Course Summary
at Mid-Term
LESE 306
Fall 2009
Slide Show #1
Important Market Linkages
Farm Input
Supply
Sectors
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
The scope of a nation’s
Food and fiber industry
Whole
And Retail
Trade Sectors
Important Market Linkages
General Domestic
Economy
Farm Input
Supply
Sectors
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
Whole
And Retail
Trade Sectors
Important Market Linkages
Domestic Macro
Policy
Farm Input
Supply
Sectors
General Domestic
Economy
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
Whole
And Retail
Trade Sectors
Important Market Linkages
Domestic Macro
Policy
Farm Input
Supply
Sectors
General Domestic
Economy
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
Global Macro Policy
Global Economy
Whole
And Retail
Trade Sectors
Important Market Linkages
Domestic Macro
Policy
Farm Input
Supply
Sectors
Farm
Policy
General Domestic
Economy
Global Macro Policy
Global Economy
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
Whole
And Retail
Trade Sectors
Environmental
Policy
Important Market Linkages
Domestic Macro
Policy
Farm Input
Supply
Sectors
Farm
Policy
General Domestic
Economy
Global Macro Policy
Global Economy
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
Farm
Credit
Markets
Whole
And Retail
Trade Sectors
Environmental
Policy
Farm and
Non-Farm
Labor Markets
Important Market Linkages
Domestic Macro
Policy
Farm Input
Supply
Sectors
Farm
Policy
Key point:
Because farmers and
ranchers are price takers
in product, input, labor
and credit markets, they
are susceptible to trends
in these other markets.
General Domestic
Economy
Global Macro Policy
Global Economy
Food Processing
And Fiber
Manufacturing Sectors
Farms and
Ranches
Farm
Credit
Markets
Whole
And Retail
Trade Sectors
Environmental
Policy
Farm and
Non-Farm
Labor Markets
Slide Show #2
Accounting Fundamentals
Structure of Financial Statements
Agribusiness Finance
LESE 306 Fall 2009
Basic Structure of the
Balance Sheet
Assets:
Liabilities and Net Worth:
Current assets
Current liabilities
plus Long term assets
plus Long term liabilities
plus Net worth
equals Total assets
Often referred
to as equity
equals Total liabilities and net
worth
Page 3 in booklet
Balance Sheet Structure
Net worth or equity is determined residually, balancing the statement
Basic Structure
of Income Statement
Minus
Equals
Plus
Plus
Less
Equals
Minus
Equals
Cash receipts from product sales
Operating and interest expenses
Net cash income from operations
Gain (loss) on sale of long term assets
Cash subsidies received
Depreciation allowances
Income (loss) before taxes
Provision for income taxes
Net income
Page 4 in booklet
Income Statement Structure
Basic Structure of
Cash Flow Statement
Cash available (including cash balance)
Minus Cash required
Equals Cash available less cash required
Plus Available savings withdrawals
Equals Cash position
Plus Net borrowing
Minus Other uses of cash
Minus Withdrawals of cash to savings
Equals Ending cash balance
Page 5 in booklet
Cash Flow Statement - 1
Cash Flow Statement -2
Need for draw on an
LOC in May. Repaid
loan in July.
Cash Flow Statement -3
Cash Flow Statement -4
Producer drew down an LOC
In months of May and June and
repaid balance in July
Value of ending cash balance
In the balance sheet
Statement Linkages
Data from cash flow statement to income
statement:
1.
2.
3.
Cash receipts from operations
Cash operating expenses
Other cash items (e.g., interest payments,
property taxes, etc.)
Cash flow
statement
Income
statement
Statement Linkages
Data from cash flow statement to balance
sheet:
1.
2.
3.
4.
Ending cash balance
Loan balances (current liability portion vs.
remaining balance outstanding)
Asset adjustments if capital expenditures are
made
Additions and withdrawals from savings
Cash flow
statement
Income
statement
Balance
Sheet
Slide Show #3
Key Financial Indicators
Agribusiness Finance
LESE 306 Fall 2009
Key Financial Indicators
Measures of asset liquidity
 See equations 1 and 2 on page 12 of booklet
Measures of solvency
 See equations 3, 4, 5 and 6 on page 13 of booklet
Measures of after-tax profitability
 See equations 7, 8 and 9 on page 13 of booklet
Measures of economic efficiency
 See equations 10, 11, 12, 13 and 14 on page 14 of booklet
Measures of debt repayment capacity
 See equations 15 – 17 on page 15 of booklet
Measures of Asset Liquidity
1. Current ratio:
• Current assets divided by current liabilities.
• Demonstrates ability to cover scheduled current liabilities for the
coming year out current assets and still have “cash” left over.
• Should exceed 1.0 to be technically liquid.
• Some firms fail despite exceeding this hurdle.
2. Working capital:
• Current assets minus current liabilities.
• Expresses liquidity in dollars rather than ratio.
• Should be positive.
• Cash is King!
Balance Sheet Structure
Current ratio = $57,314 / $79,000 = .725 = illiquid
Working capital = $57,314 - $79,000 = -21,686 = illiquid
Measures of Credit Liquidity
1. Unused credit reserves:
• LOC extended by lender less current loans on LOC. The unused
portion of your credit limit on your personal credit card is an
example of credit liquidity.
• Demonstrates ability to cover scheduled current liabilities for the
coming year out existing available credit.
• Should positive to be technically liquid.
• We will cover the implicit cost of credit liquidity later in the course.
Cash Flow Statement -4
Producer drew down an LOC
In months of May and June and
repaid balance in July
If the lender is willing to extend a maximum LOC of $100,000, the unused line of
credit or credit liquidity is $89,155 in May and June ($100,000 - $10,845).
Measures of Cash Flow Liquidity
1. Monthly cash position:
• Monthly cash position (surplus of cash available less cash
required) on the firm’s monthly cash flow statement.
• Demonstrates ability to cover scheduled current liabilities for a
particular month out expected surplus cash position.
• Should positive to be technically liquid.
• Knowledge of the firm’s cash flow liquidity requires that the firm
maintain a monthly cash flow statement.
Cash Flow Statement - 1
The firm has cash flow liquidity until April when it must draw on LOC
Measures of Solvency
1. Debt ratio:
• Total debt divided by total assets.
• Demonstrates ability to liquidate the firm, pay off all liabilities from
the net proceeds from the sale of all assets, and still have “cash”
left over.
• Should not exceed 0.50 to minimize financial risk exposure.
• Some firms fail however at lower levels.
2. Leverage ratio:
• Total debt divided by equity or net worth.
• Often a credit standard in loan approval decisions.
• Should not exceed 1.0 to minimize financial risk exposure.
• Effects of rising interest rates.
Balance Sheet Structure
The debt ratio = $329,000 / $727,314 = .45 which is less than 0.50
The leverage ratio = $329,000 / $398,314 = .826 which is less than 1.0
Measures of Profitability
1. Rate of return on assets:
• Net income plus interest divided by total assets.
• Demonstrates the after-tax return to the total capital invested
in the firm.
• Should be positive; the higher the better.
2. Rate of return on equity:
• Net income divided equity.
• Demonstrates the after-tax return on owner equity invested
in the firm.
• Should be positive; the higher the better.
Income Statement Structure
The ROA = (9,655 + $50,000) / $727,314 = 0.082 or 8.2%
The ROE = 9,655 / $398,314 = 0.024 or 2.4%
Measure of Debt Repayment Capacity
1. Term Debt and Capital Lease Coverage Ratio:
• Cash available from operations to cover scheduled payments
(net income plus depreciation and term loan interest
payments less withdrawals) divided by scheduled principal and
interest payments on term loans and capital leases measures
the after- tax cash coverage ratio.
• After provision for taxes and withdrawals.
• Should be greater than 1.0.
• Non-farm income often factored in by lenders.
2. Debt Burden Ratio:
• Total debt outstanding divided by net income.
• Number of years required to retire total debt if net income
remains constant and used entirely for this purpose
• Should be low; the lower the better.
Debt Coverage
The debt coverage ratio of 1.20 exceeds the minimum of 1.0
Slide Show #4
Financial Check Up
Agribusiness Finance
LESE 306 Fall 2009
What is the status of your….
•
•
•
•
•
Liquidity?
Solvency?
Profitability?
Efficiency?
Debt repayment
capacity?
• Survivability?
Liquidity Trends
Current Ratio
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Survived
Failed
1
Minimum
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Liquidity Trends
Working Capital-to-Total Assets
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
Survived
Failed
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Solvency Trends
Total Debt-to-Total Assets
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Failed
Maximum
Survived
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Debt Repayment Coverage
Inverse of debt
burden ratio
assuming use of
depreciation
allowances to
retire debt.
Net Cash Income-to-Total Debt
0.60
Survived
0.50
0.40
0.30
0.20
0.10
0.00
-0.10 1
-0.20
2
3
4
5
Failed
-0.30
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Some Conclusions….
 Indicators of
growth/survival:
 Increasing liquidity
 Increasing solvency
 Increasing debt
repayment capacity
 Increasing profitability
 Indicators of
potential failure:
 Declining liquidity
 Declining solvency
 Decreasing debt
repayment capacity
 Decreasing profitability
#1:Historical Analysis
 A look backwards like
the Beaver study.
 Comparison of current
performance with past
performance.
 Recommend doing
this at the enterprise
level as well as for the
farm as a whole.
 Why is ROA falling?
Rate of Return on Assets
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#2:Comparative Analysis
 Comparing current
performance with
similar operations like
the Beaver study.
 Benchmark analysis at
enterprise level when
possible.
 Address reasons why
your firm is performing
more poorly than other
comparable
operations before it is
too late.
Rate of Return on Assets
0.15
Benchmark
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#3:Pro Forma Analysis
 Stress testing current
expected cash flows by
varying prices, unit
costs and yields.
 Look at implications of
longer run price and unit
cost trends on future
financial health when
making major decisions.
Slide Show #5
Enterprise Level Analysis Topics
Agribusiness Finance
LESE 306 Fall 2009
Relationship Between
Enterprise and Master Budgets
Overhead:
Enterprise #1
Design of an
Enterprise budget.
Construct budget
for all enterprises,
multiply times level
of activity and
check overhead to
ABC approach.
Contribution Analysis
Slide Show #6
Intro to Master Budget
Agribusiness Finance
LESE 306 Fall 2009
#3:Pro Forma Analysis
 Stress testing current
expected cash flows by
varying prices, unit
costs and yields.
 Look at implications of
longer run price and unit
cost trends on future
financial health when
making major decisions.
Master Budget Preparation
 Annual operating budgets
1.
2.
3.
4.
5.
6.
Sales budget: number of units to be sold
Production budget: expected output and inventory
Direct materials budget: planned material use
Direct labor budget: planned labor use
Other budgets: expected selling and administrative
Needed to prepare the cash budget
 Other annual budgets and statements
1.
2.
3.
4.
Capital expenditure budget
Needed to prepare budgeted cash flow statement
Needed to prepare budgeted income statement
Needed to prepare budgeted year end balance
sheet
Pro Forma Financial Statements
Sales Budget
Production Budget
Direct Materials
Budget
Direct Labor
Budget
Overhead
Budget
Selling and Administrative
Expense Budget
Cash Budget
Budgeted Cash
Flow Statement
Budgeted Income
Statement
Capital
expenditures
Budgeted
Balance Sheet
Sources of Uncertainty
 Global trends in
production and
consumption
 Energy prices and
core inflation trends
 Interest rates and
exchange rates
 Changes in industry
subsidies
Accounting for Uncertainty
 Stress testing
product prices
 Stress testing unit
input prices like fuel
costs
 Stress testing yields
 Stress test interest
rates
Slide Show #7
Cost Accounting
An Overview
Managerial Cost Concepts
1. Direct materials: raw materials
physically associated with the final
product
2. Direct labor: employees physically and
directly associated with the final product
3. Overhead: costs indirectly associated
with the final product
More Concepts
1. Period costs: costs matched with revenue for
a specific time period. (i.e., net income for a
specific period (i.e., quarterly, annual).
2. Product costs: costs associated with
producing the final product. Not considered an
expense until the product is sold.
3. Total costs: equals direct materials, direct
labor and manufacturing overhead plus indirect
costs (selling and administrative expenses).
The Master Budget and Pro Forma Financial Statements
Enterprise #1
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Sales Budget
Production Budget
Direct Materials
Budget
Enterprise #n
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Direct Labor
Budget
Overhead
Budget
Total Costs
Production Costs
Manufacturing Costs
Period Costs
Non-manufacturing Costs
Direct
Materials
Selling
Expenses
Direct
Labor
Administrative
Expenses
Manufacturing
Overhead
Other Indirect
Expenses
Three Cost Accounting Concepts
1. Process cost accounting
2. Job order cost accounting
3. Activity based cost
accounting
1. Process Cost Accounting
Tracking costs associated with a specific
process
Direct materials and labor associated with
the specific process
Manufacturing overhead costs associated
with the specific process
Comparison of Cost Systems
Features
Process Cost
System
Work in process
accounts
Multiple work in
process accounts
Documents used
Production cost
reports
Determination of
total manf. costs
Each period
Unit-cost
computations
Total manf. costs/
units produced
during the period
2. Job Order Cost Accounting
Tracking costs associated with a specific
order or job
Direct materials and labor associated with
a specific order or job
Manufacturing overhead costs associated
with a specific order or job
Comparison of Cost Systems
Features
Process Cost
System
Job Order
Cost System
Work in process
accounts
Multiple work in
process accounts
One work in
process account
Documents used
Production cost
reports
Job cost sheets
Determination of
total manf. costs
Each period
Each job
Unit-cost
computations
Total manf. costs/
units produced
during the period
Cost of each job/
units produced for
the job
3. Activity Based Cost Accounting
An approach for allocating overhead.
An activity is any event, action, transaction or
work sequence that incurs when producing a
product or providing a service.
An activity cost pool is a distinct type of activity
(e.g., ordering materials).
A cost driver is any factor or activity that has a
direct cause-effect relationship with resources
consumed (e.g., machine hours).
Steps in ABC Accounting
1. Identify and classify activities and
allocate overhead to cost pools.
2. Identify cost drivers – correlation
between driver and use.
3. Compute overhead rates – ABC rate.
4. Assign overhead costs to products – use
of cost drivers.
5. Comparison of unit total costs across
products.
Example of ABC Accounting
Step 2: Partitioning of process overhead:
Overhead
Product 1
Setting up machines
$300,000
$100,000
Machining
$500,000
$300,000
Inspecting
$100,000
$25,000
Total
$900,000
$425,000
Step 3: Process overhead costs per unit:
Units produced
25,000
Process overhead cost per unit
$17
Traditional process overhead cost per unit*
$30
Product 2
$200,000
$200,000
$75,000
$475,000
5,000
$95
$30
* $900,000 divided by 30,000 units
Avoids overstating
profitability of some
enterprises and understating
profitability of others
Example of ABC Accounting
Product 1 Product 2
COP unit costs with ABC costing:
Direct materials
Direct labor
ABC overhead
Total unit costs
$40
$12
$17
$69
$30
$12
$95
$137
COP unit costs with traditional costing:
Direct materials
Direct labor
Traditional overhead *
Total unit costs
$40
$12
$30
$82
$30
$12
$30
$72
* $900,000 divided by 30,000 units
Traditional overhead costing
suggests that Product 2 is
cheaper to produce than
Product 1, which is not true!
Slide Show #12
DuPont model of Profit
Analysis
Agribusiness Finance
LESE 306 Fall 2009
DuPont Formula
ROA can be broken down into profit
margin and asset turnover.
Gain an insight into planning for profit
improvement.
Need to improve the profit margin.
Need to improve asset turnover.
Need to improve both!!
Improving Profit Margin
Reducing expenses:
 Using less costly materials.
 Automation to improve productivity.
 Review fixed costs (advertising, R&D,
management development programs, etc.).
Raising prices:
 Requires pricing power.
 Also requires brand loyalty.
 Easier for firms with unique high quality goods.
Improve Asset Turnover
Increase sales while holding investment in
assets relatively constant:
 Dispose of obsolete and adopt technology
that enhances productivity.
 Speed up collections of receivables.
 Evaluate credit terms and policies.
 Identify unused and redundant fixed assets.
Use idle cash to repay outstanding debts
or invest in profit producing activities.
Work backwards to
find constraint on
ROA
Analyzing DuPont Formula
1. A high net profit margin or NPM signals
strong operating management.
2. A high total asset turnover ratio or TAT
signals strong asset management.
3. A high equity multiplier or EM signals
strong capital management in the
presence of low and stable cost of debt
capital.
Slide Show #13
Economic Growth Model
Agribusiness Finance
LESE 306 Fall 2009
Page 50 in booklet
Page 52 in booklet
Economic Growth Model
ROE = [(r – i)L + r](1 – tx)(1 – w)
Rate of
return on
assets
Cost of
debt
capital
Leverage
ratio or
debt/equity
Income
tax rate
Rate of
withdrawals
from firm
Page 58 in booklet
Economic Growth Model
ROE = [(r – i)L + r](1 – tx)(1 – w)
There are many applications of this model:
1. Solve for ROE given r, i, L, tx and w
2. Solve for required r given ROE, i, L, tx and w
3. Solve for maximum w for required ROE given r, i L and tx
4. Solve for maximum L for required ROE given r, i tx and w
Basically we can treat this as one equation with one unknown and
solve for that unknown value. This allows us to examine the effects
of specific internal and external constraints on the growth of the
firm’s equity base.
Page 58 in booklet
Slide Show #14
Cost of Capital and Optimal
Capital Structure
Agribusiness Finance
LESE 306 Fall 2009
Page 101 in booklet
Page 102 in booklet
Page 103 in booklet
Slide Show #15
Time Value of Money
Agribusiness Finance
LESE 306 Fall 2009
Time Value of Money…
Assume it is the year 2009 and you have been
given the choice of a single payment of $500
paid to you ten years from now (2019) or a
payment of $300 today. Which would you
choose?
2009
2010
2011
2012
2013
…….
2019
Present Value Interest Factor (PIF) Table
PIFr,n = (1 + r) -n
Will be at the back of the mid-term test booklet
I would take the $300 today since it has a higher present value, given my
discount rate of 6%, than $500 ten years from now.
Page 59 in booklet
Page 59 in booklet
Equal Payment Present Value Interest Factor (EPIF) Table
EPIFr,n = [1 – (1 / (1+ r)n)] / r
Will be at the back of the mid-term test booklet
Page 60 in booklet
Know how to manipulate this equation
Page 62-63 in booklet
Page 63 in booklet
Know equations 40, 44 and 45
Page 65-66 in booklet
Slide Show #16
Capital Budgeting
Methods
Agribusiness Finance
LESE 306 Fall 2009
Page 65 in booklet
Page 66 in booklet
NPV > 0 suggests project is economically feasible
NPV = 0 suggests indifference
NPV < 0 suggests project is economically infeasible
Page 67 in booklet
Page 68 in booklet
*
*
Pages 68-69 in booklet
Page 69 in booklet
*
Page 69 in booklet
Page 72 in booklet
*
*
Page 73 in booklet
Page 76 in booklet
Page 77 in booklet
*
Set NPV equal to zero and solve for T, the terminal value.
Page 78 in booklet
*
Page 80 in booklet
*
G is the expected rate of appreciation
Page 80 in booklet
*
Page 81 in booklet
Comparable
land values
Equal net
cash flows
Capital gains
tax rate is 25%
20 year
economic life
7% land value
appreciation rate
5% discount rate
Page 81 in booklet
*
Page 82 in booklet
Slide Show #17
Pro Forma Analysis
Agribusiness Finance
LESE 306 Fall 2009
PRESENT
PAST
FUTURE
 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
Must project
Annual price
Must project
Annual yield
Page 83 in booklet
Ad 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 average
 Using assumptions
made by others
Ad Hoc Modeling Approaches
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.
Econometric 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 Equilibrium
Price
S
D
Supply consists of:
-Beginning stocks
-Production
-Imports
Pe
Demand consists
of:
-Industrial use
-Feed use
-Exports
-Ending stocks
Qe
Quantity
Page 45 in booklet
Projecting Commodity Price
$7
D
S
D = 10 – 6P + .3YD + 1.2X
D=S
$4
S = 2 + 4P – .2C + 1.02Z
$1
10
Substitute the demand and supply
equations into the the equilibrium
condition and solve for price
Page 46 in booklet
Stress Testing Your
Forecast
Point Forecast Assumptions
Assumptions
Farm
program
policies
Weather
and
disease
One
scenario
examined
Macroeconomic
policies
Foreign
trade
policies
Global
market
events
Baseline
Scenario
Assumes
perfect
knowledge of
What does this mean for:
outcomes in all
PE
Crop and livestock
prices?
Unit input costs and farmland prices? 5 areas!!!!
Debt repayment capacity and credit risk?
Asset valuation and collateral
risk?
Q
E
Page 47 in booklet
StructuralPro
ProForma
FormaAnalysis
Analysis
Structural
Farm
program
policies
Weather
and
disease
Macroeconomic
policies
Foreign
trade
policies
Global
market
events
Multiple
scenarios
examined
Scenario
#1
Scenario
#2
Scenario
#3
Demand and supplyside risk and
potential price
variability…
Scenario
#5
Scenario
#4
D
Scenario
#6
Scenario
#7
Scenario
#8
Scenario
#9
S
PH
PEP
PL
QLQ
QEQH
Page 47 in booklet
80%
10%
$2.50
10%
$3.00
$3.50
Triangular Probability Distribution
Page 130 in booklet
Conclusions
Econometric models preferred over naïve
models and linear time trend models.
Much more accurate.
Provide much more information (e.g.,
elasticities).
Allow for sensitivity analysis with
independent (exogenous) variables when
evaluating potential variability about
expected trends.
Business Risk
Risk associated with price of the product
or products you are producing.
Risk associated with the unit costs for the
inputs used in producing the product(s).
Risk associated with yields (productivity)
in production.
NCFi=Piyieldsiunit sales – Ciunit inputs
Accounting for Business Risk
RRRH,i
RRRL,i
RFREE,i
.05
RFREE,i = risk free rate of return (i.e., govt. bond rate)
RRRL,i = required rate of return for lowly risk averse
RRRH,i = required rate of return for highly risk averse
Page 132 in booklet
Increasing Risk Over Time
Probability
Product price
distribution
90%
5%
Year 10
5%
Year 1
E(P)
Year 1
$2.95
$3.05
$3.15
Pessimistic
price
Expected
price
Optimistic
price
Year 10
Increasing Risk Over Time
Probability
Product price
distribution
60%
20%
20%
Year 10
Year 1
E(P)
Year 1
Year 10
$2.05
$2.95
$3.05
$3.15
$4.05
Pessimistic
price
Expected
price
Optimistic
price
Financial Risk
Risk 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 Risk
RRRi
RRRi
RFREE,i
.05
Page 138 in booklet
Required 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
Our Complete NPV
Capital Budgeting Model
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)]
Discounted NCF in year 1
Discounted NCF in year 2
Discounted NCF in year n
Discounted terminal value
Discounted capital gains tax
Decision rule:
NPV > 0 suggests project is economically feasible
NPV = 0 suggests indifference
NPV < 0 suggests project is economically infeasible
One Strategy to Minimizing Risk Exposure
Page 140 in booklet
The Portfolio Effect
NCFi
Average annual NCF after
making new investment.
Forecast horizon
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.
Ranking
Investment
Opportunities
How would you rank
these alternative
projects?
Page 106 in booklet
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Page 106 in booklet
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Page 107 in booklet
Page 107 in booklet
Borrowing Preparation
1. 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.