Agriculture Reference
In-Depth Information
Identifi cation of investment alternatives
An important function of management is to identify profi table investment alternatives. This
is an essential function because even though an investment may be of high value and be
profi table today, capital obsolescence and even price declines may reduce the value of the
investment in the not too distant future. Consequently, management must continuously
search for investment alternatives.
When money is tied up in a capital investment, management expects to get more
back than was invested in the project. The excess of revenue over cost is referred to as the
return. The return should be higher than that which could be earned by putting the same
money in a “safe” place, such as savings accounts or government bonds. In addition to
making a return for the use of the capital that is comparable to other investment alternatives,
the return should also compensate owners of capital for any additional risk associated with
the investment.
The idea here is a relatively straightforward one. If a person could earn 2 percent per
year on an investment in a bank certifi cate of deposit (CD), how much more than a 2 percent
return would that person require to invest in a food or agribusiness fi rm? The return for
the CD is relatively low, but so is the risk. The person will get their principal back plus the
2 percent interest at the end of the year. The investment in the agribusiness is more
risky. The general market, the competition, the management, and a host of other factors will
infl uence the investor's return from the agribusiness. This added risk means that investors
will want a lot more than 2 percent return to put their money into a food or agribusiness
fi rm.
Some people think that if their business borrows the money to purchase a new piece of
equipment, they have transferred the risk to the lender. In reality, this is not true because the
bank is almost sure to be repaid, except in the extreme case of bankruptcy. If the manager
makes a bad decision, the total business will suffer the loss because the loan will be repaid
from other, more successful ventures. So managers must have a systematic approach for
identifying investment alternatives. They must also understand that using fi nancial leverage
or debt to acquire investments can change the fi rm's risk and liquidity positions. (Financing
the agribusiness was discussed in
Chapter 11
.)
The identifi cation of investment opportunities falls into one of the four categories listed
below:
1.
Maintenance and replacement of depreciable capital items
2.
Cost-reducing investments
3.
Income-increasing investments
4.
A combination of the preceding categories
For example, consider a swine fi nishing operation that is very labor-intensive. The manager
is evaluating the changes needed to replace worn out facilities. One investment alternative to
consider is a mechanized feeding system. However, the size of the operation needs to increase
to fully use the mechanized system. This investment should cut labor costs, but the manager
needs to better understand the cost of operating the mechanized system. In addition, the
system may allow for better control of the nutrition program, which may allow the producer
to do a better job of managing carcass quality. This could potentially increase returns if the
producer sells the hogs on a carcass-merit (quality) basis. Given the complexity of the deci-
sion, the manager in this situation needs a systematic procedure to evaluate the investment
alternative.
