Title: Pro Forma Summary
1Pro Forma Summary
AGEC 489-689Spring 2010
2Timeline Required for Capital Budgeting
Assume it is the year 2009 and John Deere wants
to project farm machinery and equipment sales
over the next six years to determine if plant
expansion is necessary.
2009 2010 2011 2012 2013
2014 2015
Capital budgeting models of investment decisions
require projections of the annual revenue and
cost values over the entire 2010 to 2015 time
period.
Page 89 in booklet
3Remember the definition of annual net cash flows
Page 74 in booklet
4Must project Annual price
Must project Annual yield
Page 85 in booklet
5Alternative Forecasting Approaches
6Ad Hoc Modeling Approaches
- Naïve model using last years prices, costs and
yields - Simple linear trend extrapolation of historical
prices, costs and yields - Moving Olympic average
- Using assumptions made by others
7Ad Hoc Modeling Approaches
Naïve model Pt Pt-1 Linear trend Pt a0
a1(Year) Olympic average Pt Last 5 year
annual price, dropping high and low and calculate
the average of the remaining three years price.
All three approaches were shown last week to
perform poorly in markets exhibiting price
variability.
8Econometric Model Approach
- Capturing future supply/demand impacts on prices
and unit costs - Linkages to commodity policy
- Linkages to domestic economy
- Linkages to the global economy
9Crop Market Equilibrium
D
S
D
S
Price
S
D
- Supply consists of
- Beginning stocks
- Production
- Imports
Pe
- Demand consists of
- Industrial use
- Feed use
- Exports
- Ending stocks
Quantity
Qe
Page 45 in booklet
10Forecasting Future Commodity Price Trends
D
7
S
D a bP cYD eX
4
Own price
Other factors
Disposable income
1
10
Page 45 in booklet
11Forecasting Future Commodity Price Trends
D
7
S
Own price
Input costs
Other factors
4
S n mP rC sZ
1
10
Page 46 in booklet
12Projecting Commodity Price
D
7
S
D 10 6P .3YD 1.2X
D S
4
S 2 4P .2C 1.02Z
1
10
Substitute the demand and supply equations into
the the equilibrium condition and solve for price
Page 46 in booklet
13Stress Testing Your Forecast
14Point Forecast Assumptions
Assumes perfect knowledge of outcomes in all 5
areas!!!!
PE
QE
Page 47 in booklet
15Structural Pro Forma Analysis
Supply-side risk for a given price
PE
Page 47 in booklet
QLQEQH
16Structural Pro Forma Analysis
Demand and supply-side risk and potential price
variability
PH PE PL
QE
Page 47 in booklet
172.50 3.00
3.50
Triangular Probability Distribution
Page 131 in booklet
18Conclusions
- Econometric models preferred over naïve models
and linear time trend models. - Much more accurate.
- Provide much more information (e.g.,
elasticities). - Allow for sensitivity analysis with independent
(exogenous) variables when evaluating potential
variability about expected trends.
19NCF Summary
20Page 74 in booklet
21Allowing for unequal annual net cash flows.
Page 79 in booklet
22Allowing for unequal discount rates
Page 63 in booklet
23Concept of Required Rate of Return
24Adjusting Discount Rate
- We said to date that the discount rate is the
firms opportunity rate of return. - Realistically we must allow for business risk by
including a business risk premium. - Realistically we must also allow for financial
risk by adding an additional financial risk
premium.
25Business Risk
- Risk associated with price of the product or
products you are producing. - Risk associated with the unit costs for the
inputs used in producing the product(s). - Risk associated with yields (productivity) in
production. - NCFiPi?yieldsi?unit sales Ci?unit inputs
26Accounting for Business Risk
RRRH,i
RRRL,i
RFREE,i
.05
RFREE,i risk free rate of return (i.e., govt.
bond rate) RRRL,i required rate of return for
lowly risk averse RRRH,i required rate of
return for highly risk averse
Page 132 in booklet
27Increasing Risk Over Time
Probability
Product price distribution
E(P)
Year 1
Year 1
Year 10
Year 10
2.95 3.05 3.15
Expected price
Pessimistic price
Optimistic price
28Increasing Risk Over Time
Probability
Product price distribution
E(P)
Year 1
Year 1
Year 10
Year 10
2.05 2.95
3.05 3.15 4.05
Expected price
Pessimistic price
Optimistic price
29Financial Risk
- Risk associated with low used borrowing capacity
(remember we captures this in the implicit cost
of capital). - Risk associated with increasing explicit cost of
debt capital relative to ROA. We discussed this
when analyzing the economic growth model - ROE (r i)L r(1 tx)(1 w)
30Accounting for Financial Risk
RRRi
RRRi
RFREE,i
.05
Page 138 in booklet
31Required Rate of Return
- For the purposes of this course, we will measure
the annual required rates of return based upon a
subjective methods. - Ask yourself what additional return you require
above a risk-free rate given your perceived
annual business risk. - Ask yourself what additional return you require
given existing leverage position. - RRRi Rfree,i Rbusiness,i Rfinancial,i
32One Strategy to Minimizing Risk Exposure
Page 140 in booklet
33The Portfolio Effect
NCFi
NCF with existing assets
NCF with new assets
Forecast horizon
34The Portfolio Effect
NCFi
Average annual NCF after making new investment.
Forecast horizon
This allows use to lower the business risk
premium associated with the calculated the NPV
for the new investment project. Exchanging stable
profits for lowering exposure to risk.
35Our Final NPV Model
36Allowing for unequal annual net cash flows and
required rates of return.
Page 63 in booklet
37Our Complete NPV Capital Budgeting Model
Discounted NCF in year 1
NPV NCF11/(1RRR1)
NCF21/(1RRR1)(1RRR2)
NCFn1/(1RRR1)(1RRR2)(1RRRn)
T1/(1RRR1)(1RRR2)(1RRRn) tx(T
C)1/(1RRR1)(1RRR2)(1RRRn)
Discounted NCF in year 2
Discounted NCF in year n
Discounted terminal value
Discounted capital gains tax
Decision rule
NPV gt 0 suggests project is economically
feasible NPV 0 suggests indifference NPV lt 0
suggests project is economically infeasible
38Ranking Investment Opportunities
39Page 106 in booklet
40Page 106 in booklet
41Page 107 in booklet
42Page 107 in booklet
43Page 108 in booklet
44Borrowing planning
- Up to date financial statements.
- Demonstrate trends in key financial ratios
including debt repayment coverage. - Pro forma master budget before and after proposed
investment, including the line of credit or LOC. - Do sensitivity analysis.
- Demonstrate feasibility of investment plans by
using NPV capital budgeting using stress testing
and incorporation of risk.
45Team Presentations
- We said in the syllabus at the start of the
semester that the class will be divided into
teams of 4 students. - Half of the teams will be borrowers either
starting a new business or expanding one. - The other teams will be lenders deciding whether
or not to lend to the borrowing teams. - The material covered thus far has dealt with
analyses borrowing teams can employ in justifying
an application for a loan. - The second half of this course will focus on loan
and portfolio analysis techniques to be employed
by each of the lending teams.
46Both Sides of the Desk
- The borrower
- Enterprise analysis
- Cash management
- Line of credit needs
- Operating loan application
- Investment planning
- Term loan application
- Planning for long run
Coverage thus far this semester
47Both Sides of the Desk
- The borrower
- Enterprise analysis
- Cash management
- Line of credit needs
- Operating loan application
- Investment planning
- Term loan application
- Planning for long run
- The lender
- Loan application analysis
- Credit scoring
- Loan pricing for risk
- Loan approval process
- Loan portfolio analysis
- Loan loss reserves
- Regulatory oversight
- Lending institutions serving
- commercial agriculture and
- rural businesses.
After mid-term exam