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Michael Boehlje and Cole Ehmke Department of Agricultural Economics - page 8 / 12

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down payment will reduce the size of the loan and the annual principal and interest payments. Possibly, you could increase the net cash flow from the project by controlling expenses more carefully or increasing utilization. If you cannot reduce or eliminate the deficit, then you must subsidize with cash from some other source to make the capital purchase financially feasible. By completing a financial feasibility analysis, you can estimate the size of the needed subsidy.

A Feasibility Example

To illustrate the use of financial feasibility analysis, let’s apply it to the earlier example of the decision to invest in a tow truck. Assume that the lender has agreed to a five-year loan for the full purchase price with five equal annual principal payments and 8.3% interest on the outstanding balance.

The data used in the financial feasibility analysis are summa- rized in Table 5. You calculated the annual net cash flow (not the discounted net cash flow) earlier in the economic profitability analysis (see Step 3). The loan payment schedule calls for an annual payment of $19,387.

You calculate the tax savings from interest deductibility as the interest payments times the marginal tax bracket (35% in this example), resulting in an after-tax payment schedule as noted. As indicated in the last column of the table, cash deficits occur in several years of the project. Thus, even though the project is profitable, it will not produce sufficient cash to make the loan payments.

Principal

Payment Schedule Interest

Total

$13,013 14,093 15,262 16,529 17,901

$6,374 5294 4125 2858 1486

$19,387 19,387 19,387 19,387 19,387

Table 5. Information Used in Feasibility Calculations

Year

Annual Net Cash Flow

1 2 3 4 5

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

8

This does not necessarily mean that the mechanic should not make the investment. It does mean that it will not generate enough cash to make the loan payment. Consequently, the mechanic should consider changes such as a longer term loan or a down payment and smaller loan. Other possibilities to make the project financially feasible would be to subsidize it with cash from elsewhere or reduce expenses so as to increase the cash flow from the investment.

Final Comment

The net present value method (NPV) of evaluating an investment allows you to consider the time value of money. Essentially, it helps you find the present value in “today’s dollars” of the future net cash flow of a project. Then, you can compare that amount with the amount of money needed to implement the project. If the present value is greater than the cost, the project will provide a return on investment in excess of capital costs. If you are considering more than one project, you can compute the NPV of both and choose the one with the greatest NPV. The six steps in this publication show you how to calculate the NPV.

Calculating the net present value of a project will tell you whether you will make a profit on the project overall. But in some years you may not have positive cash flows. An NPV does not tell you how much money may need to be borrowed to make up for a loss in a particular year. To estimate the cash needs in each year, you should calculate the financial feasibil- ity of the project.

Tax Savings from Investment Deductibility

After-Tax Payment Schedule

Surplus or Deficit

$2,231 1,853 1,444 1,000 520

$17,156 17,534 17,944 18,387 18,867

$-1,015

139 -1,203 -2,496 15,802

Purdue Extension Knowledge to Go

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