Guillermo’s Furniture Store Scenario
Guillermo’s Furniture Store Scenario
QuestionWhile 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.
INSTRUCTIONS The major point of this assignment is for you to realize there are three separate alternatives presented in the case verbiage.
Using the budget figures and projection assumptions given, you are to calculate a 5 year projected income statement and cash flow as well as the WACC for each
alternative. As in a real corporation, you can take each alternative, calculate the decision-making capital budgeting analyses
(NPV and IRR) using a discount rate and risk factors (sometimes referred to as the hurdle rate and/or required rate of return).
Then, a decision can be made as to which alternative would be best for the organization. As you will see, each alternative not only has a different
projection, but a different level of risk that is built into the NPV calculations. Of course, all possible variables are not accounted – but this exercise will give you a
flavor of what is used in the real-world in regards to capital budgeting. Below are the three scenarios from the case along with additional assumptions in order for you to fulfill the requirements of this assignment.
You can use the formats provided below as a way to organize the analysis. You will need to do the calculations for the various elements and factors as part of
your analysis. Remember … Year 0 is when the initial investment is made, there are no sales or costs in that period … it is the “present” of present value. There may be
follow-on investments in subsequent years. Note — please realize that the assumptions in the three below scenarios are just that — “assumptions”. They are given to create an example of the decision
making process used Please show your calculations. If necessary, set up additional spreadsheets using the other “sheets”, linking from the Scenarios sheet to the appropriate
information on the back sheets. That will help you organize your thoughts and help in tracing data to your conclusions. Please submit your completed spreadsheet with
your written analysis. SCENARIO ONE – Paragraph 4 of Furniture Scenario – increase in technology. 1) Year one projections are the same as the June Budget x 12 2) Year 2 and beyond — Revenues projected at 10% increase per year. 3) Year 2 and beyond — Varriable costs*Â — increase at the same rate as sales. 4) Year two and beyond — Fixed costs increase at a standard inflation rate of 3% per year. 5) Year two and beyond — Depreciation increases at 20% per year. 6) Capital Expenditures — Initially $7,000,000; and an additional $700,000 is years two, four, and in year five.
7) Labor wages & benefits decrease by 20% for year two due to technology savings — then a 10% per year increase in year three and beyond.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue  High-End  Mid-Grade Total Revenue Cost of Goods *  High-End  Mid-Grade Total Cost of Goods Net Revenue Labor Wages Office Salaries Benefits Supplies Utilities Insurance Property Taxes Total Operating Expense Earnings before Taxes & Depr Depreciation Earnings before Taxes Income Taxes (42%) Net Earnings Add back Depreciation Subtract Out Capital Expenditures TOTAL CASH FLOW FOR ANALYSIS DISCOUNT RATE to use for calculating the NPV:  Add the calculated WACC to a risk rate your analysts have assigned to this scenario  Risk Rate Assigned = 1.6% WACC data needed for calculation:  Cost of Debt = 8%  Desired Mix for weighting (Debt = 40%; Equity = 60%)  Cost of Equity data needed:   Next Annual Dividend = $2   Current Stock Market Value = $40   Dividend Growth Factor = 7% NPV = IRR = SCENARIO TWO – Paragraph 5 of Furniture Scenario – converting factory from primary manufacturing to primary distribution
1) Year one projections are the same as the June Budget x 12 2) Year 2 — Revenues decrease 10% and then increase at 5% . 3) Year 2 and beyond — Varriable costs*Â — increase at the same rate as sales. 4) Year two and beyond — Fixed costs increase at a standard inflation rate of 3% per year. 5) Year two and beyond — Depreciation increases at 10% per year. 6) Capital Expenditures — Initially $5,000,000; and an additional $500,000 is years two, four, and in year five.
7) Labor wages & benefits decrease by 40% for year two due to converting to distribution — then a 5% per year increase in year three and beyond.
8) Office Salaries increase by 20% for year two due to converting to distribution — then a 5% per year increase in year three and beyond.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue  High-End  Mid-Grade Total Revenue Cost of Goods *  High-End  Mid-Grade Total Cost of Goods Net Revenue Labor Wages Office Salaries Benefits Supplies Utilities Insurance Property Taxes Total Operating Expense Earnings before Taxes & Depr Depreciation Earnings before Taxes Income Taxes (42%) Net Earnings Add back Depreciation Subtract Out Capital Expenditures TOTAL CASH FLOW FOR ANALYSIS DISCOUNT RATE to use for calculating the NPV:  Add the calculated WACC to a risk rate your analysts have assigned to this scenario  Risk Rate Assigned = 5.1% WACC data needed for calculation:  Cost of Debt = 8%  Desired Mix for weighting (Debt = 40%; Equity = 60%)  Cost of Equity data needed:   Next Annual Dividend = $2   Current Stock Market Value = $40   Dividend Growth Factor = 7% NPV = IRR = SCENARIO THREE – Paragraph 6 of Furniture Scenario – adding another product to the finish of the furniture – cost is minimal.
1) Year one projections are the same as the June Actual x 12 2) Year 2 and beyond — Revenues projected at 10% increase per year. 3) Year 2 and beyond — Varriable costs* — increase at the same rate as sales. 4) Year two and beyond — Fixed costs increase at a standard inflation rate of 3% per year. 5) Year two and beyond — Depreciation increases at 5% per year. 6) Capital Expenditures — Initially 500,000; and an additional 50,000 is years two, four, and in year five. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue  High-End  Mid-Grade Total Revenue Cost of Goods *  High-End  Mid-Grade Total Cost of Goods Net Revenue Labor Wages* Office Salaries Benefits * Supplies Utilities Insurance Property Taxes Total Operating Expense Earnings before Taxes & Depr Depreciation Earnings before Taxes Income Taxes (42%) Net Earnings Add back Depreciation Subtract Out Capital Expenditures TOTAL CASH FLOW FOR ANALYSIS DISCOUNT RATE to use for calculating the NPV:  Add the calculated WACC to a risk rate your analysts have assigned to this scenario  Risk Rate Assigned = 0% WACC data needed for calculation:  Cost of Debt = 8%  Desired Mix for weighting (Debt = 40%; Equity = 60%)  Cost of Equity data needed:   Next Annual Dividend = $2   Current Stock Market Value = $40   Dividend Growth Factor = 7% NPV = IRR =
Production Data Direct Cost Total Wood Materials Foam Chem A Chem B Chem C Flame Retardent (per liter) 10.00 1.50 0.50  Coating (per liter) 25.00 7.50 2.50 15.00  Mid-Grade (per unit) 140.00 80.00 40.00 20.00  High-End (per unit) 250.00 160.00 60.00 30.00 Alternative Coating (per liter) 27.50 Market Price of Flame Retardent (per liter) 10.00 Liters of Flame retardent per year 61 Liters of Coating per year 304 Plant Capacity  Flame Retardent 182  Coating 456  Mid-Grade 5,064  High-End 1,012