Financial Alternatives Guillermo Furniture Company

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Introduction

Guillermo Furniture Company is faced with the decision of whether to continue producing furniture, or whether to adopt a Hi-Tech technology or become a distributor of another manufacturer’s furniture. The purpose of this paper is to analyze the different financial alternatives that are available to Guillermo Furniture Company and to make a recommendation on the best alternative. The paper also discusses how the use of multiple valuation techniques reduces risks.

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Weighted Average Cost of Capital

Weighted Average Cost of Capital can be computed using the following formula: Weighted Average Cost of Capital = K e * [Equity / (Debt + Equity) + K d * [Debt / (Debt + Equity) (Brigham, M., and Ehrhardt, M 2008)

Where:

  • K e is the cost of equity
  • K d is the effective cost of debt

Cost of equity = Earnings per share/market price per share Earnings per share = Earnings attributable to ordinary shareholders/number of ordinary shares outstanding

From the financial statements, Earnings attributable to ordinary shareholders are $ 24,695, and the number of ordinary shares outstanding is 10,000, so we can compute Current Earnings per share as 24,695 / 10,000 = $ 2.47

We are not given the market price per share, so we assume that the market price is $ 10 per share.

Therefore Cost of equity = 2.47 / 10 = 24.7 %

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The effective cost of debt = (1 – corporate tax rate) * nominal cost of debt (Keown, A., Petty, W., Martin, J, and Scott, F 2007).

We are given corporate tax rate as 42 %, and interest rate on mortgage as 7.5 %.

We can therefore compute the Effective cost of mortgage as (1-0.42) * 7.5 % = 4.35 %

The current capital structure is as follows:

  • Source of funds          Amount             Cost
  • Equity                         $ 235,805          24.7 %
  • Mortgage                   $ 936,628           4.35 %
  • Total                           $ 1,172,433

Weighted Average Cost of Capital = 24.7 % * (235,805 / 1,172,433) + 4.35 % * (936,628/ 1,172,433)

Weighted Average Cost of Capital = 4.97 + 3.48 % = 8.45 %

Under the Hi-Tech alternative, Earnings attributable to ordinary shareholders are $ 113,427. Assuming that all additional funds are to be raised from the equity number of ordinary shares outstanding would be 14,500, so we can compute Current Earnings per share as 113,427 / 14,500 = $ 7.82

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We still assume that the market price is $ 10 per share.

Therefore Cost of equity = 7.82 / 10 = 78.2 %

Effective cost of mortgage remains the same as 4.35 %

Assuming that all additional funds are to be raised from equity, the capital structure would be as follows:

  • Source of funds             Amount                   Cost
  • Equity                          $ 4,735,805              78.2 %
  • Mortgage                      $ 936,628                4.35 %
  • Total                            $ 5,672,433

Weighted Average Cost of Capital = 78.2 % * (4,735,805 / 5,672,433) + 4.35 % * (936,628/ 5,672,433)

Weighted Average Cost of Capital = 65.29 + 0.72 % = 66.0 %

Under the broker alternative, Earnings attributable to ordinary shareholders are $ 29,554. Assuming that all additional funds are to be raised from the equity number of ordinary shares outstanding would be 14,500, so we can compute Current Earnings per share as 29,554 / 14,500 = $ 2.04

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We still assume that the market price is $ 10 per share.

Therefore Cost of equity = 2.04 / 10 = 20.4 %

Effective cost of mortgage remains the same as 4.35 %

Assuming that all additional funds are to be raised from equity, the capital structure would be as follows:

  • Source of funds              Amount              Cost
  • Equity                           $ 4,735,805         20.4 %
  • Mortgage                      $ 936,628            4.35 %
  • Total                             $ 5,672,433

Weighted Average Cost of Capital = 20.4 % * (4,735,805 / 5,672,433) + 4.35 % * (936,628/ 5,672,433)

Weighted Average Cost of Capital = 17.03 + 0.72 % = 17.75 %

Analysis of the financial alternatives available to Guillermo

We use the current Weighted Average Cost of Capital to discount the expected net cash flows and get the Net present value under each alternative as follows:

If the current status is maintained, the net cash flows would be as follows:

  • Net Income before taxes (17,275)
  • Less Income Tax Expense @ 42 % (7,255.5)
  • Net Income after taxes (10,020)
  • Add back depreciation 50,000
  • Net Cash flows 39,981

Present Value of net cash flows would be given by Net Cash flows / Weighted Average Cost of Capital (Emery, D., Finnerty, J., & Stowe, J. 2007).

Present Value of net cash flows = 39,981 / 8.45 % = $ 473,148

From the calculation of depreciation, we can see that additional buildings are worth $ 500,000, while additional equipment is worth $ 4,000,000. Therefore additional capital outlay for Hi Tech and Broker alternatives is $ 4,500,000.

If the Hi Tech alternative is selected, the net cash flows would be as follows:

  • Net Income before taxes $ 115,040
  • Less Income Tax Expense @ 42 % $ (48,317)
  • Net Income after taxes $ 66,723
  • Add back depreciation $ 466,667
  • Net Cash flows $ 533,390

Present Value of net cash flows would be given by Net Cash flows / Weighted Average Cost of Capital.

Present Value of net cash flows = 533,390 / 8.45 % = $ 6,312,308

Net Present Value of the Hi Tech alternative = $ 6,312,308 – $ 4,500,000 = $ 1,812,308

If the Broker alternative is selected, the net cash flows would be as follows:

Net Income before taxes $ 1,013,324

Less Income Tax Expense @ 42 % $ (425,597)

Net Income after taxes $ 587,727

Add back depreciation $ 466,667

Net Cash flows $ 1,054,394

Present Value of net cash flows would be given by Net Cash flows / Weighted Average Cost of Capital.

Present Value of net cash flows = 1,054,394 / 8.45 % = $ 12,478,036

Net Present Value of the Broker alternative= $ 12,478,036 – $ 4,500,000 = $ 7,978,036

Conclusion

From the calculation of Net Present Values under the three alternatives, it is evident that the broker alternative is the most preferable, followed by the Hi-Tech alternative, and the current situation is the least preferred.

The Guillermo Furniture Company should therefore go for the broker alternative because this alternative offers the highest returns.

Reference List

Brigham, M., and Ehrhardt, M (2008). Financial management: theory and practice Florence: Cengage Learning.

Emery, D., Finnerty, J., & Stowe, J. (2007). Corporate Financial Management. New Jersey: Prentice Hall Publishing.

Keown, A., Petty, W., Martin, J, and Scott, F (2007). Foundations of Finance. New Jersey: Prentice Hall Publishing.

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BusinessEssay. "Financial Alternatives Guillermo Furniture Company." February 26, 2022. https://business-essay.com/financial-alternatives-guillermo-furniture-company/.