Agriculture Reference
In-Depth Information
Hence, the number of periods and the interest rate per period must be adjusted to match as
determined by the problem being solved.
With this background on the time value of money, compounding and discounting, and non-
annual periods, some of the tools for evaluating capital investments can now be discussed.
Capital budgeting evaluation methods
The next step is to choose an evaluation method that can be used to rank, accept, or reject
investment alternatives. There are several methods for evaluating capital investment deci-
sions. Some of them are simple, while others are quite complex, requiring sophisticated math-
ematical analysis. Four methods will be discussed here. Listed in order of complexity they
are: payback period, simple rate of return, net present value, and internal rate of return.
Two investment alternatives for BF&G are used to illustrate the capital budgeting evalu-
ation methods discussed in the following sections. The two alternatives are to purchase a
self-propelled fertilizer applicator and to expand the grain storage and handling facility by
250,000 bushels. The applicator costs $300,000 and the grain facility expansion costs
$312,500. Both alternatives would be income-increasing investments and have initial cost
outlays that are about equal. However, the net cash fl ows for the two alternatives are very
different and are used to illustrate differences in the four capital budgeting methods.
Payback period
The length of time it will take an investment to generate suffi cient additional cash fl ows to
pay for it is called the
payback period
. This simple tool allows the agribusiness manager to
compare investment alternatives and determine which will recoup its initial investment in
the shortest period of time. Consequently, that alternative would be the most desirable. The
formula to calculate payback period is simple:
Payback PeriodInvestment
(
) (
Average Annual Net Cash Flow
)
/
The accept-reject criterion centers on whether the project's payback period is less than or equal
to a fi rm's maximum desired payback period. If two projects have payback periods that are less
than the maximum desired period, then the one with the shorter period is accepted.
For example, the new self-propelled fertilizer applicator BF&G is considering, which
costs $300,000, has fl oatation tires, a GPS system, would reduce soil compaction, allow for
site-specifi c application, and upgrade the services provided to producers. The fi rm plans to
charge customers for the full cost of these applications plus a profi t margin. Estimated aver-
age annual net cash fl ows to the business before depreciation is estimated to be $149,200.
(Note that since depreciation is a method of offsetting initial cost, it must be omitted in the
calculation of the payback period.) A second investment alternative being considered is
250,000 bushels of additional grain storage and grain handling equipment at a cost of
$312,500. Estimated annual net cash fl ow before depreciation is $70,000.
)
Applicator Payback PeriodInvestment
(
)
(
Avg
g Annual Net Cas
/
.
h
h Flo
w
(
)
=
years
$,
/$
(
3
149 2 ear
,
2
/
2
.0
=
Grain Storage
P yback PeriodInvestment
(
) (
/
Avg
g Annual Net Cash Flow
)
Pa
(
.
(
)
5 years
$3
,
/
$,
/ year
4
3 2
5
7
7
000
y
=
