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  • Slides 9

    1. 1. Estimating Investment and Corporate Cash Flows April 9, 2007 (LA) and March 29, 2007 (OCC)
    2. 2. Assumptions for Cash Flows <ul><li>Sources of Data </li></ul><ul><li>Computer sources of data </li></ul><ul><li>Financial models for valuation </li></ul><ul><li>How and why to use ratio analysis </li></ul><ul><li>Library Resources </li></ul>
    3. 3. Projecting Corporate Cash Flows <ul><li>Familiarity with financial analytical techniques in practice </li></ul><ul><li>Understand structure of PVFIRM05 and be prepared to use for Part 2 of Group Project </li></ul><ul><li>Download Compustat data from Wharton </li></ul><ul><li>Identify relevant library materials on companies, industries, and the economy </li></ul><ul><li>Team organized and functioning </li></ul>
    4. 4. Know where data comes from
    5. 5. Source of Compustat Data <ul><li>Source documents and data entry </li></ul><ul><ul><li>Annual reports </li></ul></ul><ul><ul><li>10-Ks and 10-Qs </li></ul></ul><ul><ul><li>Manual formatting and input </li></ul></ul><ul><ul><li>Cross-checking </li></ul></ul><ul><li>Wharton School </li></ul><ul><ul><li> </li></ul></ul><ul><ul><li>See “Data Sources” sheet on website </li></ul></ul>
    6. 6. Investment Analysis <ul><li>Project cash flows </li></ul><ul><ul><li>Requires sales projections and assumptions concerning operations and assets </li></ul></ul><ul><li>Fundamental analysis versus technical analysis </li></ul><ul><li>Graham and Dodd, Warren Buffett, and Copeland et al </li></ul><ul><li>Used in securities analysis, investment banking, and lending </li></ul>
    7. 7. Financial Models <ul><li>Pro formas are a useful framework </li></ul><ul><li>No-one knows the future, analysts must deal with uncertainty in model assumptions </li></ul><ul><li>Models must be internally consistent, for example balance sheets must balance </li></ul><ul><li>Models focused on valuation are most concerned with cash flows </li></ul><ul><li>We will use PVFIRM05 , an Excel spreadsheet </li></ul>
    8. 8. Structure of PVFIRM05 <ul><li>Four “sheets” in Excel “workbook” </li></ul><ul><ul><li>Sheet 1 - Market value of debt and equity </li></ul></ul><ul><ul><li>Sheet 2 - Input assumptions needed to calculate cash flows and pro formas </li></ul></ul><ul><ul><li>Sheet 3 - Choosing a discount rate, discussed nest </li></ul></ul><ul><ul><li>Sheet 4 - Present value calculations and interpretations, discussed at end of semester </li></ul></ul><ul><li>You have completed Sheet 1 </li></ul>
    9. 9. Market Value of the Firm <ul><li>Value of the entire firm = entity value </li></ul><ul><li>Sheet 1 calculates market value of the entity = market value of D + E </li></ul><ul><li>Entity value is present value of all cash flows available for investors, whether in form of debt or equity </li></ul><ul><li>Cash flows to entire firm discounted at weighted average cost of capital </li></ul>
    10. 10. Advantages of Entity Approach <ul><li>Focuses on operations and not financing, avoiding problem of changing capital structure through time </li></ul><ul><li>Focuses on free cash flow and pinpoints impact of alternative strategies </li></ul><ul><li>Free cash flow is net operating profit less an allowance for taxes (NOPLAT) minus necessary investments in working capital and fixed assets </li></ul><ul><li>Can focus on explicit forecast period and continuing values after explicit forecast period </li></ul>
    11. 11. Free Cash Flow <ul><li>Free cash flow is same as Baldwin example </li></ul><ul><li>Net Operating Profit less Adjustment for Taxes (NOPLAT) - Net Investments </li></ul><ul><li>Free cash flow does not include interest expenses (or other financing costs) </li></ul><ul><li>Net investments are from working capital and capital expenditures </li></ul><ul><li>Need sales, operating costs, cash, accounts receivable, accounts payable, and inventory assumptions </li></ul>
    12. 12. Financial Analysis <ul><li>Required for assumptions concerning future performance </li></ul><ul><li>Require historical and comparable firm data but future may not be like the past </li></ul><ul><li>We will follow handout Financial Statement Analysis and Assumptions for Valuation </li></ul><ul><li>Always apply plausibility check to both ratios, assumptions, and projections </li></ul><ul><li>Ratio analysis of projections useful in assessing plausibility of assumptions </li></ul>
    13. 13. Dupont Analysis of Performance <ul><li>Dupont Analysis focuses on return on equity (pp. 53f ): </li></ul><ul><li>Closest to goal of management </li></ul><ul><li>Ratios can be calculated in different ways </li></ul><ul><ul><li>Year-ending number balance sheet number or averages of two years </li></ul></ul><ul><ul><li>Before tax or after tax </li></ul></ul>
    14. 14. Abbreviations used in Ratios <ul><li>Abbreviations for accounting values used: ROE = return on equity EAC = earnings available to common BVE = book value of equity EBT = earnings before tax EBIT = earnings before tax and interest SLS = sales ASSTS = total operating assets </li></ul>
    15. 15. Basic Ratio Approach <ul><li>ROE can be decomposed into elements: </li></ul><ul><li>Focus first on gross return on assets (p. 38) </li></ul><ul><li>ROA = “Earning Power” determined by gross profit margin and asset turnover </li></ul>
    16. 16. Gross Profit Margin (p. 46) <ul><li>Sales </li></ul><ul><li>Components of Costs </li></ul><ul><ul><li>Materials </li></ul></ul><ul><ul><li>Labor </li></ul></ul><ul><ul><li>SG&A </li></ul></ul><ul><ul><li>Other </li></ul></ul><ul><li>Common size income statement valuable </li></ul><ul><li>Need assumptions for future on these </li></ul>
    17. 17. Asset Turnover (pp. 50ff) <ul><li>Working Capital </li></ul><ul><ul><li>Inventories </li></ul></ul><ul><ul><li>Accounts Receivable </li></ul></ul><ul><li>Look at liquidity and activity ratios </li></ul><ul><ul><li>Turnover, days </li></ul></ul><ul><li>Current liabilities: trade and bank debt </li></ul><ul><li>Fixed Assets </li></ul><ul><ul><li>Net vs. Gross </li></ul></ul><ul><ul><li>Turnover, average age </li></ul></ul><ul><li>Need assumptions to project these </li></ul>
    18. 18. Valuation in Two Parts <ul><li>Forecast horizon </li></ul><ul><ul><li>Approach stable patterns </li></ul></ul><ul><ul><li>Impact of major changes complete </li></ul></ul><ul><li>Continuing value ( CV ) after forecast </li></ul><ul><ul><li>Cannot be ignored </li></ul></ul><ul><ul><li>Present value of impact depends on when forecast horizon ends </li></ul></ul><ul><li>PVFIRM05 uses five year forecast horizon </li></ul>
    19. 19. Approaches to CV <ul><li>Capitalize cash flows or earnings after explicit forecast period </li></ul><ul><li>Use multipliers to capitalize which are based on discount rates and growth rates </li></ul><ul><li>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) </li></ul><ul><li>We discuss CV in detail later </li></ul>
    20. 20. Team Tasks <ul><li>Computer data downloading </li></ul><ul><li>Spreadsheet analysis </li></ul><ul><li>Sales projections and business analysis </li></ul><ul><li>Financial analysis and formulation of a range of relevant assumptions </li></ul><ul><li>Structuring tables, discussion, and reports for persuasive analysis </li></ul><ul><li>Plausibility checking and trouble shooting </li></ul>
    21. 21. Part 2 of Group Project <ul><li>Individual part change assumptions and note effects as in questions </li></ul><ul><li>Obtain and analyze data from Wharton data base </li></ul><ul><li>Analyze sources, trends, etc., to project sales and ratios to make operating assumptions </li></ul><ul><li>Project 5 years cash flows using Sheet 2 of PVFIRM05 </li></ul>
    22. 22. Next Week <ul><li>Read Chapter 8 and do (at a minimum) the assigned problems </li></ul><ul><li>Prepare Part 2 of the group project and related individual parts </li></ul><ul><li>Relate discussion this week to viewing the acquisition of a firm as an investment of either shares, debt, or a complete corporate acquisition </li></ul>