Labor Cost and Sugarcane Labor Cost and Sugarcane Mechanization in - - PowerPoint PPT Presentation

Labor Cost and Sugarcane Labor Cost and Sugarcane Mechanization in Florida: Mechanization in Florida: NPV and Real Options Approach NPV and Real Options Approach

Nobuyuki Iwai Nobuyuki Iwai Robert D. Emerson Robert D. Emerson

International Agricultural Trade and Policy Center International Agricultural Trade and Policy Center Department of Food and Resource Economics Department of Food and Resource Economics University of Florida University of Florida

Background Background

• Foreign workers in US agriculture

Foreign workers in US agriculture

• 77% of farm workers in 2002-04

77% of farm workers in 2002-04

• At least 50% of farm workers are

At least 50% of farm workers are undocumented in 2002-04 ( undocumented in 2002-04 (16% 1989-91, 16% 1989-91, 38% in 1993-95) 38% in 1993-95)

• Wage gap

Wage gap Average predicted wages for authorized, Average predicted wages for authorized, permanent resident, and citizen worker are permanent resident, and citizen worker are 10%, 10%, 18% and 14% 18% and 14% higher than for unauthorized higher than for unauthorized workers (Iwai et al. 2006). workers (Iwai et al. 2006).

Immigration Policy Immigration Policy Reform Reform

• Increased border and domestic

Increased border and domestic enforcement, amnesty and guest worker enforcement, amnesty and guest worker programs programs Goal: Goal: legal labor force legal labor force

• Concern that the reform might lead to

Concern that the reform might lead to labor cost increase in US labor cost increase in US ag ag. .

• Need to study the impact of labor cost

Need to study the impact of labor cost increase: increase: Mechanization Mechanization, Termination , Termination (Emerson 2007) (Emerson 2007)

Previous Previous Studies on Labor Cost Studies on Labor Cost and Sugarcane Mechanization and Sugarcane Mechanization

• Zepp

Zepp and Clayton (1975) found cost advantage and Clayton (1975) found cost advantage

• f mechanical harvesting operation over hand-
• f mechanical harvesting operation over hand-

cut as early as 72-3 season. cut as early as 72-3 season.

• Reduced revenue due to large field losses with

Reduced revenue due to large field losses with mechanical harvesting, resulting in $40.70 lower mechanical harvesting, resulting in $40.70 lower net returns per acre in comparison to hand-cut. net returns per acre in comparison to hand-cut.

• If projected 74-5 machinery operating rates had

If projected 74-5 machinery operating rates had been used, the net returns per acre would have been used, the net returns per acre would have been about equal ( been about equal (Zepp Zepp 1975). 1975).

Problems Problems

• Previous studies calculated and compared

Previous studies calculated and compared the cost and returns from two technologies the cost and returns from two technologies for a single individual season. for a single individual season.

• Dynamic decision-making analysis tools

Dynamic decision-making analysis tools

• ften used in corporate finance:
• ften used in corporate finance:

Net present value (NPV) approach, Net present value (NPV) approach, Real options approach (ROA). Real options approach (ROA).

Objective of Our Study Objective of Our Study

• Using NPV approach and ROA, we analyze the

Using NPV approach and ROA, we analyze the decision of the model sugarcane farmer (640 decision of the model sugarcane farmer (640 acres in total and 408 acres harvested) in Florida acres in total and 408 acres harvested) in Florida as to mechanization of harvesting for 72-3 as to mechanization of harvesting for 72-3 season. season.

• Simulation: We also compute the adoption

Simulation: We also compute the adoption thresholds for the labor cost that should have thresholds for the labor cost that should have triggered investment in mechanical harvesting for triggered investment in mechanical harvesting for sugarcane in Florida. sugarcane in Florida.

• Implication for mechanical harvesting for citrus.

Implication for mechanical harvesting for citrus.

NPV Approach NPV Approach

• Compares discounted cash flow (DCF) less

Compares discounted cash flow (DCF) less the investment cost of two operations. the investment cost of two operations.

• Important to forecast future free cash flow

Important to forecast future free cash flow (FCF) given information when the decision (FCF) given information when the decision is made. is made.

• Also need to use appropriate discount rate

Also need to use appropriate discount rate (Weighted Average Cost of Capital). (Weighted Average Cost of Capital).

Estimated FCF Estimated FCF

Estimated FCF from growing and harvesting sugarcane for the model farm ($ per 404 acres harvested)

31,478.18 33,467.97 FCF 13,569.20 10,855.60 CAPEX 12,857.28 13,670.02 Tax on EBIT (29%) 44,335.46 47,137.99 EBIT 13,569.20 10,855.60 Depreciation 57,904.66 57,993.59 Operating CF 104,256.41 95,995.25 Other costs 35,784.21 59,015.73 Labor cost 197,945.28 213,004.56 Revenue 72-3 72-3 Season Mechanical harvesting Hand cut harvesting

Calculated from Zepp and Clayton (1975) and Walker (1972).

Forecasting Beyond 72-3 Season Forecasting Beyond 72-3 Season

• Previous studies reported the revenue and

Previous studies reported the revenue and cost estimate only for 72-3 season. cost estimate only for 72-3 season.

• Need to forecast for longer period for NPV

Need to forecast for longer period for NPV and ROA. and ROA.

• A common approach is the Monte Carlo

A common approach is the Monte Carlo simulation in which all stochastic factors are simulation in which all stochastic factors are generated for future periods using the generated for future periods using the estimated parameters and distributions of estimated parameters and distributions of these series (Kobayashi 2003, Copeland these series (Kobayashi 2003, Copeland and and Antikarov Antikarov 2003). 2003).

Estimation of Stochastic Process Estimation of Stochastic Process

• We estimate stochastic process for yield, price,

We estimate stochastic process for yield, price, labor cost, and other costs. labor cost, and other costs.

• We make stationary series by taking 1

We make stationary series by taking 1st

st order

• rder

difference of log of each series and subtracting difference of log of each series and subtracting the mean of the 1 the mean of the 1st

st order difference.

• rder difference.
• Test of independence between yield and price

Test of independence between yield and price and between costs was rejected. and between costs was rejected.

Vector Autoregressive Model Vector Autoregressive Model

Since independence hypothesis was rejected, we estimate the VAR model for each combination. p is chosen that minimizes the bias-corrected version of the Akaike Information Criteria referred to as the AICC (Brockwell and Davis 2002): where L is likelihood function for bivariate normal distribution, n is number of obs, and m=2 is number of variables.

VAR Results VAR Results

• +
• +
• +
• =
• 2

1 2 , 2 1 , 2 2 , 1 1 , 1 2 1

40 . 60 . 077 . 45 . 17 . 67 . 077 . 66 . 00 . 00 .

t t t t t t t t

U U X X X X X X

• 74.55

AICC and 042 . 0021 . 0021 . 0054 . , ~ where

2 1

=

• WN

U U

t t

For yield and price

• +
• =
• 2

1 2 1

00 . 00 .

t t t t

U U X X

• 38.65

AICC and 027 . 00052 . 00052 . 020 . , ~ where

2 1

=

• WN

U U

t t

For labor and other cost

Monte Carlo Simulation Monte Carlo Simulation

Using the estimation results, we can generate future series as

• n.

distributi estimated from noise white a is where ˆ ˆ ˆ ˆ

2 2 1 1 t t t t t

U U X Ö X Ö ì X + + + =

• Since Xt is the change in the de-trended (mean-subtracted) log
• f the original series, we can generate a sample of the original

series by adding the trend, taking exponential and multiply it to the previous value. Repeating this nine times for each vector yields one sample of future nine-year pass for each variable. We generate 100,000 sets of the future paths of stochastic factors with which we calculate 100,000 sets of nine-year future FCF paths for each operation mode. The average of generated FCF is given next.

Monte Carlo Simulation (continued) Monte Carlo Simulation (continued)

Forecasted FCF from growing and harvesting sugarcane after 72-3 season ($)

20,617.16 20,617.16 23,726.29 23,726.29 26,970.87 26,970.87 32,698.77 32,698.77 Mechanical Mechanical

• 470.85
• 470.85

4,457.93 4,457.93 9,449.28 9,449.28 17,011.08 17,011.08 Hand cut Hand cut 81-2 81-2 80-1 80-1 79-80 79-80 78-9 78-9 35,036.43 35,036.43 33,386.73 33,386.73 37,478.13 37,478.13 42,991.52 42,991.52 36,505.76 36,505.76 Mechanical Mechanical 20,848.51 20,848.51 20,299.64 20,299.64 25,847.06 25,847.06 32,882.90 32,882.90 32,880.05 32,880.05 Hand cut Hand cut 77-8 77-8 76-7 76-7 75-6 75-6 74-5 74-5 73-4 73-4

Weighted Average Cost of Capital Weighted Average Cost of Capital

where kb is the pretax market expected yield to maturity on debt, T is the marginal tax rate, B is the value of interest- bearing debt, and S is the value of equity, and ks is the market-determined opportunity cost of equity capital. From market data we have kb=8%, T=29%, B/(B+S)=12%, and ks=10.84% from CAPM, so that WACC=10.23%.

S B S k S B B T k WACC

s b

+ + +

• =

) 1 (

Since FCF are available for payment to both sources of capital, debt and equity, the discount rate must comprise a weighted average of the marginal costs of both sources of capital (Copeland 1994). WACC is given by

NPV Calculation NPV Calculation

PV for year t for t<1982 is given as

where the second term is continuing value after the explicit forecast period in which g is the expected growth rate in FCF in perpetuity.

( ) ( ) ( ) ( )

g WACC WACC FCF E g WACC FCF E PV

t t t t

• +

+ + + =

• +

=

• 1982

1982 1982 1

) 1 ( 1 ) 1 (

• NPV for year t simply adds FCF of that year to PV:

t t t

PV FCT NPV + =

NPV Calculation Result NPV Calculation Result

• NPV less initial investment cost for mechanical

NPV less initial investment cost for mechanical

• peration is more than NPV for hand cut operation.
• peration is more than NPV for hand cut operation.
• NPV approach suggests that the model farmer

NPV approach suggests that the model farmer should have switched to mechanical operation even should have switched to mechanical operation even in 72-3 season. in 72-3 season.

NPV and initial investment cost for each operation for 1972-3 season ($)

256,384.19 256,384.19 63,431.21 63,431.21 319,815.40 319,815.40

Mechanical harvesting

181,013.87 181,013.87 181,013.87 181,013.87

Hand cut harvesting NPV – inv. cost Initial investment cost NPV

NPV Calculation Result NPV Calculation Result (continued)

(continued)

Estimated % of mechanically harvested sugarcane

0% 20% 40% 60% 80% 100% 120% 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 Year %

• NPV approach cannot explain the fact that only 15% of

NPV approach cannot explain the fact that only 15% of sugarcane was harvested mechanically for 72-3 season. sugarcane was harvested mechanically for 72-3 season.

Real Options Approach Real Options Approach

• ROA assumes that the producer has the option to

ROA assumes that the producer has the option to invest or wait, called invest or wait, called “ “investment flexibility investment flexibility” ”. .

• However, once the producer makes an irreversible

However, once the producer makes an irreversible investment, he exercises the option to invest and investment, he exercises the option to invest and gives up the option value of investment. gives up the option value of investment.

• Hence the producer does not invest until the NPV

Hence the producer does not invest until the NPV less investment cost and option value of investment less investment cost and option value of investment

• pportunity is greater than the NPV for the current
• pportunity is greater than the NPV for the current
• peration.
• peration.

Consolidated Approach Consolidated Approach

• Our case study has four stochastic factors (yield,

Our case study has four stochastic factors (yield, price, labor cost and other costs). price, labor cost and other costs).

• We use the consolidated approach (Copeland and

We use the consolidated approach (Copeland and Antikarov Antikarov 2003), which combines many stochastic 2003), which combines many stochastic factors into one through the Monte Carlo simulation. factors into one through the Monte Carlo simulation.

• The approach is based on the following theorem by

The approach is based on the following theorem by Samuelson (1973): Samuelson (1973): “ “Regardless of the pattern of cash flows expected in Regardless of the pattern of cash flows expected in the future, change in asset value is a random process the future, change in asset value is a random process so that return is so that return is iid iid process, as long all the process, as long all the information about the expected future cash flows is information about the expected future cash flows is already backed into the current value. already backed into the current value.” ”

Consolidated Approach (continued) Consolidated Approach (continued)

• In consolidated approach (Copeland and

In consolidated approach (Copeland and Antikarov Antikarov 2003) annual rate of return ( 2003) annual rate of return (z zt

t) is an

) is an iid iid process. process.

( )

1 1

• +

=

t t t t t

PV PV PV FCF z

• Using the Monte Carlo simulation result, we calculate

Using the Monte Carlo simulation result, we calculate mean and volatility (standard deviation) mean and volatility (standard deviation)

• f
• f z

zt

t :

: mean=0.1023, volatility=1.77. mean=0.1023, volatility=1.77.

• Copeland and

Copeland and Antikarov Antikarov suggest assuming less-than- suggest assuming less-than- 15 years until expiration of option. We assume 10 15 years until expiration of option. We assume 10 years until expiration. years until expiration.

Binomial Tree Binomial Tree

Binomial tree is build to approximate the PV transition Binomial tree is build to approximate the PV transition (up to 81-2 season). (up to 81-2 season).

181,014 19,983 147,546 25,047 869,161 693,447 4,084,946 3,145,836 117,717 90,655 3,392 2,612

PV with Option Value PV with Option Value

The decision in each node for the final year is The decision in each node for the final year is

( )

, InvCost ,

1981 1981 1981

• mech

PV PV Max

which yields 1,621,856 and 157,297 in each node. which yields 1,621,856 and 157,297 in each node. Then we multiply these by (1+FCF rate). Then we multiply these by (1+FCF rate).

30,535 28,490 167,827 168,982 4,836 4,870

PV with Option Value (continued) PV with Option Value (continued)

• The calculation of

The calculation of PV PV with option value is done by with option value is done by risk neutral risk neutral probability ( probability (or

• r replicated portfolio) approach

replicated portfolio) approach : : The farmer creates a hedge portfolio composed of one share The farmer creates a hedge portfolio composed of one share

• f the current operation and a short position of
• f the current operation and a short position of m

m units of the units of the investment option and the current operation. investment option and the current operation. Making appropriate the hedge ratio ( Making appropriate the hedge ratio (m m), the hedge portfolio ), the hedge portfolio can be made risk free, the non-arbitrage principle requires can be made risk free, the non-arbitrage principle requires that the farmer has to earn the risk free rate from this that the farmer has to earn the risk free rate from this portfolio. portfolio.

• The formula of

The formula of PV PV with option value for the node for 1980: with option value for the node for 1980:

( )

( )

[ ]

[ ]

• +

= +

• +

=

• e

e e r q r C q qC C PV C Max

f f d u mech

) 1 ( and 1 1 where , InvCost ,

1 1981 1981 1980 1980 1980 1980

PV with Option Value (continued) PV with Option Value (continued)

• We repeat these steps for other nodes of season 81-

We repeat these steps for other nodes of season 81- 2 and 80-1, and up to season 72-3, and result in the 2 and 80-1, and up to season 72-3, and result in the NPV NPV1972

1972 with OptValue

with OptValue1972

1972 = $357,179.45.

= $357,179.45.

• Then the option value is simply calculated as:

Then the option value is simply calculated as: ( (NPV NPV1972

1972 with OptValue

with OptValue1972

1972) -

) - NPV NPV1972

1972

= $ 357,179.45 - $181,013.87 = $176,165.58 = = $ 357,179.45 - $181,013.87 = $176,165.58 = OptValue OptValue1972

1972.

.

Decision from ROA Decision from ROA

NPV, initial investment cost and option value for 1972-3 season ($)

176,165.58 Option Value 80,218.60 63,431.21 319,815.40 Mechanical harvesting 181,013.87 181,013.87 Hand cut harvesting NPV – Inv. Cost – Opt. Value Initial Investment Cost NPV

• NPV of mechanical operation less initial investment

NPV of mechanical operation less initial investment cost and option value is less than NPV for hand cut cost and option value is less than NPV for hand cut

• peration.
• peration.
• ROA suggests that the model farmer should not

ROA suggests that the model farmer should not switch to mechanical operation in 72-3 season. switch to mechanical operation in 72-3 season.

Threshold Level Threshold Level

Threshold labor cost assuming labor cost increases at the same rate for both operation ($)

63,431.21 63,431.21 Initial Investment Initial Investment Cost Cost 132,284.63 132,284.63 181,107.56 181,107.56 54,663.96 54,663.96 ( (52.76% 52.76% increase) increase) Mechanical Mechanical harvesting harvesting

• 14,608.28
• 14,608.28

90,152.43 90,152.43 ( (52.76% 52.76% increase) increase) Hand cut Hand cut harvesting harvesting Resulting Resulting Option Option Value Value Resulting NPV Resulting NPV Labor cost Labor cost

Conclusions Conclusions

• Previous studies found cost

Previous studies found cost advantage of mechanical harvesting advantage of mechanical harvesting

• peration over hand-cut as early as
• peration over hand-cut as early as

72-3 season. 72-3 season.

• The NPV approach supports the views of

The NPV approach supports the views of previous studies: NPV less initial previous studies: NPV less initial investment cost of mechanical operation investment cost of mechanical operation ($319,815) exceeds the NPV for hand cut ($319,815) exceeds the NPV for hand cut

• peration ($181,014).
• peration ($181,014).

Conclusions (continues) Conclusions (continues)

• Conclusion from ROA is opposite: Due to a high

Conclusion from ROA is opposite: Due to a high volatility, the option value of holding investment volatility, the option value of holding investment

• pportunity is high ($176,166) enough to
• pportunity is high ($176,166) enough to
• verturn the conclusion of NPV.
• verturn the conclusion of NPV.
• Threshold value analysis shows that it takes

Threshold value analysis shows that it takes more than more than 52% 52% increase in labor cost for increase in labor cost for immediate mechanization in 72-3 season. immediate mechanization in 72-3 season.

• ROA explains better the historical fact that large

ROA explains better the historical fact that large scale mechanization was delayed until mid/late scale mechanization was delayed until mid/late 80s (only 80s (only 15% 15% in 72-3 season). in 72-3 season).

Similar Situation of Mechanical Similar Situation of Mechanical Harvesting for Citrus Harvesting for Citrus

• Currently, mechanically harvesting Florida oranges

Currently, mechanically harvesting Florida oranges results in about results in about 16% 16% cost-savings ( cost-savings (25 cent per 90 25 cent per 90 pound box) pound box) relative to hand harvesting, under typical relative to hand harvesting, under typical conditions (Roka 2008). conditions (Roka 2008).

• Cost-savings suggest only two year payback period for

Cost-savings suggest only two year payback period for the grower the grower’ ’s investment in preparing the grove. s investment in preparing the grove.

• Yet the adoption rate remains relatively low at about

Yet the adoption rate remains relatively low at about

• nly
• nly 7.5%

7.5% of the acreage.

• f the acreage.