CHAPTER 10

CASE STUDY IN FINANCIAL MODELLING AND SIMMULATION OF A

FORESTRY INVESTMENT
ANSWER TO REVIEW QUESTIONS
QUESTIONS
10.1 What are some of the difficulties in establishing cash flow estimates for longlived forestry projects?
10.2 What methods are available for allowing for risk in the evaluation of forestry
projects? Which of these methods are preferred?
10.3 In Example 10.1, the land used for the plantations was made available by a
local Council for FVC Ltd to use at no cost (see Box 1). Assume now that
FVC Ltd had to pay rental on the land from the council at the rate of 4% of the
land value per annum
(a)

Using workbook 10.1, recompute the NPV assuming that FVC Ltd had to pay
an annual land rental and that the land value on average was $2000 per ha.
(b) What effect has payment had on IRR?
(c) Using the goal seek function of Excel, calculate the final stumpage price that
FVC Ltd must receive in order to achieve a NPV of .
ANSWERS
Answer to Q 10.1
The long investment period typical of forestry projects provides a number of
challenges when estimating cash flows. In particular, wood prices are likely to
fluctuate over this period and it is difficult to predict the price that will be obtained for
timber when it is harvested. The problems with forecasting wood prices thus poses a
challenge in when estimating cash inflows as part of the financial modeling process.
Furthermore, there is risk that technological change or fashion change could result in
weak demand for some timber types (e.g. satellite communications reducing demand
for poles for phonelines, consumer preferences for wood colour changing over time).
Regulatory change in response to changing community attitudes could increase costs
and restrict areas which can be harvested.
The long time required for trees to grow also means that there is sometimes a lack of
biological growth data that can be used to predict growth rates (and hence timber
yield). Timber yield and harvest timing are critical variables in forestry financial
models. The lack of such data is most critical when new (non-traditional) species are
being used in plantations for which there are no past history of cultivation. As seen in
Chapter 4, the Delphi and other group forecasting methods can be used to develop
estimates of growth and harvest ages which can be used in financial models.
The multiple-use nature of forests has also been recognized in the management of
large industrial and government plantation estates. These management practices can
have direct impact on the financial performance of the investment and thus should be

considered in the appraisal process. For example in Finland, when a plantation estate
is harvested, a number of habitat trees must be retained. The failure to harvest these
trees directly reduces cash inflows to the investor. Similarly in the United Kingdom,
there is recognition that native Scots Pine and native broad-leaf species provide
greater non-timber benefits than the exotic Sitka Spruce. The result has been the
harvesting of Sitka Spruce plantations earlier that their optimal rotation age and their
subsequent replacement with plantations of Scots Pine and broad-leaf species. In
many countries there are also large incentives provided to establish plantations,
ranging from tax incentives to direct cash payments. Where they exist, these also need
to be incorporated in the appraisal.
As with any appraisal of a capital project, it is necessary to gain an understanding of
the social environment in which the project is being undertaken. In the case of a
forestry investment, the way in which a forest is managed, and the ultimate quantity
of timber which can be harvested, can be greatly affected by the increasing need for
forests to be managed for multiple uses.
Answer to Q 10.2
The simplest and most widely adopted method for allowing for risk in forestry
projects is to take conservative benefit estimates. Despite its widespread use, this
method is one which is theoretically unsound and should be avoided. Benefits tend to
be adjusted in a rather arbitrary manner, and the approach provides little information
to the decision-maker about the extent of risk faced. The emphasis is on protection
against downside risk, and no recognition is given of the possibility of payoffs
above the single-point estimates. As a result, projects which are financially sound
could easily be rejected.
Another method that is commonly used to allow for risk is to base decisions on
payback period. That is sometimes projects are favoured because they lead to
recovery of expenditure in relatively short period. The payback period in forestry is
usually the number of years from plantation development to clearfell (i.e. when all
remaining mature trees are harvested at the same time), since thinnings (even the later
commercial thinnings) cannot be expected to recover plantation establishment costs.
Favouring a short payback period usually means adopting a short rotation system such
as production of pulpwood from eucalypts with harvest after about seven to 10 years.
A shortened payback period means that there is less uncertainty about whether a
market will exist for the timber harvested and associated with this the stumpage price
which will be achieved. Using this method may result in inappropriate investment
decisions. A firm may choose a project with a short rotation over a project with a
higher NPV (or more appropriately LEV) simply because the later project has a longer
payback period.
A further option for allowing for risk in the evaluation of forestry projects is by
including a risk margin in the discount rate. The discount rate (k) is comprised on 3
components i.e.
k=r+u+a

where (r) is the risk free rate, (u) is the average risk premium for the firm and (a) is an
additional risk factor to account for the difference in the risk between that faced by the
firm and that of the proposed project. Adjusting a to reflect the additional riskiness
of forestry would result in an appropriate discount rate commensurate with the risk of
this investment is employed.
Sensitivity analysis can be employed to measure investment risk for forestry projects.
Timber yield (progressively calculated through mean annual increment in total cubic
meters) at a nominated harvest age, and timber price, are frequently subjected to
sensitivity analysis. These parameters may be defined for a number of product lines
from the same plantation, e.g. thinnings and final harvest, or poles, peelers (high
quality logs used to produce veneer) and sawlogs. It is also usual to test sensitivity
with respect to the discount rate, or alternatively to plot the NPV profile with respect
to discount rate.
A further way of allowing for risk is through risk or venture analysis to provide an
overall estimate of project risk. This is an extension of sensitivity analysis which is
usually designed to estimates risk with respect to one variable at a time. This
technique provides an estimate of the probability that a plantation will be profitable
(positive NPV or required rate of return achieved), which can be particularly useful
information for decision makers. Commonly, Monte Carlo simulations are used here.
Adjusting the discount rate for a risk margin for forestry and undertaking sensitivity
and risk analyses are all acceptable methods of allowing for risk in forestry
investment. The method preferred in any particular situation will be dependent on the
nature of the decision being made and the sophistication of analysis required and the
ability of the decision makers to interpret the results of the analysis. For example, the
use of a risk adjusted discount rate results in a single NPV for a project being
produced. If the NPV is positive, then the project would be acceptable. Risk analysis
on the other hand does not produce a single NPV but rather a distribution of possible
NPVs. Risk analysis provides much more information about the spread of possible
results and thus allows decision makers to better understand the upside and downside
risks associated with a project.
Answer to Q 10.3
Use Workbook 10.1 mentioned in Chapter 10 of the textbook (which is on the web)
and follow the instructions given below to find the answers for all the three parts of
this question.
(a) Recomputation using Workbook 10.1
The average land rental would be $80 per annum i.e. $2000 x 4%. Assuming that this
is paid at the end of each year, $80 (make sure it is entered as 80) would be inserted
in each of the cells in the range C16:BJ16. When this is done, the NPV changes from
58.214 to ($844)
(b) Effect on IRR
The IRR becomes 6.43%
(c) Using goal seek function to achieve an NPV of $0

To do this, select <tools><goal seek>. A dialog box appears. In this example, we

want to set the NPV to set cell B35 (i.e. the NPV) to 0 by changing cell E49
(i.e. stumpage price for the second sawlog harvest). This is illustrated in the screen
shot below. When the OK button is clicked, the goal seek returns the value of $318 in
cell E49.
NOTE: The following assumes that the worksheet has been reset to the default values
i.e. the annual land rental value inserted in a above has been removed. If the
worksheet is not reset and the land rental is included, goal seek will return a value of
$559 in cell E49.