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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
Wk 5: Capital Budgets
C. Types Of Investment Choices
2. Preference: Which Is Best
1. Screening: Which Are
Good
Wk 5: Capital Budgets
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”
Wk 5: Capital Budgets
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
Wk 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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%
WK 5: Capital Budgets
IV. Time Value Of Money
A. Future Value
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
=
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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
WK 5: Capital Budgets
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%
WK 5: Capital Budgets
Time Summary
Net Pres Value
Benefit Cost
Internal
Rate
Lump Equal Unequal
$-685 $-10,100 $1,723
.932 .790 1.43
Xx% % %
WK 5: Capital Budgets
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
WK 5: Capital Budgets
Associated LabActivities
Calculation Of Investment Measures
-- Payback
-- Acct Rate Of Return
-- Book Rate Of Return
-- Net Present Value
-- Benefit/Cost
-- Internal Rate Of Ret
WK 5: Capital Budgets
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
WK 5: Capital Budgets
Evaluation
Your Understanding Of These Capital Budget Concepts Will Evaluated On The Midterm To Be Given The Fifth Friday Of The Quarter (This Week!!!!!!!!)
WK 5: Capital Budgets
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
NEXT TOPIC
TIMELINESS
INTERNATIONAL HARVERSTER W4