DES Chapter 5 1

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 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

DES Chapter 5 4

What are the characteristics of a good forecast?

Economic plausibilityThe statements must reflect how the firm

might realistically operate in the future.

Accounting consistencyDo the financial statements balance?Do they “articulate?”Are they a good model of the firm’s

finances?

DES Chapter 5 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

DES Chapter 5 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

DES Chapter 5 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

DES Chapter 5 8

Modeling the financial statements

Operating accounts that vary directly with salesCost 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

DES Chapter 5 9

Operating accounts that vary directly with sales

CashWe 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.

InventoryClearly inventory must increase with sales

—this chapter assumes it is proportional to sales.

DES Chapter 5 10

Operating accounts that vary directly with sales

Accounts receivableMost 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.

DES Chapter 5 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.

DES Chapter 5 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.

DES Chapter 5 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.

DES Chapter 5 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.

DES Chapter 5 15

Van Leer Products, Inc.Van Leer Products, Inc. Actual Actual Actual Income Statement 2007 2008 2009 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 0 1 0

Interest expense 9 9 10 Earnings before taxes 70 64 90

Taxes 28 25 36 Net income 42 39 54

Dividends 12 11 16 Additions to RE 30 28 38

DES Chapter 5 16

Van Leer Products, Inc. Actual Actual Actual Balance sheet 2007 2008 2009 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

DES Chapter 5 17

Van Leer Products, Inc. Actual Actual Actual Balance sheet 2007 2008 2009 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 192 194 209

Common stock 125 125 125 Retained earnings 150 178 216

Total common equity 275 303 341 Total liabilities and equity 467 497 550

DES Chapter 5 18

Choosing inputs for the model

Projecting the sales growth rate

Projecting operating profit

Projecting operating capital

Projecting taxes

DES Chapter 5 19

Historical ratios used to project free cash flows

Ratios to calculate operating profit

2007 2008 2009 AverageSales 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% 39.7%

DES Chapter 5 20

How to think about projected sales growth rate for 2010

9.2% average growth rate over the past two years

Economy is predicted to recover substantially by 2010, so the analyst predicts more rapid growth than in 2009, 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.

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

DES Chapter 5 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.

DES Chapter 5 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.

DES Chapter 5 24

Tax rate

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

DES Chapter 5 25

Operating items on balance sheets

Ratios to calculate operating capital

2007 2008 2009 AverageCash / Sales 5.00% 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 / Sales 32.7% 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 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.

DES Chapter 5 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.

DES Chapter 5 28

Operating items

InventoriesHigher 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 2010 to support the projected summer recovery, so will be 11% of sales.

DES Chapter 5 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 2010, so PPE will increase to 34% of sales. PPE as % of sales will decrease as it grows into its 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)Has been 45.6 days. This corresponds to

accounts payable of 8.1% of sales.Van Leer will maintain this policy.

DES Chapter 5 31

Operating items

AccrualsArise 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%.

DES Chapter 5 32

Projections and Free Cash Flow

Ratios to calculate operating profit2007 2008 2009 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%

DES Chapter 5 33

Projections and Free Cash Flow

Ratios to calculate operating capital

2007 2008 2009 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%

DES Chapter 5 34

Projections and Free Cash Flow

Ratios to calculate operating taxes

2007 2008 2009 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. Actual Actual Actual ProjectedIncome Statement 2007 2008 2009 2010

Net Sales 840.0 944.0 1000.0 1110.0CGS 520.0 625.0 640.0 693.8Selling, general & administrative 200.0 205.0 215.0 249.8Depreciation 41.0 42.0 45.0 56.6

Operating profit 79.0 72.0 100.0 109.9

DES Chapter 5 36

Free Cash Flow Calculations

Actual Actual Actual Proj.Balance sheet 2007 2008 2009 2010

Cash 42.0 47.0 50.0 33.3Inventory 75.0 85.0 100.0 122.1Accts. receivable 65.0 70.0 75.0 84.4Net PP&E 275.0 280.0 300.0 377.4Accts. payable 80.0 70.0 75.0 89.9Accrued expenses 8.0 10.0 10.0 11.1

DES Chapter 5 37

Actual Actual Actual Proj.2007 2008 2009 2010

Operating Income 79.0 72.0 100.0 109.9 Tax on Operating Income (40%) 31.6 28.1 40.0 43.6 NOPAT 47.4 43.9 60.0 66.3 Net Operating WC 94.0 122.0 140.0 138.8 Net Operating Long Term Assets 275.0 280.0 300.0 377.4 Total Net Operating Assets 369.0 402.0 440.0 516.2Investment in net operating assets na 33.0 38.0 76.2 Free Cash Flow na 10.4 22.0 -9.9 ROIC na 11.89% 14.93% 15.06%