2009 2010 2011 2012 2013 2014 2015
Timeline Required for Timeline Required for Capital Budgeting…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.
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 bookletPage 89 in booklet
Page 74 in bookletPage 74 in booklet
Remember the definition of annual net cash flowsRemember the definition of annual net cash flowsRemember the definition of annual net cash flowsRemember the definition of annual net cash flows
Page 85 in bookletPage 85 in booklet
Must projectAnnual price
Must projectAnnual price
Must projectAnnual yield
Must projectAnnual yield
Ad Hoc Modeling ApproachesAd 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 averageUsing assumptions
made by others
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.
Ad Hoc Modeling ApproachesAd Hoc Modeling Approaches
All three approaches were shown last week to perform poorly in markets exhibiting price variability.
All three approaches were shown last week to perform poorly in markets exhibiting price variability.
Econometric Model ApproachEconometric 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 EquilibriumCrop Market Equilibrium
Quantity
Price
Pe
Qe
D S
Demand consists of:-Industrial use-Feed use-Exports-Ending stocks
Demand consists of:-Industrial use-Feed use-Exports-Ending stocks
Supply consists of:-Beginning stocks-Production-Imports
Supply consists of:-Beginning stocks-Production-Imports
Page 45 in bookletPage 45 in booklet
Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends
D
S
$4
10
$1
$7
D = a – bP + cYD + eXD = a – bP + cYD + eX
Ownprice
Ownprice
Disposableincome
Disposableincome
Otherfactors
Otherfactors
Page 45 in bookletPage 45 in booklet
D
S
$4
10
$1
$7
S = n + mP – rC + sZS = n + mP – rC + sZ
Ownprice
Ownprice
Inputcosts
Inputcosts
Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends
Otherfactors
Otherfactors
Page 46 in bookletPage 46 in booklet
Projecting Commodity PriceProjecting Commodity Price
D = SD = S
D
S
$4
10
$1
$7
D = 10 – 6P + .3YD + 1.2XD = 10 – 6P + .3YD + 1.2X
S = 2 + 4P – .2C + 1.02ZS = 2 + 4P – .2C + 1.02Z
Substitute the demand and supplyequations into the the equilibriumcondition and solve for price
Substitute the demand and supplyequations into the the equilibriumcondition and solve for price Page 46 in bookletPage 46 in booklet
Point Forecast AssumptionsFarm
programpolicies
Macro-economicpolicies
Foreigntrade
policies
Globalmarketevents
Weatherand
disease
BaselineScenario
One scenario examined
What does this mean for: Crop and livestock prices? Unit input costs and farmland prices? Debt repayment capacity and credit risk? Asset valuation and collateral risk?
PE
QE
Assumes perfect
knowledge of outcomes in all
5 areas!!!!
Assumes perfect
knowledge of outcomes in all
5 areas!!!!
Point Forecast AssumptionsPoint Forecast Assumptions
Page 47 in bookletPage 47 in booklet
Structural Pro Forma AnalysisFarm
programpolicies
Macro-economicpolicies
Foreigntrade
policies
Globalmarketevents
Weatherand
disease
Scenario# 1
Scenario# 2
Scenario# 3
Scenario# 4
Scenario# 5
Scenario# 6
Scenario# 7
Scenario# 8
Scenario# 9
Multiple scenarios examined
D S
P
Q
Supply-side risk Supply-side risk for a given for a given
price…price…
Supply-side risk Supply-side risk for a given for a given
price…price…
QLQEQH
PE
Structural Pro Forma AnalysisStructural Pro Forma Analysis
Page 47 in bookletPage 47 in booklet
Structural Pro Forma AnalysisFarm
programpolicies
Macro-economicpolicies
Foreigntrade
policies
Globalmarketevents
Weatherand
disease
Scenario# 1
Scenario# 2
Scenario# 3
Scenario# 4
Scenario# 5
Scenario# 6
Scenario# 7
Scenario# 8
Scenario# 9
Multiple scenarios examined
D S
P
Q
Demand and supply-side risk and
potential price variability…
Demand and supply-side risk and
potential price variability…
QE
PH
PE
PL
Structural Pro Forma AnalysisStructural Pro Forma Analysis
Page 47 in bookletPage 47 in booklet
Triangular Probability DistributionTriangular Probability Distribution
$2.50 $3.00 $3.50$2.50 $3.00 $3.50
Page 131 in bookletPage 131 in booklet
ConclusionsConclusionsEconometric models preferred over naïve
models and linear time trend models.Much more accurate.Provide much more information (e.g.,
elasticitieselasticities).Allow for sensitivity analysissensitivity analysis with
independent (exogenous) variables when evaluating potential variabilitypotential variability about expected trends.
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Allowing for unequal annual net cash flows….Allowing for unequal annual net cash flows….
Page 63 in bookletPage 63 in bookletAllowing for unequal discount rates…Allowing for unequal discount rates…
Adjusting Discount RateAdjusting 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 riskbusiness risk premium.
Realistically we must also allow for financial risk by adding an additional financial riskfinancial risk premium.
Business RiskBusiness RiskRisk associated with priceprice of the product or
products you are producing.Risk associated with the unit costsunit costs for the
inputs used in producing the product(s).Risk associated with yieldsyields (productivity) in
production.
NCFi=Piyieldsiunit sales – Ciunit inputs
Accounting for Business RiskAccounting for Business Risk
RFREE,i = risk free rate of return (i.e., govt. bond rate)RRRL,i = required rate of return for lowly risk averseRRRH,i = required rate of return for highly risk averse
RFREE,i
RRRL,i
RRRH,i
.05
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Increasing Risk Over TimeIncreasing Risk Over Time
Expectedprice
Expectedprice
E(P)Year 1 Year 1 Year 10Year 10
Pessimisticprice
Pessimisticprice
Optimisticprice
Optimisticprice
Product pricedistribution
Product pricedistribution
$2.95 $3.05 $3.15
Probability
Increasing Risk Over TimeIncreasing Risk Over Time
Expectedprice
Expectedprice
E(P)Year 1 Year 1 Year 10Year 10
Pessimisticprice
Pessimisticprice
Optimisticprice
Optimisticprice
Product pricedistribution
Product pricedistribution
$2.05 $2.95 $3.05 $3.15 $4.05
Probability
Financial RiskFinancial RiskRisk 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 RiskAccounting for Financial Risk
RFREE,i
RRRi
RRRi
.05
Page 138 in bookletPage 138 in booklet
Required Rate of ReturnRequired 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 ExposureOne Strategy to Minimizing Risk Exposure
Page 140 in bookletPage 140 in booklet
Forecast horizon
NCFi
NCF with existing assetsNCF with existing assets
NCF with new assetsNCF with new assets
The Portfolio EffectThe Portfolio Effect
Forecast horizon
NCFi
Average annual NCF after making new investment.
Average annual NCF after making new investment.
The Portfolio EffectThe Portfolio Effect
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.
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.
Page 63 in bookletPage 63 in booklet
Allowing for unequal annual net cash flows and required rates of return….
Allowing for unequal annual net cash flows and required rates of return….
NPV = NCF1[1/(1+RRR1)] + NCF2[1/(1+RRR1)(1+RRR2)] + … + NCFn[1/(1+RRR1)(1+RRR2)…(1+RRRn)] + T[1/(1+RRR1)(1+RRR2)…(1+RRRn)] – tx(T – C)[1/(1+RRR1)(1+RRR2)…(1+RRRn)]
Our Complete NPV Our Complete NPV Capital Budgeting ModelCapital Budgeting Model
Discounted NCF in year 1
Discounted NCF in year 2
Discounted NCF in year n
Discounted terminal value
Discounted capital gains tax
NPV > 0 suggests project is economically feasibleNPV = 0 suggests indifferenceNPV < 0 suggests project is economically infeasible
Decision rule:
Borrowing planningBorrowing planning1. 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 PresentationsTeam PresentationsWe 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 DeskBoth 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 semesterCoverage thus far this semester
Both Sides of the DeskBoth 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 examAfter mid-term exam