1. DES Chapter 5 1 DES Chapter 5 Projecting Free Cash Flows

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

3. 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

4. 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?

5. 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.

6. 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

7. 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.

8. 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.

9. 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.

10. 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.

11. 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

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

13. 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

14. 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.

15. DES Chapter 5 15 Van Leer Products, Inc.

16. DES Chapter 5 16 Van Leer Products, Inc. Actual Balance sheet 2001 2002 2003 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. DES Chapter 5 17 Van Leer Products, Inc. Actual Balance sheet 2001 2002 2003 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. DES Chapter 5 18 Choosing inputs for the model Projecting sales growth rate Projecting Op. Profit Projecting Op. Capital Projecting taxes

19. DES Chapter 5 19 Historical ratios used to project free cash flows Ratios to calculate operating profit 200120022003Average 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. 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.

21. 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.

22. 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.

23. 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.

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

25. DES Chapter 5 25 Operating items on balance sheets Ratios to calculate operating capital 20012002 2003Average 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. 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%.

27. 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

28. 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.

29. 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.

30. 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.

31. 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%.

32. DES Chapter 5 32 Projections and Free Cash Flow Ratios to calculate operating profit 200120022003Avg.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. DES Chapter 5 33 Projections and Free Cash Flow Ratios to calculate operating capital 200120022003Avg.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. DES Chapter 5 34 Projections and Free Cash Flow Ratios to calculate operating taxes 200120022003Avg.Proj. Tax Rate (Taxes/EBT)40.0%39.1%40.0%39.7%39.7%

35. DES Chapter 5 35 Free Cash Flow Calculations Van Leer Products, Inc.ActualActualActual Projected Income Statement2001200220032004 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. DES Chapter 5 36 Free Cash Flow Calculations ActualActualActualProj. Balance sheet2001200220032004 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. DES Chapter 5 37 ActualActualActualProj. 2001200220032004 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%