How to do a discounted cash flow analysis (DCF)

Doing a discounted cash flow analysis (DCF) by hand requires a calculator, pencil, rubber and plenty of patience. A computer is very helpful for people who aren’t very patient. A Microsoft Excel™-based spreadsheet to help with the economic analysis of any farm forestry project is available for free from The Master TreeGrower web site at: www.mtg.unimelb.edu.au/tools.htm

Step 1. Setting A discount rate
The discount rate is like an interest rate. If $1000.00 is invested today at 4 per cent, in 28 years it will be worth almost $3000.00.
Future amount = $1000.00 x (1 + 0.04)28= $2999.00

Alternatively if it is assumed that in 28 years a stand of timber will be worth $23,000.00, then by discounting or reversing the interest process, it is possible to calculate how much it is worth in today's dollars.
Current value = $23,000.00 x(1 + 0.04)28 = $7670.00

If a discount rate of 8 per cent, rather than 4 per cent, is used, the present day value of the same timber would be $2665.00. The discount rate chosen is therefore critical in any long-term investment. There are two common approaches to setting the discount rate:

• Use the interest rate at which money can be borrowed, excluding inflation,
• Use a rate equal to that provided by an alternative investment of similar risk, such as the share market.

Generally, a discount rate of 4–8 percent is used to evaluate farm forestry projects.

Step 2. Present value of costs and returns
Once a discount rate is set, a discount factor can be calculated to discount future sums of money back to today's dollars—this is called Present Value. The same discount rate should be used for all years of the project.

The discount factor can be read off the Discount factor table fact sheet or calculated from the equation below:
Discount factor = 1/(1+r)n
Where r = discount rate percentage, and n = the year

Once a discount factor has been calculated, it is multiplied by the net return or loss for a particular year to provide a Present Value for the year in question.

Step 3. Net present value (NPV $/Ha)
Net present value (NPV) is a very common economic figure used to present a project’s profitability using discounted cash flow analysis. The NPV is calculated by adding all the discounted returns or losses over the rotation of the trees.

If the NPV is positive, the project is considered financially worthwhile at the discount rate used. If the NPV is negative, the project is said to be making a loss at the discount rate used.

The discount rate used has a large effect on whether agriculture or farm forestry will be more profitable. Because it generally has smaller annual returns, agriculture is comparatively more profitable when higher discount rates are used. Forestry has large returns at the end of the project so using a lower discount rate will generally make a farm forestry project appear more profitable. This is because the large return at the end of the project is not discounted as heavily. For risky investments such as tree growing, a higher discount rate is generally used.

Step 4. Annuity ($/Ha/Year)
An annuity is the average amount paid by the project each year over the life of the project. It is also calculated using a set discount rate. It is a good way of comparing yearly agricultural returns with yearly forestry returns.

An annuity is calculated from the NPV by the formula:
Annuity ($/ha/yr) = NPV ($/ha)/(Annuity factor)

The annuity factor can be calculated from the following equation:
Annuity factor = (1+r)n-1/(r x (1+r)n)
Where r = discount rate (e.g. 4% = 0.04)
n = length of rotation

Step 5. Internal rate of return (IRR % Pa)
The IRR is the discount rate at which the NPV equals zero. It is a measure of the project’s earning capacity and is the rate at which money can be borrowed from a bank and the project still break even. IRR is difficult to calculate by hand but is generated by most economic spreadsheets. A simple method to calculate the IRR for a project is to graph the NPV against the discount rate. This involves doing several DCF analyses using different discount rates and then estimating at which rate the NPV equals 0.

Example
A farmer fences out an eroded drainage line and plants eucalypts for timber and an understorey of locally indigenous shrubs. The trees are managed for high value timber by pruning and thinning. The farmer receives a grant for the fencing and trees but must do all the work himself and his labour is valued at $20.00 per hour. The cash flow below only includes the additional costs associated with establishing the eucalypts and managing them for timber. The final stocking is 100 stems per hectare with each tree producing 1.5 cubic metres of pruned butt log valued at $80.00 per cubic metre. Following small gap harvesting, at an average age of 25 years, the site is cleaned up and the eucalypts replanted at a cost of $1000.00 per hectare.

Net Present Value = $633.00 per hectare— derived by adding up the discounted cash flow

Annuity = $53.00 per hectare per year. This is the equivalent annual return provided by the trees.

Internal rate of return = 8.8 per cent
This indicates that if a landholder borrowed money from a bank at 8.8 per cent and harvested the trees after 28 years, the farmer would not make or lose any money.

The major investment for this type of plantation is the farmer’s time spent pruning and thinning. So the farmer must decide if this investment, at a nominal return of $20.00 per hour, is financially viable given that no payment will be received until after the harvest. The farmer might choose instead to invest his own money in paying contractors to do the work.

6. Comparing trees with agriculture
Once a DCF analysis has been completed for a farm forestry project, another DCF analysis should be done for the same area without the trees. The annuity value provides some indication of the project’s relative value. If, for example, the farmer was receiving a gross margin from grazing the land of about $100.00 per hectare, that would suggest that grazing is more profitable than tree growing. However, the farmer might already be committed to revegetating the site for land protection and shelter. In this case, the analysis suggests that investing additional money in managing trees for timber is justifiable. The prospect of income from timber might then be seen as a bonus.

Farmers should be very careful about estimating their returns if they are considering undertaking forestry as an alternative to grazing. Forestry is a long-term investment with many risks.

When comparing alternative enterprises such as farm forestry and agriculture, the cash flow for both projects also provides a very useful way of comparing projects. Although a farm forestry project may return a higher NPV—in dollars per hectare—many farmers might not be able to wait that long for a return on costs. The discounted cash flow process is only one of the many tools with which a decision can be made. Many issues may be ignored when comparing the financial viability of two enterprises as different as farm forestry and agriculture using only the NPV figure. They include:

• Although agriculture might not be as profitable, the returns are annual. Farm forestry has large cash spikes—both positive and negative.
• The labour requirements for the farm forestry project will have spikes during the planting, pruning and harvesting periods. It is a good idea to calculate returns per hour invested for both agriculture and farm forestry.
• Agricultural markets are relatively well known and predictable in the short term. Farm forestry markets are unclear and uncertain.
• Landholders agricultural production skills and confidence in the processes. New skills and technologies may have to be learnt and understood to successfully produce a commercially viable farm forestry product.

Risk and uncertainty
The figures used in this fact sheet are the best available guesstimates. Some, if not all, will be incorrect or will change over a project’s life. Therefore it is important to change some of the key variables to test what effect they have on the final result. This is called a sensitivity analysis. The analysis should consider a worst-case scenario and then a judgment about whether the risks involved are worth carrying.

Risk is largely a personal perception. One person might see a particular project as very risky. Another might believe the market, climate and production will all be in their favour making it a very profitable venture or low risk. In addition to testing different scenarios, the DCF analysis can account for risk by:

• increasing the value of labour;
• using higher costs if not enough is known about the exact cost of an operation
• being conservative about tree growth rates and timber yields
• being conservative with stumpage rates
• using a higher discount rate to reflect a greater conservatism in spending money.

Discount factor table (16k pdf)



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