CORPORATE FINANCE

Contents
Introduction to Corporate Finance...................................................................................................................3
1. Basic finance concepts..................................................................................................................................4
1.1 Rate of Return........................................................................................................................................4
1.2 Future Value...........................................................................................................................................4
1.3 Compounding.........................................................................................................................................5
1.4 Present Value..........................................................................................................................................5
1.5 Firm evaluation based on Present Value................................................................................................6
1.7 PV with Multiple Cash Flows...................................................................................................................6
1.10 Net Present Value.................................................................................................................................6
2. Capital Budgeting.........................................................................................................................................9
2.1 NPV rule..................................................................................................................................................9
2.2 IRR rule...................................................................................................................................................9
2.3 Profitability Index.................................................................................................................................10
2.4 Payback rule.........................................................................................................................................10
3. Bonds..........................................................................................................................................................12
3.1 Terminology bonds...............................................................................................................................12
3.2 Issuance and Trading of Bonds.............................................................................................................13
3.3 Yield......................................................................................................................................................13
3.4 Coupon rate and Yield..........................................................................................................................14
3.5 Pricing of Bonds....................................................................................................................................14
3.6 STRIPS...................................................................................................................................................14
3.7 The Yield Curve.....................................................................................................................................15
4. Stocks.........................................................................................................................................................17
4.1 Selling and trading Shares.....................................................................................................................17
4.2 Price of a Stock.....................................................................................................................................17
4.3 Gordon Growth Model.........................................................................................................................17
1. Notes, Enterprise Discounted CashFlow (DCF) Model................................................................................20
1.1 cash flow to equity method..................................................................................................................20
Book Value vs Market Value...................................................................................................................20
Blance sheet...........................................................................................................................................21
Debt........................................................................................................................................................21
1.2 Enterprise DCF Model...........................................................................................................................22
 Non-Operating assets.............................................................................................................................23
2.The Free Cash Flows....................................................................................................................................23
2.1 Free Cash Flows (FCF)...........................................................................................................................23
Net Operating profit (NOP).....................................................................................................................23
Change in netPPE....................................................................................................................................24
Change in NOWC....................................................................................................................................24
3.Estimating Future Free Cash Flows..............................................................................................................27
3.1 Sales......................................................................................................................................................27
3.2 COGS.....................................................................................................................................................27
3.3 Operating Expenses..............................................................................................................................28
3.4 Change in Net Fixed Assets...................................................................................................................28
3.4 Change in Net Operating Working Capital............................................................................................29
Accounts Receivables.............................................................................................................................29
Inventories..............................................................................................................................................29
Introduction to Corporate Finance

Knowing the value of objects is critical for making decisions. We need to know how to estimate the value of
shares of a firm, the value of a plant, and even the value of an entire company.

Introduction to Balance Sheet

Asset= something that is going to give you some future economic benefit. Cash, house

Liability= economic obligation to someone else. Loans

Equity=what do you have left over after all liabilities are resolved

A=L+E

Liabilities Asset
Equity

Introduction to Income Statement

Is one of the 3 statement you consider when looking into a company

1. Income Statement – how much a company might earn on a given period. Tells us what happened over a
time period.

2. Balance Sheet - snapshot of what you have and what you own at the end of the year

3. cash flow statement

Revenue/sale= money that you earn

- Cost of goods sold= how much it costs to make the product

Gross profit=how much money you make just from selling products, before all other expenses the company
incurs in.

- Marketing expenses
- Sales expenses
- G&A=general and administrative expenses

Operating profit=profit from the operation of the company. The assets are generating this (return on asset)

- Interest expense

Pre-tax income=what the owners of the company get before paying taxes

- Taxes

Net Income= what goes to the owners of the company – is the change in Equity. We can calculate the
return on equity
ROE=Net Income/starting Equity

-Bank’s income statement

Introduction to Cash Flow statement

Is a way of reconciling the profit with the starting and ending cash. Need to do reconciliation on the cash.

Accounts receivables Increase = you are pushing back in time when you get cash. It’s a negative in cash.

Starting cash $ 100

Net Income $ 200

Accounts receivables $ - 400

Cash from ops $ - 200 (200 – 400) just the cash from operations
Ending Cash $ -100

Accounts Payable= we are increasing liability but it’s a surce of cash because we don’t have to use our own
cash

Starting cash $ 100

Net Income $ 200

Accounts receivables $ - 400

Accounts Payable increase $100
Cash from ops $ - 100 (200 – 400+100) just the cash from
operations
Ending Cash $0

For reflecting depreciation in cash flow, is a positive value in cash. It’s an expense from previous year, no
cash went out in current period. So in current period we need to add back to the operating profit.

1. Basic finance concepts

1.1 Rate of Return
is the gain experienced over a period of time expressed in terms of the initial investment.

Investment = $100k

Payoff = $120 k

Rate of return = 20/100 = 20%

this is an annual rate of return since the payout is one year after the investment is made.

1.2 Future Value

Future value is the value of a given amount of money today at some point in the future.

The formula to derive the future value one period from now of a given amount of money is:
PV = present value or the amount of money today

FV = future value

r = rate of return over the period

1.3 Compounding
Earning a return over gains you obtained in previous periods is referred to as compounding.

We then deposit the 110$ and wait 1 more year. We apply the same formula.

The general formula for any number of period is

FV = future value,

PV = present value and is the amount you invest today,

r = rate of return per period,

t = number of periods you invest your money for.

1.4 Present Value

dollars today are more valuable. Another way to see this is that a dollar today can be invested and will yield
more than a dollar tomorrow.

The process of computing the present value of a future cash flow is called discounting. And the rate of
return used for discounting is called the discount rate.

1.5 Firm evaluation based on Present Value

1. We will compute the present value of the cash flows these assets generate using as a discount rate the
rate of return offered by alternative investment.
2. the rate of return offered by alternative investment is called the opportunity cost of capital. it is a rate of
return you are foregoing by investing your capital, instead of the alternative investment.

3. if we buy a company at the present value of its cash flows, the rate of return in that investment equals
the opportunity cost of capital.

4. the opportunity cost of capital has to be obtained from an alternative investment with similar risk
characteristics to the investment we are valuing. the alternative investment we use to value our asset has
to be similar.

1.7 PV with Multiple Cash Flows

We compute the value of each individual cash flow and then add them all up.

Cs = cash flows at different points in time

r = opportunity cost of capital or discount rate.

Acquisition Example

How much would you pay for this firm?

first thing that you need to do is compute the total cash flows at each point in time.

Next, you apply the present value formula to each of these cash flows.

the maximum you will be willing to pay for this firm is

1.81 billion.

1.10 Net Present Value

is simply the present value of all the cash flows including all the costs. if there is any cost in year zero, it
should be included in the NPV (negative if you pay).

1. Perpetuity
is a cash flow stream in which all the cash flows are the same and go on forever.

2. Growing perpetuity

A cash flow pattern in which cash flows grow at a constant rate and last forever

In case the cash flow does not start in year 1, we need to adjust the perspective from the last year with 0
CF, and then discount back to year 0 by using PV formula

3. Annuity

Cash flow constant and lasts for a fixed number of periods.

C=cash flow received

r= discount rate

T=number of periods for which you already received the cash

flow
2. Capital Budgeting
Capital budgeting refers to the process corporations use to decide which projects to take. the process that
informs corporations how to allocate their capital to different projects.

1) NPV rule

2) IRR rule

3) Profitability Index rule - especially useful when firms have limited capital and must decide on the set of
projects to take among the many potentially good ones.

5) Payback rule - a simple and quick way to decide whether to take a project. However, it has many
drawbacks.

2.1 NPV rule

NPV is the sum of all discounted cash flows. should include all costs and benefits from our project.

You need these two inputs: the cash flows and the discount rate.

The NPV rule says that whenever you are in a situation in which you have one project under consideration
and the decision is whether to take or reject the project, you should take it every time the NPV is positive.

If you are considering multiple projects, but can only take a subset of them, you should take, out of all
possible combinations of projects, the combination with the highest NPV. To compute the combined NPV of
multiple projects, you just need to add the NPV of the individual projects.

2.2 IRR rule

The IRR is the rate of return at which the NPV of a project is zero. it is a measure of the profitability of the
project.

The IRR is therefore the rate of return that solved this

equation.

 the IRR is a measure of profitability.

 is a function of the project's cash flows only.
 It is an intrinsic characteristic of the project.

The opportunity cost of capital is a rate of return that that one can obtain by investing in an alternative
project with similar risk. can be higher, lower or the same as the IRR depending on the relative
attractiveness of the project under consideration and these other alternatives.

IRR Rule: you should take the project every time the IRR is higher than the cost of capital.

When NPV and IRR rules give you different recommendations  follow the NPV rule

- IRR is a profitability measure that is not informative about the scale of the project. The NPV,
however, captures the scale of the project.
 - project with two IRRs: quick trick is to count the number of times the cash flows switch signs. If
they switch signs only once, then there can be only one IRR. If they switch signs more than once,
you have to be careful.
- sometimes the IRR of a project does not exist. That is, there is no discount rate at which the NPV of
the project is zero. When the IRR does not exist, you should use the NPV rule.

2.3 Profitability Index

The profitability index is defined as the NPV of a project divided by its initial investment.

It gives you the bang for your buck: a profitability index of 0.2 means that the project creates 0.2 dollars of
value today for each dollar invested.

The profitability index tells us which is the best combination of projects to maximize return.

2.4 Payback rule

The idea of this rule is to accept projects in which you will cover the initial investment in a short amount of
time.

1. Compute the payback period which is the number of years it takes to recoup your investment.

2. Compare the payback period with a cutoff number.

3. If the payback period is lower than the cutoff, you accept the project.

Has some important limitations:

- it disregards information beyond the cutoff period.

- it simply adds the cash flows, and hence it does not take into account the time value of money.
3. Bonds
stock = ownership interest in a company,

bond =contract between two parties, in which one party promises future payments to the other.

Financial instruments that are readily tradable, as is the case of publicly traded stocks and bonds, are
referred to as "securities."

Bonds are securities that governments or corporations sell to raise money from investors.

Investors buy bonds in exchange for a promise of future payment. Investors receive not only the amount
they lent, but also an interest on it.

Why important?

- a very large number of corporations all over the world, and most governments, use bonds to raise
money.
- These markets are huge
- we can use prices of government bonds to calculate what is called the "risk-free rate,"

3.1 Terminology bonds

Bonds = securities that promise payments until a final payment date. Bonds make payments periodically.

maturity date = the bond final payment date

There are typically two types of payments:

1. Coupons are the promised interest payments of a bond and are paid throughout the life of the bond.

2. The face value, or principal, is the amount the bond pays back at each maturity date. This is in addition
to the final coupon that is also paid at maturity.

The amount of the coupon is computed based

on the coupon rate.

bond certificate = the document describing the coupon rate, face value, and maturity date.

zero coupon bonds = special type of bond that pays no coupons. The only payment these bonds make is the
face value at maturity.

In the U.S., the bonds the governments sell receive different names, depending on their maturity:

1. treasury bills, or T-bills are bonds with a maturity of one year or less. These bonds are zero coupon
bonds.
2. treasury notes are bonds with maturity of two to 10 years
3. treasury bonds are bonds with maturities of 10 to 30 years

Both treasury bonds and notes pay semiannual coupons. Treasuries are very safe.
3.2 Issuance and Trading of Bonds
The act of selling a security for the first time is referred to as issuing a security. And the entity that issues
the security is called the issuer.

The market in which investors buy newly-issued securities is called the primary market.

 Investors buy these newly-minted bonds from the Treasury at a price determined in the auction.
 money is transferred from the investors to the government, and these investors receive the bonds.
 Treasury makes coupon and principal payments to the investors

In secondary market investors trade with each other and the issuer is not involved.

 You transfer ownership of the note to this new investor at a price.

 The new investor will then only receive the remaining two coupons and principal payment unless of
course she decides to sell before maturity.

- When we talk about the price of a bond, we refer either to the price at which the bond is issued or
its price in the secondary market.
- the price of the bond will depend, among other things, on when you buy it.
- Bond prices are expressed per $100 of face value.

3.3 Yield
When investing in bonds, the IRR receive a special name: the "Yield to Maturity," or simply, the "yield."

the IRR is the rate of return at which the cash flows of the bond must be discounted to obtain the current
bond price.

Note that to compute the yield of a bond, you only need information about future payments and current
market price.

because Treasuries are safe, their yields are also referred to as a "risk-free rate," that is, they are the rate of
return offered by risk-free investments.

if the price of the bond decreases, the yield goes up. There’s a reverse relationship between yield and bond
price.

recall that the yield is the rate of return you obtain by

investing in the bond.

The bond's cash flows are fixed since they are determined by
the bond certificate.

Therefore, if you can buy the bond at the lower price, but get
the same cash flows, your return, that is the IRR or yield must
be higher.
3.4 Coupon rate and Yield
the coupon rate is written in the bond certificate, and it is used to compute the coupon payments.

The yield is the rate of return an investor obtains by buying the bond and receiving all payments until
maturity. the yield is a function of both the bond's cash flows and its current market price.

- the same bond with the same coupon rate at maturity can have different yields depending on its
price.
- the coupon rate only determines the payments.
- yield depends on both the payments and the current market price.

When the bond price is above the face value they are said to be trading at a premium or above par.

When bonds trade at a price below their face value, they are said to be trading at a discount or below par.

When the yield to maturity is equal to the coupon rate, the bond is purchased at par.

3.5 Pricing of Bonds

to compute the price of an asset, we discount its cash flows at the opportunity cost of capital.

you can use the yield on a government bond as an opportunity cost of capital when valuing other bonds.
Prices adjust so that the returns on the bonds are equalized.

3.6 STRIPS
STRIPS are zero coupon bonds, as opposed to T-Bills, notes, and bonds, they are not sold directly by the
Department of the Treasury, but rather, they are created by brokerage houses. Brokerage houses buy notes
or bonds and strip the coupons and principal.

STRIPS are zero coupon bonds, that is, they pay no coupons, and at maturity, pay the face value.

yT=yield for the strip  the yield is the annual return and not the total
cumulative return over the five years.

T= years to maturity

P=price
3.7 The Yield Curve

One common way to represent the yields over the years is by means of a graph.

The Yield Curve shows the years to maturity on the x-axis and the yield on the y-axis. Represents the annual
rate of return an investor can obtain at a specific point in time. this particular curve slopes up, but this is
not always the case. There are times when the Yield Curve slopes down.

Discounting using the yield curve

The opportunity cost of capital depends on the risk of the asset you are valuing, but we have just seen
when discussing the yield curve that rates also depend on the timing of the cash flows.

 these affects the way we compute present value.

Suppose that you want to value a project: the way to do this is to discount each cash flow by the yield from
the corresponding maturity.
Maturity 1 2 3
Price 98.52 96.12 93
Yield 1.50% 2.00% 2.45%
CF 4 4 104
PV $ 3.94 $ 3.84 $ 96.72 $ 104.51
sum

While computing the yield on government bonds is useful, we cannot use them to discount cash flows of
risky projects. The reason is that we use as opportunity cost of capital the rate of return offered by asset
with similar risk to the project we are valuing.

the rate of return on the risky asset can be written as the risk free rate plus one additional term called the
"risk premium." The risk premium is the additional return offered by the asset to compensate the investor
for bearing the risk.
4. Stocks
A share/stock represents ownership in a corporation. The owners of the stocks are entitled to all earnings
of a company after all the obligations are paid.

Stockholder = someone who owns stock in a corporation, is entitled to all earnings of a company after all
obligations are paid. For this reason, stocks are said to be a residual income security.

Stock owners have limited liability = they cannot lose more than their investment.

4.1 Selling and trading Shares

You can buy stocks from:

1. the firm itself issues equity to raise capital

when a firm wants to raise capital, the firm issues new shares and sells them to investors.
2. investors sell shares to cash in
shareholder needs cash or wants to sell some of her shares for whatever reason. the number of
shares outstanding does not change. Majority of trading activity.

revenue per share is the revenue of the firm divided by the number of shares outstanding.

Dividends per share = growth rate in the dividend that each share receives.

Earnings per share = growth in earnings per share.

4.2 Price of a Stock

How much would you pay today for a stock that will pay a dividend of DIV 1 next year and will have a price of
P1 next year?

 DIV1 and P1 are not certain. You should enter here what
investors expect today these quantities to be in the
future.
 rE = opportunity cost of equity capital or simply the cost
of equity. the discount rate we use is the rate of
returnthat can be earned on other investments that are
as risky as the stock we are considering.

this formula is difficult to apply as it requires knowledge of P1, the price of the stock next year.

For infinite periods, we can express the price of stock as

the stock price is the present value

of all future dividends.

4.3 Gordon Growth Model

An important case is a firm that increases its dividend at a constant rate G.
Where do we get the inputs from?

1. The dividend next period is not difficult to estimate. Typically, you will have access to the dividend
the firm paid this year and will be able to adjust accordingly.
2. Second input is the cost of equity.
3. The dividend growth rate can be taken from a simple model to compute the dividend growth rate.

Model to calculate g

Earnings per share EPS1= the profits of the firm divided by the number of shares.

retention ratio of b = the firm retains a fraction b of its earnings for investment and pays out a fraction (1-b)
of its earnings as dividends.

Dividends per share = will be given by EPS1 times one minus b.

b = retention ratio

RIR = Reinvestment Rate of Return.

The formula should be intuitive. The growth rate is higher either

when the firm invests more, that is higher b, or when it earns a higher return on its investment, higher RIR.
A firm that retains more for investment, has a higher growth rate.

Is important whether the firm can invest at the rate above the cost of capital.

To increase share price the firm must invest only when the rate of return they can obtain is higher than the
cost of capital. the firm should invest when the NPV of the projects is positive.

Calculate Rate of return:

 The fact that Firm C has superior performance is reflected on its price today (is priced-in)
 The price is such that the rate of return offered by the asset equals the cost of capital. When the
price is determined by the PV formula, the IRR equals the cost of capital

Free Cash Flow Analysis
We will learn how to value entire firms, as well as their equity.

Methods corporation, investors, and bankers use to value firms:

1. Firm or enterprise discounted cash flow analysis.

2. relative valuation, or valuation using multiples.

There are many applications:

 evaluation to acquire a firm

 investors buying shares need to value the shares

1. Notes, Enterprise Discounted CashFlow (DCF) Model

Describing how the enterprise discounted cash flow model works.

1.1 cash flow to equity method

1. One approach to this problem is to look at what the firm owns, its assets. These $45,000 are referred to
as the book value of the assets = the value of the assets the firm owns at their historical cost. This is not
recommended.

2. second approach is to value firms by the future cash flow they generate. calculate the cash flows, as the
investor when she buys the firm gets the future cash flow the firm generates.

buying your coffee shop is equivalent to buying a cash flow stream

of 10,000 dollars per year. We can calculate the value of this cash
flow stream as a perpetuity.

The market value of the firm is $100,000.

Book Value vs Market Value

book value is a measure based on historical cost, while market value depends on the future cash flows your
firm generates.

 The more successful the business is, the larger the cash flows you obtain, and hence the larger
discrepancy between book and market values.
  when the business is not going well, it is likely that the market value is below the book value.

Blance sheet
ACCOUNTING BALANCE SHEET

MARKET VALUE BALANCE SHEET - the assets generate $10,000 per year and the discount rate is 10%.

Debt

Cash flow is different, from this we can calculate the value to equity.

The discount rate we use to discount cash flows to equity holders increase when the firm has debt, but we
use 10%.

We do 2 different calculations, one for the first years and one for the perpetuity, discounted to year 3.
The cash flows we computed here are called cash flows to equity, and this approach to equity valuation is
called the cash flow to equity method.

1.2 Enterprise DCF Model

This method is called the Firm Discounted Cash Flow Model, or sometimes Enterprise Discounted Cash Flow
Model. People also abbreviate discount cash flows as simply DCF.

1. starts by first computing the Free Cash Flows = the value of the cash flows that the assets of the firm
generate. These are cash flows purely from operations and we do not subtract any payment to any of the
capital providers of the firm, either equity or debt holders.

2. we calculate the present value of the free cash flows. This value belongs to both equity and debt holders.

3. We subtract to the PV of free cash flow the debt, leaving the value to equity owners

when used correctly, the two methods I described give you the same answer.

 one important advantage of the Enterprise DCF method is that it focuses attention on the operating
side of the business. we did not need to worry about exactly how the firm plans to pay the debt.
 to find the value of equity today, we must subtract the value of debt today. This is to capture the value
of the payments you will make to the debt holders
 future borrowing is a zero-NPV transaction and hence does not affect our calculations. Debt the firm
plans to take in the future does not appear in the balance sheet today and hence does not affect our
calculations.

Non-Operating assets
Firms sometimes have assets they do not use in their core businesses. We refer to these assets as non-
operating assets.

When we value a firm, we will separate assets into these two categories, and we'll value each class of
assets independently.

1. The value of the operating assets will still be the present value of the free cash flows.

2. The method we use to value the non-operating assets will depend on the specific type of asset.

CASH= the value is simply the cash value

2.The Free Cash Flows

value of the assets = the present value of the free cash flows.

value of equity = subtract the value of debt from the value of the assets.

price per share = divide the value of equity by the number of shares outstanding.

2.1 Free Cash Flows (FCF)

Free cash flows = the cash flows generated by the firm's operations after all required investments are
funded. They are free in the sense that they're available to be paid to debt and equity holders.

To calculate the free cash flows you will have information about the firm's financials, such as the balance
sheet and income statement.

NOP = the profits available for equity and the holders.

change in NetPPE and the change in Net Operating Working Capital = investments

The formula can be adjusted to incorporate other items that affect the cash flows that are not included in
this basic formulation.

Net Operating profit (NOP)

NOP is the profit left for the owners, that is debt and equity holders, after taxes are taken away, but before
investment is taken into account.

EBIT = Earnings Before Interest and Taxes,

 We do not subtract interest from NOP. Because free cash flow is the cash flow available to both
debt and equity holders. We want to capture the total cash flows that the operating assets
 generate. If we subtracted interest, we would instead obtain the cash flows to equity, which is only
a part of the operating cash flows.
 The formula calls for taxes on EBIT, which is tax rate times EBIT, but corporations pay taxes after
interest is subtracted from EBIT. The difference between these 2 tax calculation is the Interest Tax
Shield, and represents the reduction in taxes due to the interest expense.

The reason is that FCF relates only to the firm's operations and not on the way the firm is financed.
The free cash flows relate only to the operations, while the Interest Tax Shield is a benefit the firm
obtains when it borrows (a financing benefit).

 Do not include non-operating income, we will value the non-operating assets separately from the
operating assets.

Change in netPPE
PPE = property, plant, and equipment.

net = depreciation has been subtracted from gross PP and E.

1. compute by subtracting the net PP and E in one period minus the net PP and E in the previous period.

2. capex stands for capital expenditures. Every period, net PP and E increases by the amount the firm
devotes to capital expenditures and decreases by the depreciation amount

Change in NOWC
Net operating working capital = net operating working capital equals operating current assets, minus
operating current liabilities.

When we compute net operating working capital, we include only current assets and current liabilities that
are operating.

Operating Current Assets:

 Accounts receivables= the amount outstanding owed to the firm by its customers
 Inventories
 pre-paid expenses = future expenses that have been paid in advance.

cash or marketable securities are current assets, but because they are not needed for the core business of
the firm, they are not operating, and hence not part of operating current assets.
Operating Current Liabilities:

 accounts payables = the amount the firm owes its suppliers

 accrued expenses = expenses the firm has incurred but not yet paid
 accrued wages = wages earned by employees that the firm has not yet paid
 deferred revenues= amount received by the firm for goods or services still not delivered to the
customers.

An example of a current liability that is not operating, is short term debt. Short term debt is related to
financing and as a result we do not include it as part of current operating liabilities.
3.Estimating Future Free Cash Flows

to estimate the enterprise value of a firm we need to compute the future free cash flows of a firm. The
problem is that while we always have access to firm financials for past years, we typically do not have
financials for future years, we need to estimate them.

we will follow a two step process:

1. First, we will estimate firm financials for future years

2. second, based on these financials we will estimate the free cash flows.

Essentially, we need forecast of firm operating policy and performance.

To estimate the level of fixed assets  we will need to forecast the firm investment policy.

To estimate accounts receivables  we will need not only forecasts of sales but also how long customers
will take to pay the firm back.

To estimate accounts payables  we will need forecast of firm purchases and the type of credit the firm
gets from its suppliers.

How good your estimate is will depend on how much you know about the firm and the industry. In general,
the process will be to analyze firm policies and performance in the past and adjust them to forecast the
future.

3.1 Sales
The first one is sales.

We can have an estimate that sales are going to grow by a certain percentage per year. We can get it from
contact with customers and therefore have a sense of the demand for next year.

3.2 COGS
COGS changes over time. One possibility is that the ratio of the cost to the price of a can is always the same.
We can check this by looking at historical information.

The ratio of COGS to sales is an example of a financial ratio. Financial ratio are simply ratios between two
items in the firm financials. In this case, the ratio of COGS to sales is more informative than COGS alone
because this ratio normalizes COGS by sales. This allows us to compare numbers from different years when
the size of the firm is different.

The ratio might not be constant. If you see these ratios increasing over time, using the average COGS to
sales ratio to project COGS may not be appropriate as this average would capture a competitive
environment.

Important ratios:

Gross Profit Margin. Gross Profit is defined as sales minus COGS. And this ratio, is the Gross Profit over
sales.

Operating expenses to sales. We will be using this ratio to project operating expenses.
Operating Profit Margin. This is the defined as EBIT (Earnings Before Interest and Taxes) over sales.
Alternatively, it can be computed as the Gross Profit Margin minus the Operating Expenses to sales ratio.
This is an important ratio that inform us about the Operating Performance of the business.

3.3 Operating Expenses

If the ratio of operating expenses to sales is fairly constant, we can use the average of the operating
expenses.

We can then calculate EBIT, taxes on EBIT (we do not subtract interest payment in the NOP formula
Because NOP represents the profit to both shareholders and debtholders of the firm) and NOP.

3.4 Change in Net Fixed Assets

To estimate the change in net PP&E, we will estimate net PP&E in next year and then take the difference
from the previous (known) year.

To do this, we will use another well-known financial ratio, the fixed asset turnover ratio. This ratio is
defined as sales over net PP&E.

This ratio tells you the dollar in sales a company generates for each dollar in net PP&E. A higher number
would imply that more sales are generated per dollar of fixed asset.

If the ratio is constant, we can use the average of Fixed Asset Turnover Ratio over the previous years to
estimate the one next year. Knowing sakes and ratio, we can solve for net PPE.

This ratio measures how efficiently a firm uses its fixed assets.

 A higher number would imply that more sales are generated per dollar of fixed assets.
 If a firm is not operating at capacity, it can increase sales without a need to invest in more
equipment. This will show up as an increase in the fixed asset turnover ratio.
 It is possible that as a firm becomes bigger, they also become more efficient, increasing the Fixed
Asset Turnover Ratio. Economists refer to this effect as increasing returns to scale. In terms of our
ratio, increasing returns to scale implies a higher ratio as the firm grows.
3.4 Change in Net Operating Working Capital
Looking at the balance sheet, there are three items for us to forecast: accounts receivables and inventories
on the operating current assets side and accounts payable on the operating current liabilities side.

Accounts Receivables
If the firm sells more every year, accounts receivable, that is the amount customers owe the firm, also
increases.

To normalize accounts receivables by sales, we use accounts receivables over daily sales. The reason I use
daily sales is that the financial ratio I will obtain has a very natural interpretation. It is the average collection
period measured in days. it's also called days of sales outstanding.

If this ratio is not constant, simply taking an average might not be a good idea. Something is going on, and
we should understand what it is before trying to estimate accounts receivable for next year.

Possible explanation why accounts receivable days on hand has been increasing:

1. Firm have had some problems with the collection department. Less efficient in collecting from customers
because an employee left. The firm has recently found someone great for the position, and they expect to
return to accounts receivable days on hand of about 30. In this case, you should use 30 as your estimate for
next year.

2. there is more competition in the market. While the new competitors are not decreasing price, they are
all giving customers 45 days to pay. As competition intensifies, the CEO believe they will change their policy
and give 45 days across the board. In this scenario, it will make more sense to estimate accounts receivable
days on hand for 2018 at 45.

We can then solve for Accounts receivables.

Inventories
It makes more sense to normalize inventories by COGS rather than sales. The reason is that inventories
have a value in the books at their cost.