Financial Management Assignment Evaluating Financial Situation of Business Cases

Question

Task: Prepare a financial management assignment addressing the following parts:
1) Reliable Movers Pte Ltd is evaluating the purchase of a new delivery truck based on the following data:
Cost of truck: $22,500
Useful life: 5 years (50 salvage value)
Sales revenue per year: $6,260
Operating expenses excluding depreciation per year: $10
Net operating cashflows per year: $6,250
Discount rate/ Cost of Capital: 10%

Required:
a. Assuming Reliable Movers Pte Ltd decides to operate the truck for the full 5 years until the end of its physical life, compute the following:
i. Payback Period
ii. Average Accounting Return
iii. Profitability Index
iv. Net Present Value
v. Internal Rate of Return
b. Suppose the truck has a salvage value at the end of each year as shown in the table below:

Should the firm operate the truck until the end of it’s 5-year physical life, or if not, what is its optimal economic life?
2) State 3 risks or costs of offering credit to customers. For each risk, suggest at least one way the risk/cost can be mitigated or minimized.

Answer

Answer 1
In this part of financial management assignment, it is discussed that Reliable Movers Pte Ltd is evaluating its financial position to buy a new delivery truck worth $22,500 having a shelf life of 5 years. The delivery truck is supposed to generate and annual revenue of $6,260 incurring an operating expense of $10. This exercise will conduct an investment appraisal mechanism by working out the payback period, average accounting return, profitability index, net present value, and internal rate of return.

a. Investment appraisal mechanism
Reliable Movers Pte Ltd decided to operate the truck for full five years exploiting its shelf life completely. Accordingly, the various aspects of the investment appraisal system are as follows:

The above cash flow is derived by deducting the operating expenses from the respective annual revenues. In this case, depreciation is not considered despite the useful life of the truck for 5 years. It is because depreciation does not leads to any sorts of cash outflow, so it is not considered for the investment appraisal process. Further, the cost of capital is considered as 10% to work out the different investment appraisal exercise.

i. Payback period

The payback period of 3.6 means that Reliable Movers will take around 3 years and 6 months to recover the initial investment worth $22,500 to buy the truck.
ii. Average Accounting Return

The average accounting return is derived using the following formula:
Average accounting return = Average profit / Average investment
= ($1,750 / $11,250) x 100 = 15.56%
[Average profit = Total profit / 5 = $8,750 / 5 = $1,750]
[Average investment = $22,500 / 2 = $11,250]
The average accounting return shows that Reliable Movers can have an average accounting return of 15.56%. It is derived by adding the profits of the five years and get the average value by dividing with 5 and then, divide the outcome by the average value of the investment.

iii. Profitability Index

The profitability index is derived using the following formula: Profitability index = Total present value / Initial investment = $23,692.42 / $22,500 = 1.05

The profitability index of Reliable Movers is 1.05 indicating a good business proposition considering the present value of the cash flows. The total value of the present cash flows are divided by the initial investment to have the profitability index of 1.05.

iv. Net Present Value

The net present value (NPV) is derived using the following formula: NPV = Present value of the cash flows – Initial investment
= $23,692.42 – $22,500 = $1,192.42
The NPV of the investment project is worth $1,192.42 which is a positive value and can be accepted by Reliable Movers to yield profitability. It is because only those projects having a positive NPV will be accepted or else rejected.

v. Internal Rate of Return

The internal rate of return (IRR) is derived using the following formula:
IRR = [(Cash flows) / (1 + r)i] –Initial investment
=[$31,250 / (1.1)^5] – $22,500 = 12.05%
The IRR for the project on Reliable Movers is 12.05% which is a higher figure than the cost of capital of the project. To have a successful project, a higher IRR is preferable.

b. Optimal economic life

The table above shows the salvage value of the truck worth $22,500 in the corresponding years. As time passes, the salvage value of the truck reduces considering the sorts of depreciation and maintenance costs. Thus salvage value is the estimated book value of the asset after depreciation that the owner can gain if the asset is sold(Kenton, 2021). A question may arise in context to the above table showcasing the salvage value of the truck, how long Reliable Movers can use the truck. Its physical life is for 5 years or should the firm utilize it till its economic life.

Economic life is the anticipated period until which the asset remains productive to the owners. The economic life is determined as the asset can generate a certain amount of productivity(Chen, 2020). This proposition can be better understood by the relevance of the NPV of the truck as depicted below:

Optimal life of the truck

NPV = Cumulative present value + Discounted salvage value – Initial investment
Year 01: NPV = $5,681.82 + $15,909.09 – $22,500 = -$909.09
Year 02: NPV = $10,847.11 + $11,570.25 – $22,500 = -$82.64
Year 03: NPV = $15,542.82 + $8,264.46 – $22,500 = $1.307.29
Year 04:NPV = $19,811.66 + $3,415.07 – $22,500 = $726.73
Year 05:NPV = $23,692.42 – $22,500 = $1,192.42

The above table shows that at the end of the 3rd year, the NPV is the maximum at a worth $1,307.29.Hence it is advisable to the firm to operate the truck till the end of the 3rd year rather relying on the optimal value(Corporate Finance Institute, 2022). ?

Answer 2
Offering credit to customers is an integral part of the business to carry on the deals and maintain a good relationship with them. But the situation turns ugly when the customer delays the payment or is unable to pay,thus creating a financial crisis for the business. The situation is intense for a small business owner having limited resourcesand lacking a full-proof strategy to address the credit debacle(Hilton-Baird Collection Services, 2019). The different risks that a business may face while offering credit to the customers are as follows:

Risk 1 – Funding the debtors’ book
It happens that the customer exploits the credit strategy to fund his business. Simultaneously, the firm faces a shortage in cash flow to run the business operations efficiently affecting the working capital. The customer may ask for a longer credit periodto make the deal showing grave concerns for the business(Uwins, 2018).

Solution:
The business may offer trade discounts to the customers to accelerate the payment. This is plausible by active negotiation and strengthening the business relationship to benefit both parties(QuickBooks, 2021). The efficiency of the collection team can be upgraded by financially motivating them to collect the receivables timely.

Risk 2 – Credit risk of the customers
The credit worthiness of the customers ought to be determined to evaluate whether the customer can pay off the credit suitably. It is because customers with varied capacity and potential can ask for credit but it is the firm to undertake the required decision.

Solution:
It is the company’s responsibility to evaluate the credit worthiness of the customers before granting them the desired credit(Hilton-Baird Collection Services, 2019). The credit evaluation is one of the aspects to determine the financial position of the customer in terms of his credit history and capability to pay off the loan.

Risk 3 – Potential for bad debts
Bad debt is a serious issue that firms often come across in the business scenario(QuickBooks, 2021). This may be beyond the control of the firm or even the debtor cannot manage, say the pandemic scenario has stalled the business scenario worldwide.

Solution:
The firm will undertake a stringent credit policy to reduce the instances of the credit debacle(Uwins, 2018). Further, adopting a suitable credit insurance policy will safeguard the business from such plausible losses on bad debts.

Bibliography
Chen, J., 2020. Economic Life Definition. [Online] Available at: https://www.investopedia.com/terms/e/economic-life.asp [Accessed 06 January 2022]. Corporate Finance Institute, 2022. Economic Life. [Online] Available at: https://corporatefinanceinstitute.com/resources/knowledge/accounting/economic-life/ [Accessed 06 January 2022].

Hilton-Baird Collection Services, 2019. The problems with offering credit to your customers | Blog. [Online]
Available at: https://www.hiltonbairdcollections.co.uk/the-problems-with-offering-credit-to-your-customers-and-the-solutions/ [Accessed 06 January 2022].
Kenton, W., 2021. Salvage Value Definition. [Online] Available at: https://www.investopedia.com/terms/s/salvagevalue.asp [Accessed 06 January 2022].
QuickBooks, 2021. How to offer customer credit: A guide for businesses | QuickBooks. financial management assignment[Online]
Available at: https://quickbooks.intuit.com/r/getting-paid/customer-credit-policy/ [Accessed 06 January 2022].
Uwins, S., 2018. The advantages and disadvantages of selling to customers on credit. [Online] Available at: https://cmris.co.uk/blog/advantages-and-disadvantages-selling-customers-credit [Accessed 06 January 2022].