Mr. Agirich of Aggie Farms is considering the purchase of 100 acres of prime ranch land that is adjacent the ranch he now owns. Mr. Agirich can operate the additional 100 acres with present labor, machinery and breeding livestock. The land is selling for $400 per acre. Mr. Agirich believes that the operating receipts per acre of land per year will $450 and operating expenses will be $420 in present dollars. Mr. Agirich expects that the inflation rate will be 3% and operating receipts and expenses per acre will increase at the rate of inflation. The farmer will sell the land in three years and he anticipates that land prices will increase at the rate of inflation (from a base price of $400). A bank will loan him $350 per acre of land and the loan will be fully amortized over 15 years at 10% (annual payments). The outstanding balance of the loan will be paid at the end of the third year (balloon payment). Assume that the marginal tax rate is 30% and that Mr. Agirich requires at least a 6% pre-tax, risk-free return on capital and a 4% risk premium on projects of comparable risk. (Do the analysis on a per acre basis.)
A. Lay out the cash flows for the investment.
B. Calculate the net present value. [NPV=$6.12]
C. Layout the financing cash flows associated with this investment.
D. Is there a potential liquidity problem?
E. What maximum price should Mr. Agirich be willing to pay for an acre of land? [$408.13]
F. Calculate the net present value if the real net returns of $30.00 per acre and the real purchase price of land of $400 per acre are assumed to increase by 4% each year. Remember that you still need to adjust for inflation. Everything else is the same as before.