Without careful planning you could lose it all.
This is the time of year when you have a good idea of your income for the year and may want to look at expansion for next year. That can be a risky decision but can also provide opportunity to meet your long-range goals. Expansion risk is a difficult risk to assess because there are many unknowns.
How many times do we make a decision not knowing that it's decreasing our future wealth? Based on my experience, it happens more often than we think.
One tool that has been very helpful for our clients is a program that determines net present value and the internal rate of return for any investment. It's on an Excel spreadsheet and easy to use.
Net present value is today's value of future income. If it's positive, the project is feasible, and the day you make the deal you increase your future wealth by the amount of the net present value. If it's negative and you make the deal, you decrease your future wealth by that amount. Modified internal rate of return is the annual return on your down payment.
The figures you need include the amount of the investment, the amount you're going to borrow and terms, expected revenue or cost offset, variable costs, fixed costs, salvage value and the amount that can be depreciated.
After you enter those figures into the program, it provides data, as in this example for a new bean drill.
$32,000 Bean Drill - Summary Analysis Net Present Value (NPV) $10,735 Internal Rate of Return (IRR) 33.61% Modified IRR (MIRR) 25.00% Profitability Index (PI) 1.89
I've recently done the analysis on buying farms, tractors, combines, grain carts, hog buildings, feedlots, planters, sprayers and a host of other items. You can do the same calculations with pencil and paper. The computer program just speeds up the process.
This is the same decision-making analysis major companies use in expansions or acquisitions. I like it because it puts you on a level playing field with them when making decisions.
A client in Missouri told me the net present value analysis not only gives him peace of mind in assessing expansion risk, it's also helpful in communicating the feasibility of a project to his spouse, business partner and lender.
Another useful tip: When you're planning a project, anticipate what would happen if you have a 25% cost overrun. This is the most frequent mistake I see in expansions: Things end up costing more than what you originally thought.
Another common mistake is not thinking through all the related costs. For example, many of our clients don't just add 80 or 160 acres when they rent more land. They add 500 or 1,000 acres, and that creates a bevy of new costs.
One of our Iowa clients recently added 1,200 acres. This resulted, not only in more operating line needs, but needs for an additional tractor, a 24-row planter rather than his 16, and another combine. That's considerable expansion risk. Using the risk analysis program, which showed a positive net present value, provided peace of mind for him and his banker.