Department of Economics. Agricultural Finance Economics 466 Capital budgeting with finance, inflation, taxes and risk (Chapters 10 &11)

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Robyn Singleton
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1 Agricultural Finance Economics 466 Capital budgeting with finance, inflation, taxes and risk (Chapters 10 &11)

2 Review of Team Project #6 Your conclusions: Investment is profitable NPV > 0 Investment is feasible Can meet all cash obligations each period given the financing terms Risk is significant but manageable Insurance, longer term contracts. Go for it!

obligations each period given the financing terms Risk is

3 Review of Team Project #6 OK this sounds too good to be true for driving around the country side hauling putrefying chickens Did we leave something out? Another opportunity cost perhaps? Right labor OK some of you included it How would you incorporate an opportunity cost on labor into this analysis?

4 TTYN MODIFY YOUR SPREADSHEET TO INCLUDE LABOR

5 Show and tell time

6 Adding taxes to the model Need to calculate after-tax cash flows Calculate taxable income Determine taxes due Subtract tax outflows from cash flows

7 Calculating taxes due Taxable income (using cash accounting) = + Revenue - Operating expenses - Depreciation - Interest on debt Tax due = Taxable income * tax rate After-tax cash flow = Before-tax cash flow tax due Easy huh?

8 OK.. What about inflation Modeling inflation effects lets start with the discount rate: Let i f = expected rate of inflation i t = real rate of return i = nominal rate of return Then we can write the nominal discount factor as 1 + i = (1 + i t )(1 + i f ) = 1 + i t + i f + i t i f i= i t + i f + i t i f

return i = nominal rate of return Then we can write the nominal discount

9 TTYN Suppose i f = expected rate of inflation = 3.0% i t = real rate of return = 5.0% Calculate i = nominal rate of return i = x.05 =.0815 = 8.15%

10 Modeling inflation Consider the following present value calculation where P 0 = Current payment i f = expected rate of inflation i t = real rate of return V 0 = Present value V 0 = P 0 (1+i f )/(1+i f )(1+i t ) + P 0 (1+i f ) 2 /(1+i f ) 2 (1+i t ) 2 + P 0 (1+i f ) 3 /(1+i f ) 3 (1+i t ) 3.. Cancelling we get V 0 = P 0 /(1+i t ) + P 0 /(1+i t ) 2 + P 0 /(1+i t ) 3..

= P 0 (1+i f )/(1+i f )(1+i t ) + P 0 (1+i f ) 2 /(1+i f ) 2 (1+i t ) 2 + P 0 (1+i f ) 3

11 So what does this mean -- practically 1. If you are using real valued cash flows use a real discount rate 2. If you are using nominal valued cash flows use a nominal discount rate And don t mix them up! From a practical point of view I suggest working in nominal values

If you are using nominal valued cash flows use a nominal discount

12 Finally, a little on risk Some approaches to assessing risk with a financial model Adjust the discount rate Increase the discount rate to reflect risk premium Certainty-equivalent Adjust the cash flows to a risk free basis Break-even (sensitivity) analysis Monte Carlo analysis Scenario analysis

reflect risk premium Certainty-equivalent Adjust the cash flows to a risk

13 Break-even analysis Determine the value of a variable in the model that sets a financial measure to a specific value. In our dump truck model, what is the lowest hauling price that we could receive and still have a profitable investment? Use GoalSeek to estimate this.

In our dump truck model, what is the lowest hauling price that we

14 Example of a sensitivity table (really just a table of breakevens) Corn Price Where 50:50 = 2/3:1/3 ($5.75 Beans) Soybean Yield Corn Yield

34 3.56 3.77 160 2.78 2.98 3.18 3.39 3.59 170 2.66 2.85 3.04 3.23 3.42 180 2.56 2.

15 Monte Carlo analysis Identify key random variables in the financial model Specify (subjectively, empirically ) a distribution for the random variables Correlation among variables is tricky Run the model many times using a different set of random variables for each run (sampling) Calculate the means, variances, ranges or distribution of the financial measures of interest

variables is tricky Run the model many times using a different set of random variables for

16 Using a Monte Carlo model estimate a cumulative distribution function

17 Monte Carlo analysis -- practically Use a commercially available program such or Chrystal Ball Or write your own using spreadsheet functions

18 Scenario analysis Prepare a list of possible futures or scenarios For each scenario try to estimate values for key variables prices, policies, technology etc. Analyze performance under each scenario using the financial model

key variables prices, policies, technology etc.

19 Scenario example for an ethanol plant investment decision Scenario descriptors Continued high oil prices Rapid technological change in corn production No significant advances in cellulosic ethanol technologies Rapid economic growth in China, India and Brazil Continued conflict in the middle east Translate these descriptors into economic variables

advances in cellulosic ethanol technologies Rapid economic growth in China, India and

20 Risk analysis -- practically Use the model to explore the impact of variables that seem risky Estimation Volatility Shockers The model is a learning device, not a magical mystery machine

21 Now lets work on Team project #7 Add taxes, inflation and risk assessment

] (3.3) ] (1 + r)t (3.4)

] (3.3) ] (1 + r)t (3.4) Present value = future value after t periods (3.1) (1 + r) t PV of perpetuity = C = cash payment (3.2) r interest rate Present value of t-year annuity = C [ 1 1 ] (3.3) r r(1 + r) t Future value of annuity