Forecasting: Questions & Answers Q7.1

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.
Q7.1
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.
Q7.2
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
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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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.
Q7.3
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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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.
Q7.5
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."
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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?
Q7.6
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.
Q7.7
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.
Q7.8
ANSWER
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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.
Q7.9
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
What are the main characteristics of accurate forecasts?
Q7.10
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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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
SOLUTION
A.
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.
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:
B.
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
Squared Forecast
Time
Error
Period
(GDP - Forecast
GDP)2
-$173.2
$29,994.1
51
-431.9
186,561.8
52
Forecast Error
(GDP -Forecast
GDP)
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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
Correlation 99.50%
-1,024.5
-1,595.7
-2,121.3
-$1,069.3
1,049,657.6
2,546,191.5
4,499,913.7
$1,662,463.7
Mean squared
error
$1,289.4
53
54
55
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
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
Average 1,286
Minimum 1,089
Maximum 1,515
111
109
129
124
117
106
135
117
147
124
103
140
115
119
138
122
105
145
138
116
148
134
127
82
81
82
91
76
90
88
99
76
83
98
78
83
76
100
90
86
96
97
97
84
88
87
821
843
849
797
988
914
913
867
785
817
846
768
856
771
947
831
905
996
929
1,000
951
848
891
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
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
127
103
149
87
76
100
870
768
1,000
46,788
37,809
55,839
1,286
1,024
1,478
Regression Statistics
R Square
90.4%
Standard Error
34.97
Observations
30
Intercept
Price, P
Competitor Price, Px
Advertising, Ad
Household Income, I
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
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Chapter 7
A.
Interpret the coefficient estimate for each respective independent variable.
B.
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
SOLUTION
A.
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.
B.
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..
C.
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
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.
B.
Compare your answers and discuss any differences.
P7.1
SOLUTION
A.
Using the assumption of annual compounding,

Et
= E0(1 + g)t
420
= 311(1 + g)10
1.35
= (1 + g)10
ln(1.35)
0.300/10
e0.030
1.031 - 1
g
= 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
= E0egt
420
= 311e10g
1.35
= e10g
ln(1.35)
= 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
1998 2008
311
420
299
622
66
98
86
123
617
Continuous Growth Model

Annual
Continuous
Compounding Compounding
3.05%
3.00%
7.60%
7.32%
4.03%
3.95%
3.64%
3.57%
1,194
6.82%
6.60%
B.
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.
P7.2
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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Chapter 7
Percent
change
Month
Visitors
January
7,481
February
9,686
29.5%
March
13,316
37.5%
April
24,166
81.5%
May
89,166
269.0%
June
255,237
186.2%
July
540,488
111.8%
August
528,716
-2.2%
September
286,602
-45.8%
October
57,164
-80.1%
November
12,029
-79.0%
6,913
-42.5%
152,580
42.4%
December
Average
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?
B.
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.
P7.2
SOLUTION
A.
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.
B.
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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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
B.
= 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%
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
P7.4
A.
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.
B.
Forecast when unit labor costs will equal the current cost of importing.
SOLUTION
Ct = C0egt
$100 = $80e3g
1.25 = e3g
ln(1.25) = 3g
- 182 -
Forecasting
g = 0.223/3
= 0.074 or 7.4%
Import Cost = C0egt
B.
$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
P7.5
A.
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.
B.
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?
SOLUTION
At = At-1 + At-1
At = At-1 - B t-1 - 1 A t-1

B t-2
- 183 -
Chapter 7
At = At-1 - B t-1 - 1 A t-1

B t-2
B.
90
= 100 - - 1 100
75
= 80.
P7.6
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.
B.
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.
SOLUTION
A.
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
- 184 -
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
P7.7
A.
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.
B.
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.
SOLUTION
Dt+1
= a0 + a1 M
- 185 -
Chapter 7
= Dt - D
= Dt - M t M t-1 D t
M t-1
Dt+1
B.
50 - 40
=500 -
500
40
= 375 hours of downtime
P7.8
P7.8
A.
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.
B.
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.
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

- 186 -
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.
B.
Forecast total revenues for both regular and special Tuesday night pricing.
C.
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.
P7.9
SOLUTION
A.
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)]
- 187 -
Chapter 7
= $2.40Q
Therefore,
Concession
Total Revenue
Ticket
Popcorn
Other
Revenue Revenue Revenue
= 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
Regular Price
C.
Profit Contribution
= 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
- 188 -
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
= $2,500 billion
Annual consumption expenditures C
= $900 billion + 0.75Y
Annual investment expenditures I
= $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)
- 189 -
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
- 190 -
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
- 191 -
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
- 192 -
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):
- 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)
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)
D.
Pt
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):
= -$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)
- 194 -
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:
- 195 -
Chapter 7
Pt = -$1.112 + $21.777(1.65) + $0.869(17.55) = $50.08
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.
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:
D.
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
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..)
- 196 -

Forecasting: Questions & Answers Q7.1

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Chapter 7

QUESTIONS & ANSWERS

Accurate company sales and profit forecasting requires careful consideration of

Forecasting the success of new product introductions is notoriously difficult.

Would a linear regression model of the advertising/sales relation be appropriate for

If the statistical analysis of economic relations, or econometrics, is to provide a

Cite some examples of forecasting problems that might be addressed using

What are the main characteristics of accurate forecasts?

SELF-TEST PROBLEMS & SOLUTIONS

Gross Domestic Product (GDP) is a measure of overall activity in the economy. It is

Multiple Regression. Branded Products, Inc., based in Oakland, California, is a

Interpret the coefficient estimate for each respective independent variable.

Characterize the overall explanatory power of this multiple regression model in

Price per Case, P

Competitor Price, Advertising,

Notice that each prospective market displays characteristics similar to those of

PROBLEMS & SOLUTIONS

Using a spreadsheet or hand-held calculator, calculate the ten-year growth

Compare your answers and discuss any differences.

Using the assumption of annual compounding,

Using the continuous compounding assumption,

Continuous Growth Model

Notice that park attendance is lower in December than in January, despite a

Derive a five-year and a ten-year sales forecast.

Five-Year Sales Forecast

Cost Forecasting. Dorothy Gale, a quality-control supervisor for Wizard Products,

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

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

= St + 2St Y t - 2St + 2St A t - 2St

Write an equation to predict next month's downtime using the variables D =

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

Simultaneous Equations. Mid-Atlantic Cinema, Inc., runs a chain of movie theaters

If Q is the number of moviegoers, then:

= $4 (Popcorn buyers + Other buyers)

Revenue Revenue Revenue

Simultaneous Equations. Supersonic Industries, based in Seattle, Washington,

Annual consumption expenditures C

= $900 billion + 0.75Y

Annual investment expenditures I

= $920 billion + 0.9Pt-1

Annual tax receipts T = 0.16GDP

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

Forecast each of the preceding variables through the simultaneous relations

CASE STUDY FOR CHAPTER 7

Pt = $3.161 + $2.182BVt, R2 = 76.9%

Pt = -$1.112 + $21.777EPSt + $0.869BVt, R2 = 90.9%

= -$2.453 + $2.377REVt + $0.822CFt + $13.603CAPXt + $17.706DIVt + $0.437EPSt - $1.665BVt, R2 = 94.3%

= -$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

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