In: Finance
Identify and discuss four inherent operational risk factors in terms of the business exposures and potential consequences that Mr Baloyi will face according to the business strategy. Explain possible mitigating measures that can be taken to minimise/eliminate the risk (The maximum length of your answer should be one page).
Scenario
The cement industry in South Africa is currently undergoing mixed
sentiments by various economic and financial specialists. From an
economic perspective, this industry should grow, especially in view
of the growing property markets. There are several initiatives
surrounding new housing and shopping complexes across the country,
which is ensuring a growing market for building cement and related
products. There are also opportunities to develop cement production
facilities in African countries such as Ethiopia, Zimbabwe,
Botswana and Rwanda. From a financial perspective, there seems to
be a growing (bullish) trend in cement shares; however, this market
might be influenced by cheap importers of cement from other
countries such as Pakistan. Notwithstanding, it seems that this
market will show a steady increase in the future, providing local
and foreign investment opportunities. Due to these potential views
of the cement market, there might be ample work opportunities,
including for small and medium enterprises (SMEs).
In this regard, Mr Baloyi decided to investigate an SME to provide
ready mixed cement to builders. He is aware that all SMEs are
subject to specific risk exposures. As such, it is essential to
determine if such an investment would be worth the risk. As a risk
specialist, he approached you to analyse the following business and
make recommendations.
The business involves the use of cement mixing trucks to provide ready mixed cement to builders for building purposes. To start such a business, it is imperative to get a licence from the appropriate government department and be a registered supplier of this product and service. Due to the price of these cement-mixing trucks, it will be an expensive business to start. The cost of one truck is R1.5m, and usually, two trucks are required to start such a business. It is also imperative to confirm a customer base to ensure that there is a market for the business. This would mean a detailed marketing campaign to advertise the business and to establish a customer base. The cost for such a campaign will amount to R500 000 and after that R50 000 per annum (This will only come into effect the second year after establishing the business). Furthermore, it is crucial that the business must have skilled employees. Firstly, skilled to ensure that the mixed cement consists of the correct volume of sand, stone, cement and water. Secondly, the drivers of the trucks must be trained and have a special license to drive these trucks and thirdly have the skill to operate the mechanics of the truck’s mixing machines. Training is thus, essential to ensure a successful business. The average training cost per employee will be R65 000, which will include the required license fees. In order to operate two cement trucks, the following staff members are required with an annual compensation package:
2 x truck drivers R470 000 per driver
2 x machine operators R350 000 per operator
2 x Cement mixing specialists R225 000 per specialist
1 x Administration officer R300 000
To employ the above staff members, it is required that the total
annual compensation must be available upfront in order to protect
the employees for at least a year should the business fail.
The trucks require a maintenance service after 20 000 km. A normal
service costs approximately R8 500 and the average distance per
month for a truck is about 10 000 km. To ensure that the trucks
operate at their full capacity, these maintenance services are
crucial. Should a truck break down, it will cause a major problem
for Mr Baloyi in the sense that he will incur penalties for not
delivering cement on specified times.
One truck can provide three loads of cement per day which will
ensure a net income of R16 000 (after the cement, sand and water
costs). Mr Baloyi envisaged that he would provide cement for only
20 days per month, which will allow him time for the maintenance of
the trucks on a monthly basis. The building industry closes during
the months of December and January each year, meaning that there
are only ten months available for business.
A potential problem that Mr Baloyi will face is the availability of cement which could be influenced by strikes at the cement factories. As such, Mr Baloyi must make provision for these incidents should they occur. Another potential threat to this business is the exposure to road accidents involving the trucks. Since the trucks form the basis of this enterprise, Mr Baloyi must be insured against accidents. This is also essential to cover any third-party claims against the business such as the non-delivery of cement as per agreed times as well as claims from other accident victims. Potential monthly insurance premiums are:
· R5 500.00 per month (12 x months) per truck (including third
party costs) for accidents.
· R2 500.00 per month (12 months) to insure against claims for
non-delivery.
The availability of skilled and trained drivers on these cement
trucks are scarce in South Africa and should one of the drivers
fall ill or want to go on leave. Mr Baloyi will have a serious
problem to achieve his business objectives. Furthermore, the
availability of diesel could be a problem if the country
experiences a shortage. This is a high possibility which could also
negatively influence the business. The safety of the trucks also
requires attention, and they must be parked in a safe environment
when they are not in use. In this instance, Mr Baloyi will have to
rent buildings with adequate parking facilities and office space.
These rental costs (including water and electricity) for a suitable
building is R20 000 per month. Security is also vital to safeguard
the equipment, which will cost R6 500 per month (including a
24-hour security guard) and rapid response from ABS Security. It is
also imperative to ensure that there is a process to clean the
trucks when not in use to ensure the longevity thereof. In
addition, the trucks must be monitored in terms of its fuel usage;
the oil services and the kilometres travelled to ensure that the
trucks are serviced when it is due. It is therefore imperative that
those above be technologically supported. A system for the business
will cost R50 000 and R2 000 per month.
Due to the fact that the trucks make use of the public roads, it
is eminent that the drivers are exposed to traffic fines resulting
in possible legal action against the business. This should also be
adequately addressed during the business strategy.
Mr Baloyi envisaged that to make the business worth his while,
he must, at a minimum, receive a monthly income, before tax, of R90
000. The total tax implications for the business can be calculated
at 28% on the gross income per annum. To ensure the continuity and
the growth of the business, a minimum annual amount of R1 000 000
must be invested. Should this target not be achieved, the business
will not grow and go bankrupt after five years (this is also the
lifetime of the trucks and must be replaced after five
years).
To start the business, Mr Baloyi is prepared to invest R5 000 000 into the business for ten years at 5% interest per year. The monthly amount for this loan is R67 870.
Question 2 (12 x Marks)
Identify and discuss four inherent operational risk factors in
terms of the business exposures and potential consequences that Mr
Baloyi will face according to the business strategy. Explain
possible mitigating measures that can be taken to
minimise/eliminate the risk (The maximum length of your answer
should be one page).
Business operational risks include:
1. Risk due to substitute product - Threat of substitute , as defined in porters five forces, plays as one of the major risks tge business is exposed to. As The market may be affected by cheap cement importers from other countries, such as Pakistan.
2 Risks faced due to potential legalizations in FDI rules - It appears that this sector will continue to expand in the future, offering local and foreign investment opportunities. Due to these possible views of the cement industry, there may be enough job opportunities, including for small and medium-sized enterprises ( SMEs). Regulatory obligations may hinder the same.
3. Costs of human resource- advance compensation package including
annual compensation package:
2 x truck drivers R470 000 per driver
2 x machine operators R350 000 per operator
2 x Cement mixing specialists R225 000 per specialist
1 x Administration officer R300 000
4. Insurance and additional overhead and maintainenece costs
The exposure to road accidents involving trucks is another potential threat to this company. Since the trucks form the foundation of this undertaking, Mr. Baloyi must be covered against accidents. This is also necessary to cover any claims raised by third parties against the company, such as non-delivery of cement as agreed times, as well as claims made by other accident victims.
The monthly armotization payment for the loan stands at 67870 for a 5Milln loann.
So The yearly payments goes upto
67870*12= 814,440.
So in order to achieve breakeven this point Mr Baloyi must have an Operating income of this amount considering the deferring of further tax obligations of 28% to next year in order to mitigate the operational risk.