LIMITED LEVERAGE
One thing that is clear from the vignette is Frank does not want to close his business and work for someone else. However, he must replace his primary asset, his truck, or he will be forced to close the business. Since he does not have the equity to purchase the truck, he must find the funds somewhere else. The only options are to find an investor or borrow the money. The vignette mentions nothing about an option to find an investor. He is adamantly against using debt. His daughter Stephanie suspects he does not know the proper use of debt in a business.
She should tell Frank not all debt is bad. In the business world, it is referred to as using leverage. The main benefit is additional access to capital to fund future growth. That certainly is the case here. The main premise is that income will grow faster than debt (principle and interest) (Nuding, 2016). With low interest rates, the environment is good for borrowing. The vignette does not mention anything about interest rates or terms of the loan, but looking at the after tax earnings, they seem more than adequate to service the debt payments. In addition, there is a tax benefit as interest is tax deductible.
Frank is correct in his apprehension of accumulating debt. Leverage should be limited in its use. It should be used to increase productivity. It should not be used to increase consumption (Nuding, 2016). Low rates can tempt someone to accumulate more debt than they should. The result is the misallocation of resources that may not pan out in the long term. Financially speaking, the projected cash flows from the new truck support using leverage.
ETHICAL DILEMA
There is an ethical dilemma with Elena suggesting using a personal relationship to bypass standard protocol to get the loan. This is an excellent example of cronyism. This kind of cronyism was a main cause of the financial crisis of 2008. Of course, this is on a much smaller scale, but the concept is the same. Stephanie is correct in explaining this to her mother. The big reason is what if the bank manager and his wife say no? What kind of strain would that put on the friendship? Stephanie should ask Elena if it is worth that risk. Another reason could be Elena may actually be breaking the law. One result of the financial crisis was the implementation of new regulations for banks. Going outside the normal loan process could be construed as a bribe of some sort. Finally, there is the issue of credibility. What would happen to the bank if they approved a loan for someone not qualified and they defaulted? What would that do to Frank if he incurred debt he could not pay back? He could end up declaring bankruptcy. Once Stephanie explains these to her mother, Elena would most likely be inclined to reconsider.
There are several things Stephanie should present to the loan officer. The first is past financial statements including a balance sheet, profit and loss statement, and a statement of cash flows. The next is to mention Frank’s reputation in the community and how he built his business from scratch 30 years ago. Banks consider qualitative information in addition to quantitative. After this, she can mention the bank manager, Hosea Garcia, and his wife as a reference, assuming they agreed to it. Finally, she can present her cash flow analysis of the new truck.
CASH FLOWS
The first part of the analysis is calculating the projected cash flows from the truck. The cost of truck is $200,000 plus and additional $15,000 of plumbing equipment. Stephanie projects earnings from the truck for the next eight years:
Next, she needs to project the net cash flows using the following formula: Earnings- Depreciation * (1-tax rate) + Depreciation. See the excel spreadsheet. The following are the projected cash flows for the truck:
These are the amounts that will be used in the analysis.
NET PRESENT VALUE
Net Present Value (NPV) is perhaps the most used tool in capital budgeting forecasting. It is the difference between the present values of inflows and the present value of outflows. A positive amount means a project is worth investing. The inputs needed to do the calculation are the cash flows and the cost of capital (12%). Looking at the excel spreadsheet (cell B34), we see the NPV of the truck is $28,681.97. The vignette does not state if principle and interest is included in earnings or not. If it is not, then the project is not profitable as we would need it to be at least $215,000 plus interest.
INTERNAL RATE OF RETURN
Internal rate of return (IRR) is often used in conjunction with NPV. It is the discount rate which makes the present value of inflows equal to the present value of outflows (NPV = 0). We use the same cash flow amounts we calculated for NVP. With IRR, we calculate a return percentage versus a dollar amount. If the IRR is greater than the cost of capital (12%), we accept the project. Looking at the excel spreadsheet (cell B35), we see an IRR of 16.51%. Since it is greater than cost of capital, we accept the project. We should have expected this since NPV was positive. But there can be instances where NPV is positive and the IRR is less than the cost of capital.
PAYBACK PERIOD
The payback period (PB) is the amount of time it takes to recoup the cost of the project. It is simply the break-even point. If the cash flows are equal in each period, then the payback period is the cost divided by cash flow. However, that is not the case for Frank’s truck. The following list the cash flows and the outstanding balance for each year:
We can see that the break-even point occurs somewhere in year four. We can find out exactly by dividing the outstanding balance ($10,000) by the cash flow ($60,000). Cell N31 shows the calculation on the excel spreadsheet. We accept the project because the payback period is less than the life of the project, which is eight years.
DISCOUNTED PAYBACK PERIOD
Discounted payback period (DPB) is similar to the payback period except we are accounting for the time value of money. Because we are discounting at the cost of capital, we would expect the break-even point to be greater. The following table demonstrates that:
The analysis is the same as payback period. Since the period is less than the life of the truck, we would accept.
PROFITABILITY INDEX
The profitability index (PI) indicates how much profit is made on each dollar invested. If the index is 1.0, there is neither a gain nor loss. Anything over 1.0 means we would accept the project. The calculation of the project is simply the present value of cash flows divided by the initial investment. Looking at the excel spreadsheet (cell B36), we see an index of $1.13. This means the truck earns $0.13 for every dollar invested.
CONCLUSION
NPV, IRR, PB, DPB, and PI are excellent tools for capital budget analysis. They can be used to compare multiple projects or as a stand-alone like this case. Based on the information given, Stephanie should advise her father to take out a loan and invest in a new truck, rather than close the business and work for someone else. It is important to note that these calculations are only as good as the inputs. If actual earnings differ significantly from Stephanie’s projected earnings, the analysis is useless. Accurately projecting cash flows, as well as determining the cost of capital, are the two most important factors when using discounted cash flow analysis.
References
https://blogs.cfainstitute.org/investor/2014/04/23/is-leverage-good-or-bad/
