Download 5 - Finance

DES Chapter 5
Projecting Free Cash Flows
DES Chapter 5
1
Objective
Chapter 4 assumed you already had
projected financial statements. In this
chapter, you will construct projected
financial statements.
DES Chapter 5
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Why project financial
statements?
Forces you to articulate your assumptions
Helps you understand your firm’s value
drivers
Requires you to verify that your assumptions
are economically reasonable
Identifies external funding needed
Provides data needed to project FCF and
perform a valuation
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What are the characteristics of
a good forecast?
Economic plausibility

The statements must reflect how the firm
might realistically operate in the future.
Accounting consistency
Do the financial statements balance?
 Do they “articulate?”
 Are they a good model of the firm’s
finances?

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Van Leer Products, Inc.
Manufactures extruded plastic products.
Statements are just a bit different from
Acme's:
They have short term investments—this is
where Van Leer “parks” its excess cash.
 They have only net PPE. Gross PPE has
been omitted. This is because many
companies only report Net PPE.

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Modeling the financial statements
Operating accounts that vary directly with
sales

Cost of goods sold (COGS)


For most firms, COGS is pretty close to
proportional to sales
Selling, general and administrative
expenses (SGA)

Although in the 1-2 year range, SGA may not
be directly proportional, for most firms it is
roughly proportional over our longer projection
periods
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DES Chapter 5
Operating accounts that vary
directly with sales
Cash

We will consider only that level of cash
necessary to “grease the wheels” of the
company’s operations. This amount is
required to keep checks from bouncing.
Inventory

Clearly inventory must increase with
sales—this chapter assumes it is
proportional to sales.
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Operating accounts that vary
directly with sales
Accounts receivable

Most firms must have more AR if they sell
more.
Net PPE

In the short run, like SGA, net PPE may not
be directly related to sales, but over the
longer run, most firms’ net PPE is pretty
closely related to sales.
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Accounts that vary directly with
sales
Accounts payable

If you sell more, then you produce more
and use more materials. Your credit
purchases will increase with sales.
Accrued expenses

If you sell more, then labor expense and
payroll taxes due will be higher—these will
also increase with sales.
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Operating accounts that vary with
other things
Depreciation charges are set by the
depreciation schedule—in general they
will depend on net PPE, not directly on
sales.
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Modeling items required for
projecting FCF
You don’t need the entire statements to
calculate FCF—start with what is
necessary for FCF and then add the
rest of the statements so we can
calculate the funding mix
Need operating income
Need investment in operating capital
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Projecting partial financial
statements
Income statement
Net sales
Cost of goods sold
SGA
Depreciation
Operating profit
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Forecast method
Forecast growth
Percent of sales
Percent of sales
Percent net PPE
Calculated
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Projecting partial financial
statements
Balance Sheet
Cash
Inventory
Accounts receivable
Net PPE
Accounts payable
Accrued expenses
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Forecast method
Percent of sales
Percent of sales
Percent of sales
Percent of sales
Percent of sales
Percent of sales
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Information about Van Leer
The analysis uses some information
about Van Leer that won’t come from
the 10k or annual report. The analyst
may have access to it as a corporate
“insider” performing this valuation for
internal purposes. If the analyst is an
“outsider” then some of this information
would have to come from extensive
research on the company and industry.
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Van Leer Products, Inc.
Van Leer Products, Inc.
Actual Actual Actual
Income Statement
2001
2002
2003
Net Sales
840
944 1,000
Cost Of Goods Sold
520
625
640
Selling, general & administrative
200
205
215
Depreciation
41
42
45
Operating profit
79
72
100
Interest income
0
1
0
Interest expense
9
9
10
Earnings before taxes
70
64
90
Taxes
28
25
36
Net income
42
39
54
Dividends
12
11
16
Additions to RE
30
28
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DES Chapter 5
Van Leer Products, Inc.
Actual Actual Actual
2001
2002
2003
Balance sheet
Cash
42
47
50
Short-term investments
10
15
25
Inventory
75
85
100
Accounts receivable
65
70
75
Total current assets
192
217
250
Net PP&E
275
280
300
Total assets
467
497
550
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Van Leer Products, Inc.
Actual Actual Actual
2001
2002
2003
Balance sheet
Accounts payable
80
70
75
Accrued expenses
8
10
10
Short-term debt
50
30
25
Total current liabilities
138
110
110
Long-term debt
54
84
99
Total liabilities
192
194
209
125
125
125
Common stock
Retained earnings
150
178
216
Total common equity
275
303
341
Total liabilities and equity
467
497
550
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Choosing inputs for the model
Projecting the sales growth rate
Projecting operating profit
Projecting operating capital
Projecting taxes
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Historical ratios used to project
free cash flows
Ratios to calculate operating profit
2002
12.4%
66.2%
21.7%
2003
5.9%
64.0%
21.5%
Average
9.2%
64.0%
22.3%
14.9% 15.0%
15.0%
15.0%
Tax rate (Taxes/EBT) 40.0% 39.1%
40.0%
39.7%
Sales growth rate
COGS / Sales
SGA / Sales
Depreciation
/ Net PPE
2001
na
61.9%
23.8%
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How to think about projected
sales growth rate for 2004
9.2% average growth rate over the past two years
Economy is predicted to recover substantially by
2004, so the analyst predicts more rapid growth
than in 2003, and more rapid than the average.
After speaking with marketing and operations, the
analyst predicts that Van Leer’s sales will
increase by 9% next year due to increased unit
sales, and by 2% due to anticipated inflation.
Dollar sales therefore are projected to increase
by a total of 11% from $1,000 to $1,110.
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How to think about COGS as
a percent of sales
Higher COGS comes from higher
production costs or lower sales price, or
both.
Lower COGS comes from cost
containment with stable prices, or
higher prices with stable costs, or both.
Marketing predicts COGS will decrease
from last year’s 64% to 62.5% of sales.
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SGA as a percent of sales
Van Leer has minimal advertising
Sales commission rate will increase
next year and a half from 9% to 12%.
Staffing will remain constant, salaries
will increase with inflation.
Net impact is SGA will increase from
21.5% to 22.5% of sales.
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Depreciation
Depreciation schedule is set by the cost of
the assets purchased and accounting rules.
Overall this will change dramatically only if a
company changes the type (long-term or
short-term) of assets it is purchasing.
Van Leer will continue using the same type of
assets it has been using, so depreciation will
remain at 15% of net PPE.
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Tax rate
Combined federal, state and local taxes
are 39.7% of sales, and are expected to
remain the same.
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Operating items on balance
sheets
Ratios to calculate operating capital
2001
Cash / Sales
5.00%
Inventory/ Sales
8.9%
Accts. Rec. / Sales 7.7%
Net PPE / Sales
32.7%
Accts. Pay./ Sales 9.5%
Accruals / Sales
0.9%
2002 2003
Average
5.0%
5.0% 5.0%
9.0% 10.0% 9.3%
7.4%
7.5% 7.6%
29.7% 30.0% 30.8%
7.4%
7.5% 8.1%
1.1%
1.0% 1.0%
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Projecting operating items on
the balance sheet
Cash: This is the minimum cash
balance required for the business to
function.
Has been 5% historically.
 Expects to drop to 3% with better
information technology.

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Operating items
Accounts Receivable


Depend on credit policy: Tighter policy means
less accounts receivable, but also fewer sales.
Looser policy means more sales, but more
accounts receivable and more bad debt writeoffs.
Averaged 7.6% over last 3 years. Plans to
maintain same credit policy, so the percent
should remain the same.
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Operating items
Inventories
Higher inventory means more investment,
but lower chance of a stockout. Lower
inventory may increase chance of missed
sales.
 Averaged 9% of sales. Expects to stock up
in 2004 to support the projected summer
recovery, so will be 11% of sales.

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Operating items
Net PPE as a % of sales


This ratio will decrease as the firm uses up
capacity, and will be large just after building a
plant and operating at under-full capacity.
Also changes as the firm alters its technology.
Van Leer must invest in another plant in 2004,
so PPE will increase to 34% of sales. PPE as
% of sales will decrease as it grows into its
new facilities.
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Operating items
Accounts payable
Increasing AP means paying later,
decreasing means paying earlier.
Payables deferral period = AP/(COGS/365)
 Has been 45.6 days. This corresponds to
accounts payable of 8.1% of sales.
 Van Leer will maintain this policy.

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Operating items
Accruals
Arise from lag in reporting payroll taxes
due, and actually paying the taxes.
 Payment schedule is set by the various
government entities, so Van Leer can’t
change it very much.
 Has been 1%, and Van Leer expects it to
remain at 1%.

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Projections and Free Cash
Flow
Ratios to calculate operating profit
2001 2002
2003
Avg.
Proj.
Sales growth rate na
9.2%
11.0%
12.4% 5.9%
COGS / Sales
61.9% 66.2% 64.0% 64.0% 62.5%
SGA / Sales
23.8% 21.7% 21.5% 22.3% 22.5%
Depreciation
/ Net PPE
14.9% 15.0% 15.0% 15.0% 15.0%
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Projections and Free Cash
Flow
Ratios to calculate operating capital
2001
2002
2003
Avg.
Proj.
Cash / Sales
5.0% 5.0% 5.0% 5.0% 3.0%
Inventory/ Sales
8.9% 9.0% 10.0% 9.3% 11.0%
Accts. Rec. / Sales 7.7% 7.4% 7.5% 7.6% 7.6%
Net PPE / Sales
32.7% 29.7% 30.0% 30.8% 34.0%
Accts. Pay./ Sales
9.5% 7.4% 7.5% 8.1% 8.1%
Accruals / Sales
0.9% 1.1% 1.0% 1.0% 1.0%
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Projections and Free Cash
Flow
Ratios to calculate operating taxes
Tax Rate
(Taxes/EBT)
2001
2002
40.0%
39.1% 40.0%
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2003
Avg.
Proj.
39.7% 39.7%
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Free Cash Flow Calculations
Van Leer
Products, Inc.
Actual Actual Actual Projected
Income Statement 2001
2002
2003
2004
Net Sales
840.0
CGS
520.0
Selling, general &
administrative
200.0
Depreciation
41.0
Operating profit
79.0
944.0 1000.0
625.0 640.0
1110.0
693.8
205.0
42.0
215.0
45.0
249.8
56.6
72.0
100.0
109.9
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Free Cash Flow Calculations
Balance sheet
Actual Actual Actual
2001
2002 2003
Cash
42.0
Inventory
75.0
Accts. receivable
65.0
Net PP&E
275.0
Accts. payable
80.0
Accrued expenses
8.0
47.0
85.0
70.0
280.0
70.0
10.0
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50.0
100.0
75.0
300.0
75.0
10.0
Proj.
2004
33.3
122.1
84.4
377.4
89.9
11.1
36
Operating Income
Tax on Operating
Income (40%)
NOPAT
Net Operating WC
Net Operating Long
Term Assets
Total Net Operating
Assets
Investment in net
operating assets
Free Cash Flow
ROIC
Actual
2001
Actual
2002
Actual
2003
Proj.
2004
79.0
72.0
100.0
109.9
31.6
47.4
94.0
28.1
43.9
122.0
40.0
60.0
140.0
43.6
66.3
138.8
275.0
280.0
300.0
377.4
369.0
402.0
440.0
516.2
na
na
na
33.0
38.0
76.2
10.4
22.0
-9.9
11.89% 14.93% 15.06%
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