Dairy Foods Processing Investment Analysis Tool

Investment analysis is a financial analysis tool that can be used whether assessing startup or expansion of a value-added dairy foods processing business. Specifically, net present value (NPV) investment analysis can serve as a tool for determining the feasibility of a dairy processing investment by calculating whether the discounted value of all future cash flows is positive (e.g. greater than zero). 

Understanding Net Present Value Investment Analysis

Net present value (NPV) investment analysis is a method for determining the current value of projected cash flows for an investment. Individuals (existing dairy farmers or food entrepreneurs) desiring to start a value-added dairy foods processing business need to assess the projected profitability of their investment as well as ensure that they do not overinvest relative to projected sales and revenue.

For business owners considering the expansion of a value-added dairy business, there is likely a need to make additional capital investments – higher capacity processing equipment for instance. For example, value-added processing businesses will sometimes launch with small equipment due to uncertainty regarding how the business will grow or due to financial constraints that must be navigated. Down the road many of these businesses find that they've outgrown the capacity of this equipment and must invest in new buildings, higher capacity pasteurizers, etc. With a new investment it is important to think about the projected cash flows that will result. This is where sales forecasting becomes important because well-researched sales forecasts will allow the business owner to better estimate and understand future cash flows.

Key advantages to net present value (NPV) investment analysis are that this method considers:

1. the time value of money
2. the size of cash flows over the life of the investment – that is, looking at multiple years not a single point in time.

By performing an NPV analysis you will be able to answer the question of whether an investment is profitable (given the assumptions used).

Performing Net Present Value Investment Analysis

Net present value investment analysis is performed by discounting each year's cash flow to the present value and summing. The mathematical equation is:

If the net present value is greater than zero, then the investment is profitable.

Information Requirements

To perform a net present investment analysis, you need four pieces of information:

1. Initial investment amount (INV)
2. Net cash flows over the lifetime of the investment (P)
3. Planning horizon (N). The number of years you are planning for. This typically aligns with the lifetime of the investment.
4. Discount rate (i).

Additional information about each piece of data follows.

Initial Investment

What capital resources will be required to expand the processing business? For instance, facilities (new build or retrofit), additional and/or greater capacity equipment (vats, bottling machine, cheese press, etc.), and additional multi-use supplies (ex. cheese molds) may be required.

Net Cash Flows

Map out the anticipated net cash flow over the investment's planning horizon. Net cash flow is the difference between revenue and expenses. Well-researched sales forecasts should allow a business owner to estimate cash revenues. Keep in mind that when performing a NPV analysis, non-cash expenses (e.g. depreciation) are not included.

Planning Horizon

The planning horizon is the number of years over which the projected cash flows for the investment will be calculated. One way to determine an investment's planning horizon is to use the useful life of the investment.  For example, if a pasteurizer has a useful life of 15 years, a business owner may decide to use 15 years as the planning horizon. Determining an appropriate planning horizon becomes more difficult when the capital resources being invested in have variable useful lifetimes. In this situation, it may be appropriate to use the average lifetime of the most expensive investments under the assumption that less costly items with shorter lifetimes (such as multi-use cheese molds) would not significantly impact the analysis.

Discount Rate

The discount rate is the rate used when calculating the present value of a series of cash flows. The rate may represent an opportunity cost, cost of capital, or required rate of return. Factors that influence the discount rate used in NPV analysis include:

Expected and current returns

What sort of return is expected from investments? One approach is to look at the current returns of the dairy farm business.

Project/Investment Risk

A business owner should also assess the risk associated with a project. Study the potential risk that may occur with the launch or expansion of a value-added dairy business. Current consumer demand for local farm products may make an expansion less risky compared to pre-2000 when farm-based creameries were less prevalent. Also consider factors such as the number of competitors in the business's geographic area. For instance, if there are other dairy farms launching or expanding their own creamery business then there will be greater risk perhaps than if there are fewer surrounding farms pursuing the same goals.

Inflation Rate

The inflation rate at the time an investment is being made, as well as the projected rate during the planning horizon is another factor that may influence the choice of discount rate used in NPV analysis.

Project/Investment Financing

A final influencing factor is how the project is being financed. Is equity, cash reserves, grant(s), or a loan being used to finance the project?  If loan financing will be obtained, a discount rate at least equal to the loan's interest rate should be used for analysis.

NPV Investment Analysis Spreadsheet Tool

The accompanying NPV investment analysis spreadsheet tool has been designed for business owners to use to assist them in analyzing the profitability of starting or expanding a small-scale dairy foods processing business.  The tool allows users to enter their own figures for capital costs, projected cash flows (revenues and expenses), select income and expense growth rates, and inflation and discount rates. By adjusting the input data and/or assumptions, the user can compare different scenarios. Results can serve as a starting point for additional, more complex analysis and discussion with a business or financial advisor.

Spreadsheet users: Please read the instructions on the ReadMe tab.  Failing to do so carries the risk of breaking formula connections.

Resources

Barry, P. J., and Ellinger, P. N. (2012). Financial Management in Agriculture. Pearson Prentice Hall.