Materials for Lecture 20 Financial Models Finish Scenario Ranking Lecture New Material for Lecture 15 –Read Chapters 13 and 14 –Lecture 20 Pro Forma.xlsx –Lecture 20 Farm 2015.xlsx –Lecture 20 Farm Simulator.xlsx –Lecture 20 Annual Payments.xlsx –Lecture 20 Income Taxes.xlsx –Lecture 20 Ranking Scenarios.xlsx –Lecture 20 Ranking Scenarios Whole Farm.xlsx –Lecture 20 CEs.xlsx

Multi-Year Financial Models Business decisions often are made based on simple rules –Mean net return (IRR, NPV, etc.) –Worst case and best case –Number of years to payoff debt –Give the business control of its supply chain, etc. These business decisions are inherently multi-year in nature

KOVS for Multi-Year Financial Models –Annual net cash income Probability of negative NCI t –Annual ending cash reserves Probability of negative ending cash t Probability of having to refinance deficits t –Annual net worth (nominal t and real t ) Probability of decreasing RNW relative to BNW –Annual debt to asset ratio Probability of insolvency –NPV summarizes returns over multiple years Probability of positive NPV or P(economic success)

Multi-Year Financial Models Common theme or features for multi-year financial models –Input values have annual projections Prices paid and received Annual inflation rates for costs of production Inflation rates for asset values Machinery replacement plans –Management controls are expressed as annual values so, can be strategically managed Assumptions about changing productivity Assumptions about possible structural changes Assumptions about competition and demand Assumptions about beginning cash reserves

Multi-Year Financial Models Common set of intermediate calculations –Income Statement Receipts from each source –Total Receipts Cash expenses for each category (non-cash expenses such as depreciation not included here) –Total Cash Expenses Net Cash Income –Cash Flow Statement Net cash income and all other sources of income (interest) All cash outflows: taxes, principal payments, owner withdrawals or dividends Ending Cash Reserves –Balance Sheet Assets starting with positive cash balance Liabilities –Including cash flow deficits Net Worth –Financial summary ratios: Debt Asset, PVENW, NPV

Multi-Year Financial Models A significant problem can occur with multiple year simulation models –Ending cash reserves can be negative, which causes problems in all three pro forma financial statements What happens if ending cash is negative? –Cash reserves are zero –Must create a short-term liability –Must pay interest for this loan next year –Must repay the short-term loan next year –This is why Ending Cash is a KOV

Multi-Year Financial Models Problem of negative ending cash is much greater in agriculture and agribusiness models -- it occurs more often than in non-ag businesses Risk on prices and production greater than for non-ag business interests If you build financial models that do not accommodate this problem, you understate the risk involved with an investment

Modeling Negative Cash Flow for Multi-Year Financial Models Modification to the pro forma financials for negative cash flows are simple Change the Income statement –Add an expense for interest paid on cash flow deficit loans – keep it separate from operating interest paid (-5 on Lab Exam!) Change the Cash Flow Statement –Make Beginning Cash equal to Cash Balance in the Balance Sheet (it should be this way but many students make the mistake of making it equal to ending cash t on Lab Exam!) –Add a cash outflow to repay the short-term loan borrowed in the previous year to meet a deficit (-5 on Lab Exam!) Change the Balance Sheet –IF() statement for Beginning Cash – that it must be positive or zero (-5 on Lab Exam!) –IF() statement for a Short-Term Liability to have a positive value if ending cash reserve is negative (-5 on Lab Exam!)

Reconciled Financial Statements

Multi-Year Financial Models – Income Taxes Income taxes must be considered explicitly Calculate taxable income Taxable Income = Total receipts + interest earned– total cash expenses - depreciation allowance - deductions Use a tax table to compute taxes due Enter taxes paid in the Cashflow Statement

Multi-Year Financial Models – Applications Financial risk management –Analysis of the economic impact of changes in the business plan for a firm on Ability to repay loans on time Ability to remain solvent – Probability (D/A > 0.5) Ability to cash flow – Probability (Ending cash flow > 0) Ability to earn a satisfactory rate of return on investment – Probability (ROI > x) –Analysis of alternative marketing schemes that use contracts, futures or options to manage price risk Testing Portfolios –Analysis of alternative combinations of investment instruments (stocks, bonds, land, etc.) –A portfolio of investments is similar to a derivative in the investment world

Financial Risk Management A farm level simulation model developed to analyze the financial risk faced by a farm or to appraise a farm in a risky world Input data for initial financial situation of a farm with 10 years of price and yield history providing measures of risk in production and marketing Several financial instruments are available to test the effects of different financial arrangements on firm’s cash flows and ability to repay operating loan and remain current on long- and intermediate-term loans

Financial Risk Management

Ranking Risky Alternatives After simulating multiple scenarios your job is to help the decision maker pick the best alternative Two ways to approach this problem –Positive economics – role of economist is to present consequences and not make recommendations – consistent with simulation –Normative economics – role of economist is to make recommendations – consistent with linear programming methodology

Ranking Risky Alternatives Simulation results can be presented many different ways to help the decision makers (DM) make the best decision for themselves –Tables of summary statistics –Probabilities for KOVs –PDFs and CDFs –StopLight charts –Fan graphs –SERF and SDRF Purpose of here is to present the best methods for ranking risky alternatives so the DM can make the best decision

Decision Making for Risky Alternatives Decision makers rank risky alternatives based on their utility for income and risk Several of the ranking procedures ignore utility, but they are easy to use and are frequently used by those who do not know better The more complex procedures incorporate utility but can be complicated to use

Easy to Use Ranking Procedures Mean only – Pick scenario with the highest mean – ignores all risk Minimize Risk – Pick the scenario with lowest Std Dev – this ranking strategy ignores the level of returns (mean and relative risk) Mean Variance – Always select the scenario in lower right quadrant often difficult to read and often results in tied rankings, does not work well for non-normal distributions. - From diagram below A is preferred to C; E is preferred to B - Indifferent between A and E (income) D A C E B (risk)

Easy to Use Ranking Procedures Worst case – Bases decisions on scenario with highest minimum, but it was observed with only a 1% chance. Worst case had a 1 out of 500 chance of being observed -- has merit in that it avoids catastrophic losses, but ignores the level of returns and ignores upside risk. Best case –Looks at only one iteration, the best, which had < 1% chance. Best case had a 1 out of 500 chance of being observed -- ignores the overall risk and downside potential risk.

Easy to Use Ranking Procedures Relative Risk – Coefficient of Variation (CV), pick the scenario that has lowest absolute CV. Easy to use, considers risk relative to the level of returns but ignores the decision makers risk aversion and does not work when the mean is small. CV = (Std Dev / Mean) * 100.0

Easy to Use Ranking Procedures Probabilities of Target Values – Calculate and report the probability of achieving a preferred target and probability of failing to achieve a minimum target, i.e., the StopLight chart. This method is easy to use and easy to present to decision makers who do not understand risk.

Easy to Use to Rank Procedures Rank Scenarios Based on Complete Distribution – Graph the distributions as CDFs and compare the relative risk of the returns for each distribution at alternative levels of return. Pick the distribution with the highest return at each risk level or pick the distribution with the lowest risk for each level of returns, i.e., the distribution furthest to the right.