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Forest Finance: Sunk Costs versus Falling Knives

The phone rings.  Our forest manager wants to increase the budget for fertilization in 2014.  How do we account for the original investment – the original capital used to acquire the timberland – when evaluating new projects for the same forest?

We don’t.  Let’s discuss.

We evaluate new projects or investments “on the margin” and ignore sunk costs.  We evaluate forest investments based on their ability to generate income and returns moving forward.  Consider the following example:

You paid $2,000 per acre for a pine plantation during a peak in the market.  A recent timberland appraisal indicates that the market now values this plantation at $1,500 per acre, putting the investment “under water” when compared to what you paid for it.  Ugh.

Then your forest manager calls asking for $100 per acre to fertilize the plantation.  His analysis indicates you would realize the benefit of the fertilization in the next five years earning an IRR of 20% on the $100 per acre. Do we approve the forest manager’s request and invest?  We can think about this two ways.

One, the fertilization is trying to “catch a falling knife” and simply throwing good money after bad.   Or, two, our forester’s analysis of this investment on the margin looks attractive and we ignore the sunk costs.

We can’t do anything about the $2,000 original investment.  We have complete control over the $100 investment request. Does this look like a good use of capital moving forward?  Yes.

Click here to learn about and register for “Applied Forest Finance” on February 10th in Atlanta, Georgia.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments. 

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