DES Chapter 5
Projecting Free Cash Flows
DES Chapter 5
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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 articulation of assumptions
Helps to understand firm’s value drivers
Must verify assumptions are economically
reasonable
Identifies external funding needed
Provides data needed to project FCF and
perform valuation
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Characteristics of a good
forecast?
Economic plausibility

Statements must reflect how firm might
realistically operate in future.
Accounting consistency
Do financial statements balance?
 Do they “articulate?”
 Are they a good model of firm’s finances?

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Van Leer Products, Inc.
Manufactures extruded plastic products.
Statements bit different from Acme's:
Have S/T investments—where it “parks”
excess cash.
 Only net PPE. Gross PPE omitted.

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Modeling the financial statements
Operating accounts varying directly w/ sales

Cost of goods sold (COGS)


For most firms, COGS close to proportional to sales
Selling, general & administrative expenses (SGA)

Although in S/T 1-2 year range, SGA may not be
directly proportional, for most firms roughly
proportional over longer projection periods
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Operating accounts varying
directly w/ sales
Cash

Consider only level of cash necessary to “grease
the wheels” of company’s operations. Amount
needed to keep checks from bouncing.
Inventory

Must increase with sales—start at proportional
to sales, then adjust later.
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Operating accounts varying directly
w/ sales
Accounts receivable

More AR if more sales.
Net PPE

In S/T, like SGA, net PPE may not be
directly related to sales; Over L/T most
firms’ net PPE pretty closely related to
sales.
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Operating accounts varying directly
w/ sales
Accounts payable

If sell more, then produce & use more
materials. T/4, credit purchases increase
with sales.
Accrued expenses

If sell more, then labor expense and payroll
taxes more — also increase with sales.
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Operating accounts that vary with
other things
Depreciation exp. set by deprec.
schedule—generally depends on net
PPE, not directly on sales.
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Modeling items required for
projecting FCF
Don’t need entire statements to calculate
FCF—start with what’s necessary for FCF,
then add rest of statements to determine
funding mix req’d.
Need operating income
Need investment in Op. Capital
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Projecting partial financial
statements
Income statement
Net sales
COGS
SGA
Deprec.
Op. Profit
Forecast method
Forecast growth
% sales
% sales
% net PPE
Calculated
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Projecting partial financial
statements
Balance Sheet
Cash
Inventory
Accounts receivable
Net PPE
Accounts payable
Accrued expenses
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Forecast method
% sales
% sales
% sales
% sales
% sales
% sales
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Information about Van Leer
Analysts use info about Company not
from 10k or annual report. Analyst may
have access to it as a corporate
“insider” performing this valuation for
internal purposes. If analyst is an
“outsider” then much of this information
comes from extensive company &
industry research.
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Van Leer Products, Inc.
Van Leer Products, Inc.
Actual Actual Actual
Income Statement
2001
2002
2003
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
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DES Chapter 5
Van Leer Products, Inc.
Actual Actual Actual
2001
2002
2003
Balance sheet
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
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Van Leer Products, Inc.
Actual Actual Actual
2001
2002
2003
Balance sheet
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
125
125
125
Common stock
Retained earnings
150
178
216
Total common equity
275
303
341
Total liabilities and equity
467
497
550
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Choosing inputs for the model
Projecting sales growth rate
Projecting Op. Profit
Projecting Op. Capital
Projecting taxes
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Historical ratios used to project
free cash flows
Ratios to calculate operating profit
2002
12.4%
66.2%
21.7%
2003
5.9%
64.0%
21.5%
Average
9.2%
64.0%
22.3%
14.9% 15.0%
15.0%
15.0%
Tax rate (Taxes/EBT) 40.0% 39.1%
40.0%
39.7%
Sales growth rate
COGS / Sales
SGA / Sales
Depreciation
/ Net PPE
2001
na
61.9%
23.8%
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Projected sales growth rate for
2004 ?
9.2% average growth rate over past 2 yrs
Economy predicted to recover substantially by
2004, so analyst predicts more rapid growth than
2003, & more rapid than ave.
After speaking with marketing and operations,
predicts firm’s sales to increase 9% next year due
to increased unit sales, and 2% due to anticipated
inflation.
So, $ sales projected to increase by 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 to decrease
from last year’s 64% to 62.5% of sales.
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SGA as % of sales
Co. has minimal advertising
Sales commission rate increases next
year and a half from 9% to 12%.
Staffing remains constant, salaries
increase with inflation.
Net impact is SGA to increase from
21.5% to 22.5% of sales.
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Depreciation
Depreciation schedule is set by cost of the
assets purchased and accounting rules.
Will change dramatically only if a company
changes the type (L/T or S/T) of assets it’s
purchasing.
Firm to continue using same type of assets
it’s been using, so depreciation remains at
15% of net PPE.
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Tax rate
Combined federal, state & local taxes
are 39.7% of sales; and expected to
remain same.
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Operating items on balance
sheets
Ratios to calculate operating capital
2001
Cash / Sales
5.00%
Inventory/ Sales
8.9%
Accts. Rec. / Sales 7.7%
Net PPE / Sales
32.7%
Accts. Pay./ Sales 9.5%
Accruals / Sales
0.9%
2002 2003
Average
5.0%
5.0% 5.0%
9.0% 10.0% 9.3%
7.4%
7.5% 7.6%
29.7% 30.0% 30.8%
7.4%
7.5% 8.1%
1.1%
1.0% 1.0%
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Projecting B/S Op. Items
Cash: Minimum balance required for
business to function.
5% historically.
 With better information technology, drops
to 3%.

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Operating items
Accounts Receivable


Depend on credit policy: Tighter policy means
less A/R, but also fewer sales.
Looser policy = more sales, but more A/R and
more bad debt writeoffs.
Averaged 7.6% over last 3 years. Plans to
maintain same credit policy, so % unchanged
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Operating items
Inventories
Higher inventory means more investment,
but lower chance of stockout. Lower
inventory may increase chance of missed
sales.
 Averaged 9% of sales. Expects to stock up
in 2004 to support projected summer
recovery, so = 11% of sales.

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Operating items
Net PPE as % of sales


Ratio decreases as firm uses up capacity, and will
be large just after building a plant and operating at
under-full capacity.
Also changes as firm alters its technology.
Van Leer must invest in another plant in
2004, so PPE increases to 34% of sales.
PPE as % of sales decreases as grows into
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)
 Was 45.6 days. Leads to A/P of 8.1% of
sales.
 Firm maintains this policy.

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Operating items
Accruals
Arise from lag in reporting payroll taxes
due, and actually paying taxes.
 Payment schedule is set by government
entities, so Firm can’t change it very much.
 Was 1%, & expected to remain at 1%.

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Projections and Free Cash
Flow
Ratios to calculate operating profit
2001 2002
2003
Avg.
Proj.
Sales growth rate na
9.2%
11.0%
12.4% 5.9%
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%
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Projections and Free Cash
Flow
Ratios to calculate operating capital
2001
2002
2003
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%
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Projections and Free Cash
Flow
Ratios to calculate operating taxes
Tax Rate
(Taxes/EBT)
2001
2002
40.0%
39.1% 40.0%
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2003
Avg.
Proj.
39.7% 39.7%
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Free Cash Flow Calculations
Van Leer
Products, Inc.
Actual Actual Actual Projected
Income Statement 2001
2002
2003
2004
Net Sales
840.0
CGS
520.0
Selling, general &
administrative
200.0
Depreciation
41.0
Operating profit
79.0
944.0 1000.0
625.0 640.0
1110.0
693.8
205.0
42.0
215.0
45.0
249.8
56.6
72.0
100.0
109.9
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Free Cash Flow Calculations
Balance sheet
Actual Actual Actual
2001
2002 2003
Cash
42.0
Inventory
75.0
Accts. receivable
65.0
Net PP&E
275.0
Accts. payable
80.0
Accrued expenses
8.0
47.0
85.0
70.0
280.0
70.0
10.0
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50.0
100.0
75.0
300.0
75.0
10.0
Proj.
2004
33.3
122.1
84.4
377.4
89.9
11.1
36
Operating Income
Tax on Operating
Income (40%)
NOPAT
Net Operating WC
Net Operating Long
Term Assets
Total Net Operating
Assets
Investment in net
operating assets
Free Cash Flow
ROIC
Actual
2001
Actual
2002
Actual
2003
Proj.
2004
79.0
72.0
100.0
109.9
31.6
47.4
94.0
28.1
43.9
122.0
40.0
60.0
140.0
43.6
66.3
138.8
275.0
280.0
300.0
377.4
369.0
402.0
440.0
516.2
na
na
na
33.0
38.0
76.2
10.4
22.0
-9.9
11.89% 14.93% 15.06%
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