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## Materials for Lecture 15 Financial Models

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**Materials for Lecture 15 Financial Models**• Finish Scenario Ranking Lecture • New Material for Lecture 15 • Read Chapters 13 and 14 • Lecture 15 Pro Forma.xlsx • Lecture 15 Fin Risk Manager.xlsx • Lecture 15 Farm Simulator.xlsx • Lecture 15 Income Taxes.xlsx**3. Stochastic Efficiency (SERF)**• Stochastic Efficiency with Respect to a Function (SERF) calculates the certainty equivalent for risky alternatives at 25 different RAC levels • Compare CE of all risky alternatives at each RAC level • Scenario with the highest CE for the DM’s RAC is the preferred scenario • Summarize the CE results for possible RACs in a chart • Identify the “efficient set” based on the highest CE within a range of RACs • Efficient Set • This is utility shorthand for saying the risky alternative(s) that is (are) the most preferred**Ranking Scenarios with Stochastic Efficiency (SERF)**• SERF requires an assumption about the decision makers’ utility function and like SDRF uses a range of RAC’s • SERF ranks risky strategies based on expected utility which is expressed as CE at the DM’s RAC level • Simetar includes SERF and calculates a table of CE’s over a range of RAC values from the LRAC to the URAC and develops a chart for ranking alternatives**Ranking Scenarios with SERF**• SERF results point out the reason that SDRF produces inconsistent rankings • SDRF only uses the minimum and maximum RACs • The efficient set (ranking) can differ from minimum the RAC to the maximum RAC • Changing the RACs and re-running SDRF can be slow • SERF can show the actual RAC where the decision maker is indifferent between scenarios (this is the BRAC or breakeven risk aversion coefficient) • The SERF Table is best understood as a chart developed by Simetar**Ranking Scenarios with SERF**• Two examples are presented next • The first is for ranking an annual decision using annual net cash income • Uses negative exponential utility function • Lower ARAC = zero • Upper ARAC = 4.0/Wealth • The second example is for ranking a multiple year decision using NPV variable • Uses Power Utility function • Lower RRAC = zero • Upper RRAC = 4.001**Ranking Risky Alternatives with SERF**• Interpret the SERF chart as follows • The risky alternative that has the highest CE at a particular RAC is the preferred strategy • Within a range of RACs the risky alternative which has the highest CE line is preferred • If the CE lines cross at that point the DM is indifferent between the two risky alternatives and find a BRAC • If the CE line goes negative, the DM would rather earn nothing than to invest in that alternative • Interpret the rankings within risk aversion intervals • RAC = 0 is for risk neutral DM’s • RAC = 1 or 1/W is for normal slightly risk aversion DM’s • RAC = 2 or 2/W is for moderately risk averse DM’s • RAC = 4 or 4/W is for extremely risk averse DM’s**Ranking Using Risk Premiums**• Risk Premium (RP) - calculate the risk premium between each of the scenarios and another scenario. • Risk Premiums equals difference between the CE’s for the risky scenarios: RPG to F = CEG – CEF • Rank the risky scenarios based on the RPs • Advantage is that the full distribution (F(x) and G(x)) of values for the KOV are compared to each other distribution, based on the decision maker’s RAC • A wide range of RACs can be tested to allow for a wider range of decision makers given an assumed utility function • Base scenario should be the current situation or the scenario picked best by stochastic efficiency (SERF)**Ranking Using Risk Premiums Table**• The RP Table is calculated like the SERF Table using the same range of 25 RACs • The user specifies the base scenario; Option 1 was selected for this example • Select the scenario that has highest risk premium for the RAC which best defines the decision maker**Ranking Using Risk Premiums**Risk Premium decision maker must be paid to accept an inferior scenario Based on the Risk Premium, decision maker would pay to move from Base to Alt 4 • Risk premiums are presented relative to a base scenario, Alt 1, above • Alt 4 is preferred for all risk averse decision makers. • Distance between Red line and Base line, $18,347, is how much a risk averse decision maker would pay to move from Alt 2 to Alt 1. • Risk averse decision makers prefer Alt 4 to Alt 1 and would pay about $8,000 to gain Alt 4 over Alt 1.**Roy’s Safety First Rule**• Roy (Econometrica, 1952) • Select the strategy which minimizes the chance of falling below a critical level of net cash income • Rank risky alternatives based on the scenario with the smallest probability of low net cash incomes • This is essentially a two light “Stop Light chart”**Roy’s Safety First Rule**• A Roy’s Safety First Rule presented as the probability of NCIi < target each year i • With Roy’s Rule, can calculate the probability of a “low” net cash income for two or more consecutive years, as: =IF(AND(NCI1<0, NCI2<0),1,0) =IF(AND(NCI2<0, NCI3<0),1,0) =IF(AND(NCI3<0, NCI4<0),1,0) =IF(AND(NCI4<0, NCI5<0),1,0) • Repeat the =IF(AND()) statement for all years 2-T and summarize the counter variables for all iterations • Roy’s probability is sum for all of the =IF(AND()) values divided by (No. Years – 1) * No. Iterations • If 10 years and 500 iterations the denominator is 4,500 representing all possible sample observations that could be 1**Roy’s Safety First Rule**• The scenario was simulated 100 iterations • Net cash income is for 10 years • Roy’s values are for 2 consecutive years with negative NCI • Roy’s Probability is the sum of the =IF(AND()) counter variables divided by 900, which is = 9 * no. iterations**Roy’s Safety First Rule**• The Stop Light displays the probabilities of having two years of negative NCI in a row, years 1 & 2 or Years 3 & 4, etc. • Chart developed from the data in the previous overhead, over all 100 iterations • The counter variables can be 0 or 1 so not marginal probabilities and thus no yellow in the Stop Light**Multi-Year Financial Models**• Business decisions often are made based on simple rules • Mean net return (IRR, NPV, etc.) • Worst case and best case • Number of years to payoff debt • Give the business control of its supply chain, etc. • These business decisions are inherently multi-year in nature**KOVS for a Multi-Year Financial Models**• Annual net cash income • Probability of negative NCIt • Annual ending cash reserves • Probability of negative ending casht • Probability of having to refinance deficitst • Annual net worth (nominalt and realt) • Probability of decreasing RNW relative to BNW • Annual debt to asset ratio • Probability of insolvency • NPV summarizes returns over multiple years • Probability of positive NPV or P(economic success)**Multi-Year Financial Models**• Common theme or features for multi-year financial models • Input values have annual projections • Prices paid and received • Annual inflation rates for costs of production • Inflation rates for asset values • Machinery replacement plans • Management controls are expressed as annual values so, can be strategically managed • Assumptions about changing productivity • Assumptions about possible structural changes • Assumptions about competition and demand • Assumptions about beginning cash reserves**Multi-Year Financial Models**• Common set of intermediate calculations • Income Statement • Receipts from each source • Total Receipts • Cash expenses for each category (non-cash expenses such as depreciation not included here) • Total Cash Expenses • Net Cash Income • Cash Flow Statement • Net cash income and all other sources of income • All cash outflows: taxes, principal payments, owner withdrawals or dividends • Ending Cash Reserves • Balance Sheet • Assets starting with positive cash balance • Liabilities • Including cash flow deficits • Net Worth • Financial summary ratios: • Debt Asset, PVENW, NPV**Multi-Year Financial Models**• A significant problem can occur with multiple year simulation models • Ending cash reserves can be negative, which causes problems in all three pro forma financial statements • What happens if ending cash is negative? • Cash reserves are zero • Must create a short-term liability • Must pay interest for this loan next year • Must repay the short-term loan next year • This is why Ending Cash is a KOV**Multi-Year Financial Models**• Problem of negative ending cash is much greater in agriculture and agribusiness models -- it occurs more often than in non-ag businesses • Risk on prices and production greater than for non-ag business interests • If you build financial models that do not accommodate this problem, you understate the risk involved with an investment**Modeling Negative Cash Flow for Multi-Year Financial Models**• Modification to the pro forma financials for negative cash flows are simple • Change the Income statement • Add an expense for interest paid on cash flow deficit loans – keep it separate from operating interest paid (-5 on Lab Exam!) • Change the Cash Flow Statement • Make Beginning Cash equal to Cash Balance in the Balance Sheet (it should be this way but many students make the mistake of making it equal to ending cash t-1 -- -5 on Lab Exam!) • Add a cash outflow to repay the short-term loan borrowed in the previous year to meet a deficit (-5 on Lab Exam!) • Change the Balance Sheet • IF() statement for Beginning Cash – that it must be positive or zero (-5 on Lab Exam!) • IF() statement for a Short-Term Liability to have a positive value if ending cash reserve is negative (-5 on Lab Exam!)**A**B C D 1 Income Statement 2000 2001 2002 2 Receipts 3 Total Receipts = B2 = C2 = D2 4 Expenses 5 All Non-Interest Expenses 6 Interest for Land Loans 7 Interest for Machinery Loans 8 Interest for Operating Loans 9 Interest for Carry over Loans = 0.0 = B33 * iRate = C33 * iRate 10 Total Expenses = SUM (B5:B9) = SUM (C5:C9) = SUM (D5:D9) 11 12 Net Cash Income = B3 – B10 = C3 – C10 = D3 – D10 13 14 Cash Flow Statement 15 Beginning Cash Jan. 1 = Initial Value = B27 = C27 16 17 Net Cash Income = B12 = C12 = D12 18 Other Inflows 19 Total Inflows = B17 + B18 + B15 = C17 + C18 + C15 = D15 + D17 + D18 20 Repay cash flow deficits = 0.0 = B33 = C33 21 Other Outflows 22 Total Outflows = B20 + B21 = C20 + C21 = D20 + D21 23 Ending Cash Balance Dec. 31 = B19 – B22 = C19 – C22 = D19 – D22 24 25 Balance Sheet 26 Assets Dec. 31 27 Cash Reserves = IF (B23 > = 0, B23, 0) = IF (C23 > = 0, C23, 0) = IF (D23 > = 0, D23, 0) 28 Land Value 29 Machinery 30 Other Assets 31 Total Assets = SUM (B27:B30) = SUM (C27:C30) = SUM (D27:D30) 32 Liabilities Dec. 31 33 Cash Flow Deficits = IF (B23 < 0, (-1 * B23), 0) = IF (C23 < 0, (-1 * C23), 0) = IF (D23 < 0, (-1 * D23), 0) 34 Land 35 Machinery 36 Total Debts = SUM (B33:B35) = SUM (C33:C35) = SUM (D33:D35) 37 Net Worth = B31 – B37 = C31 – C37 = D31 – D37**Multi-Year Financial Models – Income Taxes**• Income taxes must be considered explicitly • Calculate taxable income Taxable Income = Total receipts – total cash expenses - depreciation allowance - deductions • Use a tax table to compute taxes due • Enter taxes paid in the Cashflow Statement**Multi-Year Financial Models – Applications**• Financial risk management • Analysis of the economic impact of changes in the business plan for a firm on • Ability to repay loans on time • Ability to remain solvent • Ability to earn a satisfactory rate of return on investment • Analysis of alternative marketing schemes that use contracts, futures and options to manage price risk • Testing Portfolios • Analysis of alternative combinations of investment instruments (stocks, bonds, land, etc.) • A portfolio of investments is similar to a derivative in the investment world**Financial Risk Management**• A farm level simulation model developed to analyze the financial risk faced by a farm or to appraise a farm in a risky world • Input data for initial financial situation of a farm with 10 years of price and yield history providing measures of risk in production and marketing • Several financial instruments are available to test the effects of different financial arrangements on firm’s cash flows and ability to repay operating loan and remain current on long- and intermediate-term loans**Financial Risk Management**• Uses of this type of model • Test ability of firm to repay operating debt under alternative assumptions about • Other income • Family/dividend withdrawal assumptions • Machinery replacement plans • Re-financing the initial machinery loans • Insurance, pricing, and marketing options for the crops • Farm program provisions • Costs of production including rental rates for land • Purchasing land rather than leasing • Users of this type of model • Lenders concerned about loan solvency • Borrowers concerned about impacts of growth or adding a family member