Net Present Value Analysis – Converting Wheat to Native Range
For investment decisions and decisions that have financial impacts spanning more than one year, a more appropriate tool for decision-making is one called net present value (NPV). This technique uses a discount factor to put income and expenses in future years on a current year basis. The important variables in the decision are the level and timing of the income and expenses, the length of time over which the investment is used, and the discount factor (typically, an opportunity cost for money such as an interest rate) . The present value of annual cash flows are summed. If the total is positive, it indicates the benefits of the investment are larger than the cost of funds used to make the investment; if the total is negative, it indicates that the income from the investment is less than the cost of funds to make the investment. Note that NPV does not say that this is the best use of resources; it simply indicates whether the financial impacts of the investment over time are positive relative to the financing costs. Nor does NPV indicate the financial feasibility of an investment, that is, whether loan payments could be made if money were borrowed to make the investment.
Here’s an example of a NPV calculation made for the High Noon Ranch for converting wheat to native range with forbs and legumes. The time frame is 10 years as that is the expected life of the stand, given proper management and appropriate stocking rates. The discount rate chosen was 7%.
Table 4. NPV of converting wheat to native range with forbs
Year
Column 1
Cash Income
Column 2
Cash Expenses
Column 3
Annual Net Cash Flow
(1-2)
Column 4
Discount Factor
Column 5
Present Value of Annual Net Cash Flow
(3×4)
0
89.93
-89.93
1
-89.93
1
0
0
0
0.9346
0
2
0
0
0
0.8734
0
3
23.18
14.47
8.71
0.8163
7.11
4
23.18
14.47
8.71
0.7629
6.64
5
23.18
14.47
8.71
0.7130
6.21
6
23.18
14.47
8.71
0.6663
5.80
7
23.18
14.47
8.71
0.6227
5.42
8
23.18
14.47
8.71
0.5820
5.07
9
23.18
14.47
8.71
0.5439
4.72
10
23.18
14.47
8.71
0.5083
4.43
Total
-44.51
Here, the NPV calculation indicates the investment should not be made since the sum of the discounted annual cash flows is negative. However, the answer could be different if fewer than 7 acres were needed per cow, the stand had an expected life longer than 10 years, income were higher, costs were lower, or a different interest rate was appropriate.
The discount factor is calculated as 1/[(1+I)n] where I is the interest rate and n is the number of annual periods over which the sum is to be compounded. It can be calculated or referenced in farm management or agricultural finance textbooks.
Establishment costs of native range (table 2, pg. 15).
Cash income and cash expenses from spring cow-calf enterprise (page 13) with income per head divided by 17 assuming 17 acres per cow. Thus, cash income per acre is $394.44/17 acres; cash expenses are $245.96/17 acres. No income is received until the range is established in Year 3.