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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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