Financial aspects of farm forestry

Size: px

Start display at page:

Download "Financial aspects of farm forestry"

Gregory McCarthy
5 years ago
Views:

1 Part 1 Chapter Financial aspects of farm foresty Financial aspects of farm forestry are measured over a long period of time. Financial aspects of farm forestry John Lord Financial measurement of farm forestry Financial measurement of farm forestry is difficult because we are measuring dollars over a long period of time. From a business perspective, we need to be able to measure farm forestry and see if it has the potential to be a profitable enterprise, and to compare it financially against our other enterprises. We can calculate the gross margins from our barley crop by deducting our costs from our sales. Because it is all happening in the one year, we don t usually take into account that we had to pay for the cost of planting the crop some time before we received our money from sales. With farm forestry we may well be spending money now and not receiving money back from the sale of timber for fifteen to thirty years or longer. How can we understand and compare the financial returns from growing trees against our other enterprises such as our barley crop? To do this we need to understand: that money has a time value, the concept of present value (the present value of a sum of money to be received or paid at sometime in the future), the concept of net present value (the net present value of the sum or sums of money to be paid and/or received over a period of time). Worked examples of the value of various forestry enterprises are presented in Chapter 11, Profit. Time value of money Would we rather have $100 now or in a year s time? We d probably rather have it now. We d be able to invest at say 5% and earn $5. Money has a time value. So we can t sensibly measure a $100 now against a $100 in a year s time. They have different values. To do so would be like trying to measure apples against oranges. 42

2 snapshot - finanicial aspects of farm forestry The tables below demonstrate the change in the value of money with time. This is why it is so important to conduct a financial analysis to compare various land management options before you start establishing trees as a business. The common ways of doing this are Net Present Value (NPV) and Internal Rate of Return (IRR). Table 1 (a) For example: at 5% interest, $1 is worth $34 in 120 years (b) For example: If you are given $1.00 today, in 0 years it would be worth only 2 cents in today s money if discounted at 5%. Table 1a: Compound interest table The starting value is $1.00 at year 0. Each year interest is calculated on the starting value plus all previous interest. Interest percentage 5% 6% 7% % 9% 10% 12% Year Year Year Year Year Year Year Year Year Year Year Part 1 Chapter Financial aspects of farm foresty Year Year Year Year Year Year Year Year Year Table 1b: Compound discount table The starting value is $1.00 at year 0. Each year discount is calculated on the previous year s discounted value (I.e. the starting value minus the discounts for all previous years). Discount percentage 5% 6% 7% % 9% 10% 12% Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year

3 Part 1 Chapter Financial aspects of farm foresty Present value What if we were offered $100 now or $105 in a year? We decide whether we would prefer the cash now or in a year s time by calculating the present value of the money offered in a year and comparing it with the money offered now. This enables us to compare apples with apples. What is $105 in a year worth to us now, if our opportunity to use the money now (ie the interest) is 5%? We discount the $105 by 5% for one year as follows: Future value x fraction = present value $105 x 100 = $ We could say $105 in a year s time has a present value of $100. In this case we wouldn t mind whether we received $100 now or $105 in a year. They have the same value. value of these five amounts offered over the five year period is $454. Net present value When we grow a crop we normally have to spend money to plant it. Let s assume we plant a perennial crop in year zero. This costs us $100. Let s assume we will receive an income of $30 from it for each of the four years before it runs out. Our nominal cash flows will look like this: Year Total cash flows Discounted at 5% $(100) $30 $30 $30 $30 $(100) $2.50 $27.20 $25.90 $24.70 $6.30 Let s assume that if we had the same amount of money ($100) in the bank it would earn us 5% (i.e. 5% is the opportunity ). Discounting the nominal cash flows by this amount, we get a positive net present value of $ What if we were offered $100 per year for 5 years, what is this worth today? Let s set the offer out: Years Total Offer $100 $100 $100 $100 $100 $500? We can t simply add them together because they have different values. If our opportunity to use the money (i.e. the interest) was 5% we could discount these figures by 5% per annum to give us the present value of each. Years Total Offer $100 $100 $100 $100 $100 Present Value $100 $95 $91 $6 $2 $454 We can sensibly add them together because we have brought them back to the same value in today s dollars. The present Net present value = annual income (discounted by 5%) - costs today Therefore, in this case: Net present value = ($ $ $ $24.70) - $100 = $6.50 This means this investment offers a better financial return than leaving the dollars in the bank earning 5%. This investment is better by $6.30. But, how much better is it? What earning rate does this investment offer? Internal rate of return IRR IRR is a commonly used means of measuring the profitability of a business venture. It is a means of calculating the discount rate of a venture so that the net present value is zero (i.e. the breakeven point, where discounted costs = discounted returns). If we discount the

4 cash flows in our perennial crop in the example above by 7.7%, what will the net present value be? The answer is zero. Our calculation looks like this: Year Total cash flows Discounted at 7.7% This means our perennial crop offers us the opportunity of a 7.7% return. What is the rate of return of this venture? The answer is 7.7%. Its IRR is 7.7%. Calculating IRR used to be a tedious job when all we had was a calculator and a pencil. If we have access to a computer, the task is easy. Most spreadsheet programs have built in financial formulae, including one for calculating IRR. All we need to do is have the formula to calculate the IRR of the nominal cash flows in the venture or investment we are contemplating. Remember not to include finance costs or charges in such projections. We want to see how profitable the venture we are contemplating might be. The questions that follow this might be: Will we have enough money to fund the venture? Will we have to borrow? Can we afford to borrow? We need to know how healthy the animal is in order to decide whether we would like to buy it, before we work out whether we have to borrow money to buy it. Remember also that we live in times of inflation. This is another variable. It is better to leave inflation out of calculations because all it does is increase the complexity. $(100) $30 $30 $30 $30 $(100) $27.20 $25.90 $24.70 $22.30 $6.30 When inflation is left out, the costs we plan to spend today and the income we expect to receive in the future are all expressed in today s values. Then when we calculate the IRR to see how profitable the proposed venture might be, we call it a real IRR, i.e. the IRR is not made to look better than it really is because of the effects of inflation. Look carefully at advertised rates of return on investments. See if the rates are real or if the prices used to calculate the rates of return have been assumed to rise each year by an inflation amount. Now we understand how IRR works, and especially if we have access to a computer with spreadsheet software, we can easily build simple models to enable us to compare the real and relative financial returns from enterprises or ventures we are conducting or contemplating. Remember the spreadsheets won t factor in the risks of loss or failure due to poor seasons or markets. The information we use in our models has to build in whatever level of risk we perceive may exist. We can have an IRR calculation for a one year crop such as barley for a three year cropping rotation on a cropping farm, and a fifteen or thirty year investment in farm forestry. The IRR will enable us to compare the relative financial returns from each enterprise. What real IRRs might we expect from farm forestry? We can calculate IRRs for growing trees in shelterbelts, in plantations and for managing areas of native forest. When we are building a financial model and want to calculate the IRR, we have to include the value of the assets we use. When we are building a model of farm forestry, we need to include (on a notional basis at least) the cost of the land we need. To correctly calculate IRR we need to include the fact that we will be using the value of this land during the years of the venture. We probably already own the land and don t have to buy more. We don t really have to sell our land at say year 15. We 45 Part 1 Chapter Financial aspects of farm foresty

5 Part 1 Chapter Financial aspects of farm foresty just have to notionally do so in our model in order to obtain the correct IRR. Including the value of the land assumes we could otherwise use it for something else. The shelter effect on stock, pasture and crops of well placed farm forestry tree planting may mean the same stock and crop production can be obtained from the remaining land. Note, as a general rule 10% of land can be planted to trees without overall loss of production to the farm. Where this is possible, we are able to, in effect, obtain the land on which to plant trees at no cost, at least in terms of no lost production from an existing enterprise. Sometimes we have areas of land that really cannot be used efficiently for anything else. Sometimes these are cleared areas that cannot be replanted and sometimes these are areas of existing native forest. In these cases we can calculate the financial return from our farm forestry opportunities on a marginal basis and leave out the value of the land. This would show a higher rate of return because we are in effect saying we have the use of this land for free. perspective, the likely returns are just as good, and in some cases better, than from plantations. The ABARE study considered sites which were poor, average and good and also considered the impact of distance from markets. Because wood is very heavy relative to its value, cartage is one of the biggest costs. For average sites located 50 km from markets the average of the ABAREcalculated real IRRs was 6.4%. For sites 200 km from the markets the average IRR was 4%. On good sites the average of the IRRs were 11.2% and 9.2% respectively for 50 and 200 km distances. We can compare these with our existing enterprises. 46 What is the range of IRRs that one may expect from farm forestry? The range will vary greatly depending on the growth rate achieved and distance from markets. In 1994, ABARE prepared a paper (ABARE Conference paper 94.1: An economic assessment of private forestry in Tasmania ) in which they calculated the likely IRRs of various farm forestry operations in northern Tasmania. This included managing native forests and plantations. Most interestingly, the ABARE study showed that the likely IRR from managing native forests is similar to the IRR from growing trees in plantations. This is very important and means that we can keep and manage our areas of native forest in the knowledge that, from a financial Indirect financial returns We can build in the effect of shelter into our financial model as set out above. We may also find that well placed farm forestry planting and well managed areas of native forest may help us sell up and move or retire, and may even help secure a higher price.

6 Last but not least, some farms are now running out of fire wood. A benefit from farm forestry for many of us will be the provision, on an ongoing basis, of domestic fire wood. Financing your farm forestry venture If we are lucky enough to have some mature native forests, our management plan will probably include some harvesting. This will produce a cash-flow first up! We can use the cash received to plant trees elsewhere on our farm. If we do not have this opportunity or have any spare cash, we can nonetheless proceed with the farm forestry venture by: entering into a private joint venture with another person who does not have the land but has the money; or Part 1 Chapter Financial aspects of farm foresty entering into a joint venture with one of the commercial forestry companies; or In these two cases we will receive our income when the trees mature, and are harvested and sold. Leasing our land to one of the commercial forestry companies. In this case we will receive a cash flow in the form of land rentals each year. Remember also that trees are like us and have a finite life. Old trees, especially old pine trees that are dropping branches and falling over, are a real problem and cost money to remove and replant. Wherever we can do so, in a way that satisfies our other objectives, we should include some commercially saleable species in our plantings. If we do this we, or the next generation, will have a better chance of having the financial means of maintaining and enhancing the trees on our farm in the future. 47

Investment Appraisal

Investment Appraisal Introduction to Investment Appraisal Whatever level of management authorises a capital expenditure, the proposed investment should be properly evaluated, and found to be worthwhile