1. Materials for Lecture 19 Financial Models
New Material for Lecture 19
Read Chapters 13 and 14
Lecture 19 Pro Forma.xlsx
Lecture 19 Farm Example.xlsx
Lecture 19 Whole Farm Model.xlsx
Lecture 19 Annual Payments.xlsx
Lecture 19 Income Taxes.xlsx

2. Financial Models Business uses a variety of financial models
The primary objectives of these models are:
Forecast cash flows to support loan applications
Debt repayment capacity to justify loans
Feasibility of proposed businesses
Feasibility of proposed changes in existing businesses
Forecast the benefits of alternative marketing plans
ETC.
Most all of these models are deterministic
Business managers know risk is present in their decisions
They just do not know how to include risk properly
Many think they included risk by analyzing best & worst case scenarios

3. These business decisions are inherently multi-year in nature
Financial Models
Business decisions often are made based on simple rules using annual models
Mean net return (IRR, NPV, etc.)
Worst case and best case
Number of years to payoff debt
Best case and worst case scenarios
These business decisions are inherently multi-year in nature
We need to develop multi-year models to analyze risky business decisions

4. KOVS for Multi-Year Financial Models
Annual net cash income
Probability of negative annual NCIt
Annual ending cash reserves
Probability of negative ending casht
Probability of having to refinance deficitst
Annual net worth (nominalt and realt)
Probability of decreasing RNW relative to BNW
Annual debt to asset ratio
Probability of insolvency (bankruptcy)
NPV summarizes returns over multiple years
Probability of positive NPV or P(economic success)

5. Multi-Year Financial Models
Common theme or features for multi-year financial models
Input values have annual projections for:
Prices paid and received
Annual inflation rates for costs of production
Inflation rates for asset values
Machinery replacement plans
Management controls should be expressed as annual values to be strategically managed
Assumptions about changing productivity
Assumptions about possible structural changes
Assumptions about competition and demand
Assumptions about expansion or contraction

6. Multi-Year Financial Models
Common set of intermediate calculations
Income Statement
Receipts from each source
Total Receipts
Cash expenses for each category (non-cash expenses such as depreciation not included here)
Total Cash Expenses
Net Cash Income
Cash Flow Statement
Net cash income and all other sources of income (interest)
All cash outflows: taxes, principal payments, owner withdrawals or dividends
Ending Cash Reserves
Balance Sheet
Assets starting with positive cash balance
Liabilities
Including cash flow deficits
Net Worth
Financial summary ratios:
Debt Asset, PVENW, NPV

7. Multi-Year Financial Models
A significant problem can occur with multiple year simulation models
Ending cash reserves can be negative, which causes problems in all three pro forma financial statements
What happens if ending cash is negative?
Next years beginning cash equals zero
Creates a short-term liability in Balance Sheet
Interest paid next year in Income Statement
Repay loan next year in Cash Flow Statement
This is why Ending Cash is a KOV

8. Multi-Year Financial Models
Probability of negative ending cash is much greater in agriculture and agribusiness models -- it occurs more often than in non-ag businesses
Risk on output prices and production is greater than for non-ag businesses
If you build financial models that do not accommodate this problem, you understate the risk involved with an investment

9. Modeling Negative Cash Flow for Multi-Year Financial Models
Modification to the pro forma financials for negative cash flows are simple
Change the Income statement
Add an expense for interest paid on cash flow deficit loans – keep it separate from operating interest paid (-5 on Lab Exam!)
Change the Cash Flow Statement
Make Beginning Cash equal to Cash Assets in the Balance Sheet (it should be this way but many students make the mistake of making it equal to ending cash t on Lab Exam!)
Add a cash outflow to repay the short-term loan borrowed in the previous year to meet a deficit (-5 on Lab Exam!)
Change the Balance Sheet
Cash Asset is calculated with an IF() or MAX() statement – the value must be positive or zero (-5 on Lab Exam!)
Short-Term Liability equal to the negative cash balance BUT it has to be multiplied by “-1” to make it a positive value, otherwise zero (-5 on Lab Exam!)

10. Reconciled Financial StatementsA B C D 1
Income Statement
2000
2001
2002 2
Receipts 3
Total Receipts
= B2
= C2
= D2 4
Expenses 5
All Non-Interest Expenses  6
Interest for Land Loans 7
Interest for Machinery Loans 8
Interest for Operating Loans 9
Interest for Carry over Loans
= 0.0
= B33 * iRate
= C33 * iRate 10
Total Expenses
= SUM (B5:B9)
= SUM (C5:C9)
= SUM (D5:D9) 11 12
Net Cash Income
= B3 – B10
= C3 – C10
= D3 – D10 13 14
Cash Flow Statement 15
Beginning Cash Jan. 1
= Initial Value
= B27
= C27 16 17
= B12
= C12
= D12 18
Other Inflows 19
Total Inflows
= B17 + B18 + B15
= C17 + C18 + C15
= D15 + D17 + D18 20
Repay cash flow deficits
= B33
= C33 21
Other Outflows 22
Total Outflows
= B20 + B21
= C20 + C21
= D20 + D21 23
Ending Cash Balance Dec. 31
= B19 – B22
= C19 – C22
= D19 – D22 24 25
Balance Sheet 26
Assets Dec. 31 27
Cash Reserves
= IF (B23 > = 0, B23, 0)
= IF (C23 > = 0, C23, 0)
= IF (D23 > = 0, D23, 0) 28
Land Value 29
Machinery 30
Other Assets 31
Total Assets
= SUM (B27:B30)
= SUM (C27:C30)
= SUM (D27:D30) 32
Liabilities Dec. 31 33
Cash Flow Deficits
= IF (B23 < 0, (-1 * B23), 0)
= IF (C23 < 0, (-1 * C23), 0)
= IF (D23 < 0, (-1 * D23), 0) 34
Land 35 36
Total Debts
= SUM (B33:B35)
= SUM (C33:C35)
= SUM (D33:D35) 37
Net Worth
= B31 – B37
= C31 – C37
= D31 – D37

11. Reconciled Financial Statements

12. Multi-Year Financial Models – Income Taxes
Income taxes must be considered explicitly
Corporations pay income taxes
Sole proprietors also pay self-employment and Medicare taxes
Calculate taxable income
Taxable Income = Total receipts + interest earned– total cash expenses - depreciation allowance - deductions
Use a tax table to compute taxes due
Enter taxes paid in the Cash Flow Statement
The corporate income tax schedule is below

13. 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 – Probability (D/A > 0.5)
Ability to cash flow – Probability (Ending cash flow > 0)
Ability to earn a satisfactory rate of return on investment – Probability (ROI > x)
Analysis of alternative marketing schemes that use contracts, futures or options to manage price risk
Testing Portfolios
Analysis of alternative combinations of investment instruments (stocks, bonds, land, etc.)
A portfolio of investments is similar to a derivative in the investment world

14. Financial Risk Management
A farm level simulation model developed to analyze the financial risk faced by a farm or to appraise a farm in a risky world
Input data for initial financial situation of a farm with 10 years of price and yield history providing measures of risk in production and marketing
Several financial instruments are available to test the effects of different financial arrangements on firm’s cash flows and ability to repay operating loan and remain current on long- and intermediate-term loans

15. Ranking Risky Alternatives
After simulating multiple scenarios your job is to help the decision maker pick the best alternative
Two ways to approach this problem
Positive economics – role of economist is to present consequences and not make recommendations – consistent with simulation
Normative economics – role of economist is to make recommendations – consistent with linear programming methodology

16. Ranking Risky Alternatives
Simulation results can be presented many different ways to help the decision makers (DM) make the best decision for themselves
Tables of summary statistics
Probabilities for KOVs
PDFs and CDFs
StopLight charts
Fan graphs
SERF and SDRF
Purpose here is to present the best methods for ranking risky alternatives so the DM can make the best decision

17. Decision Making for Risky Alternatives
Decision makers rank risky alternatives based on their utility for income and risk
Several of the ranking procedures ignore utility, but they are easy to use and are frequently used by those who do not know better
The more complex procedures incorporate utility but can be complicated to use

18. Easy to Use Ranking Procedures
Mean only – Pick scenario with the highest mean – ignores all risk
Minimize Risk – Pick the scenario with lowest Std Dev – this ranking strategy ignores the level of returns (mean and relative risk)
Mean Variance – Always select the scenario in lower right quadrant often difficult to read and often results in tied rankings, does not work well for non-normal distributions.
From diagram below A is preferred to C; E is preferred to B
Indifferent between A and E 8 6 4 2 1 3 D A C E B
(risk)
(income)

19. Easy to Use Ranking Procedures
Worst case – Bases decisions on scenario with highest minimum, but it was observed with only a 1% chance. Worst case had a 1 out of 500 chance of being observed -- has merit in that it avoids catastrophic losses, but ignores the level of returns and ignores upside risk.
Best case –Looks at only one iteration, the best, which had < 1% chance. Best case had a 1 out of 500 chance of being observed -- ignores the overall risk and downside potential risk.

20. Easy to Use Ranking Procedures
Relative Risk – Coefficient of Variation (CV), pick the scenario that has lowest absolute CV. Easy to use, considers risk relative to the level of returns but ignores the decision makers risk aversion and does not work when the mean is small.
CV = (Std Dev / Mean) * 100.0

21. Easy to Use Ranking Procedures
Probabilities of Target Values – Calculate and report the probability of achieving a preferred target and probability of failing to achieve a minimum target, i.e., the StopLight chart. This method is easy to use and easy to present to decision makers who do not understand risk.

22. Easy to Use to Rank Procedures
Rank Scenarios Based on Complete Distribution – Graph the distributions as CDFs and compare the relative risk of the returns for each distribution at alternative levels of return. Pick the distribution with the highest return at each risk level or pick the distribution with the lowest risk for each level of returns, i.e., the distribution furthest to the right.