Estimating Investment and Corporate Cash Flows

1. Estimating Investmentand Corporate Cash Flows April 9, 2007 (LA) and March 29, 2007 (OCC)

2. Assumptions for Cash Flows • Sources of Data • Computer sources of data • Financial models for valuation • How and why to use ratio analysis • Library Resources

3. Projecting Corporate Cash Flows • Familiarity with financial analytical techniques in practice • Understand structure of PVFIRM05 and be prepared to use for Part 2 of Group Project • Download Compustat data from Wharton • Identify relevant library materials on companies, industries, and the economy • Team organized and functioning

4. Know where data comes from

5. Source of Compustat Data • Source documents and data entry • Annual reports • 10-Ks and 10-Qs • Manual formatting and input • Cross-checking • Wharton School • wrdsx.wharton.upenn.edu • See “Data Sources” sheet on website

6. Investment Analysis • Project cash flows • Requires sales projections and assumptions concerning operations and assets • Fundamental analysis versus technical analysis • Graham and Dodd, Warren Buffett, and Copeland et al • Used in securities analysis, investment banking, and lending

7. Financial Models • Pro formas are a useful framework • No-one knows the future, analysts must deal with uncertainty in model assumptions • Models must be internally consistent, for example balance sheets must balance • Models focused on valuation are most concerned with cash flows • We will use PVFIRM05, an Excel spreadsheet

8. Structure of PVFIRM05 • Four “sheets” in Excel “workbook” • Sheet 1 - Market value of debt and equity • Sheet 2 - Input assumptions needed to calculate cash flows and pro formas • Sheet 3 - Choosing a discount rate, discussed nest • Sheet 4 - Present value calculations and interpretations, discussed at end of semester • You have completed Sheet 1

9. Market Value of the Firm • Value of the entire firm = entity value • Sheet 1 calculates market value of the entity = market value of D + E • Entity value is present value of all cash flows available for investors, whether in form of debt or equity • Cash flows to entire firm discounted at weighted average cost of capital

10. Advantages of Entity Approach • Focuses on operations and not financing, avoiding problem of changing capital structure through time • Focuses on free cash flow and pinpoints impact of alternative strategies • Free cash flow is net operating profit less an allowance for taxes (NOPLAT) minus necessary investments in working capital and fixed assets • Can focus on explicit forecast period and continuing values after explicit forecast period

11. Free Cash Flow • Free cash flow is same as Baldwin example • Net Operating Profit less Adjustment for Taxes (NOPLAT) - Net Investments • Free cash flow does not include interest expenses (or other financing costs) • Net investments are from working capital and capital expenditures • Need sales, operating costs, cash, accounts receivable, accounts payable, and inventory assumptions

12. Financial Analysis • Required for assumptions concerning future performance • Require historical and comparable firm data but future may not be like the past • We will follow handout Financial Statement Analysis and Assumptions for Valuation • Always apply plausibility check to both ratios, assumptions, and projections • Ratio analysis of projections useful in assessing plausibility of assumptions

13. Dupont Analysis of Performance • Dupont Analysis focuses on return on equity (pp. 53f ): • Closest to goal of management • Ratios can be calculated in different ways • Year-ending number balance sheet number or averages of two years • Before tax or after tax

14. Abbreviations used in Ratios • Abbreviations for accounting values used:ROE = return on equityEAC = earnings available to commonBVE = book value of equityEBT = earnings before taxEBIT = earnings before tax and interestSLS = salesASSTS = total operating assets

15. Basic Ratio Approach • ROE can be decomposed into elements: • Focus first on gross return on assets (p. 38) • ROA = “Earning Power” determined by gross profit margin and asset turnover

16. Gross Profit Margin (p. 46) • Sales • Components of Costs • Materials • Labor • SG&A • Other • Common size income statement valuable • Need assumptions for future on these

17. Asset Turnover (pp. 50ff) • Working Capital • Inventories • Accounts Receivable • Look at liquidity and activity ratios • Turnover, days • Current liabilities: trade and bank debt • Fixed Assets • Net vs. Gross • Turnover, average age • Need assumptions to project these

18. Valuation in Two Parts • Forecast horizon • Approach stable patterns • Impact of major changes complete • Continuing value (CV) after forecast • Cannot be ignored • Present value of impact depends on when forecast horizon ends • PVFIRM05 uses five year forecast horizon

19. Approaches to CV • Capitalize cash flows or earnings after explicit forecast period • Use multipliers to capitalize which are based on discount rates and growth rates • Multipliers rely on projections of return on equity (pp. 53-4), sustainable growth rate (p. 74), price-earnings ratio (p. 53), and market-to-book ratio (p. 54) • We discuss CV in detail later

20. Team Tasks • Computer data downloading • Spreadsheet analysis • Sales projections and business analysis • Financial analysis and formulation of a range of relevant assumptions • Structuring tables, discussion, and reports for persuasive analysis • Plausibility checking and trouble shooting

21. Part 2 of Group Project • Individual part change assumptions and note effects as in questions • Obtain and analyze data from Wharton data base • Analyze sources, trends, etc., to project sales and ratios to make operating assumptions • Project 5 years cash flows using Sheet 2 of PVFIRM05

22. Next Week • Read Chapter 8 and do (at a minimum) the assigned problems • Prepare Part 2 of the group project and related individual parts • Relate discussion this week to viewing the acquisition of a firm as an investment of either shares, debt, or a complete corporate acquisition