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Chapter 09 - Prospective Analysis



Chapter 9 Prospective Analysis REVIEW Prospective analysis is the final step in the financial statement analysis process. It includes forecasting of the balance sheet, income statement and statement of cash flows. Prospective analysis is central to security valuation. Both the free cash flow and residual income valuation models described in Chapter 1 require estimates of future financial statements. We provide a detailed example of the forecasting process to project the income statement, the balance sheet, and the statement of cash flows. We describe the relevance of forecasting for security valuation and provide an example utilizing forecasted financial statements to implement the residual income valuation model. We discuss the concept of value drivers and their reversion to long-run equilibrium levels. In the appendix, we provide a detailed example of short-term cash flow forecasting.



9-1



Chapter 09 - Prospective Analysis



OUTLINE 



The Projection Process Projecting Financial Statements Application of Prospective Analysis in the Residual Income Valuation Model Trends in Value Drivers







Short-term Forecasting (Appendix)



9-2



Chapter 09 - Prospective Analysis



ANALYSIS OBJECTIVES 



Describe the importance of prospective analysis.







Explain the process of projecting the income statement, the balance sheet and the statement of cash flows.







Discuss and illustrate the Importance of Sensitivity Analysis.







Describe the implementation of the projection process in the valuation of equity securities.







Discuss the concept of value drivers and their reversion to long-run equilibrium levels.



9-3



Chapter 09 - Prospective Analysis



QUESTIONS 1.



Prospective analysis is central to security valuation. All valuation models rely on forecasts of earnings or cash flows that are, then, discounted back to the present to arrive at the estimated value of the security. Prospective analysis is also useful to examine the viability of companies’ strategic plans, that is, whether they will be able to generate sufficient cash flows from operations to finance expected growth or whether they will be required to seek external financing. In addition, prospective analysis is useful to examine whether announcing strategies will yield the benefits expected by management. Finally, prospective analysis can be used by creditors to assess companies’ ability to meet debt service requirements.



2.



Prior to the forecasting process, financial statements can be recast to better portray economic reality. Adjustments might include elimination of transitory items or reallocating them to past or future years, capitalizing (expensing) items that have been expensed (capitalized) by management, capitalizing operating leases and other forms of off-balance sheet financing, and so forth.



3.



In addition to trend analysis, analysts frequently incorporate external (nonfinancial) information into the prospective process. Some examples are the expected level of macroeconomic activity, the degree to which the competitive landscape is changing, any strategic initiatives that have been announced by management, and so forth.



4.



The forecast horizon is the period for which specific estimates are made. It is usually 5-7 years. Forecasts beyond the forecast horizon are of dubious value since estimates are uncertain.



5.



Since all valuation models are infinite horizon models, analysts frequently assume a steady state into perpetuity after the forecast horizon. A common assumption is that the company will grow at the long-run rate of inflation, that is, remaining constant in real terms.



6.



The projection process begins with an expected growth in sales. Gross profit and operating expenses are, then, estimated as a percentage of forecasted sales using historical ratios and external information. Depreciation expense is usually estimated as a percentage of beginning gross depreciable assets under the assumption that depreciation policies will remain constant. Interest expense is usually estimated at an average borrowing rate applied to the beginning balance of interest bearing liabilities. Projections of expected interest rates are used for variable rate indebtedness and new borrowings. Finally, tax expense is estimated using the effective tax rate on pre-tax income.



7.



In the first step, balance sheet items are projected using forecasted income sales (COGS) and relevant turnover ratios. Long-term assets are projected using forecasted capital expenditures. Long-term liabilities are projected from current maturities of long-term debt disclosed in the debt footnote, and paid-in-capital is assumed to be constant in this stage. Retained earnings are projected adding (subtracting) projected profits (losses) and subtracting projected dividends. Once total liabilities and equities are forecasted, total assets is set equal to this amount and forecasted cash is computed as the plug figure.



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Chapter 09 - Prospective Analysis



In the second step, long-term liabilities and equities are adjusted to yield the desired level of cash. The analyst must be careful to maintain the historical leverage ratio and adjust liabilities and equities proportionately. 8.



The residual income model expresses stock price as the book value of stockholders’ equity plus the present value of expected residual income (RI). Residual income can be expressed in ratio form as, RI = (ROEt – k) * BVt-1 Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so long as ROE  k. In equilibrium, competitive forces will tend to drive rates of return (ROE) to cost (k) so that abnormal profits are competed away. The estimation of stock price, then, amounts to the projection of the reversion of ROE to its long-run value for a particular company and industry. ROE is a value driver since it impacts our valuation of the stock price. Its components (asset turnover and profit margin) are also value drivers



9. We can make two observations regarding the reversion of ROE: a. ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition. Furthermore, the reversion rate for the least profitable firms is greater than that for the most profitable firms. And finally, reversion rates for the most extreme levels of ROE are greater than those for firms at more moderate levels of ROE. b. The reversion is incomplete. That is, there remains a difference of about 12% between the highest and lowest ROE firms even after ten years. This may be the result of two factors: differences in risk that are reflected in differences in their costs of capital (k); or, greater (lesser) degrees of conservatism in accounting policies. The reversion of ROA and NPM are similar. While some reversion of TAT is evident, it is much less than that of the other value drivers. 10. Short-term cash forecasts are key to assessments of short-term liquidity. An asset is called "liquid" because it will or can be converted into cash within the current period. The analysis of short-term cash forecasts will reveal whether an entity will be able to repay short-term loans as planned. This also means such analysis is extremely important for a potential short-term credit grantor. Short-term cash forecasts often are relatively realistic and accurate because of the shortness of the time span covered. 11.



A cash forecast, to be most meaningful, must be for a relatively short-term period of time. There are many unpredictable variables involved in the preparation of a reliable forecast for a highly liquid asset such as cash. Over a long period of time (that is, beyond the time span of one year), the difference in the degree of liquidity among items in the current assets group is usually insignificant. What is more important for long time spans are the projections of net income and other sources and uses of funds. The focus should be shifted to working capital (and other accrual measures), and away from cash flows, for longer forecast horizons of, say, thirty months—where the time required to convert current assets into cash is insignificant.



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Chapter 09 - Prospective Analysis



12. Cash inflows and outflows are highly interrelated. These two flows are crucial to a company’s “circulation system." A deficiency in any part of the system can affect the entire system. For example, a reduction or cessation of sales affects the vital conversion of finished goods into receivables or cash, which in turn leads to a drop in the cash reservoir. If the system is not strengthened by "transfusion" (such as additional investment by owners or creditors), production must be curtailed or discontinued. Lack of cash inflows also will reduce other expenses such as advertising, promotion, and marketing expenses, which will further adversely affect sales. This can yield a vicious cycle leading to business failure. 13. Most would agree with this assertion. Cash is the most liquid asset and when management urgently needs to purchase assets or incur expenses, a cash exchange is the quickest and easiest means to execute a transaction. Moreover, unless management has a credit line established with a reliable outsider (such as a revolving account at a bank), lack of cash can mean a permanent loss of profitable opportunities. 14. Ratio analysis is a static measurement tool. Ratios measure relations among financial statement items as of a given moment and time. In contrast, funds flow analysis is a dynamic measure covering a period of time. A dynamic model of funds flow analysis uses the present only as a starting point and utilizes the best available estimates of future plans and conditions to forecast the future availability and disposition of cash or working capital. Analyzing funds flow also encompasses the projected operations of a company. Since one of the fundamental assumptions of accounting is the going-concern concept, some assert that the dynamic model is more realistic and is superior to static representations. However, care should be taken in placing too much reliance on funds flow analysis as it is primarily based on estimates, and not on realized observations. 15. Except for transactions involving the raising of money from external sources (such as through loans or additional investments) and the investments of money in long-term assets, almost all internally generated cash flows relate to and depend on sales. Accordingly, the usual first step in preparing a cash forecast is to estimate sales for the period under consideration. The reliability of any cash forecast depends on the accuracy of this forecast of sales. In arriving at the sales forecast, the analyst should consider: (1) past trends of sales volume, (2) market share, (3) industry and general economic conditions, (4) productive and financial capacity, and (5) competitive factors, among other variables.



9-6



Chapter 09 - Prospective Analysis



EXERCISES Exercise 9-1 (45 minutes) Projected Income Statement for Year 12 Quaker Oats Company Forecasted Income Statement For Year Ended June 30, Year 12 Revenues [given]..................................................................



$6,000.0



Costs and expenses Cost of goods sold [a]....................................................



$3,186.0



Selling, general, and administrative [b]........................



2,439.4



Other expenses [c]..........................................................



35.2



Interest, net [d].................................................................



91.4



Total costs and expenses....................................................



5,752.0



Income from continuing operations ..................................



248.0



Income taxes [e]....................................................................



105.9



Income before discontinued operations ...........................



142.1



(Loss) on disposal of discontinued operations [given]... Net income.............................................................................



(2.0) $ 140.1



Notes: [a] Cost of sales is estimated to be at a level representing the average percentage of cost of sales to sales as prevailed in the four-year period ending June 30, Year 11, which is 53.1% (19,909.2 – 9,331.3)/19,909.2. Therefore, 6,000 x .531 = $3,186. [b] Selling, general & administrative expenses in Year 12 are expected to increase by the same percentage as these expenses increased from Year 10 to Year 11, which is 15%. Therefore, $2,121.2 x 1.15 = $2,439.4. [c] Other expenses are expected to be 8% higher in Year 12. Therefore, 32.6 x 1.08 = $35.2. [d] Interest expense (net of interest capitalized) and interest income will increase by 6% due to increased financial needs. Therefore, $86.2 x 1.06 = $91.4 [e] The effective tax rate in Year 12 will equal that of Year 11, which is 42.7% ($175.7/$411.5). Therefore, tax expense = $248 x .427 = $105.9.



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Chapter 09 - Prospective Analysis



Exercise 9-2 (25 minutes) Spreadsheet to Compute Forecasts of Sales and Income Date Dec-Y1 Mar-Y2 Jun-Y2 Sep-Y2 Dec-Y2 Mar-Y3 Jun-Y3 Sep-Y3 Dec-Y3 Mar-Y4 Jun-Y4 Sep-Y4 Dec-Y4 Mar-Y5 Jun-Y5 Sep-Y5 Dec-Y5 Mar-Y6 Jun-Y6 Sep-Y6 Dec-Y6 Mar-Y7 Jun-Y7 Sep-Y7 Dec-Y7 Mar-Y8 Jun-Y8 Sep-Y8 Dec-Y8 Mar-Y9 Jun-Y9 Average change for each quarter



Forecast Sep.Y9* Forecast Dec.Y9* Forecast Mar. Y0* Forecast Jun. Y0*



Sales



$17,349 12,278 13,984 13,972 16,040 12,700 14,566 14,669 17,892 12,621 14,725 14,442 17,528 14,948 17,630 17,151 19,547 16,931 18,901 19,861 22,848 19,998 21,860 21,806 24,876 22,459 24,928 23,978 28,455 24,062 27,410



N.I.



$1,263 964 1,130 996 1,215 1,085 656 1,206 1,477 1,219 1,554 1,457 1,685 1,372 1,726 1,610 1,865 1,517 1,908 1,788 2,067 1,677 2,162 2,014 2,350 1,891 2,450 2,284 2,671 2,155 2,820



Change In Dec. Sales



-$1,309



Change in Dec. NI



Change In March Sales



Change in March



NI



Change In June Sales



2,709



153



2,710



178



1,945



226



2,172



270



$1,667.67



$214.67



25,645.67



2,498.67



172



145 1,271



182



202 3,067



160 2,959



254



283 2,461



214 3,068



288



321 1,603



30,041.57



251



180 1,983



$1,586.57



-227



898



153 2,905



3,579



$210



208 2,327



2,028



$697 134 159



3,301



-$474



262 -79



2,019



Change in Sept. NI



$121 $582



-364



Change In Sept. Sales



-$48 $422



1,852



Change In June NI



$201.14 $1,683.43



264



$170.14



2,482



370



$1,918.00



$241.43



2,872.14 25,745.43



2,325.14 29,328.00



* Most recent actual quarter + average change for the quarter. Note: Reported quarterly sales and net income for General Electric are: Sales Net income Sep Y9 $27,200 $2,653 Dec Y9 32,855 3,089 Mar Y0 29,996 2,592



9-8



3,061.43



Chapter 09 - Prospective Analysis



Exercise 9-3 (40 minutes) a. To illustrate how predictions of market share and total market sales can be used in the forecasting process, consider the following example. If an analyst, for instance, predicts that (i) Cough.com will maintain its 0.08% share of the market for children's cough medicine and (ii) total Industry sales of children's cough medicine for year 2006 is $3.2 billion, then a reasonable estimate of Cough.com's year 2006 sales is $2.56 million. This is computed as 0.08% market share multiplied by the expected $3.2 billion of industry sales. b. All relevant data should be sought out, subject to cost-benefit considerations, in the prediction of sales. The importance of sales to predictions of financial performance and financial condition cannot be overemphasized. Accordingly, companies invest considerable research and effort in predicting sales. Regarding what types of data to seek and how to obtain them, let’s consider a retailer. To project the sales of a retailer, an analyst might consider visiting outlets that sell the retailers’ products and observe customer-buying patterns versus the patterns observed for key competing products. This activity can be done using anecdotal observation or using formal statistical sampling depending upon the analysts' perceived need for accuracy. Moreover, the analyst can seek information from insiders via interview or interpretation of formal or informal disclosures made by the company. The analyst can also review company strategies and industry trends. In sum, good predictions involve more than sophisticated models—they demand that the analyst take the perspective of a customer constrained by the economic environment predicted to exist. c. Relying on predicted year 2006 total industry sales of $3.2 billion, the sales of Cough.com are predicted to be as follows 2006 Market share is 5% greater [105% x .08%] x $3.2 billion = $2.688 million



2006 Market share is 5% worse [95% x .08%] x $3.2 billion = $2.432 million



d. What-If industry sales are 10% higher: [105% x .08%] x [110% x $3.2 billion] = $2.9568 million What-If industry sales are 10% lower: [105% x .08%] x [90% x $3.2 billion] = $2.4192 million



9-9



[95% x .08%] x [110% x $3.2 billion] = $2.6752 million [95% x .08%] x [90% x $3.2 billion] = $2.1888 million



Chapter 09 - Prospective Analysis



Exercise 9–4A (30 minutes) Lyon Corporation Cash Forecast For July, Year 6 Beginning cash balance.......................................................



$ 20



Cash collections Beginning accounts receivable................................



$ 20



Sales for month..........................................................



150 170



Less: Ending accounts receivable...........................



21



Cash available.......................................................................



149 $169



Cash disbursements Beginning accounts payable....................................



18



Purchases (note a).....................................................



115 133



Ending accounts payable (25% of purchases)......



29



104



Miscellaneous outlays...............................................



11



Cash balance..............................................................



$ 54



Minimum cash balance desired................................



30



Excess cash................................................................



$ 24



[a] Ending inventory...................................................................................................... Cost of goods sold (5/6 of sales)............................................................................ Less beginning inventory....................................................................................... Purchases.................................................................................................................



9-10



$ 15 125 140 25 $115



Chapter 09 - Prospective Analysis



PROBLEMS Problem 9-1 (90 minutes) a. Coca-Cola Year 3 Estimate 20,297



Year 2 20,092



Year 1 19,889



6,106



6,044



6,204



14,191



14,048



13,685



7,972



7,893



9,221



Depreciation & amortization expense



863



803



773



Interest expense



-66



-308



292



Income before tax



5,422



5,660



3,399



Income tax expense



1,620



1,691



1,222



Net income



3,802



3,969



2,177



Outstanding shares



3,491



3,491



3,481



1.02%



1.02%



Gross Profit Margin



69.92%



69.92%



Selling General & Administrative Exp / Sales



39.28%



39.28%



Depreciation (depn exp / pr yr PPE gross)



12.14%



12.14%



INT (int / pr yr LTD)



-5.45%



-5.45%



Tax (Inc Tax / Pre-tax inc)



29.88%



29.88%



INCOME STATEMENT Net sales Cost of goods Gross profit Selling general & administrative expense



RATIOS Sales growth



9-11



Chapter 09 - Prospective Analysis



Problem 9-1 — continued Year 3 Estimate 587 1,901 1,066 2,300 5,854



Year 2 1,934 1,882 1,055 2,300 7,171



Year 1 1,892 1,757 1,066 1,905 6,620



8,305 3,515 4,791 10,793 21,438



7,105 2,652 4,453 10,793 22,417



6,614 2,446 4,168 10,046 20,834



3,717 3,899 815 8,431



3,679 3,899 851 8,429



3,905 4,816 600 9,321



Deferred income, taxes & other Long term debt Total liabilities



1,403 1,219 11,053



1,403 1,219 2,622



1,362 835 2,197



Common stock Capital surplus Retained earnings Treasury stock Shareholder equity Total liabilities & net worth



873 3,520 19,674 13,682 10,385 21,438



873 3,520 20,655 13,682 11,366 22,417



870 3,196 18,543 13,293 9,316 20,834



RATIOS AR turn INV turn AP turn Tax Pay (Tax pay / tax exp) FLEV Div/sh



10.68 5.73 1.64 50.33% 2.06 $1.37



10.68 5.73 1.64 50.33% 1.97 $1.37



11.32 5.82 1.59 49.10% 2.24 $1.21



1,200 5.91%



1188 5.91%



1165 5.86%



BALANCE SHEET Cash Receivables Inventories Other Total current assets Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets Accounts payable & accrued liabilities Short-term debt & cmltd Income taxes Total current liab



CAPEX CAPEX/Sales



9-12



Chapter 09 - Prospective Analysis



Problem 9-1 — continued Year 3 Estimate



Statement of Cash Flows Net income



3,802



Depreciation



863



Accounts receivable



-19



Inventories



-11



Accounts payable



38



Income taxes



-36



Net cash flow from operations



4,636



CAPEX Net cash flow from investing activities



-1,200 -1,200



Long term debt Additional paid in capital Dividends Net cash flow from financing activities



0 0 -4,783 -4,783 _____ -1,347 1,934 587



Net change in cash Beginning cash Ending cash



b. Based on our initial projection of Coca-Cola’s balance sheet, it appears that the company will require approximately $1.5 billion of external financing in Year 3. This amount will yield a cash balance of approximately $2 billion, consistent with prior years.



9-13



Chapter 09 - Prospective Analysis



Problem 9-2 (95 minutes) a. Best Buy Year 3 Estimate



Year 2



Year 1



Net sales



18,800



15,326



12,494



Cost of goods



15,048



12,267



10,101



Gross profit



3,752



3,059



2,393



Selling general & administrative expense



2,761



2,251



1,728



Depreciation & amortization expense



304



167



103



Income before tax



688



641



562



Income tax expense



263



245



215



Net income



425



396



347



Outstanding shares



208



208



200



Sales growth



22.67%



22.67%



Gross Profit Margin



19.96%



19.96%



Selling General & Administrative Exp / Sales



14.69%



14.69%



DEPRECIATION (depn exp / pr yr PPE gross)



15.28%



15.28%



Tax (Inc Tax / Pre-tax inc)



38.22%



38.22%



Income statement



RATIOS



9-14



Chapter 09 - Prospective Analysis



Problem 9-2 — continued BALANCE SHEET Cash Receivables Inventories Other Total current assets



Year 3 Estimate 196 384 2,168 102 2,850



Year 2 746 313 1,767 102 2,928



Year 1 751 262 1,184 41 2,238



Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets



3,249 847 2,403 466 5,719



1,987 543 1,444 466 4,838



1,093 395 698 59 2,995



Accounts payable & accrued liabilities Short-term debt & cmltd Income taxes Total current liab



3,034 114 136 3,284



2,473 114 127 2,714



1,704 16 65 1,785



122 67 189



122 181 303



100 15 115



Common stock Capital surplus Retained earnings Shareholder equity Total liabilities & net worth



20 576 1,650 2,246 5,719



20 576 1,225 1,821 4,838



20 247 828 1,095 2,995



RATIOS AR turn INV turn AP turn Tax Pay (Tax pay / tax exp) FLEV Div/sh



48.96 6.94 4.96 51.84% 2.55 $0.00



48.96 6.94 4.96 51.84% 2.66 $0.00



47.69 8.53 5.93 30.23% 2.74 $0.00



1,262 6.71%



1029 6.71%



416 3.33%



Long term liabilities Long term debt Total long-term liabilities



CAPEX CAPEX/Sales



9-15



Chapter 09 - Prospective Analysis



Problem 9-2 — continued Statement of Cash Flows Net income Depreciation Accounts receivable Inventories Accounts payable Income taxes Net cash flow from operations



Year 3 Estimate 425 304 -71 -401 561 9 827



CAPEX Net cash flow from investing activities



-1,262 -1,262



Long term debt Additional paid in capital Dividends Net cash flow from financing activities



-114 0 0 -114 ____ -550 746 196



Net change in cash Beginning cash Ending cash



b. Based on our projection, it appears that Best Buy will require about $550 Million of external financing to yield a cash balance of approximately $750 million. Analysts must allocate this external financing between debt and equity so as to preserve the financial leverage level presently used by Best Buy.



9-16



Chapter 09 - Prospective Analysis



Problem 9-3 (90 minutes) a. Merck Year 3 Estimate



Year 2



Year 1



Net sales



56,435



47,716



40,343



Cost of goods



34,272



28,977



22,444



Gross profit



22,164



18,739



17,900



Selling general & administrative expense



7,725



6,531



6,469



Depreciation & amortization expense



1,661



1,464



1,277



237



342



329



12,541



10,403



9,824



Income tax expense



3,762



3,121



3,002



Net income



8,779



7,282



6,822



Outstanding shares



2,976



2,976



2,968



Sales growth



18.27%



18.27%



Gross Profit Margin



39.27%



39.27%



Selling General & Administrative Exp / Sales



13.69%



13.69%



DEPRECIATION (depn exp / pr yr PPE gross)



8.76%



8.76%



INT (int / pr yr LTD)



4.94%



4.94%



30.00%



30.00%



INCOME STATEMENT



Interest expense Income before tax



RATIOS



Tax (Inc Tax / Pre-tax inc)



9-17



Chapter 09 - Prospective Analysis



Problem 9-3 — continued Year 3 Estimate 5,254 6,168 4,233 880 16,536



Year 2 3,287 5,215 3,579 880 12,961



Year 1 4,255 5,262 3,022 1,059 13,598



Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets



24,056 7,514 16,543 17,942 51,020



18,956 5,853 13,103 17,942 44,007



16,707 5,225 11,482 15,075 40,155



Accounts payable & accrued liabilities Short-term debt & cmltd Income taxes Total current liab



6,983 4,067 1,897 12,947



5,904 4,067 1,573 11,544



5,391 3,319 1,244 9,954



Deferred income, taxes and other Long term debt Total liabilities



11,614 4,787 29,347



11,614 4,799 27,957



11,768 3,601 25,323



Common stock Capital surplus Retained earnings Treasury stock Shareholder equity Total liabilities & net worth



30 6,907 37,123 22,387 21,673 51,020



30 6,907 31,500 22,387 16,050 44,007



30 6,266 27,395 18,858 14,832 40,155



RATIOS AR turn INV turn AP turn Tax Pay (Tax pay / tax exp) FLEV Div/sh CAPEX CAPEX/Sales



9.15 8.10 4.91 50.41% 2.35 $1.06 5,100 9.04%



9.15 8.10 4.91 50.41% 2.74 $1.06 4312 9.04%



7.67 7.43 4.16 41.45% 2.71 $0.98 3641 9.03%



BALANCE SHEET Cash Receivables Inventories Other Total current assets



9-18



Chapter 09 - Prospective Analysis



Problem 9-3 — continued Year 3 Estimate



Statement of Cash Flows Net income



$ 8,779



Depreciation



1,661



Accounts receivable



-953



Inventories



-654



Accounts payable



1,079



Income taxes



323



Net cash flow from operations



10,235



CAPEX



-5,100



Net cash flow from investing activities



-5,100



Long term debt



-12



Additional paid in capital



0



Dividends



-3,156



Net cash flow from financing activities



-3,168 _____



Net change in cash



1,967



Beginning cash



3,287



Ending cash



5,254



b. Based on our initial projections, it appears that Merck will have excess cash of approximately $2 billion in year 3. This excess cash should be used to reduce both debt and equity so as to maintain historical financial leverage.



9-19



Chapter 09 - Prospective Analysis



Problem 9-4 (90 minutes) Historical figures Year 2 Year 3 Sales growth Net profit Margin (Net income/Sales) NWC turn (Sales/avg NWC) FA turn (Sales/avg FA) Total operating assets/Total equity Cost of equity ($ Thousands) Sales Net income ($ Mil) Net working capital Fixed assets Total Operating assets L-T Liabilities Total Stockholder's Equity ($ Mil) Residual Income Computation Net Income Beginning Equity Required Equity Return Expected Earnings Residual Income Discount factor Present value of residual income Cum PV residual income Terminal value of abnormal earnings Beg book value of equity Value of equity - Abnormal Earnings Common shares outstanding (mil) per share



Forecast Horizon Year 4



Year 5



Year 6



Year 7



20x8



Terminal Year 20x8 3.50% 8.22% 9.33 1.64 2.01



8.50% 6.71% 8.98 1.67 1.96



10.65% 8.22% 9.33 1.64 2.01



10.65% 8.22% 9.33 1.64 2.01 12.5%



10.65% 8.22% 9.33 1.64 2.01



10.65% 8.22% 9.33 1.64 2.01



10.65% 8.22% 9.33 1.64 2.01



10.65% 8.22% 9.33 1.64 2.01



25,423 1,706 2,832 15,232 18,064 8,832 9,232



28,131 2,312 3,015 17,136 20,151 10,132 10,019



31,127 2,558 3,336 18,961 22,297 11,211 11,086



34,443 2,831 3,692 20,981 24,673 12,405 12,267



38,112 3,132 4,085 23,216 27,301 13,727 13,574



42,171 3,466 4,520 25,689 30,209 15,189 15,020



46,663 3,835 5,001 28,425 33,426 16,807 16,619



48,297 3,969 5,176 29,420 34,596 17,395 17,201



2,558 10,019 12.5% 1,252 1,306 0.89



2,831 11,086 12.5% 1,386 1,445 0.79



3,132 12,267 12.5% 1,533 1,599 0.70



3,466 13,574 12.5% 1,697 1,769 0.62



3,835 15,020 12.5% 1,877 1,958 0.55



3,969 16,619 12.5% 2,077 1,892



1,161 1,161



1,142 2,303



1,123 3,425



1,105 4,530



1,086 5,616 11,665 10,019 27,301 1,737 $15.72



9-20



Chapter 09 - Prospective Analysis



Problem 9-5 (90 minutes) a. Telnet Corporation Pro Forma Income Statement ($000s) Six Months Ended June 30, Year 2 Sales revenue ($250 x 6 mos.).....................................................................



$1,500



Cost of goods sold (note [a]).......................................................................



1,199



Gross margin.................................................................................................



301



Selling and administrative expenses ($47.5 x 6 mos.)..............................



285



Expected pre-tax income..............................................................................



16



Estimated income taxes (at 50%)................................................................



8



Expected net income....................................................................................



$



8



Note [a]: We use T-accounts to compute cost of goods sold ($ thousands) Raw Material Inventory Beginning (given) Material purchases ($125 x 6 mos.) Ending (given)



0 750



715



To W.I.P. inventory [a] (plug)



35 Work in Process Inventory



Beginning (given) From raw materials inventory [a] Labor ($30.5 x 6 mos.) Variable overhead ($22.5 x 6 mos.) Rent ($10 x 6 mos.) Depreciation ($35 x 6 mos.) Patent amortization ($.5 x 6 mos.) Ending (given)



0 715 183 135 60 210 3



7 1,299



Prepaid expenses (given) To F.G. inventory [b] (plug)



0 Finished Goods Inventory



Beginning (given) From W.I.P. inventory [b] Ending (given)



0 1,299



1,199



100



9-21



Cost of goods sold (plug)



Chapter 09 - Prospective Analysis



Problem 9-5 — continued b. Telnet Corporation Pro forma Balance Sheet ($000s) June 30, Year 2 ASSETS Cash.............................................................................. $



40



(minimum cash)



Accounts receivable....................................................



375



(45 days' sales)*



Inventories ($35 + $100)..............................................



135



(given)



Prepaid expenses........................................................



7



(given)



Total current assets...................................................



557



(subtotal)



Equipment....................................................................



1,200



(given)



Less accumulated depreciation.................................



210



($35 x 6 mos.)



Equipment, net...........................................................



990



(subtotal)



Patents..........................................................................



40



(given)



Less amortization........................................................



3



($500 x 6 mos.)



Patents, net................................................................



37



(subtotal)



Total Assets.................................................................. $1,584 LIABILITIES AND STOCKHOLDERS’ EQUITY Accounts payable........................................................ $ 125



(30 days' purchases)**



Accrued taxes..............................................................



8



(from Inc. Stmt.)



Stockholders' equity...................................................



1,300



(given)



Retained earnings.......................................................



8



(from Inc. Stmt.)



Additional funds needed.............................................



143



"plug"



Total liabilities and equity........................................... $1,584 * ($250,000 x 6) / 180 days = $8,333 per day x 45 days = $375,000 ** ($125,000 x 6) / 180 days = $4,166 per day x 30 days = $125,000



9-22



Chapter 09 - Prospective Analysis



Problem 9-5 — continued c. Telnet Corporation Forecasted Statement of Cash Flows For Six Months Ended June 30, Year 2 Cash balance, beginning ....................................................



$



60,000



Add collection of accounts receivable *............................



1,125,000



$1,185,000



Less disbursements for Material purchases **.....................................................



625,000



Labor................................................................................



183,000



Rent.................................................................................



60,000



Overhead.........................................................................



135,000



Selling expense.............................................................. ...............................................................................................



285,000



Tentative cash balance........................................................



(1,288,000) $ (103,000)



Minimum cash balance required........................................



40,000



Additional borrowing required............................................



$ 143,000



Ending cash balance ..........................................................



$



Loan balance........................................................................



$ 143,000



40,000



* Collection of accounts receivable Sales.......................................................................... Collections................................................................ Accumulated Collections........................................



Jan. 250 0 0



Feb. 250 125 125



Mar. 250 250 375



Apr. 250 250 625



May 250 250 875



June 250 250 1,125



** Payment of accounts payable



Jan.



Feb.



Mar.



Apr.



May



June



125 0 0



125 125 125



125 125 250



125 125 375



125 125 500



Purchases................................................................. Payments.................................................................. Accumulated Payments...........................................



9-23



125 125 625



Chapter 09 - Prospective Analysis



Problem 9-6 (95 minutes) Quaker Oats Forecasted Statement of Cash Flows For Year Ended June 30, Year 12 Cash provided by (used for) operations Net income (a).............................................................................................. Items in income not affecting cash Depreciation & amortization (b)................................................................ Deferred income taxes (c)......................................................................... Provision for restructuring charges (given)........................................... Increase in receivables (d).......................................................................... Increase in inventories (e)........................................................................... Increase in other current assets (f)............................................................ Increase in accounts payable (g)............................................................... Increase in other current liabilities (h)..................................................... Cash provided by operating activities.......................................................



$ 238.8 196.6 54.7 0.0 (8.9) (45.2) (25.6) 42.1 24.5 $ 477.0



Cash provided by (used for) investment activities Capital expenditures, PP&E (given)........................................................... Asset retirements (given)............................................................................ Other changes (given)................................................................................ Cash used for investing activities..............................................................



$ (300.0) 20.0 (30.0) $ (310.0)



Cash provided by (used for) financing activities Repayments of L-T debt (given)................................................................. Net decrease in S-T debt (given)................................................................ Cash dividend paid (given)......................................................................... Additions to L-T debt—plug (i).................................................................... Cash provided by financing activities........................................................



$ (45.0) (40.0) (135.0) 55.8 $(164.2)



Net increase in cash (j)................................................................................



$



Cash, beginning balance............................................................................. Cash, balance at end of year.....................................................................



30.2 $ 33.0



Notes: (a) Average percent of income from continuing operations to sales, Years 9-11 ($235.8 +$228.9 + $148.9) / ($5,491.2 + $5,030.6 + $4,879.4) = 3.98% Net income in Year 12 = $6,000 x .0398 = $238.8



9-24



2.8



Chapter 09 - Prospective Analysis



Problem 9-6 – continued (b) Depreciation and amortization in Year 12 = $238.8 x .8233 = $196.6 (c) Average percent of deferred income taxes (noncurrent) and other items to income from continuing operations, Years 9-11: $140.4 / $613.6 = 22.9% Noncurrent deferred income tax in Year 12 = $238.8 x .229 = $54.7 (d) Ending accounts receivable = $6,000 x (42/360) = $700.0 For Year 12: Accounts receivable, beg $691.1 Accounts receivable, end 700.0 Increase $ 8.9 (e) Year 12 cost of sales = $6,000 x .51 = $3,060 Ending inventory = $3,060 x (55/360) = $467.5 For Year 12: Inventory, beg $422.3 Inventory, end 467.5 Increase $ 45.2 (f) ($13.7 + $14.1 + $48.9)/3 = $25.6 (g) Year 12 purchases = $2,807.2 x 1.12 = $3,144.1 Accounts payable, end = $3,144.1 x (45/360) = $393.0 For Year 12: Accounts payable, beg $350.9 Accounts payable, end 393.0 Increase $ 42.1 (h) ($43.2 + $83.4 - $53.1)/3 = $24.5 (i) Amount required to balance statement. (j) Percent of cash to revenues in Year 11 = $30.2 / $5,491.2 = 0.55% Year-end cash in Year 12 = $6,000 x 0.55% = $33 Increase in cash for Year 12 = $33 - $30.2 = $2.8



9-25



Chapter 09 - Prospective Analysis



CASES Case 9-1 (60 minutes) Kodak INCOME STATEMENT



20x7 Est



20x6



20x5



12,515



13,234



13,994



Cost of goods



8,199



8,670



8,375



Gross profit



4,316



4,564



5,619



Selling general & administrative expense (except depreciation)



1,761



1,862



1,776



Depreciation expense



766



765



738



Research & development costs



737



779



784



Goodwill amortization



0



154



151



Restructuring costs (credits)



0



659



-44



1,052



345



2,214



208



219



178



18



18



-96



Income before tax



827



108



2,132



Income tax expense



245



32



725



Net income



582



76



1,407



Outstanding shares



290



290



290



-5.43% 34.49% 14.07% 5.90% 5.89% 6.49% 29.63%



-5.43% 34.49% 14.07% 5.90% 5.89% 6.49% 29.63%



Net sales



Earnings from operations Interest expense Other expense (income)



RATIOS Sales growth Gross Profit Margin Selling General & Administrative Exp / Sales DEPRECIATION (depn exp / pr yr PPE gross) R&D/sales INT (int / pr yr STD and LTD) Tax (Inc Tax / Pre-tax inc)



9-26



Chapter 09 - Prospective Analysis



Case 9-1 – continued BALANCE SHEET Cash Receivables Inventories Other Total current assets



20x7 Est $ 17 2,210 1,075 761 4,064



Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets



20x6 $ 448 2,337 1,137 761 4,683



20x5 $ 246 2,653 1,718 874 5,491



13,972 12,982 12,963 (NOTE 4) 8,089 7,323 7,044 5,883 5,659 5,919 3,020 3,020 2,802 $12,967 $13,362 $14,212



Accounts payable & accrued liabilities Short-term debt Current maturities of l-t debt Income taxes Total current liab



3,098 1,378 13 544 5,033



3,276 1,378 156 544 5,354



Long term debt Postemployment liabilities Other long-term liabilities Total liabilities



1,653 2,728 720 10,134



1,666 2,728 720 10,468



1,166 2,722 681 10,784



Common stock Capital surplus Retained earnings Treasury stock Shareholder equity Total liabilities & net worth



978 849 6,773 5,767 2,833 12,967



978 849 6,834 5,767 2,894 13,362



978 871 7,387 5,808 3,428 14,212



RATIOS AR turn INV turn AP turn FLEV Div/sh



5.66 7.63 2.65 4.58 $2.22



5.66 7.63 2.65 4.62 $2.22



5.27 4.87 2.46 4.15 $1.88



CAPEX CAPEX/Sales



990 7.91%



1047 7.91%



783 5.60%



9-27



3,403 2,058 148 (NOTE 8) 606 6,215



Chapter 09 - Prospective Analysis



Case 9-1 – continued Statement of Cash Flows



20x7 Estim.



Net income



$ 582



Depreciation



766



Accounts receivable



127



Inventories



62



Accounts payable



(178)



Net cash flow from operations



1,359



CAPEX Net cash flow from investing activities



(990) (990)



Long term debt Dividends Net cash flow from financing activities



(156) (643) (799) _____ (431) 448 $ 17



Net change in cash Beginning cash Ending cash



9-28



Chapter 09 - Prospective Analysis



Case 9-2 (120 minutes) Miller Company Cash Forecast For Years Ended December 31, Years 2 through 4 Year 2 Year 3 Cash balance at beginning of period.................. $ 0 $1,929,000 Cash received from stockholders........................ 100,000 0 Proceeds of loan (see [a])..................................... 1,700,000 100,000 Cash receipts less cash payments (see [b])....... 129,000 125,500 Payments for construction................................... 0 (1,700,000) Payments on loan (see [a])................................... 0 (200,000) Cash balance at end of period............................. $1,929,000 $ 254,500



Year 4 $254,500 0 0 146,500 (100,000) (200,000) $101,000



Supporting Schedules for the Cash Forecast [a] Schedule of interest and commitment fees Amount of Loan Year 2: To be borrowed 1/1.................................................................. To be borrowed 4/1.................................................................. Commitment fee due 4/1 ($1,000,000 x 1% x 1/4)................. To be borrowed 7/1.................................................................. Commitment fee due 7/1 ($500,000 x 1% x 1/4).................... To be borrowed 12/31.............................................................. Commitment fee due 12/31 ($200,000 x 1% x 1/2)................ Interest due on loan: On $800,000 @ 5%............................................................. On $500,000 @ 5% x 3/4.................................................... On $300,000 @ 5% x 1/2................................................... Total at 12/31/Year 2................................................................ Year 3: To be borrowed 4/1.................................................................. Commitment fee due 4/1 ($100,000 x 1% x 1/4).................... Repayment of loan: Due 6/30.............................................................................. Due 12/31............................................................................ Interest due on loan: On $1,700,000 @ 5% x 1/4................................................. On $1,800,000 @ 5% x 1/4................................................. On $1,700,000 @ 5% x 1/2................................................ Total at 12/31/Year 3................................................................ Year 4: Repayment of loan: Due 6/30.............................................................................. Due 12/31............................................................................ Interest due on loan: On $1,600,000 @ 5% x 1/2................................................. On $1,500,000 @ 5% x 1/2................................................ Total at 12/31/Year 4................................................................



9-29



$ 800,000 500,000 300,000 100,000



$1,700,000 100,000



Interest or Fee



$ 2,500 1,250 1,000 40,000 18,750 7,500 $71,000 250



(100,000) (100,000)



$1,600,000



21,250 22,500 42,500 $86,500



(100,000) (100,000)



$1,400,000



40,000 37,500 $77,500



Chapter 09 - Prospective Analysis



Case 9-2 – continued [b] Schedule of Operating Results Year 2



Year 3



Year 4



Operating profit (at $.04 per ton handled).................. $200,000



$212,000



$224,000



Results of operations Interest and commitment fees (above).......................



71,000



86,500



77,500



Cash derived from operations....................................



129,000



125,500



146,500



Depreciation (at $.03 per ton handled).......................



150,000



159,000



168,000



Operating loss..............................................................



$ 21,000



33,500



21,500



Operating loss from prior year(s)...............................



21,000



54,500



Accumulated operating loss.......................................



$ 54,500



$ 76,000



Interpretation and Evaluation As revealed in note [b], reporting on the "results of operations," Miller Company is expected to record operating losses for each of the next three years under analysis. Nevertheless, the analysis also reveals that Miller is expected to generate sufficient cash flow to cover the various cash commitments.



9-30



Chapter 09 - Prospective Analysis



Case 9-3 (100 minutes) Royal Company Cash Forecast For Years Ending March 31, Years 6 and 7 Year 6



Beginning balance of cash.......................................



$



Year 7



0



$



75,000



Cash receipt from customers (see Schedule A)..... Cash disbursements Direct materials (see Schedule B).......................... Direct labor ................................................300,000 Variable overhead.................................................... Fixed costs ............................................. 130,000 Total cash disbursements....................................... Operating cash receipts less disbursements.........



825,000



1,065,000



220,000 360,000 100,000 130,000 750,000 75,000



245,000



Cash from sale of receivables and inventories...... Total cash available...................................................



90,000 $165,000



0 $ 285,000



Payments to general creditors................................. Ending balance of cash.............................................



90,000 $ 75,000



270,000 $ 15,000



1



2



120,000 855,000 210,000



1



2



This amount could have been used to pay general creditors or carried forward to the beginning of the next year. Computed as: ($600,000 x 60%) - ($50,000 + $40,000).



Schedule A Cash Receipts from Customers Year 6 Sales......................................................................................... $900,000 Beginning accounts receivable.............................................. 0 Total........................................................................................ 900,000 Less: Ending accounts receivable........................................ 75,000 Cash receipts from customers............................................... $825,000



Year 7 $1,080,000 75,000 1,155,000 90,000 $1,065,000



Schedule B Cash Disbursements for Direct Materials Year 6 Direct materials required for production.................... $200,000 Required ending inventory......................................... 40,000 Total............................................................................ Less: Beginning inventory.......................................... Purchases .................................................................. Beginning accounts payable...................................... Total............................................................................ Less: Ending accounts payable................................. Disbursements for direct materials............................ 3 4



3



240,000 0 240,000 0 240,000 20,000 $220,000



Computed as: 12,000 units x 2/12 = 2,000; 2,000 x $20 per unit = $40,000. Computed as: 15,000 units x 2/12 = 2,500; 2,500 x $20 per unit = $50,000.



9-31



Year 7 $240,000 50,000 290,000 40,000 250,000 20,000 270,000 25,000 $245,000



4



Chapter 09 - Prospective Analysis



Case 9-4 (115 minutes) a. (1) Estimated Total Cash Receipts Sep. Oct. Total sales.............................................. $40,000 $48,000 Credit sales (25%)................................. 10,000 12,000 Cash sales.................................$30,000 36,000 $45,000 Receipts of past month's credit sales 10,000 Total cash receipts................................ $46,000



Nov. $60,000 15,000 $60,000 12,000 $57,000



Dec. $80,000 20,000 15,000 $75,000



(2) Estimated Cash Disbursements for Purchases Oct. Nov. Dec. Total Sales........................................ $48,000 $60,000 $80,000 Purchases (70% next mo. sales).... Less: 2% purchase discount......... Cash disbursements........................



$42,000 840 $41,160



$56,000 1,120 $54,880



Total —



$25,200 $123,200 504 2,464 $24,696 $120,736



(3) Estimated Cash Disbursements for Operating Expenses Oct. Nov. Dec. Sales.................................................. $48,000 $60,000 $80,000 Salaries and Wages (15%)............... $ 7,200 Rent (5%)........................................... 2,400 Other Expenses (4%)....................... 1,920 Cash disbursements........................ $11,520



$ 9,000 3,000 2,400 $14,400



Total —



$12,000 4,000 3,200 $19,200



$28,200 9,400 7,520 $45,120



Estimated Total Cash Disbursements Oct. Nov. Dec. Purchases [part (2)]......................... $41,160 $54,880 $24,696 Operating expenses [part (3)]......... 11,520 14,400 19,200 Plant and equipment (given)........... 600 400 Total cash disbursements............... $53,280 $69,680 $43,896



Total $120,736 45,120 1,000 $166,856



(4)



(5) Estimated Net Cash Receipts and Disbursements Oct. Nov. Dec. Total cash receipts........................... $46,000 $57,000 $75,000 Total cash disbursements.............. 53,280 69,680 43,896 Net cash increase............................. $31,104 Net cash decrease........................... $ 7,280 $12,680



9-32



Total $178,000 166,856 $ 11,144



Chapter 09 - Prospective Analysis



Case 9-4 — continued (6) Estimated Financing Required Oct. Nov.



Beginning cash balance.................. $12,000



Dec.



$ 8,720



Net cash increase............................. Net cash decrease...........................



7,280



Cash position before financing...... $ 4,720 Financing required...........................



4,000



Total



$ 8,040



$12,000



31,104



11,144



$39,144



$23,144



12,680 $(3,960) 12,000



16,000



Interest expense 1.............................



(180)



(180)



Financing retired.............................



(16,000)



(16,000)



$22,964



$22,964



Ending cash balance....................... $ 8,720 1



$ 8,040



Computed as: ($4,000 x .06 x 3/12) + ($12,000 x .06 x 2/12).



b. (1) Union Corporation Forecasted Income Statement For the Quarter Ended December 31, Year 6



Sales [see (1) in part a]........................................................



$188,000



Deduct Cost of goods sold (70% of sales)............................... $131,600 Less: Purchase discounts taken [see (2) in part a]...



2,464



Gross profit ........................................................................



58,864



129,136



Selling and administrative expenses Salaries and wages [see (3) in part a]..........................



28,200



Rent [see (3) in part a]....................................................



9,400



Other expenses [see (3) in part a]................................



7,520



Depreciation ($750 x 3 months)...................................



2,250



Total selling and administrative expenses........................



47,370



Operating income.................................................................



11,494



Interest expense...................................................................



180



Net income .........................................................................



$ 11,314



9-33



Chapter 09 - Prospective Analysis



Case 9-4 — continued (2) Union Corporation Forecasted Balance Sheet As of December 31, Year 6



ASSETS Current Assets Cash [see (6) in part a]...................................................



$ 22,964



Accounts receivable (25% of Dec. sales).....................



20,000



Inventory [($30,000 + 70% of $36,000) x 98%]............



54,096



Total current assets.............................................................



$ 97,060



Plant and equipment............................................................



101,000



Less: Accumulated depreciation........................................



2,250



Total assets..........................................................................



98,750 $195,810



LIABILITIES AND EQUITY Liabilities...............................................................................



$



0



Stockholders' equity............................................................



195,810



Total liabilities and equity...................................................



$195,810



9-34