Investment Analysis: What Investments Should I Make?

2. Investment Analysis: What Investments Should I Make?

3. Objectives • What are the important issues/considerations in making investment decisions? • What is capital budgeting? • How do we analyze a project?

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

5. 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

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

7. Economic Profitability

8. 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

9. $100 Today or $100 Tomorrow • Why $100 today • Opportunity costs/earnings foregone • Adjust for cost of waiting • Discount /penalize future income

10. Present and Future Values Present Future Compounding Discounting

11. 7% $50,000 $50,000 Year 1 2 3 4 5 $43,670 $35,650 $79,320 = Present Value of Net Cash Flows 0.9346 0.8734 0.8163 0.7629 0.7130 What is Discounting?

12. 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

13. 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.

14. Steps in Economic Profitability (NPV analysis) • Compute discount rate • Calculate present value of cash outlay • Calculate annual net cash flows • Calculate present value of net cash flows • Compute net present value • Accept or reject investment

15. 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)

16. 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

17. 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

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

19. 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

20. 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

21. Two Sources of Income • Specialty grain revenue • Storage revenue

22. Calculate Cash Revenue

23. Calculate Cash Expenses

24. Calculate Cash Income

25. Calculate Taxes Net Income x tax rate = taxes $15,971 x .35 = $5,590

26. Calculate Net Cash Flow: year one

27. Step 3. Calculate the Annual Net Cash Flows

28. 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

29. Discount Factors (present value of $1)

30. $16,141 $17,673 $16,741 $15,891 $34,669 8% Year 1 2 3 4 5 $14,945 $15,151 $13,289 $11,680 $23,592 $78,658 = Present Value of Net Cash Flows 0.9259 0.8573 0.7938 0.7350 0.6806 What’s the Present Value of Net Cash Flows?

31. Step 4. Annual Net Cash Flows

32. 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

33. Step 6. Accept or Reject NPV > 0 Accept NPV < 0 Reject

34. 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

35. Feasibility Analysis

36. Feasibility Analysis Will the project cash flow?

37. Steps in Financial Feasibility Analysis • Calculate annual net cash flow • Calculate loan repayment schedule • Calculate tax savings from interest deductibility • Calculate after tax payment schedule • Calculate surplus or deficit each year

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

39. Step 1. Calculate the Annual Net Cash Flows

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

41. 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

42. Step 3. Calculate tax savings from interest deductibility

43. Step 4. Calculate after tax payment schedule

44. 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

45. The Financial Feasibility: On-Farm Storage for Specialty Crops

46. 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

47. Strategic Business Planning for Commercial Producers