Basic Forest Finance

1. Basic Forest Finance Financial Concepts Financial Analysis Risk Marketing By Kris Irwin, UGA Forestry Published by Georgia Agricultural Education Curriculum Office July 2003

2. Basic Financial Concepts

3. Some Definitions

4. Interest • From the borrower’s point of view, it is the cost of borrowing money. • From the lender’s point of view, it is rent from lending money. • From the investor’s point of view, it is the obtainable return from invested money.

5. Interest Rate • Expressed as a percentage for a specific period of time • In Forest investments, the period of time is usually in 1 year increments. • For example: If the interest is 5% (0.05) per year, then the interest on $100 after 1 year would be $5.00. $100.00 x 0.05 = $5.00

6. Types of Interest • Simple Interest: Interest charged (or paid) on the beginning principal only • Compound Interest: Interest charged (or paid) on the principal, plus accumulated interest from previous years

7. Simple Intereston $100 for 3 years

8. Compound Intereston $100 for 3 years

9. Simple versus Compound Interest • The difference between simple and compound interest can be quite dramatic over time. • The accumulated simple interest from the previous example would amount to $125.00 after 25 years. • The accumulated compound interest from the previous example would amount to $238.64 after 25 years. • Use compound interest when analyzing Forest Investments

10. More Definitions • Principal • A sum of money on which interest is figured.

11. Principal Simple Intereston $100 for 3 years

12. Compound Intereston $100 for 3 years Principal

13. More Definitions • Future Value • A value (or cost) at some point in the future.

14. Future Value • An exercise in Compound Interest (You are multiplying by some interest and time factor) • Answers the question “What will it be worth (or cost) in future years?” • Most commonly addresses the issue of inflation • Risky when used speculatively

15. Future Value • A cord of Pine Sawtimber sells for $125.00 per cord today • The inflation rate is 3% per year • What will that cord of wood sell for 5 years from now?

16. Method 1 The hard way

17. Method 2 Compound Factor Table $125/cord X 1.159 = $144.88

18. Method 3 The $11 Calculator Method • Represented by the formula: V x (1+i)n • Where V = Value - in this case, $125.00 per cord • Where i = interest rate - in this case, 3% (0.03) inflation • And where n = the number of years - in this case, 5 years $125 x (1 + 0.03)5 $125 x (1.03)5 $125 x 1.159 = $144.88

19. A few comments on…Inflation • When assessing inflation, look at long term historical trends of 15 years or more. • Looking at short term inflation trends may cause you to factor in short term spikes or dips in the inflation rate.

20. More Definitions • Present Value • The value (or cost) of a sum expressed in today’s dollars.

21. Present Value • An exercise in discounting - We are dividing by some interest and time factor. • Present Value answers the question, “If we invest money for the future what is that investment worth in today’s dollars?” • Represented by the formula: V/(1+i)n • Where V = Future value • Where i = interest rate. • And where n = the number of years.

22. This can be found in a compound factor table Present Value • If a cord of sawtimber will sell for $144.88 five years from now, what is that worth today? • Use a discount rate of 3% (0.03). We will assume that the only price difference between now and 5 years from now is due to inflation. • The formula V/(1+i)n then reads: $144.88 / (1 + .03)5 $144.88 / (1.03)5 $144.88 / 1.159 = $125

23. Present Value • Discount rates have return expectations built into them. • A zero present value means we stand to meet our expectations. • A positive present value means we stand to exceed our expectations. • A negative present value is a bad thing - we’re not meeting our expectations.

24. Discount Rates • Why do we discount? • To adjust future revenues and cost for inflation • This has the effect of putting those future amounts into today’s dollars. • Discount further (beyond inflation) to simulate additional return on our investment. • If we discount at 10%, and 3% of that is inflation, the other 7% represents our return expectations on our investment.

25. How do we determine the discount rate? This is a warm and fuzzy thing! • It’s driven by our expectations. What kind of return do we want? • Some use the % return from other types of investments, such as the stock market or government securities. • Some will say to themselves, “I want X% return.” • All of the above can get tweaked to adjust for risk.

26. Financial Analysis

27. Evaluate This Forest Land Investment • 100 acres of 25 year old planted pine • Has had minimal management • Has a growth rate that averages 0.97 cords per acre per year • The seller is asking $1,700 per acre for land and timber • You think that with more intensive management, you can achieve an average growth rate of 1.5 cords per acre per year.

28. You Plan to: • Cut the standing timber and reforest • Fertilize the new stand at age 3 • Apply herbicide at age 10 • Thin at age 15 • Clearcut at age 25 Is this a good investment?

29. Evaluation Steps – Cash flow analysis • Step 1: Chart each revenue and cost item according to when they occur. • Step 2: Apply today’s values to each item. • Step 3: Calculate the future value of each item using a compound rate. In this exercise we will adjust for inflation only. • Step 4: Calculate the present value of each item using a discount rate. • Step 5: Sum the present value of each item to get the total present value.

30. Step 1: Chart Revenues and Cost by when each occurs.

31. ($/Acres) x (Acres) Step 2: Apply today’s value to each item.

32. V x (1 + i)n Costs are compounded the same as revenue, however the sign is negative. Step 3: Calculate Future Value n V Our crystal ball tells us that inflation will average 3% over the next 28 years. i = .03

33. V / (1 + i)n Costs are discounted the same as revenue, however the sign is negative. Step 4: Calculate the Present Value n V i = .10 This is our return expectation!

34. Step 5: Sum the present value of each item to get the total present value.

35. What is this telling us?

36. It’s a positive value – that’s good! • We will recover our initial investment of $170,000. • We will recover our Reforestation, Herbicide, and Fertilizer costs. • We may clear $2,228.78 over and above our 10% return expectation. Is this a good investment?

37. Risk

38. Anything that threatens this return. What do we mean by risk?

39. This is the only risk we can’t mitigate. What are some of the risks in our scenario? • The increase from 0.97 cds/ac/yr to 1.5 cds/ac/yr does not materialize • Timber prices fall at the time we market our trees • Fertilizer or herbicide prices spike just when we need to apply them • Fire, beetles, and other natural disasters • Re-zoning • Condemnation

40. Mitigating Risk • RISK: The increase from 0.97 cords/ac/yr to 1.5 cords/ac/yr does not materialize. • That we will boost our growth rate through good reforestation, fertilization, and the use of herbicides is a slam dunk, the question is - How much of a boost will we get? • Build some conservatism in this estimate. • There is a lot of research data available, and a good deal of it is in the public domain – just know the inherent limitations of this data. • Chemical representatives will often share information. However, always remember, they are trying to sell you something.

41. Mitigating Risk • Risk: Timber prices fall at the time we market our trees. • Be flexible in marketing. Defer sales until prices rise again, and be willing to wait 18 months or more. • If we anticipate falling prices, then sell 12 to 18 months ahead of that anticipated fall. Too, too early is a Bad Thing!

42. Mitigating Risk • Risk: Fertilizer or herbicide prices spike just when we need to apply them. • As with marketing, be flexible in the timing. • Your window is not as wide with these kinds of treatments. Too early and the competing vegetation gets the benefit rather than the trees. Too late and the trees don’t have enough time to fully respond to the treatment. • Look before you treat. The treatment may not even be necessary, or you may get away with a cheaper chemistry.

43. Mitigating Risk • Risk: Re-zoning • More often than not, this can be converted into an opportunity. • Timber land is most generally in areas zoned for agriculture. • Rezoning usually results in the land being reclassified as Commercial or Residential. • Managing the property for real estate potential would then become the goal.

44. Mitigating Risk • Condemnation • Usually this occurs for road widening or utility rights-of-way and rarely involves every acre. • Those entities that have the power of eminent domain (condemnation) rarely exercise their full legal rights. • Compensating the land owner at Fair Market Value (FMV). • Landowners can usually negotiate for compensation that is substantially higher than FMV… as long as we don’t get greedy.

45. Mitigating Risk Play “what if” scenarios with discount and compound rates, prices, and costs.

46. Marketing Simply put, it is the buying, selling, or trading of our timber assets.

47. Knowledge is power! • We need to know: • Who are the buyers and sellers? • Current, past and future market trends • Types of transactions

48. Find out who buys and who sells • Join professional or trade associations • Subscribe to trade journals • Ask friends, neighbors, or other people in the business • Phone book • Extension office

49. Market Information • Be cognizant of anti-trust laws • Be cognizant of anti-trust laws • Be cognizant of anti-trust laws • Be cognizant of anti-trust laws • Be cognizant of anti-trust laws • Extension offices • Farm Bureaus • Public records • Subscriptions • Layman’s Guide or Timber Mart South are but two examples • Appraisals • Ask • Attend bids

50. Types of Transactions • Delivered Agreement • Buyer agrees to purchase a given amount of wood (usually a specific product) at an agreed upon price. • Seller is responsible for cutting and hauling the timber to the facility. • Price and delivered volume (tons, cords, mbf, etc) are valid for a set amount of time. • Sorting and merchandising burden is the responsibility of the seller or the seller’s agent.