The use of technology can greatly increase harvest yields for farming operations. This research focuses on the advantages of purchasing equipment that lowers operational costs and increases revenues. We will focus on Net Present Value, Payback, and Discounted Payback methods. Original Article By: Jason Neal ussneal@aol.com

INTRODUCTION
McIntosh Farms, Inc. has asked for help in analyzing an asset purchase to decide if it is indeed worthwhile to undertake. The equipment in question is a combine for harvesting soybeans. It is the scope of this research to prove whether a buy decision is acceptable. To do this we will start by examining forecasted production rates for soybean yields. From there we will look at depreciation of the new equipment and use the Net Present Value, Payback, and the Discounted Payback method for the analysis.

BACKGROUND

McIntosh Farms, Inc. (MFI) is a farming operation in northern Kentucky that specializes in the production of grains, namely soybeans. Their main land base is a 2000-acre tract devoted totally to soybeans. However, due to equipment limitations MFI has only been able to use 1500 acres of the available land for planting and harvest.

MFI has asked for help in identifying and analyzing new assets that would allow for full use of the harvestable land as well as lowering operating costs. Their existing equipment is too small to handle the additional 500 acres of production and is at the end of its usefulness. It is also costing more to operate as mechanical assets always succumb to stresses of use, i.e. they wear out.

In looking for new assets that would fit the bill, it was agreed that MFI would only want to purchase one piece of equipment to handle the original 1500 acres plus the new duties. This led to searching for a rather large combine. The new piece of equipment to be analyzed was agreed upon: a John Deere 9860STS combine.

The reason for looking
at this particular model had to do with size and options. This is
one of the biggest combines John Deere manufactures. It is able to
hold 300 bushels of grain before it needs to be unloaded. This means
it is in the fields longer, harvesting more soybeans per trip. This
also cuts down on the number of trips the grain trucks have to make
to the fields for the unloading process, affecting operations costs.

The 9860STS also has a
high flow rate for unloading. According to literature it can move
3.3 bushels per second. This means that the contents of a full grain
bin can be offloaded in about ninety seconds. The rate of the old
machine was much slower, causing slack time.

MFI also believes that
with an ergonomically designed cab, the longer hours in the field
will be much more comfortable for the operator. This means that no
other labor would be hired to operate the machine due to fatigue.

ASSUMPTIONS & DATA

In order to get a good idea as to potential
revenue increases from the new equipment, production forecasts had to
be made. To do this, information on soybean yields were obtained
from the National Agricultural Statistics Service. In looking at the
data, Appendix I, it was determined that an average of MFI’s
county and two surrounding counties should be used in order to get a
good idea of the harvest capability of the area.

After the averages were calculated, trend
analysis was used to deseasonalize the data. This process evened the
playing field, so to speak, in that if there was a particular trend
present the deseasonalized data would take that into account and make
adjustments. This allowed us to limit the bias in the data due to
large numbers or the seasonal effect.

A trend equation was then developed to forecast
production rates of the 500 additional acres. For each year
2004-2007 we found the rates would be 32.499 bu, 32.662 bu, 32.825
bu, and 32.988 bu respectively.

Another assumption that had to be made was the
price the soybeans would be sold at. MFI uses futures contracts for
their production. Futures allow producers to lock in the selling
price before they harvest adding some security to an otherwise risky
business. For this analysis it is assumed that all the additional
soybean harvest will be sold for $6/bu. This assumption may tend to
be below what the market is willing to pay now, with recent prices
being in the high-$7 to low-$8 range. But MFI believes that $6 is a
realistic estimate based on their past experiences.

Operating cost savings were also estimated by
MFI. They looked at the savings in labor costs by not hiring another
machine operator. They also looked at the lower maintenance costs
associated with a new piece of equipment and the use of technology in
the combine itself to reduce wear and tear as well as monitor vital
functions (oil temp, oil life, hours, etc.). All of this together
was estimated to save about 15,000/year.

MFI has determined that
the combine model they are looking at, the 9860STS, will cost them
$232,873. This price was quoted from www.deere.com
under the Build & Price tab.

For depreciation
purposes, MFI has decided to use a useful life of seven years. This
will help in determining the depreciation per year. We chose seven
years as a useful life because of the demands put upon highly used
agricultural equipment. We have also assumed that MFI will want to
sell the equipment after four years in order to keep current on
technology in the industry. Otherwise, waiting the full seven years
could lead to obsolescence and lost revenue. MFI believes it will be
able to sell the combine for $90,000 at the end of four years.

The depreciation method
to be used will be the double declining balance method. Since MFI
wants to sell the equipment before the end of its useful life, they
want to realize the full effects of depreciation on their purchase.
To do this, the seven-year straight-line depreciation has to be
calculated and the yearly amount is then divided by the total to get
the percentage per year depreciated. Once this is calculated, the
percentage is doubled and applied to the depreciation each year until
that amount falls below the straight-line amount, at which time the
straight-line amount is used.

In this case the
depreciation percentage would be 28.6%. This was calculated by
subtracting the salvage value from the purchase price. It is
represented as follows:

Salvage
Value = Purchase Price x 27%

 

The factor of 27% was
gained from information provided by Iowa State University Extension
Office.

Salvage Value =
232,873 x 27%

Salvage Value =
62,875 (rounded)

The depreciable amount
can then be determined by:

Depreciation
= Purchase Price – Salvage Value

Depreciation =
232,873 – 62,875

Depreciation =
169,998

Per-year depreciation
using seven-year straight-line method yields:

Per-year
depreciation = Total depreciation/7

PYD = 169,998/7

PYD = 24,285
(rounded)

On a percentage bases,
PYD is equal to 14.3% of total depreciation. For the double
declining balance method, the coefficient would be 28.6% and will be
what we use in the cash flow computations to follow.

The last thing needed
to start the analysis was the Required Rate of Return for MFI. Since
they would be using cash that was earning 3% in a money market, it
was calculated that the RRR would need to be 6%. This takes into
account the earnings lost in the money market as well as other
opportunity loss through financing other endeavors.

ANALYSIS

In looking at Figure 1, we see that using the Net
Present Value method yields a positive result. For this we
calculated uneven cash flows for each of the years that MFI would own
and use the equipment. After adding the increased revenues from the
additional 500 acres and the operational savings we came up with the
Total Increase from owning the equipment. From there we subtracted
out the depreciation in order to offset the purchase price against
earnings, thus lowering the taxable income. Since MFI is a
corporation, it is taxed at 40% (includes both state and federal
rates). Subtracting the taxes from the Taxable Amount gives the Net
After Tax Cash Flow amount. This was done for each subsequent year.

Figure 1

Year

2003

2004

2005

2006

2007

 

The cash flows then need to be discounted back to
today’s values to account for the time value of money
principle. To do that the individual cash flows were multiplied by
discounting factors for 6%, the RRR. These were provided by Ingram
et al in Managerial Accounting. This final computation yields
the present value of the future cash flows. Summing these and
subtracting the purchase price gives us a NPV of $3669.19, a positive
amount.

According to NPV principles, since this is a
positive amount, it would be advantageous for MFI to undertake the
purchase. The amount by which the combine increases revenues and
lowers operating costs more that outstrips the cost of the machine.

Another technique for looking at capital asset
purchases is the Payback Method. This looks at the estimated cash
flows with out discounting to determine “the time required to
recover the original investment”. In an uneven cash flow
situation, such as MFI faces, you would add the cash flows until they
equaled the purchase price. Figure 2 shows that the investment will
be recovered in less than four years, 3.6.

Figure 2

Year

0

1

2

3

4

 

The last method we will look at is the Discounted
Payback Method. Unlike the regular Payback, Discounted Payback takes
into account the time value of money by using the discounted cash
flows. In figure 3 we see that the investment will also be recovered
in less than 4 years, 3.96. With discounting it will take longer to
recover the investment because adjustments have to be made to the
cash flow value to correct for the discounting rate.

 

 

Figure 3

Discounted Payback

 

CONCLUSIONS

Based on the assumptions MFI has made, it is
feasible to undertake the purchase of a new combine. This is due to
the positive NPV and Payback periods, both regular and discounted,
that are less than the proposed ownership of the equipment.

We have also looked at only one scenario.
Section 179 of the tax code allows for the deduction of a full
$100,000 in the first year on top of the regular depreciation. Along
with this, the Jobs and Growth Tax Relief Reconciliation Act of
2003 allows for an additional fifty percent first-year
depreciation to be taken. Under the circumstances here, neither of
these additional depreciation amounts was taken. This is due to the
marginal nature of the cash flows in comparison to the purchase
price. Had they been higher, the decision may need to be
reconsidered, but in this case the double declining depreciation
provided enough tax shelter while providing positive cash flows.

Bibliography

Edwards, W. (2002). Estimating Farm Machinery
Costs. Ag Decision Maker, April, A3-A29. Retrieved November 30,
2003 from Internet.

Ingram, W. (2003). Control, Measurement, and
Evaluation. Managerial Accounting, 382-421.

National Agricultural Statistics Service (2003).
[Crop Yields by County in the U.S.]. Unpublished raw data.

Appendix

Year

Period

Time

Yield

4 year MA

Cen Ave

Sea. Irr. V

 

 

 

 

 

Year

Period

Time

Yield

SI

Desea. Yi

tYield

t^2

 

Year

Period

Time

Yield

Forecast

Error

error^2

 

Year

2003

2004

2005

2006

2007

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