###### Investment calculations can help you decide if it makes financial sense to buy machinery

By Paul Dietmann, *Badgerland Financial*

For many farmers, one of the largest asset categories on a farm’s balance sheet is “Machinery and Equipment.” It’s usually second only to real estate in terms of dollars invested.

Machinery investment per farm increased significantly during the profitable years in conventional agriculture between 2004 and 2013 or so. Some agriculture economists estimate that the capital investment in machinery more than doubled over that time.

A number of factors typically come into play when a farmer decides to make an investment in a piece of machinery. Sometimes it’s simply to replace a piece that is worn out. Sometimes it’s to upgrade to newer or more efficient technology. Sometimes it’s to get bigger equipment that allows coverage of more acres in less time. And, during boom times, it might be to reduce the farmer’s income tax liability by taking on a new pool of depreciation.

Lately, investments in machinery have been down. New equipment isn’t exactly flying off of dealers’ lots. Prices of large used equipment selling at auctions have been lower. This could be a good time to take advantage of attractive prices and buy.

Not many farmers have an unlimited amount of money to invest in equipment on their farms, and have to make choices. How can you determine if you’re making a wise investment decision when you’re spending your hard-earned cash to buy equipment?

Outside of agriculture, investors use “Internal Rate of Return” (IRR) calculations to help them make decisions on where to invest their money to get the best possible returns. Although it isn’t commonly used, we can use the same tool in agriculture to assess a variety of potential capital investments, such as machinery and equipment, buildings, and farmland. IRR isn’t as intimidating as it sounds!

The IRR calculation is based off the expected cash flow from an investment. It first looks at the initial cash outlay required to make the capital purchase. It then considers the annual net cash flow expected from the investment. Finally, it takes into account the value of the investment at the end of a certain number of years.

Time is the key element in the IRR calculation. We know that a dollar received today is worth more than a dollar we get in a year or two. We can use today’s dollar to pay down principal on a loan and save the interest that would otherwise have accrued. Inflation reduces the buying power of the dollar we get in a year or two. In return for having to wait to receive those future dollars, we have to discount their value in order to compare them to the dollar we get today.

The IRR calculation essentially figures out the annual percentage rate at which you recoup your initial cash investment, given the fact that your cash comes back to you slowly and in small increments over a long period of time. It’s a way of discounting the value of those future cash flow dollars. IRR is a useful decision-making tool because it allows a farmer to compare a range of potential cash investments that might have very different cash flows, or different lengths of useful life with different residual cash values at the end.

**Calculating IRR**

In order to calculate the IRR on an equipment purchase, first you need to know the initial cash outlay for the equipment. You then need to estimate the change in your net cash flow that is likely to result from owning the equipment for each year that you will operate it. Finally, determine a rough estimate of what the equipment will be worth in the year that you intend to sell or trade it.

Back in my college days, we had to calculate IRR with some printed tables and a calculator. If, after 10 minutes of ciphering, we were able to get within 2 or 3 percent of the actual IRR, we thought we were doing pretty well. Now we can plug our numbers into a preset Excel spreadsheet (there’s a good one available in the Knowledge Library at BadgerlandFinancial.com) and have an accurate number in less than a minute.

Here is a simple example to show you how IRR works in real life. Let’s say you operate an organic vegetable farm and are planning to buy a new potato digger for $10,000 cash. You figure that the digger will increase your farm’s net cash flow by $2,000 per year in each of the next five years. At the end of five years, you think it should be worth $5,000 in trade on a new digger. You’ve got everything you need for the IRR calculation.

When your numbers are plugged into the IRR spreadsheet, it calculates a 12.5 percent internal rate of return on the potato digger investment. If you don’t have any other use for your $10,000 that would give you an annual rate of return better than 12.5 percent, it makes economic sense to move forward with the purchase.

At this point you might be thinking, “I wouldn’t want to use all of my available cash to buy a potato digger even if it will give me a 12.5 percent rate of return. I’d only want to put down $3,000 and finance the rest.” No problem—we can easily run the numbers to see what this does to IRR.

Again, IRR is based off of the expected cash flow. Your initial cash outlay is now only $3,000 instead of $10,000. Your annual cash flow is going to be reduced by the amount of your annual loan payment. A $7,000 loan for five years at 5.5 percent interest is $1,639 per year, so annual cash flow drops to $361 (net cash income of $2,000 minus the annual payment of $1,639). Trade-in value in five years is still $5,000. We plug our numbers into the spreadsheet and find the IRR is now 20.84 percent.

The IRR calculation gets particularly interesting when a farmer is considering a capital investment on a farm that she or he doesn’t own. Most farmers wouldn’t even think of making capital improvements on a rented farm, yet they can often yield very good rates of return. Time is the key element. You have to have enough years of cash flow to generate a return on your initial investment, particularly if the investment is worth zero to you at the end of the lease term. If you are considering something like this, plug your estimates into the spreadsheet and see what kind of IRR you might get.

There are a few more things to mention about IRR. First, future cash flows can often be difficult to project. We need to use conservative numbers, especially as we start projecting four or five years into the future. Second, there are some machinery or equipment investments that don’t easily lend themselves to cash flow projections, as it is hard to estimate what kind of cash impact they will have on an operation. Third, there can be logical reasons to make a capital investment even when the IRR doesn’t look good. For instance, maybe the new potato digger in our example wasn’t going to add much to cash flow but it saved years of wear and tear on the farmer’s back.

Business investors outside of agriculture have been using IRR for many years to help them decide when it makes financial sense to invest their capital. There’s no reason that wise farmers can’t use this great tool, too.

Find the Internal Rate of Return Worksheet and other presentations on investment analysis in the Knowledge Library at BadgerlandFinancial.com.

*Paul Dietmann is the Emerging Markets Specialist with Badgerland Financial, a member-owned Farm Credit System institution in southern Wisconsin.*

From the May | June 2016 Issue