Capital Budgeting for Investment, using the Discounted Cash-Flow (DCF) Method, and Net Present Value (NPV)
This analysis by Michael Vail from Tre Ponte corporate business advisors and accountants, Brisbane, follows previous contributions to Beef Central (links at bottom of page), and is addressed to investors making capital budgeting decisions towards a long-term investment in the agricultural production industry.
It is important to understand the methods used by sophisticated and experienced business-people in the world of finance and economics, both here in Australia and overseas, when making large-scale capital expenditure budgeting decisions; whether it be for investments below one million dollars or up to several hundred million dollars.
One excellent method which is technically sound, and is supported by courts when deciding cases, is the Expected Net Present Value of a Future Expected Cash-Flow Income-Stream, also called Discounted Cash-Flow (DCF) Analysis.
When finance and economic analysis is in progress, the concept of ‘flows’ is used, to show where the money goes. Money flows ‘in’ or ‘out’, with Net Cash-Flow available to pay dividends to owners of capital.
The basic premise is as follows, you:
1. Understand a business’ past cash-flows (both in and out),
2. Understand the nature of the income cycle,
3. Understand the cost structure of the business,
4. Understand what influences (both internal and external) the business model is sensitive towards,
5. Understand the accounting and economic break-even points, for sales dollars and sales quantity,
6. Understand supply and demand issues, at the micro and macro level, for this type of business, and
7. Have a view of the future, and for the business.
8. Make assumptions (which are documented), for each line of the cash-flow.
9. Project the cash-flow forward in time for three years, using zero-based budgeting; with the balance of the current year, plus one full year, shown month-by-month, and then two further years shown on an annual basis.
10. Identify and understand the risks of the project, and, whilst mitigating where you may, come to a conclusion whether the business is more or less risky than the market (using a proxy company where you can).
11. Derive a Before-Tax, Discount Rate, which fully describes the expected risk in the project going forward over the life of the project (eg Opportunity Cost of Capital).
12. Do not use the Weighted Average Cost of Capital (WACC) method to derive the Discount Rate, unless there is an appropriate amount of equity ‘hurt-money’ on the table, and the owner’s residential property is not being used as collateral for any loans; as evidenced in the balance sheet. Otherwise use an Opportunity Cost of Capital proxy, such as the Borrowing Rate plus a Margin-of-Safety.
13. Insert the Discount Rate into the Present Value (PV) formula applicable to the circumstance, and derive a Multiple.
14. Apply this Multiple to the Earnings Before Interest and Taxes (EBIT) figure from the cash-flows above, bringing these future cash-flows back to a single number, as it would be in the present-day, discounting for time and risk.
15. A way to think about it is; if I was offered a dollar today, or a dollar in one year’s time, and the opportunity cost of not taking the dollar today is 10pc, which will I prefer? If I take the dollar today, and put it in the bank, where I can earn 10pc, I will have $1.10 in one year’s time. So, if I wait, I will be $0.10 out of pocket. Conversely, how much would I have to invest today to receive a dollar in one year’s time? The answer is $0.91 ($1.00 / 1.1). A rational person will choose to take the dollar today.
16. This is similar to what is termed a ‘perpetuity’; where an amount is “grossed-up” to what it might look like ‘at the end-of-time’.
17. Take one dollar and invest it ‘perpetually’ at 10pc per annum, and it becomes $10.00 ($1.00/ 0.1); however, when you calculate the number of years (n) to ‘perpetuity’ ($10 = $1 x (1.1)n), it is only 24-years and 58-days. Granted, this is a long period of time, though it is hardly what we imagine as perpetuity; whatever that means. However in our modelling, some assumptions are made.
18. Another example: If $1.00 @ 25pc in perpetuity equals $4.00, then the time to perpetuity equals 6.212567-years (n = log 4 / log 1.25), or 6-years and 78-days.
19. So we may observe that as perceived risk rises, the pay-off horizon shortens; or the PV shrinks. The converse is also true. This is an example of the risk/return trade-off; as there is an inverse relationship (and therefore a negative slope) between them.
20. This adjustment for interest income (or expense), is referred-to as the ‘time-value-of-money’.
21. Another concept to understand in relation to NPV analysis (where positive NPV projects are acceptable investments) is the question, what is the hurdle rate of return (IRR), or the maximum borrowing-rate (less a Margin-of-Safety), where NPV equals zero?
22. A rational investor will surely pay no more than the number this discount hurdle rate equates to under the assumptions given; yet if the long-term view of interest rates over the term of the project is less than this hurdle rate, one will see a higher NPV and is more likely to invest.
23. And if expected EBIT increases, due to better management or market conditions, then the NPV will also rise.
24. A positive side effect of a higher EBIT as a percentage of Revenue, is that perceived lending risk will also fall, leading to lower risk premiums being applied.
I shall illustrate with an example.
If rural, pastoral and grazing land in the Blackall/Tambo Shire of Central Western Queensland, in large part, has an average carrying capacity for a cow-and-calf unit of 1:21-Acres, then the carrying capacity of the cow alone is 1:14.69-Acres (if weaning percentages are 80pc and bulls are joined at 3pc).
If a Margin-of-Safety of 10pc is added-on to this carrying capacity, then the number becomes 1:16.15-Acres per cow (Dry Unit Equivalent).
To arrive at a fair estimate of market value, for what this parcel of land is worth on a per-Acre basis (Walk-In, Walk-Out, including stock, plant and all things necessary for the continuing operation of a Going Concern enterprise), you should request trading and profit and loss statements from the vendor (under signed Confidentiality and Non-Disclosure Agreements) going back at least five years, and the lodged income tax returns which accompanied them. This is an important step as a part of the data verification process.
There may well be resistance to this request from the vendor, as this data is of a private and sensitive nature. However this level of disclosure, is what everyone else in the real world complies with, to ensure there is full-information on the table for a prospective purchaser to review.
The production of same gives the purchaser some higher level of comfort around the numbers, and therefore a lower level of risk premium will be applied in the NPV analysis. Also, where there is un-certainty beyond rationality, lenders will also put a higher risk premium on any funding requirements.
To continue with my example, I will assume the following inputs and equations:
1. A purchaser will not borrow more than one-half of the expected market value of the total adult cattle herd.
2. A purchaser will not borrow more than 20pc of the total Asset Value of the enterprise including all things necessary; including the land component.
3. The parcel of land is around 36,000-Acres in size.
4. The average market value of the herd is $850.00 each. (It should be around $1300.00 per Head.)
5. The average adjusted EBIT, over the period covering the past five years, and expected over the next three years, is $450,000.
6. The carrying capacity, as calculated above, is 1:16.15-Acres (Dry Unit Equivalent).
7. That an appropriate regression equation to calculate a ‘Bare of Stock and Plant’ Price for comparison, may be:-
• Y = $770.00 x (X) -0.717,where ‘X’ equals Carrying Capacity expressed as ‘Acres per Beast’.
8. That an appropriate regression equation to calculate a ‘WIWO (Operating)’ Price for comparison, may be:-
• Y = $1,417.30 x (X) -0.86,where ‘X’ equals Carrying Capacity expressed as ‘Acres per Beast’.
9. That the average Opportunity Cost of Investment is 9.5 percent per annum (Compound).
10. That a purchase should be looked-at like a perpetual Bond, paying annuity income as a coupon, and with NPV at Zero (0), to find the ‘price you should pay no more than’; using a multiple of income, and a cost to buy (reflecting perceived risk).
11. The formula for this calculation may be:-
• NPV = (EBIT x (1 + (1/Opportunity Cost))) – Original Cost.
• Setting NPV to Zero (0), the equation changes to,
• (EBIT x (1 + (1/Opportunity Cost))) = Original Cost
12. A rational risk-averse investor, only invests in positive NPV projects; so where NPV equals zero(0), you are indifferent as to whether you will invest or not.
13. There is no ‘one-true-value’.
14. Equations which model what might happen, only model our expectations of future expected cash-flow and value, and are not accurate; as only actual outcomes are measurable and real.
15. The concept of ‘common-sense’ should be fastidiously applied, and in large doses.
Expected Value per Acre: To Buy
• Bare of Stock and Plant:
– Y = $770.00 x (21.0) -0.717 = $3.124M. (or $86.79 per Acre.)
– We use the higher carrying capacity of 1:21.0 -Acres because the place is a blank piece of paper, and may have many uses; however that is the long-term carrying capacity of the place, on the average.
• WIWO (as a Going Concern):-
– Y = $1,417.30 x (16.15) -0.86 = $4.664M. (or $129.55 per Acre.)
• Value to Pay No More Than (WIWO):
– NPV = (EBIT x (1 + (1/Opportunity Cost))) – Original Cost.
– Set NPV equal to Zero (0).
– Equation becomes:-
o (EBIT x (1 + (1/Opportunity Cost))) = Original Cost.
o ($450K. x (1 + (1/0.095))) = Original Cost.
– Original Cost = $5.1868M. (or $144.08 per Acre)
– Therefore, the break-even value per Acre above, is the maximum you should pay; if the EBIT is $450K. and the borrowing cost is 9.5pcpa.
– Of course, if either variable changes, then so will the answer.
• ‘True’ value for WIWO lies between $129.55 and $144.08 per Acre.
• As you can see, it is important to have a view of the future, to ensure you do not pay too much.
• As each case is different, please consult with your advisor; however, the above should give you food for thought.
• Of course, ‘value’ is in the eye of the beholder; price is what you pay, and value is what you get.
• Be aware that under this model, if all else remains constant under the WIWO example above, except if Item-2 changes to 30pc, then the value per Acre you are willing to pay may fall to $87.72. This is a big difference, and it indicates the higher level of perceived operating and financial risk, as Debt/Equity ratio moves from 20pc or 2/8 (25pc), to 30pc or 3/7 (43pc).
• Alternately, if the Expected Future Revenue looks set to jump (due to the signing of a long-term trade agreement with another country), then the Demand Curve for beef will shift quickly relative to the Supply Curve (which is fixed in the short-term), and of course you should expect to receive a higher capital payment if you are a seller; and conversely pay more if you are a buyer.
Expected Value per Acre: To Lease or for Agistment
If you did not want to buy through lack of access to capital, and merely required Agistment, or a Lease, on a per-Head-per-Week basis (as applied to adult cattle), and the expected yield was similar to the Opportunity Cost of Capital, then the following may apply:-
– ((Value / Acre) x (Opportunity Cost) x (Carrying Capacity / Acre)) / 52-Weeks.
– Or, our old friend, (Beast Area Valuation x Opportunity Cost) / 52-Weeks.
– Dry Cattle = ($144.08 x 9.5pc x 16.15) / 52 = $4.25 per Head per Week, or
– Dry Cattle = ($2,326.89 x 9.5pc) / 52-Weeks = $4.25 per Head per Week.
– Wet Cattle = ($144.08 x 9.5pc x 23.10) / 52 = $6.08 per Head per Week, or
– Wet Cattle = ($3,328.25 x 9.5pc) / 52-Weeks = $6.08 per Head per Week.
– Same income overall will eventuate, but able to carry less adult cattle; per the assumptions above.
– You will note BAV is different for Wet or Dry cattle. How can this be? It is exactly the same block of land! Therefore, BAV may be confusing, and should only be used as a rough guide when valuing agricultural land.
What I have tried to show here, in the above assumptions and calculations, is that a rational approach needs to be made to the valuation of any investment, no matter where, or what it is; else you run the risk of paying too much.
It may also mean having your banker/financier see the investment as more high-risk than it otherwise should be, and therefore self-justifying charging you a higher interest rate premium, as applied on borrowed funds, than necessary; which may have the unintended consequence of leading to a higher risk of bankruptcy in marginal investments; remember this type of business is usually asset-rich, but cash-poor (though it should not be); so always build into your calculations a Margin-of-Safety.
The Discounted Cash-Flow (DCF) Method and the calculation of the Net Present Value (NPV) of an income stream, is a very appropriate way to value an asset of this type, and is used by investors from all walks of life; whilst also being strongly supported by the Courts, as a valid and robust approach to valuing assets.
The ‘accounting equation’ (where Assets = Liabilities + Equity), like all good algebra, must stay in balance. When valuing a business using this Method, you are valuing the Assets which you need to operate the business; however, if you are buying the business’ legal structure (ie a Pty Ltd company, for example), then take out any Surplus Assets and remove any Liabilities you are not absorbing, to arrive at the Equity Value (where Assets minus Liabilities = Equity).
Look to the long-term patterns in the data for randomness, trend, cycle, and seasonality, etcetera, by using a 13-week Weighted Moving Average of Revenue (for example), only looking back to learn; however, have a view of the future, and remember, you value an asset with a view to the future expected income from it.
The past has a memory, which carries forward, though dissipating with the passage of time; usually exponentially, depending upon the accepted usage and effect. Remember the past is just a guide to the future, so only look back to learn.
Do not pay too much; as you make your profit when you buy, not when you sell.
I encourage debate, and am happy to be proved wrong.
Good Luck, and thank you for your time.
Previous articles by Michael Vail: