Financial Analysis, Planning and Forecasting Theory and Application

Financial Analysis, Planning and
Forecasting
Theory and Application
By
Alice C. Lee
San Francisco State University
John C. Lee
J.P. Morgan Chase
Cheng F. Lee
Rutgers University
Chapter 25
Econometric Approach to Financial Analysis,
Planning, and Forecasting
Outline
25.1 Introduction
25.2 Simultaneous nature of financial analysis, planning,
and forecasting
25.3 The simultaneity and dynamics of corporate-budgeting
decisions
25.4 Applications of SUR estimation method in financial analysis
and planning
25.5 Applications of structural econometric models in financial
analysis and planning
25.6 Programming vs. simultaneous vs. econometric financial
models
25.7 Financial analysis and business policy decisions
25.8 Summary
Appendix 25A. Johnson & Johnson as a case study
25.1 Introduction
25.2 Simultaneous nature of financial
analysis, planning, and forecasting
Basic concepts of simultaneous
econometric models

Interrelationship of accounting
information

Interrelationship of financial
policies
25.3 The simultaneity and dynamics of
corporate-budgeting decisions
Definitions of endogenous and
exogenous variables

Model specification and
applications
TABLE 25.1 Endogenous and exogenous variables

1. The endogenous variables are:
a) X1,t = DIV
t
= Cash dividends paid in period t;
b) X2,t = IST
t
= Net investment in short-term assets
during period t;
c) X3,t = ILT
t
= Gross investment in long-term assets
during period t;
d) X4,t = -DF
t
= Minus the net proceeds from the
new debt issues during period t;
e) X5,t = -EQF
t
= Minus the net proceeds from new
equity issues during period t.

2. The exogenous variables are:

5

5
a) Y
t
= X
i,t
= X
*
i,t
, where Y = net profits +

i=1

i=1
depreciation allowance;
a reformulation of the sources = uses identity.

TABLE 25.1 Endogenous and exogenous variables (Cont.)

b) RCB = Corporate Bond Rate (which corresponds to the
weighted-average cost of long-term debt in the FR
Model [Eqs. (20), (23), and (24) in Table 23.10],
and the parameter for average interest rate in the
WS Model [Eq. (7) in Table 23.1].
c) RDP
t
= Average Dividend-Price Ratio (or dividend yield,
related to the P/E ratio used by WS as well as the
Gordon cost-of-capital model, discussed in Chapter 8).
The dividend-price ratio represents the yield expected by
investors in a no-growth, no-dividend firm.
d) DEL
t
= Debt Equity Ratio (parameter used by WS in Eq. (18)
of Table 23.1).
e) R
t
= The rates-of-return the corporation could expect to
earn on its future long-term investment (or the
internal rate-of-return discussed in Chapter 12).
f) CU
t
= Rates of Capacity Utilization (used by FR to lag
capital requirements behind changes in percent sales;
used here to define the R
t
expected).

5

5

Xi,t = X
*
i,1 = Yt, (25.1)

i=1

i=1

where X
1,t
, X
2,t
, X
3,t
, X
4,t
, X
5,t
, X
*
1,t
and Y
t
are identical to those defined in Table
25.1.

Expanding Eq. (25.1) we obtain

X1,t + X2,t + X3,t + X4,t + X5,t = X
*
1,t + X
*
2,t + X
*
3,t + X
*
4,t
+ X
*
5,t = Yt. (25.1')

X
*
t
= AZ
t
, (25.2)
where
X
*
' = (DIV
*
IST
*
ILT
*
- DF
*
- EQF
*
),
Z' = (1 Q1 Q2 Q3 Y RCB RDP DEL R CU),
a
10
a
11
... a
19

. .
A = . . .
. .
a
50
a
51
... a
59

DIV
*
t
= a
10
+ a
11
Q
1
+ a
12
Q
2
+ a
13
Q
3
+ a
14
Y
t

+ a
5
RCB
t
+ a
16
RDP
t
+ a
17
DEL
t

+ a
18
R
t
+ a
19
CU
t
,

IST
*
t
= a
20
+ a
21
Q
1
+ a
22
Q
2
+ a
23
Q
3
+ a
24
Y
t

+ a
25
RCB
t
+ a
26
RDP
t
+ a
27
DEL
t

+ a
28
R
t
+ a
29
CU
t
,
ILT
*
t
= a
30
+ a
31
Q
1
+ a
32
Q
2
+ a
33
Q
3
+ a
34
Y
t

+ a
35
RCB
t
+ a
36
RDP
t
+ a
37
DEL
t

+ a
38
R
t
+ a
39
CU
t
,

-DF
*
t
= a
40
+ a
41
Q
1
+ a
42
Q
2
+ a
43
Q
3
+ a
44
Y
t

+ a
45
RCB
t
+ a
46
RDP
t
+ a
47
DEL
t

+ a
48
R
t
+ a
49
CU
t
,

-EQF
*
t
= a
50
+ a
51
Q
1
+ a
52
Q
2
+ a
53
Q
3
+ a
54
Y
t

+ a
55
RCB
t
+ a
56
RDP
t
+ a
57
DEL
t

+ a
58
R
t
+ a
59
CU
t
.
X
i,t
= X
i,t-1
+
i
(X
*
i,t
- X
i,t-1
) (25.3)
or
(a) X
1,t
= X
1,t-1
+
1
(X
*
1,t
- X
1,t-1
),
(b) X
2,t
= X
2,t-1
+
2
(X
*
2,t
- X
2,t-1
),
(c) X
3,t
= X
3,t-1
+
3
(X
*
3,t
- X
3,t-1
),
(d) X
4,t
= X
4,t-1
+ (X
*
4,t
- X
4,t-1
),
(e) X
5,t
= X
5,t-1
+
5
(X
*
5,t
- X
5,t-1
).

5

5
X
*
i,t
= X
i,t
= Y
t
.

i=1 i=1

X
2,t
= X
2,t-1
+ (1 -
1
)(X
*
1,t
- X
1,t-1
).

5
X
i,t
= X
i,t-1
+
ij
(X
*
j,t
- X
j,t-1
) (i = 1, 2, 3, 4, 5), (25.4)

j=1

5

ij
= 1.

i=1
X
t
= X
t-1
+ D(X
*
t
- X
t-1
)
= X
t-1
+ D(AZ
t
- X
t-1
) (25.5)
= X
t-1
+ DAZ
t
- DX
t-1

= (I - D)X
t-1
+ DAZ
t
,

11

12
...
15

. .
. . .
D = . .

51

52
...
55

TABLE 25.2 An expanded version of Eq. (25.5)

X = BX
t-1
+ CZ
t
+ U
t
, (25.6)
* * * * *
1 1 11 1 12 1 13 1 14 1 15 1
* * * * *
2 1 21 1 22 1 23 1 24 1 25
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) (
t t t t t t t t t t t t
t t t t t t t t t t t
X DIV DIV DIV DIV IST IST ILT ILT DF DF EQF EQF
X IST IDT DIV DIV IST IST ILT ILT DF DF EQF E
o o o o o
o o o o o

= = + + + + + + +
= = + + + + + + +
1
* * * * *
3 1 31 1 312 1 33 1 34 1 35 1
* * * *
4 1 41 1 52 1 43 1 44 1 45
)
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) (
t
t t t t t t t t t t
QF
X ILT ILT DIV DIV IST IST ILT ILT DF DF EQF EQF
X DF DF DIV DIV IST IST ILT ILT DF DF
o o o o o
o o o o o

= = + + + + + + +
= = + + + + + +
*
1
* * * * *
5 1 51 1 52 1 53 1 54 1 515 1
)
( ) ( ) ( ) ( ) ( )
t t
EQF EQF
X EQF EQF DIV DIV IST IST ILT ILT DF DF EQF EQF o o o o o

+
= = + + + + + + +

TABLE 25.3 An expanded form of Eq. (25.6)
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
(
=
(
(
(
(
(
(
CU
R
DEL
RDP
RCB
Y
Q
Q
Q
I
EQF
DF
LTI
STI
DIV
c c c c c c c c c c b b b b b
EQF
DF
ILT
IST
DIV
t
t
t
t
t
t
t
t
t
t
3
2
1
1
1
1
1
1
59 58 57 56 55 54 53 52 51 50 55 54 53 52 51
49 48 47 46 45 44 43 42 41 40 45 44 43 42 41
39 38 37 36 35 34 33 32 31 30 35 34 33 32 31
29 28 27 26 25 24 23 22 21 20 25 24 23 22 21
19 18 17 16 15 14 13 12 11 10 15 14 13 12 11
D = i - B, (25.7)

A = D
-1
C. (25.8)

5

X
it
= Y
t
for every period t.

i=1

5 5

b
ij
=
ik
= 0 for all j and all k4,

i=1 i=1

and that

5

= 1.

i=1
TABLE 25.4 Adjustment coefficients of
1
t t
DIV DIV
TABLE 25.4 Adjustment coefficients of (Cont.)
1
t t
DIV DIV
TABLE 25.5 Summary of results
Fig. 25.1 (From Spies, R. R., The dynamics of corporate capital budging, Journal
of Finance 29 (September 1974): Fig. 1. Reprinted by permission.)
25.4 Applications of SUR estimation method
in financial analysis and planning
The role of firm-related
variables in capital-asset
pricing

The role of capital structure in
corporate-financing decisions

R
1t
=
1
+
1
R
mt
+
11
X
11
+
12
X
12
+
13
X
13
+ E
1t
,
R
2t
=
2
+
2
R
mt
+
21
X
21
+
22
X
22
+
23
X
23
+ E
2t
,
.
.
.
R
nt
=
n
+
n
R
mt
+
n1
X
n1
+
n2
X
n2
+
n3
X
n3
+ E
nt
,

(25.9)

where
R
jt
= Return on the jth security over time interval t
(j = 1, 2, ..., n),
R
mt
= Return on a market index over time interval t,
X
j1t
= Profitability index of jth firm over time interval
t (j = 1, 2, ..., n),
X
j2t
= Leverage index of jth firm over time period t
(j = 1, 2, ..., n),
X
j3t
= Dividend policy index of jth firm over time
period t (j = 1, 2, ..., n),

jk
= Coefficient of the kth firm-related variable in
the jth equation (k = 1, 2, 3),

j
= Coefficient of market rate-of-return in the jth equation
E
jt
= Disturbance term for the jth equation, and
a
j
's are intercepts ( j = 1, 2, ..., n).

R
jt
= + + E
jt
. (25.10)
TABLE 25.6 OLS and SUR estimates of oil industry
TABLE 25.6 OLS and SUR estimates of oil industry (Cont.)

*t-values appear in parentheses beneath the corresponding coefficients.
Denotes significant at 0.10 level of significant or better for two-tailed test.
Denotes significant at 0.05 level of significant or better for two-tailed test.
From Lee, C. F., and J. D. Vinso, Single vs. simultaneous-equation models in capital-asset pricing: The role of firm-related variables,
Journal of Business Research (1980): Table 3. Copyright 1980 by Elsevier Science Publishing Co., Inc. Reprinted by permission of
the publisher.
TABLE 25.7 OLS parameter estimates of oil industry-Sharpe Model*

* t-values appear in parenthesis beneath the corresponding coefficients
From Lee, C.F., and J.D. Vinso, Single vs. simultaneous-equation models in capital-asset pricing: The role of firm-related variables. Journal
of Business Research (1980): Table 2. Copyright 1980 by Elsevire Science Publishing Co., Inc. Reprinted by permission of the publisher.
TABLE 25.8 Residual correlation coefficient matrix after OLS
estimate

LDBT =
1
(LDBT
*
- LDBT
t-1
) +
2
(PCB
*
- PCB
t-1
- RE)

+
3
STOCKT +
4
RT +
1
, (25.11)

GSTK =
1
(LDBT
*
- LDBT
t-1
) +
2
(PCB
*
- PCB
t-1
- RE)

+
3
STOCKT +
4
RT +
2
, (25.12)

STRET =
1
(LDBT
*
- LDBT
t-1
) +
2
(PCB
*
- PCB
t-1
- RE)

+
4
RT +
3
, (25.13)

LIQ = LIQ
*
+
2
(TC
*
- TC
t-1
) +
3
(A - RE) +
4
RT

+
4
, (25.14)
SDBT = LIQ
*
+
2
(TC
*
- TC
t-1
) +
3
(A - RE) +
4
RT +
5
,
(25.15)
where
LDBT
*
= bSTOCK (i/i) = A target for the book value of long-term debt,
STOCK = Market value of equity,
b = LDM/STOCK = Desired debt-equity ratio,
LDM = Market value of debt = (LDBT)(i/i),
i/i = Ratio between the average contractual interest rate on long-term debt outstanding and the current new-issue rate
on long-term debt,
LDBT
t-1
= Book value of long-term debt in previous period,
PCB
*
= Permanent capital (book value) = net capital stock (NK) + the permanent portion of working assets (NWA),
PCB
t-1
= Permanent capital in the previous period,
RE = Stock retirements,
STOCKT = Stock-market timing variable = average short-term market value of equity divided by average long-term
market value of equity,
RT = Interest timing variable, weighted average (with weight 0.67 and 0.33) of two most recent quarters' changes
in the commercial paper rate,
TC
*
= Target short-term capital = short-term asset-liquid assets,
TC
t-1
= Short-term debt in the previous period,
A = Changes in total assets,
LIQ
*
= Change of target liquidity assets.
25.5 Applications of structural econometric
models in financial analysis and planning
A brief review

AT&Ts econometric
planning model
25.2
Applications
of structural
econometric
models in
financial
analysis and
planning
Fig. 25.2
Flow chart of FORECYT.
(From Davis, B. E., G. C. Caccappolo,
and M. A. Chaudry, An
econometric planning model for
American Telephone and
Telegraph Company, The Bell
Journal of Economics and
Management Science 4 (Spring
1973): Fig. 2. Copyright 1973,
The American Telephone and
Telegraph Company. Reprinted
with permission.
25.3 Applications of structural econometric
models in financial analysis and planning
Fig. 25.3 Tripartite structure of FORECYT.
25.6
Programming vs. simultaneous vs.
econometric financial models
25.7
Financial analysis and business
policy decisions
25.8 Summary
Based upon the information, theory, and methods
discussed in previous chapters, we discussed how
the econometrics approach can be used as
alternative to both the programming approach and
simultaneous-equation approach to financial
planning and forecasting. Both the SUR method
and the structural simultaneous-equation method
were used to show how the interrelationships
among different financial-policy variables can be
more effectively taken into account. In addition, it
is also shown that financial planning and
forecasting models can also be incorporated with
the environment model and the management
model to perform business-policy decisions.
NOTES
1. The stacking technique, which was first suggested by de Leeuw (1965),
can be replaced by either the SUR or the constrained SUR technique.
(See the next section and Appendix A for detail.) It should be noted
that these techniques themselves can be omitted from the lecture
without affecting the substance of the econometric approach to
financial analysis and planning.

2. This section is essentially drawn from Spies' (1974) paper. Reprinted
with permission of the Journal of Finance and the author. Basic
concepts of matrix algebra used in this section can be found in Chapter
3. The simultaneous equation used in this section can be found in
Appendix 2B in Chapter 2 of this book. In addition, the autoregressive
model used in this chapter can be found in section 24.6 in chapter 24.

3. Theoretical development of this optimal model can be found in Spies'
(1971) dissertation.

4. Bower (1970) provides an interesting discussion of corporate decision-
making and its ability to adapt to a changing environment.
NOTES
5. The constraint on the values of
ij
is a result of the "uses-equals-sources identity.
Summing Eq. (18.4) over i gives

5 5 5 5

X
i,t
= X
i,t-1
+
ij
(X
*
j,t-1
),

i=1 i=1 i=1 i=1

This can be rewritten as

(X
i,t
- X
i,t-1
) = (X
*
j,t
- X
j,t-1
)
ij
.

i j i

The identity ensures that
j
X
j,t
=
j
X
*
j,t
, and therefore,

(X
i,t
- X
i,t-1
) = (X
j,t
- X
j,t-1
)
ij

i j i

Changing the notation slightly, this becomes

(X
j,t
- X
j,t-1
) = (X
j,t
- X
j,t-1
)
ij

j j i

or
1 =
ij
.

i
NOTES
6. This constraint ensures that the "uses-equals-sources" identity will hold
for the estimated equations. First of all, we know that
i

ij
= 1, since

1 -b
ij
for i = j,

ij
=
-b
ij
for i =.
Therefore,

ij
= 1 - b
ij
= 1 - 0 = 1.

i i

In addition, it can be shown that X
*
i,t
= Y
t
. To show this, it is necessary
only to show that

0 for all k = 4,
a
jk
=

j
1 for all k = 4.

Note that
ik
=
jijajk
. Since we have constrained

0 for all k = 4,
c
ik
=

i
1 for all k = 4.
NOTES
6 (Cont.)

we can see that
C
ik
= a
ijajk

i i j

= (a
ij
)
jk

j i

= (1)a
jk

j

= a
jk
.

j

Therefore,

0 for all k = 4,
a
jk
=

j
1 for all k = 4.

From all this it is clear that

^ ^

X
i,t
= X
*
i,t
= Y
t
.

i i
NOTES
7. Major portion of this section was drawn from Lee and
Vinso (1980). Reprinted with permission of Journal of
Business Research.

8. The economic forecasts from other econometrics models
(e.g., Chase Econometric and Wharton Econometrics can
also be used as inputs for corporate-analysis planning and
forecasting.
Appendix 25A. Johnson & Johnson as a
case study
25.A.1 INTRODUCTION

25.A.2 STUDY OF THE COMPANYS OPERATIONS
Consumer
Pharmaceuticals
Medical Devices and Diagnostics

25.A.3 ANALYSIS OF THE COMPANYS
FINANCIAL PERFORMANCE
Appendix 25A. Johnson & Johnson as a
case study
2003 2004 2005 2006
Division Sales Profits Sales Profits Sales Profits Sales Profits
% % % %
Consumer 18% 13% 18% 11% 18% 12% 18% 10%
Pharmaceuticals 47% 56% 47% 58% 44% 48% 44% 48%
Medical Devices
and Diagnostics
36% 31% 36% 31% 38% 40% 38% 43%
Total 100% 100% 100% 100% 100% 100% 100% 100%
Domestic 60% 59% 56% 56%
International 40% 41% 44% 44%
Total 100% 100% 100% 100%
TABLE 25.A.1 Sales in Different Segment

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