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Archer Daniels Midland Company is evaluating an investment proposal to acquire a new farm intended to be operational over a span of ten years. This investment involves an initial capital outlay of $11.90 million, comprising $2.20 million allocated to land acquisition and $9.70 million invested in trucks and equipment. At the end of the ten-year period, all assets—including land, trucks, and equipment—are projected to be sold for $5.08 million, which exceeds their book value by $2.12 million. The farm is expected to generate annual revenues of $2.05 million, with actual cash flows from operations amounting to $1.89 million each year. The company faces a marginal tax rate of 35%, and the appropriate discount rate for evaluating this investment is 10%. The task is to calculate the Net Present Value (NPV) of this project based on these parameters.

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Investment decisions within the agricultural and manufacturing sectors often hinge on detailed financial analyses, including calculations of net present value (NPV). NPV serves as a critical measure of an investment’s profitability, incorporating estimates of future cash flows discounted at the company's required rate of return, and accounting for initial investments and salvage values. In assessing Archer Daniels Midland’s proposed farm acquisition, understanding the components of cash flows, the impact of taxes, and the appropriate discount rate is essential for an accurate valuation.

To compute the NPV, first, we examine the initial investment outlay, which is $11.90 million. This includes all costs associated with land, trucks, and other equipment. Next, we project the annual cash flows generated from operations, which amount to $1.89 million per year. These cash flows are after taxes, as taxes influence the net cash flows available to the company. The income taxes on the operational cash flows are calculated considering the marginal tax rate of 35%, and since cash flows are given as cash from operations, they are presumed to be tax-adjusted or need to be adjusted depending on further tax considerations. In this context, the cash flows from operations are assumed to be the after-tax cash flow, which simplifies calculations.

The project’s salvage or residual value at the end of ten years is $5.08 million. This amount exceeds the book value, implying a gain on sale of $2.12 million, which is subject to taxes. The tax on the salvage value gain is calculated at 35%, resulting in net after-tax salvage proceeds of $5.08 million minus 35% of $2.12 million ($0.742 million), totaling approximately $4.338 million. This salvage value, when discounted to the present, contributes to the overall NPV calculation.

The NPV calculation encompasses the present value of all future cash flows, including the terminal value (salvage proceeds) and the annual operational cash flows, minus the initial investment. Using the formula for NPV:

NPV = ∑ (Cash flow in year t / (1 + discount rate)^t) + (Salvage value / (1 + discount rate)^t) - Initial investment

where t ranges from 1 to 10. Plugging in the appropriate values:

- Annual after-tax cash flow: $1.89 million

- Salvage value after tax: $4.338 million at year 10

- Discount rate: 10%

- Investment: $11.90 million

Calculating the present value of the annuity of annual cash flows over ten years using the formula for the present value of an annuity:

PV of cash flows = $1.89 million [(1 - (1 + r)^-n) / r] = $1.89 million [(1 - (1 + 0.10)^-10) / 0.10]

Evaluating the annuity factor:

(1 - (1 + 0.10)^-10) / 0.10 ≈ 6.1446

So, PV of annual cash flows ≈ $1.89 million * 6.1446 ≈ $11.62 million

Now, discount the salvage value:

PV of salvage value ≈ $4.338 million / (1 + 0.10)^10 ≈ $4.338 million / 2.5937 ≈ $1.672 million

Summing these, the total present value (PV) of cash inflows is approximately:

PV total ≈ $11.62 million + $1.672 million ≈ $13.292 million

Finally, subtract the initial investment to compute the NPV:

NPV ≈ $13.292 million - $11.90 million ≈ $1.392 million

Therefore, the net present value of this investment is approximately $1.392 million, indicating a potentially profitable project that exceeds the company's required rate of return.

References

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