New Lecture 9 Spr 09

Spring 2009

NBA 5060

Lectures 9 – Pro Forma Financial Statements & Forecasting II

1. Pro forma financial statements 2. Some Coaching Tips 3. A structured forecasting approach • Step 1: Forecasting Sales • Step 2: Forecasting the rest of the income statement • Step 3: Forecasting the balance sheet • Step 4: Computing the statement of cash flows and free cash flows to equity • Step 5: Terminal year assumptions • Step 6: Economic reality checks and an iterative process

For next class: Read SBW, chapters 11, 12, and 13 Lecture 9

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Step 2. Forecast the rest of the income statement 2007 2351.6

2008 2384.5 Total Revenues

-744.3 -892.8 -138.7 -411.9 0.0 -59.4 7.8 112.2

-773.8 -909.5 -128.7 -422.3 0.0 -57.4 0.2 93.0

-39.0 0.0 73.2

-28.0 0.0 64.9

Forecast as:

Also Consider:

Expenses Cost of Goods Sold Labor and Other Related Expenses General and Administrative Expenses Other Store Operating Expenses Impairment and Store Closing Charges Interest Expense Interest Income Earnings before Taxes Taxes and Other Expenses Provision for Income Tax Earnings of Discontinued Operations Net Income (Loss)

Additional considerations: Cost of Goods Sold:

SGA:

Other operating expenses:

Lecture 9

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Step 3. Forecasting the Balance Sheet Balance Sheet Current Assets Cash and Cash Equivalents Accounts Receivables Incomes Taxes Receivable Inventories Deferred Income Taxes Prepaid Expenses Prepaid Expenses Property Held for Sale Current Assets of Disc. Ops Total Current Assets Non Current Assets PPE, net Goodwill Other Assets Total Assets Current Liabilities Accounts Payable Accrued Employee Benefits Taxes W ithheld and Accrued Other Accrued Expenses Accrued Employees Comp. Accrued Interest Expense Current Maturities of L TD Income Taxes Payable Deferred Revenue Current Liabilities of Disc. Ops Total Current Liabilities Non Current Liabilities Long-term Debt Deferred Income Taxes Interest Rate Swap Liability Other Long-term Obligations Shareholders' Equity Total Liabilities & Equity

2007

2008

14.2 11.8 0.0 144.4 12.6 0.0 12.6 4.7 0.0 200.3

Assumptions

2009

2010

12.0 13.5 6.9 156.0 18.1 0.0 11.0 3.2 0.0 220.6

23.6 14.2 7.1 159.2 18.9 0.0 11.8 0.0 0.0 234.7

47.7 14.3 7.2 164.7 19.1 0.0 11.9 0.0 0.0 264.9

1019.0 0.0 45.8 1265.0

1045.2 0.0 47.8 1313.7

1058.6 0.0 47.2 1340.5

1077.7 0.0 47.7 1390.4

93.1 34.9 32.2 18.3 48.6 0.2 8.2 18.1 21.2 0.0 274.7

93.1 34.2 29.5 17.9 46.2 12.5 8.7 0.0 22.6 0.0 264.7

94.4 42.5 30.7 16.5 47.2 11.8 8.7 0.0 23.6 0.0 275.3

83.5 38.2 31.0 16.7 47.7 11.9 8.7 0.0 23.9 0.0 261.7

756.3 62.4 13.7 53.8 104.1 1265.0

779.1 54.3 39.6 83.2 92.8 1313.7

768.8 59.0 38.3 82.6 116.6 1340.5

754.4 59.7 37.7 83.5 193.3 1390.4

General Procedure: 1. 2. 3. 4.

Forecast operating assets and liabilities (e.g., as turnovers) Forecast intangible assets (amortize applicable amount) Forecast non-operating assets and liabilities Forecast long-term debt (e.g. as a percentage of projected total assets) 5. Plug the shareholders equity to insure the statements balance Lecture 9

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Steps in Forecasting a Balance Sheet 1. Forecasting operating assets and liabilities • Working capital accounts (and usually PPE) are expected to grow with the level of sales. Hence, forecast future turnover levels for these accounts using historical turnover ratios as a guide. Are recent turnover ratios likely to change? 2. Forecasting Intangible Assets • These do not necessarily grow with sales. Thus, we often just take the balance of intangibles and depreciate at the current rate. • This might vary depending on the company specifics. 3. Forecasting Other non-operating assets and liabilities • Often these are not predictable and, hence, the best future prediction is to leave these at the current level, or as a constant percentage of sales. 4. Forecasting Long-term liabilities • The projected amount of LTD will depend on the ‘optimal’ capital structure for the firm. A useful starting point is the current capital structure. Consider a long-term capital structure that matches industry averages. 5. Forecasting Shareholders Equity • Equity will increase with net income and decrease with net payments to equity holders (dividends and repurchases). For simplicity, collapse equity into a single line-item. Alternatively, you can plug debt.

Lecture 9

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Step 4. Compute the statement of cash flows and derive Free Cash Flow to Equity Given a beginning balance sheet, an ending balance sheet, and an income statement for the period, we can compute the statement of cash flows. See the supplemental notes for lecture 6 and chapter 3 from the text for information on how to do this. Once the statement of cash flows is computed, we can calculate free cash flow to equity. Free cash flow to equity is the cash flow available to shareholders without hampering the firm’s operations and after servicing the debt. Three common ways to define FCFE: 1. FCFE = Net income – Increase in Common Equity

2. FCFE = Cash dividends + Net repurchases

3. FCFE = CFO – CFI – Net debt payments – Increase in cash + Other financing cash flows

All three approaches will give you the same estimate of FCFE as long as equity is the plug.

Lecture 9

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Step 4. Computing the SCF and FCFE (continued) All items required for free cash flow are derived directly from the forecast of the income statement and balance sheet. Simply derive the statement of cash flows using techniques outlined in lecture 6 and in the text.

Statement of Cash Flows

2009

Operating Activities Net Income Depreciation and Amortization Change in working capital accounts Operating Cash Flows

48.7 61.0 12.7 122.4

Investing Activities Capital Expenditures Goodwill Investing Cash Flows

-74.3 0.0 -74.3

Financing Activities Current Maturities of Long-term Debt Long-term Debt Interest Rate Swap Liability Dividends Repurchases of Common Stock Financing Cash Flows

0.0 -10.3 -1.3 -12.2 -12.7 -36.4

Change in Cash Beginning Cash on Balance Sheet Ending Cash per SCF Ending Cash per Balance Sheet Unreconciled Difference

Lecture 9

11.6 12.0 23.6 23.6 0.0

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Step 5. Computing Terminal Year You should include one year past the forecasting horizon for your terminal year. In the CBRL example, we forecast for 10 years (20092018), and use 2019as the terminal year. This step is critical to keep all relations constant with the immediately preceding year (i.e. assume the firm has reached steady state). This will ensure your valuations converge under the residual income and discounted cash flow models. Sales growth can be projected at the growth in GDP. We will come back to this in the lectures on valuation.

Lecture 9

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Step 6. Check for economic consistency After you have ensured the mathematical consistency of your forecast (via balancing the balance sheet and reconciling the balance sheet with the statement of cash flows), you should check for economic consistency. Check to see that near the end of the forecasting horizon, the ROA, ROE, asset turnovers, and profit margins appear attainable and plausible. In particular, ROE at the end of the forecast horizon should be close to the cost of equity capital.

Lecture 9

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Step 6. Check for economic consistency (cont’d) Also, RONA at the end of the forecast horizon should be close to weighted average cost of capital.

Why should ROE be close to the cost of equity capital? Why should RONA be close to the weighted average cost of capital?

Lecture 9

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Reasonableness checks for CBRL Profitability Analysis ROA Decomposition ROE CSL CEL ROA PM ATO

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

13.5% 1.66 0.95 8.5% 4.9% 1.72

12.1% 1.70 0.95 7.5% 5.1% 1.48

16.9% 2.74 0.87 7.1% 5.1% 1.38

36.0% 7.25 0.65 7.6% 4.8% 1.60

65.9% 13.10 0.62 8.1% 4.4% 1.85

46.5% 12.68 0.56 6.6% 3.7% 1.78

32.5% 8.81 0.59 6.3% 3.6% 1.75

25.5% 6.22 0.63 6.5% 3.7% 1.76

22.0% 4.99 0.66 6.7% 3.8% 1.76

19.7% 4.27 0.68 6.8% 3.9% 1.75

18.4% 3.77 0.71 6.9% 3.9% 1.76

17.4% 3.40 0.73 7.0% 3.9% 1.78

16.6% 3.10 0.76 7.1% 3.9% 1.80

15.9% 2.85 0.78 7.2% 3.9% 1.82

15.4% 2.63 0.80 7.3% 4.0% 1.84

RONA Decomposition ROE Debt/Equity Spread Eff. Interest Rate RONA

13.5% 0.22 8.6% 2.9% 11.5%

12.1% 0.23 7.6% 2.8% 10.4%

16.9% 0.97 7.2% 2.7% 9.9%

36.0% 4.14 6.1% 4.6% 10.7%

65.9% 7.88 6.8% 5.2% 12.0%

46.5% 7.48 4.9% 5.0% 9.9%

32.5% 4.97 4.7% 4.6% 9.2%

25.5% 3.31 4.9% 4.6% 9.4%

22.0% 2.51 5.0% 4.6% 9.5%

19.7% 2.01 5.0% 4.6% 9.6%

18.4% 1.66 5.2% 4.6% 9.7%

17.4% 1.39 5.4% 4.6% 9.9%

16.6% 1.17 5.6% 4.6% 10.1%

15.9% 0.99 5.7% 4.6% 10.3%

15.4% 0.83 5.9% 4.6% 10.5%

Turnover Decomposition FATO ITO

2.21 17.14

1.88 15.39

2.02 16.37

2.35 17.25

2.31 15.88

2.24 14.97

2.23 14.74

2.28 14.82

2.30 14.82

2.33 14.76

2.37 14.71

2.41 14.66

2.45 14.61

2.49 14.57

2.54 14.57

Common Size Income Statement

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018 Terminal

100.0% 100.0% -32.7% -31.8% -37.5% -37.5% -5.2% -5.8% -16.9% -17.3% 0.0% 0.0% 0.0% 0.0% 7.3% 6.6% -2.5% -2.1% 0.0% 0.0% 5.1% 5.1%

100.0% -31.7% -38.0% -5.9% -17.5% 0.0% 0.3% 4.8% -1.7% 0.0% 4.8%

100.0% -32.4% -38.1% -5.4% -17.7% 0.0% 0.0% 3.9% -1.2% 0.0% 4.4%

100.0% 100.0% -33.0% -32.9% -38.0% -38.0% -5.4% -5.4% -18.4% -18.2% 0.0% 0.0% 0.0% 0.0% 2.9% 3.2% -0.8% -1.1% 0.0% 0.0% 3.7% 3.6%

100.0% -32.9% -38.1% -5.3% -18.1% 0.0% 0.0% 3.6% -1.3% 0.0% 3.7%

100.0% -32.8% -38.1% -5.3% -18.0% 0.0% 0.0% 3.8% -1.3% 0.0% 3.8%

100.0% 100.0% -32.8% -32.7% -38.1% -38.2% -5.2% -5.2% -18.0% -18.0% 0.0% 0.0% 0.1% 0.1% 4.1% 4.2% -1.4% -1.5% 0.0% 0.0% 3.9% 3.9%

100.0% -32.7% -38.2% -5.1% -18.0% 0.0% 0.1% 4.4% -1.5% 0.0% 3.9%

100.0% -32.6% -38.2% -5.1% -18.1% 0.0% 0.1% 4.6% -1.6% 0.0% 3.9%

Total Revenues Cost of Goods Sold Labor and Other Related Expenses General and Administrative Expenses Other Store Operating Expenses Impairment and Store Closing Charges Interest Income Earnings before Taxes Provision for Income Tax Earnings of Discontinued Operations Net Income (Loss)

Lecture 9

100.0% -33.0% -37.0% -5.3% -17.0% 0.0% 0.0% 7.3% -2.6% 0.0% 4.9%

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2017 Terminal 2018

100.0% 100.0% -32.6% -32.5% -38.3% -38.3% -5.0% -5.0% -18.1% -18.2% 0.0% 0.0% 0.1% 0.1% 4.7% 4.9% -1.7% -1.7% 0.0% 0.0% 3.9% 4.0%