Agriculture Reference
In-Depth Information
The risk premium refl ects the riskiness associated with the expected net cash fl ow. The infl a-
tion premium refl ects the anticipated rate of infl ation. This rate should refl ect the rate of
return that the fi rm expects to earn on its equity capital.
Planning horizon
A multi-year planning horizon is used for the investment in capital assets, because the assets
generate cash fl ows for the fi rm for more than one year. A major factor that infl uences the
length of the planning horizon is the productive life of the asset that is being purchased.
The acceptability of an investment depends on whether the net present value is positive
or negative. The criteria used for decision-making are:
•
If the net present value exceeds zero, accept the investment
•
If the net present value equals zero, be indifferent
•
If the net present value is less than zero, reject the investment
Keep in mind that when the net present value exceeds zero the method implies that the
investment is profi table; however, it is profi table relative to the required rate of return implied
by the discount rate. Rejection of an investment, which is based on a negative net present
value, implies that an alternative investment with the rate of return (discount) used in the
analysis is more profi table than the investment being evaluated.
When several investments are being considered, all are income generating, and all have
positive net present values, the size of the net present value is used as part of the decision
criteria. In this situation, the investment with the largest net present value is most favored,
with the next largest net present value second, etc. If the investment under consideration is
cost reducing, then the projected cash fl ows would refl ect cash outlays (i.e., expenses). When
cost-reducing investments are compared, the decision criteria are based on the minimum net
present value of cash outlays.
Again, assume BF&G is considering two investment alternatives: the addition of the self-
propelled fertilizer applicator costing $300,000 and the expansion of the grain storage and
handling facility costing $312,500. However, this time the net present value method will be
used to perform the analysis. BF&G's owners insist that additional investment alternatives
return a minimum of 14 percent. Based on internal records from operating costs of current
application equipment and the best estimates of customer response to additional service
equipment, the net cash infl ows shown in
Table 13.7
are expected from the new custom
applicator.
The net cash infl ow generally declines each year because of increased maintenance and
repair costs as the equipment gets older. Taking this pattern of cash fl ows and the time value
of money into consideration, there is a different present value associated with each year. The
net present value of the investment is shown in
Table 13.8.
The present value of the cash fl ows for this investment using a 14 percent discount rate is
$305,351.60, which is considerably more than the $300,000 cost of the investment, so the
NPV is positive. This means that the investment will meet the owners' 14 percent cost of
capital criterion, since the NPV is $5,351.60.
The present value of the cash fl ows for the additional grain storage ($54,375) using a 14
percent discount rate is $360,131. This amount is calculated by multiplying the annual net
cash fl ow series of $54,375 by the discount factor from
Table 13.4
f
or 14 percent and 20
years, which equals 6.6231. Since the net present value of the annual series of net cash fl ows
