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[FLM JANUARY / FEBRUARY 2012 ] Financial Analysis
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In Forest Investment.

BY: Bin Mei and Michael l. clutter


Just like the risk to have broken eggs can be reduced if one puts them in ten baskets rather than in one basket, an asset’s unique risk can be eliminated by portfolio diversification under the framework of the modern portfolio theory.


Forest investment is a long-term investment.In the South, a typical rotation length for a southern pine plantation ranges 25-35 years, whereas in the Pacific Northwest the rotation length for hardwood species is much longer at 80-100 years.


During such a long time horizon, economic conditions may change dramatically, making the evaluation of forestry projects a challenging task. In addition, sivicultural technologies and forest management techniques have developed rapidly in the past several decades. Whether to adopt and how to valuate these forestry advancements from a landowner’s standpoint remains a key concern.


Lastly, landowners have some flexibility in managing timberland. For example, trees can be stored on the stump with small cost when timber prices are way too low and harvested later when the market recovers. The managerial flexibility implies option values to timberland investors. Returns from forestland come from three sources: biological growth, stumpage price and land price.


Biological growth is independent of the financial market, albeit stumpage and land prices are subject to overall supply and demand conditions. In terms of percentage contribution, biological growth is a dominant

 driver of total timberland returns (Figure 1) and therefore timberland assets have long been viewed as potential diversifiers of an investor’s portfolio (Cascio and Clutter 2008; Mei and Clutter 2010; Mei et al. 2010). In this article, we review a variety of commonly used capital budgeting approaches in forest investment analyses and examine forestland assets in the framework of modern portfolio theory.



Net Present Value Analysis and Land Expectation Value

Time value of money is a widely accepted concept in finance. Simply put, one dollar today is worth more than the same dollar tomorrow because an investor can either consume or invest it and gets better off. In other words, we must consider discount factors when looking at future cash flows.

In the net present value (NPV) analysis, all cash flows are discounted to present period, and a project is accepted whenever present value of revenues exceeds that of costs, i.e., NPV = 0. A key step in the NPV analysis is to determine an appropriate discount rate. Given the long-term nature of forestland investment, the selection of the discount rate r has a significant impact on the valuation. We will discuss it in the next several sections but assume it to be predefined for now.





For a landowner who owns some bare land, the cash flows from growing timber are displayed in Figure 2. Parameter C denotes total initial planting costs, R denotes total future timber revenues from the final harvest, T denotes the rotation length, r denotes the discount rate, and I gives the NPV from one single rotation. For instance, with C=$304/ac, R=$3,200/ac, T=26 years, and r=0.06 for a southern pine plantation the NPV for one rotation I is $399/ac. If this sivicultural practice lasts forever, the NPV for this infinite series of periodic cash flows gives the land expectation value (LEV), the maximum value an investor is willing to pay for the bare land for growing trees.

Specifically, LEV = -C (1+r)T+ R


With the same values for the parameters, the LEV for that particular land is 512 $/ac. In real world businesses, bare land transactions are less observed than lump sum sales of both timber and land, resulting limited price information of land itself. Therefore, the LEV formula offers landowners an easy way to allocate appropriate values to timber and land for tax purposes.


Internal Rate of Return

In addition to the NPV criterion, investors compare a project’s internal rate of return (IRR) with their hurdle rate. The IRR is the discount rate that makes the present value of revenues equals the present value of costs, or . Continuing with the above example, the IRR is calculated to be 0.0948. If the landowner’s hurdle rate is below that, she should invest.


Otherwise, she can be better off by investing elsewhere and achieve a higher return. Usually, the IRR cannot be solved by hand but can be easily solved with financial calculators or MS Excel. However, it should be noted that, under certain conditions, there can be multiple IRR’s for a project (express the NPV as a function of discount rate r. If the NPV(r) curve crosses the horizontal axis of discount rate multiple times, there will be multiple roots for the IRR). Thus, the IRR criterion is often combined with the NPV analysis in practice. Besides, the NPV calculation tells landowners...Members: Login to read the Next Page







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