I am interested to hear of various approaches to developing the cost of money (i.e., interest) when developing replacement and cost of cure appraisals that include references to long-term solutions (e.g., replacing a large tree w/a small tree and maintaining it for a period of years; topiary situations, etc.).

Specifically, what sources/methods are used for interest and inflation rates, etc.

Thanks....

Torrey

Reply to post by Torrey Young, on November 13, 1998 at 19:25:03:

Torey, I'm unconvinced that compound interest applications in Cost of Cure or Replacement Cost methods provide a meaningful indication of value or are theoreticcaly supported. But I haven't formed a final opinion.

In theory, an interest rate applied to a model like that should be an interest rate for a similar term. For example if the tree establishment period is 30 years then you should be using a similar TERM interest rate, say 30 yr. treasuries.

Ordinarily you would select an interest rate with a similar RISK. U.S. Treasuries are the risk free standard. Higher risk interest rates are higher. The problem is that the typical financial model uses the rate to discount a future value (FV): the higher the risk the higher the interest rate and the lower the present value (PV), reflecting the risk that you might not earn what you expect. Compounding, by contrast, results in a higher value with a higher rate which does not accurately reflect risk. That's one of the problems with compounding as a valuation model.

The literature suggests that IF compounding is at all useful it is for short periods (as in short rotation forest crops) at low rates.

All these interest rates are "nominal" rates. Nominal rates are composed of "real" rates (the actual cost of money) plus a premium for expected inflation (and premiums for risk, term and liquidity). A nominal U.S. Treasury rate (no risk, highly liquid) less the real rate should equal the expected inflation rate. The real rate is often said to be between 2.5-3.0%. That's one way to get the inflation rate. Or look at the U.S. Department of Labor or Department of Commerce reports (must have web sites too). You would use inflation rates to project future costs of establishment, e.g. what the irrigation expenses will be in year 3.

Some of the forest valuation methods, such as land expectation value, suggest that compounding of costs should be at real interest rates not nominal rates. In any event compounding is only part of the valuation exercise.

Reply to post by Torrey Young, on November 13, 1998 at 19:25:03:

Torrey, I should have pointed out that if you extract an inflation rate from a nominal interest rate you should select a term similar to the # of years out you want to project inflation, not the term of the total investment. E.g. if you have a 30 year total period select a 30 year investment inteest rate, but extract inflation from a 5 year rate for inflation of a cost to year 5.

Here are the sources I've used thusfar in researching compounding:

Interest.

Blew, J. Miller, 1984. Harvard University Graduate School of Design, Note on Dis-counted Cash Flow Analysis. Cambridge, MA: President and Fellows of Harvard College, 19 pp.
Fabozi, Frank J., 1997. A Review of the Time Value of Money, pp. 25-44. In Fabozi, Frank J. (ed.), The Handbook of Fixed Income Securities. Chicago: Irwin Professional Publishing.
Fabozi, Frank J., 1997. The Structure of Interest Rates, pp. 106-128. In Fabozi, Frank J. (ed.), The Handbook of Fixed Income Securities. Chicago: Irwin Professional Publishing.
Federal Reserve Bank of Chicago: 1992. Points of Interest, What Determines Interest Rates? Chicago: The Federal Reserve Bank of Chicago, 18 pp.
Hammond, John S. III, 1984. Harvard Business School, Introduction to Accumulated Value, Present Value and Internal Rate of Return. Boston: HBS Case Services. 13 pp.
Hewlett-Packard, 1985. HP-12C Owner’s Handbook and Problem Solving Guide. Corvallis, OR: Hewlett-Packard. 246 pp.
Homer, Sidney and Richard Sylla. 1991. A History of Interest Rates, Third Edition. New York: Rutgers University Press. 662 pp.
Ingersoll, J.E., 1987. Interest Rates, p. 897. In Eatwell, John, et al (eds.). The New Palgrave, A Dictionary of Economics, Vol. 2. London: The Macmillan Press, Ltd.
Kellison, Stephen G., 1970. The Theory of Interest. Homewood, IL: Richard D. Irwin, Inc. 243 pp.
Klein, John J., 1994. Economic Theory of Interest, pp. 557-560. In Greenwood, Douglas (ed.), McGraw-Hill Encyclopedia of Economics, 2nd Edition. New York: McGraw Hill. 1093 pp.
Mason, Robert C., 1994. Comprehensive Compounding. The Appraisal Journal, LXII(2):234-239.
Scorgie, Michael E., 1996. Evolution of the Application of Present Value to Valuation of Non-monetary Resources. Accounting and Business Research (UK). 26(3):237-248.
Trainer, Richard, D.C., 1987. The Basics of Interest Rates. New York: The Federal Reserve Bank of New York. 24 pp.
Trainer, Richard, D.C., 1984. The Arithmetic of Interest Rates. New York: The Federal Reserve Bank of New York. 33 pp.
Wiley, Robert J., 1989. Compound Interest Concepts and Calculations, pp. 175-202. In Real Estate Accounting and Mathematics Handbook, 2nd Edition. New York: John Wiley & Sons, 380 pp.

Inflation.

Barnes, Ronnie, 1997. Accounting for Changing Prices, p. 35ff. In Dickson, Tim (ed.), The Complete MBA Companion. Lanham, MD: Pittman Publishing.
Case, John, 1981. Understanding Inflation. New York, William Morrow & Co.
Derks, Scott (ed.), 1994. The Value of a Dollar 1860-1989. Detroit: Gale Research.
Downes, John and Elliot Goodman, 1990. Inflation Accounting, p. 318. In Barron’s Finance and Investment Handbook, 3rd Edition. New York: Barron’s Educational Services, Inc.
Jacobs, Eva E. (ed.), 1997. Handbook of U.S. Labor Statistics, 1st Edition. Lanham, MD: Bernam Press, pp. 237-255.
Ransen, David, 1993. Inflation, pp. 211-216. In Henderson, David R. (ed.),The Fortune Encyclopedia of Economics, New York: Waner Books (Time, Inc.).
Tobin, James, 1994. Inflation, pp. 530-543. In Greenwald, Douglas (ed.), The McGraw-Hill Encyclopedia of Economics, 2nd Edition. New York: McGraw Hill.
U.S. Department of Commerce, 1996. Statistical Abstract of the United States, The National Data Book, 116th Edition. Washington, DC: U.S. Department of Commerce.
Whittington, G., 1987. Inflation Accounting, pp. 400-401. In Eatwell, John, et al (eds.), The New Palgrave, A Dictionary of Money & Finance, Vol. 2. London: The Macmillan Press, Ltd.

Reply to post by Scott Cullen, on November 13, 1998 at 19:25:03:

Thanks Scott... outstanding response.. anybody else?

Would really like to hear some varied methodologies!

Torrey