Capital Budgeting and Investment Analysis

1. Capital Budgeting and Investment Analysis Guest Lecturer: Juan (Jillian) Yang

2. 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

3. Topic Today • Capital budgeting • NPV approach. • Examples. • Amortization.

4. 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

5. 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

6. 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

7. 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

8. 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

9. Example 2 - Solution • Annual Depreciation= • Straight line depreciation; 8

10. 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

11. 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 10

12. 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 11

13. 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

14. 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

15. 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 14

16. Example 3 - Solution • Amortization 15

17. 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

18. 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 17

19. 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. 18

20. 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

21. Any More Questions? • Please fill the evaluation form and leave on the table. • Thanks for your attendance! 20