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Pro Forma Analysis. Agribusiness Finance LESE 306 Fall 2009. PRESENT. PAST. FUTURE. Historical analysis Comparative analysis Historical price and yield trends. Pro forma analysis Forming expectations about future prices, costs and productivity Ad hoc extrapolations

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pro forma analysis

Pro Forma Analysis

Agribusiness FinanceLESE 306 Fall 2009

slide2

PRESENT

PAST

FUTURE

  • Historical analysis
  • Comparative analysis
  • Historical price and

yield trends

  • Pro forma analysis
  • Forming expectations about future prices, costs and productivity
  • Ad hoc extrapolations
  • Projections based upon available outlook data
  • Projections based upon econometric analysis
slide3

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

slide4

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

slide6

Must project

Annual yield

Must project

Annual price

Page 85 in booklet

ad hoc modeling 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
slide9

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.

econometric model approach
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
concept of derived demand for farm machinery
Concept of Derived Demand for Farm Machinery

The demand for farm machinery is driven by the expected net economic benefit from use of the machine….

crop market equilibrium

D

D

S

S

Crop Market Equilibrium

Price

S

D

  • Supply consists of:
  • Beginning stocks
  • Production
  • Imports

Pe

  • Demand consists of:
  • Industrial use
  • Feed use
  • Exports
  • Ending stocks

Quantity

Qe

Page 45 in booklet

slide16

Forecasting Future Commodity Price Trends

D

$7

S

D = a – bP + cYD + eX

$4

Own

price

Other

factors

Disposable

income

$1

10

Page 45 in booklet

slide17

Forecasting Future Commodity Price Trends

D

$7

S

Own

price

Input

costs

Other

factors

$4

S = n + mP – rC + sZ

$1

10

Page 46 in booklet

slide18

Projecting Commodity Price

D

$7

S

D = 10 – 6P + .3YD + 1.2X

D = S

$4

S = 2 + 4P – .2C + 1.02Z

$1

10

Substitute the demand and supply

equations into the the equilibrium

condition and solve for price

Page 46 in booklet

the market model
The Market Model

Demand equations:

Qd,i = a0 - a1(Price) +  ai (demand shifters)

Supply equation:

Qs,i = b0 +b1(price) +  bi (supply shifters)

Market equilibrium:

ΣQd,i = ΣQs,i

slide23

A linear time trend projection of future farm machinery and equipment sales therefore does a poor job of predicting future sales activity.

slide24

Econometric Analysis Based on Investment Theory

It = f{[E(Pt)×E(Qt)]/E(ct)}

Incorporates the economic concepts of MVP and MIC

slide25

An econometric model based on investment theory does a muchbetter job of predicting future sales activity.

slide28

Econometric Analysis – Food Use

Own price elasticity

Income elasticity

Cross price elasticity

remaining steps to forecasting the price of commodity
Remaining Steps to Forecasting the Price of Commodity
  • Develop similar econometric equations for the other uses of wheat (feed use, exports and ending stock).
  • Develop econometric equations for production and import supply.
  • Substitute the estimated equations into the market equilibrium definition (QD=QS) and solve for the price whereexcess demand equals zero.
slide32

Point Forecast Assumptions

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

PE

QE

Page 47 in booklet

slide33

Structural Pro Forma Analysis

Supply-side risk for a given price…

PE

Page 47 in booklet

QLQEQH

slide34

Structural Pro Forma Analysis

Demand and supply-side risk and potential price variability…

PH

PE

PL

QLQEQH

Page 47 in booklet

slide36

Potential Variability in Wheat Price 2008/09 MY Given

Historical Variability in Growing Conditions Ratings

Page 96 in booklet

slide38

$2.50 $3.00 $3.50

Triangular Probability Distribution

Page 131 in booklet

conclusions
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.
adjusting discount rate
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 risk premium.
  • Realistically we must also allow for financial risk by adding an additional risk premium.
business risk
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
slide49

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

slide50

Increasing Risk Over Time

Probability

Product price

distribution

E(P)

Year 1

Year 1

Year 10

Year 10

$2.95 $3.05 $3.15

Pessimistic

price

Expected

price

Optimistic

price

slide51

Increasing Risk Over Time

Probability

Product price

distribution

E(P)

Year 1

Year 10

Year 1

Year 10

$2.05 $2.95 $3.05 $3.15 $4.05

Pessimistic

price

Expected

price

Optimistic

price

financial risk
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)

slide53

Accounting for Financial Risk

RRRi

RRRi

RFREE,i

.05

Page 138 in booklet

required rate of return
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
slide56

The Portfolio Effect

NCFi

NCF with existing assets

NCF with new assets

Forecast horizon

slide57

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.

slide59

Allowing for unequal annual net cash flows and required rates of return….

Page 63 in booklet

slide60

Our Complete NPV Capital Budgeting Model

NPV = NCF1[1/(1+R1)] +

NCF2[1/(1+R1)(1+R2)] + … +

NCFn[1/(1+R1)(1+R2)…(1+Rn)] +

T[1/(1+R1)(1+R2)…(1+Rn)] –

tx(T – C)[1/(1+R1)(1+R2)…(1+Rn)]

Discounted NCF in year 1

Discounted NCF in year 2

Discounted NCF in year n

Discounted terminal value

Discounted capital gains tax

Decision rule:

NPV > 0 suggests project is economically feasible

NPV = 0 suggests indifference

NPV < 0 suggests project is economically infeasible

slide63

*

*

Page 106 in booklet

slide64

*

*

Page 107 in booklet

borrowing preparation
Borrowing Preparation
  • Up to date financial statements.
  • Demonstrate trends in key financial ratios including debt repayment coverage.
  • Pro forma master budget before and after proposed investment, including the line of credit or LOC.
  • Do sensitivity analysis.
  • Demonstrate feasibility of investment plans by using NPV capital budgeting using stress testing and incorporation of risk.
both sides of the desk
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 desk1
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

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