HCOB 2411: Financial Modelling & Forecasting The Cooperative University

TOPIC ONE: INTRODUCTION

LESSON ONE: FINANCIAL MODELING

Financial modeling is the task of building an abstract representation (a model) of a real world financial
situation. This is a mathematical model designed to represent (a simplified version of) the performance of
a financial asset or portfolio of a business, project, or any other investment. Financial modeling is a general
term that means different things to different users; the reference usually relates either to accounting and
corporate finance applications, or to quantitative finance applications. While there has been some debate in
the industry as to the nature of financial modeling—whether it is a tradecraft, such as welding, or a
science—the task of financial modeling has been gaining acceptance and rigor over the years. Typically,
financial modeling is understood to mean an exercise in either asset pricing or corporate finance, of a
quantitative nature. In other words, financial modelling is about translating a set of hypotheses about the
behavior of markets or agents into numerical predictions; for example, a firm's decisions about investments
(the firm will invest 20% of assets), or investment returns (returns on "stock A" will, on average, be 10%
higher than the market's returns).

Financial planning
 Financial planning is a continuous process of directing and allocating financial resources to meet
strategic goals and objectives.
 This can be also be viewed as a single process that encompasses both operations and financing.
The operating people focuses on sales and production while financial planners are interested on
how to finance the operations.

 The output from financial planning takes the form of budgets. The most widely used form of
budgets is Pro Forma or Budgeted Financial Statements. The foundation for Budgeted Financial
Statements is Detail Budgets. Detail Budgets include sales forecasts, production forecasts, and
other estimates in support of the Financial Plan. Collectively, all of these budgets are referred to as
the Master Budget.
Steps in financial planning.
There are six steps to the process of doing a financial plan.
1) Determining objectives for the plan. This is done by:
 Quantifying specific amount goals within definite time frames and clarify any financial
goals within those parameters;
 Rank objectives according to priorities.
2) The second step of the financial planning process is gathering data (both Qualitative and
Quantitative).
 Qualitative provides general information concerning a family’s goals and objectives,
lifestyle, health, and investment-risk tolerance level.
 Quantitative provide basic but specific identifying information concerning details of
family’s financial status. Examples include info about investments, cash flow, insurance
coverage's, and present liabilities or other obligations.
3) Processing and analyzing the information gathered. Analyze the information to determine the
strengths and weaknesses. Evaluate the objectives in view of available resources, and economic
conditions as they relate to future resources and cash flow for the firm. It is the planning role to
examine the viable options for achieving the determined objectives.

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

4) The fourth step is the actual recommendation of a comprehensive financial plan for the firm. This
is a time for the firm explore about each strategy or product as it relates to solutions for achieving
their goals and dreams.
5) Implementation of the plan.
6) Monitoring the plan. Periodically review of implemented plans to evaluate the significance of any
changes in taxation, economic conditions, and available investment techniques.
Benefits of financial planning
The benefits of financial planning for the organization are
a) Identifies advance actions to be taken in various areas.
b) Seeks to develop number of options in various areas that can be exercised under different
conditions.
c) Facilitates a systematic exploration of interaction between investment and financing
decisions.
d) Clarifies the links between present and future decisions.
e) Forecasts what is likely to happen in future and hence helps in avoiding surprises.
f) Ensures that the strategic plan of the firm is financially viable.
g) Provides benchmarks against which future performance may be measured.

Financial forecasting

A financial forecast is an estimate of future financial outcomes for a company or country (for futures
and currency markets). Using historical internal accounting and sales data, in addition to external
market and economic indicators.
 Financial Forecasting describes the process by which firms think about and prepare for the future.
The forecasting process provides the means for a firm to express its goals and priorities and to
ensure that they are internally consistent. It also assists the firm in identifying the asset requirements
and needs for external financing.
 Unlike a financial plan or a budget a financial forecast doesn't have to be used as a planning
document. Outside analysts can use a financial forecast to estimate a company's success in the
coming year

Objectives of forecasting
 To reduce cost of responding to emergencies by anticipating the future occurrences.
 Prepare to take advantage of future opportunities.
 Prepare contingency and emergency plans.
 Prepare to deal with possible outcomes

Financial forecasting is important in the following ways:

a) Facilitate financial planning i.e. determination of cash surplus or deficit that are likely to occur in
future.
b) Facilitate control of expenditure. This will minimize wastage of financial resources in order to
achieve financial targets.

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c) It avoids surprise to the managers’ e.g. any cash deficit is known well in advance thus the firm can
plan for sources of short term funds such as bank drafts or short term loans.
d) Motivation to the employees – Financial forecasting using budgets and targets will enhance unity
of purpose and objectives among employees who are determined to achieve the set target.

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

LESSON TWO: METHODS/TECHNIQUES OF FINANCIAL FORECASTING

1. Use of Cash Budgets

A cash budget is a financial statement indicating:

a) Sources of revenue and capital cash inflows

b) How the inflows are expended to meets revenue and capital expenditure of the firm.
c) Any anticipated cash deficit/surplus at any point during forecasting period.

2. Regression Analysis
This is a statistical method which involves identification of dependent and independent variable to form a
regression equation *y = a + bx) on which forecasting will be based.

3. Percentage of Sales Method

This method involves expressing various balance sheet items that are directly related to sales as a percentage
of sales. It involves the following steps:

i) Identify various balance sheet items that are directly with sales this items include:
a) Net fixed asset – If the current production capacity of the firm is full an increase in sales will require
acquisition of new assets e.g. machinery to increase production.
b) Current Asset – An increase in sales due to increased production will lead to increase in stock of
raw materials, finished goods and work in progress. Increased credit sales will increase debtors
while more cash will be required to buy more raw materials in cash.
c) Current liabilities – Increased sales will lead to purchase of more raw materials
d) Retained earnings – This will increase with sales if and only if, the firm is operating profitability
and all net profits are not paid out as dividend.

Note
The increase in sales does not require an increase in ordinary share capital, preference share capital and
debentures since long term capital is used to finance long term project.

ii) Express the various balance sheet items varying with sales as percentage of sales e.g. assume for
year 2002 stock and net fixed assets amount to Sh.12M and 18M respectively sales amount to
Sh.40M. Therefore stock as percentage of sales”

12M
Stock = x10030%
40M
Fixed asset = 18M x10045%
40M
iii) Determine the increase in total asset as a result of increase in sales e.g suppose sales increases from
Sh.40 M to Sh.60 M during year 2003. The additional stock and net fixed asset required would be
determined as follows:

Increase in stock = % of sales x increase in sales

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= 30% (60 – 40) = Sh.6M

Increase in fixed asset = % of sales x increase in sales

= 45 %( 60 – 40) = Sh.9 M

iv) Determine the total increase in assets which will be financed by:

a) Spontaneous source of finance i.e increase in current liabilities

Where Increase = % of sales x increase in sales

b) Retained earnings for the forecasting period

Retained earnings = Net profit – Dividend paid

Net profit margin = Net profit

Sales

Therefore: Net profit = Net profit margin (%) x sales

Note
Generally Net profit margin is called after tax return on sales.

Out of the total assets that are required as a result of increase in sales, the financing will come from the
two sources identified. Any amount that cannot be met from the two sources will be borrowed
externally on short term basis which will be a current liability.

Assumptions underlying % of sales method

The fundamental assumption underlying the use of % of sales method is that, there is no inflation in the
economy i.e the increase in sales is caused by increase in production and not increase in selling price.

Other assumptions include:

1. The firm is operating at full or 100% capacity. Therefore the increase in production will require
acquisition of new fixed assets.
2. The firm will not issue new ordinary shares or debenture or preference shares thus this capital will
remain constant during the forecasting period.
3. The relationship between balance sheet item and sales i.e balance sheet items as % of sales will be
maintained during forecasting period.
4. The after tax, profit on sale or net profit margin will be achieved and shall remain constant during
the forecasting period.

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

Illustration
The following is the balance sheet of XYZ Ltd as at 31st December 2002:

Sh.’000’
Net fixed asset 300
Current assets 100
400
Financed by:
Ordinary share capital 100
Retained earnings 70
10% debentures 150
Trade creditors 50
Accrued expenses 30
400

Additional Information

1. The sales for year 2002 amounted to Sh.500,000. The sales will increase by 15% during year 2003
and 10% during year 2004.
2. The after tax return on sales is 12% which shall be maintained in future.
3. The company’s dividend payout ratio is 80%. This will be maintained during forecasting period.
4. Any additional financing from external sources will be affected through the issue of commercial
paper by company.

Required
a) Determine the amount of external finance for 2 years upto 31st December 2004.
b) Prepare a proforma balance as at 31 December 2004

Solution
Identify various items in balance sheet directly with sales:

• Fixed Asset
• Current Asset
• Trade creditors
• Accrued expenses

Net fixed assets = 300/500 x = 60%

100

Current Assets = 100/500 x = 20%

100

Trade creditors = 50 x 100 = 10%

500

Accrued expenses = 30 x 100 = 6%

500

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c) Compute the increase in sales over the 2 years.

Year 2002 sales = 500x 575M

Year 2003 sales = 575x 632.5M

Increase in sales in 2003-03-26= 632.5 – 500 = 132.5

d) Compute the amount of external requirement of the firm over the 2 years of forecasting period.

i) Increase in F. Assets = % of sales x increase in sales

= 60% x 132.5 = 79.5
ii) Increase in C. Assets = % of sales x increase in sales
= 20% of 132.5 = 26.5
Total additional investment/asset required 106

Interpretation
For the company to earn increase in sales of 132.5M it will have to acquire additional assets costing 106M.

Sh.’000’
Additional investment/asset required 106,000
Less: Spontaneous source of finance
Increase in creditors = % of sales x increase in sales
= 132,500 x 10% (13,250)
Increase in accrued expenses = % of sales x increase in sales
= 132,500 x 6% (7,950)
Less: Retained earnings during 2 years of operation (initial sources)
Net profit for 2003 = Net profit margin x sales of 2003
= 12% of 575,000 = 69,000
Less: Dividend payable 80% of 69,000 = 55,200
Net profit for 2004 = Net profit margin x sales of 2004 (13,800)
= 12% of 632,500 = 75,900
Less: dividend payable 80% of 75,900 = 60,720
(15,180)
External financial needs (commercial paper)
55,820

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

LESSON THREE: PROFORMA BALANCE SHEET

This refers to the projected balance sheet at the end of forecasting period. The items in the proforma balance
which vary with sales would be determined in any of the following two ways:

i) % of sales x sales at last year of forecasting (2004); or

ii) Balance sheet item before forecasting plus increase in balance sheet item as a result of increase in
sales.

Proforma balance sheet as at 31st December 2004

Shs.
Net fixed assets 60% x 632.5 or 300 + 79.5 379.50
Current Assets 20% x 632.5 or 100 + 26.5 126.50
506.00
Ordinary shares (will remain constant) 100.00
Retained earnings 70 + 13.8 + 15.18 98.98
10% debenture (remain constant) 150.00
Trade creditor 10% x 632.5 or 50 + 13.25 63.25
Accrued expenses 6% x 632.5 or 30 + 7.95 37.95
External borrowing – commercial 55.82
506.00

What's the difference between a financial plan and a financial forecast?

A financial forecast is an estimation or projection of likely future income or revenue and expenses, while a
financial plan lays out the necessary steps to generate future income and cover future expenses.
Alternatively, a financial plan can be looked at as what an individual or company plans to do with income
or revenue received.
Financial forecasting is critical for business success. To effectively manage working capital and cash flow,
a company must have a reasonable idea of how much revenue it plans to receive over a given time period
and what its necessary expenses will be over that same period of time. Financial forecasts are commonly
reviewed and revised annually as new information regarding income and costs becomes available and as
additional data enables an individual or business to make more accurate financial projections. It is easier
for established companies that generate steady revenues to make accurate financial forecasts than it is for
new businesses or companies whose revenue is subject to significant seasonal or cyclical fluctuation.
A financial plan is the process a company lays out, typically broken down into a step-by-step format, for
utilizing its available capital and other assets to meet its goals for growth or profit based on a reasonable
financial forecast. A financial plan can be considered synonymous with a business plan in that it lays out
what a company plans to do in terms of putting resources to work to generate maximum possible revenues.
For an individual, a financial forecast is an estimate of his income and expenses over a period of time. Based
on that forecast, the individual can then construct a financial plan that includes saving, investing or planning
for obtaining additional income to supplement his personal finances.

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

TOPIC TWO: FORECASTING METHODOLOGY

LESSON FOUR: TIME-SERIES MODELS AND MEASURING FORECAST ERROR

Time-Series Models and Measuring Forecast Error

In general, there are four types of components in time series analysis: Seasonality, Trend, Cycling and
Irregularity (random)

General Form: Y = T * C * S ± ε,

Where
T = Trend - long term movement of mean
C = (Business) Cycle - an upturn or downturn not caused by seasonal variation; effect of the economy
S = Seasonal Variation - repetitive pattern observed over a specific time period
ε = Error (random variation)

Practical Forecast Form: Ŷ = T * S

C is important, but difficult to forecast
Don’t forecast an error!

Stationary Model Assumptions

 Assumes item forecasted will stay steady over time (constant mean; random variation only)
 Techniques will smooth out short-term irregularities
 Forecast for period t+1 is equal to forecast for period t+k; the forecast is revised only when new
data becomes available.

Stationary Model Types

a) Naïve Forecast
b) Moving Average
c) Weighted Moving Average
d) Exponential Smoothing

The Naïve Model

Forecasting technique in which the last period's actuals are used as the current period's forecast, without
adjusting them or attempting to establish causal factors. It is used only for comparison with the forecasts
generated by the better (sophisticated) techniques.

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Naïve forecasts are the most cost-effective forecasting model, and provide a benchmark against which more
sophisticated models can be compared. This forecasting method is only suitable for time series data. Using
the naïve approach, forecasts are produced that are equal to the last observed value. This method works
quite well for economic and financial time series, which often have patterns that are difficult to reliably and
accurately predict. If the time series is believed to have seasonality, seasonal naïve approach may be more
appropriate where the forecasts are equal to the value from last season.

Features
i. Whatever happened last period will happen again this time
ii. The model is simple and flexible
iii. Provides a baseline to measure other models
iv. Attempts to capture seasonal factors at the expense of ignoring trend
Wallace Garden Supply
Forecasting
Storage Shed Sales

Actual Naïve Absolute Percent Squared

Period Value Forecast Error Error Error Error
January 10 N/A
February 12 10 2 2 16.67% 4.0
March 16 12 4 4 25.00% 16.0
April 13 16 -3 3 23.08% 9.0
May 17 13 4 4 23.53% 16.0
June 19 17 2 2 10.53% 4.0
July 15 19 -4 4 26.67% 16.0
August 20 15 5 5 25.00% 25.0
September 22 20 2 2 9.09% 4.0
October 19 22 -3 3 15.79% 9.0
November 21 19 2 2 9.52% 4.0
December 19 21 -2 2 10.53% 4.0
0.818 3 17.76% 10.091
BIAS MAD MAPE MSE

Standard Error (Square Root of MSE) = 3.176619

Measures of Forecast Error

( Forecast Error  Yt  Ft )
Bias - The arithmetic sum of the errors
MAD - Mean Absolute Deviation
MAPE – Mean Absolute Percentage Error
Mean Square Error (MSE) - Similar to simple sample variance
Standard Error - Standard deviation of the sampling distribution (the square root of the MSE)
Bias, MAD, and MAPE – typically used for time series
T
Bias   (forecast error) /T
T
MSE   | forecast error |2 /T
t 1 t 1
T
  (Yt  Ft ) / T
T

t 1
  (Y
t 1
t  Ft ) 2 / T
T
MAPE  100 [|Yt  Ft | / Yt ] / T
T T
MAD   | forecast error | /T   |Yt  Ft | / T
t 1 t 1 t 1

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

Time series and analysis

This is the mathematical or statistical analysis on past data arranged in a periodic sequence.
Decision making and planning in an organization involves forecasting which is one of the time
series analysis.

Impediments in time series analysis

Accuracy of data in reflecting
a) Drastic changes e.g. in the advent of a major competitor, period of war or sudden change of
taste.
b) For long term forecasting internal and external pressures makes historical data less effective.

1. Simple Moving Average

Periodical data e.g. monthly sales may have random fluctuation every month despite a general
trend being evident. Moving average helps in smoothing away these random changes. A moving
average is the forecast for a period that takes the average of the previous periods.

Example:
The table below represents company sales, calculate 3 and 6 monthly moving averages, for the
data

Months Sales
January 1200
February 1280
March 1310
April 1270
May 1190
June 1290
July 1410
August 1360
September 1430
October 1280
November 1410
December 1390

Solution.
These are calculated as follows
Jan + Feb + Mar 1200 +1280 +1310
April’s forecast = =
3 3
Feb + Mar + Apr 1280 +1310 +1270
May’s forecast = =
3 3

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And so on…

Similarly for 6 monthly moving average

Jan + Feb + Mar + Apr + May + Jun 1200 +1280 +1310 +1270 +1190 +1290
July forecast = =
6 6
And so on…
3 months moving average 6 months moving average
April 1263
May 1287
June 1257
July 1250 1257
August 1297 1292
September 1353 1305
October 1400 1325
November 1357 1327
December 1373 1363

Note:
When plotting moving average on graphs the points are plotted as the midpoint of the period of the average,
e.g. in our example the forecast for April (1263) is plotted on mid Feb.
Characteristics of moving average
1) The more the number of periods in the moving average, the greater the smoothing effect.
2) Different moving averages produce different forecasts.
3) The more the randomness of data with underlying trend being constant then the more the
periods should be involved in the moving averages.

Limitations of moving averages.

1) Equal weighing with disregard to how more recent data is more relevant.
2) Moving average ignores data outside the period of the average thus it doesn’t fully utilize
available data.
3) Where there is an underlying seasonal variation, forecasting with unadjusted moving average
can be misleading.

2. Weighted Moving Average

When a detectable trend or pattern is present, weights can be used to place more emphasis on recent values.
This practice makes forecasting techniques more responsive to changes because more recent periods may
be more heavily weighted. Choice of weights is somewhat arbitrary because there is no set formula to
determine them. Therefore, deciding which weights to use requires some experience. For example, if the
latest month of period is weighted too heavily, the forecast may reflect a large unusual change in the demand
or sales pattern too quickly.

A weighted moving average may be expressed mathematically as:

Weighted moving average = Σ (weight for period n) (Demand in period n)

Σ Weights

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Example

Actual
Month Sales 3-Month Weighted Moving Average
January 10
February 12
March 13
April 16 (3x13) + (2x12) + (1x10) /6 =12.17
May 19 (3x16) + (2x13) + (1x12) /6 =14.33
June 23 (3x19) + (2x16) + (1x13) /6 =17
July 26 (3x23) + (2x19) + (1x16) /6 =20.50
August 30 (3x26) + (2x23) + (1x19) /6 =23.83
September 28 (3x30) + (2x26) + (1x23) /6 =27.50
October 18 (3x28) + (2x30) + (1x26) /6 =28.33
November 16 (3x18) + (2x28) + (1x30) /6 =23.33
December 14 (3x16) + (2x18) + (1x28) /6 =18.67

Both simple and weighted moving averages are effective in smoothing out sudden fluctuations in the
demand pattern to provide stable estimates. Moving averages do, however, present three problems:
a) Increasing the size of n (the number of periods averaged) does smooth out fluctuations better, but
it makes the method less sensitive to real changes in the data.
b) Moving averages cannot pick up trends very well. Because they are averages, they will always stay
within past levels and will not predict changes to either higher or lower levels. That is, they lag the
actual values.
c) Moving averages require extensive records of past data.

3. Exponential smoothing
This is a weighted moving average technique, it is given by:
New forecast = Old forecast +  (Latest Observation – Old forecast)
Where  = Smoothing constant
This method involves automatic weighing of past data with weights that decrease exponentially with time.

Example
Using the previous example and smoothing constant 0.3 generate monthly forecasts
Months Sales Forecasts:  = 0.3
January 1200
February 1280 1200
March 1310 1224
April 1270 1250
May 1190 1256
June 1290 1233
July 1410 1250
August 1360 1283

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September 1430 1327

October 1280 1358
November 1410 1335
December 1390 1357

Solution
Since there were no forecasts before January we take Jan to be the forecast for February.
 Feb – 1200
For March;
March forecast = Feb forecast + 0.3 ( Feb sales – Feb forecast)
= 1200 + 0.3 (1280 – 1200)
=1224

Note:
 The value  lies between 0 and 1.
 The higher the  value, the more the forecast is sensitive to the current status.

Characteristics of exponential smoothing

 More weight is given to the most recent data.
 All past data are incorporated unlike in moving averages.
 Less data is needed to be stored unlike in periodic moving averages.

Decomposition of time series

Time series has the following characteristics.
a) A long term trend (T) –tendency of the whole series to rise and fall.
b) Seasonal variation (S) – short term periodic fluctuations in values. e. g. in Kenya maize yield is
high in November and low in March or matatus have better business on Friday and very low on
Sundays.
c) Cyclical variation (C) – These are medium term changes caused by factors which apply for a while
then disappear, and come back again in a repetitive cycle. e. g. drought hits Kenya every 7 years.
Note that cyclic variation has a longer term than seasonal variation e.g. seasonal variation may
occur once every year while cyclic variation occurs once every several years.
d) Random residual variation (R) – These are non-recurring random variations e.g. war, fire, coup
e.t.c.

For accurate forecasts these aspects are qualified separately (i.e. T, C, S and R) from data. This is known
as time decomposition or time series analysis
The separate elements are then combined to produce a forecast.

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

LESSON FIVE: TIME SERIES MODELS

Additive Model
Time series value = T +S +C +R
Where S, C and R are expressed in absolute value.
This model is best suited where the component factors are independent e.g. where the seasonal variation is
unaffected by trend.

Multiplicative Model:
Time series value = T × S× C × R
Where S, C and are expressed as percentage or proportions.
This model is best applied where characteristics interact e.g. where high trends increase seasonal variations.
Multiplicative model is more commonly used in practice.

Of the four elements of time series the most important are trend and seasonal variation. The following
illustration shows how the trend (T) and seasonal variation (S) are separated out from a time series and how
the calculated T and S values are used to prepare forecast. The process of separating out the trend and
seasonal variation is known as deseasonalising the data.

There are two approaches to this process: one is based on regression through the actual data points and the
other calculates the regression line through moving average trend points. The method using the actual data
is demonstrated first followed by the moving average method.

1. Time series analysis: trend and seasonal variation using regression on the data

The following data will be used to illustrate how the trend and seasonal variation are calculated.

Example 1

Sales of widgets in ‘000s

Quarter 1 Quarter 2 Quarter 3 Quarter 4
Year 1 20 32 62 29
2 21 42 75 31
3 23 39 77 48
4 27 39 92 53

It will be apparent that there is a strong seasonal element in the above data (low in Quarter 1 and high in
Quarter 3) and there is a generally upward trend.

The steps in analyzing the data and preparing a forecast are:

Step 1: Calculate the trend in the data using the least squares method.

Step 2: Estimate the sales for each quarter using the regression formula established in
step 1.

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Step 3: Calculate the percentage variation of each quarter’s actual sales from the
estimates, obtained in step 2.

Step 4: Average the percentage variations from step 3. This establishes the average
seasonal variations.

Step 5: Prepare forecast based on trend percentage seasonal variations.

Solution

Step 1
Calculate the trend in the data by calculating the linear regression line y = a + bx.

x (quarters) x (sales) xy x2
 1 20 20 1
2 32 64 4
Year 1 3 62 186 9
4 29 116 16

 5 21 105 25
6 42 252 36
Year 2 7 75 525 49
8 31 248 64

 9 23 207 81
10 39 390 100
Year 3 11 77 847 121
12 38 576 144

 13 27 351 169
14 39 546 196
Year 4 15 92 1380 225
16 53 848 256
x=136 y= 710 xy= 6661  x2 =1496

Least square equations

y = an + bx

xy = ax + bx2

710 = 16a + 136b

6661 = 136a + 1496b

626 = 340b

b = 1.84 and substituting we obtain

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a = 28.74

Trend line = 28.74 + 1.84x

Steps 2 and 3
Use the trend line to calculate the estimated sales for each quarter.

For example, the estimate for the first quarter in year 1 is

Estimate = 28.74 + 1.84 (1) = 30.58

The actual value of sales is then expressed as a percentage of this estimate. For example, actual sales in the
first quarter were 20 so the seasonal variation is
Actual sales 20
%  65%
Estimate 30.58

x (quarters) y (sales) Trend Actual

%
Trend
 1 20 30.58 65
2 32 32.42 99
Year 1 3 62 34.26 181
4 29 36.10 80

 5 21 37.94 55
6 42 39.78 106
Year 2 7 75 41.62 180
8 31 43.46 71

 9 23 45.30 51
10 39 47.14 83
Year 3 11 77 48.98 157
12 48 50.82 94

 13 27 52.66 51
14 39 54.50 72
Year 4 15 92 56.34 163
16 53 58.18 91

Trend estimates and percentage variations table.

Step 4

Average the percentage variations to find the average seasonal variations.

Q1 Q2 Q3 Q4
% % % %
65 99 181 80
55 106 180 71

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

51 83 157 94
51 72 163 91
222 360 681 336
4= 56% 90% 170% 84%

These then are the average variations expected from the trend for each of the quarters; for example, on
average the first quarter of each year will be 56% of the value of the trend. Because the variations have
been averaged, the amounts over 100% (Q3 in this example). This can be checked by adding the average
and verifying that they total 400% thus:

56% + 90% + 170% + 84% = 400%.

On occasions, roundings in the calculations will make slight adjustments necessary to the average
variations.

Step 5

Prepare final forecasts based on the trend line estimates from “trend estimates and percentages variation
table” (i.e. 30.58, 32.42, etc) and the averaged seasonal variations from the table above. (i.e. 56%, 90%,
170% and 84%)

The seasonally adjusted forecast is calculated thus:

Seasonally adjusted forecast = Trend estimate × Seasonal variation%

X (quarters) Y (sales) Seasonally adjusted

forecast
 1 20 17.12
Year 1 2 32 29.18
3 62 58.24
4 29 30.32

 5 21 21.24
Year 2 6 42 35.80
7 75 70.75
8 31 36.51

 9 23 25.37
Year 3 10 39 42.43
11 77 83.27
12 48 42.69

 13 27 29.49
Year 4 14 39 49.05
15 92 95.78
16 53 48.87

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LESSON SIX: SEASONALLY ADJUSTED FORECASTS

The forecasts are compared with the actual data to get some idea of how good extrapolated forecasts might
be. With further analysis they enable us to quantify the residual variations.

Extrapolation using the trend and seasonal factors

Once the formulae above have been calculated, they can be used to forecast (extrapolate) future sales. If it
is required to estimate the sales for the next year (i.e. Quarters 17, 18, 19 and 20 in our series) this is done
as follows:

Quarter 17 Basic trend = 28.74 + 1.84 (17)

= 60.02

Seasonal adjustment for a first quarter = 56%

Adjusted forecast = 60.02 × 56%
= 33.61

A similar process produces the following figures:

Adjusted forecasts Quarter 18 = 55.67

19 = 108.29
20 = 55.05
Notes:
a) Time series decomposition is not an adaptive forecasting system like moving averages and
exponential smoothing.
b) Forecasts produced by such an analysis should always be treated with caution. Changing
conditions and changing seasonal factors make long term forecasting a difficult task.
c) The above illustration has been an example of a multiplicative model. This is the seasonal
variations were expressed in percentage or proportionate terms. Similar steps would have been
necessary if the additive model had been used except that the variations from the trend would
have been the absolute values. For example, the first two variations would have been

Q1: 20 – 30.58 = absolute variation = -10.58

Q2: 32 – 32.42 = absolute variation = - 0.42
And so on.

The absolute variations would have been averaged in the normal way to find the average absolute variation,
whether + or -, and these values would have been used to make the final seasonally adjusted forecasts.

2. Trend and seasonal variation using moving averages

When the correlation coefficient is low the method of calculating the regression line through the actual data
points should not be used. This is because the regression line is too sensitive to changes in the data values.
In such circumstances, calculating a regression line through the moving average trend points is more robust
and stable.

Example 1 is reworked below using this method and, because there are many similarities to the earlier
method, only the key stages are shown.

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x y 3 point moving Trend line (2) Actual

average (1) %
Trend
1 20 34.38 58
2 32 38 35.70 90
3 62 41 37.02 167
4 29 37.3 38.34 76
5 21 30.7 39.66 53
6 42 46 40.98 102
7 75 49.3 42.30 177
8 31 43 43.62 71
9 23 31 44.94 51
10 39 46.3 46.26 84
11 77 54.7 47.58 162
12 48 50.7 48.90 98
13 27 38 50.22 54
14 39 52.7 51.54 76
15 92 61.3 52.86 174
16 53 54.18 98

Trend estimates and percentage variations utilizing moving averages

The first three moving average is calculated as follows

20  32  62
= 38 which is entered opposite period 2
3

The next calculated:

32  62  29
= 41, and so on
3
The regression line y = a + bx of the moving average values is calculated in the normal manner and results
in the following:
y = 33.06 + 1.32x

This is used to calculate the trend line:

e.g. For Period 1:y = 33.06 + 1.32(1) = 34.38

For Period 2:y = 33.06 + 1.32 (2) = 35.70

The percentage variations are averaged as previously shown, resulting in the following values:

Q1 Q2 Q3 Q4
Average seasonal variation % 54 89 170 86

The trend line and the average seasonal variations are then used in a similar manner to that
previously described.

For example, to extrapolate future sales for the next year (i.e. quarters 17, 18, 19 and 20) is as follows:

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Quarter 17
Forecast sales = (33.06 + 1.32(17)) × 0.54 = 29.97

A similar process produces the following figures:

Quarter 18 = 50.57
19 = 98.84
20 = 51.13

Forecast errors
Differences between actual results and predictions may arise from many reasons. They may arise from
random influences, normal sampling errors, choice of the wrong forecasting system or alpha value or simply
that the future conditions turn out to be radically different from the past. Whatever the cause(s) management
wish to know the extent of the forecast errors and various methods exist to calculate these errors.

A commonly used technique, appropriate to time series, is to calculate the mean squared error of the
deviations between forecast and actual values then choose the forecasting system and/or parameters which
gives the lowest value of mean squared errors, i.e. akin to the ‘least squares’ method of establishing a
regression line.

Longer- term forecasting

Moving averages, exponential smoothing and decomposition methods tend to be used for short to medium
term forecasting. Longer term forecasting is usually less detailed and is normally concerned with
forecasting the main trends on a year to year basis. Any of the techniques of regression analysis described
in the preceding chapters could be used depending on the assumptions about linearity or non- linearity, the
number of independent variables and so on. The least squares regression approach is often used for trend
forecasting.

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TOPIC THREE: FORECASTING WITH REGRESSION AND MARKOV

METHODS
LESSON SEVEN: CORRELATION

This is an important statistical concept which refers to interrelationship or association between

variables. The purpose of studying correlation is for one to be able to establish a relationship, plan
and control the inputs (independent variables) and the output (dependent variables)
In business one may be interested to establish whether there exists a relationship between the
i. Amount of fertilizer applied on a given farm and the resulting harvest
ii. Amount of experience one has and the corresponding performance
iii. Amount of money spent on advertisement and the expected incomes after sale of the
goods/service
There are two methods that measure the degree of correlation between two variables these are denoted
by R and r.

(a) Coefficient of correlation denoted by r, this provides a measure of the strength of association
between two variables one the dependent variable the other the independent variable r can
range between +1 and – 1 for perfect positive correlation and perfect negative correlation
respectively with zero indicating no relation i.e. for perfect positive correlation y increase
linearly with x increments.
(b) Rank correlation coefficient denoted by R is used to measure association between two sets of
ranked or ordered data. R can also vary from +1, perfect positive rank correlation and -1
perfect negative rank correlation where O or any number near zero representing no
correlation.

SCATTER GRAPHS
- A scatter graph is a graph which comprises of points which have been plotted but are not
joined by line segments
- The pattern of the points will definitely reveal the types of relationship existing between
variables
- The following sketch graphs will greatly assist in the interpretation of scatter graphs.

Perfect positive correlation

y
Dependant variable x
x
x
x
x
x
x

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x
Independent variable

NB: For the above pattern, it is referred to as perfect because the points may easily be represented by
a single line graph e.g. when measuring relationship between volumes of sales and profits in a
company, the more the company sales the higher the profits.

Perfect negative correlation

y x
Quantity sold x
X
x
x
x
x
x
x

10 20 Price X
This example considers volume of sale in relation to the price, the cheaper the goods the bigger the
sale.

High positive correlation

y
Dependant variable xx
xx
x
x
xx
xx
xx
xx
x
xxx
x
x

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

independent variable x

High negative correlation

y
quantity sold x
x
xx
x
xx
x
x
x
x
xx
x
price
No correlation
y

600 x x x x x
x x x
400 x x x x x
x x x x
200 x x x x x
x x x x
0
10 20 30 40 50 x

Spurious Correlations
- in some rare situations when plotting the data for x and y we may have a group showing either
positive correlation or –ve correlation but when you analyze the data for x and y in normal life
there may be no convincing evidence that there is such a relationship. This implies therefore
that the relationship only exists in theory and hence it is referred to as spurious or non-sense
e.g. when high pass rates of student show high relation with increased accidents.

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Correlation coefficient
- These are numerical measures of the correlations existing between the dependent and the
independent variables
- These are better measures of correlation than scatter graphs (diagrams)
- The range for correlation coefficients lies between +ve 1 and –ve 1. A correlation coefficient
of +1 implies that there is perfect positive correlation. A value of –ve shows that there is
perfect negative correlation. A value of 0 implies no correlation at all
- The following chart will be found useful in interpreting correlation coefficients

- __ 1.0 } Perfect +ve correlation

} High positive correlation
__ 0.5 }
} Low positive correlation
__0 }
} Low negative correlation
__-0.5}
} High negative correlation
__-1.0} Perfect –ve correlation

There are usually two types of correlation coefficients normally used namely;-

Product Moment Coefficient (r)

It gives an indication of the strength of the linear relationship between two variables.
n xy   x  y
r=
n x 2    x   n y 2    y 
2 2

Note that this formula can be rearranged to have different outlooks but the resultant is always the
same.

Example
The following data was observed and it is required to establish if there exists a relationship between
the two.
X 15 24 25 30 35 40 45 65 70 75
Y 60 45 50 35 42 46 28 20 22 15

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Solution
Compute the product moment coefficient of correlation (r)
X Y X2 Y2 XY
15 60 225 3,600 900
24 45 576 2,025 1,080
25 50 625 2,500 1,250
30 35 900 1,225 1,050
35 42 1,225 1,764 1,470
40 46 1,600 2,116 1,840
45 28 2,025 784 1,260
65 20 4,225 400 1,300
70 22 4,900 484 1,540
75 15 5,625 225 1,125
 X  424  Y  363  X  21,926  Y 2  15,123
2
 XY  12,815

n xy   x  y
r=
n x 2    x   n y 2    y 
2 2

10 12,815  424  363

r=
10  21,926  424   10 15,123  363 
2 2

25, 762
=  0.93
 39, 484   19, 461
The correlation coefficient thus indicates a strong negative linear association between the two
variables.

Interpretation of r – Problems in interpreting r values

NOTE:
 A high value of r (+0.9 or – 0.9) only shows a strong association between the two variables but
doesn’t imply that there is a causal relationship i.e. change in one variable causes change in the
other it is possible to find two variables which produce a high calculated r yet they don’t have a
causal relationship. This is known as spurious or nonsense correlation e.g. high pass rates in QT
in Kenya and increased inflation in Asian countries.
 Also note that a low correlation coefficient doesn’t imply lack of relation between variables but
lack of linear relationship between the variables i.e. there could exist a curvilinear relation.
 A further problem in interpretation arises from the fact that the r value here measures the
relationship between a single independent variable and dependent variable, where as a particular
variable may be dependent on several independent variables (e.g. crop yield may be dependent on
fertilizer used, soil exhaustion, soil acidity level, season of the year, type of seed etc.) in which case
multiple correlation should be used instead.

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The Rank Correlation Coefficient (R)

Also known as the spearman rank correlation coefficient, its purpose is to establish whether there is
any form of association between two variables where the variables arranged in a ranked form.
6 d 2
R=1-
n  n 2  1

Where d = difference between the pairs of ranked values.

n = numbers of pairs of rankings

Example
A group of 8 accountancy students are tested in Quantitative Techniques and Law II. Their rankings
in the two tests were.
Student Q. T. ranking Law II ranking d d2
A 2 3 -1 1
B 7 6 1 1
C 6 4 2 4
D 1 2 -1 1
E 4 5 -1 1
F 3 1 2 4
G 5 8 -3 9
H 8 7 1 1
 d  22
2

d = Q. T. ranking – Law II ranking

6 d 2 6  22
R=1-  1
n  n  1
2
8  82  1

= 0.74
Thus we conclude that there is a reasonable agreement between student’s performances in the two
types of tests.
NOTE: in this example, if we are given the actual marks then we find r. R varies between +1
and -1.
Tied Rankings
A slight adjustment to the formula is made if some students tie and have the same ranking the
adjustment is
t3  t
where t = number of tied rankings the adjusted formula becomes
12

R=1-
6  d  
2 t 3 t
12

n  n  1
2

Example
Assume that in our previous example student E & F achieved equal marks in Q. T. and were given
joint 3rd place.

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Solution
Student Q. T. ranking Law II ranking d d2
A 2 3 -1 1
B 7 6 1 1
C 6 4 2 4
D 1 2 -1 1
E 3½ 5 -1 ½ 2¼
F 3½ 1 2½ 6¼
G 5 8 -3 9
H 8 7 1 1
 d 2  26 1 2

R = 1-
6  d  
2 t 3 t
12
= 1-

6 26 1 2  212 2
3
 since t  2
n  n  1
2
8  8  1
2

= 0.68
NOTE: It is conventional to show the shared rankings as above, i.e. E, & F take up the 3 rd and
4 rank which are shared between the two as 3½ each.
th

ii. Coefficient of Determination

This refers to the ratio of the explained variation to the total variation and is used to measure the
strength of the linear relationship. The stronger the linear relationship the closer the ratio will be to
one.

Coefficient determination = Explained variation

Total variation
Example (Rank Correlation Coefficient)
In a beauty competition 2 assessors were asked to rank the 10 contestants using the professional
assessment skills. The results obtained were given as shown in the table below

Contestants 1st assessor 2nd assessor

A 6 5
B 1 3
C 3 4
D 7 6
E 8 7
F 2 1
G 4 8
H 5 2
J 10 9
K 9 10

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REQUIRED
Calculate the rank correlation coefficient and hence comment briefly on the value obtained
d d2
A 6 5 1 1
B 1 3 -2 4
C 3 4 -1 1
D 7 6 1 1
E 8 7 1 1
F 2 1 1 1
G 4 8 -4 16
H 5 2 3 9
J 10 9 +1 1
K 9 10 -1 1
Σd2 = 36

∴ The rank correlation coefficient R

6 d 2
R=1-
n  n 2  1
6  36
=1-
10 10 2  1
216
=1-
990
= 1 – 0.22
= 0.78
Comment: since the correlation is 0.78 it implies that there is high positive correlation between the
ranks awarded to the contestants. 0.78 > 0 and 0.78 > 0.5
Example (Rank Correlation Coefficient)
Sometimes numerical data which refers to the quantifiable variables may be given after which a rank
correlation coefficient may be worked out.
Is such a situation, the rank correlation coefficient will be determined after the given variables have
been converted into ranks. See the following example;

Candidates Math r Accounts r d d2

P 92 1 67 5 -4 16
Q 82 3 88 1 2 4
R 60 5(5.5) 58 7(7.5) -2 4
S 87 2 80 2 0 0
T 72 4 69 4 0 0
U 60 5(5.5) 77 3 -2.50 6.25
V 52 8 58 7(7.5) 0.5 0.25
W 50 9 60 6 3 9
X 47 10 32 10 0 0
Y 59 7 54 9 -2 4

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Σd2 = 43.5
6 d 2
∴ Rank correlation r = 1-
n  n 2  1
6  43.5 261
=1- =1–
10 10  1
2
990
= 0.74 (High positive correlation between mathematics
Marks and accounts)

Example
(Product moment correlation)
The following data was obtained during a social survey conducted in a given urban area regarding the
annual income of given families and the corresponding expenditures.

Family (x)Annual (y)Annual xy x2 Y2

income £ 000 expenditure £
000
A 420 360 151200 176400 129600
B 380 390 148200 144400 152100
C 520 510 265200 270400 260100
D 610 500 305000 372100 250000
E 400 360 144000 160000 129600
F 320 290 92800 102400 84100
G 280 250 70000 78400 62500
H 410 380 155800 168100 144400
J 380 240 91200 144400 57600
K 300 270 81000 90000 72900
Total 4020 3550 1504400 1706600 1342900
Required
Calculate the product moment correlation coefficient briefly comment on the value obtained
The produce moment correlation
n xy   x  y
r=
n x 2    x   n y 2    y 
2 2

Workings:
4020 3550
X = = 402 Y  355
10 10

10 1,504, 400    4020  3550 

r=
10 1, 706, 600   40202  10 1,342,900    3550 
2

= 0.89

Comment: The value obtained 0.89 suggests that the correlation between annual income and annual
expenditure is high and positive. This implies that the more one earns the more one spends.

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LESSON EIGHT: LEAST SQUARES AND REGRESSION

- This is a concept, which refers to the changes which occur in the dependent variable as a result
of changes occurring on the independent variable.
- Knowledge of regression is particularly very useful in business statistics and forecasting where
it is necessary to consider the corresponding changes on dependant variables whenever
independent variables change
- It should be noted that most business activities involve a dependant variable and either one or
more independent variable. Therefore knowledge of regression will enable a business
statistician to predict or estimate the expenditure value of a dependant variable when given an
independent variable e.g. consider the above example for annual incomes and annual
expenditures. Using the regression techniques one can be able to determine the estimated
expenditure of a given family if the annual income is known and vice versa
- The general equation used in simple regression analysis is as follows
y = a + bx
Where y = Dependant variable
a= Interception y axis (constant)
b = Slope on the y axis
x = Independent variable

i. The determination of the regression equation such as given above is normally done by
using a technique known as “the method of least squares’.

Regression equation of y on x i.e. y = a + bx

y x x Line of best fit

x x
x x
x x
x x
x x

x
The following sets of equations normally known as normal equation are used to determine the
equation of the above regression line when given a set of data.
Σy = an + bΣx
Σxy = aΣx + bΣx2
Where Σy = Sum of y values

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Σxy = sum of the product of x and y

Σx = sum of x values
Σx2= sum of the squares of the x values
a = The intercept on the y axis
b = Slope gradient line of y on x

NB: The above regression line is normally used in one way only i.e. it is used to estimate the y values
when the x values are given.
Regression line of x on y i.e. x = a + by
- The fact that regression lines can only be used in one way leads to what is known as a
regression paradox
- This means that the regression lines are not ordinary mathematical line graphs which may be
used to estimate the x and y simultaneously
- Therefore one has to be careful when using regression lines as it becomes necessary to develop
an equation for x and y before doing the estimation.
The following example will illustrate how regression lines are used

Example
An investment company advertised the sale of pieces of land at different prices. The following table
shows the pieces of land their acreage and costs

Piece of land (x)Acreage (y) Cost £ 000 xy x2

Hectares
A 2.3 230 529 5.29
B 1.7 150 255 2.89
C 4.2 450 1890 17.64
D 3.3 310 1023 10.89
E 5.2 550 2860 27.04
F 6.0 590 3540 36
G 7.3 740 5402 53.29
H 8.4 850 7140 70.56
J 5.6 530 2969 31.36
Σx =44.0 Σy = 4400 Σxy= 25607 Σx = 254.96
2

Required
Determine the regression equations of
i. y on x and hence estimate the cost of a piece of land with 4.5 hectares
ii. Estimate the expected average if the piece of land costs £ 900,000

Σy = an + bΣxy
Σxy = a∑x + bΣx2

By substituting of the appropriate values in the above equations we have

4400 = 9a + 44b …….. (i)
25607 = 44a + 254.96b ……..(ii)
By multiplying equation …. (i) by 44 and equation …… (ii) by 9 we have

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193600 = 396a + 1936b …….. (iii)

230463 = 396a + 2294.64b ……..(iv)
By subtraction of equation …. (iii) from equation …… (iv) we have
36863 = 358.64b
102.78 = b
by substituting for b in …….. (i)
4400 = 9a + 44( 102.78)
4400 – 4522.32 = 9a
–122.32 = 9a
-13.59 = a
Therefore the equation of the regression line of y on x is
Y = 13.59 + 102.78x
When the acreage (hectares) is 4.5 then the cost
(y) = -13.59 + (102.78 x 4.5)
= 448.92
= £ 448, 920
Note that
Where the regression equation is given by
y= a + bx
Where a is the intercept on the y axis and
b is the slope of the line or regression coefficient
n is the sample size
then,

intercept a =
 y  b x
n
n xy   x y
Slope b =
n x 2    x 
2

Example
The calculations for our sample size n = 10 are given below. The linear regression model is
y = a + bx
Table

Distance x Time y mins xy x2 y2

miles
3.5 16 56.0 12.25 256
2.4 13 31.0 5.76 169
4.9 19 93.1 24.01 361
4.2 18 75.6 17.64 324
3.0 12 36.0 9.0 144
1.3 11 14.3 1.69 121
1.0 8 8.0 1.0 64
3.0 14 42.0 9.0 196
1.5 9 13.5 2.25 81
4.1 16 65.6 16.81 256

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Σx = 28.9 Σy = 136 Σxy = Σx2 = 99.41 Σy2= 1972

435.3

10  435.3  28.9  136 422.6

The Slope b = 
10  99.41  28.9 2 158.9

= 2.66

136   2.66  28.9 

and the intercept a =
10

= 5.91
We now insert these values in the linear model giving
y = 5.91 + 2.66x
or
Delivery time (mins) = 5.91 + 2.66 (delivery distance in miles)
The slope of the regression line is the estimated number of minutes per mile needed for a delivery.
The intercept is the estimated time to prepare for the journey and to deliver the goods, that is the time
needed for each journey other than the actual traveling time.

Prediction within the range of sample data

We can use the linear regression model to predict the mean of dependant variable for any given value
of independent variable
For example if the sample model is given by
Time (min) = 5.91 + 2.66 (distance in miles)
Then if the distance is 4.0 miles then our estimated mean time is
Ý = 5.91 + 2.66 x 4.0 = 16.6 minutes

Multiple Linear Regression Models

There are situations in which there is more than one factor which influence the dependent variable
Example
Cost of production per week in a large department depends on several factors;
i. Total numbers of hours worked
ii. Raw material used during the week
iii. Total number of items produced during the week
iv. Number of hours spent on repair and maintenance

It is sensible to use all the identified factors to predict department costs. Scatter diagram will not give
the relationship between the various factors and total costs. The linear model for multiple linear
regression if of the type; (which is the line of best fit).
y = α + b1x1 +b2x2 +………… + bnxn
We assume that errors or residuals are negligible.

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In order to choose between the models we examine the values of the multiple correlation coefficient
r and the standard deviation of the residuals α. A model which describes well the relationship between
y and x’s has multiple correlation coefficient r close to ±1 and the value of α which is small.

Example
Odino chemicals limited are aware that its power costs are semi variable cost and over the last six
months these costs have shown the following relationship with a standard measure of output.

Month Output (standard units) Total power costs £

000
1 12 6.2
2 18 8.0
3 19 8.6
4 20 10.4
5 24 10.2
6 30 12.4
Required
i. Using the method of least squares, determine an appropriate linear relationship between
total power costs and output
ii. If total power costs are related to both output and time (as measured by the number of
the month) the following least squares regression equation is obtained
Power costs = 4.42 + (0.82) output + (0.10) month
Where the regression coefficients (i.e. 0.82 and 0.10) have t values 2.64 and 0.60
respectively and coefficient of multiple correlation amounts to 0.976
Compare the relative merits of this fitted relationship with one you determine in (a).
Explain (without doing any further analysis) how you might use the data to forecast total
power costs in seven months.

Solution
a)
Output (x) Power costs (y) x2 y2 xy
12 6.2 144 38.44 74.40
18 8.0 324 64.00 144.00
19 8.6 361 73.96 163.40
20 10.4 400 108.16 208.00
24 10.2 576 104.04 244.80
30 12.4 900 153.76 372.00
Σx = 123 Σy = 55.8 Σx = 2705
2
Σy = 542.36 Σxy= 1,206.60
2

n xy   x y
b=
n x 2    x 
2

61206.612355.8
62705123
= 2

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

376.2
= = 0.342
1101

1
a = (Σy – bΣx)
n

1
=  (55.8 – 0.342)  123
6

= 2.29
 (Power costs) = 2.29 + 0.342 (output)
b. For linear regression calculated above, the coefficient of correlation r is

r=
 6 1206.6   123  55.8
6  2705  123  123 6  542.36  55.8  55.8

376.2
=
1101 140.52

= 0.96
This show a strong correlation between power cost and output. The multiple correlation when both
output and time are considered at the same time is 0.976.
We observe that there has been very little increase in r which means that inclusion of time variable
does not improve the correlation significantly
The value for time variable is only 0.60 which is insignificant as compared with a t value of 2.64 for
the output variable
In fact, if we work out correlation between output and time, there will be a high correlation. Hence
there is no necessity of taking both the variables. Inclusion of time does improve the correlation
coefficient but by a very small amount.
If we use the linear regression analysis and attempt to find the linear relationship between output and
time i.e.

Month Output
1 12
2 18
3 19
4 20
5 24
6 30
The value of b and a will turn out to be 3.11 and 9.6 i.e. relationship will be of the form
Output = 9.6 + 3.11 × month
For this equation forecast for 7th month will be
Output = 9.6 + 3.11 × 7
= 9.6 + 21.77
= 31.37 units

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HCOB 2411: Financial Modelling & Forecasting The Cooperative University

Using the equation, Power costs = 2.29 + 0.34 × output

= 2.29 + 0.34 × 31.37
= 2.29 + 10.67
= 12.96 i.e. £ 12,960

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