By Jody Padgham, MOSES
Stopping to visit a neighbor I hadn’t seen for a while, I was surprised to see a tiny apricot poodle dancing and yipping at his feet.
“Yeah,” Mark chuckled. “Fifi is my penance.” He explained that a few months earlier he’d returned from a trip to town the proud owner of a new(er) $24,000 tractor. “I’d promised my wife I wouldn’t buy equipment impulsively anymore. When I came home with that new tractor, she went right out and bought this dog to punish me,” he groaned.
If you’re like Mark and buy expensive equipment on an impulse, you could get yourself into trouble, too—more trouble than a noisy poodle.
There are some simple equations you can run to tease out the financial implications of any purchase. Calculating the Net Present Value (NPV) will help you judge if buying or leasing would leave you financially better off than leaving the money in the bank. It can also show how one kind of investment compares to another.
How much does it cost to own?
Let’s start with a desire—more land, more equipment, more livestock, or a new building. Perhaps you’ve always wanted a potato digger, and just can’t get your mind off a nice 2-row unit that a fellow you met at a MOSES field day has for sale. Let’s say you can get the digger for a pretty good price: $3,000.
First, you need to figure out how much it will cost you to own and run the digger, including how much it will save you in labor. Without the digger, you put in about 100 labor hours to dig one acre of potatoes. If you bought the digger, you could collect the same number of potatoes in about two hours. But, you’d need to pay for repairs, a place to store the digger, and the tractor fuel to pull the digger. Taking all of this into account, let’s say that you’ll save about $500 per year in cash flow if you buy this digger.
If you are buying or leasing land or buildings or buying livestock, you must consider different things to estimate the cost of ownership, such as property taxes, improvements, feed, health care, etc. Each type of purchase will have its own set of associated expenses and incomes.
Since steel machines hold their value pretty well, even after five years of use, you probably still can sell the potato digger for $1,500. Let’s look at how the figures add up. You save $500 per year in costs when you own the digger, and you can sell it for $1,500. If you keep it for five years, you’re analysis looks like this:
$500 savings per year x 5 years $2,500
Resale value after 5 years $1,500
Total savings $4,000
Initial cost -$3,000
Net savings in buying the digger $1,000
After penciling out the numbers, the digger looks like a pretty good purchase, right? It’ll not only save you money, but give you or your crew time to do something other than dig potatoes.
But, there’s something we didn’t consider in this calculation—the “time value of money.” Once we take into account the time value of money, we can calculate the NPV of your investment, which is more accurate than the simple cost of ownership showed above.
The time value of money considers that every dollar you have in your pocket today is worth more than a dollar that you would receive next year, or in five years. That’s because, if you have a dollar today, you can invest it in something—a savings account, a stock purchase, pay down the principal on an existing loan (thus saving yourself some interest payments) or some other investment—that could bring you back a return. (A little difficult to fathom in these days of low interest rates, but true!) If you spend it, you are losing the potential earnings you’d have from investing it. If you have to wait a year or five years to get the dollar, it is worth less to you because inflation is eating away its buying power, and you run the risk of never receiving the dollar at all.
The way to apply this when considering a purchase that promises to give you a stream of cash income over time is to factor in a “discount rate.” The discount rate is a backwards calculation that takes into account the cost of waiting to receive your cash income. It tells you what your future income is worth to you in today’s dollars. There are different ways to figure the discount rate to use. The easiest is to simply use the interest rate you would pay if you were taking out a loan to buy the asset. Some people prefer to use the prime lending rate plus the rate of inflation.
It is a good idea to add a fudge factor that takes into account how risky the investment is—for instance, if you’re buying livestock, the animal could die, or if you buy a complicated piece of machinery, it could need a lot of maintenance, or break down a lot and not be useful for a period of time. You may want to add a point to the discount to accommodate risk in these instances. The higher the risk that you might not get the cash flow you are predicting, the higher discount factor you should use. On the other hand, if you are buying something brand new that you expect to give you little trouble, you may want to lower the discount rate.
Back to the Potato Digger…
Buying a potato digger for five years seems a pretty safe investment, so we’ll use a discount rate of 5%. Luckily, we don’t have to figure out our NPV values, they’re available from published tables. You can find a table in the back of MOSES’ book Fearless Farm Finances, or by putting “Net Present Value Table” into your Internet search engine.
When we apply a discount rate to your cost of ownership, it reduces the annual savings we expect to gain from the investment. Let’s look at the detail of our potato digger numbers.
|Year||Annual net cash flow||Discount factor (from table)||Annual net present value|
|5||500 + 1,500||.7835||1,567.00|
|Total net present value to cash flow||3,339.90|
We predict the total net present value of the cash flow we’ll have generated in the five years we’ve used the digger and then sold it will be $3,339.90, which is somewhat less than the $4,000 we saw in the cost of ownership equation. Since the digger cost us $3,000 initially, we can see that this is still a good cash investment, as the net cash flow we will have generated is worth $339.90 more (in today’s dollars) than we paid for it.
The beauty of this calculation is that you can run it on different scenarios—always figuring the cost of ownership, and calculating a discount rate—and compare the final net present value to cash flow to see which investment will bring you the greatest return.
If this amount of analysis seems like too much work—or seems to take the fun out of buying something new, as one farmer told me—consider the wise words of one of the Fearless Farm Finances co-authors, Paul Dietmann. Paul, who works for Badgerland Financial, has had many years of experience assisting farmers in desperate financial trouble. When someone grumbles about calculations taking the fun out of farming, Paul responds, “Facing bankruptcy at the end of a long series of poorly considered investment decisions tends to take the fun out of farming, too!”
Now, if my friend Mark had run his numbers, it’s possible that he could have convinced his wife that his tractor was a good investment. He may not have had to suffer the penance of an apricot poodle. But, it might not have made him as happy, as, much to his wife’s dismay, Fifi has now become Mark’s faithful friend.
University of Minnesota-Extension published Machinery Cost Estimates in June 2013 that lists the costs per acre, including lubrication, fuel, labor, etc., of many farm implements.
Jody Padgham is the Financial Director for MOSES and the Editor of Fearless Farm Finances, a 264-page book focused on setting up and managing a farm’s financial system. She writes the Finance Blog.
March | April 2014