Agriculture Reference
In-Depth Information
Initial investment
The
initial investment
refers to the initial amount the investor commits to the investment.
It is important to ensure all the costs necessary to make the investment operational
are included (i.e., freight, installation, sales taxes, modifi cations to buildings, etc.) as well
as the cost of the asset. All of these costs may not occur in the initial period, so outlays
that occur later must be refl ected in the periods in which they occur. Also, the trade-in or
salvage value of a replaced asset should be subtracted from the purchase price of the new
asset.
Net cash fl ows
For the net present value method, net cash fl ow from the business rather than
accounting profi ts is used as the measure of returns.
Net cash fl ows
include all the cash
infl ows and all the cash outfl ows for operating expenses and any other capital expenditures.
In essence, net cash fl ow is the stream of cash the owner can withdraw from the
investment.
Note that net cash fl ows are not the same as net income as reported on an income
statement, because the accrual accounting method differs from the cash basis of
accounting. And, a difference between net income reported on the income statement
using the accrual accounting method and the net cash fl ow will very likely occur.
This difference occurs because revenues and expenses reported on the income statement
are assigned to the fi scal year in which they are earned or are incurred rather than when
they are received or paid in cash. Annual depreciation and inventory changes are
examples of income statement items that do not directly impact the cash fl ow. Only
future net cash fl ows are relevant for inclusion in the net present value calculation. (Note
that income taxes complicate the analysis a bit. While we will not address this topic
here, the normal rule is to use after-tax cash fl ow fi gures and an after-tax discount
rate.)
Terminal value
The
terminal value
for the investment is the residual value the investment is
expected to have at the end of the planning horizon. For depreciable assets such as machin-
ery, this value is often called the salvage value. There could also be some appreciation in the
value of the investment, which would result in capital gains at the end of the planning
period.
Discount rate
The
discount rate
or cost of capital is the interest rate used in capital budgeting, which is the
fi rm's required rate of return on its equity capital. This was referred to earlier in this text as
the opportunity cost (
Chapter 3
). The discount rate (i) used in capital budgeting consists of
three components:
•
A risk-free interest rate
•
A risk premium
•
An infl ation premium
