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Estimating Investment and Corporate Cash Flows. April 9, 2007 (LA) and March 29, 2007 (OCC). Assumptions for Cash Flows. Sources of Data Computer sources of data Financial models for valuation How and why to use ratio analysis Library Resources. Projecting Corporate Cash Flows.
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Estimating Investmentand Corporate Cash Flows April 9, 2007 (LA) and March 29, 2007 (OCC)
Assumptions for Cash Flows • Sources of Data • Computer sources of data • Financial models for valuation • How and why to use ratio analysis • Library Resources
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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