Agricultural Economics 489/689

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Agricultural Economics 489/689

Rural Financial Markets and Financial Planning

Spring 2008

Penson

Second Hour Examination - A

March 6, 2008

NAME:____ANSWER KEY______

This examination consists of six questions. Please read each question carefully. You must show all work to receive full credit for questions involving calculations. Use the back of the last page if necessary. Make sure you answer all aspects of the question. Good luck!

Question 1 _____ of 15 points

Question 2 _____ of 15 points

Question 3 _____ of 25 points

Question 4 _____ of 20 points

Question 5 _____ of 10 points

Question 6 _____ of 15 points

TOTAL _____ of 100 points

1. Please define or illustrate each of the following terms: (15 points; 3 points each). Make sure you carefully label any graphs used.

1. Triangular probability distribution

Reflects three possible outcomes for an annual net cash flow, such as a pessimistic scenario, optimistic scenario and a most likely scenario. Each scenario has a positive probability of occurrence.

1. Weighted average cost of capital

The weighted average cost of capital (WACC) employed by the firm is given by the following equation:

WACC = WEQ(rE) + WDT(rD)

where WEQ is the relative importance of equity in the firm’s balance sheet, rE is the cost of equity capital, WDT is the relative importance of debt in the firm’s balance sheet, and rD is the total cost of debt capital.

1. Pro forma analysis

One of the more important dimensions to financial decision making is the formation of expected future values of income and cost streams over time. Accountants and economists alike have a term they use for this; it is called pro forma analysis.

1. Implicit cost of capital

There implicit costs of debt capital that cause firms to internally ration their use of debt capital that were more or less implied when we discussed the concept of financial risk and the financial risk premium. As the firm reduces its credit liquidity as it uses up its credit reserves, its implicit cost of debt capital rises, causing the total cost of debt capital to rise.

1. Optimal replacement age

This involves finding the year in the service life of an asset prior to the year where the marginal costs associated with its current use becomes greater than the cost of replacing the asset. The year in which the present value of a stream of future ownership costs is minimized represents the optimal age to replace an aging depreciable asset.

2.Fully describe the alternative approaches to forecasting future commodity price trends in the economy. Please rank them in terms of their likelihood to succesfully capture the direction of change in these commodity prices.(15 points)

We discussed five alternative approaches to projecting future trends in commodity prices. These are:

(1) the market outlook information approach – this involves using available information from trade associations, outlook conferences, projections by governmemnt extension publications.

(2) the naïve approach - this involves using the last year’s price as a proxy for next year’s and future prices.

(3) the five-year olympic average approach – this involves using the last five year’s prices, dropping the high and the low, and calculating the average of the three remaining prices.

(4) the price flexibility approach – this involves using the reciprocal of a published own price elasticity estimate to solve for the price associated with information on planting intentions for the commodity.

(5) the structural econometric simulation approach - this involves estimation of demand and supply relationships, solving for the market equilibrium price and simulating this model over the desired period of time.

The least reliable approach to capturing the direction of changes in commodity prices is the naïve approach, followed by the five-year olympic average approach. The market outlook approach is as reliable as the source of this forecast. The same is true for the price flexibility approach. The most reliable is the structural econometric simulation approach, although it requires the most resources to apply.

3.Assume you are considering investing in the following project. The economic life of the project is three years. (25 points)

Year 1 Year 2 Year 3

Expected net cash flow 25,000 30,000 40,000

Standard deviation 2,500 3,900 6,000

Risk free rate of return 0.06 0.06 0.07

Slope of risk/return curve 0.15 0.15 0.18

Shift coefficient for leverage 0.02 0.02 0.01

(SHOW ALL WORK FOR FULL CREDIT)

Assume the cost of this projects $150,000, no additional working capital is needed, and the market value of assets required under this project is $95,000 at the end of the third year. Also assume that you balance sheet after the investment reflects the following values:

Total assets 500,000 600,000 700,000

Total equity 150,000 200,000 350,000

Leverage ratio 2.332.00 1.00

Would you make the investment? Why? Use the back of the last page if you need extra space.

Coefficient of variation 0.100.13 0.15

Business risk premiumFinancial risk premium

Year 1 = .15(.10) = .015Year 1 = .02(2.33) = .0466

Year 2 = .15(.13) = .0195Year 2 = .02(2.00) = .04

Year 3 = .18(.15) = .027Year 3 = .01(1.00) = .01

Required rate of returnFV interest factor

Year 1 = .06 + .015 + .0466 = .1216Year 1 = 1.1216

Year 2 = .06 + .0195 + .04 = .1195Year 2 = (1.1216)(1.1195) = 1.2556

Year 3 = .07 + .027 + .01 = .107Year 3 = (1.2556)(1.107) = 1.389

NPV = 25,000/1.1216 + 30,000/1.2556 + 40,000/1.389+ 95,000/1.389 – 150,000

NPV = 22289.6 + 23892.9 + 28,797.7 + 68,394.5 – 150,000 = - 6,625.3

I would not make this investment since the NPV is negative.

4.Suppose that land is currently selling for $1,500 an acre and that you expect land prices to continue to go up at an annual rate of 10% over the next 10 years. (20 points)

(SHOW ALL WORK FOR FULL CREDIT)

1. Assume the annual net cash flow generated by this land is $350 per acre and that you plan to sell this land 10 years from now. Can you justify purchasing this land at this price if your required rate of return is 9% and any capital gains will be taxed at a 20% rate?

NPV = 350(EPIF.09,10)–1,500+[1,500/(PIF.10,10 .20(1,500/(PIF.10,10-1,500](PIF.09,10)

= 350(6.41766)–1,500+[(1,500/.38554-.20(1,500/.38554-1,500](.42241)

= 2,246.18 – 1,500 + [3,890.6 - .20(3,890.6 – 1,500)](.42241)

= 746.18 + [3890.6 – 478.12](.42241)

= 746.18 + [3,412.48](.42241)

= 746.18 + 1,441.47

= 2,187.65

Yes, I can justify this investment since the NPV > 0.

1. How much would your answer change to part (a) if you instead assumed the net cash flows per acre were zero over this ten year period?

NPV = -1,500 + 1,441.47

= -58.53

No, I can no longer justify this investment.

c. What is the maximum you can pay for this land if you expect annual net cash flows of $350 per acre over this ten year period?

PV = 2,246.18 + 1,441.47 = 3,687.65

5.Define the concept of “portfolio effect”. Please fully discuss the applicability of this effect and the conditions under which you would expect the portfolio effect to have the desired effect on a risky investment project.(10 points)

The firm can benefit from diversifying its portfolio of assets and enterprises if certain conditions hold. One of these conditions is that the net cash flows associated with the firm’s existing operations be highly negatively correlated with the net cash flows generated by the new project.

If this portfolio effect lowers the firm’s overall exposure to risk, you can justify lowering the new project’s required rate of return, perhaps making the difference between a positive and negative NPV, and the position of the project’s relative ranking among alternative projects being considered by the firm.

6.Please illustrate the risk-return preference curve for a highly risk averse investor and the business and financial risk premiums for a given level of risk per dollar of expected net cash flows. Assume the investor currently has a leverage ratio near the maximum permitted by lenders. Make sure you carefully label all aspects of this graph. Discuss the importance of assessing these forms of risk when evaluating alternative investment opportunities. (15 points)

Accounting for the risk associated with alternative investment projects is important from at least two perspectives: (1) it can mean the difference between a positive and negative net present value and hence whether or not a particular project is economically feasible and (2) it can affect the order of the ranking of multiple projects with different risk characteristics.