Pro Forma Analysis

1
Pro Forma Analysis
AGEC 489-689Spring 2010
2
PRESENT
PAST
FUTURE

• Historical analysis
• Comparative analysis
• Historical price and
• yield trends

• Pro forma analysis
• Forming expectations about future prices, costs
  and productivity
• Ad hoc extrapolations
• Projections based upon available outlook data
• Projections based upon econometric analysis

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Timeline 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
4
Timeline 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
5
Remember the definition of annual net cash flows
Page 74 in booklet
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Must project Annual price
Must project Annual yield
Page 85 in booklet
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Alternative Forecasting Approaches
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Ad 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

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Ad 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.
10
Page 94 in booklet
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Page 94 in booklet
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Page 95 in booklet
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Econometric 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

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Concept of Derived Demand for Farm Machinery
The demand for farm machinery is driven by the
expected net economic benefit from use of the
machine.
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Crop 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
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Forecasting 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
17
Forecasting 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
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Projecting 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
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The Market Model
Demand equations Qd,i a0 - a1(Price) ? ai
(demand shifters) Supply equation Qs,i b0
b1(price) ? bi (supply shifters) Market
equilibrium SQd,i SQs,i
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An Example
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Historical Data on Fixed Input Sales to Farmers
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Econometric Analysis Based on Time Trend
Extrapolation
It f(Yeart)
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A linear time trend projection of future farm
machinery and equipment sales therefore does a
poor job of predicting future sales activity.
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Econometric Analysis Based on Investment Theory
It fE(Pt)E(Qt)/E(ct)
Incorporates the economic concepts of MVP and MIC
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An econometric model based on investment theory
does a much better job of predicting future sales
activity.
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Another Example
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Estimating the Annual Supply and Use of Wheat
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Econometric Analysis Food Use
Own price elasticity
Income elasticity
Cross price elasticity
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Observed and Predicted Values For Wheat Food Use
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Remaining Steps to Forecasting the Price of
Commodity

• Develop similar econometric equations for the
  other uses of wheat (feed use, exports and ending
  stock).
• Develop econometric equations for production and
  import supply.
• Substitute the estimated equations into the
  market equilibrium definition (QDQS) and solve
  for the price where excess demand equals zero.

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Stress Testing Your Forecast
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Point Forecast Assumptions
Assumes perfect knowledge of outcomes in all 5
areas!!!!
PE
QE
Page 47 in booklet
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Structural Pro Forma Analysis
Supply-side risk for a given price
PE
Page 47 in booklet
QLQEQH
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Structural Pro Forma Analysis
Demand and supply-side risk and potential price
variability
PH PE PL
QLQEQH
Page 47 in booklet
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A 48 percent chance that the price of wheat will
be less than 4.16
Page 85 in booklet
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Potential Variability in Wheat Price 2008/09 MY
Given Historical Variability in Growing
Conditions Ratings
Page 96 in booklet
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Page 93 in booklet
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2.50 3.00
3.50
Triangular Probability Distribution
Page 131 in booklet
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Conclusions

• 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.

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NCF Summary
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Page 74 in booklet
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Page 82 in booklet
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G is the expected rate of appreciation
Page 82 in booklet
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Allowing for unequal annual net cash flows.
Page 79 in booklet
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Allowing for unequal discount rates
Page 63 in booklet
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Concept of Required Rate of Return
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Adjusting 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 risk premium.
• Realistically we must also allow for financial
  risk by adding an additional risk premium.

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Business 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

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Accounting 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
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Increasing 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
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Increasing 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
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Financial 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)

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Accounting for Financial Risk
RRRi
RRRi
RFREE,i
.05
Page 138 in booklet
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Required 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

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One Strategy to Minimizing Risk Exposure
Page 140 in booklet
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The Portfolio Effect
NCFi
NCF with existing assets
NCF with new assets
Forecast horizon
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The 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.
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Our Final NPV Model
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Allowing for unequal annual net cash flows and
required rates of return.
Page 63 in booklet
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Our Complete NPV Capital Budgeting Model
NPV NCF11/(1R1)
NCF21/(1R1)(1R2)
NCFn1/(1R1)(1R2)(1Rn)
T1/(1R1)(1R2)(1Rn) tx(T
C)1/(1R1)(1R2)(1Rn)
Discounted NCF in year 1
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
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Ranking Investment Opportunities
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Page 106 in booklet
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Page 106 in booklet
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Page 107 in booklet
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Page 107 in booklet
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Page 108 in booklet
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Borrowing Preparation

1. Up to date financial statements.
2. Demonstrate trends in key financial ratios
   including debt repayment coverage.
3. Pro forma master budget before and after proposed
   investment, including the line of credit or LOC.
4. Do sensitivity analysis.
5. Demonstrate feasibility of investment plans by
   using NPV capital budgeting using stress testing
   and incorporation of risk.

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Both 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
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Both 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