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Pro Forma Summary

Pro Forma Summary. AGEC 489-689 Spring 2010. 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.

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Pro Forma Summary

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  1. Pro Forma Summary AGEC 489-689Spring 2010

  2. 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

  3. Remember the definition of annual net cash flows Page 74 in booklet

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

  5. Alternative Forecasting Approaches

  6. 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

  7. 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. All three approaches were shown last week to perform poorly in markets exhibiting price variability.

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. Stress Testing Your Forecast

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

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

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

  17. $2.50 $3.00 $3.50 Triangular Probability Distribution Page 131 in booklet

  18. 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.

  19. NCF Summary

  20. Page 74 in booklet

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

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

  23. Concept of Required Rate of Return

  24. 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 business risk premium. • Realistically we must also allow for financial risk by adding an additional financial risk premium.

  25. 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

  26. 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

  27. 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

  28. Increasing Risk Over Time Probability Product price distribution E(P) Year 1 Year 10 Year 1 Year 10 $2.05 $2.95 $3.05 $3.15 $4.05 Pessimistic price Expected price Optimistic price

  29. 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)

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

  31. 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

  32. One Strategy to Minimizing Risk Exposure Page 140 in booklet

  33. The Portfolio Effect NCFi NCF with existing assets NCF with new assets Forecast horizon

  34. 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.

  35. Our Final NPV Model

  36. Allowing for unequal annual net cash flows and required rates of return…. Page 63 in booklet

  37. Our Complete NPV Capital Budgeting Model Discounted NCF in year 1 NPV = NCF1[1/(1+RRR1)] + NCF2[1/(1+RRR1)(1+RRR2)] + … + NCFn[1/(1+RRR1)(1+RRR2)…(1+RRRn)] + T[1/(1+RRR1)(1+RRR2)…(1+RRRn)] – tx(T – C)[1/(1+RRR1)(1+RRR2)…(1+RRRn)] Discounted NCF in year 2 Discounted NCF in year n Discounted terminal value Discounted capital gains tax Decision rule: NPV > 0 suggests project is economically feasible NPV = 0 suggests indifference NPV < 0 suggests project is economically infeasible

  38. Ranking Investment Opportunities

  39. Page 106 in booklet

  40. * * Page 106 in booklet

  41. * * Page 107 in booklet

  42. Page 107 in booklet

  43. Page 108 in booklet

  44. Borrowing 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.

  45. Team 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.

  46. 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

  47. 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

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