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AEC 422 Fall 2012 Unit 2 Financial Decision Making Capital Budgeting Defined as process by which a firm decides which long term investments to make Decision to accept or reject a capital budgeting project depends on an analysis of the cash flows generated by the project and its cost Five Capital Budgeting Performance Measures 1. Payback 2. Average Rate of Return 3. Net Present Value 4. Profitability Index 5. Internal Rate of Return Starting with Net Cash Flow Statement Cash Flow Statement: sources and uses of cash for a business over a certain period of time. Period coincides with the reporting period of the income statement. Cash Flow Statement is basic to calculating performance measures Cash Flow Statement A cash flow statement shows how your business is performing on a “cash” basis The income statement shows how your business performs on an “accrual” basis while the cash flow statement provides a source of cash receipts shown in the income statement Cash Versus Accrual Accounting Methods Basic difference between the two is the timing of the income and expense recording. Cash versus Accrual Cash accounting is based on real time cash flow. Revenues (expenses) are reported when received (paid). Accrual accounting reports income (expenses) when earned (or received) and expenses when earned and not necessarily when received (or paid). Three General Categories of a Cash Flow Statement Net flows from operations activities Net flows from investing activities consisting primarily of purchase or sale of equipment Net flows from financing activities such as issuing and borrowing funds. Steps in Preparing a Cash Flow Budget 1. Prepare a sales forecast 2. Project anticipated cash inflows 3. Project anticipated cash outflows 4. Putting the projections together to come up with your cash flow “bottom line” Capital Budgeting Decision Rules 1. You must consider all the project’s cash flows 2.Must consider time value of money. Dollar earned next year is not the same as a dollar earned today 3. Must always lead to the correct decision when choosing among mutually exclusive projects Time Value of Money At it’s most basic level, the time value of money demonstrates that it is better to have money now rather than later. Would you rather have $10,000 today or receive it next year? Why? Would You Rather Receive $10,000 Today or Next Year? Inflation Could have it invested and earning money Project Classification Projects being considered and evaluated can be divided into two categories: 1. Independent projects 2. Mutually exclusive projects Independent Projects A project whose cash flows are not affected by the accept or reject decision of other projects. Mutually Exclusive Projects Defined as a set of projects from which at most one will be accepted. All the projects being considered may be acceptable, but we’ll choose the “best” one. Can’t always do everything – often have a budget constraint Capital/Investment Projects in Agribusiness Wind turbine New ag chemical Plastic reusable containers vs cardboard High speed wine bottling equipment Flash freezer vs IQF freezer for fruit Electronic Point of Sale systems for retail store Employee health insurance plan A vs B New line of equipment for a farm supply store New service division for a bank Cash Flow Returns Based on project outcomes that either lead to New net revenue New net cost savings Typically over a period of time The Discount Rate It’s the firm’s cost of capital. The latter reflects the firm’s cost of acquiring capital to invest in long term assets. Discount rate reflects future value of money. Has two components: An adjustment for inflation A risk-adjusted return on the use of the money Investment Example Initial Investment: $400,000 Cash Flow Returns Year Year Year Year Year 1: 2: 3: 4: 5: $115,000 $115,000 $115,000 $115,000 $115,000 Salvage Value: $50,000 Payback Period A capital budget performance measure Defined as the length of time it takes for a capital budgeting project to recover it’s initial cost Calculating Payback Payback = Net Investment Average Annual Net Cash Flow *Note that net cash flow is after taxes Calculating Payback Using the Net Cash Flow example provided, what is the payback period? Example Calculating Payback Net Investment Payback = Average Annual Net Cash Flow = $400,000 $115,000 = 3.48 Years Decision Rule: The lower the better! Payback Advantages: Easy to calculate Give you a rough idea of liquidity Disadvantages: Ignores time value of money Ignores project profitability Average Rate of Return A second capital budgeting performance measure Defined as: Average Annual Net Cash Flow – Average Annual Depreciation Net Investment Average ROR Calculate the Average ROR using the example net cash flow statement Calculating Average ROR ROR = $115,000 - $70,000 = 11.25% $400,000 Decision Rule: Must be positive and the higher the better! Average ROR Advantages: Again, simple to calculate Does account for salvage value Begins to consider profitability Disadvantages: Ignores time value of money Net Present Value A third capital budgeting performance measure concept Net Present Value is a measure of how much value is created or added today by undertaking an investment. Net Present Value It does this by accounting for the time value of money. A $ today is worth more than a $ tomorrow because of the “erosive” effects of inflation Net Present Value It is the present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows It’s the net result of a multiyear investment expressed in today’s dollars Net Present Value T ∑ t=1 NCFt (1 + r)t - NINV Net Present Value Key NCFt Net Cash Flow in Year t T is the life of the project r is the discount rate or cost of capital NINV is the net investment of the project Note that in year T, Net Cash Flow must include the salvage value of the initial investment Calculate Net Present Value Using the example provided, how would you structure the equation for calculating net present value? Assume Discount Rate = 10% Calculating Net Present Value $115,000 (1.1)1 + $115,000 + $115,000 + 2 3 (1.1) (1.1) $115,000 (1.1)4 + $115,000 1.1 + $115,000 + $115,000 1.331 $115,000 1.4641 + 1.21 $104,545 + $95,041 $466,984 $66,987 - $400,000 + $86,401 + + $78,547 $115,000 + $50,000 (1.1)5 $165,000 1.61051 + $102,452 - $400,000 - $400,000 - $400,000 Net Present Value Decision Rule: Accept project if NPV > 0 $66,987 > 0 so we accept the project given it’s the only one we’re considering Note if mutually exclusive projects being considered, accept the one with the highest NPV NPV Advantages: -Accounts for time value of money correctly -Considers firm profitability -Consistent with notion of maximizing owner wealth NPV Disadvantages: -More complex to calculate -Difficult to explain to non-financial managers -Not always easy to determine the correct “discount rate” Profitability Index (PI) or Benefit Cost Ratio (BCR) Defined as the present value of the future cash flows divided by the initial investment Profitability Index T ∑ t=1 NCFt (1 + r)t NINV Profitability Index--Where NCFt = Net Cash Flow in Year t T = Life of the Project r = Discount Rate NINV = Net investment of Project Note that Net Cash flow must include the salvage value of the initial investment Calculating PI Using the example provided, what is the profitability index? Calculate PI For our example: PI = $466,987 = 1.17 $400,000 Calculate PI Decision Rule: Accept if PI >1.0 But the bigger the PI the better Hence, we accept this project Note: PI is a unit free performance measure Pros and Cons of PI Advantages: Accounts for time value of money Considers project profitability Considers owner wealth maximization Disadvantages: Complex to calculate Difficult to explain to non-financial types May not pick project with largest NPV Internal Rate of Return (IRR) The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate In some ways it’s an alternative to NPV Internal Rate of Return Note that NPV is some mathematical function of r (the discount rate) So IRR is the level of r (call it r*) such that the NPV = 0 Thus, Internal Rate of Return T ∑ t=1 NCFt (1 + r*)t - NINV = 0 Internal Rate of Return Unfortunately, one cannot solve for IRR using algebra. Rather we must solve by trial and error Calculating IRR-Using Example r% 6 8 10 12 14 16 18 20 22 24 NPV ($) 121,785 93,191 66,987 42,921 20,773 349 -18,520 -35,986 -52,181 -67,225 PI 1.3 1.23 1.17 1.11 1.05 1.0 .95 .91 .87 .83 Calculating IRR From previous table we note that NPV = 0 somewhere between r = 16% and r = 18%. Bit more trial and error and we can discover that IRR = 16.04% Plug 16.04% into NPV formula and you get NPV = 0 Calculating IRR Decision Rule says that for a single project accept if IRR > 0. The higher the better. Pros and Cons of IRR Advantages: Accounts for time value of money Considers profitability Consistent with maximizing wealth Doesn’t require analyst to specify r Disadvantages: Complex to calculate Difficult to explain May not pick project with largest NPV Monforte Dairy Case Considering a variety of new business extensions at the same time Auffinage Charcuterie Auberge Cheese school Which ones make sense financially? Strategically? All, some, none? What’s the investment impact on the firm’s overall financial health?