Why Invest in Timber Production 1

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1 FOR 58 Why Invest in Timber Production 1 Michael Jacobson 2 Why Invest in Timber Production What should a landowner do with his or her land? There are a number of alternatives. The choices include growing fruit or food crops, establishing a pasture for livestock, growing trees, selling it for development, or leaving it idle. This publication discusses the costs and benefits of growing timber. Understanding some basic information on environmental and economic factors can help a landowner make an informed decision. Financial Perspective Timber production is unlike most investments. A timber investor does not see any revenues until the trees are harvested. This can range from years depending on the species and product. What makes such a long-term investment worthwhile? There are a number of reasons landowners grow trees instead of using it for other uses. From a purely financial perspective, the landowner will invest in timber if: a) the revenues received at harvest exceed the costs of establishing and maintaining the trees until harvest time; and b) timber provides a better rate of return than other investments, for example, growing agricultural crops or a bank CD. Other Perspectives However, financial considerations are not the only factors a landowner can take into account before investing in timber. These factors are discussed under three broad categories. Landowner s personal considerations and objectives Is timber one of your forest management objectives? Timber production is one of multiple uses from managing forest land. Depending on the intensity and type of tree planting, timber production can be carried out concurrently with other objectives such as pine straw production, hunting and recreation. Environmental, biological and legal conditions Simply saying you want to grow trees is not enough. There may be certain conditions on the land that further encourage or prevent a landowner from producing timber. For example, what are the environmental impacts on soil, water, or wildlife from growing timber? Trees usually help reduce soil erosion and water runoff. Trees also provide suitable habitat for a variety of wildlife species. Timber production can enhance these attributes if they are important considerations. A landowner should also know whether the land is physically capable of producing trees. Soil quality should be analyzed to determine its capability to produce 1. This document is FOR 58, one of a series of the School of Forest Resources and Conservation, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida. Date printed: February Please visit the EDIS Web site at 2. Michael Jacobson, assistant professor, School of Forest Resources and Conservation, Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, The Institute of Food and Agricultural Sciences is an equal opportunity/affirmative action employer authorized to provide research, educational information and other services only to individuals and institutions that function without regard to race, color, sex, age, handicap, or national origin. For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative Extension Service / Institute of Food and Agricultural Sciences / University of Florida / Christine Taylor Waddill, Dean

2 Why Invest in Timber Production Page 2 trees. Also, legal restrictions or regulations may limit the use of the land for timber production. For example, in wet areas or along rivers there are restrictions on harvesting. Economic and financial viability A landowner should consider the costs and returns associated with the timber production. There are a variety of analytical tools available for assessing costs and benefits. In some instances, benefits may be realized from non-monetary terms. Examples include the benefit a landowner enjoys from merely walking on the land. Potential Costs (risks) All investments have costs and returns. In some cases the costs and benefits can be quantified in dollars. Quantifiable costs of timber production include preparing the site, planting the seedlings, managing the land, property taxes, and harvesting expenses. Quantifiable returns to the landowner include payments from harvesting the trees and other income from enterprises such as hunting or recreation leases or pine straw production. There are other costs (risks) and benefits associated with timber production that a landowner may wish to consider. The following is a checklist of potential risks (costs) and benefits from investing in timber production. Long wait until payment A landowner may need income annually. In timber production you receive timber after each harvest which can be many years. Depending on a landowner s income needs, annual hunting leases or periodic income from thinnings or pine straw may suffice in between harvests. Natural disturbances Hurricanes, wildfires, pest or disease outbreaks can destroy or damage trees. Higher financial returns Higher financial returns can result from alternative uses such as livestock or agricultural crop production. This depends on the markets for these products. Potential Benefits Wider choice of markets for products In agriculture or livestock there is one product. When you grow timber you have a diversity of products ranging from pulpwood to sawtimber. A landowner can delay harvest until the market prices are favorable. Multiple products In addition to timber, a landowner can receive income from hunting or other enterprises such as pine straw. Livestock production is also an option on timber land. Intangible benefits Forests provide clean water, prevent soil erosion, and provide habitat for a number of wildlife species. Value Trees can increase the underlying land value. Time consumption Managing timber lands requires less time and labor compared to other land uses such as crops. After planting, the land needs only occasional maintenance such as firebreaks. Cost-share funds Landowners can receive cost-share payments from the government for site preparation, tree planting and forest management. Most of the cost-share funds in government programs pay for a percentage of management costs such as reforestation or stand improvement. The Conservation Reserve Program provides annual rental payments for growing trees. Tax credits Landowners can also receive reforestation tax credits for reforestation expenses. Preferable tax treatment Landowners can receive preferable tax treatment for timber sales. Harvesting sales can be reported as capital gains rather than ordinary income. May 1999

3 Why Invest in Timber Production Page 3 Comparisons Table 1 compares the costs and benefits mentioned above among three alternative uses: 1) Do nothing -- leave it alone; 2) Convert to crops or livestock production; 3) Plant trees (reforestation). Summary This paper is not intended to influence a landowner s decision but to provide information. It is shown that timber receipts are not the only benefit from investing in timber. Timber investments can be profitable for a landowner if they are willing to accept the long investment period. The keys to successful timber investment planning are understanding the potential risks and benefits of tree planting, gathering pertinent information, and then using the appropriate tools to make the wisest decision possible. Table 1. A comparison of the benefits and costs for uses of your land. Benefit/Cost Do nothing Convert to crops/livestock Reforest with trees Costs none high moderate Income none yes, annual yes, periodic Tax credits/deductions possibly moderate good Cost-share funds none none yes Increased land value some yes yes Wildlife enhancement possibly generally no yes Soil conservation possibly generally no yes Financial risk no yes moderate May 1999

4 FOR 61 Comparing Values of Timber Production to Agricultural Crop Production 1 Michael Jacobson 2 The purpose of this paper is to illustrate how to compare the financial returns of alternative land uses. Using current information, the alternatives illustrated in this paper are annual crops (cotton and watermelons) and timber (pines). These crops are commonly grown by private landowners in North Florida. Many factors go into a landowner s investment decision. This publication considers only financial analysis, namely the stream of financial costs and returns specifically associated with planting, growing and harvesting the crop. Other factors to consider include cash flow needs, the environmental and economic impacts on wildlife, water quality, soil conservation, aesthetics and other attributes important to the owner. Methods There are three steps in financial analysis. First you determine your inputs (costs) and outputs (benefits). Second, you determine their value and when they occur over time. Third, you conduct an analysis of the costs and benefits using decision criteria. The most commonly used decision criteria is net present value (NPV) because it takes into account the time-value of money. A dollar earned today is not the same as a dollar earned in 20 years. The NPV technique uses a discounting procedure for finding the present value of future sums. The procedure uses the interest rate (which is your cost of money) to bring back to the present each cost and revenue item that occurs over the rotation. The NPV is the present value of the expected future revenues minus the present value of the expected future costs, with the costs and returns discounted at the appropriate interest rate. Once the NPV is determined, one can compute two other important decision criteria, the Internal Rate of Return (IRR) and Equal Annual Equivalent (EAE). When comparing land uses that have different investment time periods (cotton and watermelons are harvested annually, while timber takes many years to harvest) we need to have a common analysis period. The Equal Annual Equivalent (EAE) formula combines all costs and benefits into a single annual sum that is equivalent to all cash flows during an analysis period spread uniformly over the period. It can be viewed as the amount of an annual payment that will just pay off the NPV of an asset during its lifetime. The calculations to determine EAE are carried out in two steps. First one derives the NPV using the following formula (Equation 1): NPV = Present value (PV) of revenues - PV of costs PV = t $ t (1 + i) t, 1. This document is FOR 61, one of a series of the School of Forest Resources and Conservation, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida. March, Please visit the EDIS Web site at 2. Michael Jacobson, Assistant Professor, School of Forest Resources and Conservation, Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, The Institute of Food and Agricultural Sciences is an equal opportunity/affirmative action employer authorized to provide research, educational information and other services only to individuals and institutions that function without regard to race, color, sex, age, handicap, or national origin. For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative Extension Service / Institute of Food and Agricultural Sciences / University of Florida / Christine Taylor Waddill, Dean

5 Comparing Values of Timber Production to Agricultural Crop Production Page 2 where i = interest (discount) rate and t = number of years. Using the NPV, the EAE is then calculated as (Equation 2): EAE = NPV x Annuity Factor, where the Annuity Factor = i(1 + i) t (1 + i) t 1 Crop Production Cotton and watermelons are annual crops. Their costs and returns do not have to be discounted since they occur in the same year. The estimated costs of producing an acre of watermelons and cotton for sandy soils in North Florida in 1998 are shown in Tables 1 and 2. One reason watermelons are more expensive than cotton is that they are irrigated. Land cost was not included in order to make net returns to land comparable with the annuities from pines. 3 Using expected average costs and prices for watermelons and cotton in 1998 we did the following calculation in Tables 1 and 2 to determine net annual 3 returns. Estimated revenue and cost data from the North Florida Research and Education Center, Marianna, FL If we were only comparing watermelons and cotton, the results show watermelons are more profitable. Net annual returns after all costs are $ per acre for watermelons. Cotton had a net annual loss of $ when all costs were accounted for. These values, the net returns for crops, are the EAE. Since averages were used in these calculations, and yields and prices vary across land and management types, Tables 3 and 4 provide a range of net returns for watermelons and cotton, respectively. Table 1. Watermelon production per acre per year. (estimated for 1998) Costs: Cash Expenses $1, Fixed Costs $ Revenues = Yield Price = $1,260 where Yield = 18,000 lbs & Price = $0.07 Net annual returns = revenues - costs Net returns above cash costs = $ Net returns from fixed and cash costs = $ Table 2. Cotton Production per acre per year (estimated for 1998) Costs: Cash Expenses $ Fixed Costs $91.83 Revenue = Yield Price = $490 Net annual returns = revenues - costs Net returns above cash costs = $7.82 where Yield = 700lbs & Price = $0.70 Net returns from fixed and cash costs = -$84.01 Timber Production Unlike agricultural crops, forestry investments require a long-range commitment of resources. Any long-term investment has risks. A commonly used procedure for taking forestry risk into account is to make adjustments to the interest rate, also known as the discount rate. In this analysis, two different interest rates are used (4 and 7%). In addition, a landowner has a variety of management options on species selection and merchantable product. In this example we use slash pine since it is the most commonly grown tree species in North Florida, and there is a strong market for its products. Two different silvicultural regimes are shown to illustrate differences in returns using different production and harvest schedules. The two silvicultural regimes are: 1) a single harvest at age 20 years; and 2) a multiple harvest with a thinning at 15 years and final harvest at 25 years. March 1999

6 Comparing Values of Timber Production to Agricultural Crop Production Page 3 Any investment analysis relies to some extent on assumptions. Due to the complexities of long-term investments, such as forestry, many of these assumptions may be no better than educated guesses. Land Land value is not included since we are interested only in the annual return to the timber resource. Land alone is considered a good investment because of rising prices. Whether land is purchased or already owned, timber production is considered another investment and should be treated differently. Table 3. Net returns for WATERMELONS at various yields and prices (Total production costs: $1,100). Yield (lbs) Price per pound $0.04 $0.06 $0.08 $0.10 $ ,000 -$700 -$500 -$300 -$100 $100 13,000 -$580 -$320 -$60 $200 $460 16,000 -$460 -$140 $180 $500 $820 19,000 -$340 $40 $420 $800 $1,180 22,000 -$220 $220 $600 $1,100 $1,540 Table 4. Net returns for COTTON at various yields and prices (Total production costs: $500). Yield (lbs.) Price per pound $0.60 $0.64 $0.68 $ $170 -$148 -$126 -$ $110 -$84 -$58 -$ $50 -$20 $10 $ $10 $44 $78 $112 Stand Establishment Costs The major costs in establishing a pine plantation are preparing the site, buying the seedlings, and planting services. Since this analysis is being used as a guide to compare a forestry investment with an annual crop it is assumed that the land was previously occupied with row crops (i.e., an old field). Therefore, no costs are incurred for site preparation. Costs included are contract planting and seedling costs ($80 per acre). If site preparation is needed it may range from $100- $300 per acre. This amount would be added to the establishment costs. Annual Costs After planting, a landowner incurs annual management costs associated with property taxes and managing the land. Management costs may consist of firebreak maintenance and periodic prescribed fire. The landowner receives agricultural classification for tax purposes. A $6-per-acre-per-year figure is used in this publication to cover annual costs. Cost Share Programs Several federal and state reimbursement programs may be available to help offset the cost of establishing and managing a forestry investment. To keep the analysis simple, we assume that cost share funds are not used. March 1999

7 Comparing Values of Timber Production to Agricultural Crop Production Page 4 Tax Treatment (reforestation tax credits and capital gains exclusion) Unlike watermelons and cotton, pines have some important tax advantages. Landowners can deduct up to $10,000 over 7 years for reforestation expenses. Also, timber sales are recognized as capital gains, which exempt 60% of the return from federal income tax. For comparison purposes, before-tax analysis is carried out. After-tax analysis would make the forestry investment look more profitable than it really is. Tree Growth and Yield The volume of wood that can be grown on an acre of land during a given time period depends upon many factors such as site quality, quality of seedlings, use of herbicides to reduce competition, and use of fertilizers to increase soil fertility. In this comparison we use a typical site quality (Site Index 60) found in North Florida. We also assume that 800 trees per acre are planted. In the multiple sale example, the residual stand after thinning supports a basal area of 60 square feet per acre. Predicted yields were obtained from a growth and yield model developed by Clutter and Jones (1980). Current and Future Stumpage Prices The prices paid for trees as they stand in a forest (stumpage price) varies considerably. Some factors that affect the price include the product sold, the location of the stand, the terms of the contract, and the season of logging. We obtained the most current stumpage prices from the Timber Mart South price report (1st quarter 1998). Pulpwood was $50 per cord, chip-n-saw was $90 per cord, and sawtimber was $357 per 1000-board-feet. These prices are relatively high compared to historical values. Since the prices already tend to be high, we use the current prices in this analysis and do not assume future price increases. Single Harvest Example Figure 1. Time line for a single harvest at 20 years. Not shown are year 1-20 costs of $6/yr. 1) Calculate the Present Value (PV) of the costs: a) Establishment costs of $80 occur in 1st year (no discounting) b) Annual costs of $6 occur every year. The formula for the present value of a terminating annual series is: In this example (Equations 3 and 4): ( 1+ i) t 1 Present Value (PV) of terminating annual series = a i( 1 + i) t PV = $6 + (. ) [ ]. ( +. ) = $ = $ PV of costs are $80 + $82 = $162. 2) The present value of the returns is (Equation 5): $1500 $1500 PV = = = $685 ( ) ) The NPV = $685 - $162 = $523 4) The EAE is (Equation 6): EAE = NPV t i(1 + i) [ ] (1 + i) = $ = $38 t 1 On an annual basis the value of this investment is $38 per acre per year. A slash pine stand is grown for 20 years and then clear-cut. A time line for this example is shown in Figure 1. At 20 years, 30 cords of pulpwood are harvested for a total of $1,500. Using a 4% interest rate, the following steps are carried out: March 1999

8 Comparing Values of Timber Production to Agricultural Crop Production Page 5 Multiple Harvest Example In this example, a planted slash pine stand is thinned to 60 square feet of basal area per acre at 15 years and clear-cut at 25 years. At age 15, 8 cords per acre of pulpwood are harvested for a revenue of $400. At final harvest, 23 cords per acre are cut for a total revenue of $1,240 ($925 for pulpwood, $315 for chip-n-saw). Figure 2 is the time line for this example. Figure 2. Time line for a multiple harvest. As in the previous example, the same four steps are used to calculate the EAE. 1) Calculate the Present Value (PV) of the costs: a) Establishment costs of $80 occur in 1st year (no discounting) b) Annual costs of $6 occur every year. Using the terminating annual series formulas, we have (Equation 7): PV = $6 + (. ) [ ]. ( +. ) = $ = $ The PV of total costs are $80 + $94 = $174 2) Calculate the PV of revenues. a) At 15 years we receive $400/acre (Equation 8): $400 $400 PV = = = $222 ( ) 18. b) At 25 years we receive $1240/acre (Equation 9): $1240 $1240 PV = = = $465 ( ) 267. The PV of total revenues is $222 + $465 = $687 3) Calculate the NPV. NPV = $687 - $174 = $513 4) Calculate EAE (Equation 10). EAE t i(1 + i) = NPV [ ] (1 + i) = $ = $33 t 1 On an annual basis, the multiple harvest timber investment provides $33 of return per acre per year. Using a 4% interest rate, the single harvest example provides a higher net return than the multiple harvest. Landowners interested in intermediate returns (from thinnings) instead of waiting the full rotation may find the multiple harvest more attractive since the net difference was not very large. Table 5 shows the results using both a 4% and 7% interest rate. As the interest rate increases, the NPV and EAE will decrease. Interpreting The Results Table 6 shows that net annual returns from the timber production are very competitive with net returns from crop production. Net returns for timber ranged from $19-38 per acre per year. For watermelons the net return was $121, while the net return for cotton was negative. Current market conditions can greatly affect returns. For example, Table 1 shows that returns from watermelons can be very profitable if yields and prices are high. If a landowner needs annual cash flows, timber may not be the best decision. However, this analysis did not consider the multiple revenue sources available from timber production, including hunting leases, Christmas trees and pine straw. Including these revenue sources may make timber production a more attractive investment than annual crops. In addition, landowners can receive revenues for timber production from government costshare programs such as the Conservation Reserve Program. Conclusion Landowners must make decisions about how to use their land and its resources. One of the objectives of the paper was to show landowners how to use current economic and production information to analyze an investment decision. To be as realistic as possible, this paper used current information on prices and costs. The results one gets will change depending on the market March 1999

9 Comparing Values of Timber Production to Agricultural Crop Production Page 6 conditions. However, the process and steps involved in analyzing financial costs and returns will remain the same. The material is not presented to promote or discourage investments in timber production. Reference Clutter J.L. and E.P. Jones, Jr Prediction of growth after thinning of old-field slash pine plantations. USDA Forest Service, SE-217. Table 5. Timber scenarios at different interest rates. MULTIPLE HARVEST SINGLE Net Cost/Return 4% Discount rate 7 % Discount rate 4% Discount rate 7 % Discount rate Establishment costs $80 $80 $80 $80 PV of annual costs $94 $70 $82 $64 PV of total costs $174 $250 $162 $144 PV of revenues $686 $373 $685 $388 NPV $513 $223 $523 $244 EAE (Annual net returns) $33 $19 $38 $23 Table 6. Comparing average net returns for Single harvest rotation Multiple harvest rotation Watermelon Cotton 1998 average net return $19 - $38 $23 - $38 $121 -$84 March 1999

10 SOUTHERN HARDWOOD MANAGEMENT 13. Economics of Hardwood Timber Management: Ranking Alternative Uses John E. Gunter School of Forest Resources University of Arkansas-Monticello Monticello, AR Steven Anderson Department of Forestry Oklahoma State University Stillwater, OK Landowners often ask if it pays to own and manage hardwood stands. The correct economic answer to such a question is that "it depends." Financial returns may be competitive with other investments, depending upon strength of local markets, quality of trees, stocking levels of desirable species, site quality, size and location of the tract and several other factors. The purpose of this chapter is to present the process for financial analysis used in evaluating alternatives. The intent is to help the landowner understand the framework for analysis and evaluate options presented by professional foresters and consultants. Financial analyses are made in a variety of ways, using different assumptions, and varying measures of performance. You must have a grasp of these basic concepts to make the correct financial decisions for your particular situation. Nonindustrial private forest landowners (NIIPF) commonly ask one of two questions: "Should I buy land and manage it for timber production?" Or, "since I already own the land (and intend to keep it) should I grow trees and invest in more intensive timber management?" The first question relates to the complete timber production investment while the second concerns the return on specific treatments or marginal analysis. The main difference between the analyses of the two questions lies in handling. Assume that a landowner does not intend to sell his or her land under any circumstances and merely wants to know whether or not to make an additional investment. Then he or she may choose to exclude land costs and consider only marginal analyses. However, the basic process of financial analyses and economic decision-making are the same whether one is considering the complete timber production investment or marginal analysis. I. FRAMEWORK FOR FINANCIAL ANALYSIS The first step to any financial analysis is to identify all possible options or alternatives. This may include comparisons between forestry versus certificates of deposit, stocks, bonds, mutual funds, or other investments. When you ignore the opportunity of selling the land it may also include options such as forestry versus agricultural use or different management options for a timber stand (planting, natural regeneration, precommercial thinning, commercial thinning, fertilization, weed control, or just leaving the stand to grow). Each option or alternative must be considered suitable for the landowner's 59

11 or investor's goals. It must also specify a management activity schedule to accomplish that option. The second step is to determine the yield response to each treatment. For forestry treatments, the additional quality and quantity of timber available as a result of each treatment must be forecast for estimated harvest times. The estimates of yield response require growth projections using yield models and stand tables (see Section 111D. Since there is usually uncertainty associated with these projections, it is wise to compute a range of yields based on each treatment. This way minimum and maximum financial returns are calculated. The third step is to estimate the costs and revenues that occur with each option. These costs and revenues may be one time, annual, or periodic costs. Examples of one-time costs may be site preparation and planting. Annual management costs include those costs that are usually deductible on a yearly bans from Federal and State taxes. They include salaries, professional fees, maintenance of roads, fences and equipment, fire protection, insect and disease control, and annual property taxes. Periodic expenses may include thinning, f1brtilization and weed control. Although revenues largely accrue when the stand is harvested, revenues from commercial leases or other recreational uses and mineral revenues may occur. The process of estimating costs and revenues over time is called developing cash flows. Each activity, when it is to be done, the amount to be done and the cost per unit value are all specified. For example, site preparation will be done in year 0 on 100 acres at a cost of $50 per acre, or harvest of 100,000 board feet of timber will occur at year 30 producing an income of $85 per thousand board feet. Special Note. Although we may know the cost and prices for each activity, the cost or price of an activity at some future time involves estimates. Costs and prices change over time due to inflation and to differences in the rates of change relative to one another. The rate of value change is usually an annual percentage change of the current value. For example, we may know that red oak is selling for $85 per thousand board feet, today. We may expect a real price increase of 2 percent per year over inflation. If inflation is included in the percentage of price increase, it is a nominal rate as opposed to a real rate. Either way to estimate costs and prices in the future is acceptable as long as they are all done consistently. The fourth step of financial analysis is to compute financial returns. Financial returns are usually computed on an after-tax basis, or presented both before and after tax. Income tax laws and regulations can have a large effect on financial returns because annual taxes are a cost to the landowner. Some tax benefits can add to spendable income. Recent changes in the tax laws have altered the use of capital gains and affected how management costs, taxes and interest are deducted from gross income. A landowner/investor should be aware of how taxes are handled in computing financial returns. A sensitivity analysis should also be done when computing financial returns. As discussed above, financial analyses demand that assumptions are made concerning costs, prices, yields and discount rates. Low or high estimates can lead to unrealistic calculations of financial returns and to the wrong decision. A sensitivity analysis changes each assumption and computes the returns under a range of conditions. The final step in any financial analyses is to compare investment returns and select the best option. Landowners should remember that any one measure of financial return or performance does not convey all the important information about an investment. Although 60

12 returns may look extremely profitable, an investor may not have the capital needed to make an investment. Financial analyses usually do not consider multiple forest management goals which include wildlife management and recreation in addition to timber production. In most cases some profit will be traded away to meet nonmarket goals. A landowner needs to make these goals clear and concise before financial analyses will help in decision-making. II. FINANCIAL INVESTMENT CRITERIA The most useful measures of financial performance recognize that money in hand today is worth more than the same money received at some future date. This "time value" of money is handled by discounting costs and revenues, which occur at different times, to the same point in time, and comparing them. It is also for this reason that treatment options must be compared for investments of the same length or for investments that extend to a common year. The "discount rate" (cost of capital) is the minimum annual rate of return that is acceptable for the investment. The four performance criteria below are useful in deciding whether to undertake a certain forestry project and in choosing among mutually exclusive alternatives. Mutually exclusive means that you can do one or the other (plant soybeans or cottonwood trees), but you cannot maximize both on the same piece of land. Again, it is wise to remember that no measure of performance can convey all information about an investment. Net Present Value (NPV) In this analysis, each cost and revenue is converted to its present value using the "discount rate." For example, assume a thinning operation win cost $50 per acre 10 years from now. Then, the actual cost in today's terms (assuming a discount rate of 8 percent) is $50 divided by (1.08)'o or $ The sum of all discounted costs (negative) and revenues (positive) is the net present value (NPV). It is the increase in the present value of the landowner's wealth from undertaking the project. A net present value greater than zero means that the project will earn a profit of the discount rate plus an amount equal to the NPV. If NPV is a positive value, then the project is worthwhile. In choosing between mutually exclusive alternatives, the project with the highest NPV is preferable. NPV is the most accurate performance criteria to use. Rate of Return The rate of return (ROR) is also known as the return on investment or the internal rate of return. ROR is the most commonly used measure of financial performance. It is, by definition, the discount rate that results in a net present value (NPV) equal to zero when all costs and revenues are discounted to the present. If the rate of return exceeds the discount rate, then a project is acceptable. Between mutually exclusive projects, the project with the highest ROR is chosen. A characteristic of ROR is it measures profitability as a ratio (earnings to invested capital) rather than as an absolute dollar amount (as does NPV). The ROR also assumes that any intermediate revenues are reinvested at the same rate. While ROR cannot be computed directly and must be found by trial and error, computer programs are available to simplify this task. ROR has the advantage of being directly comparable to rates of return on other readily available investment opportunities (i.e., certificates of deposit, stocks, bonds, etc.). Benefit/Cost Ratio (B/Q The B/C ratio is found by discounting all costs and revenues (benefits) to the present as in NPV calculations above. Then, the ratio of benefits to costs is computed. A ratio greater than LOA shows that a project is acceptable because the benefits exceed the costs. Between mutually exclusive investments, the project with the highest ratio should be 61

13 chosen- A ratio of 1.2:1 means that $1.20 of benefits are produced for every $1.00 invested. Annual Equivalent Value (AEV) This measure is also known as the equal annual equivalent. It is simply the net present value (NPV) expressed as an annuity. AEV permits comparisons between investments that have annual returns (agriculture) with projects that generate periodic returns (timber). The project with the highest AEV is selected when comparing mutually exclusive investments. III. FOREST MANAGEMENT EXAMPLE The principles of financial analysis are best illustrated by an example: Ms. Tulip Poplar is actively involved in the business of tree farming. She is thinking about adding to her holdings by buying a 100 acre tract of 20-year old yellow-poplar timber growing on a good site (site index r'0 = 100). The stand fits in well with her other property and is well-stocked with trees. However, the yellow-poplar trees are not yet big enough to support a commercial thinning. Nonetheless, the asking price of $300 per acre appears reasonable. Ms. Poplar is 35 years old. In 30 years, at age 65, she plans to sell all of her timber properties, retire to a subtropical climate and enjoy the fruits of her labor. Thus, if she buys this tract she would plan to thin it in 10 years to 65 square feet of basal area, thin again in 20 years to 65 square feet of basal area and sell in 30 years. If she does not buy the 100 acres, she would invest her money in other forestry projects where she can expect an 8 percent return at minimum. Should she buy the yellow-poplar tract? Can she make an 8 percent or better return on it? To help answer these questions, M]s. Poplar sat down at her microcomputer and called up the YIELDplus program (Version 2.1 by Todd E. Hepp, Office of Natural Resources and Economic Development, Division of Land and Economic Resources, Tennessee Valley Authority, Norris, Tennessee 37828)1. This program features both biological growth and yield functions and an accompanying financial analysis package. According to YIELDplus, she could expect these yields if she followed the proposed harvest plan. Years Stand Yield in future age Sawtimber Pulpwood Total (MBF) (cords) (cords) Total: YIELDplus was developed by the Tennessee Valley Authority and is available from Forest Resources Systems Institute, 122 Helton Court, Florence, AL 36M. 62

14 Upon checking her records and other information available to her, Ms. Poplar made the following assumptions concerning costs, prices, tax rates, interest rates and rate of inflation: 1. Marginal tax bracket: 28 percent. 2. Average annual rate of inflation: 3 percent for all costs and prices. 3. Discount rate: 8 percent, before taxes. However, since interest is deductible, the after-tax discount rate is 5.8 percent. That is, After-Tax Rate = Before-Tax Rate (1-0 where, t = Marginal Tax Rate = (. 08) (1 -.28) = (.08) (.72) =.058 = 5.8% 4. Annual management and taxes: $5 per acre. 5. Timber prices: Sawtimber = $80 per MBF. Pulpwood = $5 per cord. 6. Cost of land and timber: Land = $250 per acre. Timber = $ 50 per acre. Total = $300 per acre. Combining the yield information with the cost and price assumptions generates the following cash flows for the tract CASH FLOWS BY YEAR (uninflated dollars per acre) Cumulative Year Revenue Expense Net Net (continued) 63

15 (continued) CASH FLOWS BY YEAR (uninflated dollars per acre) Cumulative Year Revenue Expense Net Net Computation of the financial returns on this investment reveals the following (per acre basis): Net Present Value = $ Rate of Return = 7.3% Annual Equivalent Value = $12.62 Benefit/Cost Ratio = 1.3:1 Based upon the results of the financial analysis, Ms. Poplar decided that this investment is sound. N_PV is a positive $ This suggests that the yellow-poplar tract will earn a profit of 5.8 percent (the after-tax discount rate) plus an increase of $17,822 ($ per acre x 100 acres) in the present value of her wealth--net of taxes. The Rate of Return actually generated by this investment is 7.3 percent. This is 1.5 percent above the discount rate. Annualizing the net returns shows an Annual Equivalent Value of $12.62 per acre per year. This can be compared to annual returns from row crops on this or similar sites. According to the Benefit/Cost Ratio, $1.30 of benefits are produced for each $1 invested in yellow-poplar. While Ms. Poplar did decide to buy the tract, she is not certain that her proposed plan is the best approach. A consulting forester presented an alternative to her. The consulting forester suggested a precommercial thinning immediately, at age 20 to 40 ft2 of residual basal area. The rest of the management scheme would remain the same. That is, the stand would be thinned to 55 ft2 of basal area at age 30, thinned again at age 40 to 65 ft2 of basal area, and sold at age 50. The precommercial thinning would cost $50 per acre. The remainder of the cost and price assumptions remain unchanged. New runs on the YIELDplus program show that the following additional yields can be expected from the pre-commercial thinning at age

16 Years Stand Additional Yields in future Age Sawtimber Pulpwood QVIBF) (cords) Total 3 0 Note that the pre-commercial thinning actually produces a 1-cord-per-acre reduction in yield at age 30. However, this loss is more than compensated for in the harvest at ages 40 and 50. Marginal cash flows from the precommercial thinning are as follows: MARGINAL CASH FLOWS BY YEAR (uninflated dollars per acre) Cumulative Year Revenue Expense Net Net Financial analysis of these cash-flows yields these results: Net present Value = $55.99 Rate of Return = 10.2% Annual Equivalent Value = $3.98 Benefit/Cost Ratio = 2.44:1 Ms. Poplar concludes from this analysis that the marginal investment of $50 per acre in a precommercial thinning is a worthwhile expenditure. Net Present Value and Annual Equivalent Value are positive, the Rate of Return is greater than the discount rate, and the Benefit/Cost Ratio is greater than 1.0:1. One final question that concerns Ms. Poplar is how sensitive are the results of the precommercial thinning analysis to the necessary underlying assumptions? To partly answer that question, Ms. Poplar varied sawtimber and pulpwood stumpage prices by plus or minus 20 percent from the average. That is: Product Price High Low Average Pulpwood $6.00 $4.00 $5.00 Sawtimber $96.00 $64.00 $

17 She then reran the financial analysis, with these results: Financial Criteria Price High Low Average Net Present Value $75.34 $37.60 $55.99 Rate of Return M Annual Equivalent Value $5.29 $2.67 $3.98 Benefit/Cost Ratio 2.90:1 1.98:1 2.44:1 Even though prices may vary by as much as 20 percent, the marginal investment in precommercial thinning is still attractive. At the low price NPV and AEV are positive, the B/C ratio is greater than 1-0:1 and the ROR is greater than the discount rate. The sensitivity of results to changes in other variables (e.g., yields, costs, discount rate, tax rates, etc.) can be examined similarly. 66

18 A practical, "how to" guide for foresters appraisers landowners investors and others with an interest in the dollars and cents involved in owning, managing, selling, buying or appraising timber and timberland. "Basic Concepts in Forest Valuation and Investment Analysis is a new, 270-page reference written by Dr. Steven H. Bullard professor in the Department of Forestry at Mississippi State University, and Dr. Thomas J. Straka, a professor in the Department of Forest Resources at Clemson University. The book is a "how to" manual a self-paced guide to forest valuation and forestry investment analysis, with practical, real world examples.. The book has ten sections, including the basics of compound interest and financial criteria, inflation, taxes, forest valuation, and computer programs. Applications include how to project stumpage prices, how to choose a guiding interest rate, and how to account for inflation and taxes in evaluating forestry investment,. The book's many examples include evaluating pruning, herbicides, fertilization, and other intensive management practices. For appraisers and investors, the book includes an entire section on estimating the value of land and timber - including the valuation of precommercial stands of timber.

19 4 Steps In Forestry Investment Analysis 1. Start with a cash flow diagram: 2. Do the compounding and discounting: Account for the time value of the cash flows on the cash-flow diagram. You can do this by using the formulas on the other side of this page, by rising "a. financial,calculator, or by using a specialized computer program. The type of compounding and discounting necessary depends on the type of analysis you're doing, the specific criterion you're calculating, etc., but, in a11 cases the analysis should be consistent with respect to taxes and inflation: Make sure that the discount rate and all costs and revenues are either in before-tax terms or in after-tax terms, and that they are also consistent in including or excluding inflation. There are four potential combinations: 1. After-Taxes, With Inflation 2. Before-Taxes, With Inflation 3. Before-Taxes, Without Inflation 4. After-Taxes, Without Inflation Consistency is critical, whether you're using a computer program or a calculator, and regardless of which financial criterion you're calculating. What discount rate should you use? The interest rate is extremely important. The appropriate rate depends on several factors see Section 5.6 Choosing a discount rate (page 5.14). As stated above, it's critical that the discount rate be consistent with costs and revenues in terms of taxes and inflation. 3. Calculate and interpret financial criteria: Financial criteria and what they should be used for: NPV Net Present Value is the present value of all revenues minus the present value of all costs. NPV can be used for accept/reject investment decisions, and is highly preferred for ranking investments. (NPV discussion begins on page 4.2.) EAI Equivalent Annual Income is the NPV for an investment expressed as an annual equivalent It can be used to rank investments of different length. (EAI discussion begins on page 4.4) To calculate EAI, use formula, 9 in the decision tree diagram, with NPV as the amount borrowed, and the length of the investment as n. B/C Ratio Benefit/Cost Ratio is the sent value of all revenues divided by the present value of all costs. B/C is used for accept/reject decisions some government agencies. (B/C discussion begins on page 4.8) ROR The Rate of Return of an investment is the avenge compound rate of capital appreciation. It's the interest rate that makes the present value of the revenues and the present value of the coats equal. The criterion is widely used for accept/reject decisions, but it should not be used to rank investments. For ranking, NPV (or a form of NPV like EAI or LEV) is recommended. (Discussion of ROR begins. on page 4.10.) LEV Land Expectation Value is special case of NPV. LEV the net present value of an infinite series of Identical even-aged stands of timber or an infinite series of periodic harvests under uneven-aged management. LEV is an estimate of the value of bare land for growing timber, so it's sometimes called Bare Land Value or Soil Expectation Value. LEV is calculated by compounding costs and revenues associated with the first rotation or cutting cycle to the end of the period, and then discounting this net future value to the present using the Present Value of a Perpetual Periodic Series formula. (LEV discussion begins on page 4 18.) 4. Consider the need for sensitivity analysis: After calculating NPV or other criteria, consider the sensitivity of your results to some of the input assumptions. When you change the assumed values, in the analysis, does the acceptability of the investment change? If you're ranking investments, does the-ranking change? In forestry, the discount rate and the stumpage prices assumed are often very important to analysis results.-(sensitivity analysis is discussed" in Section 5, beginning on page 5.4) This sheet refers to page numbers and discussion in: Basic Concepts in Forest Valuation and Investment Analysis by S.H. Bullard and T.J. Straka (1998).

20 Notation: V o = Value in year 0 (Present Value). In Formulas 9 and 10, V o is the amount of money borrowed. V n = Value in year n (Future Value). In Formulas 7 and 8, V n is the amount of money to be accumulated. i n a P = interest rate (decimal percent). In Formulas 8 and 10, i is the annual percentage rate and 1/12 is the monthly rate. = number of years. In Formula 6, n is the number of years per period. In Formulas 8 and 10, n*12 represents the number of monthly payments. = uniform series of annual revenues or payments. In Formula 6, a represents a uniform series of payments or revenues that occur periodically - every n years. = payment amount (annual or monthly). Figure 3.1. Decision tree for selecting the correct compound interest formula. [The general pattern of Figure 3.1 follows a diagram developed by J.E. Gunter and H.L. Haney, 1978, "A Decision Tree for Compound Interest Formulas," South. J. Appl. For. 2(3):107.]