Question

A tract of farmland requires an initial outlay of $30,000. The first-year net cash flow is $5,000 and will increase by 5% annually. The land value will grow by 2% annually. A farmer’s real cost of capital is 6% and the anticipated inflation rate is 3%. The farmer pays 20% tax on ordinary income and 15% tax on the capital gain. The farmer is considering making the investment on the tract of farmland and holding it for 6 years. Please help the farmer evaluate the profitability of the investment.

Answer 1

The nominal rate of return required by farmer = 1.06*1.03 -1 = 9.18%

The Free Cashflows are calculated as shown in table

	Year
	0	1	2	3	4	5	6
Cost of Land	30000
Cash flows		5000	5250	5512.5	5788.125	6077.531	6381.408
After Tax Net cashflows		4000	4200	4410	4630.5	4862.025	5105.126
Final land value							33784.87
Capital Gain							3784.873
Tax on Capital Gain							567.7309
After tax Land value							33217.14
FCF	-30000.00	4000.00	4200.00	4410.00	4630.50	4862.03	38322.27

So, the NPV

= - 30000+4000/1.0918+4200/1.0918^2+4410/1.0918^3+4630.50/1.0918^4+4862.03/1.0918^5+   38322.27/1.0918^6

= $9593.61

So, the project is profitable at the nominal discount rate of 9.18% ie. the project will be able to compensate for the 6% real cost of capital as well as the inflation of 3%