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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.

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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

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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%

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example 2 solution
Example 2 - Solution
  • Annual Depreciation=
  • Straight line depreciation;

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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

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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:

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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.

19

any more questions
Any More Questions?
  • Please fill the evaluation form and leave on the table.
  • Thanks for your attendance!

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