1. Chapter 17 Investment Analysis
Farm Management
Chapter 17
Investment Analysis

2. Chapter Outline Time Value of Money Investment Analysis
Financial Feasibility
Income Taxes, Inflation, and Risk
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3. Chapter Objectives To explain the time value of money and its use
To illustrate the process of compounding
To demonstrate the process of discounting
To discuss the payback period, simple rate of return, net present value and internal rate of return
To show how to apply these concepts
To introduce how income taxes, inflation, and risk affect investment analysis
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4. Time Value of Money A dollar today is preferred to a dollar in the
future:
The dollar could be invested to earn interest
If dollar is spent on consumption, we’d prefer to get the enjoyment now
Risk is also a factor as unforeseen circumstances could prevent us from getting the dollar
Inflation may diminish the value of the dollar over time
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5. 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
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6. 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
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7. Table 17-1 Future Value of $1,000
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8. Figure 17-1 Illustration of the concept of future value for a present value and for an annuity
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9. Figure 17-2 Relation between compounding and discounting
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10. Computing Future Value
FV = PV ( 1 + i ) n
FV = $1,000 ( ) 3
= $1,259.70
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11. Future Value of an Annuity
FV = PMT 
( 1 + i ) n  1 i
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12. Present Value FV 1 or FV  PV = (1 + i ) n (1 + i ) n
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13. Present Value of an Annuity
PV = PMT 
1  ( 1 + i ) -n i
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14. Figure 17-3 Illustration of the concept of present value for a future value and for an annuity
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15. Table 17-2 Value of an Annuity
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16. 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
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17. 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
where C is original cost
and E is the expected
annual net cash revenue E
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18. Table 17-3 Revenues for Two $10,000 Investments
no terminal value
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19. 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.
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20. 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.
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21. Simple Rate of Return Rate of return = Investment A = $1,000
average annual net revenue
Rate of return =
Investment A =
Investment B =
initial cost
$1,000
x 100% = 10%
$10,000
$1,200
x 100% = 12%
$10,000
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22. 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.
P P2 Pn
NPV =
 C
(1 + i )1 (1 + i ) (1 + i )n
. .
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23. Table 17-4 Net Present Value
10% discount rate and no terminal values
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24. 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.
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25. Annual Equivalent The annual equivalent is an annuity that
has the same present value as the
investment being analyzed.
Investment A: $1,370  = $361.41
Investment B: $1,272  = $335.55
The amortization factor for 10% and 5 years
is (Appendix Table 1)
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26. 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?
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27. Table 17-5 Cash Flow Analysis
$10,000 loan at 8% interest
with equal principal payments
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28. 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
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29. 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.
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30. 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.
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