Tuesday, February 4, 2020

Guillermo Furniture Store Analysis Essay Example | Topics and Well Written Essays - 1750 words

Guillermo Furniture Store Analysis - Essay Example By use of the weighted average cost of capital (WACC), multiple valuation methods in minimizing the risks and calculation of Net Present Value (NPV) of future cash flows including sensitivity analysis, the company can find a solution to the impending problem. Weighted Average Cost of Capital The weighted average cost of capital (WACC) refers to the rate of return that the company or business anticipates acquiring on its optimal risk ventures in order to offer a considerable anticipated return to all its shareholders. It is applied in valuing new assets that possess similar risks as the existing assets and that hold a similar debt ratio. WACC is a relevant rate of discount specifically for projects that are similar to the current business operations (Brown, & Reilly, 2006). To determine WACC, one must first understand that a majority of firms use different forms of financing. Some of the financing techniques include use of bonds, ordinary shares, preferred shares and other form of sec urities. The securities have unique types of risks and thus owners seek to get various rates of return. Under such conditions, the firm’s cost of capital might not be equal to the anticipated return on common shares. It is dependent on the anticipated return from the entire portfolio of securities that the firm has given out. Besides, taxes are also included given the point that interest payments executed by the firm are expenses which are tax deductible. In this perspective Guillermo’s cost of capital will be established as the weighted average of post-tax interest cost of debt financing and the equity cost. This is to say that the anticipated rate of return on the company’s ordinary stock. The weights are the portions of debt and equity in the company’s capital structure.  Ã‚  Ã‚  The weighted average cost of capital is utilized to assess optimal risk on the capital ventures on projects. This is means that the risk on the projects coincides with the r isks the company faces on the current operations and assets.   The average cost of capital is found by; WACC = Kd (1-T) Wd + Ke* We (Emery, Finnerty & Stowe, 2007). From the financial statements given the cost of debt before tax is 7.5%, the tax rate stands at 42%, the weight of debt in the capital structure in 2010 is 84.3% while that of 2011 is 82.4%, and the weight of equity in the capital structure is 15.7 in 2010 and 17.5 in 2011 while the cost of equity is 11.34% The above figures were derived as follows; Weight of debt: Information from assets, Liabilities & Equity Information  Ã‚  Ã‚   Wd 2010 = Total liability/ Total Equity=$1,130,963/ [$211,111+$1,130,963] = 84.3% Wd 2011 =Total liability /Total Equity=$1,109,358/ [$235,805+$1,109,358] = 82.4% Cost of equity is derived from the following steps: Risk free rate used is 4.36% while the market rate of return according to S & P rating is 13.08 %. It should be noted that the security’s contribution to the risk of a po rtfolio that is diversified is dependent on the market risk. However, some securities might not be affected by the ups and downs in the market. The sensitivity of securities to market movement is known as beta. Securities with a beta more than 1 are specifically sensitive to the market movement (Emery, Finnerty

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