Capital Budgeting and Investment Analysis

Guest Lecturer:

Juan (Jillian) Yang

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Introduction of MyselfIntroduction 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 TodayTopic Today

Capital budgeting NPV approach. Examples. Amortization.

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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) = taxd. 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

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Example 2 – QuestionExample 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

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Example 2 – Question

e. Net before tax cash flows from custom work

year 1 50,000

year 2 56,000

year 3 60,000

year 4 54,000

year 5 50,000

f. Tax rate t=25%

g. Required rate of return 15%

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Example 2 - SolutionExample 2 - Solution

Annual Depreciation=

Straight line depreciation;

000,245

000,30000,150

DCost Basis TV for Tax Purposes

Depreciable Life

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Example 2 - SolutionExample 2 - Solution

Loan paymentsdown payment 150,000*.3=45,000loan 150,000-45,000=105,000annual principal payments 105,000 / 3=35,000

At the time of sale: Book value =30,000

Component

Year Beginning Balance

rate interest Ending balance

1 105,000 0.09 9450 105,000-35,000 =70,000

2 70,000 0.09 6,300 70,000-35,000=35000

3 35,000 0.09 3,150 35,000-35,000=0

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Example 2 - SolutionExample 2 - Solution

Layout cash flows

Year 1: TCF = NBTCF-Depreciation-Interest = 50,000 - 24,000 - 9,450 = 16,550

tax = 16,550*0.25=4,138NATCF1 = NBTCF – PRINCIPAL – INTEREST -

TAX = 50,000 – 35,000 – 9,450 – 4,134 = 1,412

Year 2: TCF= 56,000 – 24,000 – 6,300 = 25,700tax = 25,700*.25 = 6,425NATCF2 = 56,000 – 35,000 – 6,300 – 6,425 = 8,725

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Example 2 - SolutionExample 2 - Solution

Year 3: TCF = 60,000 – 24,000 – 3,150 = 32,850

tax = 32,850*.25=8,213

NATCF3 = 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

NATCF4 = 54,000 – 7,500 = 46,500

Year 5: TCF = 50,000 – 24,000 = 26,000

tax = 26,000*.25 = 6,500

NATCF5 = 50,000 – 6,500 = 43,500

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Example 2 - SolutionExample 2 - Solution

Also: gain = sale value – book value = 50,000 – 30,000 = 20,000 tax = 20,000*.25 = 5,000 NATTV5 = 50,000 – 5,000 = 45,000

Calculate NPV:

time NATCF Discount Factor PV0 -45,000 1 -45,0001 1,412 SPPV(15%, 1) 0.8696 1,2282 8,275 SPPV(15%, 2) 0.7561 6,2573 13,637 SPPV(15%, 3) 0.6575 8,9674 46,500 SPPV(15%, 4) 0.5718 26,5895 43,500+45,000 SPPV(15%, 5) 0.4972 44,002

NPV= 42,039 >0

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Example 3 - QuestionExample 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.

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Example 3 - SolutionExample 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 / USPV8%,15

= 400,000/8.5595 = 46,732

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Example 3 - SolutionExample 3 - Solution

Amortization

year Beginning rate interest payment principal ending

  Balance         balance

1 400,000 0.08 32,000 46,732 14,732 385,268

2 385,268 0.08 30.821 46,732 15,911 369,357

3 369,357 0.08 29,549 46,732 17,183 352,174

4 352,174 0.08 28,174 46,732 18,558 333,616

……            

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Example 3 - SolutionExample 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 ……..

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Example 3 - SolutionExample 3 - Solution

Now we calculate NATTV in the end of year 20.– Sales price = 500,000*SPFV5%,20 = 500,000*2.6533

= 1,326,650– Book value = 0– Gain = 1,326,650 – 0 = 1,326,650– Tax = 1,326,650*0.2 = 265,330– NATTV20= 1,326,650 - 265,330 = 1,061,320

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AmortizationAmortization

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)3. Compute principal paymentprincipal 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.

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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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