Projecting cash flows

(Forecasting is very difficult, especially if its about the future.- Anonymous)

Tru Oana-Patricia

FEAA, Finance-Banking, 3rd year, Series 01

Contents

Chapter I. Concept of cash flow........................................................................................... 3

1.1 Understanding of cash flow....................................................................................3
 1.2 Classification of cash flows....................................................................................3
1.3 Importance of cash flows....................................................................................... 4
Chapter II. Projecting cash flows.......................................................................................... 6
2.1 Concept of projecting cash flow................................................................................... 6
2.2 Formulas and indicators............................................................................................. 7
2.2.1 Length of Extraordinary Growth Period..............................................................7
2.2.2 Estimating cash flows from the high growth period................................................8
2.2.3 Calculation of the terminal value.....................................................................17
2.2.4 Other determinants in forecasting....................................................................19
Chapter III. Process and importance of projecting cash flows.....................................................21

Chapter I. Concept of cash flow

1.1 Understanding of cash flow

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 Cash flow represents the circulation of money in or out of a company, project, or a certain financial
product from operating, investing and specific financing activities. The measurement of the amount of
money is realized during a specified and also limited period of time or accounting period. Also, the
measurement of cash flow it is used in the calculation of parameters that inform regarding the value of the
company, liquidity or solvency and financial situation.

In practice, any company, in a regular business cycle, preferes that the flow of cash coming in is bigger
than the one going out of the company. In other terms, a company has a negative flow if it has more cash
outflows than inflows. It can be said that represent an important indicator of the financial health of the
company. However, many businesses are obliged to deliver certain goods or services to customers whilst
paying the employees, suppliers and only in the end what remains is theirs to claim.

Considering this, many companies face issues regarding the cash flows because of the lag of in
payments and out payments affecting also the management which is also crucial for the financial health of
the company and its long term sustainability. The managing of cash flows becomes more complex
because of the number of transaction and the amounts of money which are involved, having a major
impact on the company.

The cash inflows represent any receipts of cash to a certain company and it includes: payments for
goods and services from different customers, receipt of a bank loan, interest gained from savings and
investments, investments of shareholders, tax returns. The cash outflows represents the outgoings of cash
including: purchasing stock, raw materials or certain equipment, salaries, rents and the daily operating
expenses of the firm, loan repayments, income tax, payroll tax and many other taxes, different asset
purchases.

The notion of cash flow is mainly based on the cash flow statement accounting standards. It has a
certain flexibility to it due to the fact that it refers to intervals of time spanning over the past-future. It
involves the total of flows or their subset. The subset concept includes elements such as: net cash flow,
operating cash flow and free cash flow.

1.2 Classification of cash flows

The net cash flow, which is also known as the total cash flow, from a certain period (quarter,
half year, full year) equals the change in the cash balance over a period: it is positive if the cash
balance increases (the availability of cash is bigger), it is negative if the cash balance is
decreasing. The net cash flow, representing the sum of all cash flows is classified in 3 areas,
appearing on the statement of cash flows and depends on the nature of the transaction. The
classification is as follows:

1. Operational cash flow

It represents the cash that is received or expended from the internal activities of the company.
It comprises cash earning and changes to the working capital. It is related to the cash activities
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 included in the net income. One example of operational cash flow would be the cash from sale
of goods (revenue), cash paid for merchandise (expense).In the medium term it must be net
positive in order for the company to stay solvent.

2. Investment cash flows

It consists of the cash from the sale of long-term/non-current assets, or it is spent on capital
expenditure such as: investments, acquisitions and long- term/non-current assets. The non-
current assets are: long-term investments, property, plant and equipment and the principal
amount from the loans to other entities.

3. Financing cash flows

Is the cash generated by the issue of equity and debt, or it is paid as dividends, repurchases
of shares or payments of debts. In other words, it is related to the owners equiry and the non-
current liabilities. These include: principal amount of the long term debt, stock sales and
repurchases and payment of dividend.

1.3 Importance of cash flows

Cash are mainly used in a business for the calculation of parameters disclosing the cash
movements over a period.

The importance of the cash flows is given by the following facts and factors:

The rate of return of a project. The time corresponding to the cash flows and to the
projects are used in financial models e.g. internal rate of return and net present value.
Also, cash flows shows the problems of a business regarding liquidity. A profitable
firm is not a guarantee for liquidity. Failure can occur within the company due to the
shortage of cash, while being profitable.
Because the accrual accounting does not represent the actual economic situation the
company may derive additional operating cash through the issuing of share or by the
raise of additional debt finance.
Cash flows help when evaluating the quality of the income that is generated from
the accrual accounting.
It also helps when evaluating the risks of a certain financial product e.g the matching
of the cash requirements, evaluating the default risk etc.
Cash is crucial for business owners as it is stated in the common expression cash is
king. This refers to the fact that the availability of more financial resources (cash)

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 gives to the owners of a company more buying power. A company cannot solely rely
on borrowing therefore, cash gives a higher protection against issues such as loan
defaults and foreclosure.
When borrowing money to purchase buildings, equipment and inventory, it is used
the future cash flows to accomplish the purchases. In general, companies habe long-
term loans and also short-term credit accounts with certain vendors which require
monthly payments. The monthly payments are based on an ongoing cash flow,
representing money that is available for investing in the growth of the company.
Besides the management of debt, a strong cash flow offers the comfort and capability
to invest in its growth, meaning: build new locations, invest in research and
development, renovate infrastructure, improving the technology, provide training and
the purchase of more assets and certain inventory. Also, excess cash flow aids when it
comes to operating in a strategic way, rather than in a defensive way.
Cash flows offer to a business big flexibility regarding emerging issues or when
making critical decisions. Using the cash flows wisely makes it easier when making
critical purchases in short-term rather than staying on hold. It also offers the
possibility to disperse the cash in the form of dividends to shareholders or owners. A
stronger cash flow makes a business more appealing to lenders if the company is in
debt and it also gives the ability to offer favorable credit terms in order to attract new
buyers.

Chapter II. Projecting cash flows

2.1 Concept of projecting cash flow

Cash flow projecting represents a very important trait of the financial management of a
certain company, by planning the future cash requirements in order to avoid the issue of liquidity.
In essence, the projection of a cash flow is a cashbook that forecasts the income of a company
and the outflows, for certain period of time (week, month, financial year). It is necessary to list
the payments and the expenditure that are expected for a certain period, the surplus of cash or the

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deficit that is left over after the incomes and the outgoings which are accounted for, and adding
the account balance of the business at every beginning and end of period.

In corporate finance, the projection of cash flow is the plan of a businesesss future financial
liquidity in a specific period. The term of cash stands for the total bank balances of the
company, often the forecasting being the position of the treasury representing the cash with the
short-term investments less the short-term debts. In other words, the cash flow represents the
modification in cash or the position of treasury from a certain period to another.

In the world of entrepreneurs or the one of managers of the small and medium enterprises, the
projection of cash flow is much more simple due to the fact the they plan the cash that is to come
in the company for the insurance of the management of the outgoing in order to avoid the excess
of cash flow that comes in. The motto of the entrepreneurs is Cash is king and thats why the
projection of cash flow must be positive.

The projection is usually represented as spreadsheet document, many companies using the
software of small businesses, for the further automatic calculation by subtotaling all the types of
income and outflows, by consulting the accountants for the insurance of accuracy. The forecast
of the cash flow is valuable just like the information and the detail that is put into it.

When projecting cash flows is imperative to understand the concept of timing the income of
cash with the outgo due to the operating cycle of the company. The cycle comprises a variety of
moving parts, like buying or selling on credit, the process of collecting, the necessary cost for
running the business (salaries, rent, the marketing side, etc.) and, most essentially, the pay day of
the owners.

2.2 Formulas and indicators

When valuing an asset, it is important to forecast the cash flows that are expected over its life.
The concept of valuing a publicly traded firm can be a problem due to the fact that in theory
they have a perpetual life.

One method for solving this problem is through the help of the discounted cash flow models by
estimating for a period its cash flows (it is supposed to be an extraordinary growth period)
having a terminal value at the ending period. The most consistent alternative for the estimation of
the terminal value used in a discounted cash flow model is by assuming that the cash flows will
continue to grow at a steady growth rate and it can be sustained over an undetermined period

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after the year ends. In other terms, the value of the firm expecting to have an extraordinary
growth for n years can be represented as:
t=n
Expected Cash Flow t Terminal value t
Value of the firm= (1+r )t + (1+ r)t
t =1

In order to project cash flows there are three components that make this possible:

1. Determining the length of extraordinary growth period; many firms, depending

on their position in the life cycles and the competition they encounter, will face
various growth period.
2. Estimating the cash flows from the high growth period, with the help of the
measures of the cash flows.
3. The calculation of the terminal value, which is based on the path that is expected
from the cash flows after the final year.

2.2.1 Length of Extraordinary Growth Period

The sustaining of a high growth period is not an easy task for firms when it comes to
valuation.
However, all companies, after a certain period reach to the point when they become stable
as of growth, due to the fact that a high growth will lead a firm to become larger and the size
will influence the miscellaneous high growth. But, also, firms can face liquidation.
Secondly, a major growth in valuation, or high growth creating value, derives from the fact
that the firm earns excess returns from the marginal investments. Or, in other words, the high
value comes from the firms that have a return on capital which is in exceeding the cost of
capital. Therefore, when the firm assumes that it will face a high growth in the next 5-10
years, it is also assumed that it will have excess return.

When taking into consideration the length of maintaining the high grow there should be
considered the following:

Size of the firm

Existing growth rate and the excess returns from it

The magnitude and the sustainability of the competitive advantage

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 2.2.2 Estimating cash flows from the high growth period
After establishing the length of the extraordinary growth period, there is necessary to
project cash flows over that certain period. One of the most logical sources for the estimates
is represented by the companys past, along with the risks of relying in its history.

a) Using the past a starting point

Using the past as a prologue for projecting the growth of a firm it conveys the information
that can become valuable when realizing the estimates for future.

Considering the history of a firms earning, the projecting of historical growth rates is
based on the following:

Computational options

The average growth rate varies and it depends on the fact that it can be an arithmetic average
or a geometric one. The simplest is the arithmetic because it considers the past growth rates,
whilst the geometric way takes into account the compounding occurring from one period to
another.

t =1

gt gt
Arithmetic average = t =n ; where = growth rate in year t
n

( 1n )
[ Earnings0 ] Earningsn
Geometric average = -1; where = earnings in n years ago
[ Earningsn ]

The two types of estimations vary, mostly in the case of firms which have sensitive earnings.
The geometric average is visibly accurate regarding the real growth in the past earning, mostly
when it comes to erratic yearly growth. Actually, the point regarding the two growth rates applies
to revenues, even though they tend to be smaller than one or other as of earnings. The arithmetic
growth is able to have much more weight.

Period of estimation

For a firm, the average growth rate is slightly different, depending when the estimation starts
or ends. More exactly, if the calculations begin at a bad earning year and they end with a good
earning year, in the intermediate period there will be a healthy growth.

Negative earnings

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 The measures regarding the historical growth are affected by the numbers which have negative
earnings. The change in percentage on a yearly basis can be defined as:

EPS t EPS t 1 EPS t

% change in EPS in period t = = 1
EPS t 1 EPS t1

EPS t1
If is negative or if it is zero, the calculation above has a irrelevant result. This
remains to be calculated in the geometric method. If the EPS from the initial period is negative,
the geometric method is not meaningless. Even if there are some disadvantages regarding the
growth estimates even if the earnings are negative, they dont have relevant information
regarding growth. It doesnt mean, that is not correct, and it can be good for calculation of the
historical growth rate especially when the earnings have a negative yield.

1/7
Geometric Average = ( Earnings2005 / Earnings 1998 ) -1

b) Outside the estimates of the growth

Management estimations

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 A very large number of valuation use their forecasts for their revenues and earnings which is
provided by the management of the company. This fact facilitates the estimations because the
numbers presented are realized by the managers and allows that the valuation analysts to blame
other persons when the forecast are not made. And also, the management forecasts are
combinations of assumptions which are not consistent. For example management can forecast a
revenue growth of 10 % in the next ten years without using any new capital expenses. Using the
existing assets more efficient can generate short-term growth.

Analysts estimations

Analysts, besides using the historical data, have the advantage of using financial information
that results from the firm and the general economy from the last earnings report, in order to make
predictions regarding future growth, leading to a major re- evaluation of the cash flows that are
expected. The models used for the forecast of earning depend only on the data from the past
earning and it can ignore publicly available information which can be useful when projecting
future earnings. Analysts incorporate into their forecasts financial variables like, earnings
retention, profit margin and asset turnover.

c) Fundamental growth

Growth represents an exogenous variable which is affecting value but without any connection
with the operating details from the firm. Firm owners incorporates growth into the value of it by
making growth endorgenous e.g. making a function of how much does the firm reinvest for their
future growth and the quality deriving from the investment.

Growth can be estimated as follows:

Growth in the equity earnings

When the cash flows are estimated to equity, firstly, there is estimated the net income if there is
valued equity in the aggregate; or the earnings per share, if there is valued the equity per share.

Firstly, a firm can grow its net income by the issuing of new equity for the funding of new
projects whilst the earning per share are constant. To make the difference in the relation between
net income growth and fundamentals there is used the measure of estimating directly the amount
of equity that the firm reinvests back into the businesses as net capital expenditure and the
investments in the working capital.

Growth in earnings per share

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 The most simple relationship that helps when determining growth is the retention ratio
(percentage from earnings retained by the firm) and the return on the equity from its projects.

Firms with high retention ratios and high earnings returns on their equity usually have higher
growth rates in their earning per share than the firms that do not apply these characteristics. In
order to establish this, it is necessary to be noted that:

t t1
gt =
t1

Where:

gt = Growth rate in net income;

t
= Net income in year t;

t1
Considering the definition of return on the equity, the net income in year can be
written as follows:

t 1 Equity t 2 ROEt 1
= Book value of *

Where:

ROEt 1 t1
= Return on equity in year

The net income in year t can be written as follows:

t Book value of Equity t2 Retained earningst 1 ROEt

=( + )*

ROEt ROEt 1
Supposing that the return on equity remains unchanged, i.e., = =ROE

Retained earnings t1
gt
= ( t 1 ) (ROE) = (Retained ratio) (ROE) = (b) (ROE)

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 Where (b) represents the retention ratio. It must be noted that the firm is not allowed to
increase equity through the issuance of new shares. In the same time, the growth rate in the net
income and the growth rate from earnings per share are similar in the formulation.

Examples
It is considered an expected growth rate in earnings based on the retention ratio and return on
the equity for two financial service firms- Goldman Sachs and J.P. Morgan Chase, and a real
estate investment trust (Vornado) and a telecommunication firm (Verizon).

Goldman Sachs is the firm with the highest expected growth rate in earnings per share, because
of the high return on the equity and retention ratio. Verizon has a higher return on equity, but it is
retaining less from its earnings, having a low expected growth rate. Morgan Chase has a low
return on equity and retention ratio dragging the expected growth down, and Vornados expected
growth rate is dragged by the payment of its earnings as dividends.

Growth in the net income

The growth from the net income is different from the growth in earnings per share. One
method through which a firm cam increase its net income is through the issuance of new equity
in order to fund new projects when the earnings per share stagnates. To make a distinction
through net income growth and fundamentals there is used a method to estimate directly the
amount of equity that the firm reinvests into the business, as net capital expenditures and
investments in the working capital.

Equity reinvested in business = (Capital Expenditures Depreciation) + Change in

Working Capital - (New Debt Issued Debt Repaid)

By dividing the above number by the net income it give a bigger measure of the rate of the
equity reinvestment rate:

Equity reinvested
Equity Reinvestment Rate = N et income

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 This number can be in the excess of 100% due to the fact that firms raise new equity. The
growth that is expected from the net income can be represented as:

Expected Growth in Net Income = (Equity Reinvestment Rate)*(Return on Equity)

Determinants of the Return on Equity

Earnings per share and the net income are both affected by a firms return on equity. The return
on the equity is directly affected by the leverage decisions inside the firm. In other words, the
increase in leverage will generate a higher return on the equity only if the pre-interest, after-tax
return on the capital is exceeding the after-tax interest rate paid on the debt. This can be observed
in the following formula regarding the return on equity:

D
ROE= ROC+ E (ROC- i(1-t))

Where:

EBIT (1t)
ROC= BV of Debt + BV of Equity

D BV of Debt
E = BV of Equity

Interest Expense on Debt

i= BV of Debt

t= Tax rate on ordinary income;

The derivation of the growth rate can be simplified by using the expanded version of ROE the
following way:

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 D
g= b [( ROC+ E (ROC- i(1-t) )]

The formula offers the advantage of demonstrating the changes in the leverage and the
consequences effects on the growth.

Average and Marginal Returns

The return on equity is measured by dividing the net income from the most recent year by the
equitys book value from the end of the previous year. The return on equity measures the quality
of older projects and of new projects from substantial periods of time. Usually the older
investments are a large part of the earning, and the average return may not become substantial for
large firms that are facing an issue on the returns on the new investments. In order to measure the
returns, there must be computed a certain marginal return on the equity:

Net Income t
Marginal Return on Equity= Book Value of Equityt 1

Considering that the marginal return on equity represents the returns on the new investments,
it offers a signal alarm that the return on the equity on new investments is lower than the
historical returns.

The effects of changing the return on equity

Considering that a firm has a book value of equity of $100 million and a return on the equity
of 10%, if the firm improves the returns on equity to 11%, the earnings growth rate will be 10%
even if it doesnt reinvest the money. This type of growth can be explained in the following
formula:

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 ROE tROE t 1
Addition to Expected Growth rate= ROEt 1

ROEt
Where represents the return on equity in the period t. This will be added to the
fundamental growth rate calculated as the product of the return on equity in the period t and the
retention ratio.

ROE tROE t 1
ROEt
Total expected Growth Rate= (b)( )+ ROEt 1

While the increased return on equity will generate a certain spurt in the growth rate in the
improvement period, a decline in return on the equity will lead to a proportional fall in the
growth rate in the decline period. The difference between return on equity from new investments
and the return from existing investments is that the estimated additional growth comes not from
the new investments but from the existing investments.

Growth in the Operating Income

The income growth is determined through the equity reinvested in the business and the return
made on the equity investment. There can be made a connection between growth in the operating
income to the total reinvestment made in the firm and the return from the capital invested.
Whern the return on a firms capital is stable, the expected growth in the operating income is a
product of reinvestment rate, more specifically, the part of the after-tax operating income
invested in the net capital expenditure and the non-cash working capital, and the quality of the
reinvestments are measured as the return on the capital that is invested.

Expected growth EBIT

= Reinvestment Rate* Return on capital

Where:

Capital ExpenditureDepreciation+ Noncash WC

Reinvestment rate = EBIT (1tax rate)

EBIT (1t)
Return on capital = Capital invested

Reinvestment rate

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 It measures how much the firm has to plow back in order to generate future growth. This
reinvestment rate is measured by using the most recent financial statements of the firm. It is not
considered the best estimate for the future reinvestment rate due to the fact that a firms
reinvestment rate can ebb and flow, especially at firms that are investing in relatively few, large
projects or acquisitions.
The reinvestment rate can be negative if the depreciation exceeds the capital expenditure or if
the working capital drops substantially over the year. For most of the firms the negative
reinvestment rate is temporary, reflecting the lumpy capital expenditures or the sensitive working
capotal. It can be replaced with an average reinvestment rate over the last years.
Return on Capital

It is based on the firms return on their existing investments where the capitals book value is
presumed to measure the capital that is invested in these investments. Also, it is assumed that the
current accounting return on the capital represents a good measure of the actual returns earned on
their existing investments and that the returen represents a good aproximation for the returns that
will be made on the future investments.
Besides the return on a firms capital there should also be considered the trends in this return,
as well as the industry average return on the capital. If the current return on a firms capital is
higher than the industry average, the forecasted return on the capital must be lower than the
current return in order to reflect the erosion that occurs as a response from competition.

EBIT (1t)
Return on capital = (BV of Debt + BV of EquityCash)

Growth in revenues

One major step in projecting cash flows is the forecasting of revenue in the future year, by
forecasting a growth rate in their revenue in every period. There are five important features that
need to be considered when making these estimates:
The rate of the growth in revenues will drop as the revenues of the firms will increase.
For example, if a ten-fold increase in the revenue is feasible for a firm which has
revenues of $2 million but less likely for a firm with revenues of $2 billion.
Compound growth rate in revenue over time may look low but, a growth rate of 40%
over ten year will lead to a 40-fold increase in revenues.
There must be kept track of the dollar revenues in order to ensure that they are
reasonable, considering the size of the general market that the firm is operating in.
Assumptions regarding revenue growth and operating margins must be consistent,
meaning, that the firms should adopt aggressive pricing strategies.
When realising an estimation of the revenue growth, there must be made a number of
subjective judgements regarding the competions nature, the firms capacity which is
being valued to be able to handle the revenue growth and the marketing capabilities.

Operating margin forecasts

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 When estimating the operating margin forecasts there is a necesity for projecting in the
beggininng of the valuation. The revenues in that period are low and the margins are negative. A
valuable firm with high revenue deliver certain positve earnings. When realising a valuation
model the operating margins are translated as positive in the future. One major factor for this
margin is the field that the firm is operating into.
The improvements in the margins will be bigger in early years and then taper off as the firm
matures. Another issue needs to be considered when talking about revenue growth. Some firms
are able to project high revenue growth with low magins but the trade off needs to be taken into
account.

Sales to capital ratio

Firms are obliged to invest for the further growth in revenue and in the positive operating
margins from the future years. This kind of investment has certain traditional forms such as plant
and equipment and also acquisition of other firms, partnerships, distribution and marketing
capabilities investments and also research and development.
The above mentioned ratio, it allow for an estimation for the additional investment that the firm
should make so that it can generate the projected revenue growth. The investment can take place
in internal projects, certain acquisition or the working capital.
Two major factors that influence this ratio are the firms past and the field that it is operating
into. To make the link between revenue growth and reinvestment needs, there needs to be taken
into account the revenues with the higher operating margins and the values than firms that rely
only on the revenue growth.
Example
In order to estimate how much Sirius Radio will need to invest to generate its expected revenue
growth, theres necessary to estimate the current sale to capital ratio and the average sales to
capital ratio of the firm.

Current sales to capital ratio for Sirius = Revenues/ Book value of capital = 187/ 1657 =
0.11
Average sales to capital ratio for peer group = 1.50
It was used a sales to capital ratio of 1.50 for Sirius, reflecting also the industry average. Using
this estimate, it can be calculated how much Sirius will have to reinvest each year for the next 10
years as follows:

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 Link to return on capital

One of the issues when using a sales-to-capital ratio in order to generate reinvestment needs is
the the firm might under-estimate or over-estimate the reinvestment needs. When estimating the
reinvestment needs the firms considers the after-tax return on the firm each year by analysis. In
order to estimate the return on the capital in a future yeat , it is used the estimated after- tax
operating income from that year and it is divided by the total capital invested in that firm from
that year. The former number comes from the estimated of the growth in revenue and the
operating, whilst the latter can be estimated by the aggregation of the reinvestments made by that
firm all through the future year.

2.2.3 Calculation of the terminal value

The cash flow cannot be projected on a long-term basis, but there can be imposed a certain
closure in the valuation of the discounted cash flow by stopping the estimation of the cash
flows sometime in the future and computing a terminal value which reflects the firms value
at that certain point.
t=n
CF Terminal valuen
Value of the firm=
(1+ kt )t + (1+ k c )t
t =1 c

The terminal value can be determined by three ways. One of the methods is to assume a
liquidation of the firms assets in a terminal year and then estimate how much would others pay
for the assets accumulated by the firm at that point. The second one considers the multiple
earning applied to earnings or book value to estimate the value from the terminal year. The third
one is based on the assumption that the firms cash flows will grow at a constant rate for a long
period of time, also known as stable growth rate.\

Liquidation value

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 When realizing valuations, it is assumed that the firm will discontinue operations at a certain
point in the future and sell all the assets accumulated to the highest bidders. This type of
estimation is called the liquidation value. This type of estimation has to methods through which
it can be realized. One of them is to base on the book value of assets, adjusted for any inflation
during a period. If the book value of those assets for ten year is predicted to be 2$ billion, the
average age of those assets at that certain point is 5 years and the expected inflation rate is 3%,
the liquidation value that is expected can be estimated.
Average life of assets
Expected liquidation value = ( Book value of assets Term year (1+ Inflation rate)

Example:
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$ 2 billion ( 1.03 = $2.319 billion

This approach has a limitation which is based on the accounting book value and it does not
reflect the earning power of the assets.
An alternative approach is by estimating the value based on the earning power of those assets.
To realize this estimation, there needs to be estimated the expected cash flows from the assets
and discount them back to presents, by using an appropriate discount rate. For example, if it is
assumed that the assets are expected to generate 400$ million in after-tax cash flows for 15 year
(after the terminal year) and the cost of capital is 10% the estimation of the expected liquidation
values is:

1
(1 )
Expected liquidation value = ($400 million) ( 1.10 )15 = $3.042 billion
0.10

When valuing the equity, there is another addition step that is needed to be taken. The
estimated value of the debt outstanding in the terminal year must be subtracted from the
liquidation value in order to arrive at the liquidation proceeds for the equity investors.

Multiple approach
When using this approach, the firms value in a future year can be estimated simply by
applying a multiple to earnings of the firm or revenue in that certain year. A firm with revenues
that are expected of $6 billion for ten years will have an estimated terminal value in that year of
$12 billion if a value to the sales multiple of 2 is used. When valuing equity, there must be used
equity multiples like price earnings ratios in order to arrive at the terminal value. This approach
has the advantage of simplicity, the multiple having a massive effect on the final value and where
it is obtained can be very critical. Commonly, the multiple is estimated just by looking at how
comparable firms in the business are being priced by the market. The process of valuation is
relative rather than a discounted cash flow valuation. If the multiple is being estimated through
the help of fundamentals, it converges on the stable growth model.
Considering, the using of multiples to estimate the terminal value, can be a dangerous mix of
relative and discounted cash flow valuations.
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 Stable growth model
In the liquidation value approach, it is assumed that the firm has a limited life and it will be
liquidated at its end. But, some firm reinvest their cash flows back into new assets and extend the
life period. If the cash flows, beyond the terminal year, will have a constant growth rate, the
terminal value is estimated as follows:

Cashflow
Terminal value of equity n
= equity n+1
Cost of equityn +1gn

The cash flow to equity can be strictly defined as the dividends (from the dividend discount
model) or as a free cash flow to equity. When valuing a firm, the terminal value can be written
the following way:

Cash flow
Termi nal valuen
= firmn +1
Cost of capital n+1gn

In this model the cost of capital and the growth rate can be sustained forever.
The fact that the stable growth rate has a constant rhythm, does also limit how high can it be.
Since there is no firm that can grow at a rate that is higher than the growth rate of the economy in
which it operates, the growth rate cant be bigger than the general growth rate of the existing
economy.
The limits on the stable growth rate are the following:
The firm can operate as a domestic company or as multi-national;
The terms in which the valuation are realized is in nominal or real terms;
The type of currency used to estimate the cash flows and the discount rates in the
valuation.
2.2.4 Other determinants in forecasting
Equity risk

The equity risk is linked to the market risk. High growth firms are much more exposed to
this type of risk than stable growth firms

Project return

Firms with high growth have high return on capital/equity and earn excess return. When
talking about firms with stable growth it is much more difficult to have excess returns.

Debt ratios and costs of debt

Firms with high growth use less debt than the stable growth firms. During the maturity the debt
capacity of the firm increases. When valuing the firms, the debt capacity changes the debt ratio

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that is used to compute the cost of the capital. When valuing the equity, the change in the debt
ratio will influence the cost of equity and the expected cash flows

Reinvestment and Retention ratios

Some firms reinvest less and the reinvestments and they can have a low growth on their
reinvestments. There can be made a certain adjustment that depend on the discounting dividends,
free cash flows to equity or free cash flow to the firm

Expected Growth Rate = Retention ratio * Return on Equity

The algebraic method allows for the retention ration to be a function of the expected growth
and return on the equity.

Expected growth rate

Retention ratio = Return on equity

In a free cash flow to equity model, the focus is made on the net income growth and the
expected growth rate is a function of the equity reinvestment rate and the return on the equity.

Expected Growth Rate = Equity Reinvestment rate * Return on Equity

The equity reinvestment rate can be computed the following way:

Expected growth rate

Equity reinvestment rate = Return on equity

Considering the free cash flows of the firm, the estimated expected growth in operating
income as a function of the return on the capital and reinvestment rate can be represented as
follows:

Expected Growth rate = Reinvestment rate * Return on Capital

With the help of algebra, the measure of the reinvestment rate is:

Stable growthrate
Reinvestment in stable growth= ROC n

ROC n
Where the represents the return on capital. The reinvestment rate can be used to
generate free cash flow to the firm.

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 If the return on the capital is higher than the cost of the capital in the stable growth period, an
increase in the stable growth will increase the value. If the return on the capital equals the stable
growth rate an increase in the stable growth rate will have no effect on the value. It can be
proved through the following formula:

EBIT n+1 ( 1t ) (1Reinvestment rate)

Terminal value = Cost of capital n Stable growth rate

By substituting as a function of the reinvestment rate, it results the following:

EBIT n+1 ( 1t ) (1Reinvestment rate)

Terminal value = Cost of capital n(Reinvestment rateReturnon capital)

By setting the return on capital as equal to the cost of capital, we get:

EBIT n+1 ( 1t ) (1Reinvestment rate)

Terminal value = Cost of capital n( Reinvestment rateCost on capital)

By simplifying, the terminal value can be written as:

EBIT n +1(1t)
Terminal value ROC=WACC
= Cost of capital n

Chapter III. Process and importance of projecting

cash flows

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 A cash flow projection charts the amount of cash from a certain business that expects to receive
and to pay out each month in a period of 12 months. The projections takes into account the lag
time between billing the clients and getting paid; incurring an expense and having to pay for it;
and also collecting the taxes which are not due to the government until a later time-period.

A very good prepared cash flow projection will allow for the plotting of the anticipated cash
flows over time. It also allows spotting certain sales trends and telling if the customers of a
business are taking too much to pay, and it helps to plan for major asset purchases. And another
important feature is that it helps a business when deciding to take a loan with the fact that the
banks will ask for a one-year cash flow projection by each month, and three-to-five-year
projection by quarter.

The actual process of projecting cash flows takes place as follows:

Step 1- Cash on hand

It is important that at the beginning of the first month, the cash to be counted. This amount of
cash represents the cash on hand. In the succeeding months, the ending cash balance from one
certain month will be carried over as the beginning cash balance of the next month.

Step 2- Cash receipts

Any cash sales, credit card sales and collections from credit accounts and any interest income
must be recorded. The mean through which this can be realized is through the record of the
receipts in the months that is actually expected to get the money and not the month a sales is
realized.

Step 3- Accounts receivable

The anticipated receivables in the months that are expected to be paid must be recorded. If a
firm hasnt kept records that show how long does it take for every customer to pay their bills, it
can compute the average collection by simply dividing the total sales for the previous year by
365. It gives the result for the average sales volume. After that, the dollar value must be divided
to the current accounts receivable by the average daily sales volume. The number resulted is the
average number of day that takes for the firm to collect on a bill. Using that number as guide, it
will record the payments as they will come in over the next year.

Step 4- Miscellaneous cash

The anticipated miscellaneous cash infusions must be accounted, also including new loans from
banks, or the stock offerings.

Step 5- Total cash available

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 For each month in the projection, the amounts from the first 4 steps must be added. It shows
the total cash available in each month.

Step 6- Cash paid out

It includes, firstly, the assets and the operating expenses. Every expense in the month that will
be paid must be noted, and not the month it incurred. The following items must be included in
the list of operating expenses:

Gross wages, including anticipated over the time;

Monthly dividends to owners;
Payroll taxes and certain benefits, including the paid vacations, health insurance,
unemployment insurance, etc. ;
Subcontracting and outside services, including the cost of labor and some materials;
Purchases of certain materials that are used in making the product or service, or for the
resale of it;
Supplies that are used in the business;
Repairs and maintenance (occasional large expenses like remodeling, renovation);
Packaging, shipping and the delivery costs;
Travel, car, and the parking costs;
Advertising and promotion, including the fliers, direct mail, print or the TV ads, yellow
pages listings, web site maintenance and the design;
Professional services like fees paid to the attorneys, bookkeepers, accountants,
consultants, etc. ;
Rent;
Telecommunication like phone, fax, Internet service provider;
Utilities like heat, water, electricity, gas, etc. ;
Insurance for fire, liability, workers compensation, etc. ;
Taxes;
Interest on the loans;
Other expenses that focus on cost specific to the firms are of business;
Miscellaneous (a small cushion for miscellaneous expenditures.

After finishing with the record of these items, the operating expenses must be subtotaled.

Step 7- Other costs

The other ongoing costs of doing business must be computed. The following items must be
included:

Loan principal payment- equipment purchases, vehicles, etc.

Capital expenses- depreciable expenses like equipment, vehicles, construction of new or
improvements to existing buildings, and improvements to leased facilities and the offices;

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 Start-up costs- expenses that occurred in the first month of operating and paid over the
course of the following year/s;
Reserve/ escrow- money set aside in each month for the taxes paid at the end of the year,
plus any other money escrowed to help making the payments on big insurance or
machinery bills;

Step 8- Total cash paid out

Once all the costs of doing business have been listed, they must be added to the subtotal for
operating expenses. The total cash paid out reflects the estimates for the total cash that the firm
will have to spend each month.

Step 9- Determining the monthly cash flow

The total cash paid out must be subtracted from the total cash available. The difference is the
monthly cash position or the cash flow. As the projected cash flow is projected, the cash position
must be checked at the end of each month to be sure if its positive. If it is negative, other steps
need to be taken in order to cover the shortfalls.

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