1. Projecting Free Cash Flows 1

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

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 3

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? 4

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 5

6. Projecting partial financial statements Income statementForecast method Net salesForecast growth Cost of goods soldPercent of sales SGAPercent of sales DepreciationPercent net PPE Operating profitCalculated 6

7. Projecting partial financial statements Balance SheetForecast method CashPercent of sales InventoryPercent of sales Accounts receivablePercent of sales Net PPEPercent of sales Accounts payablePercent of sales Accrued expensesPercent of sales 7

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 8

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. 9

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. 10

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. 11

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. 12

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. 13

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. 14

15. Van Leer Products, Inc. 15

16. Van Leer Products, Inc. 16 Actual Balance sheet 2012 2013 2014 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. Van Leer Products, Inc. 17 Actual Balance sheet 2012 2013 2014 Accounts payable 80 70 75 Accrued expenses 8 10 Short-term debt 50 30 25 Total current liabilities 138 110 Long-term debt 54 84 99 Total liabilities 192 194 209 Common stock 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 18

19. Historical ratios used to project free cash flows 19 Ratios to calculate operating profit 201220132014Average 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%

20. How to think about projected sales growth rate for 2015 9.2% average growth rate over the past two years Economy is predicted to recover substantially by 2015, so the analyst predicts more rapid growth than in 2014, 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. 20

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. 21

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. 22

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. 23

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

25. Operating items on balance sheets 25 Ratios to calculate operating capital 20122013 2014Average 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%

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. 26

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. 27

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 2015 to support the projected summer recovery, so will be 11% of sales. 28

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 2015, so PPE will increase to 34% of sales. PPE as % of sales will decrease as it grows into its new facilities. 29

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. 30

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%. 31

32. Projections and Free Cash Flow 32 Ratios to calculate operating profit 201220132014Avg.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%

33. Projections and Free Cash Flow 33 Ratios to calculate operating capital 201220132014Avg.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%

34. Projections and Free Cash Flow 34 Ratios to calculate operating taxes 201220132014Avg.Proj. Tax Rate (Taxes/EBT)40.0%39.1%40.0%39.7%39.7%

35. Free Cash Flow Calculations 35 Van Leer Products, Inc.ActualActualActual Projected Income Statement2012201320142015 Net Sales840.0944.01000.01110.0 CGS520.0625.0640.0693.8 Selling, general & administrative 200.0205.0215.0249.8 Depreciation41.042.045.056.6 Operating profit79.072.0100.0109.9

36. Free Cash Flow Calculations 36 ActualActualActualProj. Balance sheet2012201320142015 Cash42.047.050.033.3 Inventory75.085.0100.0122.1 Accts. receivable65.070.075.084.4 Net PP&E275.0280.0300.0377.4 Accts. payable80.070.075.089.9 Accrued expenses8.010.010.011.1

37. 37 ActualActualActualProj. 2012201320142015 Operating Income79.0 72.0 100.0 109.9 Tax on Operating Income (40%)31.6 28.1 40.0 43.6 NOPAT47.4 43.9 60.0 66.3 Net Operating WC94.0 122.0 140.0 138.8 Net Operating Long Term Assets275.0 280.0 300.0 377.4 Total Net Operating Assets369.0 402.0 440.0 516.2 Investment in net operating assetsna33.0 38.0 76.2 Free Cash Flowna10.4 22.0 -9.9 ROICna 11.89% 14.93% 15.06%