Chapter9
ProspectiveAnalysis
REVIEW
Prospectiveanalysisisthefinalstepinthefinancialstatementanalysisprocess.Itincludesforecastingofthebalancesheet,incomestatementandstatementofcashflows.Prospectiveanalysisiscentraltosecurityvaluation.BoththefreecashflowandresidualincomevaluationmodelsdescribedinChapter1requireestimatesoffuturefinancialstatements.Weprovideadetailedexampleoftheforecastingprocesstoprojecttheincomestatement,thebalancesheet,andthestatementofcashflows.Wedescribetherelevanceofforecastingforsecurityvaluationandprovideanexampleutilizingforecastedfinancialstatementstoimplementtheresidualincomevaluationmodel.Wediscusstheconceptofvaluedriversandtheirreversiontolong-runequilibriumlevels.Intheappendix,weprovideadetailedexampleofshort-termcashflowforecasting.
OUTLINE
TheProjectionProcess
ProjectingFinancialStatements
ApplicationofProspectiveAnalysisintheResidualIncomeValuationModel
TrendsinValueDrivers
Short-termForecasting(Appendix)
ANALYSISOBJECTIVES
Describetheimportanceofprospectiveanalysis.
Explaintheprocessofprojectingtheincomestatement,thebalancesheetandthestatementofcashflows.
DiscussandillustratetheImportanceofSensitivityAnalysis.
Describetheimplementationoftheprojectionprocessinthevaluationofequitysecurities.
Discusstheconceptofvaluedriversandtheirreversiontolong-runequilibriumlevels.
QUESTIONS
Prospectiveanalysisiscentraltosecurityvaluation.Allvaluationmodelsrelyonforecastsofearningsorcashflowsthatare,then,discountedbacktothepresenttoarriveattheestimatedvalueofthesecurity.Prospectiveanalysisisalsousefultoexaminetheviabilityofcompanies’strategicplans,thatis,whethertheywillbeabletogeneratesufficientcashflowsfromoperationstofinanceexpectedgrowthorwhethertheywillberequiredtoseekexternalfinancing.Inaddition,prospectiveanalysisisusefultoexaminewhetherannouncingstrategieswillyieldthebenefitsexpectedbymanagement.Finally,prospectiveanalysiscanbeusedbycreditorstoassesscompanies’abilitytomeetdebtservicerequirements.
Priortotheforecastingprocess,financialstatementscanberecasttobetterportrayeconomicreality.Adjustmentsmightincludeeliminationoftransitoryitemsorreallocatingthemtopastorfutureyears,capitalizing(expensing)itemsthathavebeenexpensed(capitalized)bymanagement,capitalizingoperatingleasesandotherformsofoff-balancesheetfinancing,andsoforth.
Inadditiontotrendanalysis,analystsfrequentlyincorporateexternal(non-financial)informationintotheprospectiveprocess.Someexamplesaretheexpectedlevelofmacroeconomicactivity,thedegreetowhichthecompetitivelandscapeischanging,anystrategicinitiativesthathavebeenannouncedbymanagement,andsoforth.
Theforecasthorizonistheperiodforwhichspecificestimatesaremade.Itisusually5-7years.Forecastsbeyondtheforecasthorizonareofdubiousvaluesinceestimatesareuncertain.
Sinceallvaluationmodelsareinfinitehorizonmodels,analystsfrequentlyassumeasteadystateintoperpetuityaftertheforecasthorizon.Acommonassumptionisthatthecompanywillgrowatthelong-runrateofinflation,thatis,remainingconstantinrealterms.
Theprojectionprocessbeginswithanexpectedgrowthinsales.Grossprofitandoperatingexpensesare,then,estimatedasapercentageofforecastedsalesusinghistoricalratiosandexternalinformation.Depreciationexpenseisusuallyestimatedasapercentageofbeginninggrossdepreciableassetsundertheassumptionthatdepreciationpolicieswillremainconstant.Interestexpenseisusuallyestimatedatanaverageborrowingrateappliedtothebeginningbalanceofinterestbearingliabilities.Projectionsofexpectedinterestratesareusedforvariablerateindebtednessandnewborrowings.Finally,taxexpenseisestimatedusingtheeffectivetaxrateonpre-taxincome.
Inthefirststep,balancesheetitemsareprojectedusingforecastedincomesales(COGS)andrelevantturnoverratios.Long-termassetsareprojectedusingforecastedcapitalexpenditures.Long-termliabilitiesareprojectedfromcurrentmaturitiesoflong-termdebtdisclosedinthedebtfootnote,andpaid-in-capitalisassumedtobeconstantinthisstage.Retainedearningsareprojectedadding(subtracting)projectedprofits(losses)andsubtractingprojecteddividends.Oncetotalliabilitiesandequitiesareforecasted,totalassetsissetequaltothisamountandforecastedcashiscomputedastheplugfigure.
Inthesecondstep,long-termliabilitiesandequitiesareadjustedtoyieldthedesiredlevelofcash.Theanalystmustbecarefultomaintainthehistoricalleverageratioandadjustliabilitiesandequitiesproportionately.
Theresidualincomemodelexpressesstockpriceasthebookvalueofstockholders’equityplusthepresentvalueofexpectedresidualincome(RI).Residualincomecanbeexpressedinratioformas,
RI=(ROEt–k)BVt-1
WhereROE=NIt/BVt-1.ThisformhighlightsthefactthatstockpriceisonlyimpactedsolongasROE(k.Inequilibrium,competitiveforceswilltendtodriveratesofreturn(ROE)tocost(k)sothatabnormalprofitsarecompetedaway.Theestimationofstockprice,then,amountstotheprojectionofthereversionofROEtoitslong-runvalueforaparticularcompanyandindustry.ROEisavaluedriversinceitimpactsourvaluationofthestockprice.Itscomponents(assetturnoverandprofitmargin)arealsovaluedrivers
9.WecanmaketwoobservationsregardingthereversionofROE:
ROEstendtoreverttoalong-runequilibrium.Thisreflectstheforcesofcompetition.Furthermore,thereversionratefortheleastprofitablefirmsisgreaterthanthatforthemostprofitablefirms.Andfinally,reversionratesforthemostextremelevelsofROEaregreaterthanthoseforfirmsatmoremoderatelevelsofROE.
Thereversionisincomplete.Thatis,thereremainsadifferenceofabout12%betweenthehighestandlowestROEfirmsevenaftertenyears.Thismaybetheresultoftwofactors:differencesinriskthatarereflectedindifferencesintheircostsofcapital(k);or,greater(lesser)degreesofconservatisminaccountingpolicies.
ThereversionofROAandNPMaresimilar.WhilesomereversionofTATisevident,itismuchlessthanthatoftheothervaluedrivers.
10. Shorttermcashforecastsarekeytoassessmentsofshorttermliquidity.Anassetiscalled"liquid"becauseitwillorcanbeconvertedintocashwithinthecurrentperiod.Theanalysisofshorttermcashforecastswillrevealwhetheranentitywillbeabletorepayshorttermloansasplanned.Thisalsomeanssuchanalysisisextremelyimportantforapotentialshorttermcreditgrantor.Shorttermcashforecastsoftenarerelativelyrealisticandaccuratebecauseoftheshortnessofthetimespancovered.
Acashforecast,tobemostmeaningful,mustbeforarelativelyshorttermperiodoftime.Therearemanyunpredictablevariablesinvolvedinthepreparationofareliableforecastforahighlyliquidassetsuchascash.Overalongperiodoftime(thatis,beyondthetimespanofoneyear),thedifferenceinthedegreeofliquidityamongitemsinthecurrentassetsgroupisusuallyinsignificant.Whatismoreimportantforlongtimespansaretheprojectionsofnetincomeandothersourcesandusesoffunds.Thefocusshouldbeshiftedtoworkingcapital(andotheraccrualmeasures),andawayfromcashflows,forlongerforecasthorizonsof,say,thirtymonths—wherethetimerequiredtoconvertcurrentassetsintocashisinsignificant.
12. Cashinflowsandoutflowsarehighlyinterrelated.Thesetwoflowsarecrucialtoacompany’s“circulationsystem."Adeficiencyinanypartofthesystemcanaffecttheentiresystem.Forexample,areductionorcessationofsalesaffectsthevitalconversionoffinishedgoodsintoreceivablesorcash,whichinturnleadstoadropinthecashreservoir.Ifthesystemisnotstrengthenedby"transfusion"(suchasadditionalinvestmentbyownersorcreditors),productionmustbecurtailedordiscontinued.Lackofcashinflowsalsowillreduceotherexpensessuchasadvertising,promotion,andmarketingexpenses,whichwillfurtheradverselyaffectsales.Thiscanyieldaviciouscycleleadingtobusinessfailure.
13. Mostwouldagreewiththisassertion.Cashisthemostliquidassetandwhenmanagementurgentlyneedstopurchaseassetsorincurexpenses,acashexchangeisthequickestandeasiestmeanstoexecuteatransaction.Moreover,unlessmanagementhasacreditlineestablishedwithareliableoutsider(suchasarevolvingaccountatabank),lackofcashcanmeanapermanentlossofprofitableopportunities.
14. Ratioanalysisisastaticmeasurementtool.Ratiosmeasurerelationsamongfinancialstatementitemsasofagivenmomentandtime.Incontrast,fundsflowanalysisisadynamicmeasurecoveringaperiodoftime.Adynamicmodeloffundsflowanalysisusesthepresentonlyasastartingpointandutilizesthebestavailableestimatesoffutureplansandconditionstoforecastthefutureavailabilityanddispositionofcashorworkingcapital.Analyzingfundsflowalsoencompassestheprojectedoperationsofacompany.Sinceoneofthefundamentalassumptionsofaccountingisthegoingconcernconcept,someassertthatthedynamicmodelismorerealisticandissuperiortostaticrepresentations.However,careshouldbetakeninplacingtoomuchrelianceonfundsflowanalysisasitisprimarilybasedonestimates,andnotonrealizedobservations.
15. Exceptfortransactionsinvolvingtheraisingofmoneyfromexternalsources(suchasthroughloansoradditionalinvestments)andtheinvestmentsofmoneyinlong-termassets,almostallinternallygeneratedcashflowsrelatetoanddependonsales.Accordingly,theusualfirststepinpreparingacashforecastistoestimatesalesfortheperiodunderconsideration.Thereliabilityofanycashforecastdependsontheaccuracyofthisforecastofsales.Inarrivingatthesalesforecast,theanalystshouldconsider:(1)pasttrendsofsalesvolume,(2)marketshare,(3)industryandgeneraleconomicconditions,(4)productiveandfinancialcapacity,and(5)competitivefactors,amongothervariables.
EXERCISES
Exercise9-1(45minutes)
ProjectedIncomeStatementforYear12
QuakerOatsCompany
ForecastedIncomeStatement
ForYearEndedJune30,Year12
Revenues[given] $6,000.0
Costsandexpenses
Costofgoodssold[a] $3,186.0
Selling,general,andadministrative[b] 2,439.4
Otherexpenses[c] 35.2
Interest,net[d] 91.4
Totalcostsandexpenses 5,752.0
Incomefromcontinuingoperations 248.0
Incometaxes[e] 105.9
Incomebeforediscontinuedoperations 142.1
(Loss)ondisposalofdiscontinuedoperations[given] (2.0)
Netincome $140.1
Notes:
[a] CostofsalesisestimatedtobeatalevelrepresentingtheaveragepercentageofcostofsalestosalesasprevailedinthefouryearperiodendingJune30,Year11,whichis53.1%(19,909.2–9,331.3)/19,909.2.Therefore,6,000x.531=$3,186.
[b] Selling,general&administrativeexpensesinYear12areexpectedtoincreasebythesamepercentageastheseexpensesincreasedfromYear10toYear11,whichis15%.Therefore,$2,121.2x1.15=$2,439.4.
[c] Otherexpensesareexpectedtobe8%higherinYear12.Therefore,32.6x1.08=$35.2.
[d] Interestexpense(netofinterestcapitalized)andinterestincomewillincreaseby6%duetoincreasedfinancialneeds.Therefore,$86.2x1.06=$91.4
[e] TheeffectivetaxrateinYear12willequalthatofYear11,whichis42.7%($175.7/$411.5).Therefore,taxexpense=$248x.427=$105.9.
Exercise9-2(25minutes)
SpreadsheettoComputeForecastsofSalesandIncome
Change
InDec. ChangeinDec. Change
InMarch ChangeinMarch Change
InJune Change
InJune Change
InSept. ChangeinSept. Date Sales N.I. Sales NI Sales NI Sales NI Sales NI Dec-Y1 $17,349 $1,263 Mar-Y2 12,278 964 Jun-Y2 13,984 1,130 Sep-Y2 13,972 996 Dec-Y2 16,040 1,215 -$1,309 -$48 Mar-Y3 12,700 1,085 $422 $121 Jun-Y3 14,566 656 $582 -$474 Sep-Y3 14,669 1,206 $697 $210 Dec-Y3 17,892 1,477 1,852 262 Mar-Y4 12,621 1,219 -79 134 Jun-Y4 14,725 1,554 159 898 Sep-Y4 14,442 1,457 -227 251 Dec-Y4 17,528 1,685 -364 208 Mar-Y5 14,948 1,372 2,327 153 Jun-Y5 17,630 1,726 2,905 172 Sep-Y5 17,151 1,610 2,709 153 Dec-Y5 19,547 1,865 2,019 180 Mar-Y6 16,931 1,517 1,983 145 Jun-Y6 18,901 1,908 1,271 182 Sep-Y6 19,861 1,788 2,710 178 Dec-Y6 22,848 2,067 3,301 202 Mar-Y7 19,998 1,677 3,067 160 Jun-Y7 21,860 2,162 2,959 254 Sep-Y7 21,806 2,014 1,945 226 Dec-Y7 24,876 2,350 2,028 283 Mar-Y8 22,459 1,891 2,461 214 Jun-Y8 24,928 2,450 3,068 288 Sep-Y8 23,978 2,284 2,172 270 Dec-Y8 28,455 2,671 3,579 321 Mar-Y9 24,062 2,155 1,603 264 Jun-Y9 27,410 2,820 2,482 370 Average change
foreach
quarter
$1,586.57
$201.14
$1,683.43
$170.14
$1,918.00
$241.43
$1,667.67
$214.67 ForecastSep.Y9
25,645.67
2,498.67 ForecastDec.Y9
30,041.57
2,872.14 ForecastMar.Y0
25,745.43
2,325.14 ForecastJun.Y0
29,328.00
3,061.43
Mostrecentactualquarter+averagechangeforthequarter.
Note:ReportedquarterlysalesandnetincomeforGeneralElectricare:
Sales Netincome
SepY9 $27,200 $2,653
DecY9 32,855 3,089
MarY0 29,996 2,592Exercise9-3(40minutes)
Toillustratehowpredictionsofmarketshareandtotalmarketsalescanbeusedintheforecastingprocess,considerthefollowingexample.Ifananalyst,forinstance,predictsthat(i)Cough.comwillmaintainits0.08%shareofthemarketforchildren''scoughmedicineand(ii)totalIndustrysalesofchildren''scoughmedicineforyear2006is$3.2billion,thenareasonableestimateofCough.com''syear2006salesis$2.56million.Thisiscomputedas0.08%marketsharemultipliedbytheexpected$3.2billionofindustrysales.
Allrelevantdatashouldbesoughtout,subjecttocost-benefitconsiderations,inthepredictionofsales.Theimportanceofsalestopredictionsoffinancialperformanceandfinancialconditioncannotbeoveremphasized.Accordingly,companiesinvestconsiderableresearchandeffortinpredictingsales.Regardingwhattypesofdatatoseekandhowtoobtainthem,let’sconsideraretailer.Toprojectthesalesofaretailer,ananalystmightconsidervisitingoutletsthatselltheretailers’productsandobservecustomer-buyingpatternsversusthepatternsobservedforkeycompetingproducts.Thisactivitycanbedoneusinganecdotalobservationorusingformalstatisticalsamplingdependingupontheanalysts''perceivedneedforaccuracy.Moreover,theanalystcanseekinformationfrominsidersviaintervieworinterpretationofformalorinformaldisclosuresmadebythecompany.Theanalystcanalsoreviewcompanystrategiesandindustrytrends.Insum,goodpredictionsinvolvemorethansophisticatedmodels—theydemandthattheanalysttaketheperspectiveofacustomerconstrainedbytheeconomicenvironmentpredictedtoexist.
Relyingonpredictedyear2006totalindustrysalesof$3.2billion,thesalesofCough.comarepredictedtobeasfollows
2006Marketshareis5%greater 2006Marketshareis5%worse
[105%x.08%]x$3.2billion [95%x.08%]x$3.2billion
=$2.688million =$2.432million
d. What-Ifindustrysalesare10%higher:
[105%x.08%]x[110%x$3.2billion] [95%x.08%]x[110%x$3.2billion]
=$2.9568million =$2.6752million
What-Ifindustrysalesare10%lower:
[105%x.08%]x[90%x$3.2billion] [95%x.08%]x[90%x$3.2billion]
=$2.4192million =$2.1888million
Exercise9–4A(30minutes)
LyonCorporation
CashForecast
ForJuly,Year6
Beginningcashbalance $20
Cashcollections
Beginningaccountsreceivable $20
Salesformonth 150
170
Less:Endingaccountsreceivable 21 149
Cashavailable $169
Cashdisbursements
Beginningaccountspayable 18
Purchases(notea) 115
133
Endingaccountspayable(25%ofpurchases) 29 104
Miscellaneousoutlays 11
Cashbalance $54
Minimumcashbalancedesired 30
Excesscash $24
[a] Endinginventory $15
Costofgoodssold(5/6ofsales) 125
140
Lessbeginninginventory 25
Purchases $115
PROBLEMS
Problem9-1(90minutes)
a.
Coca-Cola INCOMESTATEMENT Year3Estimate Year2 Year1 Netsales 20,297 20,092 19,889 Costofgoods 6,106 6,044 6,204 Grossprofit 14,191 14,048 13,685 Sellinggeneral&administrativeexpense 7,972 7,893 9,221 Depreciation&amortizationexpense 863 803 773 Interestexpense -66 -308 292 Incomebeforetax 5,422 5,660 3,399 Incometaxexpense 1,620 1,691 1,222 Netincome 3,802 3,969 2,177 Outstandingshares 3,491 3,491 3,481 RATIOS Salesgrowth 1.02% 1.02% GrossProfitMargin 69.92% 69.92% SellingGeneral&AdministrativeExp/Sales 39.28% 39.28% Depreciation(depnexp/pryrPPEgross) 12.14% 12.14% INT(int/pryrLTD) -5.45% -5.45% Tax(IncTax/Pre-taxinc) 29.88% 29.88% Problem9-1—continued
BALANCESHEET Year3Estimate Year2 Year1 Cash 587 1,934 1,892 Receivables 1,901 1,882 1,757 Inventories 1,066 1,055 1,066 Other 2,300 2,300 1,905 Totalcurrentassets 5,854 7,171 6,620 Property,plant&equipment 8,305 7,105 6,614 Accumulateddepreciation 3,515 2,652 2,446 Netproperty&equipment 4,791 4,453 4,168 Otherassets 10,793 10,793 10,046 Totalassets 21,438 22,417 20,834 Accountspayable&accruedliabilities 3,717 3,679 3,905 Short-termdebt&cmltd 3,899 3,899 4,816 Incometaxes 815 851 600 Totalcurrentliab 8,431 8,429 9,321 Deferredincome,taxes&other 1,403 1,403 1,362 Longtermdebt 1,219 1,219 835 Totalliabilities 11,053 2,622 2,197 Commonstock 873 873 870 Capitalsurplus 3,520 3,520 3,196 Retainedearnings 19,674 20,655 18,543 OTHEREQUITIES 0 0 Treasurystock 13,682 13,682 13,293 Shareholderequity 10,385 11,366 9,316 Totalliabilities&networth 21,438 22,417 20,834 RATIOS ARturn 10.68 10.68 11.32 INVturn 5.73 5.73 5.82 APturn 1.64 1.64 1.59 TaxPay(Taxpay/taxexp) 50.33% 50.33% 49.10% FLEV 2.06 1.97 2.24 Div/sh $1.37 $1.37 $1.21 CAPEX 1,200 1188 1165 CAPEX/Sales 5.91% 5.91% 5.86% Problem9-1—continued
StatementofCashFlows Year3Estimate Netincome 3,802 Depreciation 863 Accountsreceivable -19 Inventories -11 Accountspayable 38 Incometaxes -36 Netcashflowfromoperations 4,636 CAPEX -1,200 Netcashflowfrominvestingactivities -1,200 Longtermdebt 0 Additionalpaidincapital 0 Dividends -4,783 Netcashflowfromfinancingactivities -4,783 _____ Netchangeincash -1,347 Beginningcash 1,934 Endingcash 587
b. BasedonourinitialprojectionofCoca-Cola’sbalancesheet,itappearsthatthecompanywillrequireapproximately$1.5billionofexternalfinancinginYear3.Thisamountwillyieldacashbalanceofapproximately$2billion,consistentwithprioryears.
Problem9-2(95minutes)
a.
BestBuy Year3Estimate Year2 Year1 Incomestatement Netsales 18,800 15,326 12,494 Costofgoods 15,048 12,267 10,101 Grossprofit 3,752 3,059 2,393 Sellinggeneral&administrativeexpense 2,761 2,251 1,728 Depreciation&amortizationexpense 304 167 103 Incomebeforetax 688 641 562 Incometaxexpense 263 245 215 Netincome 425 396 347 Outstandingshares 208 208 200 RATIOS Salesgrowth 22.67% 22.67% GrossProfitMargin 19.96% 19.96% SellingGeneral&AdministrativeExp/Sales 14.69% 14.69% DEPRECIATION(depnexp/pryrPPEgross) 15.28% 15.28% Tax(IncTax/Pre-taxinc) 38.22% 38.22% Problem9-2—continued
BALANCESHEET Year3Estimate Year2 Year1 Cash 196 746 751 Receivables 384 313 262 Inventories 2,168 1,767 1,184 Other 102 102 41 Totalcurrentassets 2,850 2,928 2,238 Property,plant&equipment 3,249 1,987 1,093 Accumulateddepreciation 847 543 395 Netproperty&equipment 2,403 1,444 698 Otherassets 466 466 59 Totalassets 5,719 4,838 2,995 Accountspayable&accruedliabilities 3,034 2,473 1,704 Short-termdebt&cmltd 114 114 16 Incometaxes 136 127 65 Totalcurrentliab 3,284 2,714 1,785 Longtermliabilities 122 122 100 Longtermdebt 67 181 15 Totallong-termliabilities 189 303 115 Commonstock 20 20 20 Capitalsurplus 576 576 247 Retainedearnings 1,650 1,225 828 OTHEREQUITIES ? ? Shareholderequity 2,246 1,821 1,095 Totalliabilities&networth 5,719 4,838 2,995 RATIOS ARturn 48.96 48.96 47.69 INVturn 6.94 6.94 8.53 APturn 4.96 4.96 5.93 TaxPay(Taxpay/taxexp) 51.84% 51.84% 30.23% FLEV 2.55 2.66 2.74 Div/sh $0.00 $0.00 $0.00 CAPEX 1,262 1029 416 CAPEX/Sales 6.71% 6.71% 3.33% Problem9-2—continued
StatementofCashFlows Year3Estimate Netincome 425 Depreciation 304 Accountsreceivable -71 Inventories -401 Accountspayable 561 Incometaxes 9 Netcashflowfromoperations 827 CAPEX -1,262 Netcashflowfrominvestingactivities -1,262 Longtermdebt -114 Additionalpaidincapital 0 Dividends 0 Netcashflowfromfinancingactivities -114 ____ Netchangeincash -550 Beginningcash 746 Endingcash 196
b. Basedonourprojection,itappearsthatBestBuywillrequireabout$550Millionofexternalfinancingtoyieldacashbalanceofapproximately$750million.AnalystsmustallocatethisexternalfinancingbetweendebtandequitysoastopreservethefinancialleveragelevelpresentlyusedbyBestBuy.
Problem9-3(90minutes)
a.
Merck INCOMESTATEMENT Year3Estimate Year2 Year1 Netsales 56,435 47,716 40,343 Costofgoods 34,272 28,977 22,444 Grossprofit 22,164 18,739 17,900 Sellinggeneral&administrativeexpense 7,725 6,531 6,469 Depreciation&amortizationexpense 1,661 1,464 1,277 Interestexpense 237 342 329 Incomebeforetax 12,541 10,403 9,824 Incometaxexpense 3,762 3,121 3,002 Netincome 8,779 7,282 6,822 Outstandingshares 2,976 2,976 2,968 RATIOS Salesgrowth 18.27% 18.27% GrossProfitMargin 39.27% 39.27% SellingGeneral&AdministrativeExp/Sales 13.69% 13.69% DEPRECIATION(depnexp/pryrPPEgross) 8.76% 8.76% INT(int/pryrLTD) 4.94% 4.94% Tax(IncTax/Pre-taxinc) 30.00% 30.00% Problem9-3—continued
BALANCESHEET Year3Estimate Year2 Year1 Cash 5,254 3,287 4,255 Receivables 6,168 5,215 5,262 Inventories 4,233 3,579 3,022 Other 880 880 1,059 Totalcurrentassets 16,536 12,961 13,598 Property,plant&equipment 24,056 18,956 16,707 Accumulateddepreciation 7,514 5,853 5,225 Netproperty&equipment 16,543 13,103 11,482 Otherassets 17,942 17,942 15,075 Totalassets 51,020 44,007 40,155 Accountspayable&accruedliabilities 6,983 5,904 5,391 Short-termdebt&cmltd 4,067 4,067 3,319 Incometaxes 1,897 1,573 1,244 Totalcurrentliab 12,947 11,544 9,954 Deferredincome,taxesandother 11,614 11,614 11,768 Longtermdebt 4,787 4,799 3,601 Totalliabilities 29,347 27,957 25,323 Commonstock 30 30 30 Capitalsurplus 6,907 6,907 6,266 Retainedearnings 37,123 31,500 27,395 OTHEREQUITIES 0 0 Treasurystock 22,387 22,387 18,858 Shareholderequity 21,673 16,050 14,832 Totalliabilities&networth 51,020 44,007 40,155 RATIOS ARturn 9.15 9.15 7.67 INVturn 8.10 8.10 7.43 APturn 4.91 4.91 4.16 TaxPay(Taxpay/taxexp) 50.41% 50.41% 41.45% FLEV 2.35 2.74 2.71 Div/sh $1.06 $1.06 $0.98 CAPEX 5,100 4312 3641 CAPEX/Sales 9.04% 9.04% 9.03% Problem9-3—continued
StatementofCashFlows Year3Estimate Netincome $8,779 Depreciation 1,661 Accountsreceivable -953 Inventories -654 Accountspayable 1,079 Incometaxes 323 Netcashflowfromoperations 10,235 CAPEX -5,100 Netcashflowfrominvestingactivities -5,100 Longtermdebt -12 Additionalpaidincapital 0 Dividends -3,156 Netcashflowfromfinancingactivities -3,168 _____ Netchangeincash 1,967 Beginningcash 3,287 Endingcash 5,254
b. Basedonourinitialprojections,itappearsthatMerckwillhaveexcesscashofapproximately$2billioninyear3.Thisexcesscashshouldbeusedtoreducebothdebtandequitysoastomaintainhistoricalfinancialleverage.
Problem9-4(90minutes)
Historicalfigures ForecastHorizon ? TerminalYear Year2 Year3 Year4 Year5 Year6 Year7 20x8 20x8 Salesgrowth 8.50% 10.65% 10.65% 10.65% 10.65% 10.65% 10.65% 3.50% NetprofitMargin(Netincome/Sales) 6.71% 8.22% 8.22% 8.22% 8.22% 8.22% 8.22% 8.22% NWCturn(Sales/avgNWC) 8.98 9.33 9.33 9.33 9.33 9.33 9.33 9.33 FAturn(Sales/avgFA) 1.67 1.64 1.64 1.64 1.64 1.64 1.64 1.64 Totaloperatingassets/Totalequity 1.96 2.01 2.01 2.01 2.01 2.01 2.01 2.01 Costofequity ? 12.5% ? ? ? ? ? ? ($Thousands) ? ? ? ? Sales 25,423 28,131 31,127 34,443 38,112 42,171 46,663 48,297 Netincome($Mil) 1,706 2,312 2,558 2,831 3,132 3,466 3,835 3,969 Networkingcapital 2,832 3,015 3,336 3,692 4,085 4,520 5,001 5,176 Fixedassets 15,232 17,136 18,961 20,981 23,216 25,689 28,425 29,420 TotalOperatingassets 18,064 20,151 22,297 24,673 27,301 30,209 33,426 34,596 L-TLiabilities 8,832 10,132 11,211 12,405 13,727 15,189 16,807 17,395 TotalStockholder''sEquity($Mil) 9,232 10,019 11,086 12,267 13,574 15,020 16,619 17,201 ? ? ResidualIncomeComputation ? ? ? NetIncome ? 2,558 2,831 3,132 3,466 3,835 3,969 BeginningEquity ? 10,019 11,086 12,267 13,574 15,020 16,619 RequiredEquityReturn ? 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% ExpectedEarnings ? 1,252 1,386 1,533 1,697 1,877 2,077 ResidualIncome ? 1,306 1,445 1,599 1,769 1,958 1,892 Discountfactor 0.89 0.79 0.70 0.62 0.55 ? ? ? ? Presentvalueofresidualincome ? 1,161 1,142 1,123 1,105 1,086 ? CumPVresidualincome ? 1,161 2,303 3,425 4,530 5,616 ? Terminalvalueofabnormalearnings ? 11,665 ? Begbookvalueofequity ? 10,019 ? Valueofequity-AbnormalEarnings ? 27,301 ? Commonsharesoutstanding(mil) ? 1,737 ? pershare ? $15.72 ?
Problem9-5(90minutes)
a.
TelnetCorporation
ProFormaIncomeStatement($000s)
SixMonthsEndedJune30,Year2
Salesrevenue($250x6mos.) $1,500
Costofgoodssold(note[a]) 1,199
Grossmargin 301
Sellingandadministrativeexpenses($47.5x6mos.) 285
Expectedpre-taxincome 16
Estimatedincometaxes(at50%) 8
Expectednetincome $8
Note[a]:WeuseT-accountstocomputecostofgoodssold($thousands)
RawMaterialInventory
Beginning(given) 0
Materialpurchases($125x6mos.) 750
715 ToW.I.P.inventory[a](plug)
Ending(given) 35
WorkinProcessInventory
Beginning(given) 0
Fromrawmaterialsinventory[a] 715
Labor($30.5x6mos.) 183
Variableoverhead($22.5x6mos.) 135
Rent($10x6mos.) 60
Depreciation($35x6mos.) 210
Patentamortization($.5x6mos.) 3
7 Prepaidexpenses(given)
1,299 ToF.G.inventory[b](plug)
Ending(given) 0
FinishedGoodsInventory
Beginning(given) 0
FromW.I.P.inventory[b] 1,299
1,199 Costofgoodssold(plug)
Ending(given) 100
Problem9-5—continued
b.
TelnetCorporation
ProformaBalanceSheet($000s)
June30,Year2
Assets
Cash $40 (minimumcash)
Accountsreceivable 375 (45days''sales)
Inventories($35+$100) 135 (given)
Prepaidexpenses 7 (given)
Totalcurrentassets 557 (subtotal)
Equipment 1,200 (given)
Lessaccumulateddepreciation 210 ($35x6mos.)
Equipment,net 990 (subtotal)
Patents 40 (given)
Lessamortization 3 ($500x6mos.)
Patents,net 37 (subtotal)
TotalAssets $1,584
LiabilitiesandStockholders’Equity
Accountspayable $125 (30days''purchases)
Accruedtaxes 8 (fromInc.Stmt.)
Stockholders''equity 1,300 (given)
Retainedearnings 8 (fromInc.Stmt.)
Additionalfundsneeded 143 "plug"
Totalliabilitiesandequity $1,584
($250,000x6)/180days=$8,333perdayx45days=$375,000
($125,000x6)/180days=$4,166perdayx30days=$125,000
Problem9-5—continued
c.
TelnetCorporation
ForecastedStatementofCashFlows
ForSixMonthsEndedJune30,Year2
Cashbalance,beginning $60,000
Addcollectionofaccountsreceivable 1,125,000 $1,185,000
Lessdisbursementsfor
Materialpurchases 625,000
Labor 183,000
Rent 60,000
Overhead 135,000
Sellingexpense 285,000 (1,288,000)
Tentativecashbalance $(103,000)
Minimumcashbalancerequired 40,000
Additionalborrowingrequired $143,000
Endingcashbalance $40,000
Loanbalance $143,000
Collectionofaccountsreceivable Jan. Feb. Mar. Apr. May June
Sales 250 250 250 250 250 250
Collections 0 125 250 250 250 250
AccumulatedCollections 0 125 375 625 875 1,125
Paymentofaccountspayable Jan. Feb. Mar. Apr. May June
Purchases 125 125 125 125 125 125
Payments 0 125 125 125 125 125 AccumulatedPayments 0 125 250 375 500 625
Problem9-6(95minutes)
QuakerOats
ForecastedStatementofCashFlows
ForYearEndedJune30,Year12
Cashprovidedby(usedfor)operations
Netincome(a) $238.8
Itemsinincomenotaffectingcash
Depreciation&amortization(b) 196.6
Deferredincometaxes(c) 54.7
Provisionforrestructuringcharges(given) 0.0
Increaseinreceivables(d) (8.9)
Increaseininventories(e) (45.2)
Increaseinothercurrentassets(f) (25.6)
Increaseinaccountspayable(g) 42.1
Increaseinothercurrentliabilities(h) 24.5
Cashprovidedbyoperatingactivities $477.0
Cashprovidedby(usedfor)investmentactivities
Capitalexpenditures,PP&E(given) $(300.0)
Assetretirements(given) 20.0
Otherchanges(given) (30.0)
Cashusedforinvestingactivities $(310.0)
Cashprovidedby(usedfor)financingactivities
RepaymentsofLTdebt(given) $(45.0)
NetdecreaseinSTdebt(given) (40.0)
Cashdividendpaid(given) (135.0)
AdditionstoLTdebt—plug(i) 55.8
Cashprovidedbyfinancingactivities $(164.2)
Netincreaseincash(j) $2.8
Cash,beginningbalance 30.2
Cash,balanceatendofyear $33.0
Notes:
(a) Averagepercentofincomefromcontinuingoperationstosales,Years9-11
($235.8+$228.9+$148.9)/($5,491.2+$5,030.6+$4,879.4)=3.98%
NetincomeinYear12=$6,000x.0398=$238.8
Problem9-6–continued
(b) DepreciationandamortizationinYear12=$238.8x.8233=$196.6
(c) Averagepercentofdeferredincometaxes(noncurrent)andotheritemstoincomefromcontinuingoperations,Years9-11:$140.4/$613.6=22.9%
NoncurrentdeferredincometaxinYear12=$238.8x.229=$54.7
(d) Endingaccountsreceivable=$6,000x(42/360)=$700.0
ForYear12: Accountsreceivable,beg $691.1
Accountsreceivable,end 700.0
Increase $8.9
(e) Year12costofsales=$6,000x.51=$3,060
Endinginventory=$3,060x(55/360)=$467.5
ForYear12: Inventory,beg $422.3
Inventory,end 467.5
Increase $45.2
(f) ($13.7+$14.1+$48.9)/3=$25.6
(g) Year12purchases=$2,807.2x1.12=$3,144.1
Accountspayable,end=$3,144.1x(45/360)=$393.0
ForYear12: Accountspayable,beg $350.9
Accountspayable,end 393.0
Increase $42.1
(h) ($43.2+$83.4-$53.1)/3=$24.5
(i) Amountrequiredtobalancestatement.
(j) PercentofcashtorevenuesinYear11=$30.2/$5,491.2=0.55%
Year-endcashinYear12=$6,000x0.55%=$33
IncreaseincashforYear12=$33-$30.2=$2.8
CASES
Case9-1(60minutes)
Kodak INCOMESTATEMENT 20x7Est 20x6 20x5 Netsales 12,515 13,234 13,994 Costofgoods 8,199 8,670 8,375 Grossprofit 4,316 4,564 5,619 Sellinggeneral&administrativeexpense(exceptdepreciation) 1,761 1,862 1,776 Depreciationexpense 766 765 738 Research&developmentcosts 737 779 784 Goodwillamortization 0 154 151 Restructuringcosts(credits) 0 659 -44 Earningsfromoperations 1,052 345 2,214 Interestexpense 208 219 178 Otherexpense(income) 18 18 -96 Incomebeforetax 827 108 2,132 Incometaxexpense 245 32 725 Netincome 582 76 1,407 Outstandingshares 290 290 290 RATIOS Salesgrowth -5.43% -5.43% GrossProfitMargin 34.49% 34.49% SellingGeneral&AdministrativeExp/Sales 14.07% 14.07% DEPRECIATION(depnexp/pryrPPEgross) 5.90% 5.90% R&D/sales 5.89% 5.89% INT(int/pryrSTDandLTD) 6.49% 6.49% Tax(IncTax/Pre-taxinc) 29.63% 29.63% Case9-1–continued
BALANCESHEET 20x7Est 20x6 20x5 Cash $17 $448 $246 Receivables 2,210 2,337 2,653 Inventories 1,075 1,137 1,718 Other 761 761 874 Totalcurrentassets 4,064 4,683 5,491 Property,plant&equipment 13,972 12,982 12,963 (NOTE4) Accumulateddepreciation 8,089 7,323 7,044 Netproperty&equipment 5,883 5,659 5,919 Otherassets 3,020 3,020 2,802 Totalassets $12,967 $13,362 $14,212 Accountspayable&accruedliabilities 3,098 3,276 3,403 Short-termdebt 1,378 1,378 2,058 Currentmaturitiesofl-tdebt 13 156 148 (NOTE8) Incometaxes 544 544 606 Totalcurrentliab 5,033 5,354 6,215 Longtermdebt 1,653 1,666 1,166 Postemploymentliabilities 2,728 2,728 2,722 Otherlong-termliabilities 720 720 681 Totalliabilities 10,134 10,468 10,784 Commonstock 978 978 978 Capitalsurplus 849 849 871 Retainedearnings 6,773 6,834 7,387 OTHEREQUITIES 0 0 Treasurystock 5,767 5,767 5,808 Shareholderequity 2,833 2,894 3,428 Totalliabilities&networth 12,967 13,362 14,212 RATIOS ARturn 5.66 5.66 5.27 INVturn 7.63 7.63 4.87 APturn 2.65 2.65 2.46 FLEV 4.58 4.62 4.15 Div/sh $2.22 $2.22 $1.88 CAPEX 990 1047 783 CAPEX/Sales 7.91% 7.91% 5.60% Case9-1–continued
StatementofCashFlows 20x7Estim. Netincome $582 Depreciation 766 Accountsreceivable 127 Inventories 62 Accountspayable (178) Netcashflowfromoperations 1,359 CAPEX (990) Netcashflowfrominvestingactivities (990) Longtermdebt (156) Dividends (643) Netcashflowfromfinancingactivities (799) _____ Netchangeincash (431) Beginningcash 448 Endingcash $17
Case9-2(120minutes)
MillerCompany
CashForecast
ForYearsEndedDecember31,Years2through4
Year2 Year3 Year4
Cashbalanceatbeginningofperiod $0 $1,929,000 $254,500
Cashreceivedfromstockholders 100,000 0 0
Proceedsofloan(see[a]) 1,700,000 100,000 0
Cashreceiptslesscashpayments(see[b]) 129,000 125,500 146,500
Paymentsforconstruction 0 (1,700,000) (100,000)
Paymentsonloan(see[a]) 0 (200,000) (200,000)
Cashbalanceatendofperiod $1,929,000 $254,500 $101,000
SupportingSchedulesfortheCashForecast
[a]Scheduleofinterestandcommitmentfees
Amountof Interest
Loan orFee
Year2:
Tobeborrowed1/1 $800,000
Tobeborrowed4/1 500,000
Commitmentfeedue4/1($1,000,000x1%x1/4) $2,500
Tobeborrowed7/1 300,000
Commitmentfeedue7/1($500,000x1%x1/4) 1,250
Tobeborrowed12/31 100,000
Commitmentfeedue12/31($200,000x1%x1/2) 1,000
Interestdueonloan:
On$800,000@5% 40,000
On$500,000@5%x3/4 18,750
On$300,000@5%x1/2 7,500
Totalat12/31/Year2 $1,700,000 $71,000
Year3:
Tobeborrowed4/1 100,000
Commitmentfeedue4/1($100,000x1%x1/4) 250
Repaymentofloan:
Due6/30 (100,000)
Due12/31 (100,000)
Interestdueonloan:
On$1,700,000@5%x1/4 21,250
On$1,800,000@5%x1/4 22,500
On$1,700,000@5%x1/2 42,500
Totalat12/31/Year3 $1,600,000 $86,500
Year4:
Repaymentofloan:
Due6/30 (100,000)
Due12/31 (100,000)
Interestdueonloan:
On$1,600,000@5%x1/2 40,000
On$1,500,000@5%x1/2 37,500
Totalat12/31/Year4 $1,400,000 $77,500
Case9-2–continued
[b]ScheduleofOperatingResults
Year2 Year3 Year4
Resultsofoperations
Operatingprofit(at$.04pertonhandled) $200,000 $212,000 $224,000
Interestandcommitmentfees(above) 71,000 86,500 77,500
Cashderivedfromoperations 129,000 125,500 146,500
Depreciation(at$.03pertonhandled) 150,000 159,000 168,000
Operatingloss $21,000 33,500 21,500
Operatinglossfromprioryear(s) 21,000 54,500
Accumulatedoperatingloss $54,500 $76,000
InterpretationandEvaluation
Asrevealedinnote[b],reportingonthe"resultsofoperations,"MillerCompanyisexpectedtorecordoperatinglossesforeachofthenextthreeyearsunderanalysis.Nevertheless,theanalysisalsorevealsthatMillerisexpectedtogeneratesufficientcashflowtocoverthevariouscashcommitments.
Case9-3(100minutes)
RoyalCompany
CashForecast
ForYearsEndingMarch31,Years6and7
Year6 Year7
Beginningbalanceofcash $0 $75,000
Cashreceiptfromcustomers(seeScheduleA) 825,000 1,065,000
Cashdisbursements
Directmaterials(seeScheduleB) 220,000 245,000
Directlabor 300,000 360,000
Variableoverhead 100,000 120,000
Fixedcosts 130,000 130,000
Totalcashdisbursements 750,000 855,000
Operatingcashreceiptslessdisbursements 75,000 210,000
Cashfromsaleofreceivablesandinventories 90,000 0
Totalcashavailable $165,000 $285,000
Paymentstogeneralcreditors 90,000 270,000 2
Endingbalanceofcash $75,000 1 $15,000
1 Thisamountcouldhavebeenusedtopaygeneralcreditorsorcarriedforwardtothebeginningofthenextyear.
2 Computedas:($600,000x60%)-($50,000+$40,000).
ScheduleA
CashReceiptsfromCustomers
Year6 Year7
Sales $900,000 $1,080,000
Beginningaccountsreceivable 0 75,000
Total 900,000 1,155,000
Less:Endingaccountsreceivable 75,000 90,000
Cashreceiptsfromcustomers $825,000 $1,065,000
ScheduleB
CashDisbursementsforDirectMaterials
Year6 Year7
Directmaterialsrequiredforproduction $200,000 $240,000
Requiredendinginventory 40,000 3 50,000 4
Total 240,000 290,000
Less:Beginninginventory 0 40,000
Purchases 240,000 250,000
Beginningaccountspayable 0 20,000
Total 240,000 270,000
Less:Endingaccountspayable 20,000 25,000
Disbursementsfordirectmaterials $220,000 $245,000
3 Computedas:12,000unitsx2/12=2,000;2,000x$20perunit=$40,000.
4 Computedas:15,000unitsx2/12=2,500;2,500x$20perunit=$50,000.
Case9-4(115minutes)
a.
(1)
EstimatedTotalCashReceipts
Sep. Oct. Nov. Dec.
Totalsales $40,000 $48,000 $60,000 $80,000
Creditsales(25%) 10,000 12,000 15,000 20,000
Cashsales $30,000 36,000 $45,000 $60,000
Receiptsofpastmonth''screditsales 10,000 12,000 15,000
Totalcashreceipts $46,000 $57,000 $75,000
(2)
EstimatedCashDisbursementsforPurchases
Oct. Nov. Dec. Total
TotalSales $48,000 $60,000 $80,000 —
Purchases(70%nextmo.sales) $42,000 $56,000 $25,200 $123,200
Less:2%purchasediscount 840 1,120 504 2,464
Cashdisbursements $41,160 $54,880 $24,696 $120,736
(3)
EstimatedCashDisbursementsforOperatingExpenses
Oct. Nov. Dec. Total
Sales $48,000 $60,000 $80,000 —
SalariesandWages(15%) $7,200 $9,000 $12,000 $28,200
Rent(5%) 2,400 3,000 4,000 9,400
OtherExpenses(4%) 1,920 2,400 3,200 7,520
Cashdisbursements $11,520 $14,400 $19,200 $45,120
(4)
EstimatedTotalCashDisbursements
Oct. Nov. Dec. Total
Purchases[part(2)] $41,160 $54,880 $24,696 $120,736
Operatingexpenses[part(3)] 11,520 14,400 19,200 45,120
Plantandequipment(given) 600 400 1,000
Totalcashdisbursements $53,280 $69,680 $43,896 $166,856
(5)
EstimatedNetCashReceiptsandDisbursements
Oct. Nov. Dec. Total
Totalcashreceipts $46,000 $57,000 $75,000 $178,000
Totalcashdisbursements 53,280 69,680 43,896 166,856
Netcashincrease $31,104 $11,144
Netcashdecrease $7,280 $12,680
Case9-4—continued
(6)
EstimatedFinancingRequired
Oct. Nov. Dec. Total
Beginningcashbalance $12,000 $8,720 $8,040 $12,000
Netcashincrease 31,104 11,144
Netcashdecrease 7,280 12,680
Cashpositionbeforefinancing $4,720 $(3,960) $39,144 $23,144
Financingrequired 4,000 12,000 16,000
Interestexpense1 (180) (180)
Financingretired (16,000) (16,000)
Endingcashbalance $8,720 $8,040 $22,964 $22,964
1Computedas:($4,000x.06x3/12)+($12,000x.06x2/12).
b. (1)
UnionCorporation
ForecastedIncomeStatement
FortheQuarterEndedDecember31,Year6
Sales[see(1)inparta] $188,000
Deduct
Costofgoodssold(70%ofsales) $131,600
Less:Purchasediscountstaken[see(2)inparta] 2,464 129,136
Grossprofit 58,864
Sellingandadministrativeexpenses
Salariesandwages[see(3)inparta] 28,200
Rent[see(3)inparta] 9,400
Otherexpenses[see(3)inparta] 7,520
Depreciation($750x3months) 2,250
Totalsellingandadministrativeexpenses 47,370
Operatingincome 11,494
Interestexpense 180
Netincome $11,314
Case9-4—continued
(2)
UnionCorporation
ForecastedBalanceSheet
AsofDecember31,Year6
Assets
CurrentAssets
Cash[see(6)inparta] $22,964
Accountsreceivable(25%ofDec.sales) 20,000
Inventory[($30,000+70%of$36,000)x98%] 54,096
Totalcurrentassets $97,060
Plantandequipment 101,000
Less:Accumulateddepreciation 2,250 98,750
Totalassets $195,810
LiabilitiesandEquity
Liabilities $0
Stockholders''equity 195,810
Totalliabilitiesandequity $195,810
Chapter09-ProspectiveAnalysis
9-10
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