Download Present financial position and performance of the firm

Handout #2
Agricultural Economics 432
Part I - Financial Analysis
Handout #2
Spring Semester 2007
John B. Penson, Jr.
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Agricultural Economics 432
Part I - Financial Analysis
Outline
Topic 1: Review of Financial Analysis Concepts
A. Introduction to Terminology
B. Key Financial Indicators to Track
C. Other Variables to Track
D. Financial Strength and Performance of the Firm
Topic 2: Growth of the Firm
A. Economic Climate for Growth (p. 14)
B. An Economic Growth Model (p. 17)
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Topic 2: Growth of the Firm
A. Economic Climate for Growth
The firm faces a number of decisions with regards to input choices and product choices
over time. Let’s begin with short run, with the existing firm having a given amount of
land and capital, and a given level of management resources. Let’s further assume for the
moment that the firm produces a single product. While we will assume conditions of
perfect competition, imperfect competitors also follow most but not all decision rules
discussed here.
Economics of business expansion
Up to this point we have been assessing the allocation of current resources to maximize
profits. An important question pertaining to investment expenditures and planned growth
of the firm is how large the firm should be and the combination of resources to use in
expansion. These are two separate issues.
How large should the firm be? Many industries have been the subject of studies focusing
on the economies of size. Firms often benefit from growth due to increases in efficiency
as well as perhaps being able to buy in bulk and hence pay a lower price for inputs. Let’s
examine the graph below and draw some implications about the size of the firm.
P=MR=AR
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At a current market price of P, firm size #1 would not be covering its cost of production
(i.e., SAC > P at Q1). Of the options in this graph, the firm needs to operate at a
minimum of Q2 units of output. At size #2, the firm would be earning an average profit
of P – SAC2 at Q2.
Should the firm expand to size #4, earning an average profit of P – SAC4? The answer to
this question is a qualified “No” in an industry where there are no barriers to entry or exit.
Why? Suppose as other firms entered, supply increased shifting the market supply curve
to the right and depressing the price of the product to PLR. Firm size #4 would face the
prospect of downsizing its operations since it is no longer covering its costs of production
at Q4 with PLR. This brings up the problem of asset fixity faced by many businesses, or
the inability to sell specialized fixed assets in periods of economic decline. Suppose the
firm was raising cotton and had recently purchased a $300,000 cotton picker. Should
cotton prices fall sharply (like from P to PLR above) and the firm wanted to flex to
another commodity, it might find it hard to dispose of the cotton picker in a weakened
secondary farm machinery market. A cotton picker has no use to growers of other
commodities or to nonfarm sectors because of its specialized nature. Furthermore, other
cotton farmers may well be attempting to sell high cost capital items at the same time.
Firm size #3 is the only size depicted in this graph that is positioned to remain a viable
business should the price fall to PLR. It is operating at the minimum point on the long run
average cost (LAC) curve, where PLR = LAC = MC3. The LAC curve, which is an
envelope of a series of short run average cost (SAC) curves, is known as the long run
planning curve. Up to the minimum point on the LAC curve, the firm can benefit from
increasing economies of size. After that point, the firm would experience decreasing
economies of size. Previous studies for many firms in agriculture show a third range of
the LAC curve exhibiting constant returns to size, where the LAC curve is relatively flat
before decreasing returns occur.
Capital variable in the long run
A large segment of a firm’s balance sheet is concentrated in fixed assets in the short run.
The firm’s tillable land base, its milking capacity, its feedlot capacity, etc. requires
capital expansion if more production is to be forthcoming. Other forms of fixed capital
such as harvesting equipment may involve the decision of whether to increase capital or
labor, and if so, how much?
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Suppose the firm depicted above wanted to double its output from 10 units to 20 units.
You will recall that an isoquant indicates how different combinations of inputs can
produce an identical amount of output, and that the point of tangency between the isocost line and the isoquant indicates the profit maximizing level of input use. The firm is
currently producing 10 units of output using one unit of capital and 5 units of labor (point
A) in the above graph. Given the goal of doubling its output, the firm faces the decision
of how much to expand its use of capital and labor.
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B. An Economic Growth Model
Before digging into the analytics underlying specific investment analysis models, we
think it is beneficial to gain an understanding the how internal and external factors
influence the growth of firm equity. An important lesson learned here is the notion that
the use of debt capital is a “double edged sword”.
Let the following symbols represent specific variables:
R
i
D
E
tY
w
Y
Rate of return on assets
Rate of interest on debt capital
Beginning debt outstanding
Beginning net worth or equity
Income tax rate
Rate of withdrawals from income
Net income
Net income before taxes would be given by:
(20)
Y = [r(D + E) – i(D)]
while the level of retained earnings or change in equity would be given by:
(21)
Y = [r(D + E) – i(D)](1 – tY)(1 – w)
Rearranging terms, we see that
(22)
Y = [ rD + rE – iD] (1 – tY)(1 – w)
or
(23)
Y = [(r – i)D + rE] (1 – tY)(1 – w)
Dividing both sides of this equation by the beginning level of equity, the rate of growth in
equity capital would be given by:
(24)
RGE = [(r – i)L + r](1 – tY)(1 – w)
where L is the debt-to-equity ratio, or L = D/E.
Equation (24) gives us a simple yet comprehensive economic model that allows us to
examine the effects of internally and externally imposed constraints on growth.
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Internally imposed constraints on growth
Internally imposed constrains on growth refers to decisions made by the producer that
affect the annual growth in equity. Assume the following values for the variables in the
growth model:
r
i
D
E
tY
w
10% or .10
7% or.07
$0
$100,000
25% or .25
0% or 0.0
Given these values, the rate of growth in equity capital or RGE would be:
(25)
RGE = [(.10 – .07)0 + .10] )](1 – .25)(1 – 0)
= [.10](.75)(1.0)
= .075 or 7.5%
????
If the firm withdrew 50 percent of after-tax income for other uses, the firm’s RGE
would be equal instead to:
(26)
RGE = [(.10 – .07)0 + .10] )](1 – .25)(1 – .50)
= [.10](.75)(.50)
= .0375 or 3.75%
The firm above internally rationed its use of debt capital to avoid exposure to financial
risk. If the firm instead had borrowed $100,000, giving it a debt-to-asset ratio of 0.50 or
a debt-to-equity ratio of 1.00, its RGE would be:
(27)
RGE = [(.10 – .07)1.0 + .10] )](1 – .25)(1 – .50)
= [.03 + .10](.75)(.50)
= .04875 or 4.875%
which is higher than the RGE given previously. Thus, the internal rationing of the use of
debt capital and the decision to withdraw equity from the firm for other uses such as
family living expenses affects the rate of growth achieved by the firm.
Externally imposed constraints on growth
Externally imposed constrains on growth refers to external policies or events occurring in
the economy that an individual consumer has little or no control over, but that affect the
annual growth in equity.
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Let’s assume that the firm is characterized by the following values:
r
i
D
E
tY
w
10% or .10
7% or.07
$75,000
$100,000
25% or .25
40% or 0.40
The firm’s RGE under these conditions would be:
(28)
RGE = [(.10 – .07)0.75 + .10](1 – .25)(1 – .40)
= [.1225](.75)(.60)
= .055125 or 5.5125%
If the firm also must pay a one percentage point risk premium for its term loans, the
RGE would fall to:
(29)
RGE = [(.10 – .08)0.75 + .10](1 – .25)(1 – .40)
= [.115](.75)(.60)
= .05175 or 5.175%
which is 0.34% lower than earned by others who do not have to pay this risk premium of
term loans.
If lenders not only charge a one percentage point risk premium but also limited the firm
to a 50 percent debt-to-equity ratio (an example of external credit rationing), the firm’s
rate of growth in equity or RGE would be:
(30)
RGE = [(.10 – .08)0.50 + .10](1 – .25)(1 – .40)
= [.110](.50)(.60)
= .0495 or 4.95%
Another external constraint in the growth model is the income tax rate. If the effective
income tax rate is only 15 percent rather than 25 percent, staying with the parameters
in equation (30), the RGE would be:
(31)
RGE = [(.10 – .08)0.50 + .10](1 – .15)(1 – .40)
= [.110](.85)(.60)
= .0561 or 5.61%
Financial risk associated with revenue variability
The use of debt capital can be seen as a two-edge sword. As long as the rate of return on
assets (r) is greater than the cost of debt capital (i), or r > i., the use of debt capital
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contributes to the growth of the firm’s equity. The firm however is exposed to financial
risk when borrowing if events lead to the situation where the rate of return on assets (r) is
less than the interest rate on debt capital (i), or r < i. Let’s assume that the rate of return
on assets fell from 10% to 2% in a given year. Holding all other conditions as they
were in equation (31), we see that the RGE would fall to:
(32)
RGE = [(.02 – .08)0.50 + .02](1 – .15)(1 – .40)
= [-.025](1.00)(1.00)
= -.025 or –2.5%
The value of the income tax rate would be zero due to the negative net farm income.
The rate of withdrawal would also be zero for the same reason, which explains the
two “1.00” appearing in this equation.