PART IV

FINANCIAL MANAGEMENT FOR

AGRIBUSINESS

Topic 11:
Tools for evaluating capital
investment decisions
ACS3043
AGRIBUSINESS
Mohammad Nizamuddin bin Abdul Rahim
Hp.: +6012 – 708 2500
Emel: nizamuddin@umk.edu.my
 01 Describe
the role of capital investment decisions in an
agribusiness
02 Examine
and learn to apply basic tools for analyzing capital investment
decisions in agribusiness
03 Discuss
the payback, simple rate of return, net present value, and
After studying the internal rate of return methods for evaluating capital
investment decisions
chapter, you should 04 Examine
the data needs when using the net present value and internal
be able to: rate of return methods for evaluating capital investments

05 Describe
the decision criteria for making and rejecting capital
investments when using the net present value and internal rate
of return methods
 Capital investment refers to the addition of
durable assets to an agribusiness, which usually
require relatively large financial outlays and will
last over a long period of time.

• Typical capital investments might include

Introduction trucks, manufacturing equipment, or storage
facilities.

• Even relatively small firms can spend

millions each year on capital investments.

• These investments tie up funds for long

periods and release them slowly as the
investment produces revenue.
 • The impact of these investment decisions
may affect the business for years to come.

Introduction
• In addition to deciding whether to make a
specific investment, the agribusiness
manager must also decide how to finance
the investment.

• Capital investments can be financed through

cash purchase, borrowing, or leasing.
 Some of the many investment decisions
include:

• Expansion projects
• Replacement projects
• Alternative investment projects

Capital budgeting The procedure for evaluating the effects of an

agribusiness manager's investment choices on
the profitability, risk, and liquidity of a business
is called capital budgeting or investment
analysis.

Capital budgeting is an orderly sequence of

steps that produces information relevant to an
investment choice.
 The steps are:

1. Identification of investment alternatives

Capital budgeting 2. Selection of an appropriate capital

budgeting evaluation method

3. Collection of relevant data

4. Analysis of the data

5. Interpretation of the results

 The identification of investment opportunities
falls into one of the four categories listed below:

Identification of
1. Maintenance and replacement of
depreciable capital items

investment alternatives 2. Cost-reducing investments

3. Income-increasing investments

4. A combination of the preceding categories

 Two of the four methods used to evaluate
capital investments, net present value and
internal rate of return, are based on the time
value of money.

Concepts of the time value • The first of those ideas is that an interest
rate serves as the pricing mechanism for the
of money time value of money.

• The interest rate reflects investors' time

preferences for money and serves as the
exchange price between money received
today versus money received at some point
in the future.
 • In essence, a dollar received today can be
exchanged for a dollar plus an amount of

Concepts of the time value

interest (1 + i) received one period in the
future.

of money • The value for the dollar invested for multiple

periods, with the interest added to the
principal to earn interest, would be
calculated by multiplying the amount of the
investment by (1 + i) n , in which n is the
number of periods.
 • Alternatively, one dollar received one period
Concepts of the time value in the future exchanges for 1 ÷ (1 + i), or the
amount of the investment multiplied by (1 +
of money i) –n.

• The amount in today's dollars is normally

referred to as the present value.
 Hence, there are two aspects of the time value
of money:

Concepts of the time value • One is to take a present amount and

determine what that amount would equal at

of money some point in the future, if invested at a

given interest rate, or compounding.

• The second is to take an amount in the

future and determine what that amount
would equal in present dollars at a given
interest or discount rate, or discounting.
 • Compounding is a method of calculating
interest earned periodically, when that

Concepts of the time value interest is added to the principal and

becomes part of the principal base on which

of money future interest is earned.

• Compounding helps us to understand how

much money we will have at a future date if
we invest a certain amount today.
 • Discounting is a method of converting a

Concepts of the time value

future value to a present value by adjusting
the future value by its discount rate.

of money • Discounting helps us to understand how

much money we need to invest today to get
a certain amount in the future.
 There are several methods for evaluating capital

Capital budgeting
investment decisions.

evaluation methods
Listed in order of complexity they are:

• payback period,
• simple rate of return,
• net present value, and
• internal rate of return.
 The length of time it will take an investment to

Capital budgeting
generate sufficient additional cash flows to pay
for it is called the payback period.

evaluation methods The formula to calculate the payback period is

- Payback period simple:

Payback Period (Investment) / (Average Annual

Net Cash Flow)
Capital budgeting
evaluation methods
- Payback period
 The simple rate of return method refers to

Capital budgeting the profit generated by the investment as a

percentage of the investment.

evaluation methods The simple rate of return calculation is:

- Simple rate of return Simple Rate of Return = (Average Annual Return

/ Average Investment)
 The simple rate of return method refers to

Capital budgeting the profit generated by the investment as a

percentage of the investment.

evaluation methods The simple rate of return calculation is:

- Simple rate of return Simple Rate of Return = (Average Annual Return

/ Average Investment)
 The simple rate of return method refers to

Capital budgeting the profit generated by the investment as a

percentage of the investment.

evaluation methods The simple rate of return calculation is:

- Simple rate of return Simple Rate of Return = (Average Annual Return

/ Average Investment)
 • Net present value (NPV) is the current, net

Capital budgeting value of an investment, taking the time

value of money into consideration when

evaluation methods evaluating costs and returns.

- Net present value

• In essence, net present value provides a
measurement of the net value of a multi-
year investment in today's dollars.
 • Net present value (NPV) is the current, net

Capital budgeting value of an investment, taking the time

value of money into consideration when

evaluation methods evaluating costs and returns.

- Net present value

• In essence, net present value provides a
measurement of the net value of a multi-
year investment in today's dollars.
Capital budgeting
evaluation methods
- Net present value
• 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, modifications to
buildings, etc.) as well as the cost of the
asset.
Capital budgeting
evaluation methods
- Net present value
• All these costs may not occur in the initial
period, so outlays that occur later must be
reflected 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.
Capital budgeting
evaluation methods
- Net present value
• Net cash flows include all the cash inflows
and all the cash outflows for operating
expenses and any other capital
expenditures.

• In essence, net cash flow is the stream of

cash the owner can withdraw from the
investment.
Capital budgeting
evaluation methods
- Net present 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 machinery,

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 periods.
Capital budgeting
evaluation methods
- Net present value • The discount rate or cost of capital is the
interest rate used in capital budgeting,
which is the firm's required rate of return on
its equity capital.

• The discount rate (i) used in capital

budgeting consists of three components:

• A risk-free interest rate

• A risk premium
• An inflation premium
Capital budgeting
evaluation methods
- Net present value
• The risk premium reflects the riskiness
associated with the expected net cash flow.

• The inflation premium reflects the

anticipated rate of inflation.

• This rate should reflect the rate of return

that the firm expects to earn on its equity
capital.
Capital budgeting
evaluation methods
- Net present value • A multi-year planning horizon is used for the
investment in capital assets, because the
assets generate cash flows for the firm for
more than one year.

• A major factor that influences 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.
Capital budgeting
• The criteria used for decision-making are:

evaluation methods
• If the net present value exceeds zero,
accept the investment

- Net present value • If the net present value equals zero, be

indifferent

• If the net present value is less than

zero, reject the investment
Capital budgeting
• When several investments are being
considered, all are income generating, and

evaluation methods
all have positive net present values, the size
of the net present value is used as part of

- Net present value

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.
Capital budgeting • If the investment under consideration is cost
reducing, then the projected cash flows

evaluation methods would reflect cash outlays (i.e., expenses).

- Net present value • When cost-reducing investments are

compared, the decision criteria are based on
the minimum net present value of cash
outlays.
Capital budgeting • If the investment under consideration is cost
reducing, then the projected cash flows

evaluation methods would reflect cash outlays (i.e., expenses).

- Net present value • When cost-reducing investments are

compared, the decision criteria are based on
the minimum net present value of cash
outlays.
Capital budgeting • If the investment under consideration is cost
reducing, then the projected cash flows

evaluation methods would reflect cash outlays (i.e., expenses).

- Net present value • When cost-reducing investments are

compared, the decision criteria are based on
the minimum net present value of cash
outlays.
 The net present value method of investment

Capital budgeting
analysis has several advantages.

evaluation methods
• First, it deals with cash flows rather than
accounting profits.

- Net present value • Second, the method is sensitive to the actual

timing of the cash flows resulting from the
investment.
Capital budgeting
• Third, the time value of money enables the
user to compare benefits and costs in

evaluation methods
today's dollars.

- Net present value

• Finally, because investments are accepted if
a positive net present value is calculated,
the acceptance of an investment will
increase the value of the firm.
 One disadvantage of the net present value
Capital budgeting method results from the need for detailed,
long-term forecasts of cash flows.
evaluation methods • These forecasts over long time periods are
- Net present value just that, forecasts.

• So, there is considerable pressure on the

manager to forecast cash inflows and
outflows as accurately as possible.
 • The same equation used to calculate the net

Capital budgeting
present value of an investment can be used
to determine the internal rate of return (IRR)

evaluation methods
for the investment.

•
- Internal rate of return
The internal rate of return is called by
various names: discounted rate of return,
marginal efficiency of capital, yield, etc.

• However, it is essentially the discount rate

that equates the net present value of the
projected net cash flows to zero.
Capital budgeting • The Internal Rate of Return (IRR) is a formula
used to evaluate the returns of a potential
evaluation methods investment.

- Internal rate of return • It calculates the projected annual growth

rate of a specific investment over time.

• IRR is often used to compare similar

investments, or in capital planning and
budgeting.
 The acceptance of each investment depends
upon the comparison of its internal rate of
return with the investor's required rate of
return.
Capital budgeting Acceptability is based on the following decision
evaluation methods rules:

- Internal rate of return • If the internal rate of return exceeds

required rate of return, accept
the
the
investment.
• If the internal rate of return equals the
required rate of return, be indifferent.
• If the internal rate of return is less than the
required rate of return, reject the
investment.
THANK YOU