Topic Coverage1. 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.
PAST FUTUREPRESENT
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 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!!!!
Assumes perfect knowledge of outcomes in all 5 areas!!!!
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 for a given price…
Supply-side risk for a given price…
QLQEQH
PE
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…
Demand and supply-side risk and potential price variability…
QLQEQH
PH
PE
PL
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
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
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.
Capital budgeting models of investment decisions require projections of the annual farmfarm revenue and cost values over the entire 2001 to 2006 time period.
A linear time trend projection of future farm machinery and equipment sales therefore does a poor jobpoor job of predicting future sales activity.
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 Theory
IT = f{[E(PT)×E(QT)]/E(cT)}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.
An econometric model based on investment theory does a muchmuch better jobbetter job of predicting future sales activity.
Crop Market Model
Demand equationDemand equation::Qd = a0 - a1(Price) + ai (demand shifters)
Supply equationSupply equation::Qs = b0 +b1(price) + bi (supply shifters)
Market equilibriumMarket equilibrium::Qd = Qs
Crop Market Equilibrium
Quantity
Price
Pe
Qe
D S
Demand consists of:-Food use-Feed use-Exports-Ending stocks
Demand consists of:-Food use-Feed use-Exports-Ending stocks
Supply consists of:-Beginning stocks-Production-Imports
Supply consists of:-Beginning stocks-Production-Imports
Wheat Projections Made in 1997
$2.00
$2.50
$3.00
$3.50
$4.00
$4.50
$5.00
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Actual/Baseline Prolonged Asian Crisis USDA
Actual Forecast
Income elasticityIncome elasticity
Cross price elasticityCross price elasticity
Econometric Analysis – Food Use
Own price elasticityOwn price elasticity
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 (Q(QDD=Q=QSS)) and solve for the price where excess excess demand equals zerodemand equals zero.
Crop Market Model
Demand equationDemand equation::Qd = a0 - a1(Price) + ai (demand shifters)
Supply equationSupply equation::Qs = b0 +b1(price) + bi (supply shifters)
Market equilibriumMarket equilibrium::Qd = Qs
ConclusionsEconometric models are 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.