Materials for Lecture 19 Financial Models New Material for Lecture 19 Read Chapters 13 and 14 Lecture 19 Pro Forma.xlsx Lecture 19 Farm Example.xlsx Lecture 19 Whole Farm Model.xlsx Lecture 19 Annual Payments.xlsx Lecture 19 Income Taxes.xlsx

Financial Models Business uses a variety of financial models The primary objectives of these models are: Forecast cash flows to support loan applications Debt repayment capacity to justify loans Feasibility of proposed businesses Feasibility of proposed changes in existing businesses Forecast the benefits of alternative marketing plans ETC. Most all of these models are deterministic Business managers know risk is present in their decisions They just do not know how to include risk properly Many think they included risk by analyzing best & worst case scenarios

These business decisions are inherently multi-year in nature Financial Models Business decisions often are made based on simple rules using annual models Mean net return (IRR, NPV, etc.) Worst case and best case Number of years to payoff debt Best case and worst case scenarios These business decisions are inherently multi-year in nature We need to develop multi-year models to analyze risky business decisions

KOVS for Multi-Year Financial Models Annual net cash income Probability of negative annual NCIt Annual ending cash reserves Probability of negative ending casht Probability of having to refinance deficitst Annual net worth (nominalt and realt) Probability of decreasing RNW relative to BNW Annual debt to asset ratio Probability of insolvency (bankruptcy) 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 for: Prices paid and received Annual inflation rates for costs of production Inflation rates for asset values Machinery replacement plans Management controls should be expressed as annual values to be strategically managed Assumptions about changing productivity Assumptions about possible structural changes Assumptions about competition and demand Assumptions about expansion or contraction

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? Next years beginning cash equals zero Creates a short-term liability in Balance Sheet Interest paid next year in Income Statement Repay loan next year in Cash Flow Statement This is why Ending Cash is a KOV

Multi-Year Financial Models Probability of negative ending cash is much greater in agriculture and agribusiness models -- it occurs more often than in non-ag businesses Risk on output prices and production is greater than for non-ag businesses 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 Assets in the Balance Sheet (it should be this way but many students make the mistake of making it equal to ending cash t-1 --5 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 Cash Asset is calculated with an IF() or MAX() statement – the value must be positive or zero (-5 on Lab Exam!) Short-Term Liability equal to the negative cash balance BUT it has to be multiplied by “-1” to make it a positive value, otherwise zero (-5 on Lab Exam!)

Reconciled Financial Statements   A B C D 1 Income Statement 2000 2001 2002 2 Receipts 3 Total Receipts = B2 = C2 = D2 4 Expenses 5 All Non-Interest Expenses  6 Interest for Land Loans 7 Interest for Machinery Loans 8 Interest for Operating Loans 9 Interest for Carry over Loans = 0.0 = B33 * iRate = C33 * iRate 10 Total Expenses = SUM (B5:B9) = SUM (C5:C9) = SUM (D5:D9) 11 12 Net Cash Income = B3 – B10 = C3 – C10 = D3 – D10 13 14 Cash Flow Statement 15 Beginning Cash Jan. 1 = Initial Value = B27 = C27 16 17 = B12 = C12 = D12 18 Other Inflows 19 Total Inflows = B17 + B18 + B15 = C17 + C18 + C15 = D15 + D17 + D18 20 Repay cash flow deficits = B33 = C33 21 Other Outflows 22 Total Outflows = B20 + B21 = C20 + C21 = D20 + D21 23 Ending Cash Balance Dec. 31 = B19 – B22 = C19 – C22 = D19 – D22 24 25 Balance Sheet 26 Assets Dec. 31 27 Cash Reserves = IF (B23 > = 0, B23, 0) = IF (C23 > = 0, C23, 0) = IF (D23 > = 0, D23, 0) 28 Land Value 29 Machinery 30 Other Assets 31 Total Assets = SUM (B27:B30) = SUM (C27:C30) = SUM (D27:D30) 32 Liabilities Dec. 31 33 Cash Flow Deficits = IF (B23 < 0, (-1 * B23), 0) = IF (C23 < 0, (-1 * C23), 0) = IF (D23 < 0, (-1 * D23), 0) 34 Land 35 36 Total Debts = SUM (B33:B35) = SUM (C33:C35) = SUM (D33:D35) 37 Net Worth = B31 – B37 = C31 – C37 = D31 – D37

Reconciled Financial Statements

Multi-Year Financial Models – Income Taxes Income taxes must be considered explicitly Corporations pay income taxes Sole proprietors also pay self-employment and Medicare taxes 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 Cash Flow Statement The corporate income tax schedule is below

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

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 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 8 6 4 2 1 3 D A C E B (risk) (income)

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.