What Investments Should I Make?
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What Investments Should I Make?

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  • The purpose of investment analysis is to ensure that a decision that management is about to undertake truly does increase the value of the company. Proper investment analysis also provides other important pieces of decision making information such as how much investment capital will be required and when, what the risks are, and when the cumulative cash flow will become positive. This is vital information for management when comparing alternate uses of investment capital.
  • In this presentation we will talk briefly about things to consider when making investment decisions, then about how those investment decisions are implemented through capital budgeting. Finally we will present a method to assess capital investment options. The net present value method is an exceptionally powerful tool that you can use in your business. It is also easy to use.
  • Investment decisions encompass many issues. Capital investments are guided initially by the competitive strategy that your business chooses. Since capital is limited it must be used to its best advantage. This involves assessing investment projects at two levels – the economic profitability (i.e. how much value the projects adds to the business) and its feasibility (i.e. the ability of the project to generate enough cash to cover its outflows). Capital projects must then satisfy the risk restrictions you set. Finally, it is important to consider how a particular investment project contributes to the overall portfolio of assets of the business, and the tax consequences of the investment being considered. Portfolio? Tax?
  • Capital budgeting is an extremely important aspect of a firm's financial management. Capital assets usually comprise a larger percentage of a firm's total assets compared to inventory or current assets. And since capital assets are long-term, a farm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time. A manager has a number of reasons to consider capital investment options – replacing equipment, expansion, modernization, gaining a strategic asset. In each case the investment must satisfy the strategic need of the organization with an acceptable return without undo risk.
  • There are two stages to capital budgeting. The first is economic profitability which we determine if the investment option will contribute to the long run profits of the business. The second stage is to assess whether the project is financially feasible, i.e., whether the cash flows are sufficient to make the required principal and interest payments on any borrowed funds.
  • Let’s consider the first question, does it earn a profit above all costs.
  • The time value of money is probably the single most important concept in financial analysis. When we say that money has time value, we mean that a dollar to be paid (received) today is worth more than a dollar to be paid (received) at any future time. Money has a time value because of the opportunity to earn interest on savings (i.e. money held today) or the cost of paying interest on borrowed capital. Time value of money problems generally involve the relationship between a given amount of money, a period of time, and a specified rate of return. Since the benefit of the investment may not be received until some time well into the future then we must adjust for having to wait for it.
  • If given the choice, which would you rather have? The $100 right now. Receiving $100 in the future forces you to accept a penalty of whatever you could have earned with the $100 had you received it today. To account for the penalty for having to wait for the payment, you should discount the $100 you would receive in the future to its current equivalent.
  • You are familiar with the concept of compounding – adding the interest earned on principal over a year and computing interest in the second year based on the new sum (original principal and the first years’ interest). Discounted is just the reverse. It determines the present value of a future sum.
  • Discounted cash flow or present value is what someone is willing to pay today in order to receive the anticipated cash flow in future years. Here is an example of how discounting works. Say you’ve signed a contract that involves two payments to you, each of $50,000. Since the payments occur in the future you know that the money won’t be worth the same as its worth now. To find out how much the penalty is multiply the payments by the discount factor to find the present value. How much would you have of 50,000 each to receive today to be indifferent between the two future payments, and a payment right now? $79,320.
  • Net Present Value (NPV) is a measure of the profitability of an investment, expressed in current dollars. The NPV technique involves discounting net cash flows for a project, then subtracting the investment outlay from the discounted net cash flows. If a company has limited resources, they will rank the projects and pick those with the highest NPV's.
  • If the net present value is positive, adopting the project would add to the value of the company. The company should choose only projects with positive net present values.
  • Performing an economic profitability assessment with NPV involves six straightforward steps. 1) Compute the discount rate – finding the rate at which to discount future dollars. This depends on how much your money costs and how much risk there is in the investment. 2) Calculate the present value of the cash outlay – how much you will spend for the project 3) Calculate annual net cash flows – essentially this is determining the budget for the investment over its life 4)Calculate present value of net cash flows – the cash flows in each year are discounted to the present 5) Compute the net present value – subtract the investment outlay from the discounted cash flow 6) Decide whether the investment adds value, or not
  • We’ll illustrate the steps with an example. The crop business unit manager of MBC Farms is considering expanding the acres he contracts for an identity preserved specialty grain crop. To do so he needs more on-farm storage space, which will have to be built in order to gain access to the premium from the crop. The $76,800 bin has a five year life and has a $30,000 terminal value. The tax rate is expected to be 35 percent and the firm will finance the project with 60 percent equity and 40 percent debt in the long run. The target ROE is 9.8% after tax and the cost of debt to the firm is 5.3% after tax.
  • The discount rate is based on the opportunity cost of capital – it is the return you can earn by investing your money elsewhere. You could think of the discount rate as the price of exchange between now and the future. A dollar in the future is worth less than one dollar today, and the discount rate indicates how much. You could also think of it as the rate of exchange between borrowing and saving. People sacrifice income at the discount rate when they consume (they are foregoing the chance to earn money) and earn income at the discount rate when they postpone consumption and invest.
  • The discount rate chosen essentially indicates the minimum acceptable rate of return for an investment; it represents the cutoff point in judging whether or not an investment returns at least the cost of the debt and equity funds that must be committed or acquired by the firm to obtain the asset. In the long run, the funds a firm uses to acquire any capital item will come from both debt (borrowed funds) and equity (the owner’s financial contribution to the firm) sources. Therefore, the cost of capital should be based on the combination of debt and equity capital used in the “long run” to finance the operation, not the specific combination of debt and equity that may be used to finance a particular purchase. A word on risk. To include risk in an analysis you can adjust the discount rate to reflect higher risk. Riskier projects will use higher risk-adjusted discount rates. Finding an appropriate adjustment factor is a subjective process.
  • Keep this slide? A few simple calculations based on information you have can give the cost of capital number you will use as the discount rate. The purpose of the weighted cost of capital is to obtain a discount rate which accurately reflects the long-run direct cost of debt funds and the opportunity cost of equity funds, along with the long-run proportions of debt and equity that will be used in the firm. Note that the cost of equity funds is best estimated as the opportunity cost (income foregone) of committing equity to this particular investment compared to other investments. The best way to specifically measure this cost is to look at the rate of return being generated by the equity capital currently being used in the firm. This rate of return can be calculated as the sum of the cash return plus the gain in asset values divided by net worth or equity (market value basis) as measured on the balance sheet. The annual cash return is calculated as annual net income from the income statement. Annual capital gain is determined by comparing the market value of assets of the firm (particularly farmland) this year to the value last year; these data can be obtained from the balance sheet. If the balance sheet data are available on a cost basis, then dividing the annual income by the cost basis equity or net worth will provide an estimate of the cost of equity capital.
  • The cash needed to start the project is a straight forward calculation since it is essentially the purchase price. Occasionally the purchase price will not include all of the needed investments. All additional outlays that may be required should be included. For example, if a farmer were evaluating the construction of a new farrow-finish facility for his or her hog enterprise, the capital outlay would include not only the purchase price of the building and equipment, but also the cost of any additional breeding stock or additional feed and veterinary supply inventories that might be required to support the bigger operation.
  • Create a cash flow budget for each year. Even if you're not financing the purchase, you should consider creating such a budget. It's a way of systematically comparing the costs and financial benefits of a project over a period of time, and will enable you to get a good handle on how the project will affect your business. NPV analysis is used to evaluate the project's cash flows, rather than the income from the project that would be shown on an income statement . Why? Because the income statement factors in depreciation, but depreciation is an accounting allocation of the annual cost of capital item and not an out-of-pocket expense. So remember to use cash flows, not accounting earnings. Also ignore the tax consequences of depreciation at this point. Cash outflows include operating costs that will be incurred annually for the project. Cash inflows include cost savings and additional revenues that result from a project, and any proceeds of sale of assets (in particular the terminal value, or salvage value). Returns are positives and costs are negatives. A word on inflation. Inflation decreases purchasing power over time. Discount real cash flows with a real interest rate, or discount nominal cash flows with a nominal rate. If you use a nominal discount rate, make sure you include inflation adjustments to both costs and revenues.
  • In the case of a stored specialty grain we have two sources of income. First we have whatever additional revenue the specialty grain itself will provide compared to commodity grain. Second there is the revenue that would be gained through the use of the storage bin. If the product is stored for several months and sold some time later in the season there is income from expected price increase compared to selling at harvest. This needs to be better explained.
  • The revenues we calculate need to be just the revenues associated with the project. Here for instance we consider just the revenue from the specialty crop that exceeds that which we would get for producing #2 yellow corn. The same is true for the storage revenue. We wouldn’t count the total sales revenue as the revenue from storage, but the amount by which the revenue from stored grain would exceed the revenue available if it was sold at harvest. These are the revenues expected for the first year of the project only.
  • In addition to increased revenue, there are the increased costs for the project. In the case of the specialty corn crop there are higher seed, handling, harvesting and management costs. For the storage there are the variable costs of storage – electricity, handling and so on – that must be accounted for.
  • Taking the difference of the revenues and expenses we obtain the net cash income for the first year of production.
  • Another cash expense that must be considered is income tax. Cash flows should be calculated on an after-tax basis. Since depreciation is not a cash flow but an accounting entry to allocate the cost of a capital item over its useful life, it does not enter directly in the computation of annual net cash flows. Instead, depreciation enters the calculations only as it influences the tax liability or the tax savings of a particular investment.
  • To complete our cash flow for the year we now deduct taxes and incremental expenses from the incremental revenues to get the net cash flow.
  • The preceding slides show the numbers used in year one. Since this is a five year project the same process of estimating cash flows is used for each year. Note that in year five there is another cash inflow – that from the terminal value, or salvage value, of the asset. This value reflects the additional value the project (the bin in this case) contributes to the value of the business or the after tax proceeds that would be received if the asset is sold.
  • Once you’ve got the net cash flows for each year, it is time to discount those to present dollars. Here we use our discount rate or “exchange rate” to convert future dollars to present ones.
  • To find the exact exchange rate we can look to a table of discount factors. The computation of the cost of capital (8% in this case) is used to pick the column in the discount factor table. This project requires us to find 5 discount factors, one for each year. At the end of year one a dollar will be worth 0.9259 of what a dollar today is worth at 8%. If you don’t have a table you can calculate the rate yourself using the formula $1 / (1 + i) n where i is the discount rate and n is the number of periods.
  • Once we’ve gathered the discount factors to be used for each year, we multiply the net cash flow by the discount factor for the year. In year one the $16,141 net cash inflow becomes $14,945 after it has been discounted because it will be received at the end of the year. Once that is done for each year, the discounted annual values are summed to obtain the present value of net cash flows.
  • Another view of the same thing. Once we’ve gathered the discount factors to be used for each year, we multiply the net cash flow by the discount factor for the year. In year one the $16,141 net cash inflow becomes $14,945 after it has been discounted because it will be received at the end of the year. Once that is done for each year, the discounted annual values are summed to obtain the present value of net cash flows.
  • At the fifth of our six steps we compute the net present value by subtracting the initial outlay obtained in Step 2 from the present value of net cash flows obtained in Step 4. In this case our NPV is greater than zero, indicating that the project would create value for the business and should be undertaken.
  • The criterion for acceptance of a project is that the net present value must be greater than zero.
  • A net present value of zero would indicate that the particular investment is generating a return exactly equivalent to the cost of capital or the cost of debt and equity funds that have been used to finance the busines. A positive net present value indicates that the particular investment is generating a benefit stream larger than the cost of the funds used to finance the business; hence, the investment is a profitable one. In essence, the additional return adjusted by the time value of money is larger than the additional cost of the investment. In contrast, a negative net present value indicates that the increased income received from the investment will be less than the cost of funds required to support that investment. Thus, the investment is undesirable, and the funds should be committed to some alternative investment that will generate a return at least equivalent to their cost. The NPV process could also be used to assist managers in deciding what maximum price to pay for an investment. The maximum bid price is estimated as the negotiated outlay plus the NPV. A negative NPV indicates that the manager could make a profitable investment if he could reduce the purchase price by the amout of the negative NPV.
  • Now we begin the second stage of investment analysis: financial feasibility. A budget showing the effect of the project on cash income, and proving that you can make the anticipated loan payments is an important part of investment analysis.
  • There are five simple steps to this process.
  • The annual net cash flows have already been calculated as part of Step 4 in the NPV assessment.
  • These were our calculations for the specialty grain project. Note that we do not want the discounted cash flows, but the non-discounted net cash flows for each year.
  • A repayment schedule for the loan should be available from the lender.
  • Consistency in our calculations is critical. In the NPV analysis we took care to calculate net cash flows on an after tax basis. The same must be done with the cash flows associated with repaying the loan. Since interest expenses can be deducted from income taxes we must take this into account.
  • To calculate the money saved through deducting interest we take the interest expense times the tax rate - -35% in our case.
  • That tax savings is then deducted from the payment to calculate the after-tax payment.
  • Now that we have our net cash inflows and our after-tax payment, we are ready to calculate the surplus or deficit each year.
  • The net cash flows for each year. The payment schedule-total is the sum of the payment schedule principal and the payment schedule interest. The after tax payment deducts the tax savings from the annual payment total. The surplus or deficit is calculated annually as the annual net cash flow minus the after tax payment for each year. In this case there will likely be funding problems in years 1, 3 and 4.
  • If the funding deficits are severe then there are a number of ways to minimize the problem.

What Investments Should I Make? What Investments Should I Make? Presentation Transcript

  • 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 0.9346 0.8734 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)
    • 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
  • 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)
  • 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 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
  • Two Sources of Income
    • Specialty grain revenue
    • Storage revenue
  • Calculate Cash Revenue $42,032 Net Cash Revenue 18,352 Revenue from Storage $23,680 Revenue of IP crop over #2 yellow
  • Calculate Cash Expenses $20,301 Net Cash Expenses 7,341 Expenses of Storage $12,960 Expenses of IP crop over #2 yellow
  • Calculate Cash Income $21,731 Net Cash Income - 20,301 Expenses $42,032 Revenue
  • Calculate Taxes Net Income x tax rate = taxes $15,971 x .35 = $5,590 $42,032 Cash Revenue $15,971 Net Income - 5,760 Depreciation - 20,301 Cash Expenses
  • Calculate Net Cash Flow: year one - 20,301 Cash Expenses $16,141 Net Cash Flow - 5,590 Taxes $42,032 Cash Revenue
  • Step 3. Calculate the Annual Net Cash Flows $30,000 -- -- -- -- Terminal Value 34,669 15,054 21,932 41,654 5 15,891 4,413 21,583 41,887 4 16,741 4,139 21,242 42,122 3 17,673 3,777 20,910 42,360 2 $16,141 $5,590 $20,301 $42,032 1 Net Cash Flow Taxes Cash Expenses Cash Revenue Year
  • 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) .6650 .7216 .7829 .8495 .9217 8.5% .6806 .6966 .7130 5 .7350 .7488 .7629 4 .7938 .8050 .8163 3 .8573 .8653 .8734 2 .9259 .9302 .9346 1 8.0% 7.5% 7% Period Interest Rate
  • 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 0.9259 0.8573 0.7938 Year 8% $16,141 $17,673 $16,741 $15,891 $34,669
  • Step 4. Annual Net Cash Flows $78,658 Present value of the net cash flows 23,592 .6805 34,669 5 11,680 .7350 15,891 4 13,289 .7938 16,741 3 15,151 .8573 17,673 2 $14,945 .9259 $16,141 1 Present Value of Annual Net Cash Flow Discount Factor @ 8% Annual Net Cash Flow Year
  • 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 Accept
    • NPV < 0 Reject
  • 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
  • Feasibility Analysis
  • Feasibility Analysis
    • Will the project cash flow?
  • 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
  • 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 $30,000 -- -- -- -- Terminal Value 34,669 15,054 21,932 41,654 5 15,891 4,413 21,583 41,887 4 16,741 4,139 21,242 42,122 3 17,673 3,777 20,910 42,360 2 $16,141 $5,590 $20,301 $42,032 1 Net Cash Flow Taxes Cash Expenses Cash Revenue Year
  • 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
  • Step 3. Calculate tax savings from interest deductibility 5 4 3 2 1 Year 520 1,000 1,444 1,853 $2,231 Income Tax Savings (interest x tax rate) 1,486 17,902 2,858 34,431 4,125 49,694 5,294 63,787 $6,374 $76,800 Interest @ 8.3% Loan Balance
  • Step 4. Calculate after tax payment schedule 5 4 3 2 1 Year 18,867 520 19,387 18,387 1,000 19,387 17,944 1,444 19,387 17,534 1,853 19,387 $17,156 $2,231 $19,387 After tax payment Tax Savings Payment
  • 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 + 15,802 18,867 520 19,387 1,486 17,902 34,669 5 - 2,496 18,387 1,000 19,387 2,858 16,530 15,891 4 - 1,203 17,944 1,444 19,387 4,125 15,263 16,741 3 + 139 17,534 1,853 19,387 5,294 14,093 17,673 2 - 1,015 $17,156 $2,231 $19,387 $6,374 $13,013 $16,141 1 Surplus (+) or Deficit (-) After-Tax Payment Schedule Tax Savings from Interest Deductibility Payment Schedule-Total Payment Schedule-Interest Payment Schedule Principal Annual Net Cash Flow Year
  • 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