Forecasting Future Annual Forecasting Future Annual Net Cash FlowsNet Cash Flows
1. Definition of net cash flows2. Projecting future values3. Measurement of business risk4. Risk/return preferences5. Measurement of financial risk
Item:Before
new investment
After new investment
Net change
1. Cash receipts $25,000 $30,000 $5,000
2. Cash operating expenses -15,000 -18,000 -3,000
3. Depreciation -3,000 -4,000 -1,000
4. Tax deductible expenses (2+3) 18,000 22,000 4,000
5. Taxable income (1 – 4) 7,000 8,000 1,000
6. Income tax payments (5 times 25%) 1,750 2,000 250
7. Net income after taxes (1 – 4 – 6) 5,250 6,000 750
8. Net cash flow (7 + 3) 8,250 10,000 1,750
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The value circled in red is the value which appears in the numerator of each year’s discounted annual net cash flows in the NPV capital budgeting model.
Measuring Annual Net Cash FlowsMeasuring Annual Net Cash Flows
Forecasting NeedsForecasting NeedsForecast of annual
price of products from your operations
Forecast of annual cost per unit for inputs used in your operations
Forecasts any expected changes in productivity (i.e., yields)
Alternative ApproachesAlternative Approaches• Market outlook information approach• Historical based approaches:
– Naïve model (p. 64)– Olympic moving average (p. 65)
• Time series econometric approach• Flexibility coefficient approach (p. 66)• Structural econometric approach (p. 65-
67)
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
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Demand Supply
PE
QE
QD = f(P, Y-T, W, ...)QS = f(P, MIC, …)QD = QS
Solve for PE and QE
- 1 SD Mean + 1 SD
Structural Econometric Forecasting Model
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Stochastic simulation of random variable (yields) generates an empirical probability distribution for price
Non-Econometric ForecastingApproach
Subjective triangular probabilitydistribition assumed annually based upon recent trends in local spot market prices
Alternative Forecasting ApproachesAlternative Forecasting Approaches
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This is the probability distribution for the first year. One would expect the probability associated with the most likely scenario to decline over time, reflecting increasing uncertainty in subsequent years.
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We would reject making this
investment since the NPV < 0.
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Ignoring risk Ignoring risk would have led to would have led to an over evaluation an over evaluation of the projects of the projects NPV.NPV.
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Ignoring the Ignoring the increasing risk increasing risk would have led to would have led to the acceptance of the acceptance of this investment this investment project.project.
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Portfolio Effect on Risk-Adjusted NPVPortfolio Effect on Risk-Adjusted NPV
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Any Questions?Any Questions?
