Archer Daniels Midland Company Is Considering Buying 249169

Archer Daniels Midland Company Is Considering Buying A New Farm That I

Archer Daniels Midland Company is considering buying a new farm that it plans to operate for 10 years. The farm will require an initial investment of $12.00 million. This investment will consist of $2.00 million for land and $10.00 million for trucks and other equipment. The land, all trucks, and all other equipment is expected to be sold at the end of 10 years at a price of $5.00 million, $2.00 million above book value. The farm is expected to produce revenue of $2.00 million each year, and annual cash flow from operations equals $1.80 million. The marginal tax rate is 35 percent, and the appropriate discount rate is 10 percent. Calculate the NPV of this investment.

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The Net Present Value (NPV) calculation is a critical financial metric used to assess the profitability of an investment. It considers the current worth of all cash inflows and outflows associated with the project, discounted at the appropriate rate. For Archer Daniels Midland Company’s potential investment in a new farm, detailed considerations such as initial investment costs, salvage value, annual revenue, operational cash flows, taxes, and discount rate are essential components to computing the NPV accurately.

The initial investment of $12.00 million comprises $2.00 million for land and $10.00 million for trucks and equipment. Since the land, trucks, and equipment are to be sold after 10 years at a price of $5.00 million (which exceeds the book value by $2.00 million), we recognize this salvage value in our calculations. It is important to consider that the salvage value will be affected by taxes, as the sale of assets results in a gain that is taxable.

The farm generates annual revenue of $2.00 million, with operational cash flows of $1.80 million. These cash flows are subject to taxes at a rate of 35%. The after-tax annual cash flow from operations is therefore calculated as:

\[

\text{After-tax cash flow} = \text{Operational cash flow} \times (1 - \text{tax rate})

= \$1.80\, \text{million} \times (1 - 0.35) = \$1.80\, \text{million} \times 0.65 = \$1.17\, \text{million}

\]

In calculating the NPV, it’s crucial to account for the tax impact of the salvage value. The sale of the assets at the end of 10 years would generate a gain of:

\[

\text{Gain} = \text{Salvage value} - \text{Book value}

\]

Given the initial book value of all assets combined is $12 million, and the salvage value at the end is $5 million, which is below the book value, the sale results in a loss of $7 million. No capital gains tax is incurred in this case, but if the salvage value exceeds book value, taxes would apply on the gain.

Since the sale value is below book value, the entire loss of $7 million can potentially be used as a tax shield, reducing taxes payable.

However, for simplicity and considering the tax situation, we will assume no tax on salvage since there is a loss. The after-tax salvage value is thus $5 million, as there is no tax liability on a loss.

To summarize, the components of the NPV calculation include:

  • Initial investment: $12 million (outflow at Year 0)
  • Annual after-tax cash flows from operations: $1.17 million (for 10 years)
  • After-tax salvage value: $5 million (at the end of Year 10)

The NPV can now be calculated using the formula:

\[

NPV = - \text{Initial Investment} + \sum_{t=1}^{10} \frac{\text{After-tax cash flow}}{(1 + r)^t} + \frac{\text{Salvage value}}{(1 + r)^{10}}

\]

where \( r = 10\% \).

Calculating the present value of annual cash flows:

\[

PV_{\text{cash flows}} = \$1.17\, \text{million} \times \left( \frac{1 - (1 + r)^{-10}}{r} \right)

\]

\[

PV_{\text{cash flows}} = \$1.17\, \text{million} \times 6.145

\]

\[

PV_{\text{cash flows}} \approx \$7.189\, \text{million}

\]

Calculating the present value of the salvage value:

\[

PV_{\text{salvage}} = \frac{\$5\, \text{million}}{(1 + 0.10)^{10}} \approx \frac{\$5\, \text{million}}{2.5937} \approx \$1.926\, \text{million}

\]

Putting it all together, the NPV is:

\[

NPV = -\$12\, \text{million} + \$7.189\, \text{million} + \$1.926\, \text{million} = -\$2.885\, \text{million}

\]

This negative NPV indicates that, given the assumptions and calculations, the project would not be financially favorable under the specified conditions, as the discounted cash inflows do not cover the initial investment.

It’s important to note that this analysis assumes straight-line calculations of cash flows, a simple tax environment, and no consideration for other potential costs or benefits, such as operational efficiencies or environmental impacts. A comprehensive investment decision would include more detailed sensitivity analyses and consider alternative scenarios.

References

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