1. Projecting Free Cash Flows

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

3. 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

4. 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?

5. 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

6. Projecting partial financial statements
Income statement Forecast method Net sales Forecast growth Cost of goods sold Percent of sales SGA Percent of sales Depreciation Percent net PPE Operating profit Calculated

7. Projecting partial financial statements
Balance Sheet Forecast method Cash Percent of sales Inventory Percent of sales Accounts receivable Percent of sales Net PPE Percent of sales Accounts payable Percent of sales Accrued expenses Percent of sales

8. 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

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. Selling, general & administrative
Van Leer Products, Inc.
Van Leer Products, Inc.
Actual
Act
ual
Income Statement
2014
2015
2016
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 1
Interest expense 9 10
Earnings befor
e taxes 70 64 90
Taxes 28 25 36
Net income 39 54
Dividends 12 11 16
Additions to RE 30 38

16. Short-term investments
Van Leer Products, Inc.
Actual
Actual
Actual
Balance sheet
2014
2015
2016
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

17. Total liabilities and equity
Van Leer Products, Inc.
Actual
Actual
Actual
Balance sheet
2014
2015
2016
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 19 4
209
Common stock
125
125
125
Retained earnings
150
178
216
Total common equity
275
303
341
Total liabilities and equity
467
497
550

18. Choosing inputs for the model
Projecting the sales growth rate
Projecting operating profit
Projecting operating capital
Projecting taxes

19. Historical ratios used to project free cash flows
Ratios to calculate operating profit
Average Sales growth rate na 12.4% 5.9% 9.2% COGS / Sales 61.9% 66.2% 64.0% 64.0% SGA / Sales 23.8% 21.7% 21.5% 22.3% Depreciation / Net PPE 14.9% 15.0% 15.0% 15.0%
Tax rate (Taxes/EBT) 40.0% 39.1% 40.0% %

20. How to think about projected sales growth rate for 2016
9.2% average growth rate over the past two years
Economy is predicted to recover substantially by 2017, so the analyst predicts more rapid growth than in 2016, 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.

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 will decrease from last year’s 64% to 62.5% of sales.

22. 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.

23. 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.

24. Tax rate
Combined federal, state and local taxes are 39.7% of sales, and are expected to remain the same.

25. Operating items on balance sheets
Ratios to calculate operating capital
Average Cash / Sales 5.00% 5.0% 5.0% 5.0% Inventory/ Sales 8.9% 9.0% % 9.3% Accts. Rec. / Sales 7.7% 7.4% 7.5% 7.6% Net PPE / Sales 32.7% 29.7% 30.0% % Accts. Pay./ Sales 9.5% 7.4% 7.5% 8.1% Accruals / Sales 0.9% 1.1% 1.0% 1.0%

26. 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.

27. 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.

28. 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 2017 to support the projected summer recovery, so will be 11% of sales.

29. 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 2017, so PPE will increase to 34% of sales. PPE as % of sales will decrease as it grows into its new facilities.

30. 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.

31. 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%.

32. Projections and Free Cash Flow
Ratios to calculate operating profit Avg. Proj.
Sales growth rate na 12.4% 5.9% 9.2% 11.0%
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%

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 / 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%

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%

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

36. Free Cash Flow Calculations
Actual Actual Actual Proj. Balance sheet
Cash Inventory Accts. receivable Net PP&E Accts. payable Accrued expenses

37. Actual Actual Actual Proj. 2014 2015 2016 2017
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 na Free Cash Flow na ROIC na % % %