Introduction
Ongko 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 Ongko Furniture Company and to make a recommendation on the best alternative. The paper also discusses how the use of multiple valuation techniques reduces risks.
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 %
Effective cost of debt = (1 – corporate tax rate) * nominal cost of debt.
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 %
Analysis of the financial alternatives available to Ongko
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 42,577
- Less Income Tax Expense @ 42 % (17,882)
- Net Income after taxes 24,695
- Add back depreciation 50,000
- Net Cash flows 74,885
Present Value of net cash flows would be given by Net Cash flows / Weighted Average Cost of Capital.
Present Value of net cash flows = 74,885 / 8.45 % = $ 886,213
From the calculation of depreciation, we can see that additional building 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 $ 195,564
- Less Income Tax Expense @ 42 % $ (82,137)
- Net Income after taxes $ 113,427
- Add back depreciation $ 466,667
- Net Cash flows $ 580,094
Present Value of net cash flows would be given by Net Cash flows / Weighted Average Cost of Capital.
Present Value of net cash flows = 580,094 / 8.45 % = $ 6,865,018
Net Present Value of the Hi Tech alternative = $ 6,865,018 – $ 4,500,000 = $ 2,385,018
If the Broker alternative is selected, the net cash flows would be as follows:
- Net Income before taxes $ 50,955
- Less Income Tax Expense @ 42 % $ (21,401)
- Net Income after taxes $ 29,554
- Add back depreciation $ 466,667
- Net Cash flows $ 496,221
Present Value of net cash flows would be given by Net Cash flows / Weighted Average Cost of Capital.
Present Value of net cash flows = 496,221 / 8.45 % = $ 5,872,438
Net Present Value of the Broker alternative= $ 5,872,438 – $ 4,500,000 = $ 1,372,438
How the use of multiple valuation techniques can reduce risks
Business risks may be revealed and assessed much better by applying several methods to value a business, than when just one method is used(Keown, A., Petty, W., Martin, J, and Scott, F 2007).
The three main valuation techniques are:
Discounted cash flow valuation technique
This technique is based on the principle that the value of an asset is equal to the value of the future benefits that are brought about by that asset. In this technique the present value rule is used, where the present value of an asset’s cash flows is calculated by discounting the cash flows by the cost of capital used in purchasing the asset.
The main limitations of this technique are that finding out the precise value of cash flow in the future is not possible, and also finding out the discount rate is difficult. If the wrong discount rate is used, then the whole calculation of the present value of cash flows will be wrong, resulting in a wrong valuation of the asset in question. The price may therefore deviate from the intrinsic value due to future market conditions
Relative Valuation technique
This technique equates the value of an asset to a similar asset that is available in the market. The value of an asset is therefore derived from the pricing of a comparable asset. Price multiples are created by converting the market value of the comparable asset into standardized values.
Comparison is then made between the prices multiples for the asset being analyzed and the comparable asset, allowing for effects of differences between the firms. This comparison helps in judging whether the asset is correctly valued.
Contingent valuation method
This method values ecosystem and environmental services, (Emery, D., Finnerty, J., and Stowe, J. 2007)
This method is the most preferred among the few methods for valuing nonuse values of the environment in dollars. Such are values that do not involve market purchases.
Conclusion
From the calculation of Net Present Values under the three alternatives, it is evident that the Hi-Tech alternative is the most preferable, followed by the broker alternative, and the current situation is the least preferred.
The Ongko Furniture Company should therefore invest in the Hi-Tech technology, 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.