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Advance Corporate Finance

Term Project Guide Lines (Winter 2013) Please think innovatively and start a new business of large size. Large means at least one billion rupees initial investment of total capital as long term debt and OE. To start the new venture, please form a private limited company. You are main task is to prepare a Financial Plan for the next 5 years for the proposed new business. The following paragraphs would help you understand how to do it? TASKS TO BE PERFORMED 1. Projecting the next 5 years income statements and balance sheets is the main item 2. then do the ratio analysis of 6 performance areas, namely, a. b. c. d. e. f. liquidity, profitability, asset productivity ( asset utilization also called asset turnover of different assets), financial leverage (also called capital structure and financial risk), return on capital market measure: here make use of proxy MV to BV ratio and Proxy PE ratio calculated as average of these same ratios in comparable businesses, and then applying these average ratios to estimate share price at the end of year 5

Based on expected 5 years performance in 6 areas of performance , you will make recommendation as to acceptability of this project 3. then do capital budgeting analysis. To do this estimate 3 types of projected related cash flows: a) NICO (net investment cash outflows), these are equal to your project cost , also called capital invested in the project; and it is NWC + FA at the beginning of the first year or equally LTL + OE at the beginning of the first year; and it must be more than one billion rupees. b) Operating cash flows (OCFs) per year for 5 years and keep in mind that for capital budgeting annual OCFs are calculated as: OCF per year = EBIT (1 - T) + Depreciation expense of that year c) terminal cash flows at the end of 5th year. If you want to be very conservative you can these as equal to the book value of total capital at the end of 5th year, that is , NWC +FA the balance sheet prepared at the end of the 5th year. If you want to be more technically correct a trust your growth rate forecast , then Terminal Cash flows at the end of year 5 can be estimated as: [EBIT (1 T) + depreciation expense increase in total capital in year 5](1 + g) / (WACC g); or alternatively it is written as FCF5 (1 + g) / (WACC g); but be careful and do not use too high a growth rate such as 10% plus because it is a constant growth rate, not a for year 6 , but for all subsequent years till infinity, therefore using a growth rate higher than the long term growth potential of that countrys economy is not defensible as with such a high growth there would come a time in distant future that the size of FCFs of this business would exceed the size of countrys GDP, and that is none sense.

Once these 3 types of cash flows have been estimated by you , then use these to calculate

NPV, IRR, and payback period of this project to judge feasibility / acceptability of project. NPV = PV of 5 years OCFs and terminal cash flows - project cost , that is initial investment beginning of year one in NWC + FA NPV =[ OCF1/ (1 + WACC) 1 + OCF2 / (1 + WACC)2 + OCF3 / (1 + WACC) 3 + ..+ OCF4 / (1 + WACC)4 + {OCF5 + terminal cash flows in year 5} / (1 + WACC) 5 ] - NICO at beginning of first year. see item 4 below about guidance for WACC calculations 4. then do valuation of shares of this new company at the end of 5th year, that is , estimate P5, which is the share price you expect to experience at the end off 5th year; and at that time if you decide to take this company public and offer some of your personal shares in this company to public you can expect to sell your shares at this estimated price, P5 . Hopefully, for a good business venture this price of share at the end of 5th year would be much higher than the initial investment of 10 rupees per share that you made when you formed this company; and thus after 5 years you initial investment in the shares of this company may become many time more valuable: may be 10 or 20 time more so that 10 rupee share may come to be valued at 100 or 200 rupees after 5 years.

To estimate P5, do the following: use free cash flows method to estimate MV of TA at the end of year 5 by using constant growth model as given below: MV of TA 5 = PV of free cash flows after year 5 till infinity. MV of TA 5 = {FCF5 (1 + g)} / (WACC g). Please note it is same as the terminal cash flows for NPV calculations that you estimated in item 3 above. FCF5 = EBIT5(1 - T) + depreciation expense of year 5 - increase in total capital in year 5 Increase in total capital in year 5 = total capital in year 5 - total capital in year 4. Please remember that total capital in any year is NWC + FA, or alternatively, LTL + OE ; and it is calculated from the balance sheet. WACC of the Project Since in item 3 and also in item 4 above the discount rate is weighted average cost of capital (WAAC), therefore you need to estimate it. But WACC you need is only at the time capital is being invested in this business, that is only at the beginning of year one when capital is raised for the project. Please do not estimate WACC for each year, because it is meaningless in this context. For NPV in item 3, each future years OCF as well as FCF of year 5 would be discounted at the WACC you have estimated in the manner stated above; also in item 4, to estimate P5 you need WACC of year one. WACC = Wd* Kd(1 T) + Wc* Kc Growth rate ,g, is usually estimated as ROE (1 d) whereas d is dividend payout ratio, since you are advised to pay no cash dividends so d= 0, and therefore g = ROE; but there is a possibility that ROE in year 5 is negative (such as -3%) or a very big positive number such as

45%, both of these would be unrealistic constant annual growth rates till year infinity; therefore as a rule of thumb long term constant growth rate of any business should not be estimated higher than the long term growth potential of that particular country. In case of Pakistan it is 5 to 6% per year, so a good working number for constant growth rate would be around 5%. Wd = debt capital / total capital in the beginning (note total capital must be more than1 billion rupees for this project in year zero), all debt capital should be in the form of a bank loan of at least 5 year. Wc = equity capital / total capital in the beginning Kd = interest rate on long term debt ( bank loan) Kc = rate of return you as owners hope to earn by starting this business; it must be higher than interest rate you can earn by putting your funds 5 year fixed deposit in a bank; it must also be higher than the interest rate your business is going to pay on the long term bank loans because risk of bank is lower in this business as lending bank has first legal right on assets of this business in case of default on loans while you as equity holders have the last right and can go empty hand (loose all your equity investment in this business) if in case of liquidation of assets the cash realized by liquidating the assets is not enough to pay all the liabilities. Therefore, as your risk is higher naturally you should expect higher rate of return; so Kc for this project MUST be higher than Kd, as it should be for all types of business projects, every where in the world. Estimating Kc is an enigma in corporate finance. One rule of thumb for arriving at Kc is interest rate on long term loan + a few %age points say 5 or 8 or 10 as equity risk premium over and above the cost of debt of this project . Or you can look at historical rate of return earned by shareholders of similar businesses by calculating their capital gains yield + dividend yield for the last couple of years and then averaging those; and then decide are you happy earning average of those returns by investing in this new business? Or you can use CAPM model ; to do so you would need to estimate beta of shares of this new business; which, of course is not available as it is a new business. You can use beta of similar companies as starting point and find their beta (unlevered ) using Hamda equation given below beta levered = beta unlevered(1 + (1 T)debt / OE by inserting debt to equity ratio as zero, you get unlevered beta of a similar co; and this would act as proxy for beta unlevered for your project. Then again use Hamda equation and your projects debt to equity ratio in that equation to estimate beta levered of this project. In any case please use tax rate (T) of 30%. As estimate of Rf please use yield on one year t-bills, and estimate of Rm has to be higher than Rf.

After calculating MV of TA at the end of year 5 using free cash flows method as explained above, you can find MV of equity in year 5 as follows: MV of OE 5 = MV of TA5 - TL5. And then share price at the end of year 5 can be estimated as: P5 = MV of OE 5 / number of shares outstanding at the end of year 5 For a profitable project, your estimated price at the end of year 5 should be much higher than the 10 rupees per share you initially paid to buy shares in this co.

The Size Of Project Your Financial plans first page must show clearly the cost of project. This is also called size of project. It must be at least 1,000 million Rs ( 1 billion Rs) but you are urged to go as big as you can ; 1 billion dollars, that is 100 billion rupees is even better: money is no problem. So initial project cost, that is, total capital invested at the beginning of year one as NWC + FA must be at least 1 billion Rs, which isd raised as long term bank loan and OE. Think big ideas such as starting new air line, starting an oil refinery, starting a new power project to produce electricity, starting a fertilizer factory to produce fertilizer, starting a mobile phone set manufacturing business, starting a steel mills, starting an integrated textile mills including spinning, weaving, dyeing and bleaching, and garment & apparel making all under one roof, starting a recreational theme park, starting a 10 theater ciniplex, starting a 4 star or 5 star hotel, starting a golf course plus hotel plus resort as one integrated facility, starting an inter-city luxury bus company, starting a trucking company, running a cargo train, producing various types of packaged food items, producing various types of consumer products in toiletries, personal hygiene, producing key board and other computer accessories, the list is unending; you can think of traditional cement, sugar, motorcycle, automobile, etc production as well, etc.

The proposed business should not be in financial services area, such as a commercial bank or leasing company; otherwise you are free to start business in any trading, manufacturing, or service industry.

You should include brief but to the point analyses of multiple related areas such as market analysis, technical / engineering analysis, decision about production technology and decision about the selection of vendor for machinery, choice of location for factory, labor/man power needs/ HR requirements (man powers of different types), electric, water, gas needs and availability of these utilities at the proposed site of the business, import substitution or export enhancing impact from this project, etc.

Please be as realistic as possible by doing actual field research by checking on the already installed production units, their capacity, their technology, investment in NWC & FA, employed by similar companies already in business. Also you should do search on internet for similar plants, machines, etc, in other countries to confirm prices and availability of raw materials, machinery, build-up covered area needed, etc, as well as to learn performance benchmark in production , quality, HR requirements, Marketing, etc.

MARKET ANALYSIS It is important that you carefully chose the product / services you want to produce. Demand & Supply Gap between existing installed production capacity in the country must be addressed, and you should check what portion of total annual domestic demand of that item is imported. Try to forecast growth in demand , if local supply is more than the current demand then excess output is being exported where? These are the issues you want to explore in some detail; and only then you can argue about the economic justification and business viability of your proposed product or service. The present demand-supply gap for the chose product or service can be filled by increasing local production. Or if current local

supply is in excess of local demand then the surplus output can be exported. There is no harm in proposing a project which is exclusively export oriented. So justify your project from the national economic benefit view point, employment generation view point, foreign exchange earnings/ or saving view point , etc. The outcome of this analysis is your forecast for market potential and sales.

FINANCIAL PLAN FOR THE NEXT FIVE YEARS

Bulk of your project report should be focused on FINANCIALS of the proposed project as this is a course in corporate finance. You start by estimating assets required for the project:

Investment in Project ( also called capital cost or investment cash outflows): Assets needed for Project: Investment in FA (fixed assets) needed for the project include land, build-up covered area for factory , offices, storage / warehousing, show rooms, etc. Machinery, both locally manufactured and imported, fixtures, vehicles, computers, air conditioning, stand-by power generation, etc. For Machinery and equipments please estimate the following: Import Cost plus duties , insurance , transportation to your site , plus Cost of local machinery + Installation + testing costs. Some long term deposits , such as security deposits for connections of electricity, gas line, etc are also part of FA though not productive ones, the same is true for any license fees, initial incorporating expenses to form a corporation, these are shown as long term assets but are not production related. License fees and incorporating expenses are usually termed deferred costs and are amortized over 5 years. Security Deposits given to Gas, phone, electric, water companies are shown as long term deposits and would be recovered when you disconnect these services, these are also shown as FA assets. It is advised that you spend ime and effort in getting from inter-net realistic prices from plants and machines from various suppliers and choose a technology that is suitable for local conditions. Investment in NWC initially would be composed of CA including cash at hand for day to day operating needs, any account R/A at the end of the year due to estimated credit Sales, some inventory to keep operations smoothly running without production shut downs. CL at the end of the year would include some accrued operating expenses such as salaries, and utility bills of at least one month which accrue at then of each year, some accounts payables as a result of purchase of raw material inventory on credit. See if similar companies have a big chunk of their CL as short term bank loan then you can assume that though you are a new business organization yet banks would be willing to lend you some short term loans to finance some of your CA. Please do not rely on short term loan greatly in the first couple of year as source of CL, in later years you may find that due to profitable operations even half or more of your CA the banks are willing to finance by giving you short term bank loan. Capital invested in the project is called project cost.

Project Cost = F A + NWC in the beginning of year one. And it is financed as Long term loans plus OE. It must be at least 1,000 million Rs. At the beginning of year one, initially you have zero CL so NWC = CA needed to start the operations; but in subsequent years , that is end of year 1 , end of year 2, etc, you shall have CL, and NWC would be less than CA. So in the beginning of year one investment in both FA and

CA needed to start the operations would be finance from LT debt + OE.

Financing of Project How Project cost will be financed ? You are allowed to raise as: Debt Capital 60 % maximum, so for WACC calculation this is your (Wd) . Debt capital may be raised as long term bank loan of at least 5 years, it would be an amortized loan which would be repayable in equal installment payments which can be monthly, or quarterly, or semi annually. Mostly it is semi-annual payments in real ife. Or you can take plant on long term lease; but do not use TFCs as yours is a new and private limited co , therefore issuing TFCs wont be feasible; remember you are also not issuing shares to public, rather your group members are subscribing the shares and thus providing equity capital to this company; and therefore it is is a private limited company that you and your friends are forming to start this new business venture. You must prepare loan amortization schedule to show how the long term debt would decrease in the balance sheet over the years and also how much would be interest expense from this debt each year that goes in the income statement of each of the future 5 years. Loan balance would be zero at the end of 5th year in balance sheet.

OE, Equity capital supplied by you, the group members, must be minimum 40% of project cost, and for WACC calculations that would be your (Wc = equity capital /total capital). Equity capital is going to be your investment in the project as owners, each group member will subscribe (purchase) equal number of shares of this newly formed private limited company, and it would appear as paid up share capital in balance sheets OE section. Keep par value of shares at Rs 10. If you decide 600 million Rs equity investment in this project, then each of the 3 group members would subscribe 600/3 = 200 million Rs of equity by purchasing in the new corporation 200, 000, 000 / 10 Rs = 20 million shares of rupees 10 par value. Please note that State Bank of Pakistan recommends to the commercial banks that for most of the projects the banks can lend maximum 60% of the project cost (total capital) as long term loans, the remaining 40% of the total capital invested in this project must be invested by owners (called sponsors) as equity investment.

PREPARING PROJECTD INCOME STATEMENTS FOR 5 YEARS

Your yearly forecast of sales revenues will be based on MARKET ANALYSIS, as discussed in previous paragraphs; as well as your projection about installed capacity utilization. Initially it is better to assume 50% to 60% of production capacity utilization in the first year of project life, keeping in view the competition in the market; and in subsequent years capacity utilization may be increased , say 10%, in each next year, thereby reaching full, 100%, capacity utilization, in 4th or 5th year. Capacity of production is based on the specifications of plant (machinery) you installed. Please note that sales is result of quantity sold (Q) multiplied by price per unit (P) of product /service. It is not necessary that all the units produced in a year are also sold in the same year, cost of unsold units appear as part of ending inventory in the balance sheet; while cost of units sold during the year is CGS which appears on the income statement. Please include in your estimates increase in product/service price due to inflation, or decrease in per unit CGS due to economy of scale achieved in future years due to more capacity utilization. Per unit selling price

in subsequent years may have to be decreased or increased depending on competition, inflation, or market share considerations. Please Make explicit statements about these assumptions. Pricing policy such as premium pricing, penetration pricing, or competitive pricing must be spelled out by you clearly; usually for new entrants, like you, initially slightly lower selling price is set than the competitors. Q x P = Sales While estimating sale do not make capacity utilization the only criterion but address the competition and the market share you plan to wrestle from competitors or penetration in export markets you plan to attain; and after all these consideration, set a realistic sales target for each of the next 5 year . Expenses Estimate: Annual Operating Costs are of 2 types 1) Production costs 2) and operating expenses. In Manufacturing business, production costs show up as CGS in the income statement and are composed of 3 items: Cost of Raw Materials used in a year, Cost of Direct labor, and Factory Overhead costs. Operating Expenses are of 2 types: marketing expenses and administrative expenses. Note: in service businesses such as airlines, hotels, theme parks, there is no CGS ; there are only various operating costs. But in manufacturing businesses such as textile, cement, ghee, sugar, steel, etc the operating costs are bifurcated into CGS and operating expenses. You can use % age of sales method to estimate various types of expenses; and you can use competitors %age of sales for estimating your operating expenses and CGS as a starting point; or you can work with the details of your plant specifications and estimate your CGS in detail. For estimating operating expenses related to marketing you can make detailed marketing budget including advertising budget, sales force budget, etc, or you can use %age of sales, may be slightly higher %age initially than competitors, because to launch new products/ brands requires initially higher marketing expenses to snatch market share from competitors. It is usually simpler to estimate administrative expenses as %age of sales or you can make a detail budget of admin staff including managers, offices, vehicles petrol, electricity ,etc, used by admin . Depreciation expense is an operating cost and mostly it is part of FOH which goes into CGS, but some depreciation may belong to assets not located in factory such as sales force vehicles, distribution trucks, office furniture and fixture in head offices or branch offices, that part of depreciation goes into operating expenses. Interest Expense is below the EBIT (operating profit) so it is not an operating cost, it is a financial cost. Interest expense is based on Debt Financing used , here you would need to prepare loan amortization schedule of long term bank loan to estimate each years interest expense. If in certain years you took some short term bank loans as well, then do not forget to include interest on such loans as well in your interest expense on each years income statement. For Income Tax Expense, please use 30 % of EBT as tax rate (T) For manufacturing business the format of income statement is: Sales -CGS Gross Profit -Operating expenses EBIT -interest expense

EBT -income tax NI

For service businesses income statement format is: Revenues -Operating costs EBIT Interest expense EBT -Income tax NI

PREPARE PROJECTED BALANCE SHEETS FOR 5 YEARS Current Assets (CA) To forecast Cash balance in the balance sheet , make cash budget, or if that is too difficult, use a percentage of sales as cash balance initially, but if balance sheet does not balance use cash as the balancing figure but do not insert negative cash amount to balance the balance sheet because that is meaningless: assets cannot have negative value. Negative Cash amount required to balance the balance sheet means the right hand side (TL + OE) is too small and you need to take loans or inject equity in that year because assets have grown too fast and to finance such growth in assets financing as debt and equity is needed in that year. Use as guide competitors balance sheet to see cash is what %age of sales in their printed annual reports; but doing so may result in balance sheet not balancing. It is easiest to use cash as a plug number to balance the balance sheet after all other items in balance sheet have been forecasted; but please do not adopt the folly of using negative amount of cash as plug to balance the balance sheet simply because TA were already too big a number than TL + OE. In such case the need is to inject more financing as Long term debt or equity or both because business assets have expanded and you have to finance those addition in assets by raising more funds; so issue more shares to inject further equity or take more long term loan , or even short term loan. Please remember assets cannot have negative value in balance sheet. Also there must be some cash in a business always, therefore zero cash balance in any years balance sheet is not acceptable.

To forecast Accounts Receivable (R/ A) in balance sheet , use competitors %age of sales, or a slightly higher %age as you are new and would be constrained to offer relaxed credit terms to your customers to sell your products or services. To forecast Inventory in balance sheet, use competitors %age of sales, or slightly higher %age as you are new and may face slow sales initially resulting in some piling up of inventory of

finished goods in early years. Also if some raw materials are imported , then you may need to stock such material and this may cause bigger investment in inventory , the same is true for raw materials which are available seasonally such as cotton . This state of affairs may result in inventory as %age of sales being higher in your co as compared to other similar companies.

Current Liabilities (CL) use %age of sales of competitors as guide to forecast accounts payables ( P/A) generated due to purchases of raw materials inventory on credit; or you can use a slightly lower %age of sales than competitors because you are new and not many parties (suppliers) would be willing to sell raw material to you on credit basis. For accrued operating expenses you can safely assume salaries, wages, and utilities bills of at least 1 month to accrue at the end of each year and appear as CL in balance sheet, because it is common to pay salaries in the beginning of next month, and same is true for utilities bills. Assume there would be no Accrued Taxes Payable (deferred taxes) because each year tax would be paid in that year. If you make cash budget then need for Short Term bank loan would be determined in the cash budget; assume short term bank loans would be paid off fully or partly in the same year along with interest if end of the year there is excess cash over and above the minimum cash balance required . But if you do not make cash budget , then short term bank loan as %age of CA should be lower in your co compared to other companies in the first couple of years because you are new in business and banks wont be eager to finance your CA by giving you short term bank loans, and therefore you would be constrained to finance a big chunk of CA from long term debt and OE or from accounts payable and accrued expenses payables. In any case your short term bank loan cannot exceed CA, because that means some of the fixed assets are being financed by short term bank loan and NWC is negative ; and banks do not allow that, banks give short term loans to finance short term assets, that is current assets.

If making cash budget is too tedious then based on CA forecast assume that some CA will be financed by accounts payable and accruals so deduct from CA forecast the forecasted amounts of accounts payable and accruals, the remaining CA you may decide to finance half and half from short term bank loan and long term debt.

Long Term Liabilities (LTL) use long term bank loans or Long Term Lease contracts but dont issue TFCs because your co is new and private limited co, so issuing your corporate bonds to public wont be practical. Please prepare loan amortization schedule of Long term Loan. Assume at least 5 years loan and traditionally repayments are in semi-annual (6 monthly) equal installments. Check from banks the interest rate on 5 years long term loan and use that to complete amortization schedule, and from interest column calculate interest expense of each year. OE in the beginning of first year issue shares to your group members to raise funds and record it as paid up capital. You wont have RE (retained earnings) in the beginning of first year ; but there would be RE (positive or negative) at the end of first year and would appear in the balance sheet

prepared on the last day of year one, and same is true for balance sheets prepared on the last day of year 2 to year 5. You may decide not to cash pay dividends in any of the 5 years. You are also advised not to pay stock dividends (bonus shares) in any of these 5 years Do not forget transferring NI balances from income statement to RE in balance sheet each year while working out ending RE, then calculate ending OE balance each year in the balance sheet. Note that at the end of any year in the balance sheet you calculate RE balance as: End RE = Beg RE + NI cash dividends stock dividends End of year OE balance in the balance sheet is: End OE = Share paid up capital + End RE As you are advised not to give cash dividends therefore you can transfer NI after tax to RE portion of OE in your balance sheet each year, so each year this balance of RE in balance sheet would increase if each year NI is positive in the income statement, and RE balance in the balance sheet would go down in a year when NI was negative , that is losses were incurred. WARNING: Failure to treat NI in this manner and failure to show that each year balance of RE in the balance sheet was calculated as: ending RE = Beg RE + NI cash dividends stock dividends would result in zero score in the project. OE each year in the balance sheet must be confirmed to the following statement of changes in OE: End OE = Beg OE + NI cash dividends + shares issued shares repurchased. But it is recommended that you give no cash dividends or stock dividends for the 5 years, nor it is advised to do any repurchase of shares from the shareholders because that is equal to returning their investment back to owners, and we want owners (that is you and your group members) to remain committed for 5 years in this business . Do not issue more shares also during 5 years to keep life simple; but if there is need for more capital in future years because in a certain year TA exceed TL +OE, and bank loans are too expensive due to high interest rate, then you may decide to raise additional equity capital in your plan by issuing more shares to existing shareholders thus forcing them (that is you) to invest more cash in the business say in 3rd or 4th year. That would increase share paid up capital in the OE portion of balance sheet in those and subsequent years.

Instructions for those who make cash budget of each year as well If you decide to make annual cash budget then the following forma can be used CASH BUDGET: To estimate cash in balance sheet at the end of each of the 5 years, please prepare annual cash budget for 5 years. You can use the format given below YEARS 0 a. b. c. d. e. f. g. h. i. j. 1 2 3 4 5

Cash Inflows Cash outflows Net CFs (a b) +Beg Cash Balance -Minimum Cash balance required Cash excess or shortage (c + d e) ST Bank loan taken ST bank loan repaid along with interest ST Bank loan Balance End Cash balance

If item f is negative, there is cash shortage expected in that year then you will take short term bank loan to make-up for the shortage. Therefore in that year item j ending cash balance = item e minimum cash balance required. On the other hand, If item f is positive in a year, there is excess cash expected in that year then

you can use that surplus to repay short term bank loan or some of it if there was some such loan outstanding from the previous year, and in that case ending cash balance = minimum cash balance required. But if there was no outstanding short term bank loan then ending cash balance = minimum cash balance required (e) + cash excess (f). Excess cash is more than the short term bank loan balance then ending cash (j) = excess cash (f) short term bank loan balance (i) + minimum cash required (e). So be careful. Ending cash of year one becomes beginning cash (d) for year 2, and so on for each year. Ending cash of each year goes in balance sheet as cash , a current asset.

Cash Inflows: In year zero cash inflows would be only your equity investment and long term loan received from bank. In years 1 to 5 major cash inflows would be from sales, if all sales are cash sales then the cash inflows would equal sales and there wont be any account R/A; but if you sell , as a marketing tactic, on credit then some sales of previous year would be collected in the current year; and some sales of the current year would be collected in the next year. In such case you would use : cash collected from customers in a year = beg Acc R/A + Sales End R/A It is possible some cash inflows may occur if you decide in a certain year to replace some old equipment by selling it. It is possible for certain businesses that during 5 years owners may have to invest further in the business due to fast expansion of business or due to heavy losses, such investment can take the form of issuing new shares to directors or taking loan from directors (you and your group members are directors in this company) , in any case cash inflows would occur in that year. Usually instead of owners investing further by issuing more shares, in Pakistan they like to show further investment as LOAN FROM DIRECTORS which the business has to pay back to its Directors, and is shown as liability in balance sheet; in a year when such loan from directors is taken , it should be shown as cash inflow in cash budget , and a liability in balance sheet until repaid. Cash Outflows: In year zero it would be for purchase of FA such as land , machines, construction of building, that is FA; and also for acquiring raw material inventory, also for security deposits for gas, electric, phone connections, any licensing fees to the government, and legal expenses for the formation of corporation. Operating expenses for salaries , advertising etc would be zero in year zero. In the subsequent years that is from year 1 to 5, cash out flows would be for cash payment for CGS that includes payments for Acc P/A from purchases of raw material inventory bought initially on credit. You can use : Cash paid for raw material = Beg Acc P/A + purchases of Raw material End Acc P/A in any year except first year when cash paid for raw material purchases = purchases of raw materials ending accounts payable. Payments for direct labor, and FOH cost , except depreciation expense, are also CGS related Cash out flows in each year. Similarly payment of various operating expenses except depreciation expense, payment of interest expense, repayment of loan principal, are also various cash outflows experienced each year. Any further acquisition of FA in subsequent years would also result in cash outflows. Income tax may be paid full in each year, so you wont have any deferred tax P/A liability. If any of CGS related costs or operating expenses are not fully paid in that year then cash out flow for that expense = Beg accrued P/A related to that expense + that expense for the current year End Accrued P/A related to that exp. Loan balance of short term bank loan at the end of any year goes in balance sheet as CL , and interest expense paid in any year on S T Bank loan goes in income statement as interest expense along with the same treatment of the same items related to L T Loan.

PERFORMANCE ANALYSIS OF 5 YEARS Please perform ratio analysis on your 5 years projected income statements and balance sheets , and include the ratios in the areas of : a) Liquidity b) Profitability c) Return on Capital d) Asset Management e) Debt Management, i.e. Financial Leverage and Capital Structure f) market measures Based on the expected ratios of 5 years , make a decision about acceptance or rejection of this project.

Please NOTE: You do not need to make the project artificially acceptable ; if your projections and analysis leads you to a decision of NOT ACCEPTING the project, that is also OK .

You may decide to Reject the project if ROE remains too low or negative for all 5 years. As a rule of thumb ROE is low if it is below your expected cost of equity , Kc. Or if equity is shrinking due to losses each year.

Do The Capital Budgeting Analysis of The Project Instructions to calculate NPV were given on previous pages. The data of 3 types of cash flows (NICO, PCFs, and terminal cash flows) is also used to calculate IRR, and profitability index , note that profitability index is also called cost-benefit ratio. You can also calculate accounting rate of return of this project . To do that Avg NI is sum of 5 years NI from income statements of 5 years divided by 5; and Avg Owners investment is sum of 5 years OE from balance sheets of 5 years divided by 5. You can use discounted values of yearly OCFs to find discounted payback period for this project. NPV should be Positive, IRR should be greater than WACC, Profitability Index should be more than One, and ideally its payback period should be less than 5 years for the project to be acceptable.

For WACC calculation instructions were given on previous pages.

FINALLY DO THE SHARE VALUATION Please do the valuation after 5 years i.e. estimate what P5, share price at the end of year 5, you

hope to see.. The detail of how you would do that using free cash flows method has been given on the previous pages.

For well managed businesses it should be the case that value per share comes out 20, 30, 40 times of BV per share , that is, MV to BV ratio can be a large number such as 20 or 30, etc. Note: BV per share in year 5 is OE in year five from balance sheet divided by number of shares outstanding. In such a case, the promoters (that is you) end up being very rich by off loading some of your share holding to general public and by doing so by converting it from private limited co to public limited co, and having its shares listed for trading on a stock exchange, and at the same time cashing in some of your investment after waiting for 5 years to become rich. So! Good luck to you