Enterprise Choice Under Water Constraint and Price Risk
A 500 ha mixed farm has 300 ha of arable land and a water allocation of 400 ML for irrigation. The grower is choosing between three enterprises for the coming season: wheat on 300 ha dryland at a yield of 2.5 t/ha and a price of $340/t, with variable costs of $380/ha; irrigated lucerne on 100 ha using 350 ML, yielding 12 t/ha of hay at $280/t with variable costs of $1,800/ha; or irrigated potatoes on 40 ha using 380 ML, yielding 55 t/ha at $420/t with variable costs of $9,500/ha. The grower has $400,000 of working capital and can borrow at 8%. Water beyond the allocation can be bought at $450/ML.
1. Calculate the gross margin for each enterprise and recommend a combination that fits the water and capital constraints.
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Wheat: revenue is 2.5 t/ha × $340/t = $850/ha. Gross margin is $850 - $380 = $470/ha, or $141,000 across 300 ha. Lucerne: revenue is 12 t/ha × $280/t = $3,360/ha. Gross margin is $3,360 - $1,800 = $1,560/ha, or $156,000 across 100 ha. Potatoes: revenue is 55 t/ha × $420/t = $23,100/ha. Gross margin is $23,100 - $9,500 = $13,600/ha, or $544,000 across 40 ha. Potatoes have by far the highest gross margin per hectare, but they use 380 ML for 40 ha, which is 9.5 ML/ha, and they require $380,000 of variable costs, which is close to the $400,000 working capital limit. Lucerne uses 3.5 ML/ha and wheat uses no irrigation water. A feasible combination is 300 ha of wheat plus 40 ha of potatoes, using 380 ML and $380,000 of working capital, leaving 20 ML of water and $20,000 of capital. That combination returns $141,000 + $544,000 = $685,000 in gross margin. Lucerne could be added only if water and capital were freed, but the capital constraint binds before the water constraint.
2. The grower is worried about potato price risk and is considering buying 20 ML of extra water at $450/ML to expand potatoes. Assess whether this is a sound decision.
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Buying extra water to expand potatoes is a high-risk decision. Each megalitre of water supports about 40/380 = 0.105 ha of potatoes, which yields 0.105 × 55 = 5.79 t of potatoes worth 5.79 × $420 = $2,432. The variable cost of that area is 0.105 × $9,500 = $1,000, so the extra gross margin before water cost is about $1,432 per ML. The water costs $450/ML, leaving a net benefit of about $982/ML, which looks positive. However, the capital constraint is already binding: the grower has only $20,000 of working capital left, and expanding potatoes by 20 ML would require about 2.1 ha and $20,000 of variable costs, which consumes the remaining capital entirely. More importantly, potato prices are volatile, and a 20% price fall to $336/t would reduce revenue per ML to about $1,946, cutting the net benefit to roughly $496/ML before considering the risk of yield loss. The grower should not expand potatoes on borrowed water and borrowed capital without a price hedge or contract. A safer use of the $450/ML water would be lucerne, which has a lower capital requirement and a more stable hay market, or to hold the water as a reserve for the following season.
3. Recommend how the grower should manage the capital constraint, including whether to borrow at 8% to fund potatoes.
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The capital constraint is the binding limit, not water. Potatoes return $13,600/ha of gross margin, which is far above wheat at $470/ha and lucerne at $1,560/ha, so borrowing to fund potatoes can be justified if the price and yield assumptions hold. The grower needs $380,000 for 40 ha of potatoes and has $400,000, so no borrowing is strictly required for that combination, but it leaves almost no buffer for cash flow, and the wheat enterprise also needs $114,000 of variable costs. In practice, the grower cannot fund both wheat and potatoes from $400,000 without borrowing. Borrowing $100,000 at 8% costs $8,000 in interest, which is small relative to the $544,000 gross margin from potatoes, so borrowing is defensible. However, the grower should borrow against a contract or forward price for potatoes to reduce price risk, and should keep a cash reserve for the wheat crop. A staged approach, planting 30 ha of potatoes and 300 ha of wheat in the first year, would reduce exposure while testing the market and the irrigation system.