Farm Investment Analysis

Lecture 5 and 6

NMKC Premarathne
Senior Lecturer in Agricultural Economics
ILOs
After completion of this section, you should be able to,

1. explain the time value of money

2. illustrate the process of compounding &
discounting
3. distinguish the payback period, simple rate of
return, net present value and internal rate of return
4. evaluate the investment worthiness
 Time Value of Money
• Money received today is not worth that of money
received at a time in the future.
• In other words the present value of money
is more value than that of future value of
money.
• Hundred rupees received today has more
value than hundred rupees received tomorrow.
• Time value of money reflects declining of
money value over time.
• Inflation reduces the value of money.
 Present and Future Values

P Compounding
F
r u
e t

s u

e Discounting
r

n e
 Present Value

• Project/investment evaluation usually

requires costs and benefits
comparing
from different time periods.
• Money across time are not
periods
immediately comparable, because of
inflation.
• Compounding procedure is used to
compute the future value of the present
money.
5
 Present Rupee into the Future
• Suppose you invest Rs 100 today in the
bank at 5% interest
– At the end of year 1, it is worth (1+.05)xRs100,
or Rs105
– At the end of year 2, it is worth (1+.05)xRs105,
or Rs110.25
– The interest compounds over time, that is the
interest is also earning interest

6
 Present Rupee into the Future
• Define
– R=initial investment amount
– r=rate of return on investment
– T=years of investment
• The future value (FV) of the investment is:

FV  R1r T
 Future Rupee into the Present

• Suppose someone promises to pay you

Rs.100 one year from now for your lending.

• What is the maximum amount you should be

willing to pay today for such a promise?
• You are forgoing the interest that you could
earn on the money that is being loaned.

8
 Future Rupee into the Present
• The present value of a future amount of
money is the maximum amount you would
be willing to pay today for the right to receive
the money in the future.
• Discounting procedure is used to compute
the present value of the future money.

9
 Future Rupee into the Present

• Define
– R = amount to be received in future
– r = rate of return on investment
– T = years of investment

• The present value (PV) of the investment is:

R
PV 
1 
r T
10
 Future Rupee into the Present

• In previous equation, r is often referred to as the

discount rate, and (1+r)-T is the discount factor.
• Finally consider a promise to pay a stream of
money, .R0 today, R1 one year from now, and so on,
for T years?

R1 R2 RT
PV  R0   ...
1  1  1 
r r 2 r T
11
 Investment
• Investment means use of money to
earn money in the future as return to
investment.
• Investment analysis is applied when
the returns will be beyond one year.

• Agricultural investment refers to use money in

agriculture to earn money in the future.
 Investment (cont.)

• Investment is an addition to the stock of capital.

Ex: Purchase a new tractor increases the capital
assets.
• Return on investment is measured in terms of
cash flows; per week, per month or per year.
• Question is whether investment to be made in
future is economically sound.
• Investment analysis is also referred to capital
budgeting, financial feasibility analysis,
project evaluation and project appraisal.
 Investment Opportunities in Agriculture

1. Purchasing or renting properties such

as land, buildings, machineries, animals
etc.
2. Cultivation of perennial crops such as mango
banana and pineapples
3. Selling agricultural inputs and outputs such
as wholesaling and retailing, exporting
4. Storing products such as paddy onions,
potatoes, apples
5. Setting up agro industries such as food
processing
 Steps in Investment Analysis

1. Identify potentially profitable

investment alternatives
1.Collect relevant data on:
– Capital outlays
– Costs
– Returns
 Steps in Investment Analysis (cont.)

3.Use an appropriate method /tool to

analyze the data.
4.Decide whether to accept or reject the
investment or select the top ranking
among different projects.
 Tools of Investment Analysis
– Payback method
– Simple rate of return
– Net present value (NPV)
– Internal rate of return (IRR)
– Benefit-cost ratio (BCR)
 Payback Method
ආපසු ගෙවීමේ ක්රමය
• The payback method gives the number of
years necessary to recover the initial
investment.ආපසු ගෙවීමේ ක්රමය ආරම්භක
ආයෝජනය නැවත ලබා ගැනීම සඳහා අවශ්ය වසර
ගණන ලබා දෙයි.
• It does not account for the timing of cash
flows.එය මුදල් ප්රවාහයේ කාලය සඳහා ගිණුම්
ගත නොවේ.
• Only cash cost is taken into account. For
instance, depreciation is not considered.මුදල්
පිරිවැය පමණක් සැලකිල්ලට ගනු ලැබේ. නිදසුනක් වශයෙන්, ක්ෂය වීම සලකා
බලනු නොලැබේ.
 Payback Method (Cont.)
P=I/E
Where:
P = Payback period in years
ආපසු ගෙවීමේ කාලය වසර වලින්
I = Initial investment outlay
ආරම්භක ආයෝජන පිරිවැය

E = Annual net cash flows

වාර්ෂික ශුද්ධ මුදල් ප්රවාහ
(Cash receipts less cash
expensesමුදල් ලැබීම් අඩු මුදල්
 Decision
Criteria
• If the calculated payback period is shorter
than or equal to the desired payback period,
the project is accepted otherwise it is
rejected.
• If a firm to recover the cost of a
machine
wants within 5 years purchase the
of maximum desired period of the
payback would be 5 years.
company
 Example 1
A company consider to purchase a new equipment to
increase the production. Is it worth?
The initial cost of investment = Rs.37,500
ආරම්භක ආයෝජන පිරිවැය = රු.37,500
Annual cash inflow
Sales = Rs.75,000
Annual cash outflow
Cost of ingredients = Rs.45,000
Salaries = Rs.13,500
Maintenance expenses = Rs.1500
Non cash expenses
Depreciationක්ෂය වීම = Rs.5000
Maximum desired payback period is 4 years.
 Example 1 (cont.)
Net cash inflow = Rs.75,000 – (Rs.45,000+13,500+1500)
= Rs.75,000 – 60,000 = 15,000

Payback period = Rs.37,500/15,000

= 2.5 years

Since the estimated payback period is shorter than the

maximum desired payback period the equipment
should be purchased.
A firm wants to reduceExample 2 cost by installing a
its labour
new machine. Two types of machines are available in
the market: machineනව යන්ත් රයක් සවි කිරීමෙන්
සමාගමකට තම ශ් රම පිරිවැය අඩු කර ගැනීමට අවශ් ය වේ.
යන්ත්ර වර්ග දෙකක් වෙළඳපොලේ ඇත: යන්ත්රය
X and machine Y. Machine X would cost
Rs.18,000 and Y would
Rs.15,000. machine Both machines can cost
annual labour cost
theby reduce
Rs3000. Which is the
best machine purchase according
to
payback method? to
 Example 2 (cont.)
Machine X Machine Y
Cost of machine (a) Rs.18,000 Rs.15,000
Annual cost saving (b) Rs.3000 Rs. 3000
Payback period (a/b) 6 years 5 years

According to payback method, machine Y is

more desirable than machine X because it has
a shorter payback period than machine X.
 Example 3
An investment of Rs.200,000 is expected to
generate the following net cash flows In six years.
Year Net cash flow (Rs.)
1 30,000
2 40,000
3 60,000
4 70,000
5 55,000
6 45,000
Compute the payback period of the investment. Should
the investment be made if management wants to
recover the initial investment in 3 years or less?
 Example 3 (cont.)
When a project generates different cash inflows
differentinperiods the payback period formula given above
cannot be used. Instead, cumulative net cash flow
should be worked out and find the year when initial
capital becomes equal.
Year Net cash flow (Rs.) Cumulative
1 30,000 30,000
2 40,000 70,000
3 60,000 130,000
4 70,000 200,000
5 55,000 255,000
6 45,000 300,000
Payback period is 4 years which is less than the maximum
period of 3 years the investment should not be made.
 Payback method - advantages
1. An investment project with a short payback period
promises the quick inflow of cash.
2. A project with short payback period can improve
the liquidity position of the business quickly.
3. An investment with short payback period makes the
funds available soon to invest in another project.
4. A short payback period reduces the risk caused by
changing economic conditions and other
unavoidable reasons.
5. Payback period is very easy to compute.
 Payback method - disadvantages

1. The payback method does not take into account

the time value of money.
2. It does not consider the useful life of the assets
and inflow of cash after payback period.
Suppose that project A and B require an
investment of Rs.5000. Project A generates cash
inflow Rs.1000 for five years where as project B
generates a cash inflow Rs.1000 for seven years.
Under the payback method both projects are
equally desirable though project B has longer
cash flow.
 Simple Rate of Returnසරල ප්රතිලාභ
අනුපාතය
• Expresses the average annual net income as a
percentage of the amount invested.සාමාන්ය වාර්ෂික
ශුද්ධ ආදායම ආයෝජනය කරන ලද මුදලේ ප්රතිශතයක් ලෙස ප්රකාශ කරයි.

• This may be in terms of the initial capital

outlay or the average amount invested over
the useful life of the investment.මෙය ආරම්භක ප්රාග්ධන
පිරිවැය හෝ ආයෝජනයේ ප්රයෝජනවත් ආයු කාලය තුළ ආයෝජනය කරන ලද සාමාන්ය
මුදල අනුව විය හැකිය.
 Calculation of Annual Net Income

Y =(E – D)
Where:
Y = Average annual net income
E = Total expected annual net cash receipts
D= Total annual depreciation
Return As A Percent of Initial Capital Outlay

SRR = Y/I
Where:
SRR = Simple rate of return
Y =Average annual net income
(depreciation taken into account)
I = Initial investment outlay
 What is NPV?
• Net present value (NPV) is the sum of
discounted value of the future net returns
minus initial investment.
• It converts money flows in the future into a
single current value.
• It is used to evaluate alternative investments.
 Net Present Value- Decision rule

• If NPV<0, the project is not worth

and cannot be accepted.
• If NPV>0, the project is worth and can
be accepted.
 Steps in NPV
1. analysis
Compute discount rate
2. Calculate annual value of cash outlay (cost)
3. Calculate the annual value of returns
4. Calculate annual net cash flows
5. Calculate present value of net cash flows
6. Compute net present value
7. Accept or reject investment
• වට්ටම් අනුපාතය ගණනය කරන්න
• මුදල් පිරිවැය වාර්ෂික වටිනාකම ගණනය (පිරිවැය)
• ප් රතිලාභවල වාර්ෂික වටිනාකම ගණනය කරන්න
• වාර්ෂික ශුද්ධ මුදල් ප්රවාහ ගණනය කරන්න
• ශුද්ධ මුදල් ප්රවාහවල වර්තමාන වටිනාකම ගණනය කරන්න
• ශුද්ධ වර්තමාන අගය ගණනය කරන්න
• ආයෝජන පිළිගැනීම හෝ ප්රතික්ෂේප කිරීම
 NPV
NPV = - INV + P1/(1+i) + P2/(1+i)2 + …. + PN/(1+i)N + VN/(1+i)N
Where:
INV = Initial investment
PN = Annual net cash flows attributed to the
investmentආයෝජනය සඳහා ආරෝපණය කරන ලද
වාර්ෂික ශුද්ධ මුදල් ප්රවාහයන්
VN= Salvage value or terminal investment valueගලවා
ගැනීමේ වටිනාකම හෝ පර්යන්ත ආයෝජන වටිනාකම
N = Length of planning horizon සැලසුම් ක්ෂිතිජයේ දිග
i = The interest rate or required rate-of-return or
discount rateපොලී අනුපාතය හෝ අවශ්ය ප්රතිලාභ අනුපාතය
හෝ වට්ටම් අනුපාතය
 Example

A farmer is considering investing in a new irrigation system for their cornfield. The system will

cost $5,000 to install, but it is expected to increase the corn yield by 20%. The farmer expects to

sell the corn for $2 per bushel. The farmer's current yield is 100 bushels per acre, and they

expect to plant 10 acres of corn this year.

 Steps
NPV Calculation:
1. Gather all relevant information: This includes the initial investment cost, expected increase
in yield, expected selling price per bushel, current yield, and number of acres to be planted.

2. Calculate the expected additional yield: Multiply the expected increase in yield by the
current yield to determine the additional yield per acre. In this case, the additional yield is
20% * 100 bushels/acre = 20 bushels/acre.

3. Calculate the total additional revenue: Multiply the additional yield by the expected selling
price per bushel to determine the total additional revenue per acre. In this case, the
additional revenue is 20 bushels/acre * $2/bushel = $40/acre.

4. Calculate the total additional cash flow: Multiply the additional revenue per acre by the
number of acres to be planted to determine the total additional cash flow. In this case, the
additional cash flow is $40/acre * 10 acres = $400/year.
 Steps
NPV Calculation:

5. Create a table of cash flows: List the cash flows for each year of the project's life. In this case, the table
will have four rows, one for each year of the project. The first row will have a cash flow of -$5,000 for
the initial investment. The remaining rows will each have a cash flow of $400 for the additional
revenue.

6. Discount the future cash flows: Multiply each future cash flow by the discount factor for the
corresponding year. The discount factor is calculated by dividing 1 by (1 + discount rate)^year. In this
case, the discount rate is 10%, so the discount factors are 0.909 for year 1, 0.826 for year 2, 0.751 for
year 3, and 0.683 for year 4.

7. Calculate the present value of each discounted cash flow: Multiply each discounted cash flow by the
corresponding discount factor. In this case, the present values are $2,180 for year 1, $1,981 for year 2,
$1,802 for year 3, and $1,635 for year 4.

8. Sum the present values of the discounted cash flows: Add the present values of the discounted cash
flows to find the net present value (NPV) of the project. In this case, the NPV is $2,598.
Solution
 Internal Rate of Return (IRR)
• The IRR is the compound interest rate that
equates the present value of the future net
cash flows with the initial outlay. In other
words the discount rate that gives a NPV =
zero.
• Both the NPV and IRR take into account the
time value of money.
• The purpose of these investment analysis
techniques is to evaluate the acceptability of
investments relative to an acceptable rate of
return.
 Comparing NPV And IRR

• As the discount rate used to calculate net

present value is increased the NPV will
decrease.
• The IRR is the discount rate that gives a NPV of
zero.
IRR calculation- Manual Trail and error method
IRR calculation- Manual Trail and error method

Example
Step 01
Step 02
Step 03

18%

18
Why worry?

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ay=1&rel=0&showinfo=0

Use a finical calculator

 Why worry?

Use an application software

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https://www.drnishikantjha.com/booksCollection/Fina
ncial%20Analysis%20with%20Microsoft%20Excel%20(%
20PDFDrive%20).pdf
 Reinvestment Assumption
• The IRR method implicitly assumes that
cash
net from an investment
reinvested to earn
inflows are the same
internal rate of return.rate as the
• The NPV method assumes that net cash
inflows can be reinvested at the discount rate
used.
• Which reinvestment rate is more realistic?
• The discount rate used to calculate the NPV
has the advantage of being consistently
applied to all investments being evaluated.
 Benefit-cost ratio (BCR)

• BCR is worked out by discounting the net

returns during the life period of the project
and compare with the initial investment. This
will give return on rupee /dollar ව්‍යාපෘතියේ ජීවිත කාලය තුළ ශුද්ධ ප්‍රතිලාභ

වට්ටම් කිරීම සහ මූලික ආයෝජනය සමඟ සංසන්දනය කිරීම මගින් BCR සකස් කර ඇත. මෙය රුපියල / ඩොලරය මත ප්රතිලාභ ලබා

දෙනු ඇත

BCR = Discounted net returns (DNR)/Initial

investment (I)BCR = වට්ටම් සහිත ශුද්ධ ප්‍රතිලාභ (DNR)/මුල් ආයෝජන (I)
DNR = P1/(1+i) + P2/(1+i)2 + …. + PN/(1+i)N
The project is accepted if BCR is grater than one
otherwise it is rejected.BCR එකකට වඩා වැඩි නම් ව්‍
යාපෘතිය පිළිගනු ලැබේ, එසේ නොමැති නම් එය ප්‍රතික්ෂේප වේ.
 Cash Flows for Three Investments

YEAR A B C
0 -20,000 - 20,000 - 20,000
1 2,000 5,800 10,000
2 4,000 5,800 8,000
3 6,000 5,800 6,000
4 8,000 5,800 3,000
5 10,000 5,800 1,000
AVG 6,000 5,800 5,600
 Payback Period
• A 4 years

• B 20000/5800 = 3.45 years

• C 20000/5600 = 3 years
 Simple Rate of Return
• A (30000-20000)/5 = 2000
• 2000/20000 = 0.10
10%
• B (29000-20000)/5 =
1800
• 1800/20000 = 0.09 9%
• C (28000-20000)/5 =
1600
• 1600/20000 =
0.08 8%
* Assume that the investment is fully
 Net Present Value

• A: NPV = -20000 + 2000/(1.08)

+ 4000/(1.08)2 + 6000/(1.08)3
+ 8000/(1.08)4 + 10000/(1.08)5
+ 0/(1.08)5

• B: NPV = -20000 + 1852 + 3429

+ 4763 + 5880 + 6806 + 0

• C: NPV = 2730
 BCR
• Discounted net returns (DNR) = 2000/(1.08)
+ 4000/(1.08)2 + 6000/(1.08)3
+ 8000/(1.08)4 + 10000/(1.08)5
+ 0/(1.08)5
DNR = 22730
BCR = DNR/I = 22730/20000 = 1.14

Task: Find BCR for B and C options

Net Present Value, Internal Rate of Return
and Benefit-cost Ratio
• A NPV = 2730 IRR = 12.01 BCR =
1.14

• B NPV = 3158 IRR = 13.82 BCR =

1.16

• C NPV = 3766 IRR = 17.57 BCR =

1.19
All three projects are economically feasible but
project C is the most profitable one.