CH 09

Chapter 09 - Prospective Analysis
Prospective Analysis
REVIEW
Prospective analysis is the final step in the financial statement analysis process. It
includes forecasting of the balance sheet, income statement and statement of cash
flows. Prospective analysis is central to security valuation. Both the free cash flow
and residual income valuation models described in Chapter 1 require estimates of
future financial statements. We provide a detailed example of the forecasting
process to project the income statement, the balance sheet, and the statement of
cash flows. We describe the relevance of forecasting for security valuation and
provide an example utilizing forecasted financial statements to implement the
residual income valuation model. We discuss the concept of value drivers and their
reversion to long-run equilibrium levels. In the appendix, we provide a detailed
example of short-term cash flow forecasting.
9-
1
OUTLINE
The Projection Process
Projecting Financial Statements
Application of Prospective Analysis in the Residual Income Valuation Model Trends in

Value Drivers
Short-term Forecasting (Appendix)
9-
2
ANALYSIS OBJECTIVES
Describe the importance of prospective analysis.
Explain the process of projecting the income statement, the balance sheet and the
statement of cash flows.
Discuss and illustrate the Importance of Sensitivity Analysis.
Describe the implementation of the projection process in the valuation of equity

securities.
Discuss the concept of value drivers and their reversion to long-run equilibrium levels.
9-
3
QUESTIONS
Prospective analysis is central to security valuation. All valuation models rely on forecasts
of earnings or cash flows that are, then, discounted back to the present to arrive at the
estimated value of the security. Prospective analysis is also useful to examine the viability
of companies strategic plans, that is, whether they will be able to generate sufficient cash
flows from operations to finance expected growth or whether they will be required to seek
external financing. In addition, prospective analysis is useful to examine whether
announcing strategies will yield the benefits expected by management. Finally, prospective
analysis can be used by creditors to assess companies ability to meet debt service
requirements.
Prior to the forecasting process, financial statements can be recast to better portray
economic reality. Adjustments might include elimination of transitory items or reallocating
them to past or future years, capitalizing (expensing) items that have been expensed
(capitalized) by management, capitalizing operating leases and other forms of off-balance
sheet financing, and so forth.
In addition to trend analysis, analysts frequently incorporate external (non-financial)

information into the prospective process. Some examples are the expected level of
macroeconomic activity, the degree to which the competitive landscape is changing, any
strategic initiatives that have been announced by management, and so forth.
The forecast horizon is the period for which specific estimates are made. It is usually 5-7
years. Forecasts beyond the forecast horizon are of dubious value since estimates are
uncertain.
Since all valuation models are infinite horizon models, analysts frequently assume a
steady state into perpetuity after the forecast horizon. A common assumption is that the
company will grow at the long-run rate of inflation, that is, remaining constant in real
terms.
The projection process begins with an expected growth in sales. Gross profit and
operating expenses are, then, estimated as a percentage of forecasted sales using
historical ratios and external information. Depreciation expense is usually estimated as a
percentage of beginning gross depreciable assets under the assumption that depreciation
policies will remain constant. Interest expense is usually estimated at an average
borrowing rate applied to the beginning balance of interest bearing liabilities. Projections
of expected interest rates are used for variable rate indebtedness and new borrowings.
Finally, tax expense is estimated using the effective tax rate on pre-tax income.
In the first step, balance sheet items are projected using forecasted income sales (COGS)
and relevant turnover ratios. Long-term assets are projected using forecasted capital
expenditures. Long-term liabilities are projected from current maturities of long-term debt
disclosed in the debt footnote, and paid-in-capital is assumed to be constant in this stage.
Retained earnings are projected adding (subtracting) projected profits (losses) and
subtracting projected dividends. Once total liabilities and equities are forecasted, total
assets is set equal to this amount and forecasted cash is computed as the plug figure.
9-
4
In the second step, long-term liabilities and equities are adjusted to yield the desired level
of cash. The analyst must be careful to maintain the historical leverage ratio and adjust
liabilities and equities proportionately.
The residual income model expresses stock price as the book value of stockholders equity
plus the present value of expected residual income (RI). Residual income can be expressed
in ratio form as,
RI = (ROEt k) * BVt-1
Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so long as
ROE k. In equilibrium, competitive forces will tend to drive rates of return (ROE) to cost (k) so
that abnormal profits are competed away. The estimation of stock price, then, amounts to the
projection of the reversion of ROE to its long-run value for a particular company and industry.
ROE is a value driver since it impacts our valuation of the stock price. Its components (asset
turnover and profit margin) are also value drivers
We can make two observations regarding the reversion of ROE:
ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition.
Furthermore, the reversion rate for the least profitable firms is greater than that for the most
profitable firms. And finally, reversion rates for the most extreme levels of ROE are greater than
those for firms at more moderate levels of ROE.
The reversion is incomplete. That is, there remains a difference of about 12% between the
highest and lowest ROE firms even after ten years. This may be the result of two factors:
differences in risk that are reflected in differences in their costs of capital (k); or, greater (lesser)
degrees of conservatism in accounting policies.
The reversion of ROA and NPM are similar. While some reversion of TAT is evident, it is
much less than that of the other value drivers.
Short-term cash forecasts are key to assessments of short-term liquidity. An asset is called
"liquid" because it will or can be converted into cash within the current period. The
analysis of short-term cash forecasts will reveal whether an entity will be able to repay
short-term loans as planned. This also means such analysis is extremely important for a
potential short-term credit grantor. Short-term cash forecasts often are relatively realistic
and accurate because of the shortness of the time span covered.
A cash forecast, to be most meaningful, must be for a relatively short-term period of time.
There are many unpredictable variables involved in the preparation of a reliable forecast for
a highly liquid asset such as cash. Over a long period of time (that is, beyond the time span
of one year), the difference in the degree of liquidity among items in the current assets
group is usually insignificant. What is more important for long time spans are the
projections of net income and other sources and uses of funds. The focus should be
shifted to working capital (and other accrual measures), and away from cash flows, for
longer forecast horizons of, say, thirty monthswhere the time required to convert current
assets into cash is insignificant.
9-5
Cash inflows and outflows are highly interrelated. These two flows are crucial to a
companys circulation system." A deficiency in any part of the system can affect the
entire system. For example, a reduction or cessation of sales affects the vital conversion
of finished goods into receivables or cash, which in turn leads to a drop in the cash
reservoir. If the system is not strengthened by "transfusion" (such as additional
investment by owners or creditors), production must be curtailed or discontinued. Lack of
cash inflows also will reduce other expenses such as advertising, promotion, and
marketing expenses, which will further adversely affect sales. This can yield a vicious
cycle leading to business failure.
Most would agree with this assertion. Cash is the most liquid asset and when management
urgently needs to purchase assets or incur expenses, a cash exchange is the quickest and
easiest means to execute a transaction. Moreover, unless management has a credit line
established with a reliable outsider (such as a revolving account at a bank), lack of cash
can mean a permanent loss of profitable opportunities.
Ratio analysis is a static measurement tool. Ratios measure relations among financial
statement items as of a given moment and time. In contrast, funds flow analysis is a dynamic
measure covering a period of time. A dynamic model of funds flow analysis uses the present
only as a starting point and utilizes the best available estimates of future plans and conditions
to forecast the future availability and disposition of cash or working capital. Analyzing funds
flow also encompasses the projected operations of a company. Since one of the fundamental
assumptions of accounting is the going-concern concept, some assert that the dynamic model
is more realistic and is superior to static representations. However, care should be taken in
placing too much reliance on funds flow analysis as it is primarily based on estimates, and not
on realized observations.
Except for transactions involving the raising of money from external sources (such as
through loans or additional investments) and the investments of money in long-term
assets, almost all internally generated cash flows relate to and depend on sales.
Accordingly, the usual first step in preparing a cash forecast is to estimate sales for the
period under consideration. The reliability of any cash forecast depends on the accuracy
of this forecast of sales. In arriving at the sales forecast, the analyst should consider: (1)
past trends of sales volume, (2) market share, (3) industry and general economic
conditions, (4) productive and financial capacity, and (5) competitive factors, among other
variables.
9-
6
EXERCISES
Exercise 9-1 (45 minutes)
Projected Income Statement for Year 12
Quaker Oats Company
Forecasted Income Statement
For Year Ended June 30, Year 12
Revenues [given] .................................................................

$6,000.0
Costs and expenses
Cost of goods sold [a] ...................................................

$3,186.0
Selling, general, and administrative [b] .......................

2,439.4
Other expenses [c] .........................................................

35.2
Interest, net [d] ...............................................................
91.4
Total costs and expenses ...................................................

5,752.0
Income from continuing operations .................................

248.0
Income taxes [e] ...................................................................
105.9
Income before discontinued operations ..........................
142.1
(Loss) on disposal of discontinued operations [given] ...
(2.0)
Net income ...........................................................................
$ 140.1
Notes:
Cost of sales is estimated to be at a level representing the average percentage of cost of sales
to sales as prevailed in the four-year period ending June 30, Year 11, which is 53.1% (19,909.2
9,331.3)/19,909.2. Therefore, 6,000 x .531 = $3,186.
Selling, general & administrative expenses in Year 12 are expected to increase by the same
percentage as these expenses increased from Year 10 to Year 11, which is 15%. Therefore,
$2,121.2 x 1.15 = $2,439.4.
Other expenses are expected to be 8% higher in Year 12. Therefore, 32.6 x 1.08 = $35.2.
Interest expense (net of interest capitalized) and interest income will increase by 6% due to
increased financial needs. Therefore, $86.2 x 1.06 = $91.4
The effective tax rate in Year 12 will equal that of Year 11, which is 42.7% ($175.7/$411.5).
Therefore, tax expense = $248 x .427 = $105.9.
9-7
Spreadsheet to Compute Forecasts of Sales and Income
Change
Change
Change
Change
Change
Change
Change
Change
In Dec.
in Dec.
In March
in March
In June
In June
In Sept.
in Sept.
Date
Sales
N.I.
Sales
NI
Sales
NI
Sales
NI
Sales
NI
Dec-Y1
$17,349
$1,263
Mar-Y2
12,278
964
Jun-Y2
13,984
1,130
Sep-Y2
13,972
996
Dec-Y2
16,040
1,215
-$1,309
-$48
Mar-Y3
12,700
1,085
$422
$121
Jun-Y3
14,566
656
$582
-$474
Sep-Y3
14,669
1,206
$697
$210
Dec-Y3
17,892
1,477
1,852
262
Mar-Y4
12,621
1,219
-79
134
Jun-Y4
14,725
1,554
159
898
Sep-Y4
14,442
1,457
-227
251
Dec-Y4
17,528
1,685
-364
208
Mar-Y5
14,948
1,372
2,327
153
Jun-Y5
17,630
1,726
2,905
172
Sep-Y5
17,151
1,610
2,709
153
Dec-Y5
19,547
1,865
2,019
180
Mar-Y6
16,931
1,517
1,983
145
Jun-Y6
18,901
1,908
1,271
182
Sep-Y6
19,861
1,788
2,710
178
Dec-Y6
22,848
2,067
3,301
202
Mar-Y7
19,998
1,677
3,067
160
Jun-Y7
21,860
2,162
2,959
254
Sep-Y7
21,806
2,014
1,945
226
Dec-Y7
24,876
2,350
2,028
283
Mar-Y8
22,459
1,891
2,461
214
Jun-Y8
24,928
2,450
3,068
288
Sep-Y8
23,978
2,284
2,172
270
Dec-Y8
28,455
2,671
3,579
321
Mar-Y9
24,062
2,155
1,603
264
Jun-Y9
27,410
2,820
2,482
370
Average
change
for each
quarter
$1,586.57
$201.14
$1,683.43
$170.14
$1,918.00
$241.43
$1,667.67
$214.67
Forecast
Sep.Y9*
25,645.67
2,498.67
Forecast
30,041.57
2,872.14
Dec.Y9*
Forecast
25,745.43
2,325.14
Mar. Y0*
Forecast
Jun. Y0*
29,328.00
3,061.43
Most recent actual quarter + average change for the quarter.
Note: Reported quarterly sales and net income for General Electric are:
Sales
Net income
Sep Y9
$27,200
$2,653
Dec Y9
32,855
3,089
Mar Y0
29,996
2,592
9-8
To illustrate how predictions of market share and total market sales can be used in
the forecasting process, consider the following example. If an analyst, for instance,
predicts that (i) Cough.com will maintain its 0.08% share of the market for
children's cough medicine and (ii) total Industry sales of children's cough medicine
for year 2006 is $3.2 billion, then a reasonable estimate of Cough.com's year 2006
sales is $2.56 million. This is computed as 0.08% market share multiplied by the
expected $3.2 billion of industry sales.
All relevant data should be sought out, subject to cost-benefit considerations, in the
prediction of sales. The importance of sales to predictions of financial performance
and financial condition cannot be overemphasized. Accordingly, companies invest
considerable research and effort in predicting sales. Regarding what types of data to
seek and how to obtain them, lets consider a retailer. To project the sales of a retailer,
an analyst might consider visiting outlets that sell the retailers products and observe
customer-buying patterns versus the patterns observed for key competing products.
This activity can be done using anecdotal observation or using formal statistical
sampling depending upon the analysts' perceived need for accuracy. Moreover, the
analyst can seek information from insiders via interview or interpretation of formal or
informal disclosures made by the company. The analyst can also review company
strategies and industry trends. In sum, good predictions involve more than
sophisticated modelsthey demand that the analyst take the perspective of a
customer constrained by the economic environment predicted to exist.
Relying on predicted year 2006 total industry sales of $3.2 billion, the sales of
Cough.com are predicted to be as follows
2006 Market share is 5% greater

2006 Market share is 5% worse
[105% x .08%] x $3.2 billion

[95% x .08%] x $3.2 billion
= $2.688 million
= $2.432 million
d. What-If industry sales are 10% higher:
[105% x .08%] x [110% x $3.2 billion]

[95% x .08%] x [110% x $3.2 billion]
= $2.9568 million
= $2.6752 million
What-If industry sales are 10% lower:
[105% x .08%] x [90% x $3.2 billion]

[95% x .08%] x [90% x $3.2 billion]
= $2.4192 million
= $2.1888 million
9-9
A
Exercise 94 (30 minutes)
Lyon Corporation
Cash Forecast
For July, Year 6
Beginning cash balance ......................................................
$ 20
Cash collections
Beginning accounts receivable ...............................

$ 20
Sales for month .........................................................

150
170
Less: Ending accounts receivable ..........................

21
149
Cash available ......................................................................
$169
Cash disbursements
Beginning accounts payable ...................................

18
Purchases (note a) ....................................................

115
133
Ending accounts payable (25% of purchases) .......

29
104
Miscellaneous outlays ..............................................
11
Cash balance .............................................................
$ 54
Minimum cash balance desired ...............................
30
Excess cash ..............................................................
$ 24
[a] Ending inventory .......................................................................................................

$
15
Cost of goods sold (5/6 of sales) .............................................................................
125
140
Less beginning inventory .........................................................................................
25
Purchases ..................................................................................................................
$115
9-
10
PROBLEMS
Problem 9-1 (90 minutes)
a.
Coca-Cola
Year 3
INCOME STATEMENT
Estimate
Year 2
Year 1
Net sales
20,297
20,092
19,889
Cost of goods
6,106
6,044
6,204
Gross profit
14,191
14,048
13,685
Selling general & administrative expense
7,972
7,893
9,221
Depreciation & amortization expense
863
803
773
Interest expense
-66
-308
292
Income before tax
5,422
5,660
3,399
Income tax expense
1,620
1,691
1,222
Net income
3,802
3,969
2,177
Outstanding shares
3,491
3,491
3,481
RATIOS
Sales growth
1.02%
1.02%
Gross Profit Margin

69.92%
69.92%
Selling General & Administrative Exp / Sales

39.28%
39.28%
Depreciation (depn exp / pr yr PPE gross)

12.14%
12.14%
INT (int / pr yr LTD)

-5.45%
-5.45%
Tax (Inc Tax / Pre-tax inc)

29.88%
29.88%
9-11
Problem 9-1 continued
Year 3
BALANCE SHEET
Estimate
Year 2
Year 1
Cash
587
1,934
1,892
Receivables
1,901
1,882
1,757
Inventories
1,066
1,055
1,066
Other
2,300
2,300
1,905
Total current assets
5,854
7,171
6,620
Property, plant & equipment
8,305
7,105
6,614
Accumulated depreciation
3,515
2,652
2,446
Net property & equipment
4,791
4,453
4,168
Other assets
10,793
10,793
10,046
Total assets
21,438
22,417
20,834
Accounts payable & accrued liabilities
3,717
3,679
3,905
Short-term debt & cmltd
3,899
3,899
4,816
Income taxes
815
851
600
Total current liab
8,431
8,429
9,321
Deferred income, taxes & other
1,403
1,403
1,362
Long term debt
1,219
1,219
835
Total liabilities
11,053
2,622
2,197
Common stock
873
873
870
Capital surplus
3,520
3,520
3,196
Retained earnings
19,674
20,655
18,543
Treasury stock
13,682
13,682
13,293
Shareholder equity
10,385
11,366
9,316
Total liabilities & net worth
21,438
22,417
20,834
RATIOS
AR turn
10.68
10.68
11.32
INV turn
5.73
5.73
5.82
AP turn
1.64
1.64
1.59
Tax Pay (Tax pay / tax exp)
50.33%
50.33%
49.10%
FLEV
2.06
1.97
2.24
Div/sh
$1.37
$1.37
$1.21
CAPEX
1,200
1188
1165
CAPEX/Sales
5.91%
5.91%
5.86%
9-
12
Year 3
Statement of Cash Flows

Estimate
Net income
3,802
Depreciation
863
Accounts receivable
-19
Inventories
-11
Accounts payable
38
Income taxes
-36
Net cash flow from operations

4,636
CAPEX
-1,200
Net cash flow from investing activities

-1,200
Long term debt
0
Additional paid in capital

0
Dividends
-4,783
Net cash flow from financing activities

-4,783
_____
Net change in cash

-1,347
Beginning cash
1,934
Ending cash
587
Based on our initial projection of Coca-Colas balance sheet, it appears that the
company will require approximately $1.5 billion of external financing in Year 3. This
amount will yield a cash balance of approximately $2 billion, consistent with prior
years.
9-
13
Problem 9-2 (95 minutes) a.

Best Buy
Year 3
Estimate
Year 2
Year 1
Income statement
Net sales
18,800
15,326
12,494
Cost of goods
15,048
12,267
10,101
Gross profit
3,752
3,059
2,393
2,761
2,251
1,728
304
167
103
Income before tax
688
641
562
Income tax expense
263
245
215
Net income
425
396
347
Outstanding shares
208
208
200
RATIOS
Sales growth
22.67%
22.67%
Gross Profit Margin

19.96%
19.96%

14.69%
14.69%
DEPRECIATION (depn exp / pr yr PPE gross)

15.28%
15.28%

38.22%
38.22%
9-
14
Year 3
BALANCE SHEET
Estimate
Year 2
Year 1
Cash
196
746
751
Receivables
384
313
262
Inventories
2,168
1,767
1,184
Other
102
102
41
2,850
2,928
2,238
3,249
1,987
1,093
847
543
395
2,403
1,444
698
Other assets
466
466
59
Total assets
5,719
4,838
2,995
3,034
2,473
1,704
114
114
16
Income taxes
136
127
65
Total current liab
3,284
2,714
1,785
Long term liabilities
122
122
100
Long term debt
67
181
15
Total long-term liabilities
189
303
115
Common stock
20
20
20
Capital surplus
576
576
247
Retained earnings
1,650
1,225
828
Shareholder equity
2,246
1,821
1,095
5,719
4,838
2,995
RATIOS
AR turn
48.96
48.96
47.69
INV turn
6.94
6.94
8.53
AP turn
4.96
4.96
5.93
51.84%
51.84%
30.23%
FLEV
2.55
2.66
2.74
Div/sh
$0.00
$0.00
$0.00
CAPEX
1,262
1029
416
CAPEX/Sales
6.71%
6.71%
3.33%
9-
15
Year 3

Estimate
Net income
425
Depreciation
304
Accounts receivable
-71
Inventories
-401
Accounts payable
561
Income taxes
9
827
CAPEX
-1,262

-1,262
Long term debt

-114
0
Dividends
0
-114
____
Net change in cash

-550
Beginning cash
746
Ending cash
196
Based on our projection, it appears that Best Buy will require about $550 Million of
external financing to yield a cash balance of approximately $750 million. Analysts
must allocate this external financing between debt and equity so as to preserve the
financial leverage level presently used by Best Buy.
9-
16

Merck
Year 3
INCOME STATEMENT
Estimate
Year 2
Year 1
Net sales
56,435
47,716
40,343
Cost of goods
34,272
28,977
22,444
Gross profit
22,164
18,739
17,900
7,725
6,531
6,469
1,661
1,464
1,277
Interest expense
237
342
329
Income before tax
12,541
10,403
9,824
Income tax expense
3,762
3,121
3,002
Net income
8,779
7,282
6,822
Outstanding shares
2,976
2,976
2,968
RATIOS
Sales growth
18.27%
18.27%
Gross Profit Margin

39.27%
39.27%

13.69%
13.69%

8.76%
8.76%
INT (int / pr yr LTD)

4.94%
4.94%

30.00%
30.00%
9-
17
Year 3
BALANCE SHEET
Estimate
Year 2
Year 1
Cash
5,254
3,287
4,255
Receivables
6,168
5,215
5,262
Inventories
4,233
3,579
3,022
Other
880
880
1,059
16,536
12,961
13,598
24,056
18,956
16,707
7,514
5,853
5,225
16,543
13,103
11,482
Other assets
17,942
17,942
15,075
Total assets
51,020
44,007
40,155
6,983
5,904
5,391
4,067
4,067
3,319
Income taxes
1,897
1,573
1,244
Total current liab
12,947
11,544
9,954
Deferred income, taxes and other
11,614
11,614
11,768
Long term debt
4,787
4,799
3,601
Total liabilities
29,347
27,957
25,323
Common stock
30
30
30
Capital surplus
6,907
6,907
6,266
Retained earnings
37,123
31,500
27,395
Treasury stock
22,387
22,387
18,858
Shareholder equity
21,673
16,050
14,832
51,020
44,007
40,155
RATIOS
AR turn
9.15
9.15
7.67
INV turn
8.10
8.10
7.43
AP turn
4.91
4.91
4.16
50.41%
50.41%
41.45%
FLEV
2.35
2.74
2.71
Div/sh
$1.06
$1.06
$0.98
CAPEX
5,100
4312
3641
CAPEX/Sales
9.04%
9.04%
9.03%
9-
18
Year 3

Estimate
Net income
$ 8,779
Depreciation
1,661
Accounts receivable
-953
Inventories
-654
Accounts payable
1,079
Income taxes
323

10,235
CAPEX
-5,100

-5,100
Long term debt

-12
0
Dividends
-3,156

-3,168
_____
Net change in cash

1,967
Beginning cash
3,287
Ending cash
5,254
Based on our initial projections, it appears that Merck will have excess cash of
approximately $2 billion in year 3. This excess cash should be used to reduce both
debt and equity so as to maintain historical financial leverage.
9-
19
Historical
Forecast
Terminal
figures
Horizon
Year
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
20x8
20x8
Sales growth
8.50%
10.65%
10.65%
10.65%
10.65%
10.65%
10.65%
3.50%
Net profit Margin (Net income/Sales)
6.71%
8.22%
8.22%
8.22%
8.22%
8.22%
8.22%
8.22%
NWC turn (Sales/avg NWC)
8.98
9.33
9.33
9.33
9.33
9.33
9.33
9.33
FA turn (Sales/avg FA)
1.67
1.64
1.64
1.64
1.64
1.64
1.64
1.64
Total operating assets/Total equity
1.96
2.01
2.01
2.01
2.01
2.01
2.01
2.01
Cost of equity
12.5%
($ Thousands)
Sales
25,423
28,131
31,127
34,443
38,112
42,171
46,663
48,297
Net income ($ Mil)
1,706
2,312
2,558
2,831
3,132
3,466
3,835
3,969
Net working capital
2,832
3,015
3,336
3,692
4,085
4,520
5,001
5,176
Fixed assets
15,232
17,136
18,961
20,981
23,216
25,689
28,425
29,420
Total Operating assets
18,064
20,151
22,297
24,673
27,301
30,209
33,426
34,596
L-T Liabilities
8,832
10,132
11,211
12,405
13,727
15,189
16,807
17,395
Total Stockholder's Equity ($ Mil)
9,232
10,019
11,086
12,267
13,574
15,020
16,619
17,201
Residual Income Computation
Net Income
2,558
2,831
3,132
3,466
3,835
3,969
Beginning Equity
10,019
11,086
12,267
13,574
15,020
16,619
Required Equity Return
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%
Expected Earnings
1,252
1,386
1,533
1,697
1,877
2,077
Residual Income
1,306
1,445
1,599
1,769
1,958
1,892
Discount factor
0.89
0.79
0.70
0.62
0.55
Present value of residual income
1,161
1,142
1,123
1,105
1,086
Cum PV residual income
1,161
2,303
3,425
4,530
5,616
Terminal value of abnormal earnings
11,665
Beg book value of equity
10,019
Value of equity - Abnormal Earnings
27,301
Common shares outstanding (mil)
1,737
per share
$15.72
9-20
Telnet Corporation
Pro Forma Income Statement ($000s)
Six Months Ended June 30, Year 2
Sales revenue ($250 x 6 mos.) ....................................................................

$1,500
Cost of goods sold (note [a]) ......................................................................
1,199
Gross margin ...............................................................................................
301
Selling and administrative expenses ($47.5 x 6 mos.) .............................
285
Expected pre-tax income ............................................................................
16
Estimated income taxes (at 50%) ...............................................................
Expected net income ...................................................................................

$
8
Note [a]: We use T-accounts to compute cost of goods sold ($ thousands)
Raw Material Inventory
Beginning (given)
0
Material purchases ($125 x 6 mos.)

750
715
To W.I.P. inventory [a] (plug)
Ending (given)
35
Work in Process Inventory
Beginning (given)
0
From raw materials inventory [a]

715
7
Prepaid expenses (given)
Labor ($30.5 x 6 mos.)
183
1,299
To F.G. inventory [b] (plug)
Variable overhead ($22.5 x 6 mos.)
135
Rent ($10 x 6 mos.)

60
Depreciation ($35 x 6 mos.)

210
Patent amortization ($.5 x 6 mos.)

3
Ending (given)
0
Finished Goods Inventory
Beginning (given)
0
From W.I.P. inventory [b]

1,299
1,199
Cost of goods sold (plug)
Ending (given)
100
9-
21
b.
Telnet Corporation
Pro forma Balance Sheet ($000s)
June 30, Year 2
ASSETS
Cash .............................................................................
$
40
(minimum cash)
Accounts receivable ...................................................
375
(45 days' sales)*

Inventories ($35 + $100) .............................................
135
(given)
Prepaid expenses ........................................................
7
(given)
Total current assets ..................................................
557
(subtotal)
Equipment ...................................................................
1,200
(given)
Less accumulated depreciation .................................
210
($35 x 6 mos.)
Equipment, net ..........................................................
990
(subtotal)
Patents .........................................................................
40
(given)
Less amortization ........................................................
3
($500 x 6 mos.)
Patents, net ................................................................
37
(subtotal)
Total Assets .................................................................
$
1,584
LIABILITIES AND STOCKHOLDERS EQUITY

Accounts payable .......................................................
$
125
(30 days' purchases)**

Accrued taxes..............................................................
(from Inc. Stmt.)

Stockholders' equity ...................................................
1,300
(given)
Retained earnings .......................................................
(from Inc. Stmt.)

Additional funds needed ............................................
143
"plug"
Total liabilities and equity ..........................................
$
1,584
($250,000 x 6) / 180 days = $8,333 per day x 45 days = $375,000

($125,000 x 6) / 180 days = $4,166 per day x 30 days = $125,000
9-
22
c.
Telnet Corporation
Forecasted Statement of Cash Flows
For Six Months Ended June 30, Year 2
Cash balance, beginning ...................................................
$
60,000
Add collection of accounts receivable * ...........................
1,125,000
$1,185,000
Less disbursements for
Material purchases ** ....................................................
625,000
Labor ..............................................................................
183,000
Rent ................................................................................
60,000
Overhead ........................................................................
135,000
Selling expense .............................................................
285,000
(1,288,000)
Tentative cash balance .......................................................
$ (103,000)
Minimum cash balance required .......................................
40,000
Additional borrowing required ...........................................
$ 143,000
Ending cash balance .........................................................
$ 40,000
Loan balance .......................................................................
$ 143,000
* Collection of accounts receivable
Jan.
Feb.
Mar.
Apr.
May
June
Sales ..........................................................................
250
250
250
250
250
250
Collections ................................................................
0
125
250
250
250
250
Accumulated Collections ........................................
0
125
375
625
875
1,125
** Payment of accounts payable
Jan.
Feb.
Mar.
Apr.
May
June
Purchases .................................................................
125
125
125
125
125
125
Payments ..................................................................
0
125
125
125
125
125
Accumulated Payments ..........................................
0
125
250
375
500
625
9-
23
Quaker Oats
Forecasted Statement of Cash Flows
For Year Ended June 30, Year 12
Cash provided by (used for) operations
Net income (a) .............................................................................................

$
238.8
Items in income not affecting cash
Depreciation & amortization (b) ...............................................................
196.6
Deferred income taxes (c) ........................................................................
54.7
Provision for restructuring charges (given) ...........................................
0.0
Increase in receivables (d) .........................................................................

(8.9)
Increase in inventories (e) ..........................................................................
(45.2)
Increase in other current assets (f) ...........................................................
(25.6)
Increase in accounts payable (g) ...............................................................
42.1
Increase in other current liabilities (h) ......................................................
24.5
Cash provided by operating activities ......................................................

$
477.0
Cash provided by (used for) investment activities
Capital expenditures, PP&E (given) ..........................................................

$
(300.0)
Asset retirements (given) ...........................................................................
20.0
Other changes (given) ................................................................................
(30.0)
Cash used for investing activities .............................................................
$
(310.0)
Cash provided by (used for) financing activities
Repayments of L-T debt (given) ................................................................

$
(45.0)
Net decrease in S-T debt (given) ...............................................................
(40.0)
Cash dividend paid (given) ........................................................................
(135.0)
Additions to L-T debtplug (i) ..................................................................
55.8
Cash provided by financing activities .......................................................

$
(164.2)
Net increase in cash (j) ...............................................................................

$
2.8
Cash, beginning balance ............................................................................
30.2
Cash, balance at end of year ......................................................................

$
33.0
Notes:
Average percent of income from continuing operations to sales, Years 9-11 ($235.8 +$228.9 +
$148.9) / ($5,491.2 + $5,030.6 + $4,879.4) = 3.98%
Net income in Year 12 = $6,000 x .0398 = $238.8
9-
24
Depreciation and amortization in Year 12 = $238.8 x .8233 = $196.6
Average percent of deferred income taxes (noncurrent) and other items to income from
continuing operations, Years 9-11: $140.4 / $613.6 = 22.9%
Noncurrent deferred income tax in Year 12 = $238.8 x .229 = $54.7
Ending accounts receivable = $6,000 x (42/360) = $700.0

For Year 12: Accounts receivable, beg
$691.1
Accounts receivable, end
700.0
Increase
$
8.9
Year 12 cost of sales = $6,000 x .51 = $3,060 Ending inventory = $3,060 x (55/360) = $467.5
For Year 12: Inventory, beg
$422.3
Inventory, end
467.5
Increase
$
45.2
($13.7 + $14.1 + $48.9)/3 = $25.6
Year 12 purchases = $2,807.2 x 1.12 = $3,144.1 Accounts payable, end = $3,144.1 x (45/360) =
$393.0
For Year 12: Accounts payable, beg
$350.9
Accounts payable, end
393.0
Increase
$
42.1
($43.2 + $83.4 - $53.1)/3 = $24.5
Amount required to balance statement.
Percent of cash to revenues in Year 11 = $30.2 / $5,491.2 = 0.55% Year-end cash in Year 12 =
$6,000 x 0.55% = $33
Increase in cash for Year 12 = $33 - $30.2 = $2.8

9-
25
CASES
Case 9-1 (60 minutes)
Kodak
INCOME STATEMENT
20x7 Est
20x6
20x5
Net sales
12,515
13,234
13,994
Cost of goods
8,199
8,670
8,375
Gross profit
4,316
4,564
5,619
1,862
1,776
(except depreciation)
1,761
Depreciation expense
766
765
738
Research & development costs

737
779
784
Goodwill amortization
0
154
151
Restructuring costs (credits)
0
659
-44
Earnings from operations

1,052
345
2,214
Interest expense
208
219
178
Other expense (income)

18
18
-96
Income before tax

827
108
2,132
Income tax expense

245
32
725
Net income
582
76
1,407
Outstanding shares
290
290
290
RATIOS
Sales growth
-5.43%
-5.43%
Gross Profit Margin

34.49%
34.49%
14.07%
14.07%

5.90%
5.90%
R&D/sales
5.89%
5.89%
INT (int / pr yr STD and LTD)

6.49%
6.49%

29.63%
29.63%
9-
26
Case 9-1 continued
BALANCE SHEET
20x7 Est
20x6
20x5
Cash
$ 17
$ 448
$ 246
Receivables
2,210
2,337
2,653
Inventories
1,075
1,137
1,718
Other
761
761
874

4,064
4,683
5,491

13,972
12,982
12,963
(NOTE 4)
8,089
7,323
7,044

5,883
5,659
5,919
Other assets
3,020
3,020
2,802
Total assets
$12,967
$13,362
$14,212

3,098
3,276
3,403
Short-term debt
1,378
1,378
2,058
Current maturities of l-t debt

13
156
148
(NOTE 8)
Income taxes
544
544
606
Total current liab

5,033
5,354
6,215
Long term debt

1,653
1,666
1,166
Postemployment liabilities
2,728
2,728
2,722
Other long-term liabilities

720
720
681
Total liabilities
10,134
10,468
10,784
Common stock
978
978
978
Capital surplus
849
849
871
Retained earnings
6,773
6,834
7,387
Treasury stock
5,767
5,767
5,808
Shareholder equity
2,833
2,894
3,428

12,967
13,362
14,212
RATIOS
AR turn
5.66
5.66
5.27
INV turn
7.63
7.63
4.87
AP turn
2.65
2.65
2.46
FLEV
4.58
4.62
4.15
Div/sh
$2.22
$2.22
$1.88
CAPEX
990
1047
783
CAPEX/Sales
7.91%
7.91%
5.60%
9-
27
Case 9-1 continued

20x7 Estim.
Net income
$ 582
Depreciation
766
Accounts receivable
127
Inventories
62
Accounts payable
(178)

1,359
CAPEX
(990)

(990)
Long term debt
(156)
Dividends
(643)

(799)
_____
Net change in cash

(431)
Beginning cash
448
Ending cash
$ 17
9-
28
Miller Company
Cash Forecast
For Years Ended December 31, Years 2 through 4
Year 2
Year 3
Year 4
Cash balance at beginning of period ..................

$
0
$1,929,000
$254,500
Cash received from stockholders .......................
100,000
0
0
Proceeds of loan (see [a]) ....................................

1,700,000
100,000
0
Cash receipts less cash payments (see [b]) .......
129,000
125,500
146,500
Payments for construction ...................................
0
(1,700,000) (100,000)
Payments on loan (see [a]) ...................................
0
(200,000) (200,000)
.............................Cashbalanceatendofperiod
$1,929,000
$ 254,500
$101,000
Supporting Schedules for the Cash Forecast

[a] Schedule of interest and commitment fees
Amount of
Interest
Loan
or Fee
Year 2:
$ 800,000
To be borrowed 1/1 ..................................................................
To be borrowed 4/1 ..................................................................
500,000
$ 2,500
Commitment fee due 4/1 ($1,000,000 x 1% x 1/4) ..................
300,000
To be borrowed 7/1 ..................................................................
1,250
Commitment fee due 7/1 ($500,000 x 1% x 1/4) .....................
100,000
To be borrowed 12/31 ..............................................................

1,000
Commitment fee due 12/31 ($200,000 x 1% x 1/2) .................
Interest due on loan:
40,000
On $800,000 @ 5% ..............................................................
On $500,000 @ 5% x 3/4 .....................................................
18,750
On $300,000 @ 5% x 1/2 .....................................................

7,500
.................................................................Totalat12/31/Year2
$1,700,000
$71,000
Year 3:
100,000
To be borrowed 4/1 ..................................................................
250
Commitment fee due 4/1 ($100,000 x 1% x 1/4) .....................

Repayment of loan:
(100,000)
Due 6/30 ..............................................................................
Due 12/31 ............................................................................
(100,000)
21,250
On $1,700,000 @ 5% x 1/4 ..................................................

On $1,800,000 @ 5% x 1/4 ..................................................
22,500
On $1,700,000 @ 5% x 1/2 ..................................................
42,500
.................................................................Totalat12/31/Year3
$1,600,000
$86,500
Year 4:
Repayment of loan:
(100,000)
Due 6/30 ..............................................................................
Due 12/31 ............................................................................
(100,000)
40,000
On $1,600,000 @ 5% x 1/2 ..................................................

On $1,500,000 @ 5% x 1/2 ..................................................
37,500
.................................................................Totalat12/31/Year4
$1,400,000
$77,500
9-
29
Case 9-2 continued
[b] Schedule of Operating Results
Year 2
Year 3
Year 4
Results of operations
Operating profit (at $.04 per ton handled) .................

$200,000
$212,000
$224,000
Interest and commitment fees (above) ......................
71,000
86,500
77,500
Cash derived from operations ....................................

129,000
125,500
146,500
Depreciation (at $.03 per ton handled) .......................
150,000
159,000
168,000
Operating loss ..............................................................

$ 21,000
33,500
21,500
Operating loss from prior year(s) ...............................
21,000
54,500
Accumulated operating loss .......................................
$ 54,500
$ 76,000
Interpretation and Evaluation
As revealed in note [b], reporting on the "results of operations," Miller Company is

expected to record operating losses for each of the next three years under analysis.
Nevertheless, the analysis also reveals that Miller is expected to generate sufficient
cash flow to cover the various cash commitments.
9-
30
Royal Company
Cash Forecast
For Years Ending March 31, Years 6 and 7
Year 6
Year 7
Beginning balance of cash ......................................

$
0
$ 75,000
Cash receipt from customers (see Schedule A) ....

825,000
1,065,000
Cash disbursements
Direct materials (see Schedule B) .........................
220,000
245,000
Direct labor ..............................................................
300,000
360,000
Variable overhead ...................................................
100,000
120,000
Fixed costs .............................................................
130,000
130,000
.....................................Totalcashdisbursements
750,000
855,000
........Operatingcashreceiptslessdisbursements
75,000
210,000
Cash from sale of receivables and inventories .....
90,000
..................................................Totalcashavailable
$165,000
$ 285,000
Payments to general creditors ................................
90,000
270,000
Ending balance of cash
1
$ 15,000
............................................
$
75,000
This amount could have been used to pay general creditors or carried forward to the beginning of the
next year.
Computed as: ($600,000 x 60%) - ($50,000 + $40,000).
Schedule A
Cash Receipts from Customers

Year 6
Year 7
Sales..........................................................................................
$900,000
$1,080,000
Beginning accounts receivable ..............................................
75,000
.........................................................................................Total
900,000
1,155,000
Less: Ending accounts receivable .........................................
75,000
90,000
...............................................Cashreceiptsfromcustomers
$825,000
$1,065,000
Schedule B
Cash Disbursements for Direct Materials
Year 6
Year 7
Direct materials required for production ...................

$200,000
$240,000
4
Required ending inventory ..........................................

40,000
50,000
.............................................................................Total
240,000
290,000
Less: Beginning inventory ..........................................

0
40,000
..................................................................Purchases
240,000
250,000
Beginning accounts payable ......................................

0
20,000
.............................................................................Total
240,000
270,000
Less: Ending accounts payable .................................

20,000
25,000
............................Disbursementsfordirectmaterials
$220,000
$245,000
Computed as: 12,000 units x 2/12 = 2,000; 2,000 x $20 per unit = $40,000.
Computed as: 15,000 units x 2/12 = 2,500; 2,500 x $20 per unit = $50,000.
9-
31
Case 9-4 (115 minutes) a.

(1)
Estimated Total Cash Receipts
Sep.
Oct.
Nov.
Dec.
Total sales .............................................
$40,000
$48,000
$60,000
$80,000
Credit sales (25%) .................................
10,000
12,000
15,000
20,000
Cash sales ................................
$30,000 36,000
$45,000
$60,000
Receipts of past month's credit sales
10,000
12,000
15,000
Total cash receipts ...............................
$46,000
$57,000
$75,000
(2)
Estimated Cash Disbursements for Purchases
Oct.
Nov.
Dec.
Total
Total Sales ........................................
$48,000
$60,000
$80,000
Purchases (70% next mo. sales) ....

$42,000
$56,000
$25,200
$123,200
Less: 2% purchase discount ..........
840
1,120
504
2,464
.......................Cashdisbursements
$41,160
$54,880
$24,696
$120,736
(3)
Estimated Cash Disbursements for Operating Expenses
Oct.
Nov.
Dec.
Total
Sales .................................................
$48,000
$60,000
$80,000
Salaries and Wages (15%) ..............
$ 7,200
$ 9,000
$12,000
$28,200
Rent (5%) ..........................................
2,400
3,000
4,000
9,400
Other Expenses (4%) .......................
1,920
2,400
3,200
7,520
.......................Cashdisbursements
$11,520
$14,400
$19,200
$45,120
(4)
Estimated Total Cash Disbursements
Oct.
Nov.
Dec.
Total
Purchases [part (2)] .........................
$41,160
$54,880
$24,696
$120,736
Operating expenses [part (3)] .........
11,520
14,400
19,200
45,120
Plant and equipment (given) ...........
600
400
1,000
..............Totalcashdisbursements
$53,280
$69,680
$43,896
$166,856
(5)
Estimated Net Cash Receipts and Disbursements
Oct. Nov. Dec. Total
..........................Totalcashreceipts
$46,000
$57,000
$75,000
$178,000
Total cash disbursements ..............
53,280
69,680
43,896
166,856
Net cash increase ............................
$31,104
$
11,144
Net cash decrease ...........................
$
7,280
$12,680
9-
32
Case 9-4 continued
(6)
Estimated Financing Required
Oct.
Nov.
Dec.
Total
Beginning cash balance ..................
$12,000
$ 8,720
$ 8,040
$12,000
Net cash increase ............................
31,104
11,144
Net cash decrease ...........................
7,280
12,680
Cash position before financing ......

$
4,720
$(3,960)
$39,144
$23,144
Financing required ..........................
4,000
12,000
16,000
1
Interest expense ............................
(180)
(180)
Financing retired ..............................
(16,000)
(16,000)
Ending cash balance .......................
$
8,720
$ 8,040
$22,964
$22,964
1
Computed as: ($4,000 x .06 x 3/12) + ($12,000 x .06 x 2/12).
b. (1)
Union Corporation
Forecasted Income Statement
For the Quarter Ended December 31, Year 6
Sales [see (1) in part a] .......................................................
$188,000
Deduct
Cost of goods sold (70% of sales) ...............................

$131,600
Less: Purchase discounts taken [see (2) in part a] ....

2,464
129,136
.........................................................................Grossprofit
58,864
Selling and administrative expenses
Salaries and wages [see (3) in part a] .........................

28,200
Rent [see (3) in part a] ...................................................

9,400
Other expenses [see (3) in part a] ................................

7,520
Depreciation ($750 x 3 months) ...................................
2,250
.......................Totalsellingandadministrativeexpenses
47,370
Operating income ...............................................................
11,494
Interest expense .................................................................
180
Net income .......................................................................
$ 11,314
9-
33
Case 9-4 continued
(2)
Union Corporation
Forecasted Balance Sheet
As of December 31, Year 6
ASSETS
Current Assets
Cash [see (6) in part a] ..................................................

$ 22,964
Accounts receivable (25% of Dec. sales) ....................

20,000
Inventory [($30,000 + 70% of $36,000) x 98%] .............

54,096
Total current assets ............................................................

$ 97,060
Plant and equipment ..........................................................
101,000
Less: Accumulated depreciation ......................................

2,250
98,750
Total assets .........................................................................
$195,810
LIABILITIES AND EQUITY
Liabilities .............................................................................
$
0
Stockholders' equity ...........................................................
195,810
Total liabilities and equity ..................................................
$195,810
9-
34

CH 09

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Chapter 09 - Prospective Analysis

The Projection Process

Projecting Financial Statements

Application of Prospective Analysis in the Residual Income Valuation Model Trends in

Short-term Forecasting (Appendix)

Describe the importance of prospective analysis.

Discuss and illustrate the Importance of Sensitivity Analysis.

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

In addition to trend analysis, analysts frequently incorporate external (non-financial)

We can make two observations regarding the reversion of ROE:

Projected Income Statement for Year 12

Quaker Oats Company

Forecasted Income Statement

For Year Ended June 30, Year 12

Revenues [given] .................................................................

Costs and expenses

Cost of goods sold [a] ...................................................

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

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

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

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

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

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

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

Exercise 9-2 (25 minutes)

Spreadsheet to Compute Forecasts of Sales and Income

Most recent actual quarter + average change for the quarter.

Exercise 9-3 (40 minutes)

2006 Market share is 5% greater

[105% x .08%] x $3.2 billion

[105% x .08%] x [110% x $3.2 billion]

What-If industry sales are 10% lower:

[105% x .08%] x [90% x $3.2 billion]

For July, Year 6

Beginning cash balance ......................................................

Beginning accounts receivable ...............................

Sales for month .........................................................

Less: Ending accounts receivable ..........................

Cash available ......................................................................

Beginning accounts payable ...................................

Purchases (note a) ....................................................

Ending accounts payable (25% of purchases) .......

Miscellaneous outlays ..............................................

Cash balance .............................................................

Excess cash ..............................................................

[a] Ending inventory .......................................................................................................

Gross Profit Margin

Selling General & Administrative Exp / Sales

Depreciation (depn exp / pr yr PPE gross)

INT (int / pr yr LTD)

Tax (Inc Tax / Pre-tax inc)

Problem 9-1 continued

Problem 9-1 continued

Statement of Cash Flows

Net cash flow from operations

Net cash flow from investing activities

Additional paid in capital

Net cash flow from financing activities

Net change in cash

Problem 9-2 (95 minutes) a.

Gross Profit Margin

Selling General & Administrative Exp / Sales

DEPRECIATION (depn exp / pr yr PPE gross)