Pro Forma AnalysisPro Forma Analysis

Agribusiness FinanceAgribusiness FinanceLESE 306 Fall 2009LESE 306 Fall 2009

PASTPAST FUTUREFUTUREPRESENTPRESENT

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

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.

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.

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

Using assumptions made by others

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

Historical Data on Fixed Input Sales to FarmersHistorical Data on Fixed Input Sales to Farmers

Econometric Analysis Based on Time Trend ExtrapolationEconometric 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 jobpoor job of predicting future sales activity.

Econometric Analysis Based on Investment TheoryEconometric Analysis Based on Investment Theory

It = f{[E(Pt)×E(Qt)]/E(ct)}

An econometric model based on investment theory does a muchmuch better jobbetter job of predicting future sales activity.

Concept of Derived Demand for Concept of Derived Demand for Farm MachineryFarm Machinery

The demand for farm machinery is driven by the expected net economic benefit from use of the machine….

Crop Market EquilibriumCrop Market Equilibrium

Quantity

Price

Pe

Qe

D S

Demand consists of:-Industrial use-Feed use-Exports-Ending stocks

Supply consists of:-Beginning stocks-Production-Imports

Forecasting Future Commodity Price Trends

D

S

$4

10

$1

$7

D = a – bP + cYD + eX

Ownprice

Disposableincome

Otherfactors

D

S

$4

10

$1

$7

S = n + mP – rC + sZ

Ownprice

Inputcosts

Forecasting Future Commodity Price Trends

Otherfactors

Projecting Commodity Price

D = S

D

S

$4

10

$1

$7

D = 10 – 6P + .3YD + 1.2X

S = 2 + 4P – .2C + 1.02Z

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price

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!!!!

Point Forecast AssumptionsPoint Forecast Assumptions

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…QLQEQH

PE

Structural Pro Forma AnalysisStructural Pro Forma Analysis

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…

QLQEQH

PH

PE

PL

Structural Pro Forma AnalysisStructural Pro Forma Analysis

Estimating the Annual Estimating the Annual Supply and Use of WheatSupply and Use of Wheat

Income elasticity

Cross price elasticity

Econometric Analysis – Food UseEconometric Analysis – Food Use

Own price elasticity

Observed and Predicted ValuesObserved and Predicted ValuesFor Wheat Food UseFor Wheat Food Use

Remaining Steps to Forecasting Remaining Steps to Forecasting the Price of Commoditythe Price of Commodity

Develop similar econometric equations for feed use, exports and ending stock demand.

Develop econometric equations for production and import supply.

Substitute the estimated equations into the market equilibrium definition (Q(QDD=Q=QSS)) and solve for the price where excess excess demand equals zerodemand equals zero.

The Market ModelThe Market ModelDemand equationsDemand equations::Qd,i = a0 - a1(Price) + ai (demand shifters)

Supply equationSupply equation::Qs,i = b0 +b1(price) + bi (supply shifters)

Market equilibriumMarket equilibrium::ΣQd,i = ΣQs,i

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.