Projecting Free Cash Flows

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Objective

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

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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

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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?

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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

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Projecting partial financial statements

Income statement Forecast methodNet sales Forecast growthCost of goods sold Percent of salesSGA Percent of salesDepreciation Percent net PPEOperating profit Calculated

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Projecting partial financial statements

Balance Sheet Forecast methodCash Percent of salesInventory Percent of salesAccounts receivable Percent of salesNet PPE Percent of salesAccounts payable Percent of salesAccrued expenses Percent of sales

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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

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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.

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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.

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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.

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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.

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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.

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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.

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Van Leer Products, Inc.

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Van Leer Products, Inc. Actual Actual Actual Income Statement 2012 2013 2014 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

Van Leer Products, Inc.

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Actual Actual 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

Van Leer Products, Inc.

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Actual Actual Actual Balance sheet 2012 2013 2014 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

Choosing inputs for the model

• Projecting the sales growth rate• Projecting operating profit• Projecting operating capital• Projecting taxes

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Historical ratios used to project free cash flows

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Ratios to calculate operating profit

2012 2013 2014 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%

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.

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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.

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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.

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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.

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Tax rate

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

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Operating items on balance sheets

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Ratios to calculate operating capital

2012 2013 2014 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%

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.

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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.

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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.

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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.

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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.

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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%.

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Projections and Free Cash Flow

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Ratios to calculate operating profit2012 2013 2014 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%

Projections and Free Cash Flow

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Ratios to calculate operating capital

2012 2013 2014 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%

Projections and Free Cash Flow

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Ratios to calculate operating taxes

2012 2013 2014 Avg. Proj.Tax Rate (Taxes/EBT) 40.0% 39.1% 40.0% 39.7% 39.7%

Free Cash Flow Calculations

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Van Leer Products, Inc. Actual Actual Actual ProjectedIncome Statement 2012 2013 2014 2015

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

Free Cash Flow Calculations

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Actual Actual Actual Proj.Balance sheet 2012 2013 2014 2015

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

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Actual Actual Actual Proj.2012 2013 2014 2015

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%