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SETTING UP THE FINANCIAL STATEMENT MODEL

Sales growth 10%


Current assets/Sales 15%
Current liabilities/Sales 8%
Net fixed assets/Sales 77%
Costs of goods sold/Sales 50%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 40%

Year 0 1
Income statement
Sales 1,000
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Additions to: Retained earnings

Balance sheet
Cash and marketable securities 80
Current assets
Fixed assets
At cost
Depreciation (300)
Net fixed assets
Total assets

Current liabilities
Debt
Stock 450
Accumulated retained earnings 150
Total liabilities and equity 600
Given
FIRST FINANCIAL MODEL
Sales growth 10%
Current assets/Sales 15%
Current liabilities/Sales 8%
Net fixed assets/Sales 77%
Costs of goods sold/Sales 50%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 40%

Year 0 1 2 3 4
Income statement
Sales 1,000
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation (100)
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings

Balance sheet
Cash and marketable securities 80
Current assets
Fixed assets
At cost
Depreciation (300)
Net fixed assets
Total assets

Current liabilities
Debt
Stock 450
Accumulated retained earnings 150
Total liabilities and equity

Year 0 1 2 3 4
Free cash flow calculation
Profit after tax
Add back depreciation
Subtract increase in current assets
Add back increase in current liabilities
Subtract increase in fixed assets at cost
Add back after-tax interest on debt
Subtract after-tax interest on cash and+A14 mkt. securities
Free cash flow

CONSOLIDATED STATEMENT OF CASH FLOWS: RECONCILING THE CASH BALANCE


Cash flow from operating activities
Profit after tax (Net income) - - - -
Add back depreciation - - - -
Adjust for changes in net working capital:
Subtract increase in current assets - - - -
Add back increase in current liabilities - - - -
Net cash from operating activities - - - -

Cash flow from investing activities


Aquisitions of fixed assets--capital expenditures - - - -
Purchases of investment securities 0 0 0 0
Proceeds from sales of investment securities 0 0 0 0
Net cash used in investing activities - - - -

Cash flow from financing activities


Net proceeds from borrowing activities 0 0 0 0
Net proceeds from stock issues, repurchases -450 0 0 0
Dividends paid - - - -
Net cash from financing activities (450) 0 0 0

Net increase in cash and cash equivalents (450) 0 0 0


Check: changes in cash and mkt. securities (80) - - -
5

5
G THE CASH BALANCES

-
-

-
-
-

-
0
0
-

0
0
-
0

0
-
FIRST FINANCIAL MODEL
Sales growth 10%
Current assets/Sales 15%
Current liabilities/Sales 8%
Net fixed assets/Sales 77%
Costs of goods sold/Sales 50%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 40%

Year 0 1 2 3
Income statement
Sales 1,000
Costs of goods sold (500)
Interest payments on debt (32)
Interest earned on cash and marketable securities 6
Depreciation (100)
Profit before tax 374
Taxes (150)
Profit after tax 225
Dividends (90)
Retained earnings 135

Balance sheet
Cash and marketable securities 80
Current assets 150
Fixed assets
At cost 1,070
Depreciation (300)
Net fixed assets 770
Total assets 1,000

Current liabilities 80
Debt 320
Stock 450
Accumulated retained earnings 150
Total liabilities and equity 1,000

Year 0 1 2 3
Free cash flow calculation
Profit after tax
Add back depreciation
Subtract increase in current assets
Add back increase in current liabilities
Subtract increase in fixed assets at cost
Add back after-tax interest on debt
Subtract after-tax interest on cash and mkt. securities
Free cash flow

Valuing the firm


Weighted average cost of capital 20%
Long-term free cash flow growth rate 5% <-- real growth 2% + inflation 3%

Year 0 1 2 3
FCF 0 0 0
Terminal value
Total 0 0 0

Enterprise value, present value of row 60


Add in initial (year 0) cash and mkt. securities
Asset value in year 0
Subtract out value of firm's debt today
Equity value 0

Cash and marketable securities as negative debt


NPV of row 60 = enterprise value 0
Net year 0 debt: debt minus cash (240)
Equity value (240)

Valuing the firm--using mid-year discounting


Weighted average cost of capital 20%
Long-term free cash flow growth rate 5%

Year 0 1 2 3
FCF 0 0 0
Terminal value
Total 0 0 0

Enterprise value, NPV of row 81 0


Add in initial (year 0) cash and mkt. securities 80
Asset value in year 0 80
Subtract out value of firm's debt today 0
Equity value 80

Data table: The effect of sales growth (cell B2) on equity valuation
Growth
0%
2%
4%
6%
8%
10%
12%
14%
16%

WACC ¯
80.00 10% 12% 14%
0%
Growth rate of of Terminal Value FCF--> 2%
4%
6%
8%
10%
12%
14%
16%
4 5

4 5
4 5
0 0
0
0 0

4 5
0 0
0
0 0
16% 18% 20% 22% 24% 26%
NEGATIVE CASH BALANCES: ILLUSTRATION
Sales growth 20% <-- Increased from 10%
Current assets/Sales 20% <-- Increased from 15%
Current liabilities/Sales 8%
Net fixed assets/Sales 80% <-- Increased from 77%
Costs of goods sold/Sales 50%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable 8.00%
Tax rate 40%
Dividend payout ratio 50% <-- Increased from 40%

Year 0 1 2 3
Income statement
Sales 1,000
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings

Balance sheet
Cash and marketable securities
Current assets
Fixed assets
At cost
Depreciation
Net fixed assets
Total assets

Current liabilities
Debt
Stock
Accumulated retained earnings
Total liabilities and equity

Year 0 1 2 3
Free cash flow calculation
Profit after tax 0 0 0
Add back depreciation 0 0 0
Subtract increase in current assets 0 0 0
Add back increase in current liabilities 0 0 0
Subtract increase in fixed assets at cost 0 0 0
Add back after-tax interest on debt 0 0 0
Subtract after-tax interest on cash and mkt. securitie 0 0 0
Free cash flow 0 0 0
TRATION

4 5

4 5

0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
NO NEGATIVE CASH BALANCES
Sales growth 20% <-- Increased from 10%
Current assets/Sales 20% <-- Increased from 15%
Current liabilities/Sales 8%
Net fixed assets/Sales 80% <-- Increased from 77%
Costs of goods sold/Sales 50%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 50% <-- Increased from 40%

Year 0 1 2
Income statement
Sales 1,000
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation (100)
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings

Balance sheet
Cash and marketable securities 80
Current assets
Fixed assets
At cost
Depreciation (300)
Net fixed assets
Total assets

Current liabilities
Debt
Stock
Accumulated retained earnings
Total liabilities and equity

Year 0 1 2
Free cash flow calculation
Profit after tax 0 0
Add back depreciation 0 0
Subtract increase in current assets 0 0
Add back increase in current liabilities 0 0
Subtract increase in fixed assets at cost 0 0
Add back after-tax interest on debt 0 0
Subtract after-tax interest on cash and mkt. securities 0 0
Free cash flow 0 0
ANCES

3 4 5

3 4 5

0 0 0
0 0 0
0 0 0
0 0 0
0 0 0
0 0 0
0 0 0
0 0 0
TARGET DEBT-EQUITY RATIO
Cash is fixed, ratio of debt/equity changes in each year
Sales growth 10%
Current assets/Sales 15%
Current liabilities/Sales 8%
Net fixed assets/Sales 77%
Costs of goods sold/Sales 50%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash & marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 60%

Year 0 1 2 3
Income statement
Sales 1,000
Costs of goods sold (500)
Interest payments on debt (32)
Interest earned on cash & marketable securities 6
Depreciation (100)
Profit before tax 374
Taxes (150)
Profit after tax 225
Dividends (135)
Retained earnings 90

Balance sheet
Cash and marketable securities 80
Current assets 150
Fixed assets
At cost 1,070
Acc Depreciation (300)
Net fixed assets 770
Total assets 1,000

Current liabilities 80
Debt 320
Stock Initial (year 0) 450
Accumulated retained earnings debt/equity ratio: 150
Total liabilities and equity =B36/(B37+B38) 1,000

Target debt-equity ratio 0.53 0.40 0.35 0.30

Year 0 1 2 3
Free cash flow calculation
Profit after tax 0 0 0
Add back depreciation 0 0 0
Subtract increase in current assets 150 0 0
Add back increase in current liabilities (80) 0 0
Subtract increase in fixed assets at cost 1070 0 0
Add back after-tax interest on debt 0 0 0
Subtract after-tax interest on cash & mkt. securities 0 0 0
Free cash flow 1140 0 0
ach year

4 5

0.30 0.30

4 5 Initial (year 0)
debt/equity ratio:
=B36/(B37+B38)
Initial (year 0)
debt/equity ratio:
=B36/(B37+B38)
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
PROJECT FINANCE
No dividends, debt repayment schedule fixed, net fixed assets constant
Sales growth 15%
Current assets/Sales 15%
Current liabilities/Sales 8%
Costs of goods sold/Sales 45%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 0% <-- No dividends until all the debt is paid of

Year 0 1 2 3
Income statement
Sales 1,150
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings

Balance sheet
Cash and marketable securities 0
Current assets 200
Fixed assets
At cost 2,000
Acc. Depreciation 0
Net fixed assets 2,000
Total assets 2,200

Current liabilities 100


Debt 1,000
Stock 1,100
Accumulated retained earnings 0
Total liabilities and equity 2,200

FREE CASH FLOW CALCULATION


Year 0 1 2 3
Profit after tax 0 0 0
Add back depreciation 0 0 0
Subtract increase in current assets 200 0 0
Add back increase in current liabilities (100) 0 0
Subtract increase in fixed assets at cost 2,000 0 0
Add back after-tax interest on debt 0 0 0
Subtract after-tax interest on cash and mkt. securities 0 0 0
Free cash flow 2,100 0 0
Less: Paid back Debt (1,000) 0 0
Subtract back after-tax interest on debt 0 0 0
Add back 0 0 0
Change in Cash 1100 0 0
Eanding Cash Balance 1100 0 0

RETURN ON EQUITY (ROE)


Year 0 1 2 3
Equity cash flow -1,100 - - -
RETURN ON EQUITY (ROE) Err:523 <-- =IRR(B59:G59)

Data table: ROE as a function of initial


equity investment 2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
E
net fixed assets constant

e debt is paid of

4 5

<-- NFA don't change

4 5
0 0
0 0
Cash flow
0 0 generated by
0 0 depreciation equals
capital
0 0
expenditures.
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0

4 5
- - <-- =G23+G37+G38
PROJECT FINANCE
With these parameters the project cannot pay off its debt
Sales growth 15%
Current assets/Sales 15%
Current liabilities/Sales 8%
Increased COGS/Sales
Costs of goods sold/Sales 55% from 45% to 55%
Depreciation rate 10%
Interest rate on debt 10.00%
Interest paid on cash and marketable securities 8.00%
Tax rate 40%
Dividend payout ratio 0% <-- No dividends until all the debt is paid of

Year 0 1 2 3
Income statement
Sales 1,150
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings

Balance sheet
Cash and marketable securities 0
Current assets 200
Fixed assets
At cost 2,000
Depreciation 0
Net fixed assets 2,000
Total assets 2,200

Current liabilities 100


Debt 1,000
Stock 1,100
Accumulated retained earnings 0
Total liabilities and equity 2,200

FREE CASH FLOW CALCULATION


Year 0 1 2 3
Profit after tax 0 0 0
Add back depreciation 0 0 0
Subtract increase in current assets 200 0 0
Add back increase in current liabilities (100) 0 0
Subtract increase in fixed assets at cost 2000 0 0
Add back after-tax interest on debt 0 0 0
Subtract after-tax interest on cash and mkt. securities - - -
Free cash flow 2100 0 0
Note that the cash flow generated by
depreciation equals the increase in fixed
assets at cost.

RETURN ON EQUITY (ROE)


Year 0 1 2 3
Equity cash flow -1,100 - - -
RETURN ON EQUITY (ROE) Err:523

Data table: ROE as a function of initial


equity investment 2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
ff its debt

ed COGS/Sales
5% to 55%

bt is paid of

4 5

<-- NFA don't change

4 5
0 0
0 0
0 0
0 0
0 0
0 0
- -
0 0

4 5
- -