BUILDING PRO FORMA MODELS Module 4

Copyright 2009. Not to be used without permission of the author, benninga@wharton.upenn.edu

BASIC CORPORATE VALUATION MODEL
The Enterprise Value is the value of the firms operating activities (as distinguished
from its financial activities, or its operations + financing).

Enterprise value
Free cash flows,
Present Value
discounted at WACC

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DEFINITIONS (1)
Free cash flow (FCF): Cash produced by firms operating activities (different from
accounting consolidated cash flow)
Weighted average cost of capital (WACC): Risk-adjusted discount rate for firms
FCFs

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DEFINITIONS (2): ENTERPRISE VALUE
Net working capital: Bring Current Liabilities from right-hand side of balance sheet
to left.
Firm value: Enterprise Value + Cash and marketable securities

THE ENTERPRISE VALUATION "BALANCE SHEET"

Assets Liabilities
Cash and marketable securities
Operating current assets Debt
- Operating current liabilities Enterprise value=
= Net working capital =PV(FCFs discounted
Net fixed assets Equity at WACC)
Goodwill
Firm value Firm value

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DEFINITIONS (2A): ENTERPRISE VALUE
THE ENTERPRISE VALUATION "BALANCE SHEET"
A slight variation (cash netted out from debt)

Assets Liabilities
Operating current assets Debt - cash & Mkt. securities
- Operating current liabilities = Net debt
= Net working capital Enterprise value =
Net fixed assets Equity =PV(FCFs discounted
Goodwill at WACC)
Enterprise Value Enterprise Value

Note that both variations on the enterprise valuation "balance sheet"

give the same equity value.

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DEFINITIONS (3): FREE CASH FLOW (FCF)
Profit after taxes
+ Depreciation
- Increase in current assets
+ Increase in current liabilities
- Capital expenditures (CAPEX=increase in fixed assets at cost)
+ After-tax net interest
= FCF

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DEFINITIONS (4):
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
E D
WACC rE * rD * 1 TC *
ED ED
where
rE = Firm's cost of equity (Chapter 2)
E = Market value of firm's equity
rD = Firm's cost of debt (Chapter 2)
TC = Firm's tax rate
D = Market value of firm's debt
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REPRISE: WHATS ENTERPRISE VALUE?

FCFt
Enterprise value
1 WACC
t
t 1

Implementation issues (next slides)

Terminal value
Mid-year discounting

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 IMPLEMENTATION ISSUE (1): TERMINAL VALUE
N
FCFt FCFt Terminal Value
Enterprise value
t 1 1 WACC t 1 1 WACC 1 WACC
t t N

Discount only Terminal value
limited number of is PV of FCFs,
projected FCFs years N+1, N+2,
...

Big issue: Difficult to project FCFs for long horizons

Model used for Terminal Value is often different than that used for initial FCFs:
FCFs, years 1, ... , N: Use financial planning model
Terminal value: Use other model (next slides)

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TERMINAL VALUE MODEL

FCFN * 1 g
Terminal value
WACC g
where
g Long-term FCF growth rate

Common choice: g = real growth + inflation

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OTHER TERMINAL VALUE MODELS
= ( ) ( )
= ( ) (/ )
= ( ) +

FM3, Chapter 3: PRO FORMA MODELING 11

IMPLEMENTATION ISSUE (2):
MID-YEAR DISCOUNTING
Standard discounting model assumes FCFs occur at year end
But FCFs occur throughout year
Discount each FCF as if it occurs in mid-year

FM3, Chapter 3: PRO FORMA MODELING 12

IMPLEMENTING MID-YEAR DISCOUNTING
FCF1 FCF2
Enterprise value . . .
1 WACC 1 WACC
0.5 1.5

Each FCF occurs approximate in mid-year
This is reflected in discount factor

N FCFt Terminal Value

N
* 1 WACC
0.5

t 1 1 WACC 1 WACC
t

Adjustment factor
for mid-year
FCF

FM3, Chapter 3: PRO FORMA MODELING 13

FIRST FINANCIAL MODEL
THE PLUG
Plug: Item which guarantees that Assets = Liabilities
Plug is usually a financing item:
Cash (this model)
Debt
Common stock

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THE PLUG (2)
The Plug is not a number
Its an equation. Examples:

FM3, Chapter 3: PRO FORMA MODELING 15

PLUG (3): PLUG = CASH
Plug = cash means: Debt & Stock are predetermined. In our first example:
No new common stock issued
Debt paid back @ $800k/year

Plug = cash asks: Can operations be supported with these Debt/Stock financing
assumptions?
Answer: Yes, if cash > 0

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PLUG (4): PLUG = DEBT
Plug = Debt means: Cash and Stock are predetermined.
Example:
Cash balances = $250k each year
No new Stock issued

Then Plug = Debt means: All available extra cash used to pay down debt.

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PLUG = DEBT
Useful in project finance
If Debt increases, then tracks financing needs of firm

FM3, Chapter 3: PRO FORMA MODELING 18

EXCEL MODEL
Interest:
based on average debt/cash over year (Excel function =Average )
Depreciation
Value driver is net fixed assets (NFA)
Depreciation based on fixed assets at cost
Circularity?
Other models?

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DEPRECIATION: A CIRCULAR ARGUMENT?
FA at cost =
NFA + Depreciation

Accumulated Depreciation
Based on FA at cost

Net fixed assets

(Sales-driven)
=
FA at cost - depreciation
FM3, Chapter 3: PRO FORMA MODELING 20
IN EXCEL 2007

Click Cancel and then

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On Office button
go to
Excel Options

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OTHER CIRCULARITIES?
Income statement
Balance sheet
Interest:
Depends on Debt/Cash
Cash Debt

Profit after tax

Accumulated
retained

Retained earnings

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SUMMING UP: THEORETICAL
Valuing firm: Build financial planning model
Excel model of firm
Value drivers
Project FCFs
Terminal value

GREAT DISCIPLINE: TIE EVERYTHING TOGETHER

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MODEL VARIATIONS
Change the plug
Cash? (This model)
Debt?
Hard wired? (Good for debt capacity)
Plugproject finance?
Common stock?

Change Fixed Asset Model (see below)

Year-by-year value drivers?

FM3, Chapter 3: PRO FORMA MODELING 25

THREE FIXED ASSET MODELS
Net Fixed Assets = function of Sales
Appropriate when Depreciation has economic meaning

Fixed Assets at Cost = function of Sales

Depreciation has no economic meaning: Old assets perform as well as new assets

Net Fixed Assets = constant

Depreciation = Capital investment
Asset base, properly maintained, can support reasonable future levels of sales

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