DES Chapter 5 1 DES Chapter 5 Projecting Free Cash Flows

DES Chapter 5 2 Objective Chapter 4 assumed you already had projected financial statements. In this chapter, you will construct projected financial statements.

DES Chapter 5 3 Why project financial statements? Forces articulation of assumptions Helps to understand firm’s value drivers Must verify assumptions are economically reasonable Identifies external funding needed Provides data needed to project FCF and perform valuation

DES Chapter 5 4 Characteristics of a good forecast? Economic plausibility Statements must reflect how firm might realistically operate in future. Accounting consistency Do financial statements balance? Do they “articulate?” Are they a good model of firm’s finances?

DES Chapter 5 5 Van Leer Products, Inc. Manufactures extruded plastic products. Statements bit different from Acme's: Have S/T investments—where it “parks” excess cash. Only net PPE. Gross PPE omitted.

DES Chapter 5 6 Modeling the financial statements Operating accounts varying directly w/ sales Cost of goods sold (COGS) For most firms, COGS close to proportional to sales Selling, general & administrative expenses (SGA) Although in S/T 1-2 year range, SGA may not be directly proportional, for most firms roughly proportional over longer projection periods

DES Chapter 5 7 Operating accounts varying directly w/ sales Cash Consider only level of cash necessary to “grease the wheels” of company’s operations. Amount needed to keep checks from bouncing. Inventory Must increase with sales—start at proportional to sales, then adjust later.

DES Chapter 5 8 Operating accounts varying directly w/ sales Accounts receivable More AR if more sales. Net PPE In S/T, like SGA, net PPE may not be directly related to sales; Over L/T most firms’ net PPE pretty closely related to sales.

DES Chapter 5 9 Operating accounts varying directly w/ sales Accounts payable If sell more, then produce & use more materials. T/4, credit purchases increase with sales. Accrued expenses If sell more, then labor expense and payroll taxes more — also increase with sales.

DES Chapter 5 10 Operating accounts that vary with other things Depreciation exp. set by deprec. schedule—generally depends on net PPE, not directly on sales.

DES Chapter 5 11 Modeling items required for projecting FCF Don’t need entire statements to calculate FCF—start with what’s necessary for FCF, then add rest of statements to determine funding mix req’d. Need operating income Need investment in Op. Capital

DES Chapter 5 12 Projecting partial financial statements Income statementForecast method Net salesForecast growth COGS% sales SGA% sales Deprec.% net PPE Op. ProfitCalculated

DES Chapter 5 13 Projecting partial financial statements Balance SheetForecast method Cash% sales Inventory% sales Accounts receivable% sales Net PPE% sales Accounts payable% sales Accrued expenses% sales

DES Chapter 5 14 Information about Van Leer Analysts use info about Company not from 10k or annual report. Analyst may have access to it as a corporate “insider” performing this valuation for internal purposes. If analyst is an “outsider” then much of this information comes from extensive company & industry research.

DES Chapter 5 15 Van Leer Products, Inc.

DES Chapter 5 16 Van Leer Products, Inc. Actual Balance sheet Cash Short-term investments Inventory Accounts receivable Total current assets Net PP&E Total assets

DES Chapter 5 17 Van Leer Products, Inc. Actual Balance sheet Accounts payable Accrued expenses 8 10 Short-term debt Total current liabilities Long-term debt Total liabilities Common stock 125 Retained earnings Total common equity Total liabilities and equity

DES Chapter 5 18 Choosing inputs for the model Projecting sales growth rate Projecting Op. Profit Projecting Op. Capital Projecting taxes

DES Chapter 5 19 Historical ratios used to project free cash flows Ratios to calculate operating profit Average Sales growth ratena12.4%5.9%9.2% COGS / Sales61.9%66.2%64.0%64.0% SGA / Sales23.8%21.7%21.5%22.3% Depreciation / Net PPE14.9%15.0%15.0%15.0% Tax rate (Taxes/EBT) 40.0% 39.1% 40.0% 39.7%

DES Chapter 5 20 Projected sales growth rate for 2004 ? 9.2% average growth rate over past 2 yrs Economy predicted to recover substantially by 2004, so analyst predicts more rapid growth than 2003, & more rapid than ave. After speaking with marketing and operations, predicts firm’s sales to increase 9% next year due to increased unit sales, and 2% due to anticipated inflation. So, $ sales projected to increase by total of 11% from $1,000 to $1,110.

DES Chapter 5 21 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 to decrease from last year’s 64% to 62.5% of sales.

DES Chapter 5 22 SGA as % of sales Co. has minimal advertising Sales commission rate increases next year and a half from 9% to 12%. Staffing remains constant, salaries increase with inflation. Net impact is SGA to increase from 21.5% to 22.5% of sales.

DES Chapter 5 23 Depreciation Depreciation schedule is set by cost of the assets purchased and accounting rules. Will change dramatically only if a company changes the type (L/T or S/T) of assets it’s purchasing. Firm to continue using same type of assets it’s been using, so depreciation remains at 15% of net PPE.

DES Chapter 5 24 Tax rate Combined federal, state & local taxes are 39.7% of sales; and expected to remain same.

DES Chapter 5 25 Operating items on balance sheets Ratios to calculate operating capital Average Cash / Sales5.00%5.0%5.0%5.0% Inventory/ Sales 8.9%9.0% 10.0%9.3% Accts. Rec. / Sales 7.7%7.4%7.5%7.6% Net PPE / Sales32.7%29.7% 30.0% 30.8% Accts. Pay./ Sales 9.5%7.4%7.5%8.1% Accruals / Sales 0.9%1.1%1.0%1.0%

DES Chapter 5 26 Projecting B/S Op. Items Cash: Minimum balance required for business to function. 5% historically. With better information technology, drops to 3%.

DES Chapter 5 27 Operating items Accounts Receivable Depend on credit policy: Tighter policy means less A/R, but also fewer sales. Looser policy = more sales, but more A/R and more bad debt writeoffs. Averaged 7.6% over last 3 years. Plans to maintain same credit policy, so % unchanged

DES Chapter 5 28 Operating items Inventories Higher inventory means more investment, but lower chance of stockout. Lower inventory may increase chance of missed sales. Averaged 9% of sales. Expects to stock up in 2004 to support projected summer recovery, so = 11% of sales.

DES Chapter 5 29 Operating items Net PPE as % of sales Ratio decreases as firm uses up capacity, and will be large just after building a plant and operating at under-full capacity. Also changes as firm alters its technology. Van Leer must invest in another plant in 2004, so PPE increases to 34% of sales. PPE as % of sales decreases as grows into new facilities.

DES Chapter 5 30 Operating items Accounts payable Increasing AP means paying later, decreasing means paying earlier. Payables deferral period = AP/(COGS/365) Was 45.6 days. Leads to A/P of 8.1% of sales. Firm maintains this policy.

DES Chapter 5 31 Operating items Accruals Arise from lag in reporting payroll taxes due, and actually paying taxes. Payment schedule is set by government entities, so Firm can’t change it very much. Was 1%, & expected to remain at 1%.

DES Chapter 5 32 Projections and Free Cash Flow Ratios to calculate operating profit Avg.Proj. Sales growth ratena12.4%5.9%9.2%11.0% COGS / Sales61.9%66.2%64.0%64.0%62.5% SGA / Sales23.8%21.7%21.5%22.3%22.5% Depreciation / Net PPE14.9%15.0%15.0%15.0%15.0%

DES Chapter 5 33 Projections and Free Cash Flow Ratios to calculate operating capital 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 / Sales32.7%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%

DES Chapter 5 34 Projections and Free Cash Flow Ratios to calculate operating taxes Avg.Proj. Tax Rate (Taxes/EBT)40.0%39.1%40.0%39.7%39.7%

DES Chapter 5 35 Free Cash Flow Calculations Van Leer Products, Inc.ActualActualActual Projected Income Statement Net Sales CGS Selling, general & administrative Depreciation Operating profit

DES Chapter 5 36 Free Cash Flow Calculations ActualActualActualProj. Balance sheet Cash Inventory Accts. receivable Net PP&E Accts. payable Accrued expenses

DES Chapter 5 37 ActualActualActualProj Operating Income Tax on Operating Income (40%) NOPAT Net Operating WC Net Operating Long Term Assets Total Net Operating Assets Investment in net operating assetsna Free Cash Flowna ROICna 11.89% 14.93% 15.06%