Analyzing Credit Policy and Investment Appraisal for PM Pty Ltd: Enhancing Working Capital Management and Project Feasibility

Question

Task: Should PM Pty Ltd modify its credit policy and how can investment appraisal tools like the payback period and net present value assist in making effective financial decisions?

Answer

1. Introduction

The report is based on PureMilk (PM) Pty Ltd and the company wants to review its credit policy. This report analyses whether it will be effective for the company to modify its credit policy and have a comprehensive look atits working capital management scenario. The next part of the report runs an investment appraisal on a project to launch a new product. The investment appraisal of the project is determined based on the payback period and the net present value. The manager considers three distinct scenarios for the project –pessimistic, normal, and optimistic to contemplate a suitable financial decision.

The report also focuses on other aspects like the use of cash in the business scenario. It also explores the break-even point to evaluate the validity of the forecasted sales scenario and contemplate an effective business decision. Lastly, the Chief Financial Analyst of PM Pty Ltd will decide on the funding options available to the business. In this case, he uses the debt ratio and ROE to contemplate an effective funding decision. Based on the above points, the manager offers certain recommendations to the company to run the operations efficiently.

2. Working capital management of PM Pty Ltd

PM Pty Ltd has a credit period of 30 days that provides a credit window to the customers for paying their dues. The Marketing Manager of the company proposes to extend the credit period to 45 days which is the industry norm. The credit period is the average number of daysthat the company allows the customers to pay the bills(Cascino, et al., 2021). It is a norm that customers usually prefer a higher credit period and the reverse is true for businesses. The credit period is an important concept in the business to get customers’ attention as a higher credit period strengthens the business relationship with the targeted customers. So, increasing the credit period from 30 to 45 days is strategically efficient for the company.

Increasing the credit period to 45 days is strategically important for PM Pty Ltd as the industry benchmark is of equivalent days. Hence, the company by increasing the credit period will be at par with the industry standard. The phenomenon will encourage more customers to engage with the business(Santamaria, et al., 2021). But a review of the credit policy is subject to the financial aspects of the organization. It is because the credit period directly influences the working capital management of the business. Working capital provides the requisite capital for the business to run its daily business operations. A substantial portion of working capital comes from the sale of the products. If PM Pty decides to increase the credit period, it is due to affect the working capital as well.

Indeed, a delay in getting the payment will bother the cash flow of PM Pty. The cash flows help the business to run its daily operations and activities to generate further sales. In such a scenario, a delay in payment may cause trouble to its operations and sales activities. Again, if the company bears a little trouble, the phenomenon can bring more customers owing to a higher credit period. It may extend the company’s horizon to new markets and generate additional revenue in the process(Yüksel, et al., 2019). Besides, PM Pty can indulge in invoice factoring to get funds for its working capital. It is a system wherein the company can discount its bill to a third party to get the requisite funds. Hence, PM Pty Ltd can do wonders by nodding to the proposed credit policy.

3. Payback period and net present value as an investment appraisal tool

The payback period and the net present value (NPV) are important tools for the investment appraisal mechanism. Businesses like PM Pty often abide by such measures before contemplating their investment decisions on a project. Similarly, PM Pty got three scenarios to adjudge the best investment for the business in terms of the payback period and NPV.

Payback period –

The payback period is expressed in terms of years to understand how long the business or project takes to recover the invested capital(Edmonds, et al., 2019). It is an important determinant for the business to get an idea of the returns within a specified time. The payback period is derived using the formula:

Payback period = Initial investment / Net annual cash inflows

Usefulness of payback period –

• Payback period is an effective tool in the business to understand how quickly the project can recover the capital(Ameen, et al., 2018).

• It is easy to determine and is one of the simplest investment appraisal tools that managers use to evaluate project feasibility.

• Since the payback period is concerned with the liquidity proposition, the phenomenon helps in reducing the business risks and losses.

• A shorter payback period is indicative of the projected liquidity and higher scope of profitability.

Net present value –

The net present value (NPV) is a financial determinant to evaluate the investment scope effectively. It is the most important element of the investment appraisal mechanism as only a project with a positive NPV is considerable, otherwise, the project is rejected straightaway. Theoretically, NPV is the variation of the present worth of the cash inflows alongside the present worth of the cash outflows and the initial investment(Cascino, et al., 2021). It is derived using the following formula:

Usefulness of NPV –

• NPV is used in the capital budgeting process to contemplate important investment or business decisions. A positive NPV points out the acceptability of the project and vice versa(Vishny & Zingales, 2017). Thus, the determination of NPV makes it easy for the decision-makers whether to accept or reject the investment proposal.

• NPV is carried out before the start of the project. Thus, it helps to save the efforts, time, and resources of the companies.

• NPV considers the time value of money that leads to the accurate determination of the present worth of the cash flows. It paves the authenticity of the NPV process to determine the profitability of the project in the future(Yüksel, et al., 2019).

Given conditions

To evaluate the three specified conditions of the project, PM Pty is considering a payback period of 2 years and a discount rate of 13% to determine the NPV.

Pessimistic condition –

The above table shows that under the pessimistic condition, the project cannot have any payback period while it has a negative NPV. Since its NPV is negative, the project is not considerable.

Normal condition –

In this case, the project is supposed to get a payback period of 1.95 years which is within the benchmark of 2 years. So far, the payback period is concerned, this project will help PM Pty to recover its initial investment of $600,000 within 2 years. Again, the project got a positive NPV of $483,307 which indicates the profitability of the project.

Optimistic condition –

The table below shows the investment appraisal of the project under optimistic conditions. The payback period is 1.25 years. The figure indicates that little after a year, the project can recover the investment. It is good to have a shorter payback period implying the liquidity of the project (Baker, et al., 2020). The NPV of the projects stands at $1,088,271.

Recommendation:

Both the project conditions of the payback period and NPV are fulfilled during normal and optimistic scenarios, making it acceptable to the company. It is a positive and bigger figure as in the optimistic condition that the company will choose over other conditions. It strives for a higher profitability scenario.

Other factors considerable for PM Pty Ltd:

• The payback period methodology ignores the time value concept of money. The time value is an important concept as it evaluates the present worth of the future cash inflows (Doni, et al., 2021). The payback period is silent on this aspect.

• The investment appraisal method only considers the cash inflows until the payback period is attained and does not consider the later cash inflows. It also ignores the aspect of inflation and other external happenings.

• The discount rate used to determine NPV is quite ambiguous as there is no such fixed rule to consider the rate. The manager can take a discount rate at his discretion.

4. Cash and accounting break-even points as management tools

Cash in management –

Cash is an important management resource ensuring profitability and liquidity to the business. It is a significant asset to the company that is sued to meet business obligations effectively. Proper tracking of the cash flow resources helps the business to understand its sources and disbursals(Titman, et al., 2019). It is a significant phenomenon as the business needs to continue and maintain the sources well to ensure the cash inflows. Similarly, PM Pty needs to keep a track of the business expenses through proper monitoring of its cash outflows. This is to ensure that the business does not indulge in unnecessary expenses as it operates within limited resources.

Break-even point as a management tool –

The break-even point is a specified point in the business trajectory wherein the total cost is equivalent to the total revenue. It is such a point that stands for a no-profit, no-loss scenario(Dang, et al., 2018). Businesses across the spectrum strive to attain it as a threshold because, beyond the point, it earns profitability.

The above diagram specifically shows the break-even point in the line represented by the black straight line. The line below the break-even point suffers business losses which is at its initial state as in the initial phase of a project(Gillan, et al., 2021). In this state, the business costs are more than the revenue leading to project losses. Again, the point beyond the break-even point is the phase when the business or project can earn suitable profitability as the business revenue exceeds the cost.

The proposed project is to be adjudged under three conditions – pessimistic, normal, and optimistic. In the pessimistic condition, the business costs are quite higher leaving behind very less profitability. Such a scenario tends little scope for the projected sales to meet the break-even point.

But the business is supposed to attain the break-even point under normal and optimistic conditions. In both conditions, the business attends the break-even point as within a while, the projects start getting more revenues over the costs(Baker, et al., 2020). So, PM Pty should choose either the normal condition project or the optimistic one while the latter is best suited to higher profitability.

5. Suitable funding option for PM Pty Ltd

Principles of Finance:

• Money has a time value determining the present worth of the sum for a future date. For instance, an amount worth $100 will not value the same three years down the line.

• Money also abides by the risk-return trade-off wherein an investor may undertake a higher risk for an additional return.

• Cash is the king as it determines the amount of wealth that an individual or a company possess. So before investing in a particular project, the manager should explore the opportunity cost for an effective business decision.

• The market is an important determinant of the asset price and needs to track the same before shifting the asset position.

• Cash investment boosts public confidence and invites more investment in the firms.

Accordingly, the suitable funding options for PM Pty Ltd are:

Equity financing –

It is one of the most effective and long-term funding options that PM Pty can explore. The funding process can be time-consuming but it raises funds for the long term that do not need to be repaid unless liquidated(Ameen, et al., 2018). But getting investors’ attention can be difficult as the business is suffering from a declining ROE.

Debt financing –

It is one of the convenient modes of funds that businesses across the industry can explore. PM Pty has a lower debt ratio indicating that its financial position is strong as it is more dependent on equities. Thus, the business can raise funds as loans from banks or any financial institution against a suitable interest rate. PM Pty needs to repay the principal and the interest amount within a specified period(Edmonds, et al., 2019). Owing to the financial condition and reputation of the company, it is easy to acquire debt funds. Further, this sort of funding is comparatively affordable against the equities.

PM Pty Ltd ought to have a suitable capital structure for its business. Hence, it should have a perfect blend of equities and debts to facilitate proper funding for the company. The manager can seek debt funding for the time being as it has enough room to accommodate debts due to lower gearing(Santamaria, et al., 2021). It is not so easy to raise equities at the moment as lower ROEs cannot instil confidence among the investors to get suitable equities. So, PM Pty should resort to debt funds over equities as an effective capital structure for the business.

6. Conclusion and recommendations

The report concludes that PM Pty Ltd should review its credit policy by increasing the credit period from 30 days to 45 days. The phenomenon may delay the cash inflows but is effective to build a strong business relationship with the clients.

It also shows that out of the three specified conditions, normal and optimistic conditions seem financially feasible. The payback period and NPV strives to attain the given benchmark of 2 years payback period and positive NPVs. The manager will consider a shorter payback period and a higher NPV which is there in the project under optimistic conditions.

The report points out that cash resource is an important accounting tool in the business. It is important to control cash resources efficiently for the proper running of the business and meet its working capital requirements. The break-even point is a crucial trajectory in the business scenario and projects under normal and optimistic conditions happen to meet it.

Lastly, the report also concludes that PM Pty should strike a suitable capital structure in its business spree. It has a lower debt ratio, so raising debt finance seems to be effective to address the funding process.

Recommendations –

• PM Pty Ltd should extend its credit period to 45 days by reviewing its existing credit policy. In the long run, the strategy paves for effective working capital management as it can attract more customers into the system.

• PM Pty should select projects with positive NPVs like the ones at normal and optimistic conditions. It is better to select the optimistic condition project having a shorter payback period and a higher NPV. Both elements fulfil the conditions provided to select the suitable project.

• The business should strive for a perfect blend of the capital structure having the composition of both equities and debts.

Limitations of the analysis:

The financial analysis is based on certain assumptions like the discount rate for the NPV is assumed rather than determining a suitable rate for the same. The investment appraisal was conducted based on the payback period and NPV while leaving aside the IRR, an important determinant of the capital budgeting process.

References

Ameen, A., Ahmed, M. & Abd Hafez, M., 2018. The Impact of Management Accounting and How It Can Be Implemented into the Organizational Culture. Dutch Journal of Finance and Management, 2(1), p. 02.

Baker, H., Kumar, S. & Pattnaik, D., 2020. Twenty-five years of the journal of corporate finance: a scientometric analysis. Journal of Corporate Finance, p. 101572.

Cascino, S. et al., 2021. The usefulness of financial accounting information: Evidence from the field. The Accounting Review, 96(6), pp. 73-102.