Investment Analysis: What Investments Should I Make?

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Strategic Business Planning for Commercial Producers
Investment Analysis: What
Investments Should I Make?
Objectives
• What are the important issues/considerations
in making investment decisions?
• What is capital budgeting?
• How do we analyze a project?
Investment Issues/Concepts
• Growth Strategies
• Capital Budgeting
– Economic Profitability
– Financial Feasibility
• Risk
• Portfolio Considerations
• Tax Considerations
Capital Budgeting Decisions
• Managers are responsible for identifying
investments that create value
• Impact cash flows over multiple periods
• Factors to consider:
– Strategic Direction
– Estimation of future benefits
– Uncertainty of future benefits
Capital Budgeting
• Two Questions:
– Economic profitability – Does it earn a profit above all
costs?
– Financial feasibility – Will it cash flow?
Economic Profitability
Time Value of Money
• Money has a time value
– “The sooner, the better.”
• Money preferred to inventory
– Can be invested
• Benefit of investments are in the future
– Adjust for cost of waiting
$100 Today or $100 Tomorrow
• Why $100 today
– Opportunity costs/earnings foregone
• Adjust for cost of waiting
– Discount /penalize future income
Present and Future Values
P
r
e
s
e
n
t
Compounding
Discounting
F
u
t
u
r
e
What is Discounting?
7%
Year
1
0.9346
$43,670
$50,000
2
$50,000
3
4
5
0.8734
0.8163
0.7629
0.7130
$35,650
$79,320 =
Present Value of
Net Cash Flows
What is NPV?
• Converts money flows in the future into a single
current value
• Used to evaluate alternative investments and the
effects of the timing of cash flows and opportunity
costs on the decisions
Net Present Value
• Rationale for NPV approach is related to the
“value of the firm”
• If take on a project with NPV<0, value of the
firm falls – owners are worse off.
• However, if we accept a project with NPV>0,
then the value of the firm increases – owners
are better off.
Steps in Economic Profitability (NPV
analysis)
1.
2.
3.
4.
5.
6.
Compute discount rate
Calculate present value of cash outlay
Calculate annual net cash flows
Calculate present value of net cash flows
Compute net present value
Accept or reject investment
Specialty Grain and On-Farm Storage
•
•
•
•
•
•
•
•
•
Purpose: add on farm storage to store specialty grain
Build from scratch
Investment outlay $76,800
5 year life with $30,000 salvage value
Will store 60,000 bushels IP corn
Finance with 40% debt, 60% equity
35% tax bracket
Target ROE is 15.1% (9.8% after tax)
Borrow funds at 8.3% (5.3% after tax)
Step 1. Compute the Discount Rate
• Discount rate is the price at which a dollar of cash
flow is exchanged between periods
– Exchange price between present and future dollars
• Essential element in any present value analysis
Step 1: Compute the Discount Rate
• Penalty of delay in receiving cash is the cost of
financing
• So the discount rate is the cost of capital
Step 1. Calculating Cost of Capital (discount rate)
Marginal Income Tax Rate
Federal
A
30%
State
B
5%
Total [A + B]
C
35%
Cost of debt capital
D
8.1%
After-tax cost of debt capital [D x (1 - C)]
E
5.3%
Rate of return on investment opportunities
F
15.1%
After-tax cost of equity [F x (1 - C)]
G
9.8%
Percent of assets financed with debt *
H
40%
Percent of assets financed with equity [1 - H]
I
60%
After-tax cost of capital [(E x H) + (G x I)]
J
8.0%
Cost of Borrowed Funds
After Tax Cost of Equity Capital
Weighted Cost of Capital
Step 2. Calculate the NPV of cash outlay
• Purchase price is $76,800
• No additional working capital needed and sale is
completed immediately
• Present value of outlay = $76,800
Step 3. Calculate the Annual Net Cash
Flows
Calculate for each year . . .
cash revenue
less cash expenses
less taxes
plus terminal value
= Net Cash Flows
Cash flows:
exclude depreciation
Ignore unpaid labor
and management
Two Sources of Income
• Specialty grain revenue
• Storage revenue
Calculate Cash Revenue
Revenue of IP crop over #2
yellow
Revenue from Storage
Net Cash Revenue
$23,68
0
18,352
$42,032
Calculate Cash Expenses
Expenses of IP crop over #2 $12,960
yellow
Expenses of Storage
7,341
Net Cash Expenses
$20,30
1
Calculate Cash Income
Revenue
$42,032
Expenses
- 20,301
Net Cash Income
$21,731
Calculate Taxes
Cash Revenue
$42,032
Cash Expenses
- 20,301
Depreciation
- 5,760
Net Income
$15,971
Net Income x tax rate = taxes
$15,971
x .35 = $5,590
Calculate Net Cash Flow: year one
Cash Revenue
$42,032
Cash Expenses
- 20,301
Taxes
Net Cash Flow
- 5,590
$16,141
Step 3. Calculate the Annual Net Cash
Flows
Year
Cash
Revenue
Cash
Expenses
Terminal
Value
Taxes
Net Cash
Flow
1
$42,032
$20,301
--
$5,590
$16,141
2
42,360
20,910
--
3,777
17,673
3
42,122
21,242
--
4,139
16,741
4
41,887
21,583
--
4,413
15,891
5
41,654
21,932
$30,000
15,054
34,669
Step 4. Calculate the present value of the
net cash flows
• This is the sum of the discounted annual net cash
flows (net cash flow times discount factor) for each
year
Discount Factors (present value
of $1)
Interest Rate
Period
1
7%
.9346
7.5%
.9302
8.0%
.9259
8.5%
.9217
2
3
4
5
.8734
.8163
.7629
.7130
.8653
.8050
.7488
.6966
.8573
.7938
.7350
.6806
.8495
.7829
.7216
.6650
What’s the Present Value of Net Cash
Flows?
8%
$16,141
Year
$14,945
1
0.9259
$15,151
$13,289
$11,680
$23,592
$78,658 =
Present Value of
Net Cash Flows
$17,673 $16,741
2
3
$15,891
4
$34,669
5
0.8573
0.7938
0.7350
0.6806
Step 4. Annual Net Cash Flows
Present Value of
Annual Net Cash
Flow
Year
Annual Net Cash Flow
Discount
Factor @ 8%
1
$16,141
.9259
$14,945
2
17,673
.8573
15,151
3
16,741
.7938
13,289
4
15,891
.7350
11,680
5
34,669
.6805
23,592
Present value of the net cash flows
$78,658
Step 5. Compute the NPV
NPV = Present value of the net cash flows minus the
present value of the cash outlay
$78,658 - $76,800 = $1,858
Step 6. Accept or Reject
NPV > 0
NPV < 0
Accept
Reject
Interpretation of NPV
1. If NPV is positive
 Invest
 Rate or return greater than minimum acceptable
rate (hurdle rate)
 Return exceeds cost of financing
2. Maximum Bid price
 Outlay plus/minus NPV
Feasibility Analysis
Feasibility Analysis
Will the project cash flow?
Steps in Financial Feasibility Analysis
1.
2.
3.
4.
5.
Calculate annual net cash flow
Calculate loan repayment schedule
Calculate tax savings from interest deductibility
Calculate after tax payment schedule
Calculate surplus or deficit each year
Step 1. Calculate the Annual Net Cash Flow
• Already calculated as part of economic feasibility
when doing NPV
Step 1. Calculate the Annual Net Cash
Flows
Year
Cash
Revenue
Cash
Expenses
Terminal
Value
Taxes
Net Cash
Flow
1
$42,032
$20,301
--
$5,590
$16,141
2
42,360
20,910
--
3,777
17,673
3
42,122
21,242
--
4,139
16,741
4
41,887
21,583
--
4,413
15,891
5
41,654
21,932
$30,000
15,054
34,669
Step 2. Calculate loan repayment schedule
• Calculate annual principal and interest payments
based on loan repayment schedule
Step 3. Calculate tax savings from interest
deductibility
• Net cash flows are after-tax, but the payment
schedule is pre-tax
• Payment schedule must be adjusted to after-tax by
calculating tax savings from deductibility of interest
Step 3. Calculate tax savings from interest
deductibility
Year
Loan
Balance
1
$76,800
Interest
@ 8.3%
$6,374
2
63,787
5,294
1,853
3
4
5
49,694
34,431
17,902
4,125
2,858
1,486
1,444
1,000
520
Income Tax Savings
(interest x tax rate)
$2,231
Step 4. Calculate after tax payment
schedule
Year
Payment
Tax Savings
1
$19,387
$2,231
After tax
payment
$17,156
2
19,387
1,853
17,534
3
19,387
1,444
17,944
4
19,387
1,000
18,387
5
19,387
520
18,867
Step 5. Calculate surplus/deficit each year
• Compare annual net cash flow to after-tax annual
principal and interest payments to find a surplus or
deficit
• A surplus means the project is financially feasible
• A deficit means loan servicing problems are likely
The Financial Feasibility: On-Farm Storage for
Specialty Crops
Year
Annual
Net
Cash
Flow
Payment
Schedule
Principal
Payment
ScheduleInterest
Payment
ScheduleTotal
Tax Savings
from Interest
Deductibility
After-Tax
Payment
Schedule
Surplus (+)
or Deficit (-)
1
$16,141
$13,013
$6,374
$19,387
$2,231
$17,156
- 1,015
2
17,673
14,093
5,294
19,387
1,853
17,534
+ 139
3
16,741
15,263
4,125
19,387
1,444
17,944
- 1,203
4
15,891
16,530
2,858
19,387
1,000
18,387
- 2,496
5
34,669
17,902
1,486
19,387
520
18,867
+ 15,802
Dealing with Deficits
• Extend the loan terms
• Increase the amount of the down payment
• Increase cash flow of the project by controlling
costs
• Subsidize with cash from another project (the
feasibility test will indicate the amount of the
subsidy)
• Lease/outsourcing
Strategic Business Planning for
Commercial Producers
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