Financial Modeling

AcFn 3044

Chapter Four

Pro-Forma Financial Statement Modeling

 Contents of the chapter
1.How Financial Models Work: Theory and an Initial Example
2.Free Cash Flow (FCF): Measuring the Cash Produced by the Business
3.Using the Free Cash Flow (FCF) to Value the Firm and Its Equity
4.Some Notes on the Valuation Procedure
5.Alternative Modeling of Fixed Assets
6.Sensitivity Analysis
 Overview
• The usefulness of financial statement projections for corporate financial management
is undisputed.
• Such projections, termed pro forma financial statements, are the bread and butter for
much corporate financial analysis.

• In this chapter we present a variety of financial models.

• All the models are sales driven, in that they assume that many of the balance sheet
and income statement items are directly or indirectly related to sales.
 How Financial Models Work:
Theory and an Initial Example
• Almost all financial statement models are sales driven; this term means that as
many as possible of the most important financial statement variables are
assumed to be functions of the sales level of the firm.

• For example, accounts receivable are often taken as a direct percentage of

the sales of the firm.

• A slightly more complicated example might postulate that the fixed assets (or
some other account) are a step function of the level of sales
 How Financial Models Work:
Theory and an Initial Example
• To solve a financial planning model, we must distinguish between those financial
statement items that are functional relationships of sales and perhaps of other
financial statement items and those items that involve policy decisions.

• The asset side of the balance sheet is usually assumed to be dependent only on
functional relationships.

• The current liabilities may also be taken to involve functional relationships only,
leaving the mix between long-term debt and equity as a policy decision.
 Example
A B
13 Year 0
14 Income statement
15 Sales 1000
16 Costsof goods sold -500
17 interest paymetns on debt -32
18 Interest earned on cash and marketable securities 6
19 Depereciation -100
20 Profit before tax 374
21 Taxes -150
22 Profit after taxes 225
23 Dividends -90
24 Retained earninsg 135
25
26 Balance sheet
27 Cash and marketable security 80
28 Current assest 150
29 Fixed assets
30 At cots 1070
31 Dpereciati -300
32 Net fixed assest 770
33 Total assets 1,000

35 Current liabilities 80
36 Debt 320
37 Stock 450
38 Accumulated retained earninsg 150
39 Total liabilities and equity 1,000
Example…………
• The current (year 0) level of sales is 1,000. The firm expects its sales to grow at a
rate of 10% per year, and it anticipates the following financial statement relations:

• Current assets: Assumed to be 15% of end-of-year sales

• Current liabilities: Assumed to be 8% of end-of-year sales
• Net fixed assets: 77% of end-of-year sales
• Depreciation: 10% of the average value of assets on the books during the year.
• Fixed asset at a cost: Sum of net fixed assets plus accumulated depreciation
 Example…………
• Debt: The firm neither repays any existing debt nor borrows any more money over the
5-year horizon of the pro forma (constant).

• Cash and marketable securities: This is the balance sheet plug (see explanation next
slide).

• Average balances of cash and marketable securities are assumed to earn 8%

interest.
 The “Plug”
• Perhaps the most important financial policy variable in the financial statement modeling is
the “plug”: This relates to the decision as to which balance sheet item will “close” the
model:
• A financial modeling plug is when there is a formula that automatically makes
the balance sheet balance.

• How do we guarantee that assets and liabilities are equal (this is “closure” in the
accounting sense)?

• How does the firm finance its incremental investments (this is “financial closure”)?
 The “Plug” …….
• In general the plug-in a pro forma model will be one of three financial balance sheet
items:
(i) Cash and marketable securities,
(ii) debt, or
(iii) stock.
• As an example, consider the balance sheet of our first pro forma model:

• The mechanical meaning of the plug: Formally, we define

• Cash and marketable securities = Total liabilities and equity – Current assets – Net
fixed assets
• By using this definition, we guarantee that assets and liabilities will always be equal.
Projecting Next Year’s B/S and I/S
A B
1 PRO FORMA FINANCIAL MODEL
2 Sales growth 10%
3 Currents asets/Sales 15%
4 Current liabilitiy /Sales 8%
5 Net fixed assets/Sales 77%
6 Costs of goods sold/Sales 50%
7 Depreciation rate 10%
8 Interset rate on debt 10%
9 Interest paid on cash and marketable securities 8%
10 Tax rate 40%
11 Dividend payout ratio 40%
 Income Statement Equations
Sales= Initial sales * (1 + Sales growth)

CGS = Sales * CGS/Sales

Interest payments on debt = Interest rate on debt * average debt over the year,

Interest earned on cash and marketable securities = Interest rate on cash * average cash
and marketable securities over the year.

Depreciation= Depreciation rate * Average fixed assets at a cost over the year.
 Income Statement Equations …..
Profit before taxes = Sales – CGS – Interest payments on debt + Interest earned on cash
and marketable securities – Depreciation

Taxes = Tax rate * Profit before taxes

Profit after taxes = Profit before taxes – Taxes

Dividends = Dividend payout ratio * Profit after taxes (NI).

Retained earnings = Profit after taxes – Dividends.

 Balance Sheet Equations
Cash and marketable securities(plug) = Total liabilities and equity – Current assets – Net fixed
assets.

Current assets = Current assets/Sales * Sales

Net fixed assets = Net fixed assets/Sales * Sales

Accumulated depreciation = Previous year’s accumulated depreciation + Depreciation rate *

Average fixed assets at cost over the year

Fixed assets at cost = Net fixed assets + Accumulated depreciation

 Balance Sheet Equations ……
Current liabilities = Current liabilities/Sales * Sales

Debt is assumed to be unchanged. An alternative model, which we will explore later,

assumes that debt is the balance sheet plug.

Stock is assumed to be unchanged. (Shareholders provide no additional direct financing:

the company is assumed to issue no new stock or repurchase any stock.)

Accumulated retained earnings = Previous year’s accumulated retained earnings +

Current year’s additions to retained earnings
13 Year 0 1
14 PRO FORMA Income statement
15 Sales 1,000 1,100 1,21
16 Costs of goods sold -500 -550 -60
17 Interest payments on debt -32 -32 -3
18 Interest earned on cash and marketable securities 6 9 1
19 Depreciation -100 -117 -13
20 Profit before tax 374 410 45
21 Taxes -150 -164 -18
22 Profit after tax 225 246 27
23 Dividends -90 -98 -10
24 Retained earnings 135 148 16
25
26 PRO FORMA Balance sheet
27 Cash and marketable securities 80 144 21
28 Current assets 150 165 18
29 Fixed assets
30 At cost 1,070 1,264 1,48
31 Depreciation -300 -417 -55
32 Net fixed assets 770 847 93
33 Total assets 1,000 1,156 1,32
35 Current liabilities 80 88 9
36 Debt 320 320 32
37 Stock 450 450 45
38 Accumulated retained earnings 150 298 46
39 Total liabilities and equity 1,000 1,156 1,32
Extending the Model to Years 2 and Beyond
 Free Cash Flow (FCF):
Measuring the Cash Produced by the Business
• Now that we have the model, we can use it to make financial predictions. The most
important calculation for valuation purposes is the free cash flow (FCF).

• FCF—the cash produced by a business without taking into account the way the
business is financed
• FCF is the best measure of the cash produced by a business.

• An extended discussion of the FCF was included in Chapter 2. For reference, we briefly
repeat the definition given in that chapter.
Here below is the calculation for FCF
 Using the Free Cash Flow (FCF)
to Value the Firm and Its Equity
• The enterprise value (EV) of the firm is the present value of the firm’s future
anticipated free cash flows.

• We can use the pro forma FCF projections and a cost of capital to determine the
enterprise value of the firm.

• Suppose we have firm’s weighted average cost of capital (WACC) is 20%.

• Then the enterprise value of the firm is the discounted value of the firm’s projected
FCFs plus its terminal value:
Present value formula for the determined
years cash flow and terminal value.
Enterprise value
 Some Notes on the Valuation Procedure
Terminal Value
• In determining the terminal value we used a version of the growing annuity model
described in Chapter 1. We have assumed that after the year-5 projection horizon the
cash flows will grow at a long-term growth rate of 5%. This gives the terminal value as:

• As noted in the previous section, this formula is only valid if the long-term FCF growth is
less than the WACC (g < WAAC).
 Other ways of calculating the terminal value (TV)

• Terminal value (TV) = Year-5 book value of debt + Equity

• TV = (Enterprise market/book multiple) * (Year-5 book value of debt + Equity).

• TV = P/E ratio * Year-5 profits + Year-5 book value of debt

• TV = EBITDA ratio * Year-5 anticipated EBITDA

 Treatment of Cash and Marketable
Securities in the Valuation
• We have added the initial cash balances back to the present value of the projected
FCFs to get the enterprise value. This procedure assumes the following:

A. Year-0 balance of cash and marketable securities are not needed to produce the
FCFs in subsequent years.

B. Year-0 balances of cash and marketable securities are “surpluses” which could be
drawn down or paid out by shareholders without affecting the future economic
performance of the firm
 Mid-Year Discounting
• While the NPV formula assumes that all cash flows occur at the end of the year, it is
more logical to assume that they occur smoothly throughout the year.
• For discounting purposes, we should therefore discount cash flows as if, on average,
they occur in the middle of the year. This means that the enterprise value is more
logically calculated as:
EV based on mid-year discounting
 Alternative Modeling of Fixed Assets
• The models in this chapter assume that the Net fixed assets (NFA) are a function of
sales. In effect, this means that we assume that the depreciation of the FA has actual
economic meaning so that the productive capacity of these assets is determined by
their after-depreciation value.

• There are, however, two alternative models that the financial modeler may want to
consider.
• The first of these assumes that depreciation has no economic meaning. In this
case, the gross fixed assets are a function of sales.

• The second alternative model is to assume that the existing fixed asset base, if
properly maintained, can accommodate reasonable levels of future sales.
 1. Gross Fixed Assets Are a Function of Sales

• Suppose depreciation has no economic meaning so that the fixed assets at

cost represent the future productive capacity of assets.

• The gross fixed assets are a function of sales.

• This requires only a small adjustment to our previous model:

Gross Fixed Assets Are a Function of Sales
2. Net Fixed Assets Are Constant
• In certain cases it may be appropriate to assume that the current fixed assets
if properly maintained, can accommodate reasonable levels of future sales.

• An example might be the case of a supermarket—if depreciation is taken to be

the economic expression of the maintenance and asset replacement required
to service the existing customer base, then this means that the net fixed
assets would be constant over time.
2. Net Fixed Assets Are Constant
 2. Net Fixed Assets Are Constant
• This model implies that depreciation equals capital expenditure.
Sensitivity Analysis

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End of chapter Four !!!!!!

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