Capital Budgeting and
Investment Analysis
Guest Lecturer:
Juan (Jillian) Yang
Introduction of Myself
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Research Areas:
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Agricultural Finance
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Agribusiness and Marketing
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Monetary and Macroeconomics
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Applied Econometric Analysis
Teaching Experiences:
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Financial Management
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Econometric Analysis for Agribusiness Management
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Agribusiness Marketing
Topic Today
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Capital budgeting
NPV approach.
Examples.
Amortization.
Review
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Definition of capital budgeting: analyzing the net
after tax cash flows (inflows + outflows) associate
with an investment accounting for the time value of
money.
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Why Capital Budgeting is Important?
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Capital budgeting is the most significant financial activity of
the firm.
Capital budgeting determines the core activities of the firm
over a long term future.
Capital budgeting decisions must be made carefully and
rationally.
Review
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Method
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Net Present Value (NPV)
Internal Rate of Return (IRR) – Yield
Decision Criterion and Rules
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Investment acceptable if NPV > 0
Investment earnings greater than required rate of
return
Review – Net Present Value Method
Net after tax cash flows (NATCF)
1.
a.
b.
c.
d.
Additional cash inflows due to the investment less any additional cash outflows,
together with their timing (NBTCF).
NBTCF – Depreciation = taxable cash flows (TCF)
TCF * tax rate (t) = tax
NBTCF – tax = NATCF
2.
Economic life = planning horizon
3.
Original cash outlay
4.
Net after tax terminal value (NATTV)
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5.
Market value – book value = gain
Gain * tax rate = tax
Market value – tax = NATTV
Discount rate = required rate of return
Example 2 – Question
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Purchase a combine to use for custom harvesting,
cost $150,000
a. Put 30% down, finance the balance on a 3-year note
requiring equal principal payments plus interest, using 9%
interest on the remaining balance.
b. Assume a 5 year economic life (n=5)
c. Depreciate over 5 years, using straight line depreciation
and assuming a $30,000 salvage value.
d. Actual terminal sales value is $50,000
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Example 2 – Question
e. Net before tax cash flows from custom work
year 1
50,000
year 2
56,000
year 3
60,000
year 4
54,000
year 5
50,000
f. Tax rate t=25%
g. Required rate of return 15%
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Example 2 - Solution
150,000 30,000
 24,000
 Annual Depreciation=
5
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Straight line depreciation;
Cost Basis  TV for Tax Purposes
D
Depreciable Life
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Example 2 - Solution
Loan payments
down payment 150,000*.3=45,000
loan
150,000-45,000=105,000
annual principal payments 105,000 / 3=35,000
Component
Year
Beginning
Balance
rate
interest
Ending
balance
1
105,000
0.09
9450
105,000-35,000 =70,000
2
70,000
0.09
6,300
70,000-35,000=35000
3
35,000
0.09
3,150
35,000-35,000=0
At the time of sale: Book value =30,000
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Example 2 - Solution
Layout cash flows
Year 1: TCF = NBTCF-Depreciation-Interest
= 50,000 - 24,000 - 9,450 = 16,550
tax = 16,550*0.25=4,138
NATCF1 = NBTCF – PRINCIPAL – INTEREST - TAX
= 50,000 – 35,000 – 9,450 – 4,134 = 1,412
Year 2: TCF= 56,000 – 24,000 – 6,300 = 25,700
tax = 25,700*.25 = 6,425
NATCF2 = 56,000 – 35,000 – 6,300 – 6,425 = 8,725
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Example 2 - Solution
Year 3: TCF = 60,000 – 24,000 – 3,150 = 32,850
tax = 32,850*.25=8,213
NATCF3 = 60,000 – 35,000 – 3,150 – 8,213 = 13,637
Year 4: TCF = 54,000 – 24,000 = 30,000
tax = 30,000*.25 = 7,500
NATCF4 = 54,000 – 7,500 = 46,500
Year 5: TCF = 50,000 – 24,000 = 26,000
tax = 26,000*.25 = 6,500
NATCF5 = 50,000 – 6,500 = 43,500
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Example 2 - Solution
Also:
gain = sale value – book value = 50,000 – 30,000 = 20,000
tax = 20,000*.25 = 5,000
NATTV5 = 50,000 – 5,000 = 45,000
Calculate NPV:
time
0
1
2
3
4
5
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NATCF
-45,000
1,412
8,275
13,637
46,500
43,500+45,000
Discount Factor
SPPV(15%,
SPPV(15%,
SPPV(15%,
SPPV(15%,
SPPV(15%,
1)
2)
3)
4)
5)
PV
1
-45,000
0.8696
1,228
0.7561
6,257
0.6575
8,967
0.5718
26,589
0.4972
44,002
NPV= 42,039 >0
Example 3 - Question
Purchases a small office building for 500,000
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a.
20% down, finance balance on a 15 year note requiring equally annual payments
including principal and interest. Using 8% interest on the remaining balance.
b.
Assume a 20 year economic life (n=20).
c.
Depreciate over 15 years using straight line depreciation and assuming a zero
salvage value.
d.
Actual terminal sales value will be based on the original value of the property
increasing at a rate of 5 percent per year.
e.
Net before tax cash flows from renting the building out:
f.
Year 1 75,000
Year 3 82,688
Year 2 78,750
Year 4 86,822
g.
Tax rate 28%, and capital gain tax rate 20%.
h.
Required rate of return 15%
You need calculate the NATCF for years 1-3 and the NATTV at the end of year 20.
Example 3 - Solution
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Annual depreciation = 500,000/15=33,333
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Loan payments
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Down payment 500,000*.2=100,000
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Loan 500,000 – 100,000 = 400,000
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Annual Payment (Principal + interest)
= 400,000 / USPV8%,15
= 400,000/8.5595 = 46,732
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Example 3 - Solution
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Amortization
year
Beginning
rate
interest
payment
principal
Balance
balance
1
400,000
0.08
32,000
46,732
14,732
385,268
2
385,268
0.08
30.821
46,732
15,911
369,357
3
369,357
0.08
29,549
46,732
17,183
352,174
4
352,174
0.08
28,174
46,732
18,558
333,616
……
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ending
Example 3 - Solution
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Year 1: TCF = 75,000 – 33,333 – 32,000 = 9,667
tax = 9,667*.28 = 2,707
NATCF = 75,000 – 14,732 – 32,000 – 2,707= 25,561
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Year 2: TCF = 78,750 – 33,333 – 30,821 = 9,667
tax = 14,596*.28 = 4,087
NATCF = 78,750 – 30,821 – 15,911 – 4,087= 27,931
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Year 3: TCF = 82,688 – 33,333 – 29,549 = 19,806
tax = 19,806*.28 = 5,546
NATCF = 82,688 – 29,549 – 17,183 – 5,546= 33,002
……..
Example 3 - Solution
Now we calculate NATTV in the end of year 20.
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Sales price = 500,000*SPFV5%,20 = 500,000*2.6533
= 1,326,650
Book value = 0
Gain = 1,326,650 – 0 = 1,326,650
Tax = 1,326,650*0.2 = 265,330
NATTV20= 1,326,650 - 265,330 = 1,061,320
Amortization
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Definition: The gradual elimination of a debt in regular
payments over a specified period of time. Such payments
must be sufficient to cover both principal and interest.
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Steps to amortize a loan:
1. Calculate the payment per period.
2. Determine the interest in Period t
(beginning balance * interest rate)
3. Compute principal payment in Period t.
(Payment - interest from Step 2)
4. Determine ending balance in Period t.
(Beginning Balance – Principal from Step 3)
5. Start again at Step 2 and repeat.
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Usefulness of Amortization
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Determine Interest Expense - Interest
expenses may reduce taxable income of the
firm.
Calculate Debt Outstanding - The quantity of
outstanding debt may be used in financing
the day-to-day activities of the firm.
Any More Questions?
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