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# ECONCMIC ANALYSIS WITH SYSTEMYNAMICS: D

A FORESTRY EXAMPLE

Lee Rogge and Stephen G. Boyce School of Fbrestry and Environmental Studies DukeUniversity Durham, NC 27706

ABSTRAcr

It is :i.rnp::>rtant begin any rrodeling attempt by determini.nq the primary to objectives of the decision makers in the field. In forestry there are two interests: production of IlUlltiple resources and profit (or cost). Conventional methods of analysis are incapable of handling the two foci adequately; one is always subsumedin the other. The DYNAST rrodel, with the addition of an econcmic algorithm, provides a means of analyzing the system fran both viewpoints without forcing one to daninate the other. This balance is achieved through using capital budgeting tec..lmiquessuch as net present value to represent both the IlUlltiple use and profit aspects of noney. Th.eeconcmic algorithm can be used to analyze noney as one of a host of IlUlltiple benefits in canparing management options, or as a method of estimating profitability independent of the context of the rrodel. Th.is latter application makes the algorithm potentially useful in rrany rrodeling contexts sdmul.atrinq business investment decisions. Th.eapplication transactions of econcmic analysis techniques ccrmon in business

**to the rranagementof forest land is canplicated by the IlUlltiple It is difficult resultant to isolate
**

and.

**resources flawing fran forests. individual a forest effects project investments and their
**

In addition,

evaluate

cash flows over several decades in action produces a variety of Conventional

system. or benefits

any silvicultural

including many non-nonetary resources.

analysis based on the stream of dollar incaoo and outflow generated by

a single investment is inadequate for the canplexity of forest resource management.

**The dual role of noney, as both capital is central
**

to the analysis

and one of a host of benefits, approach to this duality is

problem.

The classic

average rate of ratio or index period and benefit/cost forest management ption being simulated is viewed o actions. alters forest development in the production of all benefits. 'lb is constant and independent of investment. This ability to view !IOney both as an investment to produce all for adequate benefits and as one of a set of "forest products" is crucial evaluation of forestry investments. as the nost. 2) the cost of capital 1) the benefit algorithms of the current DYNAST model provide adequate measures of the second canponent but fail to address the investment portion [2]. they merely see multiple kinds of capital capital budgeting teChniques provide a familiar methodological framework The DYNAST simulation rrode . The teChniques rrost. Figure l and Table l shCM the model structure for calculating net index in the present value. particularly the value of cash flows. timber and wildlife. 4) . 6. Each simulation is treated as a single investment with actions. Management. from the shift of any management lan must evaluate these ccrnponentsjointly. with the addition of an econanic algorithm. payback profitability index [5].266 2 3 frameworkand attempt to express Methods to subsumemultiple use within a capitalistic all benefits remedythis shortcaning. This type of management has boO cost canponents: value resulting utility the system (over time) and the A ccroplete assessment of the The equivalent to the length of the simulation to date. moneyis another of these benefits Whichderive from the state of the forest. the production of benefits associated with this developnent is calculated with a set of "benefit" algorithms. the cost of altering in production. analysis the entire For purposes of for investment analyses. Whichescape the it allows analysis of the investment involved in any series of actions and it provides an improvedmeasure of the value of most obvious limitation of this approaChand use diverse units of measure to still fail to escape the limitations of the [4]. silvicultural represent diverse benefits capitalistic moneyas a forest product. n the form of silvicultural i and causes a shift recovery factors [3. 3) the investment opportunities are independent. as calculation of flows from this rates of return is inappropriate When sign changes in the cash flCMoccur [3]. so the classic model for project evaluation was enlarged to encarpass a series of silvicultural a project life actions. including water. The formulation is based on continuously canpounded present worth and capital simulation model of forest development. appropriate of these indices for our purposes. net present value. A we chose net present value and profitability as a single investment consisting of a series of silvicultural suite of benefits. p Conventional analytic teChniques makesix assmrptions [3]: project and firm have the same risk. investment. rate of return. The effects of individual investments cannot be separated within a biologic system. I provides a way of analyzing forest systems fran both the multiple use and profit capital perspectives without forcing either to daninate. an economicalgorithm has been developed Whichserves boO functions: in tenns of cash or "market" values. 9]. paradigm. ccmnonlyused in business are internal return. equivalent annual rent and profitability DYNAST (DYNamic Analytic Silviculture Technique) [1] is a computer conventional manner. Equivalent uniform annual cost or rent is also calculated as it is a useful meansof ccroparingalternatives with relatively continuous cash flows.

. 0) orAP.scounted outflow orAP = present value of outflows IN = dollar inflow INRP = di.TIME.K)..K * EXP (DSR.K.K FARC.l) \ \ \ I>: ::> I'< \ I I s I'< til N NEl'IN = INAP-oTAP I>: \I \ I t.JK) -.JK) "- . 0.soounted inflow INAP = present value of inflows DSR = discount rate Jl3C = di.K))) PIC.1/. \ \ \ T A A * DSR. DSC.MAX(O.1/. N -.1/.-.NEl'IN)) {l-{l/MAX (. \ A Jl3R.K where or = dollar outflow OI'RP = di.1/.K/FIFGE (DSC.K = TABHL(TDSR.K. 10.K * EXP (DSR.1 Jl3C.1/. \ \ '.i! Z I'< '} I J \ \ I I / I I I 15 H r:.KL = IN...K) \ \ \ I / I / / / \ \ '\ A \ * (EXP (Jl3R. -.K= INAP. econanic profitability R L OI'RP.oi.K. NCYl'E ° * (INRP.K.J + Dr * (orRP.K. factor NPVC= conventional net present value FARC= conventional equivalent armual rent PIC = conventiOnal profitability index NEl'IN = year net cash flow TIME = year "- .l Cl 0 -.K.1/. / r. .. TIME.267 4 Table 1: Algori-thm for calculation measures.K= (NPVC.K).K/FIFGE (DSC. 0) INAP.scount.K = EXP ({MAX(O. DSC. '\ I1 ~ o H 0 Io Z f<l :. . DSC.K) -1)/ \ \ \ \ '\ \ \ \ f<l S = INAP. 1) TDSR= .1/.. 5 of convent.1/.K)) NPVC.1/.K .. \ '-'-.: OM 5.Ional.: s :.orAP..K.K/MAX (orAP. ° x. TIME. TIME.K = N R L orAP = INRP.1/.K = INAP.J + Dr INAP = ° orAP.KL= or.>< ~ ///I ~E~ II ------~ z"o~CI H ~/ 5 o >< Q) .

5) perfect capital markets exist. differences between the discount and [7... which generally earn higher returns than the .~ "' ceo: " 11 \ A discrepancy between oorrowing and reinvestment rates creates project ranking by different measures of profitabiity \ I . . Forestry operations reinvestment rates can be a serious limitation generate a large stream of intermediate revenue which nay be reinvested at the lending rate./ The inability to represent. therefore we included . land base.. . 8].. '" o ~ rate current at that time. '/ // / .. e- The rrodel structure for conventional capital analysis cannot handle Discounting on a year by year as a change '" '" violations of both cost of capital assumptions.. Haolever.... often the reinvestment is in another part of the canpany such as a mill or processing facilities. 1/ / gj .differences between oo=owing and lending rates cannot be accounted for as all cash flows are simply discounted back to the present. l'j:j / I / ~ / I I I / inaccuracies in relative When projects differ . and 6) investment decisions are independent of consumption.. / \ / / " <7 ~ 0 _lP'. with no provision madefor reinvestment or leriding.. accommodates ariation v basis realistically in rate affects in the discount rate. The long-term nature of forestry investments renders it improbable that the full set of assumptions will hold over the planning period. 8]..... '" future cash flows only.. .. Land nanagementis subject to cash flows which decidedly vary both in timing and nagnitude between nanagernentoptions.. Each year's incare is subject to the . Violations of these assumptions produce discrepancies between various methods of value analysis. is unlikely that the cost of capital will remain constant and that borrowing and lending rates be equal. it I / I . In particular./ ..268 6 bo=ONing and lending rates are equal.~~g in the timing of cash fla-lS [3.

wildlife.1/. primarily fran the conventionally * (arRS.K= arAS.0.K present using the discount rate.1/. TIME.1/. NPV* = EARS rrodified equivalent annual rent.K/DSC. EAR* = PIS = rrodified profitability index. used NPV R L N A R L arRS.1 DSC.K. (1979). NPV*.K))) The tradeoff improved analysis between the tW'O rrodel structures under a single violation is clear. If fluctuations and the valid for that in the future discount rate" are expected to be significant.1/.K INAS.K = arAS. TIME.1 as before A A EARS. This combined use of economic and multiple s:imulations is best illustrated with an exampl.1)/ (1 .1/.PI) '>'Puldbe nore appropriate the accurrulated sum of cash flONS all discrepancies at once (NPV*. and reinvestment rate before discounting INRB.PI*).1/.K.K INAS.K= EX!? «MAX(O. TIME.K (NPVS. the measures based on annual discounting than measures based on discounting (NPV.K INASD. al.1/.arAS = ar = dollar outflow OTRS increase in future value of outflONS = arAS = accumulated future value of outflONS arASD= present value of outflONS IN = dollar inflow INRS= increase in future value of inflONS INAS= accumulated future value of inflONS INASD present value of inflows = DSR= discount rate DSC= discount factor RIN = reinvestment rate fOr intermediate income NPVS rrodified net present value.JK) The t\<p methods are equivalent N A NOTE rates are equal. of income and expenditure.K* (EX!? (DSR)-1. Anticipated the between the discount and reinvestment rates \<puld indicate opposite choice.DSC. EAR*. 1) of the conventional The choice of Which set of profitability 1) or rrodified assunptions measures to use. 1) TRIN NPVS.K arASD.K/MAX (arASD. 10.K = DSR= . Cash outflONS are cc:up:>unded forward and in both directions since they are not values * INASD. = .K.1/.K = - discounted back using the discount rate subject to reinvestment.269 8 9 alternative alternative measures of profitability in the economic algorithm.1/. 1 of rrodified economic profitability measures are based on a variant This measure differs value.(l/MAX(.JR) orss = 0 in that with this approach intermediate income is cc:up:>unded forward back to the if discount arASD.KL FIFGE (INAS.TIME.1/. conventional situation (Figure 2). each provides assunptions.K))* DSR) RIN. NETIN)) * (EX!? (DSR).KL = FIFGE (OrAS.J + INAS= 0 ])I' to the end year using the reinvestment 0.K = TABHL (TRIN.K* (EX!? (RIN.K Where NETIN INAS. 0.J + ])I' described in Clark [3].K/DSC.EAR.K) -1).0) + IN.K MAX = (0. of net present These Table 2: Algorithm for calculation measures. pp.0) + or.K arAS.Ol. are presented profitability NPV* is the difference between the present C A A T The equations responsible for these calculations in Table 2 (see Figure 2) • index are calculated Equivalent annual rent and (Figure 1). . PI* NETIN year 0 net cash flow = TIME= year = INASD. 78-84.K= INAS.e. = * (INRS. resource production The Big Ivy is an upland water and noney 1 Based on discussion in Clark et. (Figure S C PIS.K. will depend on the specific situation. hard\<Pod forest in North Carolina producing timber.

.. forest. _..': I I I I I . I ..._ ..50 0 I . I I Water Yield Index I o 5 10 Years 15 20 100 . "" . conventional ..50 0 . L Bear Habitat Index . SO-year rotation.. the Big Ivy forest.00 103 Dollars 50 Percent Attained 1.. ".270 10 11 Percent Attained 1..' .25 -25 ___. NC ..... I I / .25 -25 =:. NC Figure 4. . 200-year rotation.-... I I o -50 Index 5 10 Years 15 20 100 Figure 3. 0::..00 103 Dollars 50 Net Present Value.75 25 .75 25 "" " . .:~-=-_____" --_.--. the Big Ivy. .

271 benefits [1. all indices are low during the extended period required to regulate the distribution ages. 2]. economicbenefits rapidly decline to unacceptable levels as single rotation periods are movedaway from the harvest age whiChmaximizes production of narketable benefits. as measured Multiple rotation lengths. this produces an economic on the joint production of non-narketable benefits that can be L-------------Water Yield Index 5 10 Years 15 20 -100 relaxed by creating a mosaic of stands with super:il!pJsedperiods of rotation [1]." This conclusion is based on regulating the forest with a single period of rotation.. Figure 5. although the most noticeable response occurs with bear whiChachieves levels muCh higher than with either single rotation. mixed rotation they do rerrain solidly in the profit category under the scenario.75 25 Deer Habitat Index is highly favored on a sustained yield basis. area and forest type. diversity constraint of habitats Single-length rotations limit the . in the long term both types of wildlife habitat A longer rotation designed to produce the old growth stands preferred by species such as bear is economically discouraging (Figure 4). are reduced by movingany portion of the land off an *SO percent is rotated through an SO-year 20 percent through a 200-year period.25 -25 by age. however.. (NPV)fran timber production on a sustained yield basis in 103 Dollars 50 In the mid-term (20 years) this rranagement regime produces water in substantial am::>unts but limits the quantity of bear illustrated decline. Wildlife habitat is enhanced in all cases by increasing the different types of stands. Adjustment of the flow through each . Economic profits. Percent Attained 1. NC* by net present value. An SO-year rotation 12 (Figure 3) produces nearly opt:irral 13 economicbenefits this forest.-. Only bear habitat of stand It .-.50 is too costly for serious -' -------. the Big Ivy forest.00 and deer habitat habitat.. would be necessary to conclude from these projections that the joint production of timber and wildlife habitat consideration. period and SO-year rotation. . A balance between economicand non-economicconsiderations is aChieve by apportioning land between two or more rotation periods (Figure 5).

. profitability camonly underst<X>d aasures of m o that are useful for canparing the options under study with other types of investments.25 ability to canpare options and assess the magnitude and nature of the between them. Water Yield Index best canbinations of benefits This method also generates a set of objective. -." . Additional in economicparameters are 25 Deer Habitat Index complications are introduced Whenvariations considered. There are manysituations business decision is simulated and evaluative critera outside the model would fonn sound input £Or the decision m:!Chanism. Multiple rotation lengths with modified economic factors.. modified . Forestry cperations can be modified to produce the with minimal sacrifice of economic returns.Lookof a project (Figure 6) without affecting production of any other benefits.272 14 rotation is a way of directing 15 the production of non-rronetary resources at a minimum cost. Years The objectivity Figure 6. " with carefully considered.. tradeoffs t-----~-----. a reinvestment rate greater than the discount rate can appreciably alter the economic out. .00 103 Dollars 50 is enhanced production of a variety of resources with only moderate declines in economicprofitability. possibilities £Or modeling.. NC* of these measures renders them independent of the This independence opens interesting Wherea real world that have significance :inmediate context of the model. of The weights attached to each type of product will vary with the situation the individual forest and the objectives of the owner..75 habitat is not a simple issue.50 Analysis IlUStbe based on sets of options assunptions in order to avoid biasing o .he t . *SO percent is rotated through an SO-year period and 20 percent through a 200-year period. the Big Ivy forest. consistent estimates of production of any resource. the result Percent Attained 1. Use of the economic techniques presented here improves the analyst' s . The exchange of rroney Incore for wildlife Net Present Value.

78:740-742.. 10 p. Southeast. The Ronald Press canpany. 79:616-617. For. In Proc. State Univ. of N. capital budgeting techniques could provide a IIOremeaningful and [lJ decision than IIOreoommonly used This forroulation would be interindustry [2J Boyce. 1980..L.. Stn. Oct.. L. For. and W. N.J. Thuesen. 1981. Fin.J. For. capital budgeting: Planning and control of capital expenditures. and J. 1977. 116 p. and M.J. and W. 468 p.C. Serv.Y. Wirth.H.R. Hindelang andR. Dep.. Agric.. Inc. u. 1981 SystemDynamics Research Conference.. Dept. Engineering econaI\Y. Reinvestment rate and the analysis of forestry enterprises.G. firms. Multiple-use of renewable resources is enhanced with system dynamics methods. Res. Management eastern hardwood forests for nultiple of benefits (DYNAST-MB). SE-168. Engle\'lOOd Cliffs. 6:66-71. N. N. 1977. Sci.J. 26:121-133.E. Engle\'lOOd Cliffs.. Pritchard. 1964. For. Inc. Man. New York. Gitman. Jr. Clark. 1960. 520 p.273 16 allocation of investment funds amonga numberof technololgies is a common LITERA'IURE CITED 17 example. For. C. R. J.J.. Principles of engineering econaI\Y. Prentice-Hall. 4th ed. budgeting accurate input into the funds allocation inputs such as rrarginal or average costs. Dress and J. Fortson.G.D. 1980. [3J [4] 0001/3 [5] [6] [7] [8] [9] Grant.G. . P. especially applicable When modeling inter-campanyor investments. 1981. N. Klemperer. Forrester.s. 14-17. Field.C.. 1979. Rensselaerville. 1981.E.Y.3rd ed. A survey of capital techniques used by major U. Public Mrninstration. Asheville. J. at Albany. E. 574 p. Interpreting the realizable rate of return.J. Prentice-Hall. C. E. Pap. T. Schallau.S. Ireson. W. J. H. canplementary linear and goal prograrrmingprocedures for timber harvest scheduling. Fabrycky. N.. S. Exp.Y.