Class Business Debate Proforma Assignment

Business Cycle – Peak – Trough Industry relationship to business cycles – Cyclical – Defensive Business Cycles

Leading Indicators - tend to rise and fall in advance of the economy – Avg. weekly hours of production workers – Stock Prices – Yield Curve Coincident Indicators - indicators that tend to change directly with the economy – Industrial production – Manufacturing and trade sales Lagging Indicators - indicators that tend to follow the lag economic performance – Ratio of trade inventories to sales – Ratio of consumer installment credit outstanding to personal income NBER Cyclical Indicators:

Sensitivity to business cycles Factors affecting sensitivity of earnings to business cycles – Sensitivity of sales of the firm’s product to the business cycles – Operating leverage – Financial leverage Industry life cycles Industry Analysis

Financial Statements Income Statement – Profitability over a given time period Balance Sheet – “Stock” measure of firm’s financial position Statement of Cash Flows – Actual Flow of Funds

Old Image of 10-k Links Example First and Second Link

New Image of 10-k Links Example First and Second Link

Overview of Proforma Analysis

Forecasting Income Statement Accounts Income StatementForecast Method SalesForecasted by choice Cost of Sales (GOGS)Calculated: Sales – Gross Profit Gross ProfitPercent of Sales (“Gross Margin”) Selling, General, and Admin. Expense (SG&A)Percent of Sales Income before Depreciation and Amortization (EBITDA)Calculated: Gross Profit – SG&A Depreciation and Amortization Expense (Dep. and Amort.)Percent of Net PP&E Income after Dep. and Amort. (EBIT)Calculated: EBITDA – Dep. and Amort. Non-Operating Income (Expense)Forecast driven by expected company policy Initial Interest Expense Percent of Prior Year Net Debt (ST Borrowing + LT Debt – Excess Cash) Pretax IncomeCalculated: EBIT + Non-Operating Income – Interest Expense Income TaxesPercent of Pretax Income (“Tax Rate”) Net IncomeCalculated: Pretax Income – Income Taxes DividendsPercent of Net Income (“Payout Ratio”) Addition to Retained EarningsCalculated: Net Income – Dividends

Forecasting Balance Sheet Accounts Balance SheetForecast Method Assets Excess Cash (Plug item) Zero if operating assets are greater than sources of funds; otherwise, the amount required to make the sheet balance Current AssetsPercent of Sales Net Property, Plant, & EquipmentPercent of Sales (“Fixed Asset Turnover”) IntangiblesForecast driven by expected company policy Other Long Term AssetsPercent of Sales Total AssetsCalculated: sum of all asset accounts Liabilities & Owners’ Equity Current LiabilitiesPercent of Sales Short Term Borrowing (Plug item) Zero if sources of funds are greater than operating assets; otherwise, the amount required to make the sheet balance Long Term DebtForecast driven by expected company policy Other Liabilities & PreferredPercent of Sales Shareholders’ EquityConstant based on most recent year’s data New Retained EarningsSum of forecasted Additions to Retained Earnings Total Liabilities & Shareholders’ EquityCalculated: sum of all liability and equity accounts

More on Forecasting Forecasting – Economic Plausibility use ratios – Accounting Consistency Plug Figures – Base much of forecasts on sales forecasts

Ratio Analysis Purpose of Ratio Analysis Uses – Trend analysis – Comparative analysis – Forecasting Use by External Analysts – Important information for investment community and ratings agencies

Dividend Discount Models: General Model V D k o t t t      ()1 1 V 0 = Value of Stock D t = Dividend k = required return

Constant Growth Model Vo Dg kg o    ()1 g = constant perpetual growth rate

Estimating Dividend Growth Rates gROEb  g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate = (1- dividend payout percentage rate)

Return on Equity Financial Leverage and ROE – ROA = EBIT/Total Assets – ROE = Net Profit/Equity

ROE Example Company A and B have same ROA or same assets in total of $500 million, but B has financed 30% of their assets while A has no debt. Assume they both pay 40% corporate tax rates, interest on company B’s debt is 7%. What is A and B’s ROE if their ROA is 12%? – ROE A =.6*[.12 + ( )*0] =.072 or 7.2% – ROE B =.6*[.12 + ( )*(150/350)] =.084 or 8.4% What is A and B’s ROE if their ROA is 6%? – ROE A =.6*[.06 + ( )*0] =.036 or 3.6% – ROE B =.6*[.06 + ( )*(150/350)] =.033 or 3.3%

Du Pont Decomposition of ROE ROE = Net Profit Pretax Profit x EBIT x Sales Assets xx Equity (1) x (2) x (3) x (4) x (5) x Turnover x Leverage Interest Burden Profit Margin x xROA Compound Leverage Factor x Walmart versus Neiman-Marcus? = = Tax Burden x

Quality of Earnings: Areas of Accounting Choices Allowance for bad debts Non-securing items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities