Transcript Investment Analysis: What Investments Should I Make?
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
P r e s e n t
Present and Future Values
Compounding F u t u r e Discounting
What is Discounting?
7%
Year 1 $50,000 2 3 4 $50,000 5 $43,670
0.9346
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. 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
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 State Total [A + B]
Cost of Borrowed Funds
Cost of debt capital After-tax cost of debt capital [D x (1 - C)]
After Tax Cost of Equity Capital
Rate of return on investment opportunities After-tax cost of equity [F x (1 - C)]
Weighted Cost of Capital
Percent of assets financed with debt * Percent of assets financed with equity [1 - H] After-tax cost of capital [(E x H) + (G x I)] A B C 30% 5% 35% D E 8.1% 5.3% F G 15.1% 9.8% H I J 40% 60% 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 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 $23,68 0 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 $20,30 1
Calculate Cash Income Revenue Expenses Net Cash Income $42,032 - 20,301 $21,731
Calculate Taxes Cash Revenue Cash Expenses Depreciation Net Income $42,032 - 20,301 - 5,760 $15,971 Net Income x tax rate = taxes $15,971 x .35 = $5,590
Calculate Net Cash Flow: year one Cash Revenue Cash Expenses Taxes Net Cash Flow $42,032 - 20,301 - 5,590 $16,141
Step 3. Calculate the Annual Net Cash Flows
Year
1 2 3 4 5
Cash Revenue
$42,032 42,360 42,122 41,887 41,654
Cash Expenses
$20,301 20,910 21,242 21,583 21,932
Terminal Value
- - - - $30,000
Taxes
$5,590 3,777 4,139 4,413 15,054
Net Cash Flow
$16,141 17,673 16,741 15,891 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
Period 1 2 3 4 5 Discount Factors (present value of $1) 7% .9346
.8734
.8163
.7629
.7130
Interest Rate 7.5% .9302
.8653
.8050
.7488
.6966
8.0% .9259
.8573
.7938
.7350
.6806
8.5% .9217
.8495
.7829
.7216
.6650
What’s the Present Value of Net Cash Flows?
8%
Year $16,141 1 $17,673 $16,741 2 3 $15,891 4 $34,669 5 $14,945 $15,151 $13,289 $11,680
0.9259
$23,592
$78,658 = Present Value of Net Cash Flows 0.8573
0.7938
0.7350
0.6806
2 3 4 5
Year
1 Step 4. Annual Net Cash Flows
Annual Net Cash Flow
$16,141
Discount Factor @ 8%
.9259
Present Value of Annual Net Cash Flow
$14,945 17,673 16,741 15,891 34,669 .8573
.7938
.7350
.6805
Present value of the net cash flows 15,151 13,289 11,680 23,592 $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. 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
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
1 2 3 4 5
Cash Revenue
$42,032 42,360 42,122 41,887 41,654
Cash Expenses
$20,301 20,910 21,242 21,583 21,932
Terminal Value
- - - - $30,000
Taxes
$5,590 3,777 4,139 4,413 15,054
Net Cash Flow
$16,141 17,673 16,741 15,891 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
Year 1 2 3 4 5 Step 3. Calculate tax savings from interest deductibility Loan Balance $76,800 63,787 49,694 34,431 17,902 Interest @ 8.3% $6,374 5,294 4,125 2,858 1,486 Income Tax Savings (interest x tax rate) $2,231 1,853 1,444 1,000 520
2 3 4 5 Step 4. Calculate after tax payment schedule After tax Year Payment Tax Savings payment 1 $19,387 $2,231 $17,156 19,387 19,387 19,387 19,387 1,853 1,444 1,000 520 17,534 17,944 18,387 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 3 4 5 1 2
Year Annual Net Cash Flow
$16,141 17,673 16,741 15,891 34,669
Payment Schedule Principal Payment Schedule Interest
$13,013 14,093 15,263 16,530 17,902 $6,374 5,294 4,125 2,858 1,486
Payment Schedule Total
$19,387 19,387 19,387 19,387 19,387
Tax Savings from Interest Deductibility
$2,231 1,853 1,444 1,000 520
After-Tax Payment Schedule Surplus (+) or Deficit (-)
$17,156 17,534 17,944 18,387 18,867
- 1,015 + 139 - 1,203 - 2,496 + 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