Considering the present value of projected net cash flows relative to an initial investment is a useful capital budgeting application
By Kelly Lange
Texas Tech University
Agricultural production often requires significant investment in assets, such as tractors, irrigation systems and land. Though expensive, these types of assets are typically expected to produce economic returns for many years into the future. Before acquiring capital assets, farm managers can use various projection techniques to assist with the decision-making process.
While unable to provide a crystal-ball-type view into the future, projection and budgeting tools allow producers to consider various management strategies under multiple potential scenarios, in hopes of making the best management decisions possible given expectations of the future. Capital budgeting is a projection method that can prove especially useful when considering large capital investment decisions.
Capital Budgeting And The Time Value Of Money
Capital budgeting, also referred to as investment analysis, is extremely useful for evaluating the potential profitability of a new business investment, such as the acquisition of a new tractor or the purchase of farmland. The procedure is relatively simple, especially with the help of computer software, and is applicable to many investment scenarios for a farm business. A popular capital budgeting technique is net present value analysis.
One of the most powerful aspects of net present value analysis is the incorporation of time value of money into the investment planning process. The concept of time value of money references the reality that the value of a dollar today is not synonymous with the value of a dollar at some point in the future. In fact, the value of a dollar in the future will be less than the value of a dollar today. The reduction in value of that future dollar depends on the length of time into the future you anticipate receiving it. The further into the future, the less the equivalent value of that dollar today.
This reality is due to several factors. First, inflation erodes purchasing power. The cost of goods and services in the future will be more expensive than their costs today. Opportunity costs must be considered as well. Farmers have many alternative uses for capital. Investment of capital into one project means that an alternative project must be passed up. Thus, an opportunity cost is incurred anytime one investment is foregone in lieu of another.
This means that any potential profit that could have been received from the foregone project will not be realized. Risk also factors into consideration of the time value of money. If you are supposed to receive money in the future, there is always a risk that something occurs and the money is not received. All of these factors combined indicate the need to incorporate the concept of time value of money into financial investment considerations, and net present value analysis is one such way to accomplish this.
Net Present Value Analysis
Simply defined, net present value is the present value of an investment’s projected cash inflows less the present value of the investment’s projected cash outflows. Net present value works on the premise that we will likely make an initial investment at the onset of the project. In other words, we will have a capital outlay of some amount at the time of project initiation. The initial capital outlay, typically assumed to be made in cash, will occur at the present time, or right now. To determine the potential profitability of the project, especially if it is expected to run over multiple years, estimates of expected cash inflows and outflows occurring as a result of the initial investment would be discounted back to the present time using time value of money principles through the use of an assumed discount rate.
A discount rate can be thought of as an investor’s cost of capital. It can also be thought of as the investor’s opportunity cost of choosing to invest in one project in lieu of another. Discount rate assumption will vary from individual to individual. The smaller the assumed discount rate, the greater the potential net present value of the investment and vice versa.
Both the value and timing of expected cash flows must be estimated. Often, net present value analysis is performed on an annual basis, by estimating the cash inflows and outflows resulting each year from project investment.
First, estimates of expected cash inflows occurring as the result of an investment must be determined. These values are generally the expected returns that the producer anticipates receiving each year as a result of making the investment. It is important to ensure that all anticipated revenues are accounted for when making these estimates.
Next, similar estimates for cash outflows need to be projected, taking care to include any additional expenses such as loan or lease payments associated with the investment. Also project potential annual operating and maintenance expenses associated with tractors or other machinery, for example.
After these inflows and outflows have been estimated, the present value of each estimated cash flow must be determined. Each inflow and outflow must be discounted back to its present value, using the assumed discount rate. Cash flows occurring at further points in the future will be more heavily discounted compared to cash flows occurring in the near future. Once the present value of both inflows and outflows has been determined, the difference is taken, and the result is the net present value of the investment.
Once calculated, net present value can be positive, negative or zero. A positive net present value indicates an investment will return more than the investor’s cost of capital (assumed discount rate) and will increase profits over the life of the investment. A negative net present value indicates an investment is returning less than the investor’s cost of capital. In general, net present value analyses yielding negative results indicate that an investment opportunity should be rejected. A net present value calculation of zero indicates the investment will return the equivalent of its cost of capital, and the investor will break-even over the life of the investment.
Investment analysis can be tedious work if computed by hand, especially if calculating net present value for a multi-year investment. Because of this, software is often used. Programs, such as Microsoft Excel, have built-in functions for investment analysis, including net present value analysis. Other business management specialty software also has the capability of calculating net present value.
Net present value analysis is especially useful when considering investment in depreciable assets, which have a limited useful life. Assumptions regarding the expected useful economic life of the asset can be incorporated into the analysis. This often involves an additional cash inflow inclusion for the expected salvage value, which the asset could be sold for once fully depreciated.
In many net present value analyses, cash transactions, including the initial investment, are often assumed. However, the reality is that many capital acquisitions will be financed. If this is the case, it is important to note initial cash down payments, and then also include annual principal and interest payment estimates in your cash outflows, as these payments will affect the overall profitability of the investment. The effect of taxes should not be ignored, as these are also cash outflows, which will affect profitability.
It is often helpful to perform a sensitivity analysis, which allows managers to experiment with various “what-if” scenarios, using different assumptions of discount rate, initial investment amounts and net cash flows over the life of an investment, giving consideration to different price and yield combinations. For example, producers may want to run several analyses using low, average, and high price and yield combinations. This allows them to see what might happen over the life of an investment if unanticipated risks, such as market or weather conditions, do not match those predicted in the initial investment planning stages.
Finally, because businesses always have competing uses for capital, multiple potential projects may be considered at the same time. Performing multiple net present value analyses for each project, especially those with very different projected cash flows and time horizons, is often useful for profitability comparison.
Investment analysis is a powerful planning tool that allows producers to accurately estimate the potential profitability from an investment. Although there is no way to perfectly simulate projected returns, investment analysis provides a concise way to quickly examine the benefits versus costs of a multitude of capital investment options. Consider incorporating net present value analyses into your next project plan to reap the benefits of this budgeting tool.
Kelly Lange is assistant professor, director of Farm Operations, Department of Agricultural and Applied Economics, Texas Tech University. Contact Lange at firstname.lastname@example.org or 806-834-8914.