FrankSmith Plumbing Case Study
FrankSmith 1,050 word.doc analysis
Question3 Part One.
Whylimited leverage is good.
Leverage,in business, involves using financial instruments or capital borrowedto raise the returns an investment brings in. When a firm has lesserequity than debt, it is said to be highly leveraged. Limited leveragemeans employing a small amount of the financial instruments andborrowed capital to finance a business.
Limitedleveraged finance is advantageous because it provides the businessfinancial muscle do what it could not. It multiplies the power ofwhatever money a firm has. Its successful use can help one achievequite more than would have been possible without the injectedleverage.
Limitedleverage also increases the amount of free cash available to thebusiness without it having to pay high borrowing costs. Leveragingmay lead the firm into debt. The debt repayment is over a period andin small installments. It thus frees up funds available for immediateuse. Frank Smith can thus borrow a sum of money not only to buy thetruck but which will leave him with some money for operational use orto expand his business.
Limitedleverage may help Frank to improve his credit rating. If he can takea small loan and successfully repay it, then he will demonstrate hisability to use limited leverage correctly. The bank and otherfinancial institutions will readily provide him with more leverage infuture, when he requires additional financing, at more attractiveinterest rates. When it comes to lending, businesses with goodfinancials but no history of credit have difficulty in convincinglenders to get excellent interest rates for loans.
Profitabilityof the project
Fromanalyzing the cash flows, we see the vehicle depreciating over aperiod of eight years. When we use the payback period as the decisioncriterion, we find the investment profitable. Frank will be able torecover the cost of the truck and the cost of the additionalequipment attached to it after 2.98 years. He should buy the truckand the associated equipment since the payback period is less thanthe useful life of the investment which is approximately six years.
Thediscounted payback period is 4.06 years. Using this criterion, weconclude that Frank should buy the truck since he will have recoveredits costs and other associated cost after 4.06 years of use and yetit will fully depreciate after around six years. The investment isthus profitable.
Whenwe evaluate the project based on the Net Present Value decisioncriterion, we would advise Frank to buy the truck. Buying the vehiclewould result in a positive NPV. The vehicle is so profitable that itwould add a value of $71,093.14 to the business. Thedecision criteria are to accept projects exhibiting a positive NPVand reject projects with a negative NPV (Pogue, 2010).
Anotherdecision criteria we could use to evaluate the profitability of theproject is the internal rate of return. IRR, as it is abbreviated, isthe discount rate which pushes a project’s NPV to Zero. It is aproject’s anticipated returns. If Frank buys the truck, the IRRwill be 24.005%. This IRR is greater than the cost of capital whichis 12.00%. Frank should purchase the vehicle since the cost ofcapital is lower than the IRR making the project profitable.
WhyStephanie’smother should not call the bank managers or his wife for assistancegetting the loan approved.
DespiteStephanie’s mom being friends with the bank manager’s wife, it isnot advisable for her to use the friendship to get the loan approved.Doing so would amount to undue influence. Undue influence is a casewhere one individual controls another’s decision, to his or heradvantage, due to an existing relationship between the two.
Theundue influence could lead to Frank’s plumbing business failing toobtain the loan. Hosea, the bank manager, is required to disclose andavoid a situation which compromises his ethics and responsibilitiesto the bank. He may thus reveal Frank’s wife’s attempt to obtainthe loan through undue influence. The bank may then blacklist Frankand even take legal action against him since using undue influence,to get a loan approved, is an illegal act.
IfHosea caves in and gives Frank credit, he will be compromised andfail to be objective when evaluating Frank’s creditworthiness andother loan requirements. Failure to follow the bank’s lendingprocedure will mean Hosea will face legal action for failing to awardFrank the credit based on merit.
Frank’sfirm already deserves a loan. From our analysis of the company’srevenue streams, we see it can pay the loan comfortably. It can thusconvincingly argue its case for the loan with the bank. Chances itwill get the credit based on merit are also very high. It is thusprudent it follow the correct channel in obtaining the loan asopposed to employing undue influence like what Stephanie’s momwould like to do. Her actions may result in Frank losing out on theloan
Usingundue influence to obtain the loan may harm the relationship betweenHosea’s and Frank’s family. Hosea my take the undue influence asa bid to compromise him. He may not take legal action, but he maylose the respect he has for Frank’s family. Hosea may cut ties withFrank.
AdditionalAnalysis of the profitability of the investment in the truck
Investingin the vehicle is profitable. In 2.98 or 4.06 years, Frank wouldrecover its cost. From there on, Frank can use the revenue streamsfor operation cost, other expenses or diversifying the business. Thenew truck is efficient leading to lower fuel consumption andmaintenance fees. All these facts translate to greater profitabilityfor Frank’s plumbing business.
Toalso see how profitable business is, we look at the profitabilityindex. Profitability index shows the relationship between thebenefits and cost of a particular project. Investment in the truckhas a profitability index of 1.3742. The project’s profitabilityindex is greater than one making it financially attractive andrewarding.
Argumentagainst closing the business
Itis not more beneficial for Frank to shut down the business. Closingthe business will mean forgoing the current revenue stream and alsothe opportunity to get more revenue. The closure would also result inloss of goodwill meaning Frank may lose out on loyal clients by goingto work for another plumbing company.
WhatI would do
Inthe same situation, I would take the bank loan basing my judgment onthe fact that all the decision criteria, used to evaluate theproject, indicate it is viable. I would also follow the correctprocedure to have the bank loan approved.
Limitedleverage is good for business and should be carefully employed toensure the success and growth of the company. Business, especially anentrepreneurship, should consider borrowing as a valid source offunds if they are to grow beyond a certain limit. Part of the reasonbehind the 2008 financial crisis was unethical lending policies.Since then, banks are stricter and carefully evaluate loan seeker.Credit and loan information is also well shared. To avoid beingblacklisted by lenders, one should follow the lending procedures andalso diligently pay back their loans. Frank should not be afraid toapply for the credit.
Pogue,M. (2010). Corporateinvestment decisions: Principles and practice.New York, N.Y: Business Expert Press.