Farm Investment Analysis Paul Dietmann, Emerging Markets Specialist Badgerland Financial But Local, Buy Wisconsin Webinar March 14, 2013

2 To get a copy of this presentation, go to badgerlandfinancial.com and click on “Conference Presentations”

The big question: Does it make sense to invest our precious dollars in _____________? A farm A piece of machinery Breeding livestock A hoop house A packing shed

We can use Net Present Value and Internal Rate of Return calculations to analyze farm investments, and to compare one investment to another.

Time Value of Money Money has a time value ●The sooner you receive money, the better ●Money you get today can be invested or used to stop interest from accruing Benefit of investments are in the future ●Adjust for cost of waiting ●The longer you have to wait, the more you should receive

Would you rather have $100 today or $100 in one year? Why $100 today is better ●Could invest now and generate income ●Opportunity cost for earnings foregone ●Inflation reduces the purchasing power of the $100 over time ●Something could happen during the year that would prevent you from being paid the $100 Need to adjust for cost of waiting ●Discount /penalize future income ●Discounting converts future income into today’s dollars

Present and Future Values Discounting Compounding FutureFuture PresentPresent Source: Purdue University, Center for Food and Agricultural Business, 2002

Net Present Value Tells us what a future cash payment is worth in today’s dollars Converts a stream of future cash flows into a single current value Can tell us if an opportunity is a good investment It won’t tell us if it’s the best investment

Scenario: You are thinking about buying a used potato digger for $3,000. You’ve done some cash flow projections. You calculate that after paying extra fuel and maintenance costs, and subtracting labor cost savings, you can increase your farm’s net cash flow from potatoes by $500/year. You plan to use the digger for five seasons, then can sell it for ½ of what you paid for it: $1,500.

It is tempting to do this really simple calculation: Five years x $500/year = $2,500 Salvage value $1,500 $4,000 Minus the initial cost$3,000 $1,000 This suggest a 33% return from your initial investment, which is NOT TRUE. 10

NPV of cash flows for potato harvester YearAnnual Net Cash Flow Discount 5% Present Value of Annual Net Cash Flow 1$ $ $ $ $ $ $ $ $500 + $1, $ Net Present Value of the cash flows$3, Since the initial cash outlay for the digger was $3,000, it makes sense to make the investment. But, if the return isn’t 33%, how much is it???

How good is the potato digger investment? (You can download this free Internal Rate of Return calculator in Excel from Microsoft’s website)

Another scenario: You have been operating on a small, rented farm for years. You’ve built up a line of machinery with no debt. You have been saving money for a down-payment hoping for an opportunity to buy the farm. The day has come; you can buy the farm for $250,000. You will need to put down $75,000 and finance $175,000 on a 20- year note at 5% interest. You’ve developed cash flow projections that estimate annual net cash flow to be $4,000, which is significantly less than when you were renting the farm. You expect the farm to increase in value by 4% each year. You really want to buy this farm BUT is it a wise investment? 13

Factors to consider Cash outlay is $75,000 Net annual cash flow is estimated to be $4,000 Farm should be worth approximately $304,000 in five years Mortgage balance in five years will be $146,000 Owner’s equity will be $158,000 minus “contingent liabilities,” an estimate of sales commissions that would be paid if the farm was sold ●$304,000 x 8% = $24,000 ●$158,000 - $24,000 = $134,000 estimated owner’s equity 14

NPV of cash flows for farm YearAnnual Net Cash Flow Discount 5% Present Value of Annual Net Cash Flow 1$ $3809 2$ $3628 3$ $3455 4$ $3291 5$ $ $108,123 Net Present Value of the cash flows$122,306 Since the initial cash outlay was $75,000, this is a good investment. 15

HOW GOOD IS THE INVESTMENT OPPORTUNITY? An Internal Rate of Return calculation simply tries different discount rates until we find the one at which the Net Present Value of our expected cash flows is equal to the initial investment. 16

How good is the investment? 17

Some cautions This is only the beginning, not the whole story Don’t substitute enterprise budgeting or investment analysis for whole farm financial planning and analysis Make sure your cash flow projections include family living costs, loan payments, and a Capital Asset Replacement allowance 18

Some cautions Only with a full set of financial statements—preferably several years’ worth—can you do a complete analysis of financial strengths and vulnerabilities Your lender will need to see balance sheet and tax returns as well as cash flow projections. All of this is meaningless if an enterprise doesn’t fit with your goals and the quality of life you want to achieve. 19

Thank You! Paul Dietmann Badgerland Financial (608)