Strategic Business Planning for Commercial Producers Investment Analysis: What Investments Should I Make?

Strategic Business Planning for Commercial Producers Objectives What are the important issues/considerations in making investment decisions? What is capital budgeting? How do we analyze a project?

Strategic Business Planning for Commercial Producers Investment Issues/Concepts Growth Strategies Capital Budgeting –Economic Profitability –Financial Feasibility Risk Portfolio Considerations Tax Considerations

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Capital Budgeting Two Questions: –Economic profitability – Does it earn a profit above all costs? –Financial feasibility – Will it cash flow?

Strategic Business Planning for Commercial Producers Economic Profitability

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers $100 Today or $100 Tomorrow Why $100 today –Opportunity costs/earnings foregone Adjust for cost of waiting –Discount /penalize future income

Strategic Business Planning for Commercial Producers Present and Future Values Discounting Compounding FutureFuture PresentPresent

Strategic Business Planning for Commercial Producers What is Discounting? $43,670 $35,650 $79,320 = Present Value of Net Cash Flows Year 7% $50,000

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Steps in Economic Profitability (NPV analysis)  Compute discount rate  Calculate present value of cash outlay  Calculate annual net cash flows  Calculate present value of net cash flows  Compute net present value  Accept or reject investment

Strategic Business Planning for Commercial Producers 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)

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Step 1. Calculating Cost of Capital (discount rate)

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Step 3. Calculate the Annual Net Cash Flows Calculate for each year... cash revenue less cash expenses less taxes plus terminal value = Net Cash Flows Cash flows:  exclude depreciation  Ignore unpaid labor and management

Strategic Business Planning for Commercial Producers Two Sources of Income Specialty grain revenue Storage revenue

Strategic Business Planning for Commercial Producers Calculate Cash Revenue Revenue of IP crop over #2 yellow $23,68 0 Revenue from Storage18,352 Net Cash Revenue$42,032

Strategic Business Planning for Commercial Producers Calculate Cash Expenses Expenses of IP crop over #2 yellow $12,96 0 Expenses of Storage7,341 Net Cash Expenses$20,30 1

Strategic Business Planning for Commercial Producers Calculate Cash Income Revenue$42,032 Expenses - 20,301 Net Cash Income$21,731

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Calculate Net Cash Flow: year one Cash Revenue$42,032 Cash Expenses- 20,301 Taxes- 5,590 Net Cash Flow$16,141

Strategic Business Planning for Commercial Producers Step 3. Calculate the Annual Net Cash Flows Year Cash Revenue Cash Expenses Terminal Value Taxes Net Cash Flow 1$42,032$20,301--$5,590$16, ,36020,910--3,77717, ,12221,242--4,13916, ,88721,583--4,41315, ,65421,932$30,00015,05434,669

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Discount Factors (present value of $1) Interest Rate Period7%7.5%8.0%8.5%

Strategic Business Planning for Commercial Producers 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 Year 8% $16,141$17,673$16,741$15,891$34,669

Strategic Business Planning for Commercial Producers Step 4. Annual Net Cash Flows YearAnnual Net Cash Flow Discount 8% Present Value of Annual Net Cash Flow 1$16, $14, , , , , , , , ,592 Present value of the net cash flows$78,658

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Step 6. Accept or Reject NPV > 0 Accept NPV < 0 Reject

Strategic Business Planning for Commercial Producers Interpretation of NPV  If NPV is positive  Invest  Rate or return greater than minimum acceptable rate (hurdle rate)  Return exceeds cost of financing  Maximum Bid price  Outlay plus/minus NPV

Strategic Business Planning for Commercial Producers Feasibility Analysis

Strategic Business Planning for Commercial Producers Feasibility Analysis Will the project cash flow?

Strategic Business Planning for Commercial Producers Steps in Financial Feasibility Analysis  Calculate annual net cash flow  Calculate loan repayment schedule  Calculate tax savings from interest deductibility  Calculate after tax payment schedule  Calculate surplus or deficit each year

Strategic Business Planning for Commercial Producers Step 1. Calculate the Annual Net Cash Flow Already calculated as part of economic feasibility when doing NPV

Strategic Business Planning for Commercial Producers Step 1. Calculate the Annual Net Cash Flows Year Cash Revenue Cash Expenses Terminal Value Taxes Net Cash Flow 1$42,032$20,301--$5,590$16, ,36020,910--3,77717, ,12221,242--4,13916, ,88721,583--4,41315, ,65421,932$30,00015,05434,669

Strategic Business Planning for Commercial Producers Step 2. Calculate loan repayment schedule Calculate annual principal and interest payments based on loan repayment schedule

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers Year Loan Balance 8.3% Income Tax Savings (interest x tax rate) 1$76,800$6,374$2, ,7875,2941, ,6944,1251, ,4312,8581, ,9021, Step 3. Calculate tax savings from interest deductibility

Strategic Business Planning for Commercial Producers Step 4. Calculate after tax payment schedule YearPaymentTax Savings After tax payment 1$19,387$2,231$17, ,3871,85317, ,3871,44417, ,3871,00018, , ,867

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers 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 Deductibility After-Tax Payment Schedule Surplus (+) or Deficit (-) 1$16,141$13,013$6,374$19,387$2,231$17,156- 1, ,67314,0935,29419,3871,85317, ,74115,2634,12519,3871,44417,944- 1, ,89116,5302,85819,3871,00018,387- 2, ,66917,9021,48619, , ,802

Strategic Business Planning for Commercial Producers 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

Strategic Business Planning for Commercial Producers