Lecture 21-2 Building Financial Models Material for Lecture 21-2 –Read Chapters 13 and 14 –Lecture 21 Pro Forma.xlsx –Lecture 21 Fin Risk Manager.xlsx –Lecture 21 Farm Simulator.xlsx –Lecture 21 Income Taxes.xlsx

Step 1: KOVs What question is to be answered? –Net cash income? –Cash flow? –Change in net worth? –Number of years for the analysis? –Something else?

Step 2: Financial Statements Based on the purpose of the model what calculations are required? –Net cash income – detailed income statement Sources of all receipts and expenses Usually an annual model –Cash flow model – income and cash flow statements Details for cash outflows Requires a multi-year model –NPV or Net Worth – income, cash flow and balance sheet Multi-year models

Step 3: Income Statement All sources of receipts –Show receipts by enterprise and type (government, insurance, sales, etc. All sources of CASH expenses –Show cash costs for each enterprise –Show fixed costs in detail (taxes, insurance, etc) –Show each interest expense, by loan Net cash income = receipts – expenses

Step 4: Cash Flow Statement All sources of cash inflows –Start with beginning cash from t-1 –Net cash income –Interest earnings from cash reserves –Total inflows of cash All sources of cash outflows –Owner salary and bonus or dividends for corp. –Income taxes, principal payments paid –Down payments for machinery & livestock –Total outflows of cash Ending cash = Inflows - Outflows

Step 5: Balance Sheet Assets –Beginning cash January 1 nonzero IF (ending cash t > 0) –Land, machinery, livestock market values –Total assets Liabilities –Cash flow deficit loans IF (ending cash t <0) –Liabilities for land, machinery, livestock –Total liabilities Net worth = Assets - Liabilities

Step 6: KOVs Net present value = -Beginning Net Worth + ∑( dividends or cash withdrawals /(1+i) t ) + Ending Net Worth T / (1+i) t P(Economic Success) P(Ending Cash t > 0) P(Net Cash Income t > 0) P(Increasing Real Net Worth) P(Benefit to Cost Ratio > 1.0) Number of Years to Payoff Many others

Building the Model Stochastic worksheet –Gather historical data for all stochastic variables –Develop forecasts of random variables –Estimate parameters for alternative distributions and select the best dist. for each variable –Determine whether multivariate or univariate –Simulate the random variables for all years using stochastic forecasts of the random variables –Validate the random variables

Program Equations in the Model Use the stochastic values in the appropriate equations to calculate intermediate variables Start by programming the equations that will go into the Income Statement, eg. –Receipts t = ∑(Price it * Yield it * Acres it ) for i crops and each year t

Assemble the Financial Tables Use cell references to map calculated values above into the financial statements The only calculated equations in the financial tables should be –Totals –Operating interest expense –Interest for carryover cash flow deficit loans –Dividends or cash withdrawal bonus –IF statements to deal with ending cash in the Balance Sheet

What Was Left Out of the Model? Non-cash expenses –Unpaid family labor –Depreciation Two kinds of depreciation –Income tax deductions –Decreases in market value (this is included in the balance sheet as we use market value of assets) Depreciation can be subtracted from net cash income to calculate net income. Has no place in a cash model

Organization of a Model Model worksheet –All input data at the top so you can see the assumptions and easily make changes –Equations for all intermediate financial variables –Pro Forma Financial tables –Debt amortization tables –Income tax schedules and calculations Stoch worksheet All forecasting and parameter estimation work with validation summaries

Demonstrate Model Development

Multi-Year Financial Models – Applications Financial risk management –Analysis of the economic impact of changes in the business plan for a firm on Ability to repay loans on time Ability to remain solvent Ability to earn a satisfactory rate of return on investment –Analysis of alternative marketing schemes that use contracts, futures and options to manage price risk Testing Portfolios –Analysis of alternative combinations of investment instruments (stocks, bonds, land, etc.) –Analyze enterprise mixes –A portfolio of investments is similar to a derivative in the investment world

Financial Risk Management Uses of this type of model –Test ability of firm to repay operating debt under alternative assumptions about Other income Family/dividend withdrawal assumptions Machinery replacement plans Re-financing the initial machinery loans Insurance, pricing, and marketing options for the crops Farm program provisions Costs of production including rental rates for land Purchasing land rather than leasing Users of this type of model –Lenders concerned about loan solvency –Borrowers concerned about impacts of growth or adding a family member