Graduate Thesis Or Dissertation

Evaluating the financial risk involved in farmland investment decisions

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  • Investing in farmland is one of the most important decisions that farmers face in their lifetimes. Usually, large amounts of debt are required to purchase a substantial tract of land, thereby reducing the farmer's liquidity position and future borrowing capacity. Fixed debt commitments must be met by highly variable future farm income. Variable cash flows are the most critical in the first three to five years after the land purchase. After that time, the financial position has improved as a result of the principal payments and possible appreciation in the value of new and existing land holdings. An incorrect decision in purchasing land may result in prolonged cash flow problems and force partial liquidation or possibly bankruptcy. Oregon farmers want to know how much can be paid for land considering their objectives relating to the return they desire on their investment and the risk they are willing to accept that debt can be serviced after the proposed farm expansion. Two models were developed in this study. The first is a net present value model to determine the effect of critical variables on the maximum economically feasible price that can be paid for farmland. The second model developed for this study is a risk analysis model to evaluate the decision maker's ability to meet fixed debt payments and other cash commitments given probability distributions for prices and yields The net present value of an acre of land is determined by summing the discounted cash flows after taxes over the planning horizon for the tract to be purchased. Whole firm analysis, or direct comparison between present and proposed expanded operation, is used to determine the exact effects of tax consequences associated with the land purchase. The discount factor used is the desired after-tax rate of return on equity capital. The model considers the case where the planning horizon is shorter in years than the loan repayment period. The risk model determines gross farm income, which consists of product prices and yields, stochastically using triangular probability distributions. Operating expenses, amortization payments for term debt, net capital purchases associated with depreciable items, living expenses and withdrawals, and all taxes are subtracted from gross receipts to determine yearly cash flow. Items given in the output include the low cash balance at the end of the number of years for which the program was run, the probability of a negative cash balance occurring, and the probability of financial failure. The models were applied to two case farm studies in Sherman and Marion Counties. Empirical results of these case studies indicate that given current production costs and gross farm receipts, farmland must continue to appreciate at an annual compound rate of 9 percent for the duration of the planning horizon to justify current land prices. Other variables having a sizable impact on the net present value include gross receipts and operating expenses for the newly purchased tract, the purchase price, and the discount factor Decision makers who own their farm operations and have low previous debt commitments are the most capable of generating adequate cash flows. Farmers who have large amounts of debt outstanding and who lease portions of their operation may have problems generating a positive cash balance within four years after the purchase What farmers pay for land is influenced by the amount of risk that they are willing to take.
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