Agriculture Reference
In-Depth Information
discount rate is determined by the opportunity cost of capital. On the other hand, the internal
rate of return from each investment alternative can be compared against a common required
rate of return. The internal rate of return also represents profi tability in percentage terms,
which is often preferred by business managers, even though the increases in wealth measured
by the net present values more directly refl ect the objectives sought by the fi rm. In the end,
both approaches provide useful insights into the evaluation of capital investment decisions.
Summary
Capital investment decisions are among the most important decisions made by management.
Their impact is long range and greatly impacts the fl exibility of the business. Professional
managers approach these decisions in a systematic way by fi rst identifying the problem, then
summarizing the facts, analyzing the alternatives, taking action, and evaluating results. The
procedure for evaluating investment choices is called capital budgeting.
Four methods for evaluating capital investment decisions are discussed in this chapter.
Listed in order of complexity, the four methods are the payback period, simple rate of return,
net present value, and internal rate of return.
Simplistic approaches such as the payback period and simple rate of return are widely
used methods for making investment decisions. However, the methods may lead to incom-
plete or even inconsistent conclusions. By recognizing the time value of money and using
the net present value method or the internal rate of return method, managers can get a more
realistic assessment of investment alternatives.
Discussion questions
1.
Why are capital investment choices so important to the agribusiness manager? Why are
these decisions more complex than most operating decisions?
2.
What are the advantages and the disadvantages of the payback period method of evalu-
ating capital investments?
3.
What information is needed to calculate the simple rate of return? What are the advan-
tages and disadvantages of this method of evaluating capital investments?
4.
Why is net cash fl ow used in the net present value method rather than net income from
a pro forma income statement prepared using accrual accounting?
5.
Which type of business would likely have a higher cost of capital, a small biotechnology
company, or a large food retailer? Why?
6.
What are the advantages and disadvantages of NPV and IRR for evaluating capital
investments? Why are these approaches superior to the payback period and simple rate
of return approaches?
7.
What are the similarities and the differences between the net present value method and
the internal rate of return method?
Case study: Perfect Choice packing plant
Perfect Choice packing plant packs and ships apples and stores fruit for area growers. John
Bradley, Perfect Choice's new manager, was being pressured by the owners to evaluate
several possible changes in the business, including a major upgradng of the packing line.
