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Pro Forma Analysis Topic Coverage 1. Definition of Pro forma analysis. 2. Alternative approaches to projecting net benefits from production and investment opportunities. 3. Input to capital budgeting and valuation decisions. 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 Point Forecast Assumptions Farm program policies Weather and disease One scenario examined Macroeconomic policies Foreign trade policies Global market events Baseline Scenario Assumes perfect knowledge of outcomes in all 5 areas!!!! What does this mean for: Crop and livestock prices? PE Unit input costs and farmland prices? Debt repayment capacity and credit risk? Asset valuation and collateral risk? QE Structural Pro Forma Analysis Farm program policies Weather and disease Macroeconomic policies Foreign trade policies Global market events Multiple scenarios examined Scenario #1 Scenario #2 Scenario #3 Scenario #5 Scenario #4 D Scenario #6 Scenario #7 Scenario #8 Scenario #9 S Supply-side risk for a given price… PEP QLQ QEQH Structural Pro Forma Analysis Farm program policies Weather and disease Macroeconomic policies Foreign trade policies Global market events Multiple scenarios examined Scenario #1 Scenario #2 Scenario #3 Scenario #5 Scenario #4 D Scenario #6 Scenario #7 Scenario #8 Scenario #9 S Demand and supplyside risk and potential price variability… PH PEP PL QLQ QEQH Ad 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 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 Producers Timeline Required for Capital Budgeting… Assume it is the year 2000 and John Deere wants to project farm machinery and equipment sales over the next six years to determine if plant expansion is necessary. 2000 2001 2002 2003 2004 2005 2006 Timeline Required for Capital Budgeting… Assume it is the year 2000 and John Deere wants to project farm machinery and equipment sales over the next six years to determine if plant expansion is necessary. 2000 2001 2002 2003 2004 2005 2006 Capital budgeting models of investment decisions require projections of the annual farm revenue and cost values over the entire 2001 to 2006 time period. Econometric 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 job of predicting future sales activity. Econometric Analysis Based on Investment Theory IT = f{[E(PT)×E(QT)]/E(cT)} An econometric model based on investment theory does a much better job of predicting future sales activity. Crop Market Model Demand equation: Qd = a0 - a1(Price) + ai (demand shifters) Supply equation: Qs = b0 +b1(price) + bi (supply shifters) Market equilibrium: Qd = Qs Crop Market Equilibrium Price S D Supply consists of: -Beginning stocks -Production -Imports Pe Demand consists of: -Food use -Feed use -Exports -Ending stocks Qe Quantity Histogram for Wheat Prices 3.345 3.145 3.945 - .80 +.80 Wheat Projections Made in 1997 Actual $5.00 Forecast $4.50 $4.00 $3.50 $3.00 $2.50 Actual/Baseline Prolonged Asian Crisis USDA 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 $2.00 Estimating the Annual Supply and Use of Wheat Econometric Analysis – Food Use Own price elasticity Income elasticity Cross price elasticity Observed and Predicted Values For Wheat Food Use Remaining Steps to Forecasting the Price of Wheat 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 (QD=QS) and solve for the price where excess demand equals zero. Crop Market Model Demand equation: Qd = a0 - a1(Price) + ai (demand shifters) Supply equation: Qs = b0 +b1(price) + bi (supply shifters) Market equilibrium: Qd = Qs Conclusions Econometric models are 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.