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Investment Analysis: What Investments Should I Make?

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Discount /penalize future income. Strategic Business Planning for Commercial Producers ... So the discount rate is the cost of capital ... – PowerPoint PPT presentation

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Title: Investment Analysis: What Investments Should I Make?


1
Investment Analysis What Investments Should I
Make?
2
Objectives
  • What are the important issues/considerations in
    making investment decisions?
  • What is capital budgeting?
  • How do we analyze a project?

3
Investment Issues/Concepts
  • Growth Strategies
  • Capital Budgeting
  • Economic Profitability
  • Financial Feasibility
  • Risk
  • Portfolio Considerations
  • Tax Considerations

4
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

5
Capital Budgeting
  • Two Questions
  • Economic profitability Does it earn a profit
    above all costs?
  • Financial feasibility Will it cash flow?

6
Economic Profitability
7
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

8
100 Today or 100 Tomorrow
  • Why 100 today
  • Opportunity costs/earnings foregone
  • Adjust for cost of waiting
  • Discount /penalize future income

9
Present and Future Values
Present
Future
Compounding
Discounting
10
What is Discounting?
11
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

12
Net Present Value
  • Rationale for NPV approach is related to the
    value of the firm
  • If take on a project with NPVlt0, value of the
    firm falls owners are worse off.
  • However, if we accept a project with NPVgt0, then
    the value of the firm increases owners are
    better off.

13
Steps in Economic Profitability (NPV analysis)
  1. Compute discount rate
  2. Calculate present value of cash outlay
  3. Calculate annual net cash flows
  4. Calculate present value of net cash flows
  5. Compute net present value
  6. Accept or reject investment

14
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)

15
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

16
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

17
Step 1. Calculating Cost of Capital (discount
rate)
18
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

19
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

20
Two Sources of Income
  • Specialty grain revenue
  • Storage revenue

21
Calculate Cash Revenue
Revenue of IP crop over 2 yellow 23,680
Revenue from Storage 18,352

Net Cash Revenue 42,032



22
Calculate Cash Expenses

Expenses of IP crop over 2 yellow 12,960 12,960
Expenses of Storage 7,341 7,341
Net Cash Expenses 20,301




23
Calculate Cash Income
Revenue 42,032
Expenses - 20,301

Net Cash Income 21,731



24
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
25
Calculate Net Cash Flow year one
Cash Revenue 42,032
Cash Expenses - 20,301
Taxes - 5,590
Net Cash Flow 16,141
26
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
27
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

28
Discount Factors (present value of 1)
Interest Rate Interest Rate Interest Rate
Period 7 7.5 8.0 8.5
1 .9346 .9302 .9259 .9217
2 .8734 .8653 .8573 .8495
3 .8163 .8050 .7938 .7829
4 .7629 .7488 .7350 .7216
5 .7130 .6966 .6806 .6650
29
Whats the Present Value of Net Cash Flows?
30
Step 4. Annual Net Cash Flows
Year Annual Net Cash Flow Discount Factor _at_ 8 Present Value of Annual Net Cash Flow
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 Present value of the net cash flows 78,658
31
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

32
Step 6. Accept or Reject
  • NPV gt 0 Accept
  • NPV lt 0 Reject

33
Interpretation of NPV
  • If NPV is positive
  • Invest
  • Rate or return greater than minimum acceptable
    rate (hurdle rate)
  • Return exceeds cost of financing
  • Maximum Bid price
  • Outlay plus/minus NPV

34
Feasibility Analysis
35
Feasibility Analysis
  • Will the project cash flow?

36
Steps in Financial Feasibility Analysis
  1. Calculate annual net cash flow
  2. Calculate loan repayment schedule
  3. Calculate tax savings from interest deductibility
  4. Calculate after tax payment schedule
  5. Calculate surplus or deficit each year

37
Step 1. Calculate the Annual Net Cash Flow
  • Already calculated as part of economic
    feasibility when doing NPV

38
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
39
Step 2. Calculate loan repayment schedule
  • Calculate annual principal and interest payments
    based on loan repayment schedule

40
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

41
Step 3. Calculate tax savings from interest
deductibility
Year Loan Balance Interest _at_ 8.3 Income Tax Savings (interest x tax rate)
1 76,800 6,374 2,231
2 63,787 5,294 1,853
3 49,694 4,125 1,444
4 34,431 2,858 1,000
5 17,902 1,486 520
42
Step 4. Calculate after tax payment schedule
Year Payment Tax Savings After tax payment
1 19,387 2,231 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
43
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

44
The Financial Feasibility On-Farm Storage for
Specialty Crops
Year Annual Net Cash Flow Payment Schedule Principal Payment Schedule-Interest Payment Schedule-Total 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
45
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

46
Strategic Business Planning for Commercial
Producers
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