Deciding to be or not to be – agricultural production

In a rural neck of the woods trouble is brewing, land values are going too high! A farmer was willing to participate in CFI, albeit for a modest return. In light of stock holdings being low in the district the idea of leasing the neighbours land was attractive. Until someone decided the Internet was a good place to advertise an enthusiastically priced land sale.

Why is this important? Because everyone then develops higher wealth expectations and the issue is the inputs become higher and the price consumers are willing to pay for the agricultural and livestock remains low.

If we accept this will happen regardless, we need to re-evaluate the purpose and future in terms of commitment to incentives. But first we need to determine the price that could be and what the market will withstand. Beef and Central (www.beefcentral.com) ran an excellent story on: What value is a fair market price to pay for rural land? Written by Michael J. Vail, Tre Ponte Corporate, Brisbane 26 Oct 2012. Verbatum “Capital Budgeting for Investment, using the Discounted Cash-Flow (DCF) Method, and Net Present Value (NPV)”

Quoting: “It is important to understand the methods used by sophisticated and experienced business-people in the world of finance and economics, both here in Australia and overseas, when making large-scale capital expenditure budgeting decisions; whether it be for investments below one million dollars or up to several hundred million dollars.

One excellent method which is technically sound, and is supported by courts when deciding cases, is the Expected Net Present Value of a Future Expected Cash-Flow Income-Stream, also called Discounted Cash-Flow (DCF) Analysis.

When finance and economic analysis is in

progress, the concept of ‘flows’ is used, to show where the money goes. Money flows ‘in’ or ‘out’, with Net Cash-Flow available to pay dividends to owners of capital.

The basic premise is as follows, you:

1. Understand a business’ past cash-flows (both in and out),

2. Understand the nature of the income cycle,

3. Understand the cost structure of the business,

4. Understand what influences (both internal and external) the business model is sensitive towards,

5. Understand the accounting and economic break-even points, for sales dollars and sales quantity,

6. Understand supply and demand issues, at the micro and macro level, for this type of business, and

7. Have a view of the future, and for the business.

8. Make assumptions (which are documented), for each line of the cash-flow.

9. Project the cash-flow forward in time for three years, using zero-based budgeting; with the balance of the current year, plus one full year, shown month-by-month, and then two further years shown on an annual basis.

10. Identify and understand the risks of the project, and, whilst mitigating where you may, come to a conclusion whether the business is more or less risky than the market (using a proxy company where you can).

11. Derive a Before-Tax, Discount Rate, which fully describes the expected risk in the project going forward over the life of the project (eg Opportunity Cost of Capital).

12. Do not use the Weighted Average Cost of Capital (WACC) method to derive the Discount Rate, unless there is an appropriate amount of equity ‘hurt-money’ on the table, and the owner’s residential property is not being used as collateral for any loans; as evidenced in the balance sheet. Otherwise use an Opportunity Cost of Capital proxy, such as the Borrowing Rate plus a Margin-of-Safety.

13. Insert the Discount Rate into the Present Value (PV) formula applicable to the circumstance, and derive a Multiple.

14. Apply this Multiple to the Earnings Before Interest and Taxes (EBIT) figure from the cash-flows above, bringing these future cash-flows back to a single number, as it would be in the present-day, discounting for time and risk.

15. A way to think about it is; if I was offered a dollar today, or a dollar in one year’s time, and the opportunity cost of not taking the dollar today is 10pc, which will I prefer? If I take the dollar today, and put it in the bank, where I can earn 10pc, I will have $1.10 in one year’s time. So, if I wait, I will be $0.10 out of pocket. Conversely, how much would I have to invest today to receive a dollar in one year’s time? The answer is $0.91 ($1.00 / 1.1). A rational person will choose to take the dollar today.

16. This is similar to what is termed a ‘perpetuity’; where an amount is “grossed-up” to what it might look like ‘at the end-of-time’.

17. Take one dollar and invest it ‘perpetually’ at 10pc per annum, and it becomes $10.00 ($1.00/ 0.1); however, when you calculate the number of years (n) to ‘perpetuity’ ($10 = $1 x (1.1)n), it is only 24-years and 58-days. Granted, this is a long period of time, though it is hardly what we imagine as perpetuity; whatever that means. However in our modelling, some assumptions are made.

18. Another example: If $1.00 @ 25pc in perpetuity equals $4.00, then the time to perpetuity equals 6.212567-years (n = log 4 / log 1.25), or 6-years and 78-days.

19. So we may observe that as perceived risk rises, the pay-off horizon shortens; or the PV shrinks. The converse is also true. This is an example of the risk/return trade-off; as there is an inverse relationship (and therefore a negative slope) between them.

20. This adjustment for interest income (or expense), is referred-to as the ‘time-value-of-money’.

21. Another concept to understand in relation to NPV analysis (where positive NPV projects are acceptable investments) is the question, what is the hurdle rate of return (IRR), or the maximum borrowing-rate (less a Margin-of-Safety), where NPV equals zero?

22. A rational investor will surely pay no more than the number this discount hurdle rate equates to under the assumptions given; yet if the long-term view of interest rates over the term of the project is less than this hurdle rate, one will see a higher NPV and is more likely to invest.

23. And if expected EBIT increases, due to better management or market conditions, then the NPV will also rise.

24. A positive side effect of a higher EBIT as a percentage of Revenue, is that perceived lending risk will also fall, leading to lower risk premiums being applied.

shall illustrate with an example.

If rural, pastoral and grazing land in the Blackall/Tambo Shire of Central Western Queensland, in large part, has an average carrying capacity for a cow-and-calf unit of 1:21-Acres, then the carrying capacity of the cow alone is 1:14.69-Acres (if weaning percentages are 80pc and bulls are joined at 3pc).

If a Margin-of-Safety of 10pc is added-on to this carrying capacity, then the number becomes 1:16.15-Acres per cow (Dry Unit Equivalent).

To arrive at a fair estimate of market value, for what this parcel of land is worth on a per-Acre basis (Walk-In, Walk-Out, including stock, plant and all things necessary for the continuing operation of a Going Concern enterprise), you should request trading and profit and loss statements from the vendor (under signed Confidentiality and Non-Disclosure Agreements) going back at least five years, and the lodged income tax returns which accompanied them. This is an important step as a part of the data verification process.

There may well be resistance to this request from the vendor, as this data is of a private and sensitive nature. However this level of disclosure, is what everyone else in the real world complies with, to ensure there is full-information on the table for a prospective purchaser to review.

The production of same gives the purchaser some higher level of comfort around the numbers, and therefore a lower level of risk premium will be applied in the NPV analysis. Also, where there is un-certainty beyond rationality, lenders will also put a higher risk premium on any funding requirements.

To continue with my example, I will assume the following inputs and equations:

1. A purchaser will not borrow more than one-half of the expected market value of the total adult cattle herd.

2. A purchaser will not borrow more than 20pc of the total Asset Value of the enterprise including all things necessary; including the land component.

3. The parcel of land is around 36,000-Acres in size.

4. The average market value of the herd is $850.00 each. (It should be around $1300.00 per Head.)

5. The average adjusted EBIT, over the period covering the past five years, and expected over the next three years, is $450,000.

6. The carrying capacity, as calculated above, is 1:16.15-Acres (Dry Unit Equivalent).

7. That an appropriate regression equation to calculate a ‘Bare of Stock and Plant’ Price for comparison, may be:-

• Y = $770.00 x (X) -0.717,where ‘X’ equals Carrying Capacity expressed as ‘Acres per Beast’.

8. That an appropriate regression equation to calculate a ‘WIWO (Operating)’ Price for comparison, may be:-

• Y = $1,417.30 x (X) -0.86,where ‘X’ equals Carrying Capacity expressed as ‘Acres per Beast’.

9. That the average Opportunity Cost of Investment is 9.5 percent per annum (Compound).

10. That a purchase should be looked-at like a perpetual Bond, paying annuity income as a coupon, and with NPV at Zero (0), to find the ‘price you should pay no more than’; using a multiple of income, and a cost to buy (reflecting perceived risk).

11. The formula for this calculation may be:-

• NPV = (EBIT x (1 + (1/Opportunity Cost))) – Original Cost.

• Setting NPV to Zero (0), the equation changes to,

• (EBIT x (1 + (1/Opportunity Cost))) = Original Cost

12. A rational risk-averse investor, only invests in positive NPV projects; so where NPV equals zero(0), you are indifferent as to whether you will invest or not.

13. There is no ‘one-true-value’.

14. Equations which model what might happen, only model our expectations of future expected cash-flow and value, and are not accurate; as only actual outcomes are measurable and real.

15. The concept of ‘common-sense’ should be fastidiously applied, and in large doses.

Expected Value per Acre: To Buy

• Bare of Stock and Plant:

– Y = $770.00 x (21.0) -0.717  = $3.124M. (or $86.79 per Acre.)

– We use the higher carrying capacity of 1:21.0 -Acres because the place is a blank piece of paper, and may have many uses; however that is the long-term carrying capacity of the place, on the average.

• WIWO (as a Going Concern):-

– Y = $1,417.30 x (16.15) -0.86  = $4.664M. (or $129.55 per Acre.)

• Value to Pay No More Than (WIWO):

– NPV = (EBIT x (1 + (1/Opportunity Cost))) – Original Cost.

– Set NPV equal to Zero (0).

– Equation becomes:-

o (EBIT x (1 + (1/Opportunity Cost))) = Original Cost.

o ($450K. x (1 + (1/0.095))) = Original Cost.

– Original Cost = $5.1868M. (or $144.08 per Acre)

– Therefore, the break-even value per Acre above, is the maximum you should pay; if the EBIT is $450K. and the borrowing cost is 9.5pcpa.

– Of course, if either variable changes, then so will the answer.

• ‘True’ value for WIWO lies between $129.55 and $144.08 per Acre.

• As you can see, it is important to have a view of the future, to ensure you do not pay too much.

• As each case is different, please consult with your advisor; however, the above should give you food for thought.

• Of course, ‘value’ is in the eye of the beholder; price is what you pay, and value is what you get.

• Be aware that under this model, if all else remains constant under the WIWO example above, except if Item-2 changes to 30pc, then the value per Acre you are willing to pay may fall to $87.72. This is a big difference, and it indicates the higher level of perceived operating and financial risk, as Debt/Equity ratio moves from 20pc or 2/8 (25pc), to 30pc or 3/7 (43pc).

• Alternately, if the Expected Future Revenue looks set to jump (due to the signing of a long-term trade agreement with another country), then the Demand Curve for beef will shift quickly relative to the Supply Curve (which is fixed in the short-term), and of course you should expect to receive a higher capital payment if you are a seller; and conversely pay more if you are a buyer.

Expected Value per Acre: To Lease or for Agistment

If you did not want to buy through lack of access to capital, and merely required Agistment, or a Lease, on a per-Head-per-Week basis (as applied to adult cattle), and the expected yield was similar to the Opportunity Cost of Capital, then the following may apply:-

– ((Value / Acre) x (Opportunity Cost) x (Carrying Capacity / Acre)) / 52-Weeks.

– Or, our old friend, (Beast Area Valuation x Opportunity Cost) / 52-Weeks.

– Dry Cattle  = ($144.08 x 9.5pc x 16.15) / 52 = $4.25 per Head per Week, or

– Dry Cattle  = ($2,326.89 x 9.5pc) / 52-Weeks = $4.25 per Head per Week.

– Wet Cattle = ($144.08 x 9.5pc x 23.10) / 52 = $6.08 per Head per Week, or

– Wet Cattle = ($3,328.25 x 9.5pc) / 52-Weeks = $6.08 per Head per Week.

– Same income overall will eventuate, but able to carry less adult cattle; per the assumptions above.

– You will note BAV is different for Wet or Dry cattle. How can this be? It is exactly the same block of land! Therefore, BAV may be confusing, and should only be used as a rough guide when valuing agricultural land.

Conclusions

What I have tried to show here, in the above assumptions and calculations, is that a rational approach needs to be made to the valuation of any investment, no matter where, or what it is; else you run the risk of paying too much.

It may also mean having your banker/financier see the investment as more high-risk than it otherwise should be, and therefore self-justifying charging you a higher interest rate premium, as applied on borrowed funds, than necessary; which may have the unintended consequence of leading to a higher risk of bankruptcy in marginal investments; remember this type of business is usually asset-rich, but cash-poor (though it should not be); so always build into your calculations a Margin-of-Safety.

The Discounted Cash-Flow (DCF) Method and the calculation of the Net Present Value (NPV) of an income stream, is a very appropriate way to value an asset of this type, and is used by investors from all walks of life; whilst also being strongly supported by the Courts, as a valid and robust approach to valuing assets.

The ‘accounting equation’ (where Assets = Liabilities + Equity), like all good algebra, must stay in balance. When valuing a business using this Method, you are valuing the Assets which you need to operate the business; however, if you are buying the business’ legal structure (ie a Pty Ltd company, for example), then take out any Surplus Assets and remove any Liabilities you are not absorbing, to arrive at the Equity Value (where Assets minus Liabilities = Equity).

Look to the long-term patterns in the data for randomness, trend, cycle, and seasonality, etcetera, by using a 13-week Weighted Moving Average of Revenue (for example), only looking back to learn; however, have a view of the future, and remember, you value an asset with a view to the future expected income from it.

The past has a memory, which carries forward, though dissipating with the passage of time; usually exponentially, depending upon the accepted usage and effect. Remember the past is just a guide to the future, so only look back to learn.

Do not pay too much; as you make your profit when you buy, not when you sell.

I encourage debate, and am happy to be proved wrong.

Good Luck, and thank you for your time.” End quote. The analysis is part of a series to Beef and Central by Michael Vail, and is addressed to investors making capital budgeting decisions towards a long-term investment in the agricultural production industry. Co2Land org posts this not as advice but for information only.

CO2Land org only adds that these numbers will change as values change and if you recall sentiments over commitment periods for CFI, you may now consider insurance packages may be the new industry to protect the family – assuming families are still allowed to compete in agriculture.

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What would happen if the Carbon Farming Initiative (CFI) did not go ahead

What would happen if the Carbon Farming Initiative (CFI) did not go ahead – the faithful can take the view it is an unlikely scenario – however, the terms of what is a commitment seems to loom as a political issue.  The pros and conns of whether it should be 10, 25 or 100 years is very much part of the politics and views have been put forward in previous writings suggesting it is something that needs to be carefully evaluated and a mistake in the terms and timings could amount to a revival of feudalism for farmers (Posted on August 8, 2012 by co2landYou can’t sit on a fence, a barbed wire fence at that, and have one ear to the ground).

Recently, the Department of Climate Change and Energy Efficiency (DCCEE) in Australia made some important announcements:

  1. The case for continuing with CFI: The case can best be viewed through www.cleanenergyfuture.gov.au and recent presentations include the process of eligible activities, the intention of the positive list, baseline identification (which clearly put the illustration of what will happen if the CFI did not continue as a project), examples of the methodology proposal, preparation and the approval process (which is in complete acceptance when it appears on the Federal Register of Legislative Instruments).
  2. The appointment of Agrifood Skills Australia to develop the competency sets for CFI participants:  Associates of CO2Land org had previously lobbied both parties to argue the need for the competency sets and urged they should not believe they alone fully know the competency sets required. Examples were given where previous outreach attempts lacked some hard capability to influence other than a  ‘wait and see’ attitude and business as usual will continue until the audience can fully understand the partitioners voice is being heard. It is urged the associates should still be canvased to help resolve such dilemma in developing competency set faced by outreach entities.

CO2Land org also researches in an independent way and notes that according to US advances in ‘green businesses’ (previously we have also indicated CFI should not be described as a ‘carbon’ business initiative) the “Bay Area news channel KQED, by funneling auction revenues into green businesses, like sustainable farming, and encouraging corporate polluters to find more eco-friendly methods of conducting business, the state has a chance to reduce its greenhouse gas emissions by 80 percent by the year 2050″.

What exactly constitutes a green business? The news channel reports that sustainable agriculture is on the state’s approved list. This includes farms that “sequester carbon” with methods like reducing soil tillage, practicing water and energy conservation, and reducing synthetic fertilizer use through compost, cover crops, and crop rotation. Could we see a policy change here, suitable for Australia – soon!

Pure Gold Standard

On 28 June 2012, it was reported by the Australian Government, it “introduced the National Carbon Offset Standard (NCOS) on 1 July 2010 to provide national consistency and consumer confidence in the voluntary carbon market. The Government called for submissions into the standard, and received 34 submissions for the draft review of the standard.”

It is worth noting that NCOS serves two primary functions:

  • Provides guidance on what is a genuine voluntary offset, and
  • Sets minimum requirements for calculating, auditing and offsetting the carbon footprint of an organisation, product or event to achieve ‘carbon neutrality’.

Then on 25 July 2012, Choice www.choice.com.au said several of its members were put off because of a perceived lack of accountability and oversight in the industry, and needed more assurance before they considered offsetting their carbon emissions.

CO2Land org is now interested in what makes this such an issue especially when NCOS is set up to provide a means of ensuring the environmental integrity of the carbon offsets and carbon neutral products available in the Australian voluntary market. It is meant for consumers and businesses alike to make informed choices and be able to interpret carbon neutral claims. Business should find comfort in being able to determine their carbon footprint in line with consumer expectations etc.

Maybe a little Carbon standards 101 at this point:

The Verified Carbon Standard (VCS) is an international standard that ensures carbon reductions meet quality standards and are independently verified, numbered and listed in a central database.

The Gold Standard (GS), established by the World Wildlife Fund (WWF), certifies offset projects that demonstrate greenhouse gas reductions and positively impact the economy, health, welfare and/or environment of the community where the project is located.

The Carbon Farming Initiative (CFI) is a voluntary Australian Government carbon offsets scheme that enables farmers and land managers to generate carbon credits by reducing agricultural emissions, such as nitrous oxide and methane, and sequestering carbon in vegetation and soils. These credits can then be sold to individuals and businesses wishing to offset their own greenhouse gas emissions.

The Government’s National Carbon Offset Standard (NCOS) verifies claims of carbon neutrality in Australia. To verify carbon neutral claims, the NCOS specifies that organisations must buy their offsets from projects verified under eligible schemes. These include credits issued under the CFI, VCS and GS, among others.

Now for a little more on the comfort factor:

CO2Land org on 16 August  2012 was told it still all feels good and Gold Standard (GS) is a rigorous standard with considerable credibility, there is a problem – nothing to do with creditability, but how and who is going to run the GS market in Australia. The issue today is NCOS clearly give GS the big tick and that is why we have watch this space and note that concerns over efficacy are being addressed through such a rigorous process for the regulation of the programs will ensure the money goes where it should. However, 2 years and counting is getting a little uncomfortable when you want to participate in the standards with confidence.

The most innovative Australians are Farmers

The most innovative Australians are Farmers. The Daily Soils Digest on 15 June 2012 has written: Since 1970, arable farming land has reduced by 7.5%, but farmers have increased production by 220%.

The Nuffield Australian Farming Scholars say that the long-term capacity of Australian agriculture to compete and succeed internationally will be determined by the ability of Australian farmers to recognise changing consumer preferences, adopt new technologies and production practices and maintain the sustainability of their operations by protecting their production environment – they say in a “city-centric” world, Australia needs farmers with a world view who can convey clearly the needs of agriculture DAFF 210612.

For those that prefer biodiversity protection as their landholding option, they can enter into conservation agreements or covenants to protect biodiversity on their property. As state government run initiatives, the landholders can create private protected areas that bind future landholders to protect the property’s biodiversity, ensuring the long-term survival of plant and animal communities. Now the rub: While seems like a good deal, and while a private protected area comes at little to no cost to the government and offers protection to biodiversity that might not otherwise have been protected. Mining is not exempted from coming in and taking over with mining activities. Landholders can only weep no matter what state they live in, as all governments can still give miners permits to explore and extract in these private protected areas. Reported through The Conversation 29 May 2012.

For those that might expect market maturity to settle quickly on carbon, consider this: AFR on 12 June 2012 wrote, Wild gyrations in markets and economies are the ‘new normal’ – this requires business to be faster to innovate and be flexible and adaptive – US recruitment expert, John Sullivan, says that innovative people can produce far more revenue than more ordinary employees in this context – he says it takes nearly 8 people at IBM to produce the same revenue as one at Apple – in Silicon Valley, companies measure innovation before they measure productivity because they make huge margins through innovation.

Sourced through:  Garry Reynolds DAFF