VARDAMAN VIRTUAL FORESTRY COMPANY

Next to be considered are the characteristics of bonds, which are similar to plantations in many ways. The most widely-quoted prices are those of U.S. Treasury bonds (USTs), and there are so many issues that maturity dates can be matched to maturity of all VPPP investments. We use them as benchmarks and develop a set of adjustments to them. We also use their nominal yields because this is customary with market reports and investors, and we will explain later how to convert them to real yields, i.e., yields above inflation. The yields discussed below were developed from a study of bond-market reports in Section C of The Wall Street Journal during the last full week of October 1994.

The yield on USTs due in November 2015 is 8.20%, and that's where we'll start. There's a big market for these bonds stripped of their semi-annual interest payments, and this gives us an indication of what annual cash flows are worth. Yield of USTs stripped of interest was 8.43%, so we assume that the annual-cash-flow feature is worth 0.23%. (It would sometimes have a much higher value.)

USTs are the highest-quality bonds in the world, and for many reasons plantation investments are a long way from them, so we look for bonds that are nearer in quality. One with a similar maturity was USX of 1/15/13 (rated BB+ by S&P), well-known to investors with a yield of 9.76% and considerable liquidity. More like plantation investments are high-yield bonds, and yields on those rated B averaged 12.00%. If these are in fact more comparable, the yield on plantation investments should be the yield on USTs plus 3.80%.

The market indicates that bond buyers give great weight to safety in determining yields, for average yield on high-yield bonds quoted was only 10.00% if the bonds were secured. We have no way of knowing what "secured" means for each issue, but indications are that the "secured" feature is worth 2.00%. We think that investments in plantations more than five years old are secured because the risk of weather and fire losses has dropped almost to zero by then. On the other hand, the biggest single risk in establishing a new plantation is the possibility of a spring drought, which can kill nearly all trees planted a few months earlier. At this stage the trees are more subject to loss from fire and some insects, so we believe that this higher risk of loss is worth 0.75%.

Also important is liquidity. All bonds mentioned above have considerable liquidity, are well-known to investors, and trade nearly every day; that's why WSJ reports the market action. On the other hand, except for that provided by VPPP, there is no market for interests in plantations, especially interests that do not include ownership of the land. We believe that the liquidity feature is worth 1.0%.

We believe that risks of loss from casualty losses and price changes in plantations are the same as those in high-yield bonds.

The last feature to be considered is professional management with an ownership in the plantation. It is valuable whenever casualty losses occur or threaten to occur and very valuable when timber is sold. We believe that it is worth 0.25%.

In such a market environment, here's how we apply the foregoing. To appraise the value of a plantation before VPPP involvement, we calculate in the following manner the percentage discount rate to be used and round off to the nearest one-quarter of one percent:

After determining the cost of establishing a new plantation and estimating future yields, we insert these figures into a cash-flow model with the percentage discount rate, run enough simulations to learn the most profitable management plan, and make our offers accordingly.

The combined effect of all premiums listed above has been the major barrier to regeneration of cutover timber with pine plantations for at least 50 years, and VPPP was formed to eliminate some of them. It does this by raising capital from investors with special resources and using this capital to eliminate some of the premiums in the following manner:

What all this means is that, by adding certain plus features and subtracting certain minus features, VPPP makes the plantation a better investment according to the criteria of today's financial markets. Therefore, net present value of the investment in its original condition should be capitalized at 12.25%, whereas net present value of the VPPP-assisted investment should be capitalized at 10.50%. To put this another way, VPPP earns a higher return from these plantations because it has fewer benefits and more risks; potential sellers of an interest to VPPP earn a lower return because they have more benefits and fewer risks.

Now here is how to convert nominal yields into real yields. It's easiest to see if you realize that part of the yield from a plantation is real because it comes from tree growth and part comes from price rises due to inflation of all commodity prices. If real yield from tree growth is 8% and the inflation rate of 2.6% (as it is today), the nominal yield is NOT 8% plus 2.6% = 10.6%. It is 1.08 multiplied by 1.026 = 1.1081 or 10.8%. Look at it another way. To start the year you had 100 board feet worth $1 per foot or $100; at yearend you had 100 board feet multiplied by 1.08 = 108 now worth $1.026 per board feet, for a total value of 108 multiplied by $1.026 = $1.1081.

Therefore, real yields in our earlier example are 1.1225 divided by 1.026 = 1.0941 or 9.4% and 1.1050 divided by 1.026 = 1.077 = 7.7%.

The purpose of this exercise is merely to help buyers and sellers of young loblolly-pine plantations appraise values according to conditions in world financial markets, not to tell them what to do. Potential sellers may have several reasons for not accepting current market prices; potential buyers may have several reasons for paying premium prices. Nevertheless, they are all investors, and wise investors always welcome the chance to "mark to market."

Furthermore, there is nothing official about this system; it is simply VPPP's first answer to very important questions. If you want to comment or ask questions, call Jim Vardaman at 800+455-4568.