Guillermo Furniture store has seen better days. Due to competition, cost of labor and other economic factors the company needs to make a hard choice between three mutually exclusive options: continue without change, go high tech by acquiring an expensive machine from Norway, or become a furniture broker.
To make the best business decision Guillermo has to use capital budgeting and risk analysis techniques. Capital budgeting will establish the cost of capital and other useful rates of return, used in various business project selection criteria.
Makers of gadgets subject their products to extreme conditions like dropping the gadget from a certain height or subjecting it to extreme heat; to determine quality. Similarly, Guillermo needs to use risk analysis to subject the three options to different risky conditions so that he can choose the most suitable one.
At the moment, the company’s capital structure is 80% debt (loan) and 40% equity. This shows that the company leans a lot on debt. Due to overreliance on borrowed funds; it has very high financial risk. Although the rate of paying the loan appears to be lower than the required rate of return (RRR) which is the WACC, the optimal WACC should range between a capital structure ranging between 45% and 50%. A good one is a 55% loan and 45% equity which would result in a WACC or RRR of 11.33%. This would ensure that Guillermo satisfies the risk/return trade-off expectation.
The table below shows the ranking of four capital budgeting criteria that have been used on each of the three options open to Guillermo. The accept/reject criteria for Net Present Value is: NPV≥0 accept, NPV<0 reject. If Guillermo chooses to operate without any change, he will have a positive NPV of $27,014. If he chooses to become a broker he stands to make a negative NPV of $-26,755 which is unacceptable. If he goes high-tech he will make a large positive NPV of $955,065 which is much more preferable to staying the way he is.
|NPV||IRR||Payback Period||Discounted Payback||Rank|
The accept/reject criteria for the Internal Rate of Return is: IRR>RRR accept, IRRRRR or 11%>9.17%, therefore, accept, High-tech option IRR>RRR or 64.70%>9.17% so accept and for the Broker option IRR
Both the simple and discounted payback criteria show that going high-tech is the best option for it will take less than 2 years for Guillermo to recover his initial capital outlay. Since these are mutually exclusive options, the company should choose option 2 and drop the rest.
The options open to Guillermo can be subjected to risk analysis to determine the most stable choice. Risk analysis techniques include sensitivity analysis, risk-adjusted discount rate method and simulation. Brigham and Daves (2007) say that “Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant ” (P.464). The variable used in this case is the Required rate of return. The base case situation uses the discount rate of 9%. Different NPVs are calculated first using the WACC of 9.17%, then a pessimistic scenario of a low RRR of 5% and a high RRR of 15 %.
The graph above indicates that even when subjected to low discount rates, going high tech is the best option open to Guillermo. In the worst case scenario of a high RRR of 15% a low NPV of $681,492 is still higher than the best NPVs from the other options.
Scenario analysis is a more complicated extension of the sensitivity analysis technique. Brigham and Dave (2007) say that instead of using one input while holding the rest constant, the scenario analysis “allows us to change more than one variable at a time” (p.467). The Monte Carlo simulation uses computer packages to produce many NPVs that are used to make interpretations.
From the use of multiple selection techniques including NPV, IRR, and payback period as well as use of sensitivity analysis; the results show that Guillermo should choose the high-tech option.
Brigham, E.F. & Daves P.R. (2007). Intermediate Financial Management, 5191 Natorp Boulevard Mason OH USA: South-Western Cengage Learning.