1. Evaluating the Profitability of an Investment Jim Dunn Ag Economist Penn State University 203 Armsby Building University Park, PA 16802 jwd6@psu.edu 814-863-8625

2. Introduction Money now is more valuable than money later Some method of comparing the two is necessary Three choices – Net present value – Benefit cost ratio – Internal rate of return All imply a discount rate

3. Discount Rate Amount by which you deflate future amounts to compare them to current amounts Borrowing rate Return on alternative investment Rate which reflects the risk of unpleasant surprise – Union Pacific 25% (high interest rate period)

4. Net Present Value Take all current cash flows and discount them to now Deflate them by discount rate (1+r) n – r is discount rate – n is years in future

5. Simple Example Net Present Value YearamountDiscount factor r= 0.10 Net Value Amount 0 ($1,000) (1+r) 0 1.0000-$1,000 1 $350 (1+r) 1 1.1000$318 2 $350 (1+r) 2 1.2100$289 3 $350 (1+r) 3 1.3310$263 4 $350 (1+r) 4 1.4641$239 sum $400$109

6. Benefit Cost Ratio Use net present value numbers but put discounted benefits in numerator and discounted benefits in denominator

7. Simple Example Net Present Value YearBenefitsDiscounted Benefits CostsDiscounted Costs 0 $1,000 1 $350$318 2 $350$289 3 $350$263 4 $350$239 sum $1,109 $1,000

8. Benefit Cost Ratio Ratio = Discounted net benefits over net costs =($1,109/$1,000) = 1.109 At this discount rate the numbers say it is worth doing

9. Internal Rate of Return Discount rate where net present value equals zero For our example, the rate is 15%

10. Simple Example Net Present Value YearamountDiscount factor r= 0.15 Net Value Amount 0 ($1,000) (1+r) 0 1.0000-$1,000 1 $350 (1+r) 1 1.1500$304 2 $350 (1+r) 2 1.3225$265 3 $350 (1+r) 3 1.5209$230 4 $350 (1+r) 4 1.7490$200 sum $400-$1

11. Benefits of these tools Compare investments that are not similar Compare investments of different life Objective evaluation of the numbers

12. Important factors Include all the costs – operator labor Include all the benefits (money you don’t have to spend)

13. Challenges Benefits or costs borne by others Estimating numbers Anticipating surprises Bob Graves will address some of these issues next