How to Determine the Cost of Capital for Commercial Forestry

Abstract

Abstract This paper focuses on designing a methodological workflow to fill a knowledge gap for determining the cost of capital for commercial forestry projects. Upon reviewing the literature, a method to determine the cost of capital for profit-oriented forestry seems to be lacking. Accordingly, we selected and analyzed 42 companies that do businesses worldwide, are present on the stock exchange, and possess or lease forest land. Based on their business activities (growing forest, sawmilling, final production, paper production), these companies are classified into four subgroups. An algorithm has been devised using the concept of risk diversification and the capital asset pricing model for three groups of investors and four forestry subgroups. In doing so, the real risk-free rate (0.43%) is set as the difference between an average return on 10-year US government bonds (2.59% nominal) and the 10-year average US inflation rate (2.16%). The measure of forestry systematic risk (beta coefficient) varies between 0.83 and 1.41, while the equity (stock exchange market) risk premium is set to 6%. Unsystematic risk is determined using a process of mapping which takes into account all risk elements marked as relevant for the forestry sector. This approach provides results that reveal the cost of capital varying between 5.41% and 16.55% based on the current level of an investor's portfolio diversification and the risk characteristics of the forestry subgroup. Finally, the forestry companies meeting the investor's expectations are noted as preferable investment opportunities.