2. Course Summary at Mid-Term LESE 306 Fall 2009

3. Slide Show #1

4. Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farms and Ranches The scope of a nation’s Food and fiber industry The scope of a nation’s Food and fiber industry

5. General Domestic Economy Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farms and Ranches

6. Domestic Macro Policy General Domestic Economy Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farms and Ranches

7. Domestic Macro Policy General Domestic Economy Global Macro Policy Global Economy Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farms and Ranches

8. Domestic Macro Policy General Domestic Economy Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farm Policy Farms and Ranches Environmental Policy Global Macro Policy Global Economy

9. Domestic Macro Policy General Domestic Economy Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farm Policy Farms and Ranches Environmental Policy Global Macro Policy Global Economy Farm Credit Markets Farm and Non-Farm Labor Markets

10. Domestic Macro Policy General Domestic Economy Important Market Linkages Farm Input Supply Sectors Food Processing And Fiber Manufacturing Sectors Whole And Retail Trade Sectors Farm Policy Farms and Ranches Environmental Policy Global Macro Policy Global Economy Key point: Because farmers and ranchers are price takers in product, input, labor and credit markets, they are susceptible to trends in these other markets. Key point: Because farmers and ranchers are price takers in product, input, labor and credit markets, they are susceptible to trends in these other markets. Farm Credit Markets Farm and Non-Farm Labor Markets

11. Slide Show #2

12. Accounting Fundamentals Accounting Fundamentals Structure of Financial Statements Agribusiness Finance LESE 306 Fall 2009

13. Basic Structure of the Balance Sheet Assets:Liabilities and Net Worth: Current assetsCurrent liabilities plus Long term assetsplus Long term liabilities plus Net worth equals Total assetsequals Total liabilities and net worth Assets:Liabilities and Net Worth: Current assetsCurrent liabilities plus Long term assetsplus Long term liabilities plus Net worth equals Total assetsequals Total liabilities and net worth Often referred to as equity Often referred to as equity Page 3 in booklet

14. Balance Sheet Structure Net worth or equity is determined residually, balancing the statement

15. Basic Structure of Income Statement Cash receipts from product sales Minus Operating and interest expenses Equals Net cash income from operations Plus Gain (loss) on sale of long term assets Plus Cash subsidies received Less Depreciation allowances Equals Income (loss) before taxes Minus Provision for income taxes Equals Net income Cash receipts from product sales Minus Operating and interest expenses Equals Net cash income from operations Plus Gain (loss) on sale of long term assets Plus Cash subsidies received Less Depreciation allowances Equals Income (loss) before taxes Minus Provision for income taxes Equals Net income Page 4 in booklet

16. Income Statement Structure

17. Basic Structure of Cash Flow Statement Cash available (including cash balance) Minus Cash required Equals Cash available less cash required Plus Available savings withdrawals Equals Cash position Plus Net borrowing Minus Other uses of cash Minus Withdrawals of cash to savings Equals Ending cash balance Cash available (including cash balance) Minus Cash required Equals Cash available less cash required Plus Available savings withdrawals Equals Cash position Plus Net borrowing Minus Other uses of cash Minus Withdrawals of cash to savings Equals Ending cash balance Page 5 in booklet

18. Cash Flow Statement - 1

19. Cash Flow Statement -2 Need for draw on an LOC in May. Repaid loan in July. Need for draw on an LOC in May. Repaid loan in July.

20. Cash Flow Statement -3

21. Cash Flow Statement -4 Producer drew down an LOC In months of May and June and repaid balance in July Producer drew down an LOC In months of May and June and repaid balance in July Value of ending cash balance In the balance sheet Value of ending cash balance In the balance sheet

22. Statement Linkages Data from cash flow statement to income statement: 1.Cash receipts from operations 2.Cash operating expenses 3.Other cash items (e.g., interest payments, property taxes, etc.) Cash flow statement Income statement

23. Statement Linkages Data from cash flow statement to balance sheet: 1.Ending cash balance 2.Loan balances (current liability portion vs. remaining balance outstanding) 3.Asset adjustments if capital expenditures are made 4.Additions and withdrawals from savings Cash flow statement Income statement Balance Sheet

24. Slide Show #3

25. Key Financial Indicators Agribusiness Finance LESE 306 Fall 2009

26. Key Financial Indicators Measures of asset liquidity  See equations 1 and 2 on page 12 of booklet Measures of solvency  See equations 3, 4, 5 and 6 on page 13 of booklet Measures of after-tax profitability  See equations 7, 8 and 9 on page 13 of booklet Measures of economic efficiency  See equations 10, 11, 12, 13 and 14 on page 14 of booklet Measures of debt repayment capacity  See equations 15 – 17 on page 15 of booklet

27. Measures of Asset Liquidity Current ratio 1. Current ratio: divided by Current assets divided by current liabilities. Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over. exceed 1.0 Should exceed 1.0 to be technically liquid. Some firms fail despite exceeding this hurdle. Working capital 2. Working capital: minus Current assets minus current liabilities. Expresses liquidity in dollars rather than ratio. Should be positive. Cash is King!

28. Balance Sheet Structure.725 = illiquid Current ratio = $57,314 / $79,000 =.725 = illiquid -21,686 = illiquid Working capital = $57,314 - $79,000 = -21,686 = illiquid.725 = illiquid Current ratio = $57,314 / $79,000 =.725 = illiquid -21,686 = illiquid Working capital = $57,314 - $79,000 = -21,686 = illiquid

29. Measures of Credit Liquidity Unused credit reserves 1. Unused credit reserves: LOC extended by lender less current loans on LOC. The unused portion of your credit limit on your personal credit card is an example of credit liquidity. Demonstrates ability to cover scheduled current liabilities for the coming year out existing available credit. positive Should positive to be technically liquid. We will cover the implicit cost of credit liquidity later in the course.

30. Cash Flow Statement -4 credit liquidity is $89,155 in May and June ($100,000 - $10,845). If the lender is willing to extend a maximum LOC of $100,000, the unused line of credit or credit liquidity is $89,155 in May and June ($100,000 - $10,845). Producer drew down an LOC In months of May and June and repaid balance in July Producer drew down an LOC In months of May and June and repaid balance in July

31. Measures of Cash Flow Liquidity Monthly cash position 1. Monthly cash position: Monthly cash position (surplus of cash available less cash required) on the firm’s monthly cash flow statement. Demonstrates ability to cover scheduled current liabilities for a particular month out expected surplus cash position. positive Should positive to be technically liquid. Knowledge of the firm’s cash flow liquidity requires that the firm maintain a monthly cash flow statement.

32. Cash Flow Statement - 1 cash flow liquidity The firm has cash flow liquidity until April when it must draw on LOC

33. Measures of Solvency Debt ratio 1. Debt ratio: Total debt divided by total assets. Demonstrates ability to liquidate the firm, pay off all liabilities from the net proceeds from the sale of all assets, and still have “cash” left over. not exceed 0.50 Should not exceed 0.50 to minimize financial risk exposure. Some firms fail however at lower levels. Leverage ratio 2. Leverage ratio: Total debt divided by equity or net worth. Often a credit standard in loan approval decisions. not exceed 1.0 Should not exceed 1.0 to minimize financial risk exposure. Effects of rising interest rates.

34. Balance Sheet Structure debt ratio.45 which is less than 0.50 The debt ratio = $329,000 / $727,314 =.45 which is less than 0.50 leverage ratio.826 which is less than 1.0 The leverage ratio = $329,000 / $398,314 =.826 which is less than 1.0 debt ratio.45 which is less than 0.50 The debt ratio = $329,000 / $727,314 =.45 which is less than 0.50 leverage ratio.826 which is less than 1.0 The leverage ratio = $329,000 / $398,314 =.826 which is less than 1.0

35. Measures of Profitability Rate of return on assets 1. Rate of return on assets: Net income plus interest divided by total assets. Demonstrates the after-tax return to the total capital invested in the firm. positive Should be positive; the higher the better. Rate of return on equity 2. Rate of return on equity: Net income divided equity. Demonstrates the after-tax return on owner equity invested in the firm. positive Should be positive; the higher the better.

36. Income Statement Structure ROA= 0.082 or 8.2% The ROA = (9,655 + $50,000) / $727,314 = 0.082 or 8.2% ROE= 0.024 or 2.4% The ROE = 9,655 / $398,314 = 0.024 or 2.4% ROA= 0.082 or 8.2% The ROA = (9,655 + $50,000) / $727,314 = 0.082 or 8.2% ROE= 0.024 or 2.4% The ROE = 9,655 / $398,314 = 0.024 or 2.4%

37. Measure of Debt Repayment Capacity Term Debt and Capital Lease Coverage Ratio 1. Term Debt and Capital Lease Coverage Ratio: Cash available from operations to cover scheduled payments (net income plus depreciation and term loan interest payments less withdrawals) divided by scheduled principal and interest payments on term loans and capital leases measures the after- tax cash coverage ratio. After provision for taxes and withdrawals. greater than 1.0 Should be greater than 1.0. Non-farm income often factored in by lenders. Debt Burden Ratio 2. Debt Burden Ratio: Total debt outstanding divided by net income. Number of years required to retire total debt if net income remains constant and used entirely for this purpose low Should be low; the lower the better.

38. Debt Coverage The debt coverage ratio of 1.20 exceeds the minimum of 1.0

39. Slide Show #4

40. Financial Check Up Agribusiness Finance LESE 306 Fall 2009

41. What is the status of your…. Liquidity? Solvency? Profitability? Efficiency? Debt repayment capacity? Survivability?

42. Liquidity Trends Survived Failed Minimum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

43. Liquidity Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

44. Solvency Trends Survived Failed Maximum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

45. Debt Repayment Coverage Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Inverse of debt burden ratio assuming use of depreciation allowances to retire debt.

46. Some Conclusions….  Indicators of growth/survival:  Increasing liquidity  Increasing solvency  Increasing debt repayment capacity  Increasing profitability  Indicators of potential failure:  Declining liquidity  Declining solvency  Decreasing debt repayment capacity  Decreasing profitability

47. #1:Historical Analysis A look backwards like the Beaver study. Comparison of current performance with past performance. Recommend doing this at the enterprise level as well as for the farm as a whole. Why is ROA falling? Why is ROA falling?

48. #2:Comparative Analysis Comparing current performance with similar operations like the Beaver study. Benchmark analysis at enterprise level when possible. before it is too late Address reasons why your firm is performing more poorly than other comparable operations before it is too late. Benchmark

49. #3:Pro Forma Analysis Stress testing Stress testing current expected cash flows by varying prices, unit costs and yields. future financial health Look at implications of longer run price and unit cost trends on future financial health when making major decisions.

50. Slide Show #5

51. Enterprise Level Analysis Topics Agribusiness Finance LESE 306 Fall 2009

52. Relationship Between Enterprise and Master Budgets

53. Enterprise #1 Design of an Enterprise budget. Construct budget for all enterprises, multiply times level of activity and check overhead to ABC approach. Overhead:

54. Contribution Analysis

55. Slide Show #6

56. Intro to Master Budget Agribusiness Finance LESE 306 Fall 2009

57. #3:Pro Forma Analysis Stress testing Stress testing current expected cash flows by varying prices, unit costs and yields. future financial health Look at implications of longer run price and unit cost trends on future financial health when making major decisions.

58. Master Budget Preparation Annual operating budgets Annual operating budgets 1.Sales budget: number of units to be sold 2.Production budget: expected output and inventory 3.Direct materials budget: planned material use 4.Direct labor budget: planned labor use 5.Other budgets: expected selling and administrative 6.Needed to prepare the cash budget Other annual budgets and statements Other annual budgets and statements 1.Capital expenditure budget 2.Needed to prepare budgeted cash flow statement 3.Needed to prepare budgeted income statement 4.Needed to prepare budgeted year end balance sheet

59. Sales Budget Production Budget Direct Materials Budget Direct Materials Budget Direct Labor Budget Direct Labor Budget Overhead Budget Overhead Budget Selling and Administrative Expense Budget Selling and Administrative Expense Budget Budgeted Income Statement Budgeted Income Statement Budgeted Cash Flow Statement Budgeted Balance Sheet Budgeted Balance Sheet Pro Forma Financial Statements Capital expenditures Capital expenditures Cash Budget

60. Sources of Uncertainty Global trends in production and consumption Energy prices and core inflation trends Interest rates and exchange rates Changes in industry subsidies

61. Accounting for Uncertainty Stress testing product prices Stress testing unit input prices like fuel costs Stress testing yields Stress test interest rates

62. Slide Show #7

63. Cost Accounting An Overview

64. Managerial Cost Concepts 1.Direct materials 1.Direct materials: raw materials physically associated with the final product 2.Direct labor 2.Direct labor: employees physically and directly associated with the final product 3.Overhead 3.Overhead: costs indirectly associated with the final product

65. More Concepts 1.Period costs 1.Period costs: costs matched with revenue for a specific time period. (i.e., net income for a specific period (i.e., quarterly, annual). 2.Product costs 2.Product costs: costs associated with producing the final product. Not considered an expense until the product is sold. 3.Total costs 3.Total costs: equals direct materials, direct labor and manufacturing overhead plus indirect costs (selling and administrative expenses).

66. Sales Budget Production Budget Direct Materials Budget Direct Materials Budget Direct Labor Budget Direct Labor Budget Overhead Budget Overhead Budget The Master Budget and Pro Forma Financial Statements Enterprise #1 Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead Enterprise #n Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead

67. Total Costs Production Costs Manufacturing Costs DirectMaterialsDirectMaterials SellingExpensesSellingExpenses Period Costs Non-manufacturing Costs DirectLaborDirectLabor AdministrativeExpensesAdministrativeExpenses ManufacturingOverheadManufacturingOverhead Other Indirect Expenses Expenses

68. Three Cost Accounting Concepts 1. Process cost accounting 2. Job order cost accounting 3. Activity based cost accounting

69. 1. Process Cost Accounting a specific process Tracking costs associated with a specific process Direct materials and labor associated with the specific process Manufacturing overhead costs associated with the specific process

70. Comparison of Cost Systems Features Process Cost System Work in process accounts Multiple work in process accounts Documents usedProduction cost reports Determination of total manf. costs Each period Unit-cost computations Total manf. costs/ units produced during the period

71. 2. Job Order Cost Accounting specific order or job Tracking costs associated with a specific order or job Direct materials and labor associated with a specific order or job Manufacturing overhead costs associated with a specific order or job

72. Comparison of Cost Systems Features Process Cost System Job Order Cost System Work in process accounts Multiple work in process accounts One work in process account Documents usedProduction cost reports Job cost sheets Determination of total manf. costs Each periodEach job Unit-cost computations Total manf. costs/ units produced during the period Cost of each job/ units produced for the job

73. 3. Activity Based Cost Accounting An approach for allocating overhead. An activity is any event, action, transaction or work sequence that incurs when producing a product or providing a service. An activity cost pool is a distinct type of activity (e.g., ordering materials). A cost driver is any factor or activity that has a direct cause-effect relationship with resources consumed (e.g., machine hours).

74. Steps in ABC Accounting 1.Identify and classify activities and allocate overhead to cost pools. 2.Identify cost drivers – correlation between driver and use. 3.Compute overhead rates – ABC rate. 4.Assign overhead costs to products – use of cost drivers. 5.Comparison of unit total costs across products.

75. Step 2: Partitioning of process overhead: Overhead Product 1 Product 2 Setting up machines$300,000 $100,000$200,000 Machining$500,000 $300,000$200,000 Inspecting$100,000 $25,000 $75,000 Total$900,000 $425,000 $475,000 Step 3: Process overhead costs per unit: Units produced25,000 5,000 Process overhead cost per unit $17 $95 Traditional process overhead cost per unit* $30 $30 * $900,000 divided by 30,000 units Avoids overstating profitability of some enterprises and understating profitability of others Example of ABC Accounting

76. Product 1 Product 2 COP unit costs with ABC costing: Direct materials $40 $30 Direct labor $12 $12 ABC overhead $17 $95 Total unit costs $69 $137 COP unit costs with traditional costing: Direct materials $40 $30 Direct labor $12 $12 Traditional overhead * $30 $30 Total unit costs $82 $72 * $900,000 divided by 30,000 units Traditional overhead costing suggests that Product 2 is cheaper to produce than Product 1, which is not true! Example of ABC Accounting

77. Slide Show #12

78. Agribusiness Finance LESE 306 Fall 2009 DuPont model of Profit Analysis

79. DuPont Formula ROA can be broken down into profit margin and asset turnover. Gain an insight into planning for profit improvement. Need to improve the profit margin. Need to improve asset turnover. Need to improve both!!

80. Improving Profit Margin Reducing expenses:  Using less costly materials.  Automation to improve productivity.  Review fixed costs (advertising, R&D, management development programs, etc.). Raising prices:  Requires pricing power.  Also requires brand loyalty.  Easier for firms with unique high quality goods.

81. Improve Asset Turnover Increase sales while holding investment in assets relatively constant:  Dispose of obsolete and adopt technology that enhances productivity.  Speed up collections of receivables.  Evaluate credit terms and policies.  Identify unused and redundant fixed assets. Use idle cash to repay outstanding debts or invest in profit producing activities.

82. Work backwards to find constraint on ROA

83. Analyzing DuPont Formula strong operating management 1. A high net profit margin or NPM signals strong operating management. strong asset management 2. A high total asset turnover ratio or TAT signals strong asset management. strong capital management 3. A high equity multiplier or EM signals strong capital management in the presence of low and stable cost of debt capital.

84. Slide Show #13

85. Economic Growth Model Agribusiness Finance LESE 306 Fall 2009

86. Page 50 in booklet

87. Page 52 in booklet

88. Economic Growth Model ROE = [(r – i)L + r](1 – tx)(1 – w) Rate of return on assets Cost of debt capital Leverage ratio or debt/equity Income tax rate Rate of withdrawals from firm Page 58 in booklet

89. Economic Growth Model ROE = [(r – i)L + r](1 – tx)(1 – w) There are many applications of this model: 1.Solve for ROE given r, i, L, tx and w 2.Solve for required r given ROE, i, L, tx and w 3.Solve for maximum w for required ROE given r, i L and tx 4.Solve for maximum L for required ROE given r, i tx and w Basically we can treat this as one equation with one unknown and solve for that unknown value. This allows us to examine the effects internal and external constraints of specific internal and external constraints on the growth of the firm’s equity base. Page 58 in booklet

90. Slide Show #14

91. Cost of Capital and Optimal Capital Structure Agribusiness Finance LESE 306 Fall 2009

92. Page 101 in booklet

93. Page 102 in booklet

94. Page 103 in booklet

95. Slide Show #15

96. Time Value of Money Agribusiness Finance LESE 306 Fall 2009

97. 2009 2010 2011 2012 2013 ……. 2019 Time Value of Money… Assume it is the year 2009 and you have been given the choice of a single payment of $500 paid to you ten years from now (2019) or a payment of $300 today. Which would you choose?

98. Present Value Interest Factor (PIF) Table PIF r,n = (1 + r) -n Will be at the back of the mid-term test booklet

99. Page 59 in booklet I would take the $300 today since it has a higher present value, given my discount rate of 6%, than $500 ten years from now.

100. Page 59 in booklet

101. EPIF r,n = [1 – (1 / (1+ r) n )] / r Equal Payment Present Value Interest Factor (EPIF) Table Will be at the back of the mid-term test booklet

102. Page 60 in booklet

103. Page 62-63 in booklet Know how to manipulate this equation

104. Page 63 in booklet

105. Page 65-66 in booklet Know equations 40, 44 and 45

106. Slide Show #16

107. Capital Budgeting Methods Agribusiness Finance LESE 306 Fall 2009

108. Page 65 in booklet

109. Page 66 in booklet

110. Page 67 in booklet NPV > 0 suggests project is economically feasible NPV = 0 suggests indifference NPV < 0 suggests project is economically infeasible

111. Page 68 in booklet

112. Pages 68-69 in booklet * *

113. Page 69 in booklet

114. *

115. Page 72 in booklet

116. Page 73 in booklet * *

117. Page 76 in booklet

118. Page 77 in booklet

119. Page 78 in booklet Set NPV equal to zero and solve for T, the terminal value. *

120. Page 80 in booklet *

121. G is the expected rate of appreciation *

122. Page 81 in booklet *

123. Capital gains tax rate is 25% Capital gains tax rate is 25% 7% land value appreciation rate 7% land value appreciation rate 5% discount rate Comparable land values Comparable land values Equal net cash flows 20 year economic life

124. Page 82 in booklet *

125. Slide Show #17

126. Pro Forma Analysis Agribusiness Finance LESE 306 Fall 2009

127. PASTFUTURE PRESENT  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

128. Page 83 in booklet Must project Annual price Must project Annual price Must project Annual yield Must project Annual yield

129. 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

130. Naïve model: P t = P t-1 Linear trend: P t = a 0 + a 1 (Year) Olympic average: P t = Last 5 year annual price, dropping high and low and calculate the average of the remaining three year’s price. Ad Hoc Modeling Approaches

131. 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

132. Crop Market Equilibrium D S D S Quantity Price PePe QeQe D S Demand consists of: -Industrial use -Feed use -Exports -Ending stocks Demand consists of: -Industrial use -Feed use -Exports -Ending stocks Supply consists of: -Beginning stocks -Production -Imports Supply consists of: -Beginning stocks -Production -Imports Page 45 in booklet

133. Projecting Commodity Price D = S D S $4 10 $1 $7 D = 10 – 6P +.3YD + 1.2X S = 2 + 4P –.2C + 1.02Z Substitute the demand and supply equations into the the equilibrium condition and solve for price Substitute the demand and supply equations into the the equilibrium condition and solve for price Page 46 in booklet

134. Stress Testing Your Forecast

135. PEPE QEQE Assumes perfect knowledge of outcomes in all 5 areas!!!! Point Forecast Assumptions Page 47 in booklet

136. Demand and supply- side risk and potential price variability… QLQEQHQLQEQH PHPEPLPHPEPL Structural Pro Forma Analysis Page 47 in booklet

137. Triangular Probability Distribution $2.50 $3.00 $3.50 Page 130 in booklet 10% 80%

138. Conclusions Econometric models preferred over naïve models and linear time trend models. Much more accurate. elasticities Provide much more information (e.g., elasticities). sensitivity analysis potential variability Allow for sensitivity analysis with independent (exogenous) variables when evaluating potential variability about expected trends.

139. Business Risk price Risk associated with price of the product or products you are producing. unit costs Risk associated with the unit costs for the inputs used in producing the product(s). yields Risk associated with yields (productivity) in production. NCF i =P i  yields i  unit sales – C i  unit inputs

140. Accounting for Business Risk R FREE,i = risk free rate of return (i.e., govt. bond rate) RRR L,i = required rate of return for lowly risk averse RRR H,i = required rate of return for highly risk averse R FREE,i RRR L,i RRR H,i.05 Page 132 in booklet

141. Increasing Risk Over Time Expected price Expected price E(P) Year 1 Year 10 Pessimistic price Pessimistic price Optimistic price Optimistic price Product price distribution Product price distribution $2.95 $3.05 $3.15 Probability 5% 90%

142. Increasing Risk Over Time Expected price Expected price E(P) Year 1 Year 10 Pessimistic price Pessimistic price Optimistic price Optimistic price Product price distribution Product price distribution $2.05 $2.95 $3.05 $3.15 $4.05 Probability 20% 60%

143. 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)

144. Accounting for Financial Risk R FREE,i RRR i.05 Page 138 in booklet

145. 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. RRR i = R free,i + R business,i + R financial,i

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

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

148. Forecast horizon NCF i Average annual NCF after making new investment. The Portfolio Effect 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.

149. Ranking Investment Opportunities

150. Page 106 in booklet How would you rank these alternative projects?

151. Page 106 in booklet * *

152. Page 107 in booklet * *

154. 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.