Making Good Farm Expansion Decisions Extract from GRDC Farm Business Information Newsletter (July 2017 – Issue 40) Farm expansion involves increasing business scale to become larger or more productive. There are three categories of farm expansion and there are a number of methods for expanding within each category. Expansion by increasing the area under management. This can occur by purchasing, leasing or share-farming additional land. Expansion by increasing the amount of production from the existing area. This usually occurs by identifying the optimum level of production, establishing how far below the optimum production is currently and implementing a strategy for increasing production. Expansion by utilising machinery and/or labour.
This can involve contracting to utilise surplus machinery and labour or if labour only is in surplus then employment off-farm can be an option. The time for expansion depends on the interaction between the following factors: the motivation for expansion the view of the market opportunity the proposed expansion method; and the ability to fund the expansion. If there is no ability to fund the expansion then there is not appropriate time to expand. There may however be ways of expanding production on the existing area at no costs. For example, improving the timing of management events such as sowing or spraying in a cropping program. If the proposed method for expansion is land acquisition and capital is non-limiting then there is no timing imperative for expansion.
If the expansion method is land ownership and the decision to expand is driven primarily by capital growth then the timing will be dependent on perceived value and speculation or the view of future capital growth. There is an element of luck involved in land purchasing. There are countless situations where average managers have put a lot at risk and have been rewarded as a result of a great run of seasons or strong rates of capital growth. Similarly, there are situations where good managers, have expanded at the wrong time, copped a run of poor seasons and low capital growth and have been forced to liquidate additional assets at significant costs. Regardless of which avenue is pursued for expansion an exit strategy should be developed prior to expanding. The exit strategy has to be sufficiently dynamic that is can be implemented at short notice and under unfavourable marker circumstances. How to Explain – The Strategies and Analysis Conduct a physical inspection and estimate the likely level of production as well as the likely additional operational and capital costs to generate that level of production. Consideration should be given to those areas where cost efficiencies will be achieved.
This will require a solid understanding of the management and financial performance of the existing business to assist in projections over the expansion. Conduct a partial budget to establish the estimated additional income and expenses from the expansion. This will establish whether the perceived profit of the expansion are adequate to cover the cost of financing or financing plus lease costs. Where wealth creation is targeted through the combination of capital growth and operating return then it may be acceptable to take a cash loss after financing. This applies only when the profits of the pre-expansion operations are adequate to comfortably meet the financing and capital needs of the expansion as well as the person needs of the decision maker. Where the operating return is the only source of revenue then the profits after financing and lease costs have to be adequate to account for the risk of expansion. The level of acceptability of return in this case will be dependent on the personal risk profile and attitude of the decision maker.
Valuations for pricing opportunities on land purchase or lease (assuming the decision is motivated by profit and wealth creation) should occur on an economic valuation basis. This means that the acceptability of the budgeted returns generated will dictate the price that can be offered. Sensitivity analyses should be conducted to establish the ability of the business to meet financing obligations (financial consequences) where deviations from the probable outcome occur. Develop an exit strategy that can be readily implemented if things do not go according to plan. The implementation of the exit strategy may result in a small financial loss but its aim is to contain the loss to prevent catastrophic loss over the whole business. A financial analysis showing the sum of the capital required for the investment, the probable income and operating expenditure and projecting the annual returns, both capital and operating, is a useful means of comparing any number of investment opportunities. This method will demonstrate the greatest return on capital invested. From the point it is up to the decision maker to consider the non-financial differences between options and the difference in risk posed by each.