© Mcgraw-Hill Companies, 2008 Farm Management Chapter 17 Investment Analysis

© Mcgraw-Hill Companies, 2008 Chapter Outline Time Value of Money Investment Analysis Financial Feasibility Income Taxes, Inflation, and Risk

© Mcgraw-Hill Companies, 2008 Chapter Objectives 1.Explain the time value of money and its use 2.Illustrate the process of compounding 3.Demonstrate the process of discounting 4.Discuss the payback period, simple rate of return, net present value and internal rate of return 5.Show how to apply these concepts 6.Explain how income taxes, inflation, and risk affect investment analysis

© Mcgraw-Hill Companies, 2008 Time Value of Money 1.The dollar could be invested to earn interest 2.If dollar is spent on consumption, we’d 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:

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 Table 17-1 Future Value of $1,000

© Mcgraw-Hill Companies, 2008 Figure 17-1 Illustration of the concept of future value for a present value and for an annuity

© Mcgraw-Hill Companies, 2008 Figure 17-2 Relation between compounding and discounting

© Mcgraw-Hill Companies, 2008 Computing Future Value FV = PV ( 1 + i ) n FV = $1,000 ( ) 3 = $1,259.70

© Mcgraw-Hill Companies, 2008 Future Value of an Annuity FV = PMT  ( 1 + i ) n  1 i

© Mcgraw-Hill Companies, 2008 Present Value PV = FV (1 + i ) n or FV  1 (1 + i ) n

© Mcgraw-Hill Companies, 2008 Present Value of an Annuity PV = PMT  1  ( 1 + i ) -n i

© Mcgraw-Hill Companies, 2008 Figure 17-3 Illustration of the concept of present value for a future value and for an annuity

© Mcgraw-Hill Companies, 2008 Table 17-2 Value of an Annuity

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 Table 17-3 Net Cash Revenues for Two $10,000 Investments no terminal value

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 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%

© Mcgraw-Hill Companies, 2008 Net Present Value Net Present Value (NPV) is the sum of the present values of each year’s net cash flow minus the initial investment. NPV =  C P 1 P 2 P n (1 + i ) 1 (1 + i ) 2 (1 + i ) n.

© Mcgraw-Hill Companies, 2008 Table 17-4 Net Present Value and Internal Rate of Return for Two Investments of $10,000 10% discount rate and no terminal values

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 Annual Equivalent and Capital Recovery The annual equivalent is an annuity that has the same present value as the investment being analyzed. Investment A: $1,370  = $ Investment B: $1,272  = $ The amortization factor for 10% and 5 years is (Appendix Table 1)

© Mcgraw-Hill Companies, 2008 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?

© Mcgraw-Hill Companies, 2008 Table 17-5 Cash Flow Analysis $10,000 loan at 8% interest with equal principal payments

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 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.