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FARM MANAGEMENT

WK 5: CAPITAL BUDGETS

(INVESTMENT ANALYSIS)

MM WATERLOO

Farm Mtg Concepts

Wk 1: Introduction

Wk 2: Economics & Farm Records

Wk 3: Budgets

Wk 4: Whole Farm Budgets

WK 5: CAPITAL BUDGETSWk 6: Machinery Management

Wk 7: Land Management

Wk 8: Credit Management

Wk 9: Human Resource Management

Wk 10: Estate Planning

Discussion PointsI. IntroductionII. Capital Budget StepsIII. Non-time Methods A. Payback B. Acct Rate Of Return

C. Book Rate Of ReturnIV. Summary

Wk 5: Capital Budgets

I. Introduction

A. Definition: Allocation Of Resources For Major And/Or Long Term Projects

B. Assumptions

1. Unlimited Projects

2. Limited Resources


C. Types Of Investment Choices

2. Preference: Which Is Best

1. Screening: Which Are

Good


D. Basis Of Decisions

A. Style, “Paint Color”B. Prestige, Image

A. Profitability B. Rate Of Return

2. Quantitative: “Will It Pay”

1. Qualitative: “What I Want”


II. Capital Budget StepsA. Determine Cost Of Capital

Aft Tx Rate: Int Rate*(1-tx Rate)

+ Inflation Rate

+ Risk Factor

= Cost Of Capital

B. Determine Initial Investment

C. Determine Net Cash Flows

Net Cash = Cash Rec- Cash Exp

D. Estimate Terminal Value

E. Calculate Investment Measures


III. Non-time MethodsA. Payback 1. Advantages A. Simple & Easy B. Widely Used C. Emphasizes Liquidity 2. Disadvantages A. Profitability Not Considered B. Cash Flows After Payback Are Ignored C. Time Value Of Money Ignored

WK 5: Capital Budgets

3. Pay Back Calculation

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Tot Revenue

Profit

Payback

Lump

$10,000

$0

$0

$0

$0

$15,000

Equal

$48,000

$10,000

$10,000

$10,000

$10,000

$10,000

Unequal

$4,000

$2,000

$2,000

$3,000

$15,000 $50,000 $7000$5,000 $2,000 $3,0004.66 Yr 4.8 Yr 2.0 Yr

$0 $0 $0


B. Acct Rate Of Ret & Book Rate

1. Advantages

A. Calculation Ease

B. Good For Screening

C. Gd For Short Life Projects

2. Disadvantages

A. Time Val Of $ Not Considered

B. Doesn’t Consider The Timing

Of The Flows


3. Acct Rate Of Ret Calculation

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Lump

$10,000

$0

$0

$0

$0

$15,000

Cash-Invest

Time

========== >

Investment

15,000-10,000

5

========= >

10,000

5,000

5

==== >

10,000

1000

==== >

10,000

= 10%

$0

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Equal

Cash-Invest

Time

========== >

Investment

50,000-48,000

5

========= >

48,000

2,000

5

==== >

48,000

400

==== >

48,000

= .8%

$48,000$10,000

$10,000

$10,000

$10,000$10,000

$0


Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Unequal

Cash-invest

Time

========== >

Investment

7,000-4,000

3

========= >

4,000

3,000

3

==== >

4,000

1,000

==== >

4,000

= 25%

$4,000$2,000$2,000

$3,000

$0


4. Book Rate Of Ret Calculation

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Lump

Cash-Invest

No Of Flows

Invest + Salv

2

15,000-10,000

5

========= >

5,000

5,000

5

==== >

5,000

1000

==== >

5,000

= 20%

$10,000

$0

$0

$0

$0

$15,000

$0

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Equal

50,000-48,000

5

========= >

24,000

2,000

5

==== >

24,000

400

==== >

24,000

= 1.6%

Cash-Invest

No Of Flows==========================

Invest + Salv

2

48,000

10,000

10,00010,000

10,000

10,000

$0


Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Unequal

7,000-4,000

3

========= >

2,000

3,000

3

==== >

2,000

1,000

==== >

2,000

= 50%

Cash-Invest

No Of Flows========================

Invest + Salv

2

$4,000$2,000$2,000$3,000

$0


Non-time Summary

Tot Rev

Profit

Payback

Acct Rate

Book Rate

Lump Equal Unequal

$50,000 $20,000 $7,000

$5,000 $2,000 $3,000

4.66 Yr 4.8 Yr 2.0 Yr

10% .8% 25%

20% 1.6% 50%


IV. Time Value Of Money

A. Future Value


1 ...Of A Lump Sum

(Compounding) Looking Ahead

2 ...Of An Annuity (Regular Deposits)B. Present Value Looking Now

1 ...Of A Lump Sum

(Discounting)

2 ...Of An Annuity (Regular Deposits)

IV. Time Value Of Money

Year 1: $100 * .10 * 1 Yr = $110.00

Year 2: $110 * .10 * 1yr = $121.00

Year 3: $121 * .10 * 1 Yr = $133.10

Lump Sum

Investment

$100

1st YR INTEREST

10% * 100 = $10

2nd YR INTEREST

10% *(100+10) = $11

3rd YR INTEREST

10% *(100+10+11)=12

A. Future Value (Compounding) 1. ...Of A Lump Sum

FUT VAL = LUMP Sum*(1+i)n

=$100 *(1+.10)3

= $133.00


2. …Of A Yr End Annuity 2. …Of A Yr End Annuity END 1st YR; $100 * (1+ .1)2 = $121.00 END OF 3rd YR

END 2nd YR; $100 * (1 + .1)1 = $110.00 END OF 3rd YR

END 3rd YR; $100 * (1 + .1)0 = $100.00 END OF 3rd YR

$331.00

$331

Yr 1

Invest

$100

Yr 2 Int

$10

Yr 3 Int

$11

Yr 2

Invest

$100

Yr 3

Invest

$100

Yr 3 Int

$10

=

FUT VAL = INV STREAM*(1 + I)n -1

I


B. Present Value (Discounting)(Discounting) 1. ... Of A Future Lump SumOf A Future Lump SumPres Val (@10%) Of $ 100 Received 3 Yr From Now?

Pres Val = Future Value *[ 1/((1+.1)n)]

Pres Val = 100 *[1/(1 + .1)3] = $75.13

Proof: $75.13*(1 + .1)3 = $99.998

$ ?

Lump

Sum

$82.60

$100

Future Value

In

3 Yrs$75.13

$90.01$8.31$7.47

$9.09


2. .... Of An Investment Stream2. .... Of An Investment StreamEND 1st YR; $100 * .909 = $90.90 (Pres Val)

END 2nd YR; $100 * .826 = $82.60 (Pres Val)

END 3rd YR; $100 * .751 = $75.10 (Pres Val)

$248.60

$248.60 Is Max To Pay For Invest That Pays $100/Yr Annuity @ 10% Interest

PRES VAL = INV STRM*[1-(1 + I)-n ]/I

$75.13

Pres

Val

$82.60

Pres

Val

$90.91

Pres Val

$9.09

$7.47

$8.31

$9.09

$8.31

$9.09$248.60

$75.13

+

82.60

+

$90.91

Present Value At 10% To

Give $100 A Yr For 3 Yrs

=


IV. Present Value MethodsA. Net Present Val & Benefit/Cost

1. Advantages

A. Considers Time Val Of $

B. Focus On Cash Flows

2. Disadvantages

A. More Complex Calculations

B. Assumes Reinvestment At

Rate Of Return


B. Net Present Val Calculation

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Lump

$10,000Table 2:

10%

Present Value

-Investment

Net Present Value

Pres Val

$9,315

0.9090.826

0.751

0.683

$0$0

$0

$0

$15,000

$0

$0

$0$0

0.621 9,315

(685)

-10,000

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Equal

$48,000

$10,000

$10,000

$10,000

$10,000

$10,000

Table 2: 10%

Present Value

-Investment

Net Present Value

Pres Val

9,090

8,260

7,510

6,830

6,210

37900

$37,900

-$48,000

($10,100)

0.621

[3.790]

0.683

0.751

0.8260.909


Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Unequal

$4,000

$2,000

$2,000

$3,000

Table 2: 10%

0.909

0.826

0.751

Present Value

-Investment

Net Present Value

Pres Val

1,818

1,652

2,253

5,723

$5,723

-$4,000

$1,723


B. Benefit- Cost Calculation

Investment

Cash Flow 1

Cash Flow 2

Cash Flow 3

Cash Flow 4

Cash Flow 5

Salvage Val

Lump

$10,000

$0

$0

$0

$0

$15,000

Equal

$48,000

$10,000

$10.000

$10,000

$10,000

$10,000

Present Value

Investment

Benefit/Cost =

Unequal

$4,000

$2,000

$2,000

$3,000

9,315

10,000

37,900

48,000

5,723

4,000

1.43 .790 .932

1. Advantages

A. Considers All Cash Flows

B. Provides Base For Comparison

2. Disadvantage

A. Most Complex

B. Assumes Reinvestment At

Internal Rate Of Return

B. Internal Rate Of Return


3. Internal Rate Of Ret

1. Use Payback Period

2. Find Approp Row In Table1

3. Go Across To Find Payback

4. Read Up To Find % Ret

Lump

4.66

5 Yr

X.X - X.X%

3 - 4 %

Equal

4.8

5 Yr

X.X- X.X%

3 - 4%

Unequal

2.0

5 Yr

X.X - X.X%

3- 4%


Time Summary

Net Pres Value

Benefit Cost

Internal

Rate

Lump Equal Unequal

$-685 $-10,100 $1,723

.932 .790 1.43

Xx% % %


Summary1. Capital Budgeting Looks At The

Profitability Of Lg. Investments

2. Results Of “Non-time” Methods ( Payback, Acct Rate Of Ret, & Book Rate Of Return) Can Not Be Compared To Bank Rates.

3.Results Of “Time” Methods (Net Present Val, Benefit-cost, & Internal Rate Of Ret) Can Be Compared To Bank Rates


Associated LabActivities

Calculation Of Investment Measures

-- Payback

-- Acct Rate Of Return

-- Book Rate Of Return

-- Net Present Value

-- Benefit/Cost

-- Internal Rate Of Ret


Self TestPres Val / Investment Benefit- Cost

Simplest Method

Budget For Big Items

Quantative Basis

Non-time Method W/O Salv

Compared To Bank Rates

Image, Pretige

Non-time Method With Salv

Time To Recover Investment

Pres Val - Investment

Payback

Capital

“Will It Pay”

Acct Rate

Time Methods

Qualitative Basis

Book Rate

Payback

Net Pres Val


Evaluation

Your Understanding Of These Capital Budget Concepts Will Evaluated On The Midterm To Be Given The Fifth Friday Of The Quarter (This Week!!!!!!!!)


MidtermThis Friday !!!!!

Part 1: Objective Questions (T/F, Mc, Etc)

10 Pts: Wk 1- Introduction

10 Pts: Wk 2- Economics & Records

10 Pts: Wk 3- Budgets (Cash, Ent, Etc)

10 Pts: Wk 4- Linear Programming

10 Pts: Wk 5- Capital Budgets

Part II. Problems

20 Pts: Economics 5 Pts: Budgets

18 Pts: Linear Prog 9 Pts: Investment

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investment

pres val

regular deposits

assumes reinvestment

lump sum

book rate

internal rate

acct rate