Financial Recommendation on Olive Hill Farm Investment

Authors:

Kevin Dulic

Grant Loukmas

Laura Zeiler

IOE 201

Submission Date: October 23, 2014

University of Michigan

Industrial and Operations Engineering

ABSTRACT

To determine the viability of the purchase of Olive Hill Farm, an analysis of the investment was

completed. This was be done by examining the income statement, cash-­flow statement, and sensitivity

analysis for the farm and its assets. The income statement analyzed the income and the various expenses

to find an yearly net income of the farm which varied from an expected minimum of -­$54,616.14 (year 1)

and a maximum expected net income of $89,666.75 (year 10). The cash-­flow statement presented the

annual cash flow for the farm as well as a net present value and IRR. This resulted in a positive net value

of $262,852.13 using a MARR of 10% and a calculated IRR after taxes of 17%. Based on this data, our

initial advisement is to invest in the farm. However, due to the nature of agriculture investments, certain

factors may be a risk to the investment which must be accounted for in a sensitivity analysis. The

sensitivity analysis showed that even under worst case scenarios, the net present value (NPV) will still be

positive and therefore the farm still stands as an advisable investment.

INTRODUCTION

You are interested in purchasing Olive Hill Farm, an olive farm that will produce olive oil for

wholesale and farmer’s markets. You are trying to determine if this will be a good financial investment.

The farm is a 40 acre parcel, consisting of 15 acres of olive trees and will cost $500,000 total. The price of

the farm includes all of its many assets for collecting olives and pressing them into oil. However, there will

be overhead costs to keep the farm operating and for the production of the olive oil. At the end of ten

years, you are planning on selling the farm for an expected salvage value of $800,000. A financial

recommendation for this investment is requested. There are numerous different variables to consider for

determining if this purchase is a good financial decision. This report details how a decision will be made

on whether to purchase the olive farm.

1

CURRENT SITUATION

The farm is purchased for $500,000, which includes land (at a price of $156,640) and various

assets (totaling to $343,360). Selling olive oil at wholesale and at farmer’s markets will be the source of

revenue for the farm until it is sold ten years later for an expected salvage value of $800,000. The largest

investment is the initial purchase, however in the first year of operation additional purchases of a tractor

and storage bins are made, in the second fencing and electrical costs, and the third year water storage will

be invested in. Because this is an outdoor investment, it is possible that the expected salvage value of the

farm could vary in ten years. Severe weather or other potentially destructive occurrences (a decrease in

demand for olive oil, for example) could reduce the value. It should also be noted that increased rainfall,

demand in the market, or other positive conditions could increase the value. To account for these potential

risks in the initial $800,000 assumption, we have conducted a sensitivity analysis to determine how risky

the salvage value assumption is on the initial investment.

FINANCIAL DECISION

Given the background information on this olive farm investment opportunity, the NPV of this

investment (at an interest rate of 10%) is $262,852.13 and the IRR after taxes is 17%. This means that if

the total gain on this investment were available today, it would be equal to $262,852.13. The rate of return

of 17% represents the profit of the investment relative to the original investment over the 10-­year period.

Using net present value and rate of return analysis as the criterion for decision-­making, this

investment would result in a financial gain. This is due to NPV being positive and IRR being greater than

the MARR(10%). These findings are summarized in Table 1 on the next page.

2

Table 1: Financial Decision Summary

Analysis Criterion Value Financial Decision

NPV $262,852.13 Accept Investment

IRR 17% Accept Investment

ANALYSIS AND DATA EVALUATION

To determine if the farm purchase would be advisable or not, we created an income statement

and cash flow statement (see Appendix A) to predict the financial outcomes of the purchase. The income

statement provides an annual summary of the expenses of running the farm. This includes well repairs,

maintenance costs, picking, transportation, and pressing costs, as well as bottling expenses and the

additional purchases in years one, two and three. The depreciation for the expenses were calculated using

the 7 year MACRS recovery period. Taxes were applied only to positive taxable incomes and in years

where the taxable income was negative, we applied a 0% tax rate. Following the income statement, the

cash flow statement summarizes the annual net cash flow. Each annual cash flow was then used to

determine the net present value of the farm at an interest rate of 10%. The projected cash flow for the 10

year period is shown in Appendix A. However, certain values may vary and impact the present worth of

the olive farm. To be able to provide a more accurate recommendation, a sensitivity analysis was

conducted for yield amounts, wholesale and farmer’s market prices, maintenance costs, salvage value, as

well as interest rate (MARR). The analysis showed that the present worth is most sensitive to the

wholesale price (varied between $40 and $60 per gallon), less sensitive to the yield percentage and

minimally sensitive to the maintenance price. With these three variables, an ideal condition in a year would

be a high wholesale price along with increased yield and lowered maintenance costs. This sensitivity graph

is shown in Figure 1 on the next page.

3

Figure 1: Sensitivity Analysis on Yield, Wholesale Unit Price, and Maintenance Cost

The farmers market unit price, salvage value, and MARR all had a significant impact on the net present

value. With variable increasing by 20%, the net present value changes by $84,107.25, $56,079.02, and

-­$90,980.43 respectively. Conversely, with a 20% decrease the present worth had a difference of

-­$84,107.26 with the farmer’s market unit price, -­$56,079.03 with salvage value, and increased

$111,064.05 when the interest rate dropped. This sensitivity graph is shown in Figure 2.

Figure 2: Sensitivity Analysis on Farmer’s Market Unit Price, Salvage Value, and Interest Rate

4

CONCLUSION AND RECOMMENDATION

Given the background information on this olive farm, net present value is $262,852.13 and the IRR

is 17%. Projected cash flows are given in Appendix A, and show the farm operating at a loss for the

investment year and first year of operation, then having positive cash flows in operating years two through

ten. This means that the investment will result in a financial gain given the projected performance of the

farm.

Accounting for uncertainty in certain key variables, sensitivity analyses were performed to

determine the most crucial aspects for the investment’s success. Success is measured by the largest,

positive NPV. The first analysis compared the significance of yield, wholesale price, and maintenance cost

as they relate to the NPV. Seen in Figure 1, the unit price for the wholesale olive oil is the most critical

factor among these three. The second analysis compared the significance of farmer’s market price,

salvage value, and interest rate as they relate to the NPV. Seen in Figure 2, the interest rate is the most

critical factor among these three. However, the farmer’s market unit price and salvage value still have a

large impact on NPV.

Under worst-­case scenario circumstances for yield, wholesale price, and maintenance cost the

investment will still result in a positive NPV;; therefore it is recommended that this investment be accepted.

5

Income'StatementEnd$of$Year 0 1 2 3 4 5 6 7 8 9 10

RevenueFarmers$Market 36,000.00$$$$$$$ 72,000.00$$$$$$$ 120,000.00$$$$ 120,000.00$$$$ 120,000.00$$$$ 120,000.00$$$$ 120,000.00$$$$ 120,000.00$$$$ 120,000.00$$$$ 120,000.00$$$$$$$Wholesale$ 45,000.00$$$$$$$ 90,000.00$$$$$$$ 150,000.00$$$$ 150,000.00$$$$ 150,000.00$$$$ 150,000.00$$$$ 150,000.00$$$$ 150,000.00$$$$ 150,000.00$$$$ 150,000.00$$$$$$$

Expenses:Well$repairs 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$ 1,000.00$$$$$$$$$$$Maintenance 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$ 20,000.00$$$$$$$$$Picking$costs 11,250.00$$$$$$$ 22,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$$$Transportation 2,250.00$$$$$$$$$ 4,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$ 7,500.00$$$$$$$$$$$Olive$press 11,250.00$$$$$$$ 22,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$ 37,500.00$$$$$$$$$Year$1$Addition 30,000.00$$$$$$$Year$2$Addition 19,200.00$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$ 1,200.00$$$$$$$$$$$Year$3$Addition 9,000.00$$$$$$$$$Bottles 10,800.00$$$$$$$ 21,600.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$ 36,000.00$$$$$$$$$

Property 500,000.00$$$$

(Depreciation$percentages$R$7$yr$MACRS) 0.14 0.24 0.17 0.12 0.09 0.09 0.09 0.04

DepreciationFarm$assets 49,066.14$$$$$$$ 84,088.86$$$$$$$ 60,053.66$$$$$$$ 42,885.66$$$$$$$ 30,662.05$$$$$$$ 30,627.71$$$$$$$ 30,662.05$$$$$$$ 15,313.86$$$$$$$ R$$$$$$$$$$$$$$$$$$$ R$$$$$$$$$$$$$$$$$$$$$Year$1$Addition 4,287.00$$$$$$$$$ 7,347.00$$$$$$$$$ 5,247.00$$$$$$$$$ 3,747.00$$$$$$$$$ 2,679.00$$$$$$$$$ 2,676.00$$$$$$$$$ 2,679.00$$$$$$$$$ 1,338.00$$$$$$$$$ R$$$$$$$$$$$$$$$$$$$$$Year$2$Addition 2,572.20$$$$$$$$$ 4,408.20$$$$$$$$$ 3,148.20$$$$$$$$$ 2,248.20$$$$$$$$$ 1,607.40$$$$$$$$$ 1,605.60$$$$$$$$$ 1,607.40$$$$$$$$$ 802.80$$$$$$$$$$$$$$Year$3$Addition 1,286.10$$$$$$$$$ 2,204.10$$$$$$$$$ 1,574.10$$$$$$$$$ 1,124.10$$$$$$$$$ 803.70$$$$$$$$$$$$ 802.80$$$$$$$$$$$$ 401.85$$$$$$$$$$$$$$

Taxable$Income (54,616.14)$$$$$ (37,675.86)$$$$$ 50,327.14$$$$$$$ 75,473.04$$$$$$$ 89,538.65$$$$$$$ 92,170.99$$$$$$$ 93,230.45$$$$$$$ 108,897.84$$$$ 125,551.80$$$$ 128,095.35$$$$$$$Taxes$(30%) 15,098.14$$$$$$$ 22,641.91$$$$$$$ 26,861.60$$$$$$$ 27,651.30$$$$$$$ 27,969.14$$$$$$$ 32,669.35$$$$$$$ 37,665.54$$$$$$$ 38,428.61$$$$$$$$$

Net$Income (54,616.14)$$$$$ (37,675.86)$$$$$ 35,229.00$$$$$$$ 52,831.13$$$$$$$ 62,677.06$$$$$$$ 64,519.69$$$$$$$ 65,261.32$$$$$$$ 76,228.49$$$$$$$ 87,886.26$$$$$$$ 89,666.75$$$$$$$$$

Cash'Flow'StatementOperating$Activities:Net$Income (54,616.14)$$$$$ (37,675.86)$$$$$ 35,229.00$$$$$$$ 52,831.13$$$$$$$ 62,677.06$$$$$$$ 64,519.69$$$$$$$ 65,261.32$$$$$$$ 76,228.49$$$$$$$ 87,886.26$$$$$$$ 89,666.75$$$$$$$$$Depreciation 49,066.14$$$$$$$ 88,375.86$$$$$$$ 69,972.86$$$$$$$ 53,826.96$$$$$$$ 39,761.35$$$$$$$ 37,129.01$$$$$$$ 36,069.55$$$$$$$ 20,402.16$$$$$$$ 3,748.20$$$$$$$$$ 1,204.65$$$$$$$$$$$

Investment$Activities:Property (500,000.00)$$$Salvage$Value 800,000.00$$$$$$$

Net$Cash$Flow (500,000.00)$$$ (5,550.00)$$$$$$$ 50,700.00$$$$$$$ 105,201.86$$$$ 106,658.09$$$$ 102,438.40$$$$ 101,648.70$$$$ 101,330.86$$$$ 96,630.65$$$$$$$ 91,634.46$$$$$$$ 890,871.40$$$$$$$

NPV(10%) $262,852.13IRR 17%

Appendix'A

Sensitivity'Analysis'(yields,'wholesale,'maintenance)Yields R50.00% R40.00% R30.00% R20.00% R10.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%PW(10%) 171,961.36$$$$ 190,139.51$$$$ 208,317.62$$$$ 226,495.82$$$$ 244,673.97$$$$ 262,852.13$$$$ 271,941.20$$$$ 281,030.21$$$$ 290,119.36$$$$ 299208.43 308297.51PW(10%)$R$BasePW (90,890.77)$$$$$ (72,712.62)$$$$$ (54,534.51)$$$$$ (36,356.31)$$$$$ (18,178.16)$$$$$ R$$$$$$$$$$$$$$$$$$$ 9,089.07$$$$$$$$$ 18,178.08$$$$$$$ 27,267.23$$$$$$$ 36,356.30$$$$$$$ 45,445.38$$$$$$$$$

Wholesale' R25.00% R20.00% R15.00% R10.00% R5.00% 0.00% 5.00% 10.00% 15.00% 20.00%PW(10%) 131,434.54$$$$ 157,718.05$$$$ 184,001.57$$$$ 210,285.09$$$$ 236,568.61$$$$ 262,852.13$$$$ 289,135.64$$$$ 315,419.16$$$$ 341,702.68$$$$ 367,986.20$$$$PW(10%)$R$BasePW (131,417.59)$$$ (105,134.08)$$$ (78,850.56)$$$$$ (52,567.04)$$$$$ (26,283.52)$$$$$ R$$$$$$$$$$$$$$$$$$$ 26,283.51$$$$$$$ 52,567.03$$$$$$$ 78,850.55$$$$$$$ 105,134.07$$$$

Maintenance R25.00% R20.00% R15.00% R10.00% R5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%PW(10%) 284,769.66$$$$ 280,386.16$$$$ 276,002.65$$$$ 271,619.14$$$$ 267,235.63$$$$ 262,852.13$$$$ 258,468.62$$$$ 254,085.11$$$$ 249,701.60$$$$ 245,318.10$$$$ 240,934.59$$$$$$$PW(10%)$R$BasePW 21,917.53$$$$$$$ 17,534.03$$$$$$$ 13,150.52$$$$$$$ 8,767.01$$$$$$$$$ 4,383.50$$$$$$$$$ R$$$$$$$$$$$$$$$$$$$ (4,383.51)$$$$$$$ (8,767.02)$$$$$$$ (13,150.53)$$$$$ (17,534.03)$$$$$ (21,917.54)$$$$$$$

Appendix'B

$$(150,000.00)$

$$(100,000.00)$

$$(50,000.00)$

$$R$$$$

$$50,000.00$$

$$100,000.00$$

$$150,000.00$$

R60.00%$ R50.00%$ R40.00%$ R30.00%$ R20.00%$ R10.00%$ 0.00%$ 10.00%$ 20.00%$ 30.00%$

Yields$

Wholesale$Price$

Maintenance$Cost$

Sensitivity'Analysis'(farmer's'market'unit'price,'salvage'value,'interest'rate)Farmer's'Market'Unit'Price R20.00% R15.00% R10.00% R5.00% 0.00% 5.00% 10.00% 15.00% 20.00%PW(10%) 178,744.87$$$$ 199,771.68$$$$ 220,798.50$$$$ 241,825.31$$$$ 262,852.13$$$$ 283,878.94$$$$ 304,905.75$$$$ 325,932.57$$$$ 346,959.38$$$$PW(10%)$R$BasePW (84,107.26)$$$$$ (63,080.45)$$$$$ (42,053.63)$$$$$ (21,026.82)$$$$$ (0.00)$$$$$$$$$$$$$$$ 21,026.81$$$$$$$ 42,053.62$$$$$$$ 63,080.44$$$$$$$ 84,107.25$$$$$$$

Salvage'Value R20.00% R15.00% R10.00% R5.00% 0.00% 5.00% 10.00% 15.00% 20.00%PW(10%) 206,773.10$$$$ 220,792.86$$$$ 234,812.61$$$$ 248,832.37$$$$ 262,852.13$$$$ 276,871.88$$$$ 290,891.64$$$$ 304,911.39$$$$ 318,931.15$$$$PW(10%)$R$BasePW (56,079.03)$$$$$ (42,059.27)$$$$$ (28,039.52)$$$$$ (14,019.76)$$$$$ (0.00)$$$$$$$$$$$$$$$ 14,019.75$$$$$$$ 28,039.51$$$$$$$ 42,059.26$$$$$$$ 56,079.02$$$$$$$

Interest'Rate R20.00% R15.00% R10.00% R5.00% 0.00% 5.00% 10.00% 15.00% 20.00%PW 373,916.18$$$$ 344,017.15$$$$ 315,592.16$$$$ 288,562.00$$$$ 262,852.13$$$$ 238,392.35$$$$ 215,116.59$$$$ 192,962.59$$$$ 171,871.70$$$$PW$R$BasePW 111,064.05$$$$ 81,165.02$$$$$$$ 52,740.03$$$$$$$ 25,709.87$$$$$$$ (0.00)$$$$$$$$$$$$$$$ (24,459.78)$$$$$ (47,735.54)$$$$$ (69,889.54)$$$$$ (90,980.43)$$$$$

Appendix'C

$$(150,000.00)$

$$(100,000.00)$

$$(50,000.00)$

$$R$$$$

$$50,000.00$$

$$100,000.00$$

$$150,000.00$$

R20.00%$ R15.00%$ R10.00%$ R5.00%$ 0.00%$ 5.00%$ 10.00%$ 15.00%$ 20.00%$

Farmers$Market$Unit$Price$

Salvage$Value$

Interest$Rate$