Careful Sums Essential for all Major Capital Investments. Ian McLean, June 2015. 

Large capital investments have a major influence on the future profitability and cashflows of a business. Sums need to be done very carefully to ensure that the expected returns are sufficient to justify the investment. Exclusion fencing is a hot topic at the moment and there is significant investment either being undertaken or proposed. Reducing the incidence and effect of wild dogs and being able to better manage total grazing pressure will benefit a lot of extensive grazing businesses, this is not questioned. The purpose of this article is not to suggest that exclusion fences are, or are not, good investments for extensive pastoral businesses. They will be very good investments for some businesses and very poor investments for others. The purpose of this article is to suggest a process for evaluating an exclusion fence, or any other major capital investment, to determine whether it is a worthwhile investment for your business. Anecdotal accounts that Darren from Dingo Downs reckons his exclusion fence paid itself off in less than two years is insufficient evidence for a business to make an investment of hundreds of thousands of dollars on. The information or assumptions required in order to assess a capital investment are, 





What will it cost (capital, labour, livestock, ongoing maintenance)? What is the timing of the costs (is it all spent in year 1 or is it a staged investment)? What will the benefit be (project specific, but for an exclusion fence will usually be increased performance from current livestock, increased numbers of livestock, reduced expenditure, or a combination)? What is the timing of the benefits (does it start in year one or will it take longer)? What is the timeframe of the analysis? What is your required return on capital? Example Scenario At a recent industry field day I spoke at in Cunnamulla, hosted by Suncorp Bank and Leading Sheep, the topic came up and we went through an example scenario to demonstrate the process, using ‘back of envelope’ estimates from the audience. The scenario was an 80,000 acre mulga block running 10,000 DSE. It was to do a full exclusion fence around its 100km boundary at a cost of $7,000/km. It was presumed that the fence would increase carrying capacity by 30% as a result of being able to better manage total grazing load, with no change in year 1, a 15% increase in year 2 and a 30% increase from year 3 onwards. Cost The cost of the fence is therefore $700,000 (100km @ $7,000/km), however the increase in carrying capacity of 30% will require significant capital investment in livestock, either through purchases or forgone sales, which must be accounted for. At a value of $50/DSE the additional 3,000 DSE represent a capital investment of $150,000 over three years (a residual value is applied to the additional livestock value at the end of the analysis below). Therefore total investment is $850,000 over three years. Bush AgriBusiness Pty Ltd
PO Box 41, WITHCOTT QLD 4352 www.babusiness.com.au ABN: 75 140 768 878 Careful Sums Essential for all Major Capital Investments Benefit The key question in terms of benefit is what incremental profits will result from the investment. This is determined by estimating what the incremental revenue and incremental costs will be. Another way of estimating the benefit is to consider what the cost of not doing it is. This is a detailed process and requires a good understanding of current business performance. For this scenario it was estimated that the incremental profit would be an extra $2/DSE on the existing 10,000 DSE (starting from year 2) and $10 per additional DSE carried. Another key question is whether the investment will increase the value of the land and, if there is an increase, whether that increase should be taken into account. The main consideration here, in my opinion, is what the purpose of the investment is. Is it to increase land value for subsequent sale or is it to increase the operating profits of the business with no sale contemplated? If the purpose is to increase profits with no subsequent sale, then any increase in land value should be ignored as the investment needs to pay itself off from increased profits, if it is going to be a worthwhile investment, otherwise all the investment does is increase the asset value without sufficiently increasing future profits and cashflows. If the purpose of this exercise is increased operating profits, with no sale contemplated, then the benefit is $0 in year 1, $35,000 in year 2 (10,000DSE @$2 + 1,500 DSE @$10) and $50,000 from year 3 onwards (10,000DSE @$2 + 3,000 DSE @ $10). Timeframe A suggested time frame for most investment analyses is 10 years, however in this case a 30 year timeframe is appropriate as that is the estimated life of the fence. Required Return The required return on capital will be business specific, however a suggested starting figure is 8%, which represents the long term risk‐free rate of return plus a small risk margin. The required return should be more than your cost of debt as that is the cost of any fresh capital for most businesses. The required return figure is used to discount future cashflows back to today’s dollars in the Cost Benefit Analysis below. Cost Benefit Analysis This provides us with enough information to perform a preliminary cost benefit analysis, the measures we use are net present value (NPV), internal rate of return (IRR), years break even (YBE) and benefit cost ratio (BCR). Rather than go into detail on them here, a Wikipedia search will give you the basics and in the BusinessEDGE workshop we go through their application for agriculture in detail. The result from the above scenario, with all assumptions as detailed is as below; Net Present Value: Internal Rate of Return: Years Break Even: Benefit Cost Ratio: ($305,198)
4.2% n.a. 0.56:1 To interpret these results, the Net Present Value of the investment (total of all benefits less total of all costs in today’s dollars) is negative, it has an internal rate of return of just 4.2% (suggested hurdle is 15%), it doesn’t breakeven within the 30 years analysed and returns, in today’s dollars, 56 cents for every dollar invested. Careful Sums Essential for all Major Capital Investments Sensitivity Analysis As we don’t have a crystal ball, the next step would be to revise each of the assumptions, perhaps applying a ‘best case’, ‘worst case’ and ‘most likely’ figure, to see how changes affect the results. Increase in carrying capacity A demonstration of this is the below sensitivity table, which shows the IRR at various levels of increased carrying capacity and incremental profits (assuming for exercise proportional changes in profit on existing and additional DSE’s). To assist in interpreting IRR, if you were to borrow money at 7% over 30 years to fund a capital investment with a 30 year timeframe and an IRR of 7%, then all the returns from that investment would go into servicing and repaying the debt, making no additional contribution to the cashflows of the business. This is why a hurdle of 15% is suggested, to identify those investments which will Incremental Profit per DSE a significant Existing $1 $2
$3
$4
$5 make contribution to the cashflows Additional $5 $10
$15
$20
$25
of the business. 10% ‐2% 1%
4%
6%
8%
20% 30% 40% 50% 60% ‐1% 0% 1% 2% 2% 3%
4%
5%
6%
7%
6%
7%
9%
10%
11%
8%
10%
12%
14%
15%
11%
13%
15%
17%
19%
This shows that this scenario would require a significant increase in carrying capacity as well as significant incremental profits per DSE to be a good investment. The above should not be interpreted as meaning exclusion fences are not a good investment, but it does mean that this scenario, investing $850,000 for a $50,000 annual return, is not a good investment. For this scenario, even if the neighbours paid half of the fence cost, it would still have an IRR of less than 15%, and take 25 years to break even. Conclusion In all the talk on fencing, there appears to be a lack of properly analysed factual information on the actual costs and benefits of established fences that can be used for informed decision making. This needs addressing. You will have to do your own research, talk to a number of people who have undertaken similar exercises, particularly in terms of what the actual cost and benefit was to them. Endeavour to get hard factual data, rather than relying on anecdotal information. Having good information on the current performance of your flock (or herd) will enable you to do more accurate sums on what effect the planned investment will have on your business, as well as allow you to better understand where to target your attention to improve overall performance. Bush AgriBusiness specialises in working with extensive pastoral businesses to help them understand and improve their performance. The Cost Benefit Analysis process is covered in detail in the BusinessEDGE workshop and participants get a take home decision making tool that calculates the above measures. The BusinessEDGE Workshop was developed by Meat & Livestock Australia to build the business skills and financial literacy of producers. If you are considering a major capital investment to increase the profitability of your business, do not rely on Darren from Dingo Downs’ conclusions. It is critical that you to do your sums very carefully on what the total cost of the exercise will be and what the actual benefits will be. This will increase the likelihood that the investments you decide on will add to, rather than reduce, the future cashflows of your business.