Question

A farmer must choose between two possible investments that both require an initial outlay of $120,000 and will have no salvage value at the end of their economic life (3 years). The first investment is expected to yield annual net cash flows of $55,000 over a 3-year planning horizon. The second will yield $30,000 in the first year, $40,000 in the second and $50,000 in the third.

-The farmer finances 50% of the investment with an outside loan (interest rate 4%), and the principal will be paid in three equal yearly installments. Assume the farmer is in the 20% tax bracket and that the cost of capital is 5%. Assess the profitability of the two investments with the NPV for the ROE approach. (6 points)

Answer 1

Investment Required	$        120,000
Financed through loan	$          60,000
Repayment Schedule
Year	Opening Balance	Interest @ 4%	Installment	Closing Balance
1	$          60,000	$             2,400	$          22,400	$          40,000
2	$          40,000	$             1,600	$          21,600	$          20,000
3	$          20,000	$                800	$          20,800	$                   -
Cash Flow Statement
Year	Option 1				Option 2
	Cash Inflow	Interest	Tax	Net Cash Flow	Cash Inflow	Interest	Tax	Net Cash Flow
	A	B	C = (A-B)*20%	D = A-B-C	A	B	C = (A-B)*20%	D = A-B-C
1	$          55,000	$             2,400	$          10,520	$          42,080	$                 30,000	$            2,400	$          5,520	$          22,080
2	$          55,000	$             1,600	$          10,680	$          42,720	$                 40,000	$            1,600	$          7,680	$          30,720
3	$          55,000	$                800	$          10,840	$          43,360	$                 50,000	$                800	$          9,840	$          39,360
				$        128,160				$          92,160
Net Present Value
Year	Particulars	Discounting Factor @ 5%	Option 1		Option 2
			Cash Flow	Discounted Cash Flow	Cash Flow	Discounted Cash Flow
0	Initial Investment	1	$       (60,000)	$        (60,000)	$               (60,000)	$       (60,000)
1	Cash Flow	0.95	$          22,080	$          21,029	$                   2,080	$            1,981
2	Cash Flow	0.91	$          22,720	$          20,608	$                 10,720	$            9,723
3	Cash Flow	0.86	$          23,360	$          20,179	$                 19,360	$          16,724
	Net Present Value			$            1,816		$       (31,572)