PPT 3701: KEUSAHAWANAN PERTANIAN

(AGRICULTURE ENTREPRENEURSHIP)

LECTURE 2.2

TOOLS FOR FINANCIAL ANALYSIS

IN BUSINESS PLAN

BY: WAN MOHD MARZUKI WAN BAKAR

 Cost-Benefit-Analysis Method
Major components:

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Payback Period (PBP)

© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 2

 Net Present Value (NPV)
- NPV is a primary investment decision criterion. NPV
is defined as the difference between the present
value of a stream of benefits and that of a stream of
costs. A positive NPV occurs when the sum of the
discounted benefits exceeds the sum of the
discounted costs.
- The result of subtracting the total present value
costs from the total present value benefits. Also
referred to as net benefit or net cost.
- Simplest definition: Today's value of future costs and
benefits.
© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 3
 Formula
Each cash inflow/outflow is discounted back to its present
value (PV). Then they are summed. Therefore NPV is the sum
of all terms,
Rt
(1 + i)t
Where,
t - the time of the cash flow
i - the discount rate (the rate of return that could be earned on an
investment in the financial markets with similar risk.)
Rt - the net cash flow (the amount of cash, inflow minus outflow)
at time t. For educational purposes, R0 is commonly placed to the
left of the sum to emphasize its role as (minus) the investment.

© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 4

 NPV in Decision Making

- NPV is an indicator of how much value an

investment or project adds to the firm

- Appropriately risked projects with a positive

NPV could be accepted. This does not
necessarily mean that they should be
undertaken since NPV at the cost of capital
may not account for opportunity

© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 5

 NPV in Decision Making
- If...
NPV > 0 = the investment would add value to the firm. So, the
project may be accepted
NPV < 0 = the investment would subtract value from the firm.
So, the project should be rejected
NPV = 0 the investment would neither gain nor lose value for
the firm, so we should be indifferent in the decision whether
to accept or reject the project. This project adds no monetary
value. Decision should be based on other criteria, such as IRR
etc
- In financial theory, if there is a choice between two mutually
exclusive projects, the one yielding the higher NPV should be
selected
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 Internal Rate of Return (IRR)

- The internal rate of return (IRR) is a rate of return

used in capital budgeting to measure and compare
the profitability of investments. It is also called the
discounted cash flow rate of return (DCFROR) or
simply the rate of return (ROR). The term internal
refers to the fact that its calculation does not
incorporate environmental factors (e.g., the interest
rate or inflation)

© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 7

 Internal Rate of Return (IRR)
- The discount rate (r) often used in capital budgeting
that makes the net present value of all cash flows
from a particular project equal to zero. Generally
speaking, the higher a project's internal rate of return,
the more desirable it is to undertake the project.

- As such, IRR can be used to rank several prospective

projects a firm is considering. Assuming all other
factors are equal among the various projects, the
project with the highest IRR would probably be
considered the best and undertaken first.
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 Internal Rate of Return (IRR)
- You can think of IRR as the rate of growth a
project is expected to generate.

- While the actual rate of return that a given

project ends up generating will often differ
from its estimated IRR rate, a project with a
substantially higher IRR value than other
available options would still provide a much
better chance of strong growth.
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 Payback Period (PBP)
- Payback period in capital budgeting refers to the
period of time required for the return on an
investment to "repay" the sum of the original
investment. The time value of money is not taken into
account

- Payback period intuitively measures how long

something takes to "pay for itself." All else being
equal, shorter payback periods are preferable to
longer payback periods. Payback period is widely used
because of its ease of use despite recognized
limitations, described below
© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 10
 Payback Period (PBP)
- Formula / Equation:

The formula or equation for the calculation of

payback period is as follows:

Payback period = Investment required/Net annual

cash inflow*

*If new equipment is replacing old equipment, this

becomes incremental net annual cash inflow.

© WMB PPT 3701: LECTURE 2.2 Tools for Financial Analysis 11

 Payback Period (PBP)
Example:
York company needs a new milling machine. The company is considering two
machines. Machine A and machine B. Machine A costs $15,000 and will reduce
operating cost by $5,000 per year. Machine B costs only $12,000 but will also
reduce operating costs by $5,000 per year.

Required:
* Calculate payback period.
* Which machine should be purchased according to payback method?

Calculation:

Machine A payback period = $15,000 / $5,000 = 3.0 years

Machine B payback period = $12,000 / $5,000 = 2.4 years

According to payback calculations, York company should purchase machine B, since

it has a shorter payback period than machine A.

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