Basic Forest Finance

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Basic Forest Finance

• Financial Concepts
• Financial Analysis
• Risk
• Marketing
• By Kris Irwin, UGA Forestry
• Published by Georgia Agricultural Education
  Curriculum Office
• July 2003

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Basic Financial Concepts
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Some Definitions
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Interest

• From the borrowers point of view, it is the cost
  of borrowing money.
• From the lenders point of view, it is rent from
  lending money.
• From the investors point of view, it is the
  obtainable return from invested money.

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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

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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

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Simple Intereston 100 for 3 years
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Compound Intereston 100 for 3 years
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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

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More Definitions

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

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Simple Intereston 100 for 3 years
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Compound Intereston 100 for 3 years
Principal
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More Definitions

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

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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

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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?

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Method 1
The hard way
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Method 2
Compound Factor Table
125/cord X 1.159 144.88
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Method 3
The 11 Calculator Method

• Represented by the formula V x (1i)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

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A few comments onInflation

• 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.

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More Definitions

• Present Value
• The value (or cost) of a sum expressed in todays
  dollars.

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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 todays dollars?
• Represented by the formula V/(1i)n
• Where V Future value
• Where i interest rate.
• And where n the number of years.

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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/(1i)n then reads
• 144.88 / (1 .03)5
• 144.88 / (1.03)5
• 144.88 / 1.159 125

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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 - were
  not meeting our expectations.

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Discount Rates

• Why do we discount?
• To adjust future revenues and cost for inflation
• This has the effect of putting those future
  amounts into todays 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.

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How do we determine the discount rate?

• This is a warm and fuzzy thing!
• Its 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.

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Financial Analysis
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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.

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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?

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Evaluation Steps Cash flow analysis

• Step 1 Chart each revenue and cost item
  according to when they occur.
• Step 2 Apply todays 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.

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Step 1 Chart Revenues and Cost by when each
occurs.
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Step 2 Apply todays value to each item.
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Step 3 Calculate Future Value
Costs are compounded the same as revenue, however
the sign is negative.
V
n
Our crystal ball tells us that inflation will
average 3 over the next 28 years. i .03
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Step 4 Calculate the Present Value
Costs are discounted the same as revenue, however
the sign is negative.
n
V
i .10 This is our return expectation!
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Step 5 Sum the present value of each item to
get the total present value.
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What is this telling us?
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• Its a positive value thats 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?

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Risk
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What do we mean by risk?
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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

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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.

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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!

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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 dont 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.

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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.

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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 dont get greedy.

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Play what if scenarios with discount and
compound rates, prices, and costs.
Mitigating Risk
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Marketing
Simply put, it is the buying, selling, or trading
of our timber assets.
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Knowledge is power!

• We need to know
• Who are the buyers and sellers?
• Current, past and future market trends
• Types of transactions

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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

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Market Information

• Extension offices
• Farm Bureaus
• Public records
• Subscriptions
• Laymans Guide or Timber Mart South are but two
  examples
• Appraisals
• Ask
• Attend bids

• 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

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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 sellers
  agent.

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Types of Transactions

• Pay As Cut (Un-Blended)
• Buyer purchases timber on a per unit basis
  (/cord for example).
• The unit price is product specific
• Buyer agrees to pay 125/cord for sawtimber and
  25/cord for pulpwood, for example.
• Buyer usually assumes responsibility for cutting
  and hauling the timber.
• Price is valid for a set amount of time.
• Buyers right to harvest is usually valid for a
  set amount of time.
• Seller gets paid as the timber is cut.
• Seller is exposed to some risk from poor sorting.

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Types of Transactions

• Pay As Cut (Blended)
• Buyer purchases timber on a per unit basis
  (/cord for example).
• The unit price is not product specific
• Buyer agrees to pay 75/cord for all products,
  for example.
• Buyer usually assumes responsibility for cutting
  and hauling the timber.
• Price is valid for a set amount of time.
• Buyers right to harvest is usually valid for a
  set amount of time.
• Seller gets paid as the timber is cut.
• Seller is less exposed to risk from poor sorting.
  However, seller is at risk if they do not know
  the product mix prior to selling the timber.

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Types of Transactions

• Lump Sum
• Usually there are multiple buyers bidding on the
  timber.
• Buyer purchases timber for a single price
  (145,000 for all cords on 100 acres for
  example).
• Buyer usually assumes responsibility for cutting
  and hauling the timber.
• Buyers right to harvest is usually valid for a
  set amount of time.
• Seller is at risk if they do not know the product
  volume and mix prior to selling the timber.
• Seller is at risk if there are a low number of
  bidders.
• Buyer assumes all responsibility for sorting.

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Types of Transactions

• Combinations
• Combinations of the previously mentioned are
  quite common
• Eg A lump sum transaction for the pine, with a
  pay as cut agreement on the hardwood

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The End