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Forestry Fact Sheet Number 2

 

Introduction

Growing trees on farms is can provide a direct financial benefit to a farm from the sale of the timber they produce. They can also benefit farms indirectly by sheltering stock and crops, controlling salinity, reducing erosion and improving real estate values (Reid & Stewart, 1994). Whatever the reason for growing trees, in the end the decision about whether or not to plant them will be based on the financial contribution they will make to the property.

 

Landowners often ask how much return they will get if they invest in forestry compared with more traditional commodities such as cereal crops and livestock. Answering this question is not easy because forestry involves a long time-frame and the return from other commodities is variable. There are also the difficulties of reliable prediction of costs and returns and of choosing an appro­priate discount rate. The “Net Present Value” (NPV), which is explained in this fact sheet, provides a means of estimating the profitability of such long term investments.

 

Net Present Value

Calculating the Net Present Value (NPV) is a procedure which can be used to calculate, in today’s dollars, the likely profitability of any long-term business venture, such as forestry. NPV is defined as the difference between the present value of future revenues and the present value of future costs at a chosen discount rate.

 

 

where n = rotation length in years.

            t = the year of the cashflow.

            C = the cashflow in that year (income – costs).

            r = discount rate percentage.

            ∑ = sum

 

If the result of the NPV calculation is zero or negative, then the costs are either equal to, or greater than, the returns; hence the project is not profitable.

If the result of the NPV calculation is greater than zero, then the project is viable, provided that the discount rate has been carefully chosen.

 

Discount Rate

Choosing an appropriate discount rate is crucial to the NPV calculation. A good way to choose the discount rate is to decide the rate which the capital needed for the forestry project could return if invested in an alternative venture. If, for example, the capital required for a forestry project can earn five per cent elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between forestry and the alternative.

 

Some investors will only commit their funds to ventures which will earn more than a specified rate of return. In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made between the profitability of the forestry project and the desired rate of return.

 

Inflation

Trends in costs and returns are important because of the long time-frame for forestry investments. The following example is calculated in real terms, which is using present day dollars, thereby ignoring the effect of inflation on the discount rate, future costs and future returns. There are two reasons for this. Firstly, it avoids the need to forecast future inflation rates. Secondly, inflating all costs and returns can be misleading with large dollar values. Hence, it is simpler to assume that all costs and returns vary at the same rate over time in real terms. However, if the costs and returns are expect­ed to change at different rates, then the analysis can be calculated in normal terms (current-day dollars plus inflation) thus eliminating the need to adjust the discount rate for inflation.

 

Table 1 shows approximate costs for a Tasmanian blue gum (Eucalyptus globulus) plantation. The cost allocated to management is the estimated annual cost of fire protection, rates, insurance, and other costs associated with operating a plantation.

 

Table 1. Typical costs for a Tasmanian blue gum (E. globulus) plantation.

Year	Item	Cost per hectare ($)
0	Pre plant weed control	85
	Rip and mound	250
	Pre-plant spray (strip)	120
	Seedlings (1136 per ha @ 35c)	398
	Planting (@ 10c a tree)	114
	Insect control	55
Total - Year 0		1022
1	Second year weed control	110
	Insect control	55
	Management	50
Total - Year 1		215
2-10	Management	50
Total - Years 2-10		50 p.a.

 

The total Income from the venture, based on a Mean Annual Increment (MAI) of 20 cubic metres per hectare per annum, a 10 year rotation and $29 per tonne of product (assuming a 1:1 conversion of m3 to tonnes), is $5800 per hectare.

 

Table 2.Financial Evaluation of a Blue Gum Project using NPV

Rotation (years)	10	MAI	20 m3
Annual Discount Rate (%)	7	Price	$29 per m3
Year	Cost	Revenue	Net Cashflow	Present Venue
0	$1022		-$1022	-$1022
1	$215		-$215	-$201
2	$50		-$50	-$44
3	$50		-$50	-$41
4	$50		-$50	-$38
5	$50		-$50	-$36
6	$50		-$50	-$33
7	$50		-$50	-$31
8	$50		-$50	-$29
9	$50		-$50	-$27
10	$50	$5800	$5750	$2983

 

The NPV calculated using this particular financial data is $1421; i.e. the profit from a commercial blue gum plantation with the above cost structure and a discount rate of 7 percent is $1421 per hectare.

 

Some features of the NPV calculations are worth noting. The NPV in these examples:

·        increases with increases in the returns or the MAI;

·        decreases if the costs or the discount rate increase;

·        is reduced by lengthening the rotation unless there is a significant increase in the return.

 

Hence, to maximise NPV (that is, the profit), it is necessary not only to maximise the returns, but to get a return from the venture as early as possible in the rotation. The corollary of this is to minimise the costs and to defer them, if practicable, until as late as possible in the rotation. Note, also, that NPV is sensitive to changes in the discount rate. For example, the NPV is $1421 per hectare when calculated using a discount rate of 7% and the costs from Table 1. Using the same costs but reducing the discount rate to 5% results in an NPV of $1995 per hectare. A decrease of 2% in the discount rate has increased the profitability of the operation by $574 per hectare. This highlights the need to choose the appropriate discount rate very carefully.

 

Internal Rate of Return

Another method of evaluating the financial viability of investments is to calculate the Internal Rate of Return (IRR). The IRR of a project is the discount rate at which the present value of future rev­enues, less the present value of future costs is zero. Another way of expressing this is to say that the IRR is the discount rate at which the NVP is zero. From this, as a general guideline, it can be said that a project is acceptable if its IRR is equal to, or exceeds, the minimum acceptable discount rate.

 

Discussion and Summary

So far in this information sheet, NPV has been used to estimate the profit from a commercial for­estry venture. NPV can also be a useful decision-making tool to determine whether or not management practices such as fertiliser application or pruning are economical: would pruning or an application of fertiliser increase the monetary return from the project sufficiently to justify the expenditure? In other words, when the costs and returns of these operations are put into the calculation, the resultant NPV must exceed the NPV calculated without their inclusion.

 

In summary, methods are available for evaluating the financial outcomes of any investment project. NPV and IRR are the more commonly used methods. Calculating the NPV provides a useful method of determining the profitability of long-term enterprises, like forestry, which are characterised by irregular cash flows. IRR is closely related to NPV. A project is financially sound provided that the IRR is greater than the discount rate used to calculate the NPV. Prospective investors need to be well informed and while using these calculations will help to make better investment decisions, it is imperative that they seek the advice of their accountant or financial adviser before committing funds.

 

Further Reading

Klemperer, W. D. 1996. Forest resource economics and finance. McGraw-Hill, Inc., New York.

 

Reid, R. and Stewart, A, 1994. Agroforestry - productive trees for shelter and land protection in the Otways. Otways Forestry Network. Birregurra.

 

For further information contact PIRSA Forestry

 

 

Disclaimer: While this publication may be of assistance to you, the government of South Australia and its officers do not guarantee that it is without flaw of any kind or is wholly appropriate for your particular purpose. The Government therefore disclaims all liability for any error, loss or other consequence that may arise from you relying on any information in this publication.

 

 

Last Revised January 2007