Ch8 Financial Forecasting

Question 1

Purpose of Financial Forecasting

Answer 1

• Provides a basis for estimating venture value
• acts as a benchmark for performance comparison
• helps evaluate cash needs
• compares strategic alternatives
• identifies strengths/weaknesses of a company

Question 2

What to use for forecasting

Answer 2

• Use cash flows rather than earnings
• Focus on incremental cash flows resulting from a decisio, not total cash flow
• Use time-weighted and after-tax cash flows

Question 3

Understanding of Balance Sheet

Answer 3

Current, Fixed
Financial Investments
Intangible; Liabilities: Current, Long-term
Other Long-term; Equity

Question 4

Income Statement

Answer 4

Profit & Loss
Revenue - COGS = Gross Profit - Operating Expenses = EBIT + Interest Income - Interest Expense = EBT - Income Tax Expense = Net Income)

Question 5

Accounting Principles vs. Financial Economics

Answer 5

Accountants prefer historical costs, rule-based value adjustments (like depreciation, amortization, inventory methods), conservative estimates, and may not show certain off-balance sheet items (like employee knowledge, reputation)

Financial economics focuses on future earnings and market values

Question 6

From Accounting Earnings to Cash Flows

Answer 6

◦ Add back non-cash expenses (e.g., depreciation).
◦ Subtract cash outflows not expensed (e.g., capital expenditures).
◦ Subtract cash needed for operations (increases in net working capital)

Question 7

Approaches to Forecasting

Answer 7

• Direct historical approach
• Direct approach via comparables (Yardstick Approach)
• Indirect (top-down) approach (Fundamental Analysis)

Question 8

Direct historical approach

Answer 8

Based on existing track records using methods like average historical growth, weighted historical growth, exponential smoothing, or factors correlated with the position (e.g., sales growth tied to GDP)

Question 9

Direct approach via comparables (Yardstick Approach)

Answer 9

Used for established or new firms. Consider established, comparable firms using qualitative (market, distribution, product uniqueness) and quantitative (financial yardsticks) characteristics. Forecasts use comparable companies’ sales experience.

Question 10

Indirect (top-down) approach (Fundamental Analysis)

Answer 10

Used when no comparable companies are available, especially for innovative ventures. Revenue is evaluated based on factors like product mix, advertising, competition, and location. Data sources include industry reports, SEC filings, annual reports. Note: Market estimation does not guarantee market share. Example provided for “Oriented Flights” venture

Question 11

DCF Valuation Models

Answer 11

Different approaches exist to value a project or company, differing in perspective
- Equity approach
- Entity (firm value) approach

Question 12

DCF Equity approach

Answer 12

Discounts free cash flows to equity (FCFE) using the cost of equity (kE) to get the market value of equity. Includes models like the Flow-to-Equity Approach (FTE) and Dividend-Discount Model (DDM)

Question 13

DCF Entity (firm value) approach

Answer 13

Discounts free cash flows to the firm (FCFF) using the Weighted Average Cost of Capital (WACC) to get the enterprise value. Alternatively, the Adjusted Present Value (APV) approach discounts FCFF with the cost of capital of the unlevered firm (kU) and adds the present value of the tax shield. Includes models like WACC, APV, and Economic Value Added (EVA)

Question 14

Definition of WACC

Answer 14

Weighted Average Cost of Capital

Question 15

Definition of FCFF

Answer 15

free cash flows to the firm

Question 16

Definition of FTE

Answer 16

Flow-to-Equity Approach

Question 17

Definition of DDM

Answer 17

Dividend-Discount Model (DDM)

Question 18

Definition of APV

Answer 18

Adjusted Present Value

Question 19

Definition of FCFE

Answer 19

free cash flows to equity

Question 20

Definition of EVA

Answer 20

Economic Value Added

Question 21

Equivalence of DCF Approaches

Answer 21

Entity (WACC, APV, FCFF) and equity (FTE, FCFE) approaches yield identical firm values if consistent assumptions are made about future capital structure. However, ease of implementation differs based on capital structure assumptions
◦ Stable long-term debt-to-equity ratio: WACC and FTE are easier.
◦ Stable dollar level of debt: APV is easier.

Question 22

Terminal Value Concept

Answer 22

Project cash flow forecasts are often split into an explicit growth period (T) and an implicit period (after T). The value of future cash flows after the explicit period is the Continuing Value (CV) or Terminal Value

Question 23

Terminal Value Estimation Methods

Answer 23

◦ Liquidation Value: Useful when assets are separable and marketable.
◦ Multiple Approach: Easiest approach, but results in relative valuation.
◦ Constant Growth Model (Growing Perpetuity): Technically soundest, requires accurate judgment of perpetual growth rate and excess returns. Applicable when cash flows are expected to grow at a constant rate forever

Question 24

Terminal Value Growth Rate Considerations

Answer 24

Constant growth rates are suitable for established companies. Long-run dividend growth must equal earnings growth. Upper bound for growth is the nominal growth rate of the economy (or world growth rate for multinationals)

Question 25

Growing Perpetuity Formula

Answer 25

PV of Growing Perpetuity = CF1 / (r - g), where CF1 is the cash flow at the end of the first period, r is the discount rate, and g is the constant growth rate. Must satisfy r > g. Also known as the Gordon Growth Model when applied to dividends (P0 = D1 / (k - g))

Question 26

Depreciation Tax Benefit

Answer 26

Depreciation reduces taxable income but is a non-cash expense. The benefit is the tax reduction. Tax Benefit = Depreciation * Tax Rate. Accelerated depreciation results in lower net income but higher cash flows in earlier years compared to straight-line depreciation, due to larger tax benefits upfront

Question 27

Capital Expenditures (CapEx)

Answer 27

Cash outflows that are not accounting expenses. Can be new (growth) or maintenance. Both reduce cash flows. Maintenance CapEx increases with project life. Capitalizing and depreciating an expense initially leads to higher reported income and lower cash flows in the current year compared to expensing it

Question 28

Working Capital Effect

Answer 28

Money tied up in inventory or accounts receivable is a drain on cash flows. This drain is reduced by accounts payable. Increases in working capital reduce cash flows; decreases increase them. Working capital investments should be accounted for at the end of the project life. Failing to consider working capital overstates project cash flows. Reducing working capital requirements increases cash flows

Question 29

Sunk Costs

Answer 29

Expenditures already incurred that cannot be recovered. Should not be considered in project analysis because they are not incremental. Examples include market testing and R&D expenses

Question 30

Allocated Costs

Answer 30

Costs allocated to projects from a central pool (like G&A). Only the incremental component of allocated costs should be included in project analysis. Non-incremental allocated costs should be added back (after tax) to cash flows to get incremental cash flows. Example shown in the Disney case study