4. The Faustmann Model (Part II)

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The soil expectation value, VF for an illustrative bare land used for timber production, (926 €/ha) (Table E5) actually represents the (maximum) willingness to pay for bare forestland when used for timber production. From Table E3 we also see that net present value of the first rotation (838 €/ha) creates the major part (about 90 %) of the SEV. The discounting at a 4 % interest rate decreases so heavily on the net present value of all future rotations.

Table E5: The soil expectation value for an illustrative bare land used for timber production. The expected cash flow is presented in Table E3.

Year
Revenue/cost
Compounded value at year 60 (r=0.04)
0
-1000
-10520
6
-200
-1663
30
+800
+2595
45
+3000
+5403
60
+13000
+13000
sum

+8815


0.105
VF (€/ha)

926 (=0.105.8815)


The basic version of the Faustmann model assumes perfect capital and forestland markets. If the forestland markets are functioning properly, a forest owner has the option to sell her property at any time. Since the selling price is dependent on stand age, it is - perhaps surprisingly - worthwhile for the owner to apply an infinite planning horizon as assumed in the model.

Generally, Hultkrantz (1992) emphasized that since rotation periods normally exceed the remaining lifetime of current forest owners, the silvicultural practices are inherently transfers of assets towards future generations. From the forest policy point of view it is crucial to know what incentives lead forest owners to sacrifice resources for such transfers. In addition to land markets mentioned above, Hultkrantz points out the importance of a bequest motive - the concern for the wellbeing of the next generation that is also leading to an infinite planning horizon. Public cost sharing and technical assistance programs have also been shown to increase the probability for private timber stand improvements and reforestation investments (e.g. Hyberg & Holthausen 1989, Ovaskainen et al. 2006).

 Table E6: Comparison of the Faustmann Model and forest rent
Faustmann Model
Forest Rent
- Profitability of forestry is critical in non-fertile soils
- Forestry is one of the most profitable businesses
- Profitablity of expensive stand establishment methods, peatland drainage and dense forest road network is questionable
- All investments in forestry are profitable
- Forestry is integrated to other economies of the forest owner
- Forestry is disconnected from other economies of the forest owner
- The market value of Finnish forest land is comparable to SEV with about a 4% discount rate
- The market value of forest land is undefined

A comparison of the Faustmann Model and the forest rent approach reveals several profound differences in assumptions and implications. Although, simplified here, the Faustmann model can be quite easily be extended to forested stands and complemented by non-timber benefits. In the latter case, it may be optimal to never harvest the stand. Nowadays, investment decisions involving hundreds of million dollars are based on the formula (Chang 2001).

The business cycles (i.e., short-term price fluctuations) and financing needs (borrowing constraints) are important practical determinants for the timing of final cuts. Under these fluctuating prices, forest owners tend to sell timber when the price is highest.

In practice, the knowledge of value growth over time is essential to the rotation choice. We can, for example, directly calculate the soil expectation value for different rotations and choose the rotation expending the highest land value. This is however beyond the scope of this brief introduction for the illustrative example presented in Table E3 and E5.   (NOTE: In ECON5 we will estimate the value for the same forest stand assuming that rotation is optimized at 60 years).

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