Capital budgeting and investment analysis
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Capital Budgeting and Investment Analysis. Guest Lecturer: Juan (Jillian) Yang. Introduction of Myself. Research Areas: Agricultural Finance Agribusiness and Marketing Monetary and Macroeconomics Applied Econometric Analysis Teaching Experiences: Financial Management

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Capital budgeting and investment analysis

Capital Budgeting and Investment Analysis

Guest Lecturer:

Juan (Jillian) Yang


Introduction of myself
Introduction of Myself

  • Research Areas:

    • Agricultural Finance

    • Agribusiness and Marketing

    • Monetary and Macroeconomics

    • Applied Econometric Analysis

  • Teaching Experiences:

    • Financial Management

    • Econometric Analysis for Agribusiness Management

    • Agribusiness Marketing

1


Topic today
Topic Today

  • Capital budgeting

  • NPV approach.

  • Examples.

  • Amortization.


Review
Review

  • Definition of capital budgeting: analyzing the net after tax cash flows (inflows + outflows) associate with an investment accounting for the time value of money.

  • Why Capital Budgeting is Important?

    • 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.

3


Review1
Review

  • Method

    • Net Present Value (NPV)

    • Internal Rate of Return (IRR) – Yield

  • Decision Criterion and Rules

    • Investment acceptable if NPV > 0

    • Investment earnings greater than required rate of return


Review net present value method
Review – Net Present Value Method

  • Net after tax cash flows (NATCF)

    • Additional cash inflows due to the investment less any additional cash outflows,

      together with their timing (NBTCF).

      b. NBTCF – Depreciation = taxable cash flows (TCF)

      c. TCF * tax rate (t) = tax

      d. NBTCF – tax = NATCF

  • Economic life = planning horizon

  • Original cash outlay

    4. Net after tax terminal value (NATTV)

    • Market value – book value = gain

    • Gain * tax rate = tax

    • Market value – tax = NATTV

      5. Discount rate = required rate of return


Example 2 question
Example 2 – Question

  • 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

6


Example 2 question1
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%

7


Example 2 solution
Example 2 - Solution

  • Annual Depreciation=

  • Straight line depreciation;

8


Example 2 solution1
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

At the time of sale: Book value =30,000

9


Example 2 solution2
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 solution3
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 solution4
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:

12


Example 3 question
Example 3 - Question

Purchases a small office building for 500,000

  • 20% down, finance balance on a 15 year note requiring equally annual payments including principal and interest. Using 8% interest on the remaining balance.

  • Assume a 20 year economic life (n=20).

  • Depreciate over 15 years using straight line depreciation and assuming a zero salvage value.

  • Actual terminal sales value will be based on the original value of the property increasing at a rate of 5 percent per year.

  • Net before tax cash flows from renting the building out:

  • Year 1 75,000 Year 3 82,688

    Year 2 78,750 Year 4 86,822

  • Tax rate 28%, and capital gain tax rate 20%.

  • Required rate of return 15%

    You need calculate the NATCF for years 1-3 and the NATTV at the end of year 20.

13


Example 3 solution
Example 3 - Solution

  • Annual depreciation = 500,000/15=33,333

  • Loan payments

    • Down payment 500,000*.2=100,000

    • Loan 500,000 – 100,000 = 400,000

    • Annual Payment (Principal + interest)

      = 400,000 / USPV8%,15

      = 400,000/8.5595 = 46,732

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Example 3 solution1
Example 3 - Solution

  • Amortization

15


Example 3 solution2
Example 3 - Solution

  • 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

  • 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

  • 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

    ……..

16


Example 3 solution3
Example 3 - Solution

Now we calculate NATTV in the end of year 20.

  • 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

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Amortization
Amortization

  • 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.

  • Steps to amortize a loan:

    1. Calculate the payment per period.

    2. Determine the interest in Period t

    (beginning balance * interest rate)

    3. Computeprincipal paymentin 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
Usefulness of Amortization

  • 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.

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Any more questions
Any More Questions?

  • Please fill the evaluation form and leave on the table.

  • Thanks for your attendance!

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