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Chapter 7 FORECASTING

QUESTIONS & ANSWERS Q7.1 Accurate company sales and profit forecasting requires careful consideration of firm-specific and broader influences. Discuss some of the microeconomic and macroeconomic factors a firm must consider in its own sales and profit forecasting. ANSWER The better a company can assess future demand, the better it can plan its resources. Every corporation is exposed to three types of factors influencing demand: company, competitive and macroeconomic factors. Microeconomic company-related factors include market share trends, changes in strategy and implementation, and changes in brand value. Microeconomic industry-related factors include competitor advertising, competitor product offerings, market share. Macroeconomic factors that must be considered include income, economic growth, interest rates, and shocks. There are several methods used to assess and forecast demand. None yields demand numbers that are a 100% successful or guaranteed. However, using more than one imperfect method has proven helpful in improving forecast accuracy and confidence. Q7.2 Forecasting the success of new product introductions is notoriously difficult. Describe some of the macroeconomic and microeconomic factors that a firm might consider in forecasting sales for a new teeth whitening product. ANSWER To forecast market demand for any new product introduction, market size research must be combined with product-specific information. A useful approach would combine macroeconomic trend information with data on microeconomic and competitive performance. Customers will only buy a product if they perceive a need and are able to pay for the new good or service. Of course, ability to pay tends to be a strong determinant of demand for big-ticket items, perceived need may be more important for small-ticket items, like teeth whitening products. Advertising capability or brand name reputation is also apt to be important because consumers must be aware of new product or service offerings and perceive a given company's

Q7.1

Q7.2

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offerings as having the best value. In practice, market size research is combined with market share research to forecast product and corporate demand. Econometric models are sometimes used for answering a wide variety of Awhat if@ questions regarding the future. This stems from the fact that econometric models reflect the causal relation between Y (the forecast value) and a series of independent X variables. When a range of X values relating to various pessimistic to optimistic scenarios concerning future events is incorporated into a given econometric model, the resulting effects on Y become readily apparent. Thus, quantifiable answers to various Awhat if@ questions can be obtained. Q7.3 Blue Chip Financial Forecasts gives the latest prevailing opinion about the future direction of the economy. Survey participants include 50 business economists from Deutsche Banc Alex Brown, Banc of America Securities, Fannie Mae, and other prominent corporations. Each prediction is published along with the average, or consensus forecast. Also published are averages of the 10 highest and 10 lowest forecasts; a median forecast; the number of forecasts raised, lowered, or left unchanged from a month ago; and a diffusion index that indicates shifts in sentiment that sometimes occur prior to changes in the consensus forecast. Explain how this approach helps limit the steamroller or bandwagon problems of the panel consensus method. ANSWER Although the panel consensus method often results in forecasts that embody the collective wisdom of consulted experts, it can be unfavorably affected by the forceful personality of one or a few key individuals. To mitigate such problems, the forecasting approach adopted by Blue Chip Financial Forecasts is similar to the Delphi method. In the Delphi method, members of a panel of experts individually receive a series of questions relating to the underlying forecasting problem. Responses are analyzed by an independent party, who then tries to elicit a consensus opinion by providing feedback to panel members in a manner that prevents direct identification of individual positions. Because the 50 business economists surveyed by Blue Chip Financial Forecasts are never collected at a single location, the steamroller or bandwagon problems of the panel consensus approach tend to be minimized. The force of personality is strongest in person, and email surveys of 50 top economic forecasters are not apt to be as affected by group pressure as would be the case if Blue Chip Financial Forecasts were derived from regular group meetings. Q7.4 "Interest rates were expected to increase by 85% of all consumers in the May 2004 survey, more than ever before," said Richard Curtin, the Director of the University of Michigan=s Surveys of Consumers. "More consumers in the May 2004 survey cited the advantage of obtaining a mortgage in advance of any additional increases in interest rates than any other time in nearly ten years,@ said Curtin. Discuss this
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Q7.3

Forecasting statement and explain why consumer surveys are an imperfect guide to consumer expectations. Q7.4 ANSWER Survey data can be highly useful in short-term forecasting when carefully used to elicit consumer perceptions and attitudes. However, survey data are Asoft@ when they don't relate to actual market transactions and can be unreliable when consumers have incentives to misreport information. In the case of interest rate forecasting, consumers may have little tangible evidence upon which to base their expectations, and little expertise in interest rate forecasting. Moreover, even if consumers have an accurate fix on the future pattern of interest rates, they have incentives to complain about likely increases in the hope that by voicing this concern they might cause some moderation in tightening by the monetary authorities. Q7.5 Explain why revenue and profit data reported by shippers such as FedEx Corp. and United Parcel Service Inc. are apt to provide useful information about trends in the overall economy. ANSWER Revenue and profit data reported by shippers such as FedEx Corp. and United Parcel Service Inc. are apt to provide useful information about trends in the overall economy because the pace of goods shipped is a leading indicator of future sales. In a sense, FedEx and UPS find out about the sales revenues of major manufacturers before the stockholders of manufacturers whose goods are being shipped. Sales and profit numbers jump for shippers before sales and profit numbers tied to shipped goods reach the audited financial statements of manufacturers. For example, in mid-2004, FedEx Corp. reported a 47% jump in fiscal fourthquarter profit and offered an increasingly optimistic outlook as the economic rebound continued to spread throughout its customer base. The Memphis, Tenn., company saw growing signs of what Frederick W. Smith, its chairman, president and chief executive, called a "solid, broad-based economic recovery" that includes industrial, durable-goods and retail shipments. FedEx results provided strong evidence that more businesses around the world were revving up their operations and replenishing inventories depleted during the economic slump, and that the economy's improvement was "strong and sustainable."

Q7.5

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Chapter 7 Q7.6 AThe economy is on the verge of faster growth,@ Federal Reserve Chairman Alan Greenspan testified . "We believe we are at a turning point. Our best judgment is that things will be improving after sluggish growth and a fitful recovery from recession.@ What makes forecasting turning points difficult? What methods do economists use to forecast turning points in the overall economy? ANSWER All economic data have a strong trend elements, and turning points are, by definition, changes in trend. A basic shortcoming of trend projection is that the method is incapable of forecasting the magnitude or duration of divergences from trend and is not helpful for indicating fundamental changes in trend (i.e., turning points). Therefore, simple trend projection methods are incapable of forecasting the magnitude of cyclical fluctuations, seasonal variation, and irregular or random influences. To forecast the magnitude of such deviations from trend, managers often employ the barometric approach to forecasting. Q7.7 Would a linear regression model of the advertising/sales relation be appropriate for forecasting the advertising levels at which threshold or saturation effects become prevalent? Explain. ANSWER No, a linear model of the advertising-sales relation is not appropriate for estimating the advertising levels where Athreshold@ or Asaturation@ effects become prevalent. A nonlinear method of estimation is appropriate when advertising by a firm or an industry is subject to such influences. Quadratic, log-linear, or logistic models are often employed for this purpose. Q7.8 Perhaps the most famous early econometric forecasting firm was Wharton Economic Forecasting Associates (WEFA), founded by Nobel Prize winner Lawrence Klein. A spinoff of the Wharton School of the University of Pennsylvania, where Klein taught, WEFA was merged with Data Resources Inc. in 2001 to form Global Insight. Describe the data requirements that must be met if econometric analysis is to provide a useful forecasting tool. ANSWER
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Q7.6

Q7.7

Q7.8

Forecasting

If the statistical analysis of economic relations, or econometrics, is to provide a fruitful tool for forecasting, a number of important conditions must be met. First, a sufficient number of sample observations must be available for analysis. For small populations and simple linear regression models, as few as 30 or 40 observations may be sufficient. Larger samples are needed for larger populations and when particularly difficult forecasting problems suggest the use of highly sophisticated econometric models, some of which entail many different structural relations (equations). Second, all relevant variables must be properly incorporated in the analysis. This involves data measurement and model specification issues that must be addressed. And third, there must be a high degree of stability over time between the dependent and independent variables under consideration. Q7.9 Cite some examples of forecasting problems that might be addressed using regression analysis of complex multiple-equation systems of economic relations. ANSWER Econometric analysis of multiple-equation systems of economic relations is a forecasting technique that is useful for reflecting the effects of important economic changes on related sectors, industries, or firms. It is most useful when indirect linkages between sectors are few in number and can be estimated with a great deal of precision. At the national level, for example, this type of econometric analysis has been used extensively to analyze changes in GDP, interest rates, energy, and water requirements. Similarly, firms might use a system method of analysis to measure the effects of changing energy, labor, or capital costs on demand conditions for related products. Q7.10 Q7.10 What are the main characteristics of accurate forecasts? ANSWER The main characteristics of accurate forecasts are a close correspondence, on average, between actual and forecast values and a high correlation between the actual and forecast series. When these two criteria are met, actual and forecast data will be closely related, and a desirable low level of average forecast error (root mean squared forecast error) will be apparent.
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Q7.9

Chapter 7

SELF-TEST PROBLEMS & SOLUTIONS ST7.1 Gross Domestic Product (GDP) is a measure of overall activity in the economy. It is defined as the value at the final point of sale of all goods and services produced during a given period by both domestic and foreign-owned enterprises. GDP data for the 1950-2004 period shown in Figure 7.3 offer the basis to test the abilities of simple constant change and constant growth models to describe the trend in GDP over time. However, regression results generated over the entire 1950-2004 period cannot be used to forecast GDP over any subpart of that period. To do so would be to overstate the forecast capability of the regression model because, by definition, the regression line minimizes the sum of squared deviations over the estimation period. To test forecast reliability, it is necessary to test the predictive capability of a given regression model over data that was not used to generate that very model. In the absence of GDP data for future periods, say 2005-2010, the reliability of alternative forecast techniques can be illustrated by arbitrarily dividing historical GDP data into two subsamples: a 1950-99 50-year test period, and a 2000-04 5-year forecast period. Regression models estimated over the 1950-99 test period can be used to Aforecast@ actual GDP over the 2000-04 period. In other words, estimation results over the 1950-99 subperiod provide a forecast model that can be used to evaluate the predictive reliability of the constant growth model over the 2000-04 forecast period. A. Use the regression model approach to estimate the simple linear relation between the natural logarithm of GDP and time (T) over the 1950-99 subperiod, where ln GDPt = b0 + b1Tt + ut and ln GDPt is the natural logarithm of GDP in year t, and T is a time trend variable (where T1950 = 1, T1951 = 2, T1952 = 3, . . ., and T1999 = 50); and u is a residual term. This is called a constant growth model because it is based on the assumption of a constant percentage growth in economic activity per year. How well does the constant growth model fit actual GDP data over this period? B. Create a spreadsheet that shows constant growth model GDP forecasts over the 2000-04 period alongside actual figures. Then, subtract forecast values
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Forecasting from actual figures to obtain annual estimates of forecast error, and squared forecast error, for each year over the 2000-04 period. Finally, compute the correlation coefficient between actual and forecast values over the 2000-04 period. Also compute the sample average (or root mean squared) forecast error. Based upon these findings, how well does the constant growth model generated over the 1950-99 period forecast actual GDP data over the 2000-04 period? ST7.1 A. SOLUTION The constant growth model estimated using the simple regression model technique illustrates the linear relation between the natural logarithm of GDP and time. A constant growth regression model estimated over the 1950-99 50-year period (t-statistic in parentheses), used to forecast GDP over the 2000-04 5-year period, is: ln GDPt = 5.5026 + 0.0752t, R2 = 99.2% (188.66) (75.50) The R2 = 99.2% and a highly significant t statistic for the time trend variable indicate that the constant growth model closely describes the change in GDP over the 195099 time frame. Nevertheless, even modest changes in the intercept term and slope coefficient over the 2000-04 time frame can lead to large forecast errors. B. Each constant growth GDP forecast is derived using the constant growth model coefficients estimated in part A, along with values for each respective time trend variable over the 2000-04 period. Remember that T2000 = 51, T2001 = 52, . . ., and T2004 = 55 and that the constant growth model provides predicted, or forecast, values for ln GDPt. To obtain forecast values for GDPt, simply take the exponent (antilog) of each predicted ln GDPt variable. The following spreadsheet shows actual and constant growth model GDP forecasts for the 2000-04 forecast period:
Forecast Error (GDP -Forecast GDP) Squared Forecast Time Error Period (GDP - Forecast GDP)2 -$173.2 $29,994.1 51 -431.9 186,561.8 52

Year 2000 2001

GDP $9,268.4 9,817.0

ln GDP 9.1344 9.1919

Forecast ln GDP 9.3357 9.4109

Forecast GDP $9,441.6 10,248.9

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Chapter 7
2002 2003 2004 Average 10,100.8 10,480.8 10,987.9 $10,131.0 9.2204 9.2573 9.3045 9.2217 9.4860 9.5612 9.6364 9.4860 11,125.3 12,076.5 13,109.2 $11,200.3 -1,024.5 -1,595.7 -2,121.3 -$1,069.3 Mean squared error 1,049,657.6 2,546,191.5 4,499,913.7 $1,662,463.7 $1,289.4 53 54 55

Correlation 99.50%

The correlation coefficient between actual and constant growth model forecast GDP is rGDP, FGDP = 99.50%. The sample root mean squared forecast error is $1,298.4 billion (= $1, 662, 463.7), or 12.7% of average actual GDP over the 200004 period. Thus, despite the fact that the correlation between actual and constant growth forecast model values is relatively high, forecast error is also very high. Unusually modest economic growth at the start of the new millennium leads to large forecast errors when GDP data from more rapidly growing periods, like the 1950-99 period, are used to forecast economic growth. ST7.2 Multiple Regression. Branded Products, Inc., based in Oakland, California, is a leading producer and marketer of household laundry detergent and bleach products. About a year ago, Branded Products rolled out its new Super Detergent in 30 regional markets following its success in test markets. This isn't just a Ame too@ product in a commodity market. Branded Products' detergent contains Branded 2 bleach, a successful laundry product in its own right. At the time of the introduction, management wondered whether the company could successfully crack this market dominated by Procter & Gamble and other big players. The following spreadsheet shows weekly demand data and regression model estimation results for Super Detergent in these 30 regional markets:
Branded Products Demand Forecasting Problem Regional Demand in Price per Competitor Advertising, Market Cases, Q Case, P Price, Px Ad 1 1,290 $137 $94 $814 2 1,177 147 81 896 3 1,155 149 89 852 4 1,299 117 92 854 5 1,166 135 86 810 6 1,186 143 79 768 7 1,293 113 91 978 Household Estimated Income, I Demand, Q $53,123 1,305 51,749 1,206 49,881 1,204 43,589 1,326 42,799 1,185 55,565 1,208 37,959 1,333

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Forecasting
8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Average 1,286 Minimum 1,089 Maximum 1,515 1,322 1,338 1,160 1,293 1,413 1,299 1,238 1,467 1,089 1,203 1,474 1,235 1,367 1,310 1,331 1,293 1,437 1,165 1,328 1,515 1,223 1,293 1,215 111 109 129 124 117 106 135 117 147 124 103 140 115 119 138 122 105 145 138 116 148 134 127 127 103 149 82 81 82 91 76 90 88 99 76 83 98 78 83 76 100 90 86 96 97 97 84 88 87 87 76 100 821 843 849 797 988 914 913 867 785 817 846 768 856 771 947 831 905 996 929 1,000 951 848 891 870 768 1,000 47,196 50,163 39,080 43,263 51,291 38,343 39,473 51,501 37,809 41,471 46,663 55,839 47,438 54,348 45,066 44,166 55,380 38,656 46,084 52,249 50,855 54,546 38,085 46,788 37,809 55,839 1,328 1,366 1,176 1,264 1,359 1,345 1,199 1,433 1,024 1,216 1,449 1,220 1,326 1,304 1,302 1,288 1,476 1,208 1,291 1,478 1,226 1,314 1,215 1,286 1,024 1,478

Regression Statistics R Square 90.4% Standard Error 34.97 Observations 30 Coefficients 807.938 -5.034 4.860 0.328 0.009 Standard Error 137.846 0.457 1.006 0.104 0.001 t Stat 5.86 -11.02 4.83 3.14 7.99 P-value 4.09301E-06 4.34134E-11 5.73825E-05 0.004293208 2.38432E-08

Intercept Price, P Competitor Price, Px Advertising, Ad Household Income, I

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Chapter 7 A. B. Interpret the coefficient estimate for each respective independent variable. Characterize the overall explanatory power of this multiple regression model in light of R2 and the following plot of actual and estimated demand per week.

C.

Use the regression model estimation results to forecast weekly demand in five new markets with the following characteristics:
Regional Forecast Market A B C D E Average Price per Case, P 115 122 116 140 133 125 Competitor Price, Advertising, Px Ad 90 790 101 812 87 905 82 778 79 996 88 856 Household Income, I 41,234 39,845 47,543 53,560 39,870 44,410

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Forecasting ST7.2 A. SOLUTION Coefficient estimates for the P, Px, Ad and I independent X-variables are statistically significant at the 99% confidence level. Price of the product itself (P) has the predictably negative influence on the quantity demanded, whereas the effects of competitor price (Px), advertising (AD) and household disposable income (I)are positive as expected. The chance of finding such large t-statistics is less than 1% if, in fact, there were no relation between each variable and quantity. The R2 = 90.4% obtained by the model means that 90.4% of demand variation is explained by the underlying variation in all four independent variables. This is a relatively high level of explained variation and implies an attractive level of explanatory power. Moreover, as shown in the graph of actual and fitted (estimated) demand, the multiple regression model closely tracks week-by-week changes in demand with no worrisome divergences between actual and estimated demand over time. This means that this regression model can be used to forecast demand in similar markets under similar conditions.. Notice that each prospective market displays characteristics similar to those of markets used to estimate the regression model described above. Thus, the regression model estimated previously can be used to forecast demand in each regional market. Forecast results are as follows:
Regional Forecast Market A B C D E Average Price per Case, P 115 122 116 140 133 125 Competitor Price, Px 90 101 87 82 79 88 Advertising, Ad 790 812 905 778 996 856 Household Income, I 41,234 39,845 47,543 53,560 39,870 44,410 Forecast Demand, Q 1,285 1,298 1,358 1,223 1,196 1,272

B.

C.

PROBLEMS & SOLUTIONS P7.1 Constant Growth Model. The U.S. Bureau of the Census publishes employment statistics and demand forecasts for various occupations.

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Chapter 7
Employment (1,000) Occupation 1998 2008 Bill collectors 311 420 Computer engineers 299 622 Physicians assistants 66 98 Respiratory therapists 86 123 Systems analysts 617 1,194

A.

Using a spreadsheet or hand-held calculator, calculate the ten-year growth rate forecast using the constant growth model with annual compounding, and the constant growth model with continuous compounding for each occupation. Compare your answers and discuss any differences.

B. P7.1 A.

SOLUTION Using the assumption of annual compounding, Et 420 1.35 ln(1.35) 0.300/10 e0.030 1.031 - 1 g = E0(1 + g)t = 311(1 + g)10 = (1 + g)10 = 10 ln(1 + g) = ln(1 + g) = 1+g = g = 0.031 or 3.1%

Using the continuous compounding assumption,

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Forecasting Et 420 1.35 ln(1.35) g = E0egt = 311e10g = e10g = 10g = 0.3000/10 = 0.03 or 3.00% Using the same methods, continuous growth model estimates for various occupations are: Employment (1,000) Occupation Bill collectors Computer engineers Physicians assistants Respiratory therapists Systems analysts B. 1998 2008 311 420 299 622 66 98 86 123 617 1,194 Continuous Growth Model Annual Continuous Compounding Compounding 3.05% 3.00% 7.60% 7.32% 4.03% 3.95% 3.64% 3.57% 6.82% 6.60%

For example, if the number of jobs jumps to 420,000 from 311,000 over a ten-year period, then a 3.05% rate of job growth is indicated when annual compounding is assumed. With continuous compounding, a 3.00% rate of growth leads to a similar growth in jobs over a ten-year period. Of course, this small difference is due to the amount of Ainterest-on-interest.@ Either method can be employed to measure the rate of growth, but managers must make growth comparisons using a consistent basis. Growth Rate Estimation. Almost 2 million persons per year visit wondrous Glacier National Park. Due to the weather, monthly park attendance figures varied widely during a recent year:
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P7.2

Chapter 7

Month January February March April May June July August September October November December Average

Visitors 7,481 9,686 13,316 24,166 89,166 255,237 540,488 528,716 286,602 57,164 12,029 6,913 152,580

Percent change 29.5% 37.5% 81.5% 269.0% 186.2% 111.8% -2.2% -45.8% -80.1% -79.0% -42.5% 42.4%

A.

Notice that park attendance is lower in December than in January, despite a 42.4% average rate of growth in monthly attendance. How is that possible? Suppose the data described in the table measured park attendance over a number of years rather than during a single year. Explain how the arithmetic average annual rate of growth gives a misleading picture of the growth in park attendance.

B.

P7.2 A.

SOLUTION The arithmetic average presents a distorted view of the rate of growth over time because upside growth is theoretically unlimited, but declines are limited to no more than 100%. In this case, December park attendance is lower than January attendance despite a 42.4% average monthly gain in park attendance. Big attendance gains in May (269.0%), June (186.2%), and July (111.85%) simply overwhelm smaller positive increases or declines in other months when arithmetic averages are taken. This simple example documents the difficulty involved with measuring growth using arithmetic averages. When compound growth rates are considered, managers rely
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B.

Forecasting on the geometric average rather than the arithmetic average rate of return. The arithmetic average presents a distorted view of the rate of growth over time because upside growth is theoretically unlimited, but declines are limited to no more than 100%. Notice that when sales increase from $250,000 to $500,000 (a 100% gain), but then fall back to $250,000 (a 50% loss), the arithmetic average growth is 25% (= (100% - 50%)/2) despite the fact that no net growth has occurred. Similarly, when attendance falls from January to December levels, this decline in attendance is not captured by the 42.4% arithmetic average rate of growth in monthly attendance. P7.3 Sales Trend Analysis. Environmental Designs, Inc., produces and installs energyefficient window systems in commercial buildings. During the past ten years, sales revenue has increased from $25 million to $65 million. A. Calculate the company's growth rate in sales using the constant growth model with annual compounding. B. P7.3 A. Derive a five-year and a ten-year sales forecast.

SOLUTION St $65,000,000 2.6 ln(2.6) 0.956/10 e(0.0956) - 1 g = S0(1 + g)t = $25,000,000(1 + g)10 = (1 + g)10 = 10 ln(1 + g) = ln(1 + g) = g = 0.100 or 10.0%

B.

Five-Year Sales Forecast St = S0 (1 + g)t

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Chapter 7 = $65,000,000 (1 + 0.10)5 = $65,000,000 (1.611) = $104,715,000 Ten-Year Sales Forecast St = S0 (1 + g)t = $65,000,000 (1 + 0.10)10 = $65,000,000 (2.594) = $168,610,000 P7.4 Cost Forecasting. Dorothy Gale, a quality-control supervisor for Wizard Products, Inc., is concerned about unit labor cost increases for the assembly of electrical snapaction switches. Costs have increased from $80 to $100 per unit over the previous three years. Gale thinks that importing switches from foreign suppliers at a cost of $115.90 per unit may soon be desirable. A. Calculate the company's unit labor cost growth rate using the constant rate of change model with continuous compounding. Forecast when unit labor costs will equal the current cost of importing.

B. P7.4 A.

SOLUTION Ct = C0egt $100 = $80e3g 1.25 = e3g ln(1.25) = 3g

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Forecasting g = 0.223/3 = 0.074 or 7.4% B. Import Cost = C0egt $115.90 = $100e(0.074)t 1.159 = e(0.074)t ln(1.159) = 0.074t t = 0.148/0.074 = 2 years P7.5 Unit Sales Forecasting. Boris Badenov has discovered that the change in Product A demand in any given week is inversely proportional to the change in sales of Product B in the previous week. That is, if sales of B rose by X% last week, sales of A can be expected to fall by X% this week. A. Write the equation for next week's sales of A, using the variables A = sales of Product A, B = sales of Product B, and t = time. Assume that there will be no shortages of either product. Last week, 100 units of A and 90 units of B were sold. Two weeks ago, 75 units of B were sold. What would you predict the sales of A to be this week?

B.

P7.5 A.

SOLUTION At = At-1 + At-1

At = At-1 - B t-1 - 1 A t-1 B t-2

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Chapter 7

B.

At = At-1 - B t-1 - 1 A t-1 B t-2

90 = 100 - - 1 100 75
= 80.
P7.6 Revenue Forecasting. Gil Grissom must generate a sales forecast to convince the loan officer at a local bank of the viability of Marina Del Rey, a trendy west-coast restaurant. Grissom assumes that next-period sales are a function of current income, advertising, and advertising by a competing restaurant. A. Write an equation for predicting sales if Grissom assumes that the percentage change in sales is twice as large as the percentage changes in income and advertising but that it is only one-half as large as, and the opposite sign of, the percentage change in competitor advertising. Use the variables S = sales, Y = income, A = advertising, and CA = competitor advertising. During the current period, sales total $500,000, median income per capita in the local market is $71,400, advertising is $20,000, and competitor advertising is $66,000. Previous period levels were $70,000 (income), $25,000 (advertising), and $60,000 (competitor advertising). Forecast next-period sales.

B.

P7.6 A.

SOLUTION

St+1 = St + 2 Y t - 1 St + 2 A t - 1 St Y t-1 A t-1 CA t - 1 S t - 0.5 CA t-1 = St + 2St Y t - 2St + 2St A t - 2St Y t-1 A t-1
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Forecasting

CA t 1 - 0.5St + St CA t-1 2 1 CA t = 2St Y t + 2St A t - St Y t-1 A t-1 2 CA t-1 - 2.5St

B.
St+1 = 2($500,000)(1.02) + 2($500,000)(0.80) - 0.5 ($500,000)(1.10) - 2.5 ($500,000) = $1,020,000 + $800,000 - $275,000 - $1,250,000 = $295,000

P7.7

Cost Forecasting. Dr. Clint Cassidy is supervising physician at the Westbury HMO, a New York City-based medical facility serving the poor and indigent. Cassidy is evaluating the cost effectiveness of a preventive maintenance program, and believes that monthly downtime on the packaging line caused by equipment breakdown is related to the hours spent each month on preventive maintenance. A. Write an equation to predict next month's downtime using the variables D = downtime, M = preventive maintenance, t = time, a0 = constant term, and a1 = regression slope coefficien. Assume that downtime in the forecast (next) month decreases by the same percentage as preventive maintenance increased during the month preceding the current one. If 40 hours were spent last month on preventive maintenance and this month's downtime was 500 hours, what should downtime be next month if preventive maintenance this month is 50 hours? Use the equation developed in part A.

B.

P7.7 A.

SOLUTION
Dt+1 = a0 + a1 M

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Chapter 7

= Dt - D = Dt - M t M t-1 D t M t-1

B.

Dt+1

50 - 40 =500 - 500 40 = 375 hours of downtime

P7.8

Sales Forecast Modeling. Toys Unlimited Ltd., must forecast sales for a popular adult computer game to avoid stockouts or excessive inventory charges during the upcoming Christmas season. In percentage terms, the company estimates that game sales fall at double the rate of price increases and that they grow at triple the rate of customer traffic increases. Furthermore, these effects seem to be independent. A. Write an equation for estimating the Christmas season sales, using the variables S = sales, P = price, T = traffic, and t = time. Forecast this season's sales if Toys Unlimited sold 10,000 games last season at $15 each, this season's price is anticipated to be $16.50, and customer traffic is expected to rise by 15% over previous levels.

B.

P7.8 A.

SOLUTION

St+1 = St + S = St - SP + ST = St - 2(Pt+1/Pt - 1)St + 3(Tt+1/Tt - 1)St = -2(Pt+1/Pt)St + 3(Tt+1/Tt)St

B.

St+1 =-2(16.5/15)10,000 + 3(1.15)10,000


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Forecasting

= -22,000 + 34,500 = 12,500 games


P7.9 Simultaneous Equations. Mid-Atlantic Cinema, Inc., runs a chain of movie theaters in the east-central states and has enjoyed great success with a Tuesday Night at the Movies promotion. By offering half off its regular $9 admission price, average nightly attendance has risen from 500 to 1,500 persons. Popcorn and other concession revenues tied to attendance have also risen dramatically. Historically, Mid-Atlantic has found that 50% of all moviegoers buy a $5 cup of buttered popcorn. Eighty percent of these popcorn buyers, plus 40% of the moviegoers that do not buy popcorn, each spend an average of $4 on soda and other concessions. A. Write an expression describing total revenue from tickets plus popcorn plus other concessions. Forecast total revenues for both regular and special Tuesday night pricing. Forecast the total profit contribution earned for the regular and special Tuesday night pricing strategies if the profit contribution is 30% on movie ticket revenues and 80% on popcorn and other concession revenues.

B. C.

P7.9 A.

SOLUTION

If Q is the number of moviegoers, then: Ticket Revenue = P Q Popcorn Revenue = $5(0.5Q) = $2.50Q Other Concession Revenue = $4 (Popcorn buyers + Other buyers) = $4[0.8(0.5Q) + 0.4(0.5Q)]
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Chapter 7

= $2.40Q Therefore,
Concession Total Revenue

Ticket

Revenue Revenue Revenue

Popcorn

Other

= P Q + $2.50Q + $2.40Q = P Q + $4.90Q

B.

Regular Price Total Revenue = $9(500) + $4.90(500) = $6,950 Special Price Total Revenue = $4.50(1,500) + $4.90(1,500) = $14,100

C.
Profit Contribution

Regular Price = 0.3($9)(500) + 0.8($4.90)(500) = $3,310 Special Price Profit Contribution = 0.3($4.50)(1,500) + 0.8($4.90)(1,500) = $7,905

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Forecasting
Based on these figures, the ATuesday Night Special@ results in a $4,595 = ($7,905 - $3,310) increase in profit contribution.

P7.10

Simultaneous Equations. Supersonic Industries, based in Seattle, Washington, manufactures a wide range of parts for aircraft manufacturers. The company is currently evaluating the merits of building a new plant to fulfill a new contract with the federal government. The alternatives to expansion are to use additional overtime, to reduce other production, or both. The company will add new capacity only if the economy appears to be expanding. Therefore, forecasting the general pace of economic activity for the United States is an important input to the decision-making process. The firm has collected data and estimated the following relations for the U.S. economy:
Last year's total profits (all corporations) Pt-1 = $1,200 billion This year's government expenditures G Annual consumption expenditures C Annual investment expenditures I = $2,500 billion = $900 billion + 0.75Y = $920 billion + 0.9Pt-1

Annual tax receipts T = 0.16GDP Net Exports X National income Y = 0.03GDP = GDP - T

Gross domestic product (GDP) = C + I + G - X

Forecast each of the preceding variables through the simultaneous relations expressed in the multiple equation system. Assume that all random disturbances average out to zero. P7.10 A. SOLUTION
Investment I = $920 + 0.9Pt-1 = $920 + 0.9($1,200)
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Chapter 7
= $2,000 billion Gross Domestic Product GDP = C + I + G - X = $900 + 0.75Y + $2,000 + $2,500 - 0.03GDP = $900 + 0.75(GDP - T) + $2,000 + $2,500 - 0.03GDP = $900 + 0.75(GDP - 0.16GDP) + $2,000 + $2,500 - 0.03GDP = $900 + 0.6GDP + $2,000 + $2,500 0.4GDP = $5,400 GDP = $13,500 billion ($13.5 trillion) Consumption C = $900 + 0.75Y = $900 + 0.75(GDP - T) = $900 + 0.75(0.84GDP) = $900 + 0.63($13,500) = $9,405 billion Taxes T = 0.16GDP = 0.16($13,500) = $2,160 billion
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Forecasting

National Income Y = GDP - T = GDP - 0.16GDP = 0.84GDP = 0.84($13,500) = $11,340 billion

CASE STUDY FOR CHAPTER 7 Forecasting Global Performance for a Mickey Mouse Organization The Walt Disney Company is a diversified worldwide entertainment company with operations in four business segments: media networks, parks and resorts, studio entertainment and consumer products. The media networks segment consists of the company's television (ABC, ESPN, and Discovery) and radio networks, cable/satellite and international broadcast operations, production and distribution of television programming, and Internet operations. The studio entertainment segment produces live-action and animated motion pictures, television animation programs, musical recordings and live stage plays. The consumer products segment licenses the company's characters and other intellectual property to manufacturers, retailers, show promoters and publishers. Disney parks and resorts are at the cornerstone of a carefully integrated entertainment marketing strategy. Through the parks and resorts segment, Walt Disney owns and operates four destination resorts in the United States, Japan and France. In the United States, kids flock to Disneyland, California, and Walt Disney World, Florida--an immense entertainment center that includes the Animal Kingdom, Magic Kingdom, Epcot Center, and Disney-MGM Studios. During recent years, the company has extended its amusement park business to foreign soil with Tokyo Disneyland and Euro Disneyland, located just outside of Paris, France. Work is underway on a fifth resort, Hong Kong Disneyland, scheduled to open in late 2005 or early 2006. Disney's foreign operations provide an interesting example of the company's shrewd combination of marketing and financial skills. To conserve scarce capital resources, Disney was able to entice foreign investors to put up 100% of the financing required for both the Tokyo and
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Chapter 7 Paris facilities. In turn, Disney is responsible for the design and management of both operations, retains an important equity interest, and enjoys significant royalties on all gross revenues. Disney is also a major force in the movie picture production business with Buena Vista, Touchstone, and Hollywood Pictures, in addition to the renowned Walt Disney Studios. The company is famous for recent hit movies such as Finding Nemo, The Lion King, Pirates of the Caribbean: The Curse of the Black Pearl, and The Sixth Sense, in addition to a film library including hundreds of movie classics like Fantasia, Snow White, and Mary Poppins, among others. Disney employs an aggressive and highly successful video marketing strategy for new films and re-releases from the company's extensive film library. The Disney Store, a chain of retail specialty shops, profits from the sale of movie tie-in merchandise, books, and recorded music. Also making a significant contribution to the bottom line are earnings from Disney=s television operations which include ABC, The Disney Channel, the Discovery Channel, and sports juggernaut ESPN, the Entertainment and Sports Programming Network. The company's family entertainment marketing strategy is so broad in its reach that Disney characters such as Mickey Mouse, Donald Duck, and Goofy have become an integral part of the American culture. Given its ability to turn whimsy into outstanding operating performance, the Walt Disney Company is one firm that doesn't mind being called a AMickey Mouse Organization.@ Table 7.7 here Table 7.7 shows a variety of accounting operating statistics, including revenues, cash flow, capital spending, dividends, earnings, book value, and year-end share prices for the Walt Disney Company during the 1980-2003 period. All data are expressed in dollars per share to illustrate how individual shareholders have benefitted from the company's growth. During this time frame, revenue per share grew at an annual rate of 14.5% per year, and earnings per share grew by 9.0% per year. These performance measures exceed industry and economy-wide norms. Disney employees, CEO Michael D. Eisner, and all stockholders profited greatly from the company's outstanding stock-price performance during the 1980's and 1990's, but have grown frustrated by stagnant results during recent years. Over the 1980-2003 period, Disney common stock exploded in price from $1.07 per share to $23.33, after adjusting for stock splits. This represents a 14.3% annual rate of return, and illustrates how Disney has been an above-average stock-market performer. However, the stock price has grown stagnant since 1996, and stockholders are getting restless. Investors now want to know how the company will fare during coming years. Will the company be able to reassert itself and once again enjoy enviable growth, or, like many companies, will Disney find it impossible to maintain above-average performance? Disney=s new amusement parks and the growing popularity of ESPN sports programming promise significant future revenues and profits from previously untapped global markets. Anyone with young children who has visited Disneyland or Disney World has seen their delight and
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Forecasting fascination with Disney characters. It is also impossible not to notice how much foreign travelers to the United States seem to enjoy the Disney experience. Donald Duck and Mickey Mouse will do a lot of business abroad. Future expansion possibilities in Malaysia, China, or the former Soviet Union also hold the potential for rapid growth into the next century. On the other hand, growth of 10% per year is exceedingly hard to maintain for any length of time. At that pace, the 112,000 workers employed by Disney in 2004 would grow to over 180,000 by the year 2009. Maintaining control with such a rapidly growing workforce would be challenging; maintaining Disney's high level of creative energy might not be possible. Given the many uncertainties faced by Disney and most major corporations, forecasts of operating performance are usually restricted to a fairly short time perspective. The Value Line Investment Survey, one of the most widely respected forecast services, focuses on a three- to fiveyear time horizon. For the 2007-09 period, Value Line forecasts Disney revenues of $18.10, cash flow of $2.25, earnings of $1.65, dividends of $0.21, capital spending of $0.45, and book value per share of $17.55. Actual results will vary, but these assumptions offer a fruitful basis for measuring the relative growth potential of Disney. The most interesting economic statistic for Disney stockholders is the stock price during some future period, say 2007-09. In economic terms, stock prices represent the net present value of future cash flows, discounted at an appropriate risk-adjusted rate of return. To forecast Disney's stock price during the 2007-09 period, one might use any or all of the data in Table 7.7. Historical numbers for a recent period, like 1980-2003, represent a useful context for projecting future stock prices. For example, Fidelity's legendary mutual fund investor Peter Lynch argues that stock prices are largely determined by future earnings per share. Stock prices rise following an increase in earnings per share and plunge when earnings per share plummet. Sir John Templeton, the father of global stock market investing, focuses on book value per share. Templeton contends that future earnings are closely related to the book value of the firm, or accounting net worth. ABargains@ can be found when stock can be purchased in companies that sell in the marketplace at a significant discount to book value, or when book value per share is expected to rise dramatically. Both Lynch and Templeton have built a large following among investors who have profited mightily using their stock-market selection techniques. As an experiment, it will prove interesting to employ the data provided in Table 7.7 to estimate regression models that can be used to forecast the average common stock price for The Walt Disney Company over the 2007-09 period. A. A simple regression model over the 1980-2003 period where the Y-variable is the Disney year-end stock price and the X-variable is Disney=s earnings per share reads as follows (t-statistics in parentheses):

Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance. - 193 -

Chapter 7 Pt = -$1.661 + $31.388EPSt, R2 = 86.8% (-1.13) (12.03) Use this model to forecast Disney=s average stock price for the 2007-09 period using the Value Line estimate of Disney=s average earnings per share for 2007-09. Discuss this share-price forecast. B. A simple regression model over the 1980-2003 period where the Y-variable is the Disney year-end stock price and the X-variable is Disney=s book value per share reads as follows (t-statistics in parentheses):

Pt = $3.161 + $2.182BVt, R2 = 76.9% (1.99) (8.57) Use this model to forecast Disney=s average stock price for the 2007-09 period using the Value Line estimate of Disney=s average book value per share for 2007-09. Discuss this share-price forecast. C. A multiple regression model over the 1980-2003 period where the Y-variable is the Disney year-end stock price and the X-variables are Disney=s earnings per share and book value per share reads as follows (t-statistics in parentheses):

Pt = -$1.112 + $21.777EPSt + $0.869BVt, R2 = 90.9% (-0.88) (5.66) (3.06) Use this model to forecast Disney=s average stock price for the 2007-09 period using the Value Line estimate of Disney=s average earnings per share and book value per share for 2007-09. Discuss this share-price forecast. A multiple regression model over the 1980-2003 period where the y-variable is the Disney year-end stock price and x-variables include the accounting operating statistics shown in Table 7.7 reads as follows (t-statistics in parentheses):

D.

Pt

= -$2.453 + $2.377REVt + $0.822CFt + $13.603CAPXt + $17.706DIVt + $0.437EPSt - $1.665BVt, R2 = 94.3% (-1.75) (1.46) (0.09) (2.84) (0.24) (0.03) (-0.94)

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Forecasting Use this model and Value Line estimates to forecast Disney=s average stock price for the 2007-09 period. Discuss this share-price forecast. CASE STUDY SOLUTION A.
Using this simple regression model of stock prices and earnings per share, along with Value Line estimates of Disney=s earnings per share for 2007-09, gives a forecast of $50.13 for Disney=s average stock price for the 2007-09 period: Pt = -$1.661 + $31.388(1.65) = $50.13 In other words, this forecast means that if stock market investors accord Disney=s 2007-09 earnings per share a price-earnings ratio typical of the 1980-2003 period, and if the Value Line forecast of 2007-09 earnings per share is accurate, Disney=s stock price should grow to $50.13. From a 2003 year-end base of $23.33, this would represent a five-year average annual rate of capital appreciation of roughly 16.5% per year.

B.

Using this simple model of stock prices and book values, along with Value Line estimates of Disney=s average book value per share for 2007-09, gives a forecast of $41.46 for Disney=s average stock price for the 2007-09 period: Pt = $3.161 + $2.182(17.55) = $41.46 In words, this forecast means that if stock-market investors accord Disney=s 2007-09 book value per share a price-book ratio typical of the 1980-2003 period, and if the Value Line forecast of 2007-09 book value per share is accurate, Disney=s stock price should grow to $41.46. From a 2003 year-end base of $23.33, this would represent a five-year average annual rate of capital appreciation of roughly 12.2% per year.

C.

Using a multiple regression model of stock prices, earnings per share and book values, along with Value Line estimates of Disney=s average earnings per share and book value per share for 2007-09, gives a forecast of $50.08 for Disney=s average stock price for the 2007-09 period:

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Chapter 7
Pt = -$1.112 + $21.777(1.65) + $0.869(17.55) = $50.08 In other words, this forecast means that if stock market investors accord Disney=s 2007-09 earnings per share and book value per share a valuation typical of the 19802003 period, and if the Value Line forecasts of these numbers for 2007-09 are accurate, Disney=s stock price should grow to roughly $50.08. From a 2003 yearend base of $23.33, this would represent a five-year average annual rate of capital appreciation of roughly 16.5% per year.

D.

Using an extended multiple regression model, along with Value Line estimates for 2007-09, gives a forecast of only $23.77 for Disney=s average stock price over the 2007-09 period:
Pt = -$2.453 + $2.377(18.10) + $0.822(2.25) + $13.603(0.45) + $17.706(0.21) + $0.437(1.65) - $1.665(17.55) = $23.77

In other words, this forecast means that if stock market investors accord Disney=s 2007-09 accounting operating statistics a valuation typical of the 1980-2003 period, and if the Value Line forecasts for accounting performance over the 2007-09 period are accurate, Disney=s stock price should grow to only $23.77. From a 2003 yearend base of $23.33, this would represent a five-year average annual rate of capital appreciation of only 0.4% per year. (Note: High multicollinearity among the independent variables results in high standard errors for the coefficient estimates, and insignificant t statistics. This is despite the fact that many individual variables have the anticipated signs and statistical significance when individually considered in simple regression models. This example give a good basis for discussing estimation and forecasting problems encountered when using financial data..)

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