Manual solution chapter 9 prospective analysis PDF

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Chapter 9Prospective AnalysisREVIEWProspective analysis is the final step in the financial statement analysis process. It includes forecasting of the balance sheet, income statement and statement of cash flows. Prospective analysis is central to security valuation. Both the free cash flow and residu...

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Chapter 09 - Prospective Analysis

Chapter 9 Prospective Analysis REVIEW Prospective analysis is the final step in the financial statement analysis process. It includes forecasting of the balance sheet, income statement and statement of cash flows. Prospective analysis is central to security valuation. Both the free cash flow and residual income valuation models described in Chapter 1 require estimates of future financial statements. We provide a detailed example of the forecasting process to project the income statement, the balance sheet, and the statement of cash flows. We describe the relevance of forecasting for security valuation and provide an example utilizing forecasted financial statements to implement the residual income valuation model. We discuss the concept of value drivers and their reversion to long-run equilibrium levels. In the appendix, we provide a detailed example of short-term cash flow forecasting.

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Chapter 09 - Prospective Analysis

OUTLINE 

The Projection Process Projecting Financial Statements Application of Prospective Analysis in the Residual Income Valuation Model Trends in Value Drivers



Short-term Forecasting (Appendix)

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Chapter 09 - Prospective Analysis

ANALYSIS OBJECTIVES 

Describe the importance of prospective analysis.



Explain the process of projecting the income statement, the balance sheet and the statement of cash flows.



Discuss and illustrate the Importance of Sensitivity Analysis.



Describe the implementation of the projection process in the valuation of equity securities.



Discuss the concept of value drivers and their reversion to long-run equilibrium levels.

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Chapter 09 - Prospective Analysis

QUESTIONS 1. Prospective analysis is central to security valuation. All valuation models rely on forecasts of earnings or cash flows that are, then, discounted back to the present to arrive at the estimated value of the security. Prospective analysis is also useful to examine the viability of companies’ strategic plans, that is, whether they will be able to generate sufficient cash flows from operations to finance expected growth or whether they will be required to seek external financing. In addition, prospective analysis is useful to examine whether announcing strategies will yield the benefits expected by management. Finally, prospective analysis can be used by creditors to assess companies’ ability to meet debt service requirements. 2. Prior to the forecasting process, financial statements can be recast to better portray economic reality. Adjustments might include elimination of transitory items or reallocating them to past or future years, capitalizing (expensing) items that have been expensed (capitalized) by management, capitalizing operating leases and other forms of off-balance sheet financing, and so forth. 3. In addition to trend analysis, analysts frequently incorporate external (non-financial) information into the prospective process. Some examples are the expected level of macroeconomic activity, the degree to which the competitive landscape is changing, any strategic initiatives that have been announced by management, and so forth. 4. The forecast horizon is the period for which specific estimates are made. It is usually 5-7 years. Forecasts beyond the forecast horizon are of dubious value since estimates are uncertain. 5. Since all valuation models are infinite horizon models, analysts frequently assume a steady state into perpetuity after the forecast horizon. A common assumption is that the company will grow at the long-run rate of inflation, that is, remaining constant in real terms. 6. The projection process begins with an expected growth in sales. Gross profit and operating expenses are, then, estimated as a percentage of forecasted sales using historical ratios and external information. Depreciation expense is usually estimated as a percentage of beginning gross depreciable assets under the assumption that depreciation policies will remain constant. Interest expense is usually estimated at an average borrowing rate applied to the beginning balance of interest bearing liabilities. Projections of expected interest rates are used for variable rate indebtedness and new borrowings. Finally, tax expense is estimated using the effective tax rate on pretax income. 7. In the first step, balance sheet items are projected using forecasted income sales (COGS) and relevant turnover ratios. Long-term assets are projected using forecasted capital expenditures. Long-term liabilities are projected from current maturities of long-term debt disclosed in the debt footnote, and paid-in-capital is assumed to be constant in this stage. Retained earnings are projected adding (subtracting) projected profits (losses) and subtracting projected dividends. Once total liabilities and equities are forecasted, total assets is set equal to this amount and forecasted cash is computed as the plug figure.

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Chapter 09 - Prospective Analysis

In the second step, long-term liabilities and equities are adjusted to yield the desired level of cash. The analyst must be careful to maintain the historical leverage ratio and adjust liabilities and equities proportionately. 8. The residual income model expresses stock price as the book value of stockholders’ equity plus the present value of expected residual income (RI). Residual income can be expressed in ratio form as, RI = (ROEt – k) * BVt-1 Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so long as ROE  k. In equilibrium, competitive forces will tend to drive rates of return (ROE) to cost (k) so that abnormal profits are competed away. The estimation of stock price, then, amounts to the projection of the reversion of ROE to its long-run value for a particular company and industry. ROE is a value driver since it impacts our valuation of the stock price. Its components (asset turnover and profit margin) are also value drivers 9. We can make two observations regarding the reversion of ROE: a. ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition. Furthermore, the reversion rate for the least profitable firms is greater than that for the most profitable firms. And finally, reversion rates for the most extreme levels of ROE are greater than those for firms at more moderate levels of ROE. b. The reversion is incomplete. That is, there remains a difference of about 12% between the highest and lowest ROE firms even after ten years. This may be the result of two factors: differences in risk that are reflected in differences in their costs of capital (k); or, greater (lesser) degrees of conservatism in accounting policies. The reversion of ROA and NPM are similar. While some reversion of TAT is evident, it is much less than that of the other value drivers. 10. Short-term cash forecasts are key to assessments of short-term liquidity. An asset is called "liquid" because it will or can be converted into cash within the current period. The analysis of short-term cash forecasts will reveal whether an entity will be able to repay short-term loans as planned. This also means such analysis is extremely important for a potential short-term credit grantor. Short-term cash forecasts often are relatively realistic and accurate because of the shortness of the time span covered. 11. A cash forecast, to be most meaningful, must be for a relatively short-term period of time. There are many unpredictable variables involved in the preparation of a reliable forecast for a highly liquid asset such as cash. Over a long period of time (that is, beyond the time span of one year), the difference in the degree of liquidity among items in the current assets group is usually insignificant. What is more important for long time spans are the projections of net income and other sources and uses of funds. The focus should be shifted to working capital (and other accrual measures), and away from cash flows, for longer forecast horizons of, say, thirty months—where the time required to convert current assets into cash is insignificant.

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Chapter 09 - Prospective Analysis

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Chapter 09 - Prospective Analysis

12. Cash inflows and outflows are highly interrelated. These two flows are crucial to a company’s ―circulation system." A deficiency in any part of the system can affect the entire system. For example, a reduction or cessation of sales affects the vital conversion of finished goods into receivables or cash, which in turn leads to a drop in the cash reservoir. If the system is not strengthened by "transfusion" (such as additional investment by owners or creditors), production must be curtailed or discontinued. Lack of cash inflows also will reduce other expenses such as advertising, promotion, and marketing expenses, which will further adversely affect sales. This can yield a vicious cycle leading to business failure. 13. Most would agree with this assertion. Cash is the most liquid asset and when management urgently needs to purchase assets or incur expenses, a cash exchange is the quickest and easiest means to execute a transaction. Moreover, unless management has a credit line established with a reliable outsider (such as a revolving account at a bank), lack of cash can mean a permanent loss of profitable opportunities. 14. Ratio analysis is a static measurement tool. Ratios measure relations among financial statement items as of a given moment and time. In contrast, funds flow analysis is a dynamic measure covering a period of time. A dynamic model of funds flow analysis uses the present only as a starting point and utilizes the best available estimates of future plans and conditions to forecast the future availability and disposition of cash or working capital. Analyzing funds flow also encompasses the projected operations of a company. Since one of the fundamental assumptions of accounting is the going-concern concept, some assert that the dynamic model is more realistic and is superior to static representations. However, care should be taken in placing too much reliance on funds flow analysis as it is primarily based on estimates, and not on realized observations. 15. Except for transactions involving the raising of money from external sources (such as through loans or additional investments) and the investments of money in long-term assets, almost all internally generated cash flows relate to and depend on sales. Accordingly, the usual first step in preparing a cash forecast is to estimate sales for the period under consideration. The reliability of any cash forecast depends on the accuracy of this forecast of sales. In arriving at the sales forecast, the analyst should consider: (1) past trends of sales volume, (2) market share, (3) industry and general economic conditions, (4) productive and financial capacity, and (5) competitive factors, among other variables.

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Chapter 09 - Prospective Analysis

EXERCISES Exercise 9-1 (45 minutes) Projected Income Statement for Year 12 Quaker Oats Company Forecasted Income Statement For Year Ended June 30, Year 12 Revenues [given].................................................................

$6,000.0

Costs and expenses Cost of goods sold [a] ...................................................

$3,186.0

Selling, general, and administrative [b] .......................

2,439.4

Other expenses [c].........................................................

35.2

Interest, net [d] ...............................................................

91.4

Total costs and expenses...................................................

5,752.0

Income from continuing operations .................................

248.0

Income taxes [e] ..................................................................

105.9

Income before discontinued operations ..........................

142.1

(Loss) on disposal of discontinued operations [given] ... Net income ...........................................................................

(2.0) $ 140.1

Notes: [a] Cost of sales is estimated to be at a level representing the average percentage of cost of sales to sales as prevailed in the four-year period ending June 30, Year 11, which is 53.1% (19,909.2 – 9,331.3)/19,909.2. Therefore, 6,000 x .531 = $3,186. [b] Selling, general & administrative expenses in Year 12 are expected to increase by the same percentage as these expenses increased from Year 10 to Year 11, which is 15%. Therefore, $2,121.2 x 1.15 = $2,439.4. [c] Other expenses are expected to be 8% higher in Year 12. Therefore, 32.6 x 1.08 = $35.2. [d] Interest expense (net of interest capitalized) and interest income will increase by 6% due to increased financial needs. Therefore, $86.2 x 1.06 = $91.4 [e] The effective tax rate in Year 12 will equal that of Year 11, which is 42.7% ($175.7/$411.5). Therefore, tax expense = $248 x .427 = $105.9.

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Chapter 09 - Prospective Analysis

Exercise 9-2 (25 minutes) Spreadsheet to Compute Forecasts of Sales and Income

Date Dec-Y1 Mar-Y2 Jun-Y2 Sep-Y2 Dec-Y2 Mar-Y3 Jun-Y3 Sep-Y3 Dec-Y3 Mar-Y4 Jun-Y4 Sep-Y4 Dec-Y4 Mar-Y5 Jun-Y5 Sep-Y5 Dec-Y5 Mar-Y6 Jun-Y6 Sep-Y6 Dec-Y6 Mar-Y7 Jun-Y7 Sep-Y7 Dec-Y7 Mar-Y8 Jun-Y8 Sep-Y8 Dec-Y8 Mar-Y9 Jun-Y9 Average change for each quarter

Forecast Sep.Y9* Forecast Dec.Y9* Forecast Mar. Y0* Forecast Jun. Y0*

Sales

$17,349 12,278 13,984 13,972 16,040 12,700 14,566 14,669 17,892 12,621 14,725 14,442 17,528 14,948 17,630 17,151 19,547 16,931 18,901 19,861 22,848 19,998 21,860 21,806 24,876 22,459 24,928 23,978 28,455 24,062 27,410

N.I.

$1,263 964 1,130 996 1,215 1,085 656 1,206 1,477 1,219 1,554 1,457 1,685 1,372 1,726 1,610 1,865 1,517 1,908 1,788 2,067 1,677 2,162 2,014 2,350 1,891 2,450 2,284 2,671 2,155 2,820

Change In Dec. Sales

-$1,309

Change in Dec. NI

Change In March Sales

Change in March

NI

Change In June Sales

2,709

153

2,710

178

1,945

226

2,172

270

$1,667.67

$214.67

25,645.67

2,498.67

172

145 1,271

182

202 3,067

160 2,959

254

283 2,461

214 3,068

288

321 1,603

30,041.57

251

180 1,983

$1,586.57

-227

898

153 2,905

3,579

$210

208 2,327

2,028

$697 134 159

3,301

-$474

262 -79

2,019

Change in Sept. NI

$121 $582

-364

Change In Sept. Sales

-$48 $422

1,852

Change In June NI

$201.14 $1,683.43

264

$170.14

2,482

370

$1,918.00

$241.43

2,872.14 25,745.43

2,325.14 29,328.00 3,061.43

* Most recent actual quarter + average change for the quarter. Note: Reported quarterly sales and net income for General Electric are: Sales Net income Sep Y9 $27,200 $2,653 Dec Y9 32,855 3,089 Mar Y0 29,996 2,592

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Chapter 09 - Prospective Analysis

Exercise 9-3 (40 minutes) a. To illustrate how predictions of market share and total market sales can be used in the forecasting process, consider the following example. If an analyst, for instance, predicts that (i) Cough.com will maintain its 0.08% share of the market for children's cough medicine and (ii) total Industry sales of children's cough medicine for year 2006 is $3.2 billion, then a reasonable estimate of Cough.com's year 2006 sales is $2.56 million. This is computed as 0.08% market share multiplied by the expected $3.2 billion of industry sales. b. All relevant data should be sought out, subject to cost-benefit considerations, in the prediction of sales. The importance of sales to predictions of financial performance and financial condition cannot be overemphasized. Accordingly, companies invest considerable research and effort in predicting sales. Regarding what types of data to seek and how to obtain them, let’s consider a retailer. To project the sales of a retailer, an analyst might consider visiting outlets that sell the retailers’ products and observe customer-buying patterns versus the patterns observed for key competing products. This activity can be done using anecdotal observation or using formal statistical sampling depending upon the analysts' perceived need for accuracy. Moreover, the analyst can seek information from insiders via interview or interpretation of formal or informal disclosures made by the company. The analyst can also review company strategies and industry trends. In sum, good predictions involve more than sophisticated models—they demand that the analyst take the perspective of a customer constrained by the economic environment predicted to exist. c. Relying on predicted year 2006 total industry sales of $3.2 billion, the sales of Cough.com are predicted to be as follows 2006 Market share is 5% greater [105% x .08%] x $3.2 billion = $2.688 million

2006 Market share is 5% worse [95% x .08%] x $3.2 billion = $2.432 million

d. What-If industry sales are 10% higher: [105% x .08%] x [110% x $3.2 billion] = $2.9568 million What-If industry sales are 10% lower: [105% x .08%] x [90% x $3.2 billion] = $2.4192 million

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[95% x .08%] x [110% x $3.2 billion] = $2.6752 million [95% x .08%] x [90% x $3.2 billion] = $2.1888 million

Chapter 09 - Prospective Analysis

Exercise 9–4A (30 minutes) Lyon Corporation Cash Forecast For July, Year 6 Beginning cash balance ..................................................... Cash collections Beginning accounts receivable ............................... Sales for month ........................................................ Less: Ending accounts receivable .......................... Cash available ..................................................................... Cash disbursements Beginning accounts payable ................................... Purchases (note a) ................................................... Ending accounts payable (25% of purchases)....... Miscellaneous outlays ............................................. Cash balance ............................................................

$ 20 $ 20 150 170 21

18 115 133 29

Minimum cash balance desired............................... Excess cash ..............................................................

[a] Ending inventory ................................................................................................... Cost of goods sold (5/6 of sales) .......................................................................... Less beginning inventory ..................................................................................... Purchases .............................................................................................................

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149 $169

104 11 $ 54 30 $ 24

$ 15 125 140 25 $115

Chapter 09 - Prospective Analysis

PROBLEMS Problem 9-1 (90 minutes) a. Coca-Cola Year 3 Estimate 20,297

Year 2 20,092

Year 1 19,889

6,106

6,044

6,204

14,191

14,04...