A tract of farm land requires an initial outlay $50,000. The first-year net cash flow is...

A tract of farm land requires an initial outlay $50,000. The first-year net cash flow is $4,000 and will increase 4% annually. The land value will grow 2% annually. A farmer’s real cost of capital is 6% and the anticipated inflation rate is 3%. The farmer pays 20% tax on ordinary income and 15% tax on capital gain. The farmer is considering making the investment on the tract of farm land and holding it for 6 years. Please help the farmer evaluate the profitability of the investment.

Solutions

Expert Solution

Farmer's nominal cost of capital = 6% + 3% = 9%

We first chalk out the Net-cashflows in excel

Year	Cash-flows	Cash-flow due to tax	Net cash-flows
0	-50000	0	-50000
1	4000	-800	3200
2	4160	-832	3328
3	4326.4	-865.28	3461.12
4	4499.456	-899.8912	3599.5648
5	4679.43424	-935.886848	3743.547392
6	4866.61161	-973.3223219	3893.289288
6	56308.12096	-8446.218144	47861.90282

We calculate the NPV with nominal cost of capital 9% using NPV function in excel

NPV = Initial investment + NPV (9%, All net cash-flows from year 1-6)

Year	Net cash-flows
0	-50000
1	3200
2	3328
3	3461.12
4	3599.5648
5	3743.547392
6	51755.19211

NPV	-5747.488031

Since the NPV of the investment is negative, the investment is not profitable.

jeff jeffy answered 1 year ago

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