Lesson 5: Soil Expectation Value (SEV) The Economics of Your Dirt
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1 Economagic Lesson 5: Soil Expectation Value (SEV) The Economics of Your Dirt
2 Review In Lesson 4 we explored the concept of Net Present Value (NPV) in which all cash flows are put in present value terms NPV is an important decision-making tool that allows for apples to apples comparisons between cash flows that occur at different times We also saw the importance of having a common time horizon when looking at repeatable forest rotations In this lesson, we will look at an important forestry application of the NPV concept
3 Learning Objectives 1. Understand what Soil Expectation Value (SEV) is 2. Understand how SEV is computed 3. Be able to interpret SEV 4. Understand why SEV is an important element of forestry financial analysis
4 Economic Value of Forestland From an economic perspective, the value of forestland is based on the expected costs and revenues over time Land that can produce high revenues relative to costs should be worth more Land that would produce lower revenues relative to costs would be worth less or may not be desirable at all for forestry use In order to do an apples to apples comparison of expected costs and revenues, we need to compare their present values (i.e. NPV) Total present value of expected revenues Less the total present value of expected costs
5 NPV over what time horizon? One rotation? Two if they are short? Let s start by looking at one complete rotation of R years Establishment cost E at the beginning Harvest revenue H R at the end (year R) Land NPV E + H R Land + 1+ ( 1 + i) R ( i) R But wait the land still has value at the end of the rotation, as it can produce subsequent rotations Present value of further rotations may be small May still have economic significance
6 NPV in Perpetuity What if we calculate the NPV of the rotation repeated in perpetuity (forever)? This approach seems impractical, as it is not a reasonable management time horizon However, this approach does have practical applications: Fully accounts for the economic potential of the land for forestry use (no missing leftovers) Provides a common time horizon allowing for the direct comparison of management alternatives
7 Soil Expectation Value (SEV) The economic value of bare land for forestry use The NPV of expected revenues and costs for forest management in perpetuity Also called: Land Expectation Value (LEV) Bare Land Value Attributed to Martin Faustmann, a 19 th century German forest economist
8 SEV is an Economic Value for Forestry Use Situation specific based on an individual s costs, management regime, interest rate, etc. Not to be confused with the market value for which forestland would actually be bought or sold (which reflects the equilibrium price for an aggregate of buyers and sellers in the marketplace) Other possible land uses would have different economic values
9 Recipe for SEV Stew Future Value of a single sum Present Value of a Perpetual Periodic Series Present Value of a Perpetual Annual Series SEV
10 Computing SEV (what the Economagic Calculator is doing) Variables: E Establishment cost M T Mid-rotation cash flow in year T (e.g. PCT cost or thinning revenue) H R Harvest revenue in rotation year R a Annual administrative costs i Interest rate SEV E ( ) R i M ( i) ( RT 1+ ± 1+ ) T + H ( ) R 1+ i 1 i R a 1. Future value formulas put all periodic cash flows in terms of the rotation year R 2. This is then treated as a perpetual, periodic series with an interval of R years 3. Annual administrative costs are treated as a perpetual, annual series
11 Example: Douglas-fir plantation Recall our earlier Douglas-fir example from Lesson 4: $300/ac establishment today $100/ac PCT cost in year 15 $1,500/ac CT revenue in year 35 $10,000/ac final harvest revenue in year 50 $20/ac/year annual administrative costs 5% interest rate 50 ( ) ( ) ( 5015 ) + ( ) ( 5035 $ $1, ) $ SEV $3, $ $3, $10, $472/ac $400 + $10,000 $20.05 Try it with the Economagic Calculator
12 Example: Spruce-Fir stand with natural regeneration Suppose you want to grow a spruce-fir stand with natural regeneration and you have the following expectations: $100/ac PCT cost in year 15 $175/ac CT revenue in year 35 $1,500/ac final harvest revenue in year 55 $5/ac/year annual administrative costs 5% interest rate ( ) ( 5515 ) + ( ) ( 5535 $ ) $ SEV $704 + $ $1,500 $ $8/ac + $1,500 $5.05 Does this land really have negative value??
13 Interpretation: SEV > 0 Present value of revenues > Present value of costs Future revenues exceed costs plus interest Forestry investment earns in excess of the given interest rate Given these assumptions, you could bid up to the SEV to purchase the land and earn the target interest rate on the total investment (SEV max willingness to pay)
14 Interpretation: SEV < 0 Present value of revenues < Present value of costs under given assumptions Future revenues do not cover costs plus interest Forestry investment earns less than the given interest rate You may not be able to bid on this land BUT someone with lower costs or a lower interest rate could OR there may be non-market values to consider
15 Interpretation: SEV 0 Present value of revenues Present value of costs Forestry investment earns exactly the given interest rate (i.e. interest rate IRR) Future revenues are just enough to cover costs plus interest but there is nothing left over to cover the cost of the land itself
16 Significance of SEV Represents the overall economic competitiveness of using land for forestry under given assumptions A measure of long-term economic sustainability (i.e. the motivation for continued investment in forestry) A standardized benchmark for making apples to apples comparisons Compare forestry with other land uses Compare the economic performance of different timber regimes Evaluate economic impacts of taxes, regulations, etc.
17 Example: Loblolly pine rotations Suppose you are growing loblolly pine and you are choosing between 3 rotations with the following expectations: A pulp rotation would yield $1,000/ac at age 20 A chip and saw rotation would yield $150/ac at age 15 and $1,500/ac at age 25 A sawtimber rotation would yield $150/ac at age 15 and $2,800/ac at age 35 Which rotation performs best economically given: $215/ac establishment costs $10/ac annual administrative costs 5% interest rate
18 Compare SEVs SEV SEV SEV $ $ $ ( ) + $1,000 $10 20 ( 1.05) ( ) ( ) ( $ ) 25 ( 1.05) 1 35 ( ) + ( ) ( 3515 $ ) 35 ( 1.05) 1 $60 + $1,500 + $2,800 $10.05 $10.05 $226 $245 Of these three choices, the 35-year sawtimber rotation performs the best at 5% interest Try it with the Economagic Calculator
19 What if the interest rate was 6%? SEV SEV SEV $ $ $ ( ) + $1,000 $10 20 ( 1.06) ( ) ( ) ( $ ) 25 ( 1.06) 1 35 ( ) + ( ) ( 3515 $ ) 35 ( 1.06) 1 $26 + $1,500 + $2,800 $90 $77 Notice that: All values are lower (at higher interest, present value of future revenues is lower relative to costs that occur sooner) The 25-year chip and saw rotation is now optimal $10.06 $10.06 Higher interest rates tend to shorten rotations
20 Example: Species Choice Suppose you are deciding between growing two different species Let lodgepole pine grow naturally No establishment or tending costs Yields $2,000/ac every 90 years Establish plantations of western larch $200/ac establishment cost $75/ac PCT cost in year 15 $850/ac CT revenue in years 40 and 80 $2,700/ac harvest revenue in year 120 How do these compare given: $3/ac/year administrative costs 3% interest rate?
21 Compare SEVs SEV SEV $3.03 Pine Larch $75 $2, ( 1.03) $ $3.03 $ ( ) ( ) ( ) ( ) ( ) + ( ) ( $ $ $ ) 120 ( 1.03) 1 + $2,700 Given these assumptions, the larch plantation performs the best at 3% interest Try it with the Economagic Calculator
22 Concluding Thoughts The economic value of land for forestry expands on the NPV concept using the building blocks of compounding and discounting SEV is an important indicator of the longterm economic performance of using land for forestry SEV is an important economic measure for comparing management alternatives
23 References Faustmann, M Calculation of the value which forest land and immature stands possess for forestry. Allgemeine Forst- und Jagd-Zeitung 25: Translated in W. Linnard and M. Gane Martin Faustmann and the evolution of discounted cash flow. Commonwealth Forestry Institute Paper 42, University of Oxford. Reprinted in Journal of Forest Economics 1(1):7-44. Gunter, J.E. and H.L. Haney Essentials of Forestry Investment Analysis. Oregon State University Bookstores Inc., Corvallis, Oregon. 337 p. Klemperer, D.W Forest Resource Economics and Finance. McGraw Hill, New York. 551 p. Zobrist, K.W Economically Sustainable Working Forests: Financial Analysis Principles and Applications. Northwest Environmental Forum, College of Forest Resources, University of Washington, Seattle, WA. 16 p.
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