Advance Corporate Finance

Term Project Guide Lines

YOU MUST READ EACH AND EVERY WORD CAREFULLY AND
FOLLOW THESE INSTRUCTIONS COMPLETELY WHILE
DOING YOUR PROJECT.
Please think innovatively and start a new business of large size. Large means at least
one billion rupees initial investment of total capital; this capital would be raised as long
term debt in the form of a 5-year bank loan and OE. The total capital raised in this form
would be invested in NWC plus FA of the new business venture. Therefore end of year
zero, or, beginning of year 1, total capital invested = 1,000 million rupees minimum; and
LTL + OE = 1,000; and also FA + NWC = 1,000 million at that time. This also called the
cost of project, or capital investment, or size of project in the project.

To start the new venture, your group members will register a private limited company
with SECP, thus becoming the providers of seed money and becoming sponsors /
members of the new co, and also becoming the initial shareholders who provide equity
capital for this new venture: and the same group members would also act as the
directors of the corporation. Your group’s main task is to prepare a financial plan for
the next 5 years for the proposed new business; and to do the valuation of share price
at the end of the 5th year, that is, to estimate share value at the end of year 5, that is,
P5. The following paragraphs would help you understand how to do it?

TASKS TO BE PERFORMED
1. Projecting the next 5 years income statements and balance sheets is the main task.
The details of how you can do that is given on the following pages.
2. Then do the ratio analysis in 6 performance areas, namely:

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a. liquidity: current ratio, quick ratio, NWC, NWC to sales, days sales in
receivables, days sales in inventory, operating cycle, cash conversion cycle,
turnover of inventory, turnover of receivables, etc
b. profitability: gross profit margin on sales (GP/S ratio), operating profit margin
on sales (EBIT/S ratio), before tax profit margin on sales (EBT/s ratio), net profit
margin on sales, EPS (earnings per share)
c. asset productivity ( asset utilization also called asset turnover of different
assets): TA turnover (S/TA ratio), fixed assets turnover, turnovers of inventory,
turnover of account receivables
d. financial leverage (also called capital structure and financial risk): LTL/OE
(debt to equity ratio), TL/TA (Debt ratio), (TA/OE ratio) financial leverage, %age
of TA financed by CL, and by LTL, by TL, by OE; debt coverage ratio (EBIT /
interest expense), cash flow coverage ratio ( operating cash flows/ interest
expense; Debt service coverage ratio ( operating cash flows/ debt service
including interest expense and loan repayments, weighted average cost of debt
,Kd (interest expense/ interest bearing debt
e. return on capital: return on invested capital, ROIC, as = EBIT(1 - T) / total
capital invested, ROA (NI/TA ratio), ROE (NI/OE ratio), decomposition of ROE
according to DuPont formula into 3 components (NI/S * S/TA * TA/OE), and also
ROE calculated as= ROIC + (ROIC – Ki) TL /OE ratio. Note that Ki = Kd (1 – T)
f. market measure: here make use of proxy MV to BV ratio which average
MV/BV ratio of similar companies, and Proxy PE ratio calculated as average of
comparable businesses, and then applying these average ratios to estimate
share price at the end of year 5, growth rate as estimated by ROE (1 – d). 5 year
compound annual growth rate of each of these: TA, TL, OE, Sales, EBIT, NI, EPS,
and DPS using the 5th year value as FV and first year value as PV , n as 5, and find
i from financial calculator

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 Based on projections of 5 years in 6 areas of performance , you will make
recommendation about expected improvement and/or deterioration in these 6
areas of this business during the next 5 years.
3. Then do the capital budgeting analysis of the new project. For that purpose you
would estimate 3 types of project- related cash flows:
a) NICO (net investment cash outflows), these are equal to your project cost ,
also called capital invested in the project; and it is NWC + FA at the beginning of
the first year or equally LTL + OE at the beginning of the first year; and it must be
at least one billion rupees (1,000 million ). Please note at the start of first year
there are likely to be zero CL so NWC would be equal to CA.

b) estimate operating cash flows (OCFs) per year for 5 years and keep in mind
that for capital budgeting purposes , annual OCFs are calculated as:

OCF per year = EBIT (1 - T) + Depreciation and amortization expense of that

year

c) estimate terminal cash flows at the end of 5th year. These are also called
disposal cash flows as if business would be sold off after 5 years; some text
books call these abandonment cash flows as if business or project would be
abandoned after 5 years. If you want to be very conservative, you can use the
book value of total capital at the end of 5th year, that is , NWC +FA in the
balance sheet prepared at the end of the 5th year as a very conservative estimate
of PV of all future operating cash flows till infinity.

If you want to be more technically correct and trust your growth rate forecast,
then Terminal Cash Flows at the end of year 5 can be estimated by assuming
that OCFs of year 5 would continue to grow at a constant growth rate for ever or
to be conservative you can assume zero growth in OCFs of 5th year in all future

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years till infinity year ; and estimate terminal cash flows at the end of year 5 as:
either:
OCF 5(1 + g) / (WACC – g)
Or , If to remain conservative, zero growth rate in OCFs is assumed it becomes
OCF 5(1 + 0) / (WACC – 0)
OCF 5 / WACC
Be careful that if a constant growth rate is assumed for OCFs beyond year 5, then
do not use too high a growth rate such as 10% or above because it is a constant
growth rate per year till infinity ,and not just 6th year’s growth rate . Therefore
using a growth rate higher than the long term growth potential of country’s
economy is not defensible because with such a high growth there would come a
time in distant future that the size of OCFs of this business would exceed the size
of country’s GDP, and that is none sense. While estimating growth rate of OCFs
beyond 5th year, please look at the annual compound growth rates you already
calculated in sales, EBIT, NI, and EPS; but in any case a constant growth rate of
higher than 4 or 5% per year till infinity is questionable based on the logic
discussed above.

Once these 3 types of cash flows have been estimated by you , then use these to
calculate NPV, IRR, and payback period of this project to judge feasibility /
acceptability of your project.
NPV = (PV of 5 years OCFs + PV of terminal cash flows) - project cost (note:
project cost is (NICO) or initial investment beginning of year one in NWC + FA ,
and that was at least 1,000 million).

𝑂𝐶𝐹
1 𝑂𝐶𝐹2 𝑂𝐶𝐹3 𝑂𝐶𝐹4 𝑂𝐶𝐹5 + 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝐶𝐹𝑠5
𝑁𝑃𝑉 = ((1+𝑊𝐴𝐶𝐶) 1 + (1+𝑊𝐴𝐶𝐶)2
+ (1+𝑊𝐴𝐶𝐶)3 + (1+𝑊𝐴𝐶𝐶)4 + (1+𝑊𝐴𝐶𝐶)5
) − 𝑁𝐼𝐶𝑂

Calculation of WACC is to be done only at time zero, that is now, when you are
raising capital to start the business. Superscripts 1,2,3, etc appearing on the
term (1 + WACC) refer to discounting period as this is the discount factor used to

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 convert future OCFs into PV. The following pages give further detail about
calculating the WACC of this business
4. then do valuation of shares of this new company at the end of 5th year, that is ,
estimate P5, which is the estimated share price you expect to observe in the market if
you take this corporation public and offer its shares to general public at the end of 5th
year; and at that time if you decide to offer some of your personal shares in this
company to public you can expect to sell your shares at this estimated price, P5 .
Hopefully, for a good business venture this price of share at the end of 5th year would
be much higher than the initial investment of 10 rupees per share that you made when
you formed this company; and thus after 5 years your initial investment in the shares of
this company may become many time more valuable: may be 10 or 20 time more; so
that value after 5 years for a 10 Rs par value share may come out at 100 or 200 rupees ;
and that is increase in your wealth, and that is why you go in a business instead of
saving your money in a bank deposit account. For profitable ventures it is expected that
book value per share calculated as OE/ number of shares is much lower than the market
value of share in the stock market, therefore your estimated P5 is likely to be much
higher than BV per share at the end of year 5.

To estimate P5, that is, fair value of share, after 5 years, do the following: use free
cash flows method to estimate MV of TA at the end of year 5 as given below:
MV of TA 5 = PV of free cash flows after year 5 till infinity. To calculate this value:
MV of TA 5 = {FCF5 (1 + g)} / (WACC – g).
FCF5 = EBIT5(1 - T) - increase in total capital in year 5
Increase in total capital in year 5 = total capital in year 5 - total capital in year 4. Please
remember that total capital in any year is NWC + FA, or alternatively, LTL + OE ; and it is
calculated from the projected balance sheets of the respective years.

After calculating MV of TA at the end of year 5 using free cash flows method as
explained above, you can find MV of equity in year 5 as follows:

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MV of OE 5 = MV of TA5 - TL5. And then share price at the end of year 5 can be
estimated as:
P5 = MV of OE 5 / number of shares outstanding at the end of year 5
For a profitable project, your estimated price at the end of year 5 is likely to be much
higher than the 10 rupees per share you initially paid to buy shares in this co.

WACC of the Project

Since in item 3 and also in item 4 above the discount rate used to calculate present
value (PV) of future cash flows is weighted average cost of capital (WAAC), therefore
you need to estimate it. You need to estimate WACC only at the time capital is being
invested in this business, that is only at the beginning of year one when capital is raised
for the project. Please do not estimate WACC for each year, because it is meaningless
in this context. For NPV calculation in item 3 above, OCFs of each future year as well as
terminal cash flows of year 5 would be discounted at the WACC at time zero; also in
item 4, to estimate P5 you need WACC at time zero.
WACC = Wd* Kd(1 – T) + Wc* Kc
Wd = debt capital / total capital , please use beginning of year one data for Wd and Wc
calculations. All debt capital should be in the form of a bank loan of at least 5 year
maturity payable in semi-annual (6-monthly) installments as an amortized loan. Please
do not assume you can borrow at less than 15% per year interest rate because you are
new and have no history of borrowing relationship with banks; plus you are starting a
new business; therefore it is likely that bank would consider your proposed business as
high risk and accordingly charge you a relatively higher interest rate.
Wc = equity capital / total capital in the beginning
Kd = interest rate on long term debt ( bank loan)
Kc = rate of return you as owners hope to earn by investing in this new business;
naturally it must be higher than interest rate you can earn by putting your funds as 5
year fixed deposit in a bank. Kc must also be higher than the interest rate this new

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business is going to pay on the long term bank loan (that is your Kc must be higher than
kd, percentage cost of debt capital) because risk of bank is lower in this business as
lending bank has first legal right on assets of this business in case of default on loans,
while you, as equity holders, have the last right on assets of the co, and therefore you
can go empty hand (loose all your equity investment in this business) if in case of
bankruptcy the cash realized by liquidating the assets is not enough to pay all the
liabilities. Therefore, as your risk is higher naturally you should expect higher rate of
return; so your expected Kc from this project MUST be higher than the Kd of this
project, and that is true for all types of business projects, everywhere in the world.

Estimating Kc (Risk adjusted Required Rate of Return By Owners,

also called the cost of equity capital for the business)
Kc is an enigma in corporate finance, there is no one agreed upon theory or equation to
estimate percentage rate of return the owners want to earn by investing in a business.

1. One rule of thumb for arriving at Kc is interest rate on long term loan (Kd) that
your co is paying to banks + a few %age points say 5 or 8 or 10, or more, as equity risk
premium. So for this project if long term loan was taken at 15% then add , for example,
8 points to this Kd to arrive at 15 + 8 = 23% as your estimate for Kc. Higher the risk you
perceive in this new venture, more points you want to add to Kd to arrive at an estimate
of Kc.

2. Or you can look at historical rate of return earned by shareholders of similar

businesses by calculating their capital gains yield + dividend yield for the last couple of
years and then averaging those; and then deciding are you willing to start a business as
owner which is expected to give rate of return to shareholders around that average.

3. Or you can use CAPM model; to do so you would need to estimate beta of shares of
this new business; which, of course is not available as it is a new business. You can use

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average beta of similar companies as starting point and find their beta (unlevered )
using Hamda equation given below
beta levered = beta unlevered(1 + (1 – T)debt / OE
by inserting debt to equity ratio as zero, you get unlevered beta of a similar co; and this
would act as proxy for beta unlevered for your project. Then again use Hamda equation
and insert your project’s debt to equity ratio in year 1 in that equation to estimate beta
levered of equity of your new business project.

In any case please use tax rate (T) of 30%. As estimate of Rf please use yield on one
year t-bills. Estimate of Rm (rate of return of stock market as a whole) has to be higher
than Rf because stock market is risky therefore rate of return on overall stock market
should be higher than the rate of return on risk-free t-bill. One way of looking at Rm is
to define it as expected percentage growth in market capitalization of the whole stock
market. Market capitalization of Pakistani cos next year can be estimated by first
estimating over all PE ratio of Stock Market then multiplying it with the expected NI of
the next year of all the companies. This gives you an estimate of market capitalization
end of the year, while beginning of the year market capitalization is available from past
news papers. And then use these 2 numbers to estimate Rm for the next year as:
(market capitalization end of the year – market capitalization beginning of the year) /
market capitalization beginning of the year.

Another crude method to estimate Rm for the next year is to take average percentage
change in KSE-100 index for the last 5 years and use that as a proxy for expected
percentage change in KSE-100 index during the next year.

Growth rate ,g, is usually estimated as ROE (1 – d) whereas ‘d’ is dividend payout ratio,
but you are advised to pay no cash dividends, so for your project d= 0, and therefore
your ‘g’ for years beyond year 5 would be equal to ROE in year 5. In this method there

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is a possibility that ROE in year 5 is negative (such as -3%) or a very big positive number
such as 45%, both of these would be unrealistic constant annual growth rates of OCFs or
FCFs every year till year infinity; therefore as a rule of thumb long term constant growth
rate of any business should not be estimated higher than the long term growth potential
of that particular country. In case of Pakistan it is 5 to 6% per year, so a good working
number for constant growth rate , g, for OCFs and FCFs would be around 4% to 5%.

The Size Of Project

Your financial plan’s first page must show clearly the cost of project. This is also called
size of project. It must be at least 1,000 million Rs ( 1 billion Rs) but you are urged to go
as big as you can ; 1 billion dollars, that is 100 billion rupees is even better: money is no
problem. So initial project cost, that is, total capital invested at the beginning of year
one as NWC + FA, must be at least 1 billion Rs, which you will raise as long term bank
loan and OE. Please show that clearly in the beginning of your project report before
showing projected income statements and balance sheets of next 5 years.
For Example: Project Cost is 2,000 million or 2 billion rupees:
At the beginning of year one, that is time zero it looks like this.
NWC + FA = LTL + OE
600 + 1,400 = 1,200 + 800
Think big ideas such as starting new air line, starting an oil refinery, starting a new
power project to produce electricity, starting a fertilizer factory to produce fertilizer,
starting a mobile phone set manufacturing business, starting a steel mills, starting an
integrated textile mills including spinning, weaving, dyeing and bleaching, and garment
& apparel making all under one roof, starting a recreational theme park, starting a 10
theater cine-plex, starting a 4 star or 5 star hotel, starting a golf course plus hotel plus
resort as one integrated facility, starting an inter-city luxury bus company, starting a
trucking company, running a cargo train, producing various types of packaged food
items, producing various types of consumer products in toiletries, personal hygiene,

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producing key board and other computer accessories, producing consumers’ durables
such as washing machines, TV sets, microwave owens, producing office furniture for
global market, building commercial cum residential plazas, building housing colonies
with medium to low cost housing, the list is unending; you can think of traditional
cement, sugar, motorcycle, automobile, starting a gas/ oil pipe line to transport oil and
gas, doing oil or gas extraction, doing mining in Baluchistan and KPK for various
minerals, etc production as well, etc.

The proposed business should not be in financial services area, such as a commercial
bank or leasing company; other than these areas you are free to start business in any
trading, manufacturing, or service industry.

You should include brief but to the point analyses of multiple related areas such as
market analysis, technical / engineering analysis, decision about production technology
and decision about the selection of vendor for machinery, choice of location for factory,
labor/man power / HR requirements (man powers of different types), electric, water,
gas needs and availability of these utilities at the proposed site of the business, import
substitution or export enhancing impact of the proposed project on the economy of the
country, etc.

Please be as realistic as possible by doing actual field research by checking on the

already installed similar production units, their capacity, source and type of their
technology, covered area of building , investment in NWC and FA, number of
employees, etc. Also you should do search on internet for similar plants, machines,
etc, in other countries to confirm prices and availability of raw materials, machinery,
build-up covered area needed, etc, as well as to learn performance benchmark in
production , capacity utilization percentage of installed production capacity, quality, HR
requirements, Marketing, etc.

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MARKET ANALYSIS
It is important that you carefully chose the product / services you want to produce.
Demand & Supply Gap between existing installed production capacity in the country
must be addressed, and you should check what portion of total annual domestic
demand of that item is imported. Try to forecast growth in local demand , if local supply
is more than the local demand then excess output is being exported where? These are
the issues you want to explore in some detail; and only then you can argue about the
economic justification and business viability of your proposed product or service. If the
item is being imported , then present demand-supply gap for the chosen product or
service can be filled by increasing local production. Or if current local production is in
excess of local demand then the surplus output can be exported. There is no harm in
proposing a project which is exclusively export oriented. So justify your project from
the national economic benefit view point, employment generation view point, foreign
exchange earnings/ or saving view point , etc.

FINANCIAL PLAN FOR THE NEXT FIVE YEARS

Bulk of your project report should be focused on FINANCIALS of the proposed project as
this is a course about corporate finance. You start by estimating assets required for the
project:

Investment in Project is also called capital cost, or net investment cash outflows
(NICO), cost of project, or size of project: it is simply the Assets initially needed for the
Project to start its operations:
Investment in FA (fixed assets) needed for the project include land, build-up covered
area for factory , offices, storage / warehousing, show rooms, etc. Machinery, both
locally manufactured and imported, fixtures, vehicles, computers, air conditioning,
stand-by power generation, etc. For Machinery and equipments please estimate the
following: import cost plus duties , insurance , transportation to your site , plus cost of

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local machinery + Installation + testing costs. Some long term deposits , such as
security deposits for connections of electricity, gas line, and phone lines, etc are also
part of FA though not productive ones, the same is true for any license fees, initial
incorporating expenses to register your new company with the SECP, these are shown
as long term assets but are not production related. License fees and incorporating
expenses are usually termed deferred costs and are amortized over 5 years, and part of
FA. Security deposits given to gas, phone, electric, water companies are shown as long
term deposits and would be recovered when you disconnect these services, these are
also shown as FA assets. It is advised that you spend enough time and effort in getting
from inter-net realistic prices for plants and machines from various suppliers and choose
a technology that is suitable for local conditions.

Investment in NWC initially would be composed of CA including cash at hand for day to
day operating needs, any account receivables (R/A) at the end of the year due to
estimated credit sales, some inventory to keep operations smoothly running without
production shut downs. CL at the end of the year would include some accrued
operating expenses such as salaries payables, and utility bills payable of at least one
month which accrue at then of each year, some accounts payables as a result of
purchase of raw material inventory on credit. See if similar companies have a big chunk
of their CL as short term bank loan, if so, then you can assume that though you are a
new business organization yet banks would be willing to lend you some short term loans
to finance some of your CA. Please do not rely on short term loan greatly in the first
couple of year as source of funding your CA; but in later years you may find that due to
profitable operations even half or more of your CA the banks are willing to finance by
giving you short term bank loan.

At the beginning of year one, initially you have zero CL so NWC = CA needed to start the
operations; but by the end of year one and in subsequent years , that is end of year
2,and 3, etc, you shall have CL, and NWC would be CA - CL. So in the beginning of year

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one, investment in both FA and CA needed to start the operations would be finance
from LT debt + OE.
Total capital = CA + FA = LTL + OE = at least 1,000 million, as CL would be zero in the
beginning of year 1, but not so in the subsequent year.
Financing of Project
How Project cost will be financed ? You are allowed to raise as Debt Capital maximum
60 % of the total capital, and for WACC calculation this is your weight of debt capital
invested in this project, that is, Wd= 0.6 . Debt capital should be raised as long term
bank loan of at least 5 years, it would be an amortized loan which would be repayable in
equal semiannual installment payments. Or you can take plant on long term lease;
but do not issue TFCs (corporate bonds) to raise debt capital as yours is a new and
private limited co , therefore issuing TFCs won’t be feasible; remember you are also not
issuing shares to public, rather your group members are subscribing the shares and thus
providing equity capital to this company; and therefore it is a private limited company
that you and your friends are forming to start this new business venture. Set the par
value of a share at Rs 10, and if each group member is investing 100 million rupees then
each member is buying 10 million shares (100 million Rs / 10 Rs par value per share) in
this new co.

You must prepare loan amortization schedule to show how the long term debt would
decrease in the balance sheet over the years and also how much would be interest
expense from this debt each year that goes in the income statement of each of the
future 5 years. Loan balance would be zero at the end of 5th year in balance sheet.

Equity capital (OE) is supplied by you, the group members, and it must be minimum
40% of project cost, and for WACC calculations that would be your weight of equity
capital, that is, Wc = equity capital /total capital = 0.4. Equity capital is going to be
your investment in the project as owners, each group member will subscribe (purchase)
equal number of shares of this newly formed private limited company, and it would

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appear as paid up share capital in balance sheet’s OE section. Keep par value of shares
at Rs 10. If you decide 600 million Rs equity investment in this project, and there are 3
group members, then each member would subscribe 600/3 = 200 million Rs of equity by
purchasing in the new corporation 200, 000, 000 / 10 Rs = 20 million shares of rupees 10
par value.

Please note that State Bank of Pakistan recommends to the commercial banks that for
most of the projects the banks can lend maximum 60% of the project cost (total capital)
as long term loans, the remaining 40% of the total capital invested in this project must
be provided by owners (called sponsors) as equity investment.

PREPARING PROJECTD INCOME STATEMENTS FOR 5 YEARS

Your yearly forecast of sales revenues will be based on MARKET ANALYSIS, as discussed
in previous paragraphs; as well as your projection about installed capacity utilization.
Initially it is better to assume 50% to 60% of production capacity utilization in the first
year of project life because you would try to introduce your product and snatch market
share from others. Keeping in view the competition in the market, it is only realistic to
assume capacity utilization won’t be very high in the early years of your project life; and
in subsequent years capacity utilization may be increased , say 10%, in each next year,
thereby reaching full, 100%, capacity utilization, in 4th or 5th year. Capacity of
production is based on the specifications of plant (machinery) you installed. For example
in airline business and also in hotel business standard assumptions are 50% capacity
utilization (seats filled or rooms occupied) in regular seasons.

Please note that sales is result of quantity sold (Q) multiplied by price per unit (P) of
product /service. It is not necessary that all the units produced in a year are also sold in
the same year, cost of unsold units appears as part of ending inventory in the balance
sheet (a CA); while cost of units sold during the year is CGS which appears on the

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income statement. Please include in your estimates increase in product/service price
due to inflation, or decrease in per unit CGS due to economy of scale achieved in future
years due to more capacity utilization. Per unit selling price in subsequent years may
have to be decreased or increased depending on competition, inflation, or market share
considerations. Please Make explicit statements about these assumptions. Pricing
policy such as premium pricing, penetration pricing, or competitive pricing must be
spelled out by you clearly; usually for new entrants, like you, initially slightly lower
selling price is set by you for your product or service than the competitors’ selling price.

While estimating sales, do not make capacity utilization the only criterion but address
the competition and the market share you plan to wrestle from competitors or
penetration in export markets you plan to attain; and after all these consideration, set a
realistic sales target for each of the next 5 year . Sales estimates are of net sales after
paying sales tax, and deducting sales discount and sales returns and allowances; and
these net sales are top line of your income statement.
Expenses Estimate:
Annual Operating Costs are of 2 types 1) production costs 2) and operating expenses. In
manufacturing business, production costs show up as CGS in the income statement and
are composed of 3 items: Cost of Raw Materials used in a year, Cost of Direct Labor, and
Factory Overhead Costs. Operating Expenses are of 2 types: marketing expenses and
administrative expenses. Note: in service businesses such as airlines, hotels, theme
parks, hospitals, colleges and schools, there is no CGS ; there are only various operating
costs. But in manufacturing businesses such as textile, cement, ghee, sugar, steel, tires,
computers, etc the operating costs are bifurcated into CGS and operating expenses.

You can use % age of sales method to estimate various types of expenses; and you can
use competitors’ %age of sales for estimating your operating expenses and CGS as a
starting point; or you can work with the details of your plant specifications and estimate
your CGS in detail. For estimating operating expenses related to marketing you can

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make detailed marketing budget including advertising budget, sales force budget, etc, or
you can use %age of sales, may be slightly higher %age initially than competitors,
because to launch new products/ brands requires initially higher marketing expenses to
snatch market share from competitors. It is usually simpler to estimate administrative
expenses as %age of sales or you can make a detail budget of admin staff including
managers, offices, vehicles petrol, electricity ,etc, used by admin . Depreciation expense
is an operating cost and mostly it is part of FOH which goes into CGS, but some
depreciation may belong to assets not located in factory such as sales force vehicles,
distribution trucks, office furniture and fixture in head offices or branch offices,
depreciation on cars given to managers, that part of depreciation goes into operating
expenses.
Interest Expense appears below the EBIT (operating profit) in the income statement, so
it is not an operating cost, it is a financial cost. Interest expense is based on Debt
Financing used. To find out interest expense of each year, you would need to prepare
loan amortization schedule of long term bank loan to estimate each year’s interest
expense. If in certain years you took some short term bank loans as well, then do not
forget to include interest on such loans as well in your interest expense on each year’s
income statement.
For Income Tax Expense, please use 30 % of EBT as tax rate (T)
For manufacturing business the format of income statement is:
Sales
-CGS
Gross Profit
-Operating expenses
EBIT
-interest expense
EBT
-income tax
NI

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For service businesses income statement format is:
Revenues
-Operating costs
EBIT
Interest expense
EBT
-Income tax
NI

PREPARE PROJECTED BALANCE SHEETS FOR 5 YEARS

Current Assets (CA)
To forecast Cash balance in the balance sheet , make cash budget, or if that is too
difficult, use a percentage of sales as cash balance initially, but if balance sheet does not
balance use cash as the balancing figure but do not insert negative cash amount to
balance the balance sheet because that is meaningless: assets cannot have negative
value. Negative Cash amount required to balance the balance sheet means the right
hand side of balance sheet (TL + OE) is too small and you need to raise additional
financing as new loans or inject equity in that year by issuing more shares because
assets have grown too fast and to finance such growth in assets, you need to raise
financing as debt and equity in that year. Use as guide competitors balance sheet to see
cash is what %age of sales in their printed annual reports; but doing so may result in
balance sheet not balancing. It is easiest to use cash as a “plug number” to balance the
balance sheet after all other items in balance sheet have been estimated according to
your assumptions. If cash as balancing number is coming negative in a year, issue more
shares to inject further equity and have positive cash balance from such equity injection
or take more long term loan , or even short term loan. Please remember assets cannot

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have negative value in balance sheet. Also there must be some cash in a business
always, therefore zero cash balance in any year’s balance sheet is not acceptable.

To forecast Accounts Receivable (R/ A) in balance sheet , use competitors %age of

sales, or a slightly higher %age as you are new and would be constrained to offer
relaxed credit terms to your customers to sell your products or services.
To forecast Inventory in balance sheet, use competitors’ %age of sales, or slightly
higher %age as you are new and may face slow sales initially resulting in some piling up
of inventory of finished goods in early years. Also if some raw materials are imported ,
then you may need to stock such material and this may cause bigger investment in
inventory , the same is true for raw materials which are available seasonally such as
cotton . This state of affairs may result in inventory as %age of sales being higher in
your co as compared to other similar companies.

Current Liabilities (CL)

use %age of sales of competitors as guide to forecast accounts payables ( P/A)
generated due to purchases of raw materials inventory on credit; or you can use a
slightly lower %age of sales than competitors’ because you are new and not many
suppliers would be willing to sell raw material inventory to you on credit basis. For
accrued operating expenses you can safely assume salaries, wages, and utilities bills of
at least 1 month to accrue at the end of each year and appear as CL in balance sheet,
because it is common to pay salaries in the beginning of next month, and same is true
for utilities bills.
Assume there would be no Accrued Taxes Payable (deferred taxes) because each year
tax would be paid in that year.
If you make cash budget then need for short term bank loan would be determined in
the cash budget; assume short term bank loans would be paid off fully or partly in the
same year along with interest if end of the year there is excess cash available over and
above the minimum cash balance required .

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But if you do not make cash budget , then short term bank loan as %age of CA should be
lower in your co compared to other companies in the first couple of years because you
are new in business and banks won’t be eager to finance your CA by giving you short
term bank loans, and therefore you would be constrained to finance a big chunk of CA
from long term debt and OE or from accounts payable and accrued expenses payables.
In any case your short term bank loan cannot exceed CA, because that means some of
the fixed assets are being financed by short term bank loan and NWC is negative ; and
banks do not allow that because banks give short term loans to finance only short term
assets, that is current assets.

If making cash budget is too tedious then based on the forecast of CA, assume that
some CA will be financed by accounts payable and accruals so deduct from CA forecast
the forecasted amounts of accounts payable and accruals, the remaining CA you may
decide to finance half and half from short term bank loan and long term debt.

Long Term Liabilities (LTL)

Use long term bank loans or Long Term Lease contracts but don’t issue TFCs (corporate
bonds) because your co is new and private limited co, so issuing your corporate bonds
to public won’t be practical.
Please prepare loan amortization schedule of Long Term Loan. Assume it is a 5 years
loan and traditionally repayments are in semi-annual (6 monthly) equal installments.
Check from banks the interest rate on 5 years long term loan and use that to complete
amortization schedule, and from interest column calculate interest expense of each year
and show it in the income statement. From ending loan balance column the numbers
would go in balance sheet under long term liabilities.
The loan amortization schedule should have the following format:
Period number Beg Balance installment interest paid loan paid ending balance

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For a 5 year loan , there would be 10 lines because installments are semiannual

OE
In the beginning of first year issue shares to your group members to raise funds and
record it as paid up share capital. You won’t have RE (retained earnings) in the
beginning of first year ; but there would be RE (positive or negative) at the end of first
year and would appear in the balance sheet prepared on the last day of year one, and
same is true for balance sheets prepared on the last day of year 2 to year 5.
It is advised that you pay no cash dividends in any of the 5 years. You are also advised
not to pay stock dividends (bonus shares) in any of these 5 years
Do not forget transferring NI balances from income statement to RE in balance sheet
each year while working out ending RE, then calculate ending OE balance each year in
the balance sheet. Note that at the end of any year in the balance sheet you calculate
RE balance as:
End RE = Beg RE + NI – cash dividends – stock dividends
End of year OE balance in the balance sheet is:
End OE = Share paid up capital + End RE
As you are advised not to give cash dividends therefore you can transfer NI after tax to
RE portion of OE in your balance sheet each year, so each year this balance of RE in
balance sheet would increase if each year NI is positive in the income statement, and RE
balance in the balance sheet would go down in a year when NI was negative , that is , if
losses were incurred.

WARNING: Failure to treat NI in this manner and failure to show

that each year balance of RE in the balance sheet was calculated
as:
Ending RE = Beg RE + NI – cash dividends – stock dividends
would result in zero score in the project.
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OE each year in the balance sheet must be confirm to the following statement of
changes in OE:
End OE = Beg OE + NI – cash dividends + shares issued – shares repurchased.
But it is recommended that you give no cash dividends or stock dividends for the 5
years, nor it is advised to do any repurchase of shares from the shareholders because
that is equal to returning their investment back to owners, and we want owners (that is
you and your group members) to remain committed for 5 years in this business . Do not
issue more shares also during 5 years to keep life simple; but if there is need for more
capital in future years because in a certain year TA exceed TL +OE, and bank loans are
too expensive due to high interest rate, then you may decide to raise additional equity
capital in your financial plan by issuing more shares to existing shareholders in that year,
thus forcing them (that is your group members) to invest more cash in the business say
in 3rd or 4th year. That would increase share paid up capital in the OE portion of balance
sheet in those and subsequent years.

Instructions for those who make cash budget of each year as well
If you decide to make annual cash budget then the following format can be used
CASH BUDGET:
To estimate cash in balance sheet at the end of each of the 5 years, you can prepare
annual cash budgets for 5 years. You can use the format given below
YEARS
0 1 2 3 4 5
a) Cash Inflows
b) Cash outflows
c) Net CFs (a – b)
d) +Beg Cash Balance
e) -Minimum Cash balance required
f) Cash excess or shortage (c + d – e)

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g) ST Bank loan taken
h) ST bank loan repaid along with interest
i) ST Bank loan Balance
j) End Cash balance
If item ‘f’ is negative, there is cash shortage expected in that year then you will take
short term bank loan to make-up for the shortage. Therefore in that year item ‘j’ ending
cash balance = item ‘e’ minimum cash balance required.
On the other hand, If item ‘f’ is positive in a year, there is excess cash expected in that
year , and you can use that surplus to repay short term bank loan or some of it if there
was some such loan outstanding from the previous year, and in that case item j, ending
cash balance = minimum cash balance required. But if there was no outstanding short
term bank loan then ending cash balance = minimum cash balance required (e) + cash
excess (f). If item f, Excess cash, is more than the short term bank loan balance, then
ending cash (j) = excess cash (f) – short term bank loan balance (i) + minimum cash
required (e). So be careful. Ending cash of year one (j) becomes beginning cash (d) for
year 2, and so on for each year. Ending cash of each year goes in balance sheet as cash ,
under CA category.

Cash Inflows: In year zero cash inflows would be only your equity investment and long
term loan received from bank. In years 1 to 5 major cash inflows would be from sales, if
all sales are cash sales then the cash inflows would equal sales and there won’t be any
account R/A; but if you sell , as a marketing tactic, on credit then some sales of previous
year would be collected in the current year; and some sales of the current year would
be collected in the next year. In such case you would use for cash budget:
cash collected from customers in a year = beg Acc R/A + Sales – End R/A
It is possible some cash inflows may occur if you decide in a certain year to replace some
old equipment by selling it. It is possible for certain businesses that during 5 years
owners may have to invest further in the business due to fast expansion of business or
due to heavy losses, such investment can take the form of issuing new shares to

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directors or taking loan from directors (you and your group members are directors in
this company) , in any case cash inflows would occur in that year. Usually instead of
owners investing further by purchasing more shares in their company, in Pakistan they
like to show further investment as “LOAN FROM DIRECTORS” which the business has to
pay back to its Directors, and is shown as liability in balance sheet. In a year when such
loan from directors is taken , it should be shown as cash inflow in cash budget , and a
liability in balance sheet until repaid.
Cash Outflows: In year zero it would be for purchase of FA such as land , machines,
construction of building, that is FA; and also for acquiring raw material inventory, also
for security deposits for gas, electric, phone connections, any licensing fees to the
government, and legal expenses for the formation of corporation. Operating expenses
for salaries , advertising etc would be zero in year zero.
In the subsequent years that is from year 1 to 5, cash out flows would be for cash
payment for CGS that also includes payments for Acc P/A from purchases of raw
material inventory bought initially on credit. You can use :
Cash paid for raw material = Beg Acc P/A + purchases of Raw material – End Acc P/A in
any year. Payments for direct labor, and FOH cost , except depreciation expense, are
also CGS related Cash out flows in each year. Similarly payment of various operating
expenses except depreciation expense, payment of interest expense, repayment of loan
principal, are also various cash outflows experienced each year. Any further acquisition
of FA in subsequent years would also result in cash outflows. Income tax should be
paid full in each year and would appear as cash outflow, so you won’t have any deferred
tax P/A liability. If any of CGS related costs or operating expenses are not fully paid in
that year then cash out flow for that expense = Beg accrued P/A related to that expense
+ that expense for the current year – End Accrued P/A related to that exp.
Loan balance of short term bank loan at the end of any year goes in balance sheet as CL ,
and interest expense paid in any year on S T Bank loan goes in income statement as
interest expense . The same treatment is given to L T Loan.

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PERFORMANCE ANALYSIS OF 5 YEARS
Please perform ratio analysis on your 5 years projected income statements and balance
sheets , and include the ratios in the areas of :
a) Liquidity
b) Profitability
c) Return on Capital
d) Asset Management
e) Debt Management, i.e. Financial Leverage and Capital Structure
f) market measures
Based on the expected ratios of 5 years , write analysis in each area of performance over
the 5 year period, such as, liquidity is expected to improve in the 5 years as current ratio
would increase from 2 to 3.5 over the 5 years but profitability is likely to deteriorate as
net profit margin is likely to fell from 8% to 2% in 5 years.

Finally make decision of accepting or rejecting the proposed business idea based on
using the capital budgeting techniques such as NPV, IRR, profitability Index, Payback
period, discounted payback period, and accounting rate of return. And finally make
accept or reject decision based on expected P5 after 5 years for the shares of your
company; if P5 comes out less than initial par value of Rs 10, or even if P5 comes out less
than book value per share at the end of year 5 then project is not acceptable. So if all
of the above indicate that project is acceptable only then you can feel satisfied to start
this business by investing your equity in it.

Please NOTE: You do not need to artificially make the project

acceptable ; if your projections and analysis lead you to a
decision of NOT ACCEPTING the project, that is also OK.

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You may decide to reject the project if ROE remains too low or negative for all 5 years.
As a rule of thumb ROE is considered low if it is below your expected cost of equity , Kc.
Or if equity is shrinking in the balance sheet due to losses each year.

Do The Capital Budgeting Analysis of The Project

Instructions to calculate NPV were given on previous pages. The data of 3 types of cash
flows (NICO, OCFs, and terminal cash flows) is also used to calculate IRR, and
profitability index : note that profitability index is also called cost-benefit ratio. You can
also calculate accounting rate of return of this project . To do that find Avg NI by
summing 5 years NI from income statements and dividing it by 5; and find Avg Owners
investment in the business by summing OE from balance sheets of 5 years and dividing
it by 5. Accounting rate of return = Avg NI / Avg Owners investment. Then compare this
accounting rate of return with some pre-set benchmark to decide whether the proposed
business project is acceptable or not

You can use discounted values of yearly OCFs (using WACC as discount rate) to find
discounted payback period for this project. NPV should be Positive, IRR should be
greater than WACC, Profitability Index should be more than One, and ideally its payback
period should be less than 5 years for the project to be acceptable.

FINALLY DO THE SHARE VALUATION

Please do the valuation after 5 years (though you can also do the valuation at the end of
year 1, end of year 2, end of year 3, etc also), that is, estimate P5, it is the expected
share price you hope would prevail in the market at the end of year 5.. The detail of how
you would do that using free cash flows method has been given on the previous pages.

For a well managed business, it should be the case that value per share comes out 20,
30, 40 times of BV per share . That means MV to BV ratio can be a large number such as
20 or 30, etc. Note: BV per share in year 5 is OE in year five from balance sheet divided

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by number of shares outstanding. In case share price at the end of year 5 , P5, works out
much higher than the BV of share at the end of year 5 , then the promoters (that is you)
end up being very rich by off loading some of your share holding to general public and in
doing so converting it from private limited co to public limited co, and having its shares
listed for trading on a stock exchange, and at the same time cashing in some of your
investment after waiting for 5 years to become rich.

Please watch for situations where at the end of 5th year cash in the balance sheet is
more than the cash initially invested by you as owners equity, then you can give cash
dividends to yourself equal to the original cash you had invested as OE and thereby get
your original investment out of the project and still have a running business.
Also to see how wealthy you have become after 5 years, look at the OE at the end of 5th
year and compare it with the OE you initially had invested in year one, if it is 6, 7 time
bigger in year5 than your wealth has grown 600 0r 700% or you are 6 , 7 times wealthier
than 5 years ago. And that is the point in starting your own business: to be wealthier
quickly , as compared to keeping your funds in a bank account.
So! Good luck to you

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