strategic business planning for commercial producers investment analysis: what investments should i...

Strategic Business Planning for Commercial Producers

Investment Analysis: What Investments Should I Make?


Objectives

• What are the important issues/considerations in making investment decisions?

• What is capital budgeting?• How do we analyze a project?


Investment Issues/Concepts

• Growth Strategies• Capital Budgeting

– Economic Profitability– Financial Feasibility

• Risk• Portfolio Considerations• Tax Considerations


Capital Budgeting Decisions

• Managers are responsible for identifying investments that create value

• Impact cash flows over multiple periods

• Factors to consider:– Strategic Direction– Estimation of future benefits– Uncertainty of future benefits


Capital Budgeting

• Two Questions:– Economic profitability – Does it earn a

profit above all costs?– Financial feasibility – Will it cash flow?


Economic Profitability


Time Value of Money

• Money has a time value– “The sooner, the better.”

• Money preferred to inventory– Can be invested

• Benefit of investments are in the future– Adjust for cost of waiting


$100 Today or $100 Tomorrow

• Why $100 today– Opportunity costs/earnings foregone

• Adjust for cost of waiting– Discount /penalize future income


Present and Future Values

Discounting

Compounding Future

Present


What is Discounting?

$43,670

$35,650

$79,320 = Present Value of Net Cash Flows

1 2 3 4 5

0.7629

0.7130

0.93460.8734

0.8163

Year

7% $50,000

$50,000


What is NPV?

• Converts money flows in the future into a single current value

• Used to evaluate alternative investments and the effects of the timing of cash flows and opportunity costs on the decisions


• Rationale for NPV approach is related to the “value of the firm”

• If take on a project with NPV<0, value of the firm falls – owners are worse off.

• However, if we accept a project with NPV>0, then the value of the firm increases – owners are better off.

Net Present Value


Steps in Economic Profitability (NPV analysis)

1. Compute discount rate2. Calculate present value of cash outlay3. Calculate annual net cash flows4. Calculate present value of net cash

flows5. Compute net present value6. Accept or reject investment


Specialty Grain and On-Farm Storage

• Purpose: add on farm storage to store specialty grain

• Build from scratch• Investment outlay $76,800• 5 year life with $30,000 salvage value• Will store 60,000 bushels IP corn• Finance with 40% debt, 60% equity• 35% tax bracket• Target ROE is 15.1% (9.8% after tax)• Borrow funds at 8.3% (5.3% after tax)


Step 1. Compute the Discount Rate• Discount rate is the price at which a

dollar of cash flow is exchanged between periods– Exchange price between present and

future dollars

• Essential element in any present value analysis


Step 1: Compute the Discount Rate

• Penalty of delay in receiving cash is the cost of financing

• So the discount rate is the cost of capital


Step 1. Calculating Cost of Capital (discount rate)

Marginal Income Tax Rate

Federal A 30%

State B 5%

Total [A + B] C 35%

Cost of Borrowed Funds

Cost of debt capital D 8.1%

After-tax cost of debt capital [D x (1 - C)] E 5.3%

After Tax Cost of Equity Capital

Rate of return on investment opportunities F 15.1%

After-tax cost of equity [F x (1 - C)] G 9.8%

Weighted Cost of Capital

Percent of assets financed with debt * H 40%

Percent of assets financed with equity [1 - H] I 60%

After-tax cost of capital [(E x H) + (G x I)] J 8.0%


Step 2. Calculate the NPV of cash outlay

• Purchase price is $76,800• No additional working capital needed

and sale is completed immediately• Present value of outlay = $76,800


Step 3. Calculate the Annual Net Cash FlowsCalculate for each

year . . .

cash revenue less cash expenses less taxes plus terminal value = Net Cash Flows

Cash flows:exclude depreciationIgnore unpaid labor and management


Two Sources of Income

• Specialty grain revenue • Storage revenue


Calculate Cash Revenue

Revenue of IP crop over #2 yellow

$23,680

Revenue from Storage 18,352

Net Cash Revenue $42,032


Calculate Cash Expenses

Expenses of IP crop over #2 yellow

$12,960

Expenses of Storage 7,341

Net Cash Expenses $20,301


Calculate Cash Income

Revenue $42,032

Expenses - 20,301

Net Cash Income $21,731


Calculate Taxes

Cash Revenue $42,032

Cash Expenses - 20,301

Depreciation - 5,760

Net Income $15,971

Net Income x tax rate = taxes

$15,971 x .35 = $5,590


Calculate Net Cash Flow: year one

Cash Revenue $42,032

Cash Expenses - 20,301

Taxes - 5,590

Net Cash Flow $16,141


Step 3. Calculate the Annual Net Cash Flows

YearCash

Revenue

Cash Expense

s

Terminal Value

TaxesNet

Cash Flow

1 $42,032 $20,301 -- $5,590 $16,141

2 42,360 20,910 -- 3,777 17,673

3 42,122 21,242 -- 4,139 16,741

4 41,887 21,583 -- 4,413 15,891

5 41,654 21,932 $30,000 15,054 34,669


Step 4. Calculate the present value of the net cash flows• This is the sum of the discounted

annual net cash flows (net cash flow times discount factor) for each year


Discount Factors (present value of $1)

Interest Rate

Period 7% 7.5% 8.0% 8.5%

1 .9346 .9302 .9259 .9217

2 .8734 .8653 .8573 .8495

3 .8163 .8050 .7938 .7829

4 .7629 .7488 .7350 .7216

5 .7130 .6966 .6806 .6650


What’s the Present Value of Net Cash Flows?

$14,945

$15,151

$13,289

$11,680

$23,592

$78,658 = Present Value of Net Cash Flows

1 2 3 4 5

0.7350

0.6806

0.92590.8573

0.7938

Year8%

$16,141

$17,673

$16,741

$15,891

$34,669


Step 4. Annual Net Cash FlowsYear

Annual Net Cash Flow

Discount Factor @

8%

Present Value of Annual Net

Cash Flow

1 $16,141 .9259 $14,945

2 17,673 .8573 15,151

3 16,741 .7938 13,289

4 15,891 .7350 11,680

5 34,669 .6805 23,592

Present value of the net cash flows

$78,658


Step 5. Compute the NPV

NPV = Present value of the net cash flows minus the present value of the cash outlay

$78,658 - $76,800 = $1,858


Step 6. Accept or Reject

NPV > 0 AcceptNPV < 0 Reject


Interpretation of NPV

1. If NPV is positive Invest Rate or return greater than minimum

acceptable rate (hurdle rate) Return exceeds cost of financing

2. Maximum Bid price Outlay plus/minus NPV


Feasibility Analysis


Feasibility Analysis

Will the project cash flow?


Steps in Financial Feasibility Analysis

1. Calculate annual net cash flow2. Calculate loan repayment schedule3. Calculate tax savings from interest

deductibility4. Calculate after tax payment

schedule5. Calculate surplus or deficit each

year


Step 1. Calculate the Annual Net Cash Flow

• Already calculated as part of economic feasibility when doing NPV


Step 1. Calculate the Annual Net Cash Flows

YearCash

Revenue

Cash Expense

s

Terminal Value

TaxesNet

Cash Flow

1 $42,032 $20,301 -- $5,590 $16,141

2 42,360 20,910 -- 3,777 17,673

3 42,122 21,242 -- 4,139 16,741

4 41,887 21,583 -- 4,413 15,891

5 41,654 21,932 $30,000 15,054 34,669


Step 2. Calculate loan repayment schedule

• Calculate annual principal and interest payments based on loan repayment schedule


Step 3. Calculate tax savings from interest deductibility• Net cash flows are after-tax, but the

payment schedule is pre-tax• Payment schedule must be adjusted

to after-tax by calculating tax savings from deductibility of interest


YearLoan

BalanceInterest @ 8.3%

Income Tax Savings (interest

x tax rate)

1 $76,800 $6,374 $2,231

2 63,787 5,294 1,853

3 49,694 4,125 1,444

4 34,431 2,858 1,000

5 17,902 1,486 520

Step 3. Calculate tax savings from interest deductibility


Step 4. Calculate after tax payment scheduleYear Payment

Tax Savings

After tax payment

1 $19,387 $2,231 $17,156

2 19,387 1,853 17,534

3 19,387 1,444 17,944

4 19,387 1,000 18,387

5 19,387 520 18,867


Step 5. Calculate surplus/deficit each year

• Compare annual net cash flow to after-tax annual principal and interest payments to find a surplus or deficit

• A surplus means the project is financially feasible

• A deficit means loan servicing problems are likely


The Financial Feasibility: On-Farm Storage for Specialty Crops

Year

Annual Net Cash Flow

Payment

Schedule

Principal

Payment

Schedule-

Interest

Payment

Schedule-Total

Tax Savings from

Interest Deductibilit

y

After-Tax

Payment Schedul

e

Surplus (+) or

Deficit (-)

1 $16,141

$13,013 $6,374 $19,387 $2,231 $17,156 - 1,015

2 17,673 14,093 5,294 19,387 1,853 17,534 + 139

3 16,741 15,263 4,125 19,387 1,444 17,944 - 1,203

4 15,891 16,530 2,858 19,387 1,000 18,387 - 2,496

5 34,669 17,902 1,486 19,387 520 18,867 + 15,802


Dealing with Deficits• Extend the loan terms• Increase the amount of the down

payment• Increase cash flow of the project by

controlling costs• Subsidize with cash from another

project (the feasibility test will indicate the amount of the subsidy)

• Lease/outsourcing

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