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

1 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

Topic Today Capital budgeting NPV approach. Examples. Amortization.

3 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.

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

Review – Net Present Value Method 1. Net after tax cash flows (NATCF) a. 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 2. Economic life = planning horizon 3. 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

6 Example 2 – Question 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

7 Example 2 – Question e. Net before tax cash flows from custom work year 150,000 year 2 56,000 year 3 60,000 year 454,000 year 550,000 f. Tax rate t=25% g. Required rate of return 15%

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

9 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

10 Example 2 - Solution Layout cash flows Year 1: TCF = NBTCF-Depreciation-Interest = 50, , ,450 = 16,550 tax = 16,550*0.25=4,138 NATCF 1 = 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 NATCF 2 = 56,000 – 35,000 – 6,300 – 6,425 = 8,725

11 Example 2 - Solution Year 3: TCF = 60,000 – 24,000 – 3,150 = 32,850 tax = 32,850*.25=8,213 NATCF 3 = 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 NATCF 4 = 54,000 – 7,500 = 46,500 Year 5: TCF = 50,000 – 24,000 = 26,000 tax = 26,000*.25 = 6,500 NATCF 5 = 50,000 – 6,500 = 43,500

12 Example 2 - Solution Also: gain = sale value – book value = 50,000 – 30,000 = 20,000 tax = 20,000*.25 = 5,000 NATTV 5 = 50,000 – 5,000 = 45,000 Calculate NPV:

13 Example 3 - Question Purchases a small office building for 500,000 a. 20% down, finance balance on a 15 year note requiring equally annual payments including principal and interest. Using 8% interest on the remaining balance. b. Assume a 20 year economic life (n=20). c. Depreciate over 15 years using straight line depreciation and assuming a zero salvage value. d. Actual terminal sales value will be based on the original value of the property increasing at a rate of 5 percent per year. e. Net before tax cash flows from renting the building out: f. Year 1 75,000 Year 3 82,688 Year 2 78,750 Year 4 86,822 g. Tax rate 28%, and capital gain tax rate 20%. h. Required rate of return 15% You need calculate the NATCF for years 1-3 and the NATTV at the end of year 20.

14 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 / USPV 8%,15 = 400,000/ = 46,732

15 Example 3 - Solution Amortization yearBeginningrateinterestpaymentprincipalending Balance balance 1 400, ,00046,73214,732385, ,73215,911369, ,54946,73217,183352, ,17446,73218,558333,616 ……

16 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 ……..

17 Example 3 - Solution Now we calculate NATTV in the end of year 20. – Sales price = 500,000*SPFV 5%,20 = 500,000* = 1,326,650 – Book value = 0 – Gain = 1,326,650 – 0 = 1,326,650 – Tax = 1,326,650*0.2 = 265,330 – NATTV 20 = 1,326, ,330 = 1,061,320

18 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 ) principal payment 3. Compute principal payment in 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.

19 Usefulness of Amortization Determine Interest Expense - Determine Interest Expense - Interest expenses may reduce taxable income of the firm. Calculate Debt Outstanding Calculate Debt Outstanding - The quantity of outstanding debt may be used in financing the day-to-day activities of the firm.

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