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Financial Analysis |
INTRODUCTION
Forest and farmland owners today have a variety of investment opportunities available to them on their land. Depending on the characteristics of the property, the interested owner can in addition to growing trees, harvest pine straw, grow Christmas trees or mushrooms, or even lease hunting, fishing, or grazing rights. Some of these enterprises are added as hobbies without high financial expectations. Many landowners however are interested in the potential to increase income. This is especially true for owners of forestland who must often wait years before harvesting and selling timber. When the landowner becomes interested in managing an enterprise, a written management plan should be prepared. Management plans include a definition of objectives and level of involvement, an analysis of the market situation for the enterprise in question, a timetable of important activities, and an identification of major factors that may limit the success of the enterprise (Duryea, et al., 1988). The management of a successful forestry enterprise needs careful planning and decision-making, much like the management of a successful business. If a landowner is interested in making additional income from the land, the management plan should include a financial analysis. If properly done, the analysis can be among the most valuable tools used in the planning and decision-making process. Financial analyses give needed information on the profitability of an enterprise, or provide assistance in choosing between two or more potential enterprises. The purpose of this publication is to introduce the landowner to the financial concepts necessary to properly evaluate alternative forestry enterprises. This publication emphasizes the financial benefits and costs. However; landowners often undertake projects for a variety of reasons other than financial return. These nonmarket objectives, such as management for recreation, nongame wildlife habitat, aesthetics, or soil conservation can also be included in an analysis. Although the concepts are very similar; placing values on these benefits and costs can be a time-consuming task. Methods for valuing these are offered in Unpriced Values: Decisions Without Market Prices (Sinden and Worrell, 1979). After an introduction of the general steps involved in financial analysis
a number of detailed examples will be examined. The costs and returns for
the investments in the examples represent rough averages. The costs and
revenues for a potential enterprise should be researched and estimated
by the landowner and/or a professional.
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| Introduction | STEPS
IN FINANCIAL ANALYSIS
Sound financial analysis depends on a complete accounting of costs and benefits over time. Keeping track of the costs and revenues and when they occur is important for management of cash flow. The timing and amounts of these cash flows determine the profitability of the forest resource enterprise. The flowchart in Figure 1 illustrates the steps taken in the financial analysis. 
In the first step the owner's objective and level of involvement are
determined. This step may seem straightforward. However; this is not always
the case. It is at this stage that you must ask yourself how involved you
want to be in the enterprise. Will the project be a hobby or do you wish
to make it your major line of work? How much time do you want to devote
to the project? How much are you willing to invest? Because the amount
of involvement often depends on the perceived returns, leave room for flexibility.
Objectives can be changed and the analysis modified. This is a major advantage
of sound planning. The project can be changed much easier and cheaper on
paper than on the ground.
In the second step the schedule of activities is determined. Contact someone familiar with the product who can assist you in this step. The events should be placed in the appropriate spots on a time line. The time line is a convenient way to track these activities over time. A sample time line for a Christmas tree farm is shown in Figure 2.
In this case, planting, pruning, mowing, fertilizing, and marketing
are needed. Make sure you include any and all activities, including your
own, that the project will require. A full rotation or production cycle
should be studied including costs of preparation and postharvest cleanup.
Identify as closely as possible the time of year (or period) that the activity
takes place. Activities that occur at the beginning of the year (or period)
rather than the end may have a significant effect on the outcome of your
analysis.
The third step is to attach dollar values to the schedule of activities. Determining the timing, and amounts of cash flows can be difficult. If you are going to be personally involved in the management of your land it is important to include your time as a cost. There are two ways to incorporate your time into the financial analysis. The first, and most straightforward, is to enter a wage for your time into the cost calculations. This wage should reflect the value of your time. For example, if you were considering quitting a job to work on your land, the value of your time is your current wage. If, on the other hand, you consider working on your land as recreation or therapy, you might charge yourself a lower or even zero wage. The second alternative to evaluating your time is to estimate your hours invested but not to include your wages as a cost. The financial return calculated in this way will include both profits and wages. This figure and the number of hours invested can be used to determine whether your time is worth the returns. Predicting other costs and revenues throughout the analysis period will probably require professional assistance or at least contact with persons currently in the business. Dollar figures will depend on the present and future supplies and demands of the product and any input needs. The economic environment is constantly changing. It is therefore very important to have the best and most current information available. For example, if the economics of Christmas trees appeared very favorable 5 years ago, then many people may have planted trees at that time and the increased competition and supply may keep future prices too low to justify current investment. So even if demand for Christmas trees did not change in the last 5 years, the changes in supply may affect your investment decision. Some products have grower associations such as the Florida Christmas
Tree Association or the Shiitake Mushroom Association. These associations
may be of some assistance in determining present and future costs and revenues.
Some products however do not yet have well defined markets and prices.
In these cases, county extension agents and foresters as well as consultants
may be of some assistance.
Because the costs and revenues are spread out over the length of the planning period we must take into account that future dollars are not worth as much as today's dollar. In financial terms it is easy to see that this is true since you could put less than a dollar in the bank today to get a dollar in the future. How long you would have to wait depends on how much money you started with, the interest rate, and the frequency of compounding at your bank. The key factor in analyzing the time value of money is the discount rate or alternative rate of return. This is the cost of borrowing money or the rate of return available in other investments. These other investments may be alternative land uses or simply the rate of return available in a savings account or money market fund. Suppose you were given the choice of receiving $100 today or receiving $1,000 in 20 years. We can use financial analysis and the discount rate to compare these two "costless" investments. The objective is to determine the present value of these investments. For the first investment this is easy: the present value of receiving $100 today is $100. Determining the present value of receiving $1,000 in 20 years, however; is a little more complicated. If we consider our alternative rate of return to be the rate that we earn on our savings account, then we want to determine how much money would we have to put in our savings account today, to be able to withdraw $1,000 in 20 years. If this "present value" is greater than $100 then it is the preferable investment. The present value is calculated as:
Unfortunately, most investments involve costs. To examine investments with costs you compare their net present values (NPV), which is simply the present value of returns less the present value of costs. Assume that there are now two investments and both require you to invest $60 today and $50 at the end of 5 years. Investment A returns $150 in 5 years while investment B returns $250 in 7 years. Are these investments profitable and, if so, which is better? The time line for these two investments is shown in figure 3.  Assume a discount rate of 7 percent. Using Equation 1 as the PV for investment A, the PV of returns is $106.95 (FV= $150, n=5, i =.07). The PV of the costs is equal to the $60 paid today plus the PV of the $50 in 5 years. Discounting the $50 for 5 years (using Equation 1) gives $35.65. The total present value of costs, therefore, is $60 + $35.35 or $95.65. The net present value of investment A is therefore $106.95 - $95.65 or $11.30. Because these investments have the same costs, only the revenues need to be calculated for Investment B. In this case, the FV=$250, n=7, and i = .07. The PV of investment B therefore is equal to $155.69 (using Equation 1). The NPV of investment B is therefore $155.69 - $95.65 or $60.04. So investment B is preferred. This $60.04 represents the current value of the investment over and above an investment that yields the alternative rate of return (7 percent in this case). Any investment with a positive NPV will return more than the alternative rate of return used in its calculations. In other words, the decision to invest in A will return $11.30 more than simply putting $60 in the bank today and $50 in the bank in 5 years. Similarly, in investment B the return (NPV) of $60.04 is that much better than putting the money in a savings account. For simplicity, the above examples have not included inflation or changes in the purchasing power of the dollar. There are two ways to incorporate inflation into your analysis. The analysis can be done in real (constant) dollars or current (inflated or nominal) dollars. Real dollar analyses net out the effect of inflation from all costs, revenues, and interest rates. Current dollar analyses include the effects of inflation. For these reasons, it is important to determine if your cost and revenue forecasts include inflation. Your discount rate may also need to be adjusted depending on what type of analysis you undertake. Sometimes it is desirable to calculate an investment's internal "rate of return" (IRR). This is simply the discount rate that makes the NPV equal to zero. For investment A the IRR is 10.8 percent and for investment B, the IRR is 17.1 percent. Unfortunately, there is no shortcut formula for calculating this rate of return. To calculate the IRR by hand requires changing the discount rate in the NPV calculations by trial and error until you find the discount rate that makes the NPV zero. Most financial calculators can calculate it easily. Calculation of a unique IRR for an investment is not always possible, and rankings of investments by IRR are not always the same as rankings by NPV. It is generally preferable to rank investments by NPV. For an in-depth discussion of differences in IRR and NPV criteria see Brigham (1985) or any finance textbook. Before detailed examples are used, one other concept of the time value of money should be introduced. Often an investor would like to compare forestry investments to annual crops or leasing land on a yearly contract. Once the NPV is calculated it is easy to convert to an annual basis. This is especially important to those who are comparing two projects whose production lengths are different. Christmas trees and Shiitake Mushrooms are examples. While it takes 4 or 5 Years to grow a Christmas tree here in Florida, mushroom production may only take one year. Comparing the annual returns expected between the two makes it easy to decide which is more profitable. The calculated amount is defined as the yearly payment that would pay off the NPV of the project. To calculate the yearly, or annual equivalent (AE), the present value should first be calculated for the analysis period. Then, using the traditional formula used by many financial analysts to calculate payments, an annual equivalent can be found:
In the next section, the steps in a financial analysis will be presented
for a number of alternative forestland uses. An example of an enterprise
with yearly returns will be followed by an example of less frequent returns.
Finally, a mixture of the two types of investments will be presented in
a Christmas tree farm case.
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| Introduction | EXAMPLES
The following examples are designed to give the landowner an idea of the steps involved in financially analyzing a forestry enterprise. It should be emphasized that financial analysis of these forestry investments is basically no different than most business analyses. The procedures outlined in each example, along with estimates of cash flows, provide valuable information. In the examples, the land is assumed to be owned by the individual doing the analysis. If this is not the case, the land rent or purchase price must be included in the analysis. Example 1: Hunting Leases The situation: Wayne Baker owns 300 acres of natural pine and hardwood. A local hunting club is interested in leasing the land for hunting for 10 years. Wayne knows two neighbors who have leases with the club. The first neighbor leases a similar partial of land for $4.00 per acre. The second neighbor has made some improvements that cost him $3,000 up front. He also has maintenance costs of $500 per year. This neighbor is able to lease the tract for $7.50 per acre. Wayne would like to decide which hunting arrangement, if any, to pursue. To evaluate the profitability of the investment, Wayne must determine
his discount rate. As discussed earlier; it is often determined by the
next best alternative he may have. In this case Wayne could put his money
in a Certificate of Deposit (CD) at the local bank for 8.0%. Therefore,
at this rate, if the NPV/earning of his investment is positive, he will
be earning more than he would with the CD. If the NPV is negative, the
CD will return more. To analyze the two hunting lease arrangements each
should be analyzed independently and the one with the highest positive
NPV chosen. The projects can be identified as a low intensity (do nothing)
lease and high intensity lease (improvements and maintenance). The low
intensity lease follows:
To begin the analysis, follow the steps as outlined in the early section. Step 1 Identification of the objective. The landowner wishes to increase his annual income. In this case, a ten-year hunting lease is to be arranged in which the landowner has very little or no active participation. Step 2 Identification of activities. With the low intensity arrangement, the only activities are the execution of the lease and the yearly collection of hunting fees (Figure 4a).  Step 3 Attach dollar values to the activities. Assuming no cost of lease execution or fee collection to Wayne, the yearly expected income is equal to the per-acre revenue times the total acres in the tract, or $4.00/acre * 300 acres for $1,200 (Figure 4b).  Step 4 Discount the cash flows to the present. To calculate the NPV of a yearly return, the present value of each payment needs to be determined. Although this is simply calculating 10 present values (one for each lease payment received) and adding them together; it can become quite time consuming. Imagine a 50-year lease! A formula will be introduced to make calculations easier. This formula is used when costs or revenues are incurred at a regular rate throughout the project length. This formula saves the repetitious computations involved in yearly discounting. The formula is simply a derivation of the present value formula (Equation 1):
With low intensity hunting:
Step 1 Identification of the project and objectives. The project now involves putting in wildlife food plots, fencing, and shelters. It involves some start-up cost (and time) as well as intermediate management activities. The lease is 10 years. Objectives are to obtain additional income with some involvement in the operation. Step 2 Identification of activities. With the high intensity arrangement, Wayne, with the help of his neighbor; has identified the following activities and their timings (Figure 5a).  Step 3 Attach dollar values to the activities. Wayne's neighbor paid a start-up cost of $3,000 and $500 per year for the hunting operation. He believes these figures are close to average for the type of hunting lease arrangement and will probably remain the same for the next few years. The revenues are equal to $7.50/acre * 300 acres or $2,250 per year. These along with the costs are summarized in Figure 5b.  Step 4 Discount the cash flows to the present. The present net value is calculated in a manner similar to that of the low intensity lease:
The two projects can now be compared to determine which project has a higher financial return. The low intensity lease agreement has a net present value of $8,052.10 while the high intensity lease agreement has a NPV of $8,742.64. If all costs (including Wayne's time and effort) and revenues have been taken into account, the high intensity project returns $690.54 more than the low intensity project. Now Wayne can bring in any other nondollar variables to assist him in deciding which (if any) level of intensity he will choose. An enterprise may produce periodic revenues instead of annual revenues. Pulpwood production, for example, can provide a return every 20 to 25 years if trees are replanted after each harvest. An alternative enterprise compatible with timber production that has received attention lately is the production of pine straw. The following example shows the steps involved in calculating the NPV of periodic returns for a 5-year raking cycle associated with-pine straw production. The situation: Mary Smith is contemplating the possibility of harvesting pine straw on her 20-acre site of 5-year-old slash pine. She has heard that plantations 10 years and older with no vegetation in the understory can provide a profit of $30 per acre if raked and baled every 5 years. She has been advised however that her stand has too many shrubs and hardwoods and it will cost her $1,000 to clear away unwanted vegetation. She would like to know if the $1,000 investment needed to clean the stand will be profitable or not. She has a discount rate of 7%. Step 1 Identification of the project and objective. The project is pine straw production with an initial cost, and delayed periodic revenues. The landowner would like to obtain additional income to pay property and other taxes. Participation in the enterprise is low.Example 3: Christmas Trees An example of an enterprise where the economic analysis involves a period of time before annual income is received is the case of Christmas tree growing. In this example, an investment of between 4 and 10 years is necessary before trees can be harvested. Then, if managed properly, the trees can be grown and cut in such a manner that yearly production can become stable. The situation: Roger Jones owns a small farm in northeast Florida. He has become interested in native-grown Christmas trees. He would like to know if it can be profitable to grow trees on an acre of cropland adjacent to his pines. The acre has traditionally given him a return of 8.35% on his investment. He has the option of maintaining his current crop or investing in Christmas trees. The traditional rate therefore is his discount rate. Step 1 Identification of the project and objectives. Roger is interested in planting an acre in Christmas trees. He is only interested in one full rotation (selling in years 4 through 7). If a financial analysis looks promising, he may decide to bring the trees into continual production on more acres.
Step 3 Attach dollar values to the activities. The growers' association was also able to provide Roger with average costs and returns for Christmas tree growing in northeast Florida (Table 1, Figure 7b).
The "PV4" is the present value at year 4 of the investment. To continue with the analysis, we must bring the PV at year 4 to the present value at year 0, where the analysis is being conducted from. This is done using the simple discounting formula (Equation 1):
Costs are calculated in a similar manner: Cost of pruning for 5 years
n=5 in this case because pruning starts at the end of year three and continues through the final harvest at the end of year 7.
Other operating costs for the seven years of operation:
Total costs = Planting costs + pruning costs + other operating costs
To calculate the annual equivalent of this investment we substitute the variables into the AE equation:
Investing in this project returns the equivalent of close to $214 per acre per year. This figure can now be compared to more readily available annual production figures like corn or tomatoes, or leasing the land. |
| Introduction | ISSUES
IN THE ANALYSIS OF YOUR ENTERPRISE
Certain tax breaks are still available and should be incorporated in any financial analysis. Reforestation expenses, for example, are eligible for credit and amortization. A professional tax accountant with forestry/agricultural experience should be contacted for assistance when including taxes in financial analyses. Your county extension agent and forester should also have numerous publications on the tax laws and how they relate to the management of forest resources. Agriculture Handbook 681, “Forest Owners' Guide to Timber Investments, The Federal Income tax, and tax Recordkeeping ,” from the United States Department of agriculture-Forest Service (1989), is an excellent source for tax and financial planning. Recordkeeping
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| Introduction | SUMMARY
One of the major reasons new businesses fail is inadequate planning. A landowner interested in managing a forestry enterprise needs to develop a thorough management plan. A major component of the plan is the financial analysis. This analysis includes an estimate of the magnitude and timing of all costs and returns involved in production. The usefulness of financial analysis becomes apparent when many costs and revenues are spread out over the production length of the enterprise. Without a structured method of analyzing the situation, the average landowner would have a difficult time determining if a $100 investment today is worth $1,000 in 20 years. This publication was designed as an introduction to the financial concepts involved in planning and decision-making. Although the structure for evaluating your forestry enterprise will remain the same, each landowner must perform his or her own custom analysis. This publication was not designed to take the place of qualified professional advice and assistance. It is hoped that an understanding of the concepts introduced here will help the landowner communicate more effectively with those who provide assistance. Brigham, Eugene F. 1985. Financial Management: Theory and Practice. Fourth Edition. The Dryden Press. Chicago. Cotton, John. Keeping Records in Small Businesses. US. Small Business Administration, Management Assistance and Support Services. Management Aids Number 1.017. Duryea, M.L. (editor) 1988. Alternative Enterprises for Your Forest Land: Forest Grazing, Christmas Trees, Hunting Leases, Pine Straw, Fee Fishing, and Firewood. Florida Cooperative Extension Service, IFAS, University of Florida, Gainesville. Circular 810. Hoover, William L., William C. Siegel, George A. Mules, Harry L. Haney, and Harold E. Burghart. 1989. Forest Owners' Guide to Timber Investments, The Federal Income tax and Tax Recordkeeping. USDA-FS Agriculture Handbook No.681. Washington D.C. Sinden, John A, and Albert C. Worrell. 1979. Unpriced
Values: Decisions Without Market Prices. John Wiley and Sons. New York.
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