Frank Smith Plumbing
Importance of Limited Leverage
Limited leverage is a term used to describe the use of borrowed money to expand a business or to increase production all in a bid to increase the sales and earnings of the company. There are several advantages to limited leverage including the fact that it gives the business owner, a strong access to capital. The leverage multiplies every dollar that is put to work and careful implementation will guarantee exponential growth in the company (Gervais, 2009).
Furthermore, limited leverage is suitable for acquisitions and buyouts. Limited leverage is useful for brief periods when the business has a specific growth objective such as a one-time dividend, an acquisition, a buyout, or a share buyback (Gervais, 2009). In this instance, Frank should use leverage financing because he wants to make an acquisition of a truck.
Ethical Pursuance of a Loan
In this scenario, Frank and his wife know the bank manager of the bank he wants to borrow a loan from. His wife is convinced that it would be prudent to call the bank manager directly and inform him that they need a loan to purchase the truck. Frank’s wife hopes that her husband can get the loan easier, faster, and cheaper because they are family friends with the bank manager.
However, calling the bank manager to ask for a favor of this magnitude from him would be a breach of ethics. It is inappropriate to call the bank manager to receive assistance in getting Frank’s loan approved. Bank officials have to follow proper procedure when it comes to the approval and issuance of loans. The officials who do not follow these procedures are deemed unethical. In fact, partisan approval of loans is considered one of the greatest ethical sins in the banking industry. The bank manager risks losing his job and his pension if it is discovered that he aided his friend in getting the latter’s loan approved. Therefore, the best thing for Stephanie’s mother to do is to wait for the due process and the loan might still be approved even without undue influence from Frank and his wife.
Analysis of the Investment
Investing in the truck by borrowing from the bank is a prudent business venture. From the analysis done, Frank would have a payback period of 5.34 years. The payback period is the time required for the cash outflow generated by the truck to repay the initial investment. The initial investment in this case is $215,000. Therefore, Frank will be able to pay back the initial investment of $215,000 within 5.34 years. The payback period is slightly longer than the favored 5 years for most investors. However, it has only gone beyond five years by at least three months so it remains a viable project based solely on the payback period.
If the bank offers a discount of 12%, the outflow from the truck will be able to cover the initial cost of investment in 9.4 years. The additional time is referred to as the discounted payback period of the investment. The period can be defined as the amount of time it will take to repay the initial investment by adding a discounted cash flow that stems from the profits generated by the asset. The main advantage of using the discounted cash flow method is the fact that it also entails the time value of money. Frank should not be alarmed by the length of time it would take to repay the loan if the discounted pay back method is used. It usually takes longer to payback when using the discounted payback method than the regular payback method.
The net present value is negative in this scenario at -$32,266.89. The net present value is used to determine the profitability of the project. It is the difference between the present value of the asset’s cash outflows and the present value of the cash inflows. Theoretically, a negative NPV implies that the cost of the investment is greater than the revenue it generates. If Frank were to go with this premise, then he should not borrow money to finance the purchase of the truck. He should in fact either look for alternative sources of funding or close his business altogether.
However, practically, a negative NPV does not mean that the investment choice is a bad one. The negative metric simply means that the investment will earn a rate of return equal to the discount rate. Furthermore, a negative NPV implies that the present value of the costs of investment will exceed the present value of the revenues using the discount given. Any investment produces a negative NPV if the discount rate is high enough (Brijlal, 2008).
Rather than forego the opportunity of owning his own truck and continuing to own his own plumbing business, Frank has to go back and adjust some of the numbers. For instance, he can double check the estimated costs of investment and look for opportunities to reduce the said costs. He could also review the loan, as the financial instrument used to purchase the truck, and see if there are enhancement opportunities. He can also adjust the assumed discount rate, possibly lowering it if it is permissible to do so.
The internal rate of return also measures the profitability of a potential investment. The IRR makes all the NPV of all the present cash flows equal to zero. The higher the value of the metric, the more profitable it will be for the investor (Brijlal, 2008). In this scenario, the IRR is 6.64% p.a. indicating that the investment has a high potential of generating a lot of profit in the near future.
At this juncture, it will not be advisable for Frank to close down his business. The limited leverage from the bank can finance his new truck. The revenues generated from the truck will be able to pay the financing costs within a span of five years and three months. Thus, it is not a risky business venture for both Frank and the bank.
If I were Frank, I would heed Stephanie’s advice and ask for a loan from the local bank to purchase the new truck. From the case study, it is evident that Frank prefers to work for himself than work for a plumbing company. Entrepreneurship can be a very lucrative venture if the correct financial analysis is conducted. The investment would have paid itself off within 5.34 years, which is within the limits of a profitable investment. Furthermore, the truck has a high internal rate of return, which implies that the revenue generated will be considerably large.
However, if I were in Frank’s shoes, I would adjust the discount rate lower so that the NPV moves away from the negative side. A negative NPV can make potential investors shy away from spending their money on the project. The investor in this case is the bank, and the bank manager might see the negative NPV and conclude that the project will not be profitable even when other metrics indicate that the investment will be very lucrative for the parties involved.
Brijlal, P. (2008). The use of Capital Budgeting Techniques in Businesses: A perspective from the Western Cape. 21st Australasian Finance and Banking Conference 2008 Paper.
Gervais, S. (2009). Behavioral Finance: Capital Budgeting and Other Investment Decisions. Duke University. Retrieved on 17/3/2016 from https://faculty.fuqua.duke.edu/~sgervais/Research/Papers/BookChapter.OvCapitalBudgeting.pdf