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Michael Boehlje and Cole Ehmke Department of Agricultural Economics - page 5 / 12

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Then,

Net Income x Marginal Tax Rate = Taxes

The marginal tax rate reflects the additional taxes that will be paid on income generated by the particular investment. Note that depreciation enters in this computation of the tax liability. As shown above, the additional tax liability will reduce the net cash flow from a particular investment.

You should include the terminal value, also known as “salvage value,” of a particular machine or a piece of equipment as a positive cash flow in the last year if it is to be sold or traded on a new item. The salvage value is part of the cash benefit stream that will be received if the capital item is sold. Or if it is traded for a new capital item, as is often the case with machinery, the salvage value reflects the reduced cash outlay that will be incurred to purchase the new machine.

After you compute the annual net cash flow for each year of the project, you have produced a series of annual net cash flows.

Step 4. Calculate the present value of the annual net cash flows.

In Step 3, you calculated the annual net cash flow stream for the entire useful life of the asset. Now you want to convert this stream into a single figure that represents the current or present value of such a stream of income over time. As has been suggested earlier, you can determine the present value of income that will be received sometime in the future by multiplying the annual income times the discount factor for the appropriate discount rate and year. By multiplying the annual net cash flow for each year times the discount factor and then summing the discounted annual net cash flows, you can obtain a single present value figure.

You obtain the discount factors to be used in this computation from the table in the appendix. Determine the factor for each year by entering the number from the table for the appropri- ate discount rate in Step 1 and the appropriate year. For example, if you calculated a discount rate of 12% in Step 1, the discount factor for year 1 to be used in the computation of the present value of the annual net cash flows would be 0.8929. Likewise, the discount factor for year 2 (12 %) would be 0.7972.

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Step 5. Compute the net present value.

You simply compute net present value as the present value of the net cash flows obtained in Step 4 minus the present value of the cash outlay to purchase the investment of Step 2:

Present value of net cash flows – Present value of cash = Net present value

Step 6. Accept or reject the investment.

The criterion for accepting or rejecting an investment is simple if the alternatives are mutually exclusive: accept an investment if it has a positive net present value or reject that investment if it has a negative net present value. This simple criterion is possible because when the benefit stream or the annual net cash flows for a particular investment are discounted with the cost of capital, the resulting figure represents the maximum amount that you could afford to pay for the investment and expect to just “break even,” including opportunity costs on the money invested. Therefore, a net present value of zero indicates that the particular investment is generating a return exactly equivalent to the cost of capital or the cost of debt and equity funds that have been used to finance the investment.

A positive net present value indicates that the particular investment is generating a benefit stream larger than the cost of the funds used to finance the investment; hence, the investment is a profitable one. In essence, the additional return adjusted by the time value of money is larger than the additional cost of the investment. In contrast, a negative net present value indicates that the increased income received from the investment will be less than the cost of funds required to support that investment. Thus, the investment is undesirable, and you should commit the funds to some alternative investment that will generate a return at least equivalent to their cost.

In some cases, the decision may not be one of accepting or rejecting a particular investment but of choosing among a number of alternative investments. In this situation, you can rank the investment alternatives in order of preference based on their net present values, with the alternative having the highest net present value ranked first and the one with the

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