Pro Forma Investment

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					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
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
Ad Hoc Modeling Approaches
 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
              Linkages to commodity
               policy
              Linkages to domestic
               economy
              Linkages to the global
               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
      Forecast Assumptions
Point Forecast Assumptions
  Farm       Weather        Macro-         Foreign         Global
program        and         economic         trade          market
policies     disease        policies       policies        events




              One
                              Baseline
            scenario
                              Scenario
            examined
                                                Assumes
                                                 perfect
       What does this mean for:               knowledge of
                    PE
         Crop and livestock prices?          outcomes in all
         Unit input costs and farmland prices? 5 areas!!!!
           Debt repayment capacity and credit risk?
           Asset valuation and collateral risk?
                                QE                    Page 47 in booklet
 Structural Pro Forma Analysis
Structural Pro Forma Analysis
  Farm                 Weather             Macro-                     Foreign                Global
 program                 and              economic                     trade                 market
 policies              disease             policies                   policies               events


 Multiple
scenarios
examined


Scenario    Scenario   Scenario   Scenario       Scenario       Scenario    Scenario      Scenario   Scenario
  #1          #2         #3         #4             #5             #6          #7            #8         #9




                                             D              S
                                                                           Supply-side risk
                                  P
                                      P
                                                                             for a given
                                                                               price…
                                  E




                                                   Q
                                                 QLQEQH                                Page 47 in booklet
 Structural Pro Forma Analysis
Structural Pro Forma Analysis
  Farm                 Weather            Macro-                      Foreign              Global
 program                 and             economic                      trade               market
 policies              disease            policies                    policies             events


 Multiple
scenarios
examined


Scenario    Scenario   Scenario   Scenario       Scenario       Scenario   Scenario     Scenario   Scenario
  #1          #2         #3         #4             #5             #6         #7           #8         #9




                                             D              S
                                                                   Demand and supply-
                                  PH
                                  PE
                                                                      side risk and
                                    P
                                  PL                                 potential price
                                                                      variability…
                                                    Q
                                                    Q
                                                    E
                                                                                      Page 47 in booklet
  $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.
Provide much more information (e.g.,
 elasticities).
Allow for sensitivity analysis with
 independent (exogenous) variables when
 evaluating potential variability about
 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
  Adjusting Discount Rate
We said to date that the discount rate is the
 firm’s opportunity rate of return.
Realistically we must allow for business
 risk by including a business risk premium.
Realistically we must also allow for
 financial risk by adding an additional
 financial risk premium.
         Business Risk
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
   Accounting for Business Risk



    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.
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.
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

  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
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
  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:                 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
                               rural businesses.

                              After mid-term exam

				
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