Farm Management

Chapter 17
Investment Analysis
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Investment Analysis
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Time Value of Money
1. The dollar could be invested to earn interest
2. If dollar is spent on consumption, wed
prefer to get the enjoyment now
3. Risk is also a factor as unforeseen
circumstances could prevent us from
getting the dollar
4. Inflation may diminish the value of the
dollar over time
A dollar today is preferred to a dollar in the
future:
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Present Value and Future Value
Present Value (PV): the number of dollars
available or invested at the current time or
the current value of some amount to be
received in the future
Future Value (FV): the amount to be
received at some future time or the
amount a present value will be worth at
some future date when invested at a given
interest rate

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More Terms
Payment (PMT): number of dollars to be paid
or received in a time period
Interest Rate ( i ): also called the discount
rate the interest rate used to find present
and future values, often equal to opportunity
cost of capital
Time Periods ( n ): the number of time
periods used to compute present and future
values
Annuity: a term used to describe a series of
periodic payments
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Table 17-1
Future Value of $1,000
Value at
beginning of interest rate Interest earned Value at end
Year year (%) ($) of year ($)
1 1000.00 8 80.00 1080.00
2 1080.00 8 86.40 1166.40
3 1166.40 8 93.30 1259.70
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Figure 17-1
Illustration of the concept of future value
for a present value and for an annuity
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Figure 17-2
Relation between compounding
and discounting
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Computing Future Value
FV = PV ( 1 + i )
n

FV = $1,000 ( 1 + 0.08 )
3
= $1,259.70

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Future Value of an Annuity


FV = PMT
( 1 + i )
n
1

i
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Present Value
PV =
FV
(1 + i )
n
or FV
1
(1 + i )
n
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Present Value of an Annuity


PV = PMT
1 ( 1 + i )
-n


i
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Figure 17-3
Illustration of the concept of present value
for a future value and for an annuity
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Table 17-2
Value of an Annuity
Year Amount ($) Present Value Factor Present Value ($)
1 1,000.00 0.92593 925.93
2 1,000.00 0.85734 857.34
3 1,000.00 0.79383 793.83
Total 2,577.10
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Investment Analysis
Investment analysis, also called capital
budgeting, involves determining profitability
of an investment
Initial cost: actual total expenditure for the
investment
Net cash revenues: cash receipts minus
cash expenses
Terminal value: usually the same as salvage
value
Discount rate: opportunity cost of capital
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Payback Period
The payback period is the number of
years it would take an investment to
return its original cost. If net cash
revenues are constant each year, the
payback period (P) is:

P =
C
E
where C is original cost
and E is the expected
annual net cash revenue
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Table 17-3
Revenues for Two $10,000 Investments
Year Investment A Investment B
1 3,000 1,000
2 3,000 2,000
3 3,000 3,000
4 3,000 4,000
5 3,000 6,000
Total cash revenues 15,000 16,000
Less initial investment -10,000 -10,000
Net Cash Revenues 5,000 6,000
Average net revenue/yr 1,000 1,200
Net revenues ($)
no terminal value
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Finding Payback Period
The payback period for investment A
is 3.33 years ($10,000 3)

The payback for investment B is
4 years, which is found by summing
the revenues until they reach $10,000.
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Limitations of the Payback Period
The payback period is easy to calculate
and identifies the investments with the most
immediate cash returns. But it ignores
returns after the end of the payback period
as well as the timing of cash flows.
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Simple Rate of Return
Rate of return =


Investment A =


Investment B =
average annual net revenue
initial cost
$1,000
$10,000
x 100% = 10%
$1,200


$10,000
x 100% = 12%
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Net Present Value
Net Present Value (NPV) is the sum
of the present values of each years
net cash flow minus the initial investment.
NPV = + + +
C
P
1
P
2
P
n
(1 + i )
1
(1 + i )
2
(1 + i )
n

. .
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Table 17-4
Net Present Value
Net cash Present Present Net cash Present Present
Year flow ($) value factor value ($) flow ($) value factor value ($)
1 3,000 0.9090 2,727 1,000 0.9090 909
2 3,000 0.8260 2,478 2,000 0.8260 1,652
3 3,000 0.7510 2,253 3,000 0.7510 2,253
4 3,000 0.6830 2,049 4,000 0.6830 2,732
5 3,000 0.6210 1,863 6,000 0.6210 3,726
11,370 11,272
10,000 10,000
1,370 1,272
15.2% 13.8%
Investment B
Total
Investment A
Total
Less initial cost
Net present value Net present value
Internal rate of return Internal rate of return
Less initial cost
10% discount rate and no terminal values
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Internal Rate of Return
The internal rate of return (IRR) is the
discount rate that would make the NPV
of an investment equal to zero.

The IRR is usually calculated by
computer or with a financial calculator.
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Annual Equivalent
The annual equivalent is an annuity that
has the same present value as the
investment being analyzed.
Investment A: $1,370 0.2638 = $361.41
Investment B: $1,272 0.2638 = $335.55

The amortization factor for 10% and 5 years
is 0.2638 (Appendix Table 1)
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Financial Feasibility
The methods presented so far analyze
economic profitability
Investors also need to look at financial
feasibility
Will the investment generate sufficient
cash flow at the right times to meet
required cash outflows?

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Table 17-5
Cash Flow Analysis
Net cash Debt Net cash Net cash Debt Net cash
Year revenue payment flow revenue payment flow
1 3,000 2,800 200 1,000 2,800 -1,800
2 3,000 2,640 360 2,000 2,640 -640
3 3,000 2,480 520 3,000 2,480 520
4 3,000 2,320 680 4,000 2,320 1,680
5 3,000 2,160 840 6,000 2,160 3,840
Investment B Investment A
$10,000 loan at 8% interest
with equal principal payments
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Income Taxes, Inflation, and Risk
Different investments may have different
effects on income taxes so they should be
compared on an after-tax basis
If net cash revenues and terminal values
are adjusted for expected inflation, the
discount rate should also be adjusted
Investments with higher risk should be
assigned a higher discount factor
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Sensitivity Analysis
Sensitivity analysis is a process of
asking several what if questions. What
if net cash revenues are higher or lower?
What if the timing is different? What if
the discount rate were higher or lower?
Change one or more values and
recalculate NPV and IRR.
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Summary
The future value of a sum of money is
greater than its present value because
of the interest that could be earned.
Investments can be analyzed using:
payback period, simple rate of return,
net present value, and internal rate of
return.
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2. Explain the difference between
compounding and discounting.
Compounding finds the future value of a
present value using a compound interest
rate.
Discounting finds the present value of
some future value, using a discount rate.
They are inverse relationships.
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. Discuss economic profitability and financial feasibility.
How are they different? Why should both be considered
when analyzing a potential investment?
Economic profitability refers to an investment
having a NPV greater than zero and an IRR
greater than the opportunity cost of capital.
This means the investment will earn a rate of
return at least equal to this opportunity cost so
there will be an economic profit. Cash flow
needed to make principal and interest payments
are not included in these analyses because it is
assumed that the results are independent of
how the investment is financed.
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. Discuss economic profitability and financial feasibility.
How are they different? Why should both be considered
when analyzing a potential investment?
Financial feasibility is concerned with the
periodic net cash flows from the investment and
becomes particularly important when capital
must be borrowed to finance the investment. It
is entirely possible for an investment to be
economically profitable but result in negative net
cash flows for several time periods. This often
occurs when the loan must be paid off in a
relatively short period of time and the investment
produces little initial cash flow but larger flows in
later time periods.
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8. What two approaches can be used to account for the
effects of income taxes in investment analysis?
a) All cash flows can be estimated on a
before-tax basis and a tax-free discount
rate can be used.
b) All cash flows can be adjusted by the
amount by which income taxes would
increase or decrease them and an after-
tax discount rate used (before-tax rate
multiplied by 1 minus the marginal tax
rate).
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9. What two approaches can be used to account for the
effects of inflation in investment analysis?
a) All cash flows can be estimated as real
values (current dollars) and the discount
rate used can be a real rate (subtract the
expected rate of inflation from the nominal
discount rate).
b) All cash flows can be increased over
time by their expected rates of inflation
and a nominal discount rate can be used.
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10. Why would capital budgeting be useful in analyzing an
investment of establishing an orchard where the trees
would not become productive until 6 years after planting?
Many tree and vine crops have several
years of expenses with little or no income
while the planting reaches its productive
age. There is a serious mismatch in the
timing of cash expenses and cash
revenue. The only way to analyze an
investment of this type is to use capital
budgeting so the timing of all cash flows is
taken into account using an appropriate
discount rate or opportunity cost of capital.
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11. What advantages would present value
techniques have over partial budgeting for
analyzing the orchard investment in question 10?
A partial budget would compare the orchard investment
with some other alternative using changes in average
annual expenses and revenues. It would be difficult to
estimate average annual expenses and revenues for the
orchard because they are different for every year. To do
it correctly, adjustments must be made for differences in
the timing of revenue and expenses. In most cases it
will be easier and less time consuming to use present
value techniques on a problem of this type. However,
the concept of added and reduced cash flows can also
be used with capital budgeting techniques.