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Week Four Assignment University of Phoenix - FIN/571 December 13, 2012

Introduction Guillermos Furniture has experienced a significant drop in profit since the late 1990s. The main reasons for this drop can be directly correlated to overseas competition using high-tech manufacturing approaches and a dramatic rise in the cost of local labor. Guillermo Navallez, the owner of Guillermos Furniture is considering adopting the high-tech manufacturing processes used by the foreign competition. This process will reduce labor expenses but will require a large investment in new equipment. Guillermo Navallez is also considering the idea of becoming a distributor for one of his foreign competitors. Instead of continuing to manufacture his own furniture, Guillermo would coordinate his existing distributor network as a representative for this other manufacturer. This paper will cover the weighted cost of capital, multiple valuation techniques in reducing risks, and will calculate the net present value of future cash flows for both of these options. Weighted Average Cost of Capital The weighted average cost of capital is the rate of return an organization can expect to earn on its investment decisions. It is used to value new assets so shareholders can understand its expected rate of return. For example, organizations are often financed through an issuance of securities such as stock and bonds. These different types of securities carry with them different levels of risks and therefore different rates of return on investment. An organizations cost of capital is not only directly associated to the expected return on its common stock, it also depends on the expected return from all the capital sources the organization has issued. In addition, taxes play a role in this equation. This is because corporate interest payments are tax-deductible.

Guillermo Furnitures cost of capital is calculated as a weighted average of the after-tax interest cost of debt financing and the expected rate of return from the organizations stock (cost of equity). The weights are determined from the percentages of debt and equity existing in Guillermo Furnitures capital structure. Guillermo can use the weighted-average costs of capital as a standard discount rate for investment alternatives. The weighted average cost of capital equation is: Ke x We + Kd x Wd x (1-T) Definitions: Kd is the cost of debt before tax. (7.5%) T is the tax rate. (42%) Wd is the weight of debt in the capital structure and = Total Liability / Total Equity. $1,109,358 / $235,805 + $1,109,358 = 82.4% Ke is the cost of equity. Risk free rate of return = 3.67% (Forbes) Market rate of return = 5.08% (S&P) Beta = 0.8 (Assumed) Individual securities react differently to the up and downs of the market (market risk). This sensitivity to market risk is called a beta. Securities with a beta greater than 1.0 are very sensitive to the market risk.

Cost of equity = 3.67% + 0.8 (5.08% - 3.67%) = 4.80 % We is the weight of equity in the capital structure = Total liability / Total Equity + Total Liability. $235,805 / $235,805 + $1,109,358 = 17.5% Guillermo Furnitures Weighted Average Cost of Capitol: 17.5% x 4.80% + 82.4% x 7.5 x (1 42%) = 4.42% Valuation Techniques Discounted Cash Flow Valuation is one valuation technique useful for helping to reduce investment risk. This valuation method is used to estimate whether a potential investment opportunity is worth pursuing. Analysis with discounted cash flow takes into account future cash flow estimates and discounts these cash flows to a present value. A discount rate such as a weighted average cost of capital can be used to determine this value. Once the present value is determined, organizational decision makers can accurately evaluate the earning potential of the investment. Of course, if this present value is greater than the current return, then the investment opportunity should be considered. Relative Valuation is another valuation technique worth considering. Relative valuation is an asset comparison tool where the price of an asset is compared to other similar assets within a market. This idea has led to the harnessing technology for the development of tools used for detecting pricing anomalies. Relative valuation tools have can be by both analysts and investors to make educated decisions concerning asset allocation.

Contingent Claim Valuation is also another technique worth considering. Contingent Claim Valuation assigns a value to an asset based on an occurrence or non-occurrence of an event. The value of the asset may or may not be greater than the present value of the expected cash flow when the occurrence or non-occurrence of the event is taken into account. NPV of Alternatives Hi-Tech $416,667 $116,667 $300,000 $1,166,670 $9,000,000 $10,166,670 $610,000 $88,732 Broker $416,667 $116,667 $300,000 $1,166,670 $9,000,000 $10,166,670 $610,000 $4,859 Extra depreciation for hi-tech and broker alternatives Assumed depreciation for equipment Assumed depreciation for buildings Assumed investment in equipment Assumed investment in buildings Assumed total extra investment Cost of investment at 6% Net income from investment minus additional tax expense

The depreciation amounts indicate additional buildings and equipment will have to be purchased with both of these alternatives. With the depreciation figure of $416, 667, it is assumed $116,667 of this amount is for equipment. The assumed actual cost of the equipment is $116,667 x 10 years = $1,166,670. Similarly, the cost of building can be determined as $300,000 x 30 years = $9,000, 000. The 6% cost of investment is also an assumption. The cost of investment is

$610,000. The additional net income from the high tech alternative is $88,732 and the additional net income from the broker alternative is $4,859. With both alternatives there is a negative return an investment. (Gain from investment Cost of investment) / Cost of investment Conclusion From the information provided, Guillermo Furniture should continue with its current business model. However, a more detailed analysis could be performed if a pro forma cash flow budget is developed. Potential investments in buildings and equipment could be weighed against the percentage of net income increases over time. Additional thought could also be given to different financing alternatives and the effect they would have on net income.

References Emery, D. R., Finnerty, J. D. & Stowe, J. D, (2007). Corporate Financial Management, Third edition, Prentice Hall: Pearson Education.