Make Sound Investments
No analysis of investment choices is fool-proof. But a few hours spent with an Excel spreadsheet might allow you to sleep better at night before signing a contract for a five-, six- or seven-figure deal.
“Major investments demand due diligence,” says Allan Gray, an agricultural economist and Director of the Center for Food and Agricultural Business at Purdue University. There two key questions to ask:
• Does the investment earn a profit above all costs?
• Will the investment cash flow?
“You need to keep these questions separate because you don’t want to buy an asset [that is not profitable] even if you have a sweetheart financing deal,” says Gray.
The key is determining if the return on the asset is greater than the return you could get by investing in some other asset or financial instrument. And it’s critical to consider the time value of money. The sooner you get the return, the better.
The way to do that analysis is to calculate the net present value (NPV) of the asset over its useful life. NPV brings all the value generated by the asset over its lifetime back to the present.
This method of analysis (known as discounted cash flow) takes future cash flow and reduces it by the amount that would have been earned as interest over time. Think of it as compound interest in reverse.
If the NPV of the asset is less than zero, your farm’s equity value falls and you are worse off. If it is positive, your equity increases and you are better off.
There are six steps to NPV analysis. Fortunately, Gray has developed a spreadsheet that allows you to plug in numbers such as asset values, interest rates, revenue and costs to help you calculate an asset’s NPV.
Step 1. Compute the Discount Rate. The discount rate is the cost of capital, or the minimum rate of return you require for your farm. Setting it too low is bad because you will accept too many low-performing assets and your business will stagnate. Set it too high and you won’t accept any assets because none can perform to that high level.
Because interest is tax deductible, you also need to know your marginal tax rates for both federal and state income taxes. These should be applied to both the cost of borrowed funds and the equity the business puts into the purchase of the asset.
For example, the after-tax cost of money borrowed at 7% is actually 4.6% if your combined Federal/state marginal tax rate is 35%. The after-tax cost of equity with a target rate of return of 10% is 6.5% based on that same marginal tax return.
If your business’ long-term desired debt to asset goal is 30:70, your discount rate used in the NPV analysis would be 5.9%.
Step 2. Calculate the NPV of cash outlay. Say, for example, you are evaluating investing in two robotic milkers with a combined purchase price of $420,000 with no additional working capital required. The NPV cash outlay is simply $420,000.
Step 3. Calculate annual net cash flow. You’ll need to do a cash flow for each year of productive life of the robotic milkers, calculating cash revenues (including unpaid labor) and subtracting cash expenses and taxes.
For the robotic milkers, these would include changes in milk production, quality premiums, replacement cattle costs, feed costs, labor and other costs. In the final year, add back in the salvage value to the robotic milkers.
Step 4. Calculate the present value of the net cash flow. This is done by simply adding up the discounted annual net cash flow, which Gray’s spreadsheet does for you.
Step 5. Compute the NPV. Simply take the sum of the net present value calculated in Step Four and subtract the present value of the cash outlay from Step Two. In his example, Gray calculated a net cash flow for the two robotic milkers of $616,894. Subtracting the $420,000 cash outlay shows a positive NPV of $196,894.
Steph 6. Accept or reject the asset. With a positive NPV of nearly $200,000, it would appear to be a no-brainer in purchasing the two robots.
But Gray says the analysis is only as good as the assumptions that go into it. So you should do sensitivity analysis to test those assumptions:
• What if you don’t get as much of a milk production increase as expected?
• How sensitive is the analysis to milk prices and premiums?
• What if you have start-up problems and delays?
• What if feed or other costs jump?
• And will it cash flow if these problems arise?
In the end, all investments have risk, and regardless of the method used to analyze them, assumptions are necessary, says Gray.
“Use a method of analysis that forces you to document your assumptions. Well-documented assumptions can then become your roadmap to making your investment as successful as possible,” he says.
Constant monitoring is needed if you decide to move forward with the investment. “If the investment is not performing as expected, go back to your assumptions and make sure you are meeting your benchmarks,” says Gray.