Forest Finance Newsletter

Forestry Finance deals with the financial management of your forest resource. Determine the value of your forest, the rate of "interest" you are earning on your forest investment, and how you are doing in respect to inflation in the economy and in the forest products sector. Newsletter

The Concept of Interest

Interest is a concept absolutely critical to our understanding of forestry finance. Conceptually, interest is a measure of the time value of money. "What are you willing to give up now in favor of money in the future?" determines your preference to invest money now. If the bank pays you 3% interest on a savings account and you invest money in that account then you have a very low time preference for money now versus later. Conversely, if you borrow money from the bank at 12% interest, then that defines that you have a preference for current consumption over future consumption at a rate of at least 12%.

How then do we explain a person who invests money at 5% in the bank while borrowing money from their credit cards at 18%? What other factors influence this decision? Where do you define your limits of being an investor versus a borrower? How does a company determine this issue? Why would Weyerhaeuser Corporation have a different interest rate preference than Georgia Pacific?

Most companies have an internal discount rate they apply to revenue and expense decisions within the company. Conceptually, the internal discount rate will fluctuate as the economy of the region, state, country, and world changes. If the Federal Reserve lowers the prime interest rate for banks then companies will pay less for borrowing money. This is an effort of the Federal Reserve to control business decisions to invest now versus later. Conversely, if the Federal Reserve raises rates this is an effort to slow the economy and fend off inflation. These parameters of the US economy influence business activities.

We can observe decisions of a company and estimate their internal discount rate by evaluating many factors about a company's decision making process. We need to observe when the company invests money and when they liquidate resources. In addition, we need to determine the opportunity costs of investments they make. Opportunity cost is the cost of an investment opportunity foregone, in financial terms. We measure opportunity cost by determining the optimal interest rate or return on investment possible and the same measure for the current use of the resource. If intensive management of a forest resource can return 16% interest in the long term, and we decide to manage for other, non-monetary, resources such as recreation or partially non-monetary resources, such as a watersheds, and the modified return on the resource is 12%, then we can say that the opportunity cost of co-management for timber and recreation is 4% (16%-12%).

There are many ways of expressing opportunity cost but the concept is critical: Opportunity Cost is the cost of an investment opportunity foregone.

Risk is something we must consider when discussing interest. Risk is present in almost all investments. While we think of a savings account as "risk free" it really is not. The "FDIC Insured" sign at the bank is an indication that we have made an adjustment for risk by purchasing investment insurance on our savings accounts. In Russia, a savings account at a bank is not "FDIC Insured". A Rubble investment in a Russian bank will yield about 150% today. However, that return on your investment has 2 components: Risk and Inflation.

Risk can be thought of as the probability that the return on the investment you are making will not yield what you project it will. It is the variation in your expected cash flow both in time and magnitude. Thus, you can have expected returns, but if the returns are delayed by a long period of time we still receive less than projected because of the time value of money. This is different from uncertainty, because in uncertainty we do not know the probability of loss. Investors generally deal with risk by using a risk premium. Risk Premium is the premium added to the risk-free discount rate to account for a risk filled investment. Forestry traditionally has a lot of risks built into it: fire, disease, long rotation times, regulations, and other factors all combine to create risk and uncertainty. In the Russian bank, the risk is that the bank will close, reorganize, or not have your money for you at some point in the future.

Inflation is the general increase in prices in all goods and services in an economy. Thus $100 today will be able to purchase fewer goods and services after a year with positive inflation. This has the compounded impact of requiring that investments must not only return something to the investor but it must first outpace inflation just to break even. In the Russian economy, inflation was running around 30-60% annually for most of the 1990's.

Inflation indexing is the procedure we use to adjust a value or cash flow to increase at the inflation rate.

Therefore, an interest rate at a Russian bank of 150% includes an adjustment for risk and inflation while still trying to attract investors. On the other hand, these same banks are loaning money to Russian companies at rates as high as 250% annually. Most are short term loans lasting only 6 months to a year. Companies are actually borrowing money at these rates, but the number of companies that fold within the investment period are large.

How to compare projects

One of the prime tasks of the forest economist and the financial advisor is to compare projects and select the ones we will invest in and not invest in. This task can be very complicated for many reasons.

First, forestry projects often are evaluated over different time horizons. We must develop a method to compare projects of different time horizons in a way that is meaningful and accurate. This will be the focus of your work to begin with; developing the use of discounting and projection formulae.

Second, many projects have different risk potentials. One forest may have a very small risk of wildfire while another has a high risk. We must be able to make adjustments for risk in the selection of investments.

Third, companies and people face a limitation of financial resources. We are faced with having to select the highest return projects over other projects that may be profitable. It sometimes happens that a project that "promises" to return a rate well above the company's internal discount rate will be postponed because of a limitation in capital in the short term in favor of other projects with higher rates of return.

Next, it sometimes happens that investment decisions are not evaluated in terms of potential returns but in terms of mitigation of loss. This is the case with fire control. Building roads, maintaining fire fighting equipment and personnel, building "bucket lakes" and so forth, is an effort by forest landowners to mitigate future losses potentially caused by forest fires. The returns on these efforts can overshadow other investments that return a few percent on the investment.

Portfolio Management is an effort by individuals and companies to spread out risk and exposure financially to mitigate losses from one investment area. It works to capture marginal gains from successful sectors while limiting losses from unsuccessful sectors. Individuals do this by investment in the stock market. A "balanced portfolio" will have money held in different sectors of the economy at once. Companies do this by spreading out their investments over many different parts of the industry or even into multiple segments of the industry.

For example, under the Clinton administration the US Forest Service was required to curtail the majority of timber harvests in the Northwest. US. Sawmills that relied on federal timber for log supplies were the hardest hit because they had no private timber supplies to rely on. Those companies that had spread out their risk through vertical integration were less impacted because they could still rely on company owned lands to supply their logs. Vertical integration in an industry is one way companies stabilize their portfolios. Potlatch Corporation relies on company owned lands for a large share of their timber supplies, even though federal timber disappeared over that period they remained in business. The Bennett mill in Elk City, Idaho, relied completely on federal timber and moved their operations to Grangeville, Idaho, where additional timber supplies were available.

As "forest economists" you will be responsible for making portfolio management recommendations to your employer or on your own property. This course of study will develop the tools of financial decision making to be able to do this with skill. It is your responsibility to use them wisely while presenting information that is truthful and useful.

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© 2007 Kamiak Econometrics, a Division of Kamiak Ridge, LLC
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Kamiak Econometrics, a Division of Kamiak Ridge, LLC