Evaluating the Profitability of an Investment

1. Evaluating the Profitability of an Investment Jim Dunn Ag Economist Penn State University 203 Armsby Building University Park, PA 16802 jwd6@psu.edu 814-863-8625

2. Introduction • Money now is more valuable than money later • Some method of comparing the two is necessary • Three choices • Net present value • Benefit cost ratio • Internal rate of return • All imply a discount rate

3. Discount Rate • Amount by which you deflate future amounts to compare them to current amounts • Borrowing rate • Return on alternative investment • Rate which reflects the risk of unpleasant surprise – Union Pacific 25% (high interest rate period)

4. Net Present Value • Take all current cash flows and discount them to now • Deflate them by discount rate • (1+r)n • r is discount rate • n is years in future

5. Simple ExampleNet Present Value

6. Benefit Cost Ratio • Use net present value numbers but put discounted benefits in numerator and discounted benefits in denominator

7. Simple ExampleNet Present Value

8. Benefit Cost Ratio • Ratio = Discounted net benefits over net costs • =($1,109/$1,000) = 1.109 • At this discount rate the numbers say it is worth doing

9. Internal Rate of Return • Discount rate where net present value equals zero • For our example, the rate is 15%

10. Simple ExampleNet Present Value

11. Benefits of these tools • Compare investments that are not similar • Compare investments of different life • Objective evaluation of the numbers

12. Important factors • Include all the costs – operator labor • Include all the benefits (money you don’t have to spend)

13. Challenges • Benefits or costs borne by others • Estimating numbers • Anticipating surprises • Bob Graves will address some of these issues next