Farm ManagementChapter 17

Farm Management

Chapter 17Investment Analysis

farm management chapter 17

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• Investment Analysis

http://hspm.sph.sc.edu/COURSES/ECON/irr/irr.html


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Time Value of Money

1. The dollar could be invested to earn interest2. If dollar is spent on consumption, we’d

prefer to get the enjoyment now3. Risk is also a factor as unforeseen

circumstances could prevent us from getting the dollar

4. Inflation may diminish the value of the dollar over time

A dollar today is preferred to a dollar in the future:


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Present Value and Future Value• Present Value (PV): the number of dollars

available or invested at the current time or the current value of some amount to be received in the future

• Future Value (FV): the amount to be received at some future time or the amount a present value will be worth at some future date when invested at a given interest rate


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More Terms• Payment (PMT): number of dollars to be paid

or received in a time period• Interest Rate ( i ): also called the discount

rate the interest rate used to find present and future values, often equal to opportunity cost of capital

• Time Periods ( n ): the number of time periods used to compute present and future values

• Annuity: a term used to describe a series of periodic payments


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Table 17-1 Future Value of $1,000

Value atbeginning of interest rate Interest earned Value at end

Year year (%) ($) of year ($)

1 1000.00 8 80.00 1080.002 1080.00 8 86.40 1166.403 1166.40 8 93.30 1259.70


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Figure 17-1Illustration of the concept of future value

for a present value and for an annuity


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Figure 17-2Relation between compounding

and discounting


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Computing Future Value

FV = PV ( 1 + i ) n

FV = $1,000 ( 1 + 0.08 ) 3

= $1,259.70


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Future Value of an Annuity

FV = PMT ( 1 + i ) n 1i


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Present Value

PV = FV

(1 + i ) nor FV

1

(1 + i ) n


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Present Value of an Annuity

PV = PMT 1 ( 1 + i ) -n i


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Figure 17-3Illustration of the concept of present value

for a future value and for an annuity


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Table 17-2 Value of an Annuity

Year Amount ($) Present Value Factor Present Value ($)

1 1,000.00 0.92593 925.932 1,000.00 0.85734 857.343 1,000.00 0.79383 793.83

Total 2,577.10


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Investment Analysis• Investment analysis, also called capital

budgeting, involves determining profitability of an investment

• Initial cost: actual total expenditure for the investment

• Net cash revenues: cash receipts minus cash expenses

• Terminal value: usually the same as salvage value

• Discount rate: opportunity cost of capital


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Payback PeriodThe payback period is the number ofyears it would take an investment toreturn its original cost. If net cash revenues are constant each year, thepayback period (P) is:

P =

C

Ewhere C is original costand E is the expected annual net cash revenue


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Table 17-3 Revenues for Two $10,000 Investments

Year Investment A Investment B

1 3,000 1,0002 3,000 2,0003 3,000 3,0004 3,000 4,0005 3,000 6,000

Total cash revenues 15,000 16,000Less initial investment -10,000 -10,000Net Cash Revenues 5,000 6,000

Average net revenue/yr 1,000 1,200

Net revenues ($)

no terminal value


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Finding Payback Period

The payback period for investment Ais 3.33 years ($10,000 ÷ 3)

The payback for investment B is 4 years, which is found by summingthe revenues until they reach $10,000.


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Limitations of the Payback Period

The payback period is easy to calculate and identifies the investments with the most immediate cash returns. But it ignoresreturns after the end of the payback periodas well as the timing of cash flows.


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Simple Rate of Return

Rate of return =

Investment A =

Investment B =

average annual net revenueinitial cost

$1,000$10,000

x 100% = 10%

$1,200$10,000

x 100% = 12%


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Net Present Value

Net Present Value (NPV) is the sumof the present values of each year’snet cash flow minus the initial investment.

NPV = + + + CP1 P2 Pn

(1 + i )1 (1 + i )2 (1 + i )n . .


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Table 17-4 Net Present Value

Net cash Present Present Net cash Present PresentYear flow ($) value factor value ($) flow ($) value factor value ($)

1 3,000 0.9090 2,727 1,000 0.9090 909 2 3,000 0.8260 2,478 2,000 0.8260 1,652 3 3,000 0.7510 2,253 3,000 0.7510 2,253 4 3,000 0.6830 2,049 4,000 0.6830 2,7325 3,000 0.6210 1,863 6,000 0.6210 3,726

11,370 11,27210,000 10,0001,370 1,27215.2% 13.8%

Investment B

Total

Investment A

TotalLess initial cost

Net present valueNet present valueInternal rate of returnInternal rate of return

Less initial cost

10% discount rate and no terminal values


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Internal Rate of Return

The internal rate of return (IRR) is thediscount rate that would make the NPVof an investment equal to zero.

The IRR is usually calculated by computer or with a financial calculator.


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Annual Equivalent

The annual equivalent is an annuity thathas the same present value as theinvestment being analyzed.

Investment A: $1,370 0.2638 = $361.41Investment B: $1,272 0.2638 = $335.55

The amortization factor for 10% and 5 yearsis 0.2638 (Appendix Table 1)


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Financial Feasibility

• The methods presented so far analyze economic profitability

• Investors also need to look at financial feasibility

• Will the investment generate sufficient cash flow at the right times to meet required cash outflows?


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Table 17-5 Cash Flow Analysis

Net cash Debt Net cash Net cash Debt Net cashYear revenue payment flow revenue payment flow

1 3,000 2,800 200 1,000 2,800 -1,800 2 3,000 2,640 360 2,000 2,640 -640 3 3,000 2,480 520 3,000 2,480 520 4 3,000 2,320 680 4,000 2,320 1,6805 3,000 2,160 840 6,000 2,160 3,840

Investment BInvestment A

$10,000 loan at 8% interest with equal principal payments


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Income Taxes, Inflation, and Risk

• Different investments may have different effects on income taxes so they should be compared on an after-tax basis

• If net cash revenues and terminal values are adjusted for expected inflation, the discount rate should also be adjusted

• Investments with higher risk should be assigned a higher discount factor


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Sensitivity Analysis

Sensitivity analysis is a process ofasking several “what if” questions. Whatif net cash revenues are higher or lower?What if the timing is different? What ifthe discount rate were higher or lower?Change one or more values andrecalculate NPV and IRR.


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Summary

The future value of a sum of money isgreater than its present value becauseof the interest that could be earned. Investments can be analyzed using:payback period, simple rate of return,net present value, and internal rate ofreturn.


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2. Explain the difference between compounding and discounting.

• Compounding finds the future value of a present value using a compound interest rate.

• Discounting finds the present value of some future value, using a discount rate. They are inverse relationships.


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. Discuss economic profitability and financial feasibility. How are they different? Why should both be considered

when analyzing a potential investment?

• Economic profitability refers to an investment having a NPV greater than zero and an IRR greater than the opportunity cost of capital.

• This means the investment will earn a rate of return at least equal to this opportunity cost so there will be an economic profit. Cash flow needed to make principal and interest payments are not included in these analyses because it is assumed that the results are independent of how the investment is financed.


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. Discuss economic profitability and financial feasibility. How are they different? Why should both be considered

when analyzing a potential investment?

• Financial feasibility is concerned with the periodic net cash flows from the investment and becomes particularly important when capital must be borrowed to finance the investment. It is entirely possible for an investment to be economically profitable but result in negative net cash flows for several time periods. This often occurs when the loan must be paid off in a relatively short period of time and the investment produces little initial cash flow but larger flows in later time periods.


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8. What two approaches can be used to account for the effects of income taxes in investment analysis?

• a) All cash flows can be estimated on a before-tax basis and a tax-free discount rate can be used.

• b) All cash flows can be adjusted by the amount by which income taxes would increase or decrease them and an after-tax discount rate used (before-tax rate multiplied by 1 minus the marginal tax rate).


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9. What two approaches can be used to account for the effects of inflation in investment analysis?

• a) All cash flows can be estimated as real values (current dollars) and the discount rate used can be a real rate (subtract the expected rate of inflation from the nominal discount rate).

• b) All cash flows can be increased over time by their expected rates of inflation and a nominal discount rate can be used.


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10. Why would capital budgeting be useful in analyzing an investment of establishing an orchard where the trees

would not become productive until 6 years after planting?

• Many tree and vine crops have several years of expenses with little or no income while the planting reaches its productive age. There is a serious mismatch in the timing of cash expenses and cash revenue. The only way to analyze an investment of this type is to use capital budgeting so the timing of all cash flows is taken into account using an appropriate discount rate or opportunity cost of capital.


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11. What advantages would present value techniques have over partial budgeting for

analyzing the orchard investment in question 10? • A partial budget would compare the orchard investment

with some other alternative using changes in average annual expenses and revenues. It would be difficult to estimate average annual expenses and revenues for the orchard because they are different for every year. To do it correctly, adjustments must be made for differences in the timing of revenue and expenses. In most cases it will be easier and less time consuming to use present value techniques on a problem of this type. However, the concept of added and reduced cash flows can also be used with capital budgeting techniques.

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Farm ManagementChapter 17