Know value of capital investments

Cow sheds can be seen as depreciating assets.

Opportunities to invest in machinery and infrastructure can have far-reaching effects and need to be fully evaluated. But when should owners or directors of a business do heavy-duty analysis on a potential development? DairyNZ's Adrian van Bysterveldt explains.
Appreciating assets

In the past, over 90 per cent of a farm business' value has traditionally been in appreciating assets -- such as land and cows, with a bare minimum in depreciating assets such as sheds, plant and machinery.

Simple financial tools were adequate for farmers and their advisers to assess an investment -- such as operating profit, return on assets, return on capital, return on equity, debt per kg milksolids, and interest per kg of milksolids.

As long as the debt could be funded, the appreciating nature of the investment meant it could always be sold for more than it was bought for.

These calculations are still sufficient for investments developing the land's productive capacity, such as water rights and irrigation infrastructure.

Depreciating assets

Depreciating assets such as concrete, steel, machinery and technology often have a large capital cost, a long lifespan and a long payback period. These investments are hard to undo and sell to recover capital, and do not always add to the farm's value.

Unless the additional cashflow generated from the investment allows for a quick payback, it can be hard to avoid losing equity. To properly analyse these types of capital outlay, commercial investment tools are needed to quantify the investment's costs and benefits over time. These tools include internal rate of return (IRR), net present value (NPV) and discounted cash flow (DCF).

Because several critical assumptions must be correct or the results will be misleading, find an adviser who is proficient with these tools. They are often found in the commercial divisions of large accountancy firms, banks, valuation businesses and large consultancy firms.

Decision-making: key

Many investments will fundamentally change the ratio of appreciating to depreciating assets. The effect of these investments on farm equity can vary and must be understood during the decision-making process. To make the right decision, the analysis tools must properly assess that investment's value for earning potential and residual capital value over a long period -- because undoing the investment and recovering capital isn't possible.