Farm Management Chapter 17 Investment Analysis
Chapter Outline • Time Value of Money • Investment Analysis • Financial Feasibility • Income Taxes, Inflation, and Risk
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
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
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
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
Figure 17-1Illustration of the concept of future value for a present value and for an annuity
Computing Future Value FV = PV ( 1 + i )n FV = $1,000 ( 1 + 0.08 ) 3 = $1,259.70
Future Value of an Annuity FV = PMT ( 1 + i ) n 1 i
Present Value FV 1 or FV PV = (1 + i )n (1 + i ) n
Present Value of an Annuity PV = PMT 1 ( 1 + i ) -n i
Figure 17-3Illustration of the concept of present value for a future value and for an annuity
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
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
Table 17-3 Revenues for Two $10,000 Investments no terminal value
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.
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.
Simple Rate of Return 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
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. P1 P2 Pn NPV = + + + C (1 + i )1 (1 + i )2 (1 + i )n . .
Table 17-4 Net Present Value 10% discount rate and no terminal values
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.
Annual Equivalent The annual equivalent is an annuity that has the same present value as the investment being analyzed. Investment A: $1,370 0.2638 = $361.41 Investment B: $1,272 0.2638 = $335.55 The amortization factor for 10% and 5 years is 0.2638 (Appendix Table 1)
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?
Table 17-5 Cash Flow Analysis $10,000 loan at 8% interest with equal principal payments
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
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.
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.