Nov 14, 2020 in Analysis

Cash Flow Analysis
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Cash Flow Analysis: Frank Smith Plumbing Case

Ethical Problem with Elena Calling the Bank Manager and His Wife

 

Many financial institutions have policies, which protect their competitiveness for business, price, and their quality of service. Bank reputations for integrity and honesty are embodied in the integrity and honesty of its representatives. A banks employees are, therefore, required to protect trust, which employers have on them by avoiding situations that cause a conflict of interest. For instance, business relationships should not be mixed with families, customers, business partners, and vendors that may give rise to a conflict of interest. If Elena calls the bank manager and his wife about the loan, she will be putting the bank manager in an ethical dilemma on whether to serve the interest of the bank or his friend Elena.

Bank borrowing is a formal affair, which should be dealt with formally. Calling the bank manager in a social setting for a formal business is not only unethical, but also unprofessional. According to Madhani (2008), employees act under strict guidelines not to approve loans to immediate families or friends. In some banking institutions, employees are not even allowed to vote on matters concerning loans for their friends, business acquaintances or relatives. Calling the manager will compel him to break the code of conduct through authorizing the loan for Elenas husband without following proper procedure. Furthermore, the manager might be tempted to forgo or include exaggerated information to help Garcia get a loan, contrary to the bank code of conduct that requires its employees to make reasonable inquiry and follow the necessary steps in awarding loans. Concisely, Stephanie should remind her mother that the banks conduct of conduct and ethics does not permit the manager to process their loans, because they are family friends.

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Advantages of Limited Leverage in Business

Leverage is a technique that is used to create more gains and losses in an organization (Madhani, 2008). Use of leverage creates risks; resulting in a tradeoff between risks and return. In any business environment, additional risk can create benefits to business; however, it can also lead to damaging consequences. Having a limited leverage means that a business has the advantage of getting more leverage at any time to accomplish what it cannot achieve with the present capital. Furthermore, having a limited leverage means that a business risk is also average, implying that a business has fewer chances of sailing into financial problems, because its leverage is manageable. More often, businesses with limited leverages suffer less from the costs associated with leveraged finance products such as higher interest rates. Moreover, such businesses are easier to maintain because they do not have complex debts that require additional risks (Wadee, 2010).

Project Appraisal

The information that Stephanie has gathered includes the cost of truck, additional equipment, cost of capital, tax rate and the useful life of the truck. Table 1 and 2 represent the expected total cash flows from the truck. The calculations on the expected cash flow have been worked out in the spreadsheet (attached spreadsheet). The analysis on the viability of the project is based on payback period, discounted payback period, net present value, internal rate of return, and profitability index.

Table 1

Cash Flow Analysis Using the Payback Period Method

Year

Cash Flow ($)

Initial Investment ($)

0

0

-215,000

1

50,400

-164,600

2

53,600

-111,000

3

46,618

-64,382

4

41,415

-22,967

5

37,963

14,996

6

33,515

48,511

7

26,000

74,511

8

19,500

94,011

 
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The table above shows the payback period schedule. According to the expected cash flows, the payback period is around 4.7 years, implying that when cash flows are undiscounted, the project will take roughly four years and eight months to return the initial capital invested in the project. The method gives a green light for the project as it shows that before the fifth year, the project would have returned more than the initial capital, meaning that the project is profitable (Madhani, 2008). However, this method is not appropriate for project evaluation, because it does not take care of the time value of money.

Table 2

Analysis Using Payback Period with Discounted Cash Flow

Year

Discounted Cash Flow ($)

Initial Investment ($)

0

-

-215,000

1

44,997

-170,003

2

42,754

-127,249

3

33,178

-94,071

4

26,319

-67,752

5

21,540

-46,212

6

16,978

-29,234

7

11,759

-17,475

8

7,876

-9,599

The analysis method takes care of the time value of money; it is more accurate than the payback period. The method also shows that the project is not viable since the project will not be able to return the initial invested capital during its lifetime. In brief, the project is not viable according to this method.

Project Appraisal Using the Net Present Value Method

Net present value (NPV) method determines the current value of the total future cash flows generated by a project after deducting the initial capital investment (Wadee, 2010). Table 3 below shows the NPV of the project.

Table 3

NPV of the Project

Year

Cash Flow

Discounting 12%

Discounted Amount

0

-215,000

1

-215,000

1

50,400

0.8928

44,997

2

53,600

0.7971

42,754

3

46,618

0.7117

33,178

4

41,415

0.6355

26,319

5

37,963

0.5674

21,540

6

33,515

0.5066

16,978

7

26,000

0.4523

11,759

8

19,500

0.4039

7,876

Total

-9,599

According to the NPV method, the project is not viable, because it gives a negative NPV, implying that the truck, if bought, will make losses; it will not add any value to Mr. Garcia. According to this method, the total loss that Mr. Garcia will incur in eight years is about $9,599. Since this method of project valuation is more accurate, Mr. Garcia should be advised to abandon the idea of borrowing loan to buy the truck.

Project Appraisal Using Profitability Index Method

Profitability index is a modified NPV method; it is a relative measure that gives accounting figures as a ratio. The rule in this method is that the project is accepted if the ratio is in excess of one, stay indifference about the project if the index is at zero, and drop the project if the index is lesser than one (Wadee, 2010). The profitability index will be calculated as follows:

PI = 1+ (NPV/Initial Investment)

PI = 1 + (-9599/215,000)

PI = 0.9553

The profitability index is lesser than one, implying that the project should be dropped.

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Conclusion

Mr. Garcias Plumbing business cannot effectively repay the proposed loan for a new truck, with the project giving a negative NPV in the long run. To benefit, Mr. Garcia should join employment with an open mind in readiness to learn from people in the same profession. If I was the one in Garcias position, I would get the salvage value of the current truck, sell it, and do another analysis to check if the fortune will turn around.

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