Which Income Options are Right for You?

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1 Which Income Options are Right for You? Paul Dietmann, Emerging Markets Specialist Badgerland Financial (608) Whole Farm Planning Workshop for Landowners February 7, 2015 Dodgeville

2 Badgerland Financial Rural lending (& other financial services) cooperative Farm Credit System association 325 employees, 17 offices Serves 33 counties in Southern Wisconsin 15,000 members Largest ag lender in WI $3.6 billion loan portfolio Paid $9.55 million in cash dividends to farmers/members for 2013 business; will pay $13 million for 2014

3 Our 67 acres in the Town of Clyde, Iowa County

4 Resources Three resources provided to us for free: sunshine; wind; and precipitation Three resources we have available to invest: our labor; our time; and our wealth Everything else can be borrowed, bought, or rented About 40 productive years to do something (with apologies to Howard Buffet)

5 The big question: How do we make the wisest use of all of the resources at our disposal?

6 What are some income options available to you? Rent out cropland Have land customfarmed Rent out pasture Rent out hunting rights Rent out farmhouse Gov t/ngo program payments Crop it yourself Raise livestock Grow fruit crops Grow forest products Sell timber Sell firewood Keep bees Make maple syrup Start ag tourism venture

7 Can we make money with any of these enterprises?

8 Corn Enterprise Budget 180 bushels x $3.75/bushel $675 Seed $100 Fertilizer $150 Chemicals/spraying $40 Tillage $50 Planting $18 Harvesting $32 Hauling/drying $30 Crop ins. $30 Operating interest $10 $460 -$460 Land charge $200 -$200 $15 This budget assumes all field operations are being custom hired

9 Alfalfa Enterprise Budget 4 tons DM x $150/ton $600 Seed $0 Fertilizer $100 Chemicals/spraying $17 Tillage $0 Planting $ Cut, merge, chop, haul, pack $240 Crop ins. $0 Operating interest $5 $362 -$362 Land charge $200 -$200 $38 This budget assumes all field operations are being custom hired

10 What could you make from one hive of bees? 40 pints (60 lb. $7 $280 Bees & supplies -$122 1/5 of cost of equipment -$79 Potential net income $79

11 Important considerations Do you need immediate cash flow or are you building for longer-term return? Which options fit with your personal goals, interests, abilities, and values? Which income options fit together?

12 Once we ve narrowed our choices, we need to develop cash flow projections. We can then use Net Present Value to analyze options, and Internal Rate of Return to compare one to another.

Time value of money The sooner you receive money, the

stop interest from accruing Inflation causes money to

in the future The longer you have to wait for money to

adjust values for the cost of waiting The longer you

13 Time value of money The sooner you receive money, the better Money you get today can be invested or used to stop interest from accruing Inflation causes money to lose buying power over time Benefit of investments are in the future The longer you have to wait for money to come in, the less it is worth to you today We need to adjust values for the cost of waiting The longer you wait, the greater the risk that you won t get paid back

14 Would you rather have $10,000 today or $10,000 three years from now? To adjust the value for cost of waiting Discount (penalize) future income Discounting converts future income into today s dollars

15 In Option A, we are compounding In Option B, we are discounting 15 Source: investopedia.com, Understanding the Time Value of Money

into a single current value Can tell us if an opportunity is a

16 Net Present Value (NPV) Tells us what a future cash payment is worth in today s dollars Converts a stream of future cash flows into a single current value Can tell us if an opportunity is a good investment It won t tell us if it s our best investment of dollars

Scenario: You are thinking about buying a log splitter for $1,500 You ve done a simple cash flow projection and calculate that after paying the fuel and maintenance costs, you can net an additional

17 Scenario: You are thinking about buying a log splitter for $1,500 You ve done a simple cash flow projection and calculate that after paying the fuel and maintenance costs, you can net an additional $200 worth of firewood each year with the same amount of labor it takes to split logs by hand. You can also rent it out for a few days to a neighbor and generate another $100. Total annual cash flow: $300. You plan to use the splitter for five seasons, then believe you can sell it for $1,000.

18 It is tempting to do this really simple calculation: Five years x $300/year = $1,500 Salvage value $1,000 $2,500 Minus the initial cash cost -$1,500 =Net cash flow for 5 years $1,000 This suggests you d get a 67% return on your initial investment ($1,000/$1,500 = 67%), which is NOT TRUE. This calculation doesn t consider the time value of money. To consider the time value of money, we need to apply a discount rate. 18

19 How do we establish a discount rate? We could use the interest rate we would have to pay to get a loan for the capital purchase We could use the prime lending rate and add to it the rate of inflation We could set a personal hurdle rate the least return you re willing to accept Whichever method we use, we need to adjust for the riskiness of the investment. The more risky it is, the greater the discount factor. 19

20 NPV of cash flows for log splitter Year Annual Net Cash Flow Discount 5% Present Value of Annual Net Cash Flow 1 $ $ $ $ $ $ $ $ $300 + $1, $ Net Present Value of the cash flows $2, Since the initial cash outlay for the log splitter was $1,500, it makes sense to make the investment. But, if the return isn t 67%, how much is it???

21 How good is the investment in the log splitter? (You can download this spreadsheet from:

22 Pasture scenario: You own 40 acres of open, rolling land that is not currently generating any income. Property taxes as rec land are $1,500/year. A beef producer wants to enter into a five-year lease to use it as pasture. Your property taxes will drop to $100/year as pasture. It will cost $12,000 to build perimeter fence, watering system, etc. You could pay 100% of the cost and charge an annual rental rate of $75/acre, or split the cost 50/50 with the renter and charge $50/acre. Either way, you own the improvements at the end of the lease. Would either be a good deal? Which is better?

23 Option A: Landowner pays for pasture improvements Cash outlay for 40 acres perimeter fence, energizer, watering system will be approximately $12,000. Annual income: Pasture rent : $75 x 40 acres 3,000 Property tax savings 1,500 $4,500 $4,500 Annual costs: Electricity 150 Property taxes 100 $250 -$250 Net annual cash flow $4,250 At the end of five years, the pasture improvements will have depreciated to $5,000.

24 Return from landowner s upfront investment: 28.82%

25 Option B: Renter pays 50% of pasture improvements Landowner s cash outlay for 40 acres perimeter fence, energizer, watering system will be approximately $6,000 Annual income: Pasture rent : $50 x 40 acres 2,000 Property tax savings 1,500 $3,500 $3,500 Annual costs: Electricity 150 Property taxes 100 $250 -$250 Net annual cash flow $3,250 At the end of five years, the pasture improvements will have depreciated to $5,000.

26 Return from 50/50 upfront investment: 52.97%

27 How does it look from the renter s perspective? Cash flow assumes stocking rate of 40 $50/head net return

28 Woodland owner scenario: You are thinking of buying 40 acres of average quality wooded land in SW Wisconsin as a long-term investment. The land is valued at $100,000. You re trying to decide how to manage it. Your options are: A) Fence the perimeter & pasture it to lower the property taxes, harvest low-average quality timber in 15 years B) Do nothing, pay the taxes and in 15 years, harvest 1/3 of the timber at average quality C) Develop a forest management plan, enroll in MFL, actively manage for timber stand improvement and in 15 years, harvest 1/3 of the timber at good quality D) Develop & implement a forest management plan. Don t enroll in MFL. Lease out the hunting rights. 28

29 Assumptions: Parcel starts with 3,000 bf/acre of average quality timber Value of the timber in first year is $100/1,000 board feet (Good quality timber would be worth $175/1,000 bf) Timber prices increase 4% per year Average quality timber will be $180/1,000 bf in 15 years Good quality timber will be $315/1,000 bf in 15 years Land value increases 2% per year $135,000 in Year 15 Without management, parcel grows 100 bf/acre/year With management, parcel grows 200 bf/acre/year

30 Option A: Fence and pasture Capital outlay for 40 acres perimeter fence, energizer, watering system will be approximately $12,000. Annual income: Rent of forest pasture: $30 x 40 acres $1,200 Annual costs: Fence maintenance, 10 hrs x $15/hour 150 Electricity 150 Property taxes 75 $375 $375 Net annual cash flow $825 Income from sale of average quality timber in Year 15 1/3 of 4,500 bf/acre x 40 acres x $180/1,000 bf $10,800 Value of remaining timber is $21,600

31 Return from Option A: 3.33%

32 Option B: The do nothing plan No capital outlay for anything. Annual income: $--0-- Annual costs: Property taxes 2,000 Net annual cash flow -$2,000 Income from sale of average quality timber (4,500 bf/acre) in Year 15 1/3 of 4,500 bf/acre x 40 $180/1,000 bf = $10,800 Value of remaining timber is $21,600

33 Return from Option B: 1.92%

34 Option C: Timber stand improvement plan w/mfl Capital outlay for forest management plan (with 75% cost-share) $250 Annual income: Value of firewood harvested $500 Annual costs: Property taxes in closed MFL $427 Management 40 hrs/year x $15 x.5 $300 (1/2 paid by WFLGP) Net annual cash flow -$227 Income from sale of good quality timber (6,000 bf/acre) in Year 15 1/3 of 6,000 bf/acre x 40 $315/1,000 bf = $25,200 Less approximate MFL stumpage tax $30/acre -$1,200 NET $24,000 Value of remaining timber is $50,400

35 Return from Option C: 4.87%

36 Option D: Timber stand improvement plan, no MFL Capital outlay for forest management plan (with 75% cost-share) $250 Annual income: Value of firewood harvested $500 Hunting lease $1,500 Annual costs: Property taxes $2,000 Management 40 hrs/year x $15 x.5 $300 (1/2 paid by WFLGP) Net annual cash flow -$300 Income from sale of good quality timber (6,000 bf/acre) in Year 15 1/3 of 6,000 bf/acre x 40 $315/1,000 bf = $25,200 Value of remaining timber is $50,400

37 Return from Option D: 4.86%

38 Some cautions This is only the beginning, not the whole story Don t substitute enterprise budgeting or investment analysis for whole farm financial planning Month-by-month cash flow projections are extremely important if you are relying on income from your land to support family living costs People become farmers or landowners for many different reasons; high profitability is not usually #1. And that s okay! 38

Farm Enterprise Budgeting: Should I Grow Corn, Convert to Pasture

Farm Enterprise Budgeting: Should I Grow Corn, Convert to Pasture or? Paul Dietmann, Emerging Markets Specialist Badgerland Financial Paul.dietmann@badgerlandfinancial.com WI Land + Water Conservation