1. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Estimating Investment and Corporate Cash Flows April 9, 2007 (LA) and March 29, 2007 (OCC)

2. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Assumptions for Cash Flows u Sources of Data u Computer sources of data u Financial models for valuation u How and why to use ratio analysis u Library Resources

3. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Projecting Corporate Cash Flows u Familiarity with financial analytical techniques in practice u Understand structure of PVFIRM05 and be prepared to use for Part 2 of Group Project u Download Compustat data from Wharton u Identify relevant library materials on companies, industries, and the economy u Team organized and functioning

4. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Know where data comes from

5. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Source of Compustat Data u Source documents and data entry –Annual reports –10-Ks and 10-Qs –Manual formatting and input –Cross-checking u Wharton School –wrdsx.wharton.upenn.edu –See “Data Sources” sheet on website

6. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Investment Analysis u Project cash flows –Requires sales projections and assumptions concerning operations and assets u Fundamental analysis versus technical analysis u Graham and Dodd, Warren Buffett, and Copeland et al u Used in securities analysis, investment banking, and lending

7. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Financial Models u Pro formas are a useful framework u No-one knows the future, analysts must deal with uncertainty in model assumptions u Models must be internally consistent, for example balance sheets must balance u Models focused on valuation are most concerned with cash flows u We will use PVFIRM05, an Excel spreadsheet

8. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Structure of PVFIRM05 u 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 u You have completed Sheet 1

9. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Market Value of the Firm u Value of the entire firm = entity value u Sheet 1 calculates market value of the entity = market value of D + E u Entity value is present value of all cash flows available for investors, whether in form of debt or equity u Cash flows to entire firm discounted at weighted average cost of capital

10. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Advantages of Entity Approach u Focuses on operations and not financing, avoiding problem of changing capital structure through time u Focuses on free cash flow and pinpoints impact of alternative strategies u Free cash flow is net operating profit less an allowance for taxes (NOPLAT) minus necessary investments in working capital and fixed assets u Can focus on explicit forecast period and continuing values after explicit forecast period

11. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Free Cash Flow u Free cash flow is same as Baldwin example u Net Operating Profit less Adjustment for Taxes (NOPLAT) - Net Investments u Free cash flow does not include interest expenses (or other financing costs) u Net investments are from working capital and capital expenditures u Need sales, operating costs, cash, accounts receivable, accounts payable, and inventory assumptions

12. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Financial Analysis u Required for assumptions concerning future performance u Require historical and comparable firm data but future may not be like the past u We will follow handout Financial Statement Analysis and Assumptions for Valuation u Always apply plausibility check to both ratios, assumptions, and projections u Ratio analysis of projections useful in assessing plausibility of assumptions

13. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Dupont Analysis of Performance u Dupont Analysis focuses on return on equity (pp. 53f ): u Closest to goal of management u Ratios can be calculated in different ways –Year-ending number balance sheet number or averages of two years –Before tax or after tax

14. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Abbreviations used in Ratios u Abbreviations for accounting values used: ROE = return on equity EAC = earnings available to common BVE = book value of equity EBT = earnings before tax EBIT = earnings before tax and interest SLS = sales ASSTS = total operating assets

15. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Basic Ratio Approach u ROE can be decomposed into elements: u Focus first on gross return on assets (p. 38) u ROA = “Earning Power” determined by gross profit margin and asset turnover

16. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Gross Profit Margin (p. 46) u Sales u Components of Costs –Materials –Labor –SG&A –Other u Common size income statement valuable u Need assumptions for future on these

17. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Asset Turnover (pp. 50ff) u Working Capital –Inventories –Accounts Receivable u Look at liquidity and activity ratios –Turnover, days u Current liabilities: trade and bank debt u Fixed Assets – Net vs. Gross –Turnover, average age u Need assumptions to project these

18. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Valuation in Two Parts u Forecast horizon –Approach stable patterns –Impact of major changes complete u Continuing value (CV) after forecast –Cannot be ignored –Present value of impact depends on when forecast horizon ends u PVFIRM05 uses five year forecast horizon

19. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Approaches to CV u Capitalize cash flows or earnings after explicit forecast period u Use multipliers to capitalize which are based on discount rates and growth rates u 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) u We discuss CV in detail later

20. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Team Tasks u Computer data downloading u Spreadsheet analysis u Sales projections and business analysis u Financial analysis and formulation of a range of relevant assumptions u Structuring tables, discussion, and reports for persuasive analysis u Plausibility checking and trouble shooting

21. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Part 2 of Group Project u Individual part change assumptions and note effects as in questions u Obtain and analyze data from Wharton data base u Analyze sources, trends, etc., to project sales and ratios to make operating assumptions u Project 5 years cash flows using Sheet 2 of PVFIRM05

22. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Next Week u Read Chapter 8 and do (at a minimum) the assigned problems u Prepare Part 2 of the group project and related individual parts u Relate discussion this week to viewing the acquisition of a firm as an investment of either shares, debt, or a complete corporate acquisition