Economic Tools and Data Needed to Decide

Whether to Buy, Keep or Sell Cows⁽¹⁾

Larry Falconer

Extension Economist - Management

How do you decide what a cow is worth? The answer is not always as simple as what you have to pay for a like age and quality cow over the scale at your local auction barn. In fact, a cow is just like a machine in a factory, and as such she has both a productive value and a salvage value. She is really worth the sum of all the cash she can earn over her lifetime less all the expenses she creates, which includes her salvage value as a cull cow. As you would expect, the net cash flows the cow can generate over her life time depends on the future prices of calves, the ranch's cost structure and the eventual salvage value of the cow. Not only do the size of the cash flows impact the value of the cow, but because money has earning power of its own, the timing of when the cow generates income and expenses is important in determining its value.

Well, so what? How can the value of the cow be estimated? If we can do a reasonably good job of estimating what a cow is worth, how can we use that information? The sum of the net cash flows the cow generates that are adjusted for the time value of money is called the cow's net present value. The net present value gives you an important benchmark to use to compare with an offer from a potential buyer. For example, if the net present value that you figure for the cow is higher then the buyer's offer price, then it is economically feasible to keep the cow. However, economic and financial feasibility are not the same thing.

Economic feasibility of investing or keeping money invested in any asset (such as a brood cow) only deals with the question of whether the investment (in this case the money we have tied up in the cow) can pay itself back. Financial feasibility deals with the question of how assets that are invested in are acquired. If the investment is made using borrowed funds, then debt is taken on by the ranch, and if the funds for the investment are generated internally or by stock offerings, then equity capital is being used. In either method we use to finance a cow, if she is not an economically feasible investment, she won't be a financially feasible investment.

Two types of tools are needed to calculate the economic feasibility of an investment. These tools are two different kinds of budgets, the first of which is the enterprise budget. The enterprise budgets are used to calculate the net cash flows for the cow over her expected productive life. The second tool is a capital budget. The capital budget takes the net cash flow calculated in the enterprise budget and calculates the economic feasibility of the investment. The capital budget that we are using in to calculate the maximum feasible economic bid price for a cow is called the net present value.

To demonstrate how these tools can be used, the following figures and tables contain an example pertaining to two drought scenarios of different lengths. These production figures are used to attempt to calculate what a "good" young cow would be worth. In this case, a "good" young cow is defined as a cow with a calf and is currently rebred, and will have four more calves without skipping a year. An attempt was made to base the enterprise budgets cost structures on a representative operation, but the data does not represent an actual operation. To allow the reader to easily make adjustments to the cash flows for operator labor, no charges are included for operator labor, so these costs are low. Therefore, the resulting maximum economic bid price for need to be adjusted downward by the amount to be charged for operator labor. The detailed enterprise budget can be seen in Appendix I.

The prices forecast for 500 pound steers and heifers over the planning horizon are shown in the figure 1. The prices are based on a sharp recovery in prices from current levels due to lower feed grain prices and smaller calf crops in 1997, with modest increases to the year 2000 as the cattle numbers cycle lower over that time period.

With the price component of the revenue projection for the budget completed, the production parameters that we expect to operate with are placed in to a series of enterprise budgets. In this example, we are going to take a look at what the expected impact of both a ninety day drought and a 150 day drought that occurs this year would have on the value of a "young" cow. The budget that is associated with the ninety day drought and the type of "young" cow we are interested in is shown in Appendix I. This budget presents the cost and return information in what is called a "residual return" format. This type of format allows for examination of the value of different factors of production such as land, capital, operator labor and management. For our purposes, we are interested in the net cash receipts we can expect from this type of "young" cow. The cash flows for the ninety day drought scenario are shown in the next figure.

The following table presents the expected cash flows from the enterprise budgets for the three scenarios we decided to examine. These estimated cash flows form the basis of the calculation of the cow's expected value. To calculate the expected value, these cash flow numbers are divided by the discount factors you decide to use.

Cash Flows	1996	1997	1998	1999	2000	SalvageValue
Normal Pasture	($2.36)	$60.98	$80.38	$99.79	$123.69	$400.00
90 Day Drought	($97.30)	$60.98	$80.38	$99.79	$123.69	$400.00
150 Day Drought	($180.30)	$60.98	$80.38	$99.79	$123.69	$400.00

The numbers shown in the table below are discount factors for 5% and 10%, that are used to calculate the time value of money. This represents the idea that if we get $1 today, we can invest that money for one year and that $1 will be worth more than $1.05 if we can invest the money at 5%. We can use this to figure out whether we would be better off if we have the chance to get $1.00 now, or $1.27 five years later. By dividing the net cash flows for each period by the corresponding discount rate, we can arrive at an expected net present value for each of the three scenarios.

DiscountFactor	1996	1997	1998	1999	2000
5%	1.05	1.1025	1.1576	1.2155	1.2763
10 %	1.10	1.21	1.331	1.4641	1.6105

The following table contains the expected maximum feasible economic bid prices for the the cost structure represented in the attached enterprise budget. This is what a cow that will

produce a calf this year and four more calves without skipping is worth calculated at two discount rates, if we had a ranch that is represented by the costs shown in Appendix I.

Scenario	5% Discount Rate	10% Discount Rate
Normal Pasture	$614.92	$501.97
90 Day Drought	$524.50	$415.67
150 Day Drought	$445.46	$340.21

What this all means is that if we had "normal" pasture conditions, and we needed a five percent return on our investment we would sell our good "young" cow if someone offered us $615 dollars for her. If we expected that the drought would cause us to have to feed an extra 150 days, we would sell the same cow if we could get a bid of $445 for her. If we had to feed for an extra 150 days due to drought and we had to have the ten percent return on our money, the very same cow would only be worth $340 to us.

We can use the same tools to look at the values of different aged cows in the herd. The following table contains the maximum economic bid prices for calves with different expected productive lives. For example, if we think the drought will cause us to feed an extra 150 days, the cows that we expect to produce two calves are only worth $201 per head to us, and we should sell them at any price above that.

Scenario	Two Calves	Three Calves	Four Calves	Five Calves
Normal Pasture	$370.52	$424.84	$492.55	$614.92
90 Day Drought	$280.10	$334.42	$402.13	$529.65
150 Day Drought	$201.06	$255.38	$323.09	$454.03

As you can see, the expected value of different classes of cows in your herd depends on a lot of factors that are uncertain. Because of this uncertainty, many people totally ignore planning and consider the time spent on planning efforts to be wasted. Granted, it is highly unlikely that the future will unfold exactly as planned. However, the result of the planning process does not have to be an exact prediction to have value.

Because the cattle business is risky, the best way to explain the problem is that it is like a card game. The planning process can help assign some value to the risk we are taking, and help us evaluate whether we are undertaking what is equivalent to staying in the game and drawing to the equivalent of an inside straight (which could possibly win) or folding and saving equity for another hand.

We can look at our present cow herd just like a poker hand. Given the cost structure we set up, if we have an "old" cow herd, the less risky plan is probably to fold up and liquidate. If we have a young cow herd, liquidation is less attractive, and we may even want to purchase more cows.

There are no hard and fast rules of thumb that will consistently provide the best culling strategy. Given the age composition of different herds along with the different physical resources for a particular ranch, the "cull half" and "cull to pay feed" may not be near aggressive enough for an older herd or may be far too aggressive for a younger herd. However, the use of these tools that we have discussed can provide benchmarks to calculate what might be best to do with the hand that you as a cattle producer have been dealt.

Appendix I.

COW-CALF ENTERPRISE BUDGET

Ninety Day Drought - 1996

1. Presented at the 1996 Beef Cattle Short course, Texas A&M University, College Station, TX., August 1996.