Tips on Machinery Investment
Larry Martin
1. Beware using payback to evaluate an investment
Calculating Payback Period is relatively straight forward. Based on your budget, compare the annual net return from and investment to its initial cost. Payback period is the amount of time required for the investment to pay back its original cost.
The concept and the problem with it are illustrated in the following example of two alternative $1000 investments. Investment A pays for itself within 2.3 years. Investment B takes longer at 4.0 years.
Using payback period as the criterion for judging which investment to make would lead to investing in A. But B is clearly more profitable. There are other criteria that might be more useful.
| After-tax benefits of $1000 Investment | ||
| Year | A | B |
| 1 | $500 | $100 |
| 2 | $400 | $200 |
| 3 | $300 | $300 |
| 4 | $200 | $400 |
| 5 | $100 | $500 |
| 6 | ---- | $600 |
| Total Benefits | $1500 | $2100 |
| Payback in Years | 2.3 | 4.0 |
2. In the midst of complex concepts, focus on what’s important
Investment analysis has lots of jargon and complexity. You’ll hear about Net Present Value, Internal Rate of Return. Discounting, EBITDA, and a host of other things. These are appropriate for the subject, but the computer software deals with all of that. Fundamentally, two things are really important. One is to decide how much more $1 is worth to you next year and the year after than now. The second is to be realistic in budgeting what the costs and returns will be from an investment to your farm business.
3. Understand the potential effects of a major investment on your farm’s ability to service debt
When farms, or any business, get into financial difficulty, it happens because they’re over extended – i.e. they have more debt than the business can service. An axiom of financial management is that debt can only be serviced (i.e. principal and interest can only be paid) out of operating income. Operating income is what’s left after paying annual operating costs – i.e. the costs of growing crops, feeding livestock, running machinery, paying labour, etc.
When considering an investment, it is important to understand how well the farm business is positioned to service debt after the investment is made. There are a few excellent calculations that can be made from your historical financial records and your budget that will help determine your farm’s ability to service debt if you decide to make an investment.