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
Projections based upon
available outlook data
Projections based upon
econometric analysis
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
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
Annual price
Must project
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.
Page 94 in booklet
Page 94 in booklet
Page 95 in booklet
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
The demand for farm machinery is driven by the expected net
economic benefit from use of the machine….
Crop Market Equilibrium
Price
S
D
Supply consists of:
-Beginning stocks
-Production
-Imports
Pe
Demand consists
of:
-Industrial use
-Feed use
-Exports
-Ending stocks
Qe
Quantity
Page 45 in booklet
Forecasting Future Commodity Price Trends
$7
D
S
$4
D = a – bP + cYD + eX
Own
price
Disposable
income
Other
factors
$1
10
Page 45 in booklet
Forecasting Future Commodity Price Trends
$7
D
S
Own
price
$4
Input
costs
Other
factors
S = n + mP – rC + sZ
$1
10
Page 46 in booklet
Projecting Commodity Price
$7
D
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
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
An Example
Historical Data on Fixed Input Sales to Farmers
Econometric Analysis Based on Time Trend Extrapolation
It = f(Yeart)
A linear time trend projection of future farm
machinery and equipment sales therefore does
a poor job of predicting future sales activity.
Econometric Analysis Based on Investment Theory
It = f{[E(Pt)×E(Qt)]/E(ct)}
Incorporates the economic concepts of MVP and MIC
An econometric model based on investment
theory does a much better job of predicting
future sales activity.
Another Example
Estimating the Annual
Supply and Use of Wheat
Econometric Analysis – Food Use
Own price elasticity
Income elasticity
Cross price elasticity
Observed and Predicted Values
For Wheat Food Use
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 where excess
demand equals zero.
Stress Testing Your
Forecast
Point Forecast Assumptions
Assumptions
Farm
program
policies
Weather
and
disease
One
scenario
examined
Macroeconomic
policies
Foreign
trade
policies
Global
market
events
Baseline
Scenario
Assumes
perfect
knowledge of
What does this mean for:
outcomes in all
PE
Crop and livestock
prices?
Unit input costs and farmland prices? 5 areas!!!!
Debt repayment capacity and credit risk?
Asset valuation and collateral
risk?
Q
E
Page 47 in booklet
StructuralPro
ProForma
FormaAnalysis
Analysis
Structural
Farm
program
policies
Weather
and
disease
Macroeconomic
policies
Foreign
trade
policies
Global
market
events
Multiple
scenarios
examined
Scenario
#1
Scenario
#2
Scenario
#3
Scenario
#5
Scenario
#4
D
Scenario
#6
Scenario
#7
Scenario
#8
Scenario
#9
S
Supply-side risk
for a given
price…
PEP
QLQ
QEQH
Page 47 in booklet
StructuralPro
ProForma
FormaAnalysis
Analysis
Structural
Farm
program
policies
Weather
and
disease
Macroeconomic
policies
Foreign
trade
policies
Global
market
events
Multiple
scenarios
examined
Scenario
#1
Scenario
#2
Scenario
#3
Scenario
#5
Scenario
#4
D
Scenario
#6
S
PH
PEP
PL
QLQ
QEQH
Scenario
#7
Scenario
#8
Scenario
#9
Demand and supplyside risk and
potential price
variability…
Page 47 in booklet
A 48 percent chance that the price of wheat will be less than $4.16
Page 85 in booklet
Potential Variability in Wheat Price 2008/09 MY Given
Historical Variability in Growing Conditions Ratings
Page 96 in booklet
Page 93 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
Page 82 in booklet
G is the expected rate of appreciation
Page 82 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 risk premium.
Realistically we must also allow for
financial risk by adding an additional 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
$2.95
$3.05
$3.15
Pessimistic
price
Expected
price
Optimistic
price
Year 10
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
price
Expected
price
Optimistic
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
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
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 Preparation
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.
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