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Pro Forma Analysis

Pro Forma Analysis. Agribusiness Finance LESE 306 Fall 2009. 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

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Pro Forma Analysis

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  1. Pro Forma Analysis Agribusiness FinanceLESE 306 Fall 2009

  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

  3. 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

  6. Must project Annual yield Must project Annual price Page 85 in booklet

  7. Alternative Forecasting Approaches

  8. Ad Hoc Modeling Approaches • Naïve model – using last year’s prices, costs and yields • Simple linear trend extrapolation of historical prices, costs and yields • Moving Olympic average • Using assumptions made by others

  9. 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 year’s price.

  10. Page 94 in booklet

  11. Page 94 in booklet

  12. Page 95 in booklet

  13. 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

  14. 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….

  15. D D S S Crop Market Equilibrium 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

  16. 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

  18. 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

  19. 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: ΣQd,i = ΣQs,i

  20. An Example

  21. Historical Data on Fixed Input Sales to Farmers

  22. Econometric Analysis Based on Time Trend Extrapolation It = f(Yeart)

  23. A linear time trend projection of future farm machinery and equipment sales therefore does a poor job of predicting future sales activity.

  24. Econometric Analysis Based on Investment Theory It = f{[E(Pt)×E(Qt)]/E(ct)} Incorporates the economic concepts of MVP and MIC

  25. An econometric model based on investment theory does a muchbetter job of predicting future sales activity.

  26. Another Example

  27. Estimating the Annual Supply and Use of Wheat

  28. Econometric Analysis – Food Use Own price elasticity Income elasticity Cross price elasticity

  29. Observed and Predicted Values For Wheat Food Use

  30. 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 (QD=QS) and solve for the price whereexcess demand equals zero.

  31. Stress Testing Your Forecast

  32. Point Forecast Assumptions Assumes perfect knowledge of outcomes in all 5 areas!!!! PE QE Page 47 in booklet

  33. Structural Pro Forma Analysis Supply-side risk for a given price… PE Page 47 in booklet QLQEQH

  34. Structural Pro Forma Analysis Demand and supply-side risk and potential price variability… PH PE PL QLQEQH Page 47 in booklet

  35. A 48 percent chance that the price of wheat will be less than $4.16 Page 85 in booklet

  36. Potential Variability in Wheat Price 2008/09 MY Given Historical Variability in Growing Conditions Ratings Page 96 in booklet

  37. Page 93 in booklet

  38. $2.50 $3.00 $3.50 Triangular Probability Distribution Page 131 in booklet

  39. 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.

  40. NCF Summary

  41. Page 74 in booklet

  42. Page 82 in booklet

  43. G is the expected rate of appreciation Page 82 in booklet

  44. Allowing for unequal annual net cash flows…. Page 79 in booklet

  45. Allowing for unequal discount rates… Page 63 in booklet

  46. Concept of Required Rate of Return

  47. Adjusting Discount Rate • We said to date that the discount rate is the firm’s 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.

  48. 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. • NCFi=Piyieldsiunit sales – Ciunit inputs

  49. 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

  50. Increasing Risk Over Time Probability Product price distribution E(P) Year 1 Year 1 Year 10 Year 10 $2.95 $3.05 $3.15 Pessimistic price Expected price Optimistic price

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