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
Discounting
Compounding Future
Present
What is Discounting?
$43,670
$35,650
$79,320 = Present Value of Net Cash Flows
1 2 3 4 5
0.7629
0.7130
0.93460.8734
0.8163
Year
7% $50,000
$50,000
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. Compute discount rate2. Calculate present value of cash outlay3. Calculate annual net cash flows4. Calculate present value of net cash flows5. Compute net present value6. 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 Borrowed Funds
Cost of debt capital D 8.1%
After-tax cost of debt capital [D x (1 - C)] E 5.3%
After Tax Cost of Equity Capital
Rate of return on investment opportunities F 15.1%
After-tax cost of equity [F x (1 - C)] G 9.8%
Weighted Cost of Capital
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%
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 depreciationIgnore unpaid labor and management
Two Sources of Income
• Specialty grain revenue • Storage revenue
Calculate Cash Revenue
Revenue of IP crop over #2 yellow
$23,680
Revenue from Storage 18,352
Net Cash Revenue $42,032
Calculate Cash Expenses
Expenses of IP crop over #2 yellow
$12,960
Expenses of Storage 7,341
Net Cash Expenses $20,301
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 - 5,590
Net Cash Flow $16,141
Step 3. Calculate the Annual Net Cash Flows
YearCash
Revenue
Cash Expense
s
Terminal Value
TaxesNet
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 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
What’s the Present Value of Net Cash Flows?
$14,945
$15,151
$13,289
$11,680
$23,592
$78,658 = Present Value of Net Cash Flows
1 2 3 4 5
0.7350
0.6806
0.92590.8573
0.7938
Year8%
$16,141
$17,673
$16,741
$15,891
$34,669
Step 4. Annual Net Cash FlowsYear
Annual Net Cash Flow
Discount Factor @
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
$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 AcceptNPV < 0 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. Calculate annual net cash flow2. Calculate loan repayment schedule3. Calculate tax savings from interest deductibility4. Calculate after tax payment schedule5. 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
YearCash
Revenue
Cash Expense
s
Terminal Value
TaxesNet
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
YearLoan
BalanceInterest @ 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
Step 3. Calculate tax savings from interest deductibility
Step 4. Calculate after tax payment schedule
Year PaymentTax
SavingsAfter 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
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
Schedule-
Interest
Payment
Schedule-Total
Tax Savings from
Interest Deductibilit
y
After-Tax
Payment Schedul
e
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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