important impact on the risk of the investment. Guillermo??™s operating leverage is limited by the different methods of production, meaning it is distinctive for each investment decision. In addition, it affects diversifiable and non-diversifiable risk of the capital budgeting project. Therefore, it has an effect on the cost of capital and the project??™s beta. The sensitivity analysis will be performed using operating leverage as a base.
Therefore, the best alternative investment is to go with the existing business although it is more net margin and net income before taxes on both the hi-tech and the distributor businesses; it is also a higher initial investment of the two. For the existing business there is less of an investment with a higher return. At the end of the day, it is not about the net margin, net income before taxes, or how many goods or units one produced or sold, but about the bottom-line profits; the profits provided to the shareholders and the profits taken to the bank.