# Pro Forma Investment by vzz15822

VIEWS: 6 PAGES: 47

• pg 1
```									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.

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
Remember the definition of annual net cash flows

Page 74 in booklet
Must project   Must project
Annual price   Annual yield

Page 85 in booklet
Alternative Forecasting
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
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.
Econometric Model Approach
 Capturing future
supply/demand impacts
on prices and unit costs
policy
economy
economy
Crop Market Equilibrium

Price
D         S

Supply consists of:
-Beginning stocks
-Production
Pe                   -Imports
Demand consists
of:
-Industrial use
-Feed use
-Exports
-Ending stocks                Quantity
Qe
Page 45 in booklet
Forecasting Future Commodity Price Trends

\$7   D
S
D = a – bP + cYD + eX

\$4
Own     Disposable      Other
price    income        factors

\$1

10

Page 45 in booklet
Forecasting Future Commodity Price Trends

\$7   D
S

Own       Input        Other
\$4                         price     costs       factors

S = n + mP – rC + sZ
\$1

10

Page 46 in booklet
Projecting Commodity Price

\$7   D
S
D = 10 – 6P + .3YD + 1.2X

\$4                             D=S

S = 2 + 4P – .2C + 1.02Z
\$1

10

Substitute the demand and supply
equations into the the equilibrium
Page 46 in booklet
condition and solve for price
Stress Testing Your
Forecast
Point Forecast Assumptions

Assumes
perfect
knowledge of
PE        outcomes in all
5 areas!!!!

QE        Page 47 in booklet
Structural Pro Forma Analysis

Supply-side risk
P              for a given
price…
E

QLQEQH        Page 47 in booklet
Structural Pro Forma Analysis

Demand and supply-
PH
PE
side risk and
PL         potential price
variability…
Q          Page 47 in booklet
E
\$2.50         \$3.00         \$3.50

Triangular Probability Distribution

Page 131 in booklet
Conclusions
Econometric models preferred over naïve
models and linear time trend models.
Much more accurate.
elasticities).
Allow for sensitivity analysis with
independent (exogenous) variables when
expected trends.
NCF Summary
Page 74 in booklet
Allowing for unequal annual net cash flows….

Page 79 in booklet
Allowing for unequal discount rates…   Page 63 in booklet
Concept of Required
Rate of Return
We said to date that the discount rate is the
firm’s opportunity rate of return.
Realistically we must allow for business
Realistically we must also allow for
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

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
Increasing Risk Over Time
Probability
Product price
distribution

Year 10            Year 1     E(P)        Year 1            Year 10
\$2.95      \$3.05       \$3.15

Pessimistic       Expected           Optimistic
price             price              price
Increasing Risk Over Time
Probability
Product price
distribution

Year 10      Year 1     E(P)        Year 1   Year 10
\$2.05        \$2.95      \$3.05       \$3.15     \$4.05

Pessimistic                   Expected                    Optimistic
price                         price                       price
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

RRRi
RRRi

RFREE,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.
require above a risk-free rate given your
require given existing leverage position.
RRRi = Rfree,i + Rbusiness,i + Rfinancial,i
One Strategy to Minimizing Risk Exposure

Page 140 in booklet
The Portfolio Effect
NCFi

NCF with existing assets

NCF with new assets

Forecast horizon
The Portfolio Effect
NCFi

Average annual NCF after
making new investment.

Forecast horizon

with the calculated the NPV for the new investment project.
Exchanging stable profits for lowering exposure to risk.
Our Final NPV Model
Allowing for unequal annual net cash flows and
required rates of return….

Page 63 in booklet
Our Complete NPV
Capital Budgeting Model
Discounted NCF in year 1
NPV = NCF1[1/(1+RRR1)] +
Discounted NCF in year 2
NCF2[1/(1+RRR1)(1+RRR2)] + … +
NCFn[1/(1+RRR1)(1+RRR2)…(1+RRRn)] +      Discounted NCF in year n

T[1/(1+RRR1)(1+RRR2)…(1+RRRn)] –         Discounted terminal value
tx(T – C)[1/(1+RRR1)(1+RRR2)…(1+RRRn)]   Discounted capital gains tax

Decision   rule:
NPV > 0     suggests project is economically feasible
NPV = 0     suggests indifference
NPV < 0     suggests project is economically infeasible
Ranking
Investment
Opportunities
Page 106 in booklet
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Page 106 in booklet
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Page 107 in booklet
Page 107 in booklet
Page 108 in booklet
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
 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:                 The lender:
•Enterprise analysis          •Loan application analysis
•Cash management              •Credit scoring
•Line of credit needs         •Loan pricing for risk
•Operating loan application   •Loan approval process
•Investment planning          •Loan portfolio analysis
•Term loan application        •Loan loss reserves
•Planning for long run        •Regulatory oversight
•Lending institutions serving
commercial agriculture and