200426 Corporate Finance:Financial Analysis

200426 Corporate Finance:Financial Analysis

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200426 Corporate Finance

Question:

Case Study: Southern Suburbs Transport

Janet and John Larson run a moderately successful transport business in the southern suburbs of Sydney. The business was started by John’s father Dennis as a one truck operation carrying goods from Sydney’s various wharves to local Sydney companies. John has built the company up from this one truck operation to a four truck operation. Originally deliveries had been within NSW but now there are some interstate deliveries. The company has recently moved to a larger warehouse in Mascot which is too big for the current operation but John believed he should allow for future expansion. Janet and John run the business themselves and work very hard, sometimes working long hours. They employ four drivers but if a driver is sick John will drive a truck to keep it on the road as much as possible. He only draws a truck driver’s award wage as a salary. Janet manages the office with the help of Anna Chen, an experienced accounts clerk, who is currently doing Master of Accounting at Sydney Graduate School of Management (SGSM), Western Sydney University. Together they handle all the accounts payable, wages and invoicing. They also employ a sales and marketing manager, Michael Potter, who has ensured that there is enough work to keep the trucks at full capacity almost all year. He has done a great job but is pushing Janet and John to buy more trucks as he states he can easily increase the business by 50% and this is mainly with the same customers and thus sales and administration costs would not increase significantly. 

Janet has some concerns about the business as she believes the profits are not high enough given the work that they put into the business. By her calculation if they sold up they could invest about $400,000 and go and work for wages with another transport company and be far better off. John said he could not work for a boss and would rather work hard for himself than work hard for someone else. They both agreed that they would like to retire in about 7 years so perhaps it would be a good plan to work very hard for the next seven years to generate enough cash to retire. However John is very cautious by nature and has some doubts about expansion and after further discussions with Janet they engaged a transport consultant to advise them on the direction the company should take. The consultant had agreed to produce the report for a fixed fee of $9,000 which Janet thought was very high. They have given the consultant a forecast Income Statement for the year ended June 30th 2021 prepared by their accountant (shown as appendix 1). Janet, John and Michael all agreed that increased revenue given the current truck fleet was not possible. The current truck fleet consisted of two trucks with a 10 tonne carrying capacity and two with a 20 tonne capacity and all trucks completed over 100,000 km a year. John did not believe it was possible to work the trucks or the drivers any harder. The consultant was asked to work with Michael and assess Michael’s claim that sales could be increased significantly.

About six weeks later the consultant asked if he could meet with Janet and John and present his report. The consultant had prepared a pro-forma Income Statement for the new business (shown in Appendix 1) which showed an unbelievable profit that was five times the forecast 

for 2021. The pro-forma statement was based on Michael’s revenue forecast which the consultant believed was reasonable. The consultant explained that what he recommended was the immediate replacement of the truck fleet with three brand new trucks at a total cost of $930,000.

The new trucks would carry 30 tonne loads thus having a 50% greater capacity than the current fleet. John laughed and said it was not company policy to buy new trucks. His Dad had always bought second hand trucks and kept them for about 7 years and had managed to keep borrowings to a very low level. The company had borrowed no money for the purchase of the last trucks. The consultant explained that the current trucks were bought three years ago and if they were to last another seven years would be up for some major maintenance expense in two years time. Based on the assumption that the old trucks would not be replaced in the next seven years the consultant had prepared a maintenance schedule for the period (Appendix 2). The consultant also said that the current trucks could be sold for an average of $15,000 each and this would mean that the company would only have to borrow $870,000. Finance could be arranged over five years at 9% which would require monthly payments of $18,060 per month. John did not believe that the company could possibly afford this level of repayment but the consultant said that with increased revenue of $45,000 per month the payment would be well covered. Michael pointed out that the revenue figure used by the consultant was not going to be achieved in the first year but would take a couple of years to achieve. He presented a table of revenue forecasts for the next seven years. The consultant also pointed out that one of the drivers would have to be made redundant and that based on the wages of the last driver employed there would be a redundancy payout of $61,000. The consultant finished by saying that if the company moved quickly the new operation could be in place by July 1st and the redundancy could be paid and claimed as a deduction this 

financial year. John said he was not convinced and wanted the accountant to go through the numbers.

A few days later Janet and John met with their accountant who was an old friend and had prepared the family tax returns for years. He told them he had been through the accounts and the figures that the consultant had prepared and they looked Ok to him. He made the following comments about the accounts.

1. The current trucks are fully depreciated for tax purposes due to the accelerated depreciation allowable at the time of purchase. The new trucks could be depreciated over 10 years for tax purposes based on their cost of $930,000. For accounting purposes the accountant recommended the trucks be depreciated over 15 years.

2. The company pays tax at the corporate tax rate of 30%.

3. He confirmed that the redundancy payment would be a tax deduction when paid. The accountant also made the comment that he only worked on company tax problems these days and did not want to offer any investment advice so he was not prepared to make any recommendation to Janet and John. John did not want to take the project any further but Janet asked Anna if she could help. Anna said that it was just like some of the exercises she had completed in Corporate Finance although it looked a little more complicated and with the help of some friends at SGSM she would like the opportunity to complete a proper analysis.

Anna has asked you for help in completing the analysis and the preparation of a short report for Janet and John.

Anna has provided the following additional information:

1. After much research she believes that the nominal required rate of return for investors in the transport industry is 13%

2. Although warehouse costs will increase by the general inflation rate of 2% there will be no increases in cost due to the proposed changes in the truck fleet.

3. Anna did not believe it was realistic to assume that there would be no increase in administration costs due to the increased business and believed she would have to increase the administration staff. This would increase the 2022 administration expenses to $232,000 compared to $163,200 if the project does not go ahead. Administration expenses would be expected to increase by 2% p.a. from 2023 onwards.

4. Michael also believed it was unrealistic to expect no additional cost in selling and administration costs. After extensive calculations he believed that the selling and marketing expense in 2022 would be $238,600 compared to $179,112 if the project did not go ahead. He also agreed that a general allowance for an increase of 2% p.a. would apply from 2023 onwards.

5. At the end of the project the new trucks would be sold for an estimated total sales value of $350,000

6. If the old trucks were used for seven more years they would be unlikely to have any resale value.

7. Increased revenue would result in an increase in receivables balance. On average Southern transport customers take 60 days to pay their accounts

8. Insurance and Registration on the new trucks would increase to $77,000 but is expected to remain constant over the next seven years as increased registration charges are offset by reduced insurance charges.

Required: 

As friends of Anna you have been asked to assist her in the preparation of a recommendation. You are to prepare the following:

1. Identify the cash flows for this project and perform a capital budgeting analysis (That is, produce a spreadsheet of the cashflows for capital budgeting analysis clearly indicating the net cash flow for each year).   (9 marks)

2. Write a brief executive summary making a firm recommendation to accept or reject the project. The executive summary must clarify potential issues, present concise reasons for your recommendation and a summary of your financial analysis supporting your recommendation. (Maximum 1000 words). (8 Marks)

3. What other factors should Janet and John consider including workings if needed.  (Maximum 500 words). (3 marks)

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