Pro Forma Summary AGEC 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. 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

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

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

Alternative Forecasting Approaches

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

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

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

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

Forecasting Future Commodity Price Trends D S $4 10 $1 $7 D = a – bP + cYD + eX Own price Own price Disposable income Disposable income Other factors Other factors Page 45 in booklet

D S $4 10 $1 $7 S = n + mP – rC + sZ Own price Own price Input costs Input costs Forecasting Future Commodity Price Trends Other factors Other factors Page 46 in booklet

Projecting Commodity Price D = S D S $4 10 $1 $7 D = 10 – 6P +.3YD + 1.2X S = 2 + 4P –.2C Z 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

Stress Testing Your Forecast

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

Supply-side risk for a given price… QLQEQHQLQEQH PEPE Structural Pro Forma Analysis Page 47 in booklet

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

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

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.

NCF Summary

Page 74 in booklet

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

Page 63 in booklet Allowing for unequal discount rates…

Concept of Required Rate of Return

Adjusting Discount Rate We said to date that the discount rate is the firm’s opportunity rate of return. business risk Realistically we must allow for business risk by including a business risk premium. financial risk Realistically we must also allow for financial risk by adding an additional financial risk premium.

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

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

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

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

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)

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

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

One Strategy to Minimizing Risk Exposure Page 140 in booklet

Forecast horizon NCF i NCF with existing assets NCF with new assets The Portfolio Effect

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.

Our Final NPV Model

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

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:

Ranking Investment Opportunities

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Borrowing planning 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.

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.

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

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