Advance Corporate Finance Guidelines

Lahore School of Economics. MBA II. M. Phil. Bus. Admin. (Research). Advance Corporate Finance.
Winter
2016. Dr. Sohail Zafar
Advance Corporate Finance
Term Project Guide Lines (Winter

2016)
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 and OE, and it would be
invested in NWC plus FA of the new 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.
To start the new venture, your group members will register a private
limited company with SECP, thus becoming the providers of seed
money and sponsors of the new co, and also the initial shareholders
who provide equity capital for this new venture: and the same group
members would also act as the directors. Your main task is to
prepare a financial plan for the next 5 years for the proposed new
business; and do valuation of share price at the end of the 5th year,
that is, to estimate share value at the end of year 5, P5. The
following paragraphs would help you understand how to do it?
TASKS TO BE PERFORMED
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Lahore School of Economics. MBA II. M. Phil. Bus. Admin. (Research). Advance Corporate Finance. Winter
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 of 6 performance areas, namely:
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, operating profit
margin on sales, net profit margin on sales, EPS, growth rate of
sales, NI, and EPS
c. asset productivity ( asset utilization also called asset
turnover of different assets): TA turnover, fixed assts turnover,
turnovers of various CAs, etc
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, 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, ROE, decomposition of
ROE according to DuPont formula into 3 components, and also as
ROIC + (ROIC Ki)debt/OE ratio
f. market measure: here make use of proxy MV to BV ratio 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).
Growth rate of TA, TL, OE, Sales, EBIT, NI, EPS, and DPS
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Based on expected 5 years performance in 6 areas of

performance , you will make recommendation as to acceptability of
this project
3. then do the capital budgeting analysis of the new project. 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 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. 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
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conservative you can assume zero growth in all future years in

OCFs of year 5 ; 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)
Be careful that if a constant growth rate is assumed for OCFs,
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 years growth rate . Therefore using a growth rate
higher than the long term growth potential of countrys economy
is not defensible as 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 countrys GDP, and that is none sense.
About estimating growth rate of OCFs, please see the annual
growth rates you already calculated in sales, EBIT, NI, and EPS.
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 is (NICO) or initial investment
beginning of year one in NWC + FA , and that was at least 1,000
million).
NPV =[ OCF1/ (1 + WACC)
WACC)
+ OCF2 / (1 + WACC)2 + OCF3 / (1 +
OCF4 / (1 + WACC)4 + {OCF5 + terminal cash flows in year 5} / (1

+ WACC)
] - NICO at beginning of first year. see below about
guidance for WACC calculations
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 co 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:
MV of OE
= MV of TA5 - TL5. And then share price at the end of year
5 can be estimated as:

P5 = MV of OE
/ 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, each future years OCF 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 (6monthly) 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 borrowing relationship with banks; plus you
are starting a new business; therefore it is likely that bank would
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consider your proposed business as high risk and accordingly charge

you a relatively hig 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 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 for 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, and also 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 of for this project long term
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loan was taken at 15% then add , for example, 8 points to the 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 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 projects 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
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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 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 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 plans 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
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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.
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, 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
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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, quality, HR
requirements, Marketing, etc.
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
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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 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
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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. 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 from 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, and utility bills 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 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 less than CA. So in the beginning of year one,
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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.
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 wont 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
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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 appear as paid up share capital
in balance sheets 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
invested 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 wont 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.
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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; while cost of
units sold during the year is CGS which appears on the 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 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.
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,
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there is no CGS ; there are only various operating costs. But in

manufacturing businesses such as textile, cement, ghee, sugar, steel,
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 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 years 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 years income statement.
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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
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 (TL + OE) is too small and
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you need to 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 or take more long term loan , or even
short term loan. Please remember assets cannot have negative value
in balance sheet. Also there must be some cash in a business always,
therefore zero cash balance in any years 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)
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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 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 .
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
wont 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
20
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 dont issue
TFCs because your co is new and private limited co, so issuing your
corporate bonds to public wont be practical.
Please prepare loan amortization schedule of Long Term Loan.
Assume at least 5 years loan and traditionally repayments are in semiannual (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
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 capital. You wont 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
21
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 pay 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
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.
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.
22
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 budget for 5 years. You
can use the format given below

YEARS
0
a) Cash Inflows
b) Cash outflows
c) Net CFs (a b)
d) +Beg Cash Balance
23
e) -Minimum Cash balance required

f) Cash excess or shortage (c + d e)
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 then 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 wont 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 :
24
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 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
25
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 wont 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.

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 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
26
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.
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 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.
You can use discounted values of yearly OCFs (using WACC as discount
rate) to find discounted payback period for this project. NPV should be
27
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 , 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 by
number of shares outstanding. In such a case, 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, 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
28
wealthier quickly , as compared to keeping your funds in a bank

account.
So! Good luck to you
29

Advance Corporate Finance Guidelines

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Advance Corporate Finance Guidelines

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Lahore School of Economics. MBA II. M. Phil. Bus. Admin. (Research). Advance Corporate Finance.

Advance Corporate Finance

Term Project Guide Lines (Winter

1. Projecting the next 5 years income statements and balance sheets is

Based on expected 5 years performance in 6 areas of

want to be more technically correct and trust your

growth rate forecast , then Terminal Cash Flows at the end of

conservative you can assume zero growth in all future years in

+ OCF2 / (1 + WACC)2 + OCF3 / (1 +

OCF4 / (1 + WACC)4 + {OCF5 + terminal cash flows in year 5} / (1

] - NICO at beginning of first year. see below about

guidance for WACC calculations

4. then do valuation of shares of this new company at the end of 5th

After calculating MV of TA at the end of year 5 using free cash flows

= MV of TA5 - TL5. And then share price at the end of year

5 can be estimated as:

/ number of shares outstanding at the end of year 5

For a profitable project, your estimated price at the end of year 5 is

WACC of the Project

Wd = debt capital / total capital , please use beginning of year one

consider your proposed business as high risk and accordingly charge

Estimating Kc (Risk adjusted Required Rate of Return

Estimate of Rm (rate of return of stock

market as a whole) has to be higher than Rf because stock market is

Growth rate ,g, is usually estimated as ROE (1 d) whereas d is

The Size Of Project

you are free to start business in any trading, manufacturing, or service

viability of your proposed product or service. If the item is being

FINANCIAL PLAN FOR THE NEXT FIVE

Machinery, both locally manufactured and imported,

fixtures, vehicles, computers, air conditioning, stand-by power

incorporating expenses to register your new company with the SECP,

investment in both FA and CA needed to start the operations would be

is, Wc = equity capital /total capital = 0.4. Equity capital is going

there is no CGS ; there are only various operating costs. But in

PREPARE PROJECTED BALANCE SHEETS FOR 5 YEARS

you need to additional financing as new loans or inject equity in that

use %age of sales of competitors as guide to forecast accounts

accruals so deduct from CA forecast the forecasted amounts of

interest paid loan paid

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

WARNING: Failure to treat NI in this manner and

But it is recommended that you give no cash dividends or stock

Instructions for those who make cash budget of each

annual cash budget for 5 years. You

can use the format given below

e) -Minimum Cash balance required

further acquisition of FA in subsequent years would also result in cash

treatment is given to L T Loan.

So if all of the above

Please NOTE: You do not need to artificially

Positive, IRR should be greater than WACC, Profitability Index should be

wealthier quickly , as compared to keeping your funds in a bank

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