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Michael Boehlje and Cole Ehmke Department of Agricultural Economics - page 7 / 12

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Then,

$15,971 (net income) x 35% (marginal tax rate) = $5,590 (taxes)

Year

Cash

Cash

Salvage

Taxes

Net Cash

Revenue

Expense

Value

Flow

1

$42,032

$20,301

2

42,360

20,910

3

42,122

21,242

4

41,887

21,583

5

41,654

21,931

Annual computations, based on the mechanic’s estimations of revenue and expenses, would be as shown in Table 3.

Table 3. Annual Cash Flows for an Investment Project

$5,590

$16,141

3,777

17,673

4,139

16,741

4,413

15,891

15,054

34,669

30,000

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

The mechanic would compute the present value of the net cash flows as the sum of the discounted annual net cash flows (net cash flow times the discount factor) (Table 4).

Year

Annual Net Cash Flow

Discount Factor

1 2 3 4 5

$16,141 $17,673 $16,741 $15,891 $34,669

0.9259 0.8573 0.7938 0.7350 0.6806

Table 4. Computations to Reach Net Cash Flow for Each Year of an Investment

Present value of the net cash flows

Present Value of Annual Net Cash Flow

$14,945 $15,151 $13,289 $11,680 $23,596 $78,661

Step 5. Compute the net present value.

Net present value is computed as the present value of the net cash flows minus the present value of the cash outlay:

$78,661 – $76,800 = $1,861

7

Step 6. Accept or reject the investment.

Based on the positive net present value of Step 5, the mechan- ic’s decision would be to buy the tow truck and add that service to his business. The tow truck will generate a return that exceeds the cost of funding the venture—it generates a positive net present value.

Financial Feasibility

Once you have analyzed the profitability of various invest- ments and chosen an alternative, you need to evaluate its financial feasibility. Financial feasibility analysis determines whether or not the investment will generate sufficient cash income to make the principal and interest payments on borrowed funds used to purchase the asset. If you will be making the purchase with equity funds and a loan is not required, then financial feasibility analysis is unnecessary.

Feasibility Calculation

The first step in financial feasibility analysis is to determine the annual net cash flows for your project. Fortunately, you have already calculated these annual flows as part of your economic profitability analysis. Next, you must determine the annual principal and interest payments based on the loan repayment schedule. Because the annual net cash flows are after-tax and the payment schedule is before-tax, you must adjust this payment schedule to an after-tax basis by calculat- ing the tax savings from the deductibility of interest and subtracting this savings from the payment schedule. Then, you compare the annual net cash flow to the after-tax annual principal and interest payments to determine if a cash surplus or deficit will occur.

If a cash surplus results, the investment project will generate sufficient cash flow to make the loan payments, and the project is financially feasible as well as economically profit- able. If a cash deficit results, the project is not financially feasible—it will not generate sufficient cash income to make the loan payments. Cash deficits do not mean that the investment is unprofitable or should not be made; they simply mean that you will likely encounter loan servicing problems.

You can reduce or eliminate cash deficits in a number of ways. Extending the loan terms (i.e., more years to repay the principal) will result in lower annual debt servicing require- ments, thus reducing the deficit. Increasing the amount of the

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