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Chapter 5: Pro forma Financial Statement Models
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Basic corporate valuation model
EV = value of the firm’s operating activities
Free cash flow (FCF): Cash produced by firm’s operating activities (different from accounting consolidated cash flow)
Weighted average cost of capital (WACC): Risk-adjusted discount rate for firm’s FCFs
Enterprise value definitions
Net working capital: Bring Current Liabilities from right-hand side of balance sheet to left.
Firm value: Enterprise Value + Cash and marketable securities
Free cash flow (FCF): cash flow due to operations
Profit after tax + Depreciation – Net working capital – Capex + After-tax net interest
Implementation issues: Terminal value
Big issue: difficult to project FCFs for long horizons
Model used for Terminal Value is often different than that for initial FCFs:
FCFs, years 1, … , N: Use financial planning model
Terminal value:
Implementation issues: Mid-year Discounting
Standard discounting model assumes FCFs occur at year-end, but FCFs occur throughout year
Discount each FCF as if it occurs in mid-year
Plug: item which guarantees that Assets = Liabilities
Plug is usually a financing item:
Cash (this model)
Common stock
Plug is not a number. It’s an equation. Examples:
Cash = Total liabilities – Current Assets – Net Fixed Assets
Debt = Total assets – Current liabilities – Equity
Equity = Total assets – Current liabilities – Debt
The PLUG: Plug = Cash
Plug = cash means Debt & Stock are predetermined. For example:
No new common stock issued
Debt paid back @ $800k/year
Plug = cash asks Can operations be supported with these Debt/Stock financing assumptions?
Answer: “Yes,” if cash > 0
The PLUG: Plug = Debt
Plug = Debt means Cash and Stock are predetermined. For example:
Cash balances = $250k each year
No new Stock issued
Then Plug = Debt means All available extra cash used to pay down debt.
Useful in project finance
If Debt increases, then tracks financing needs of firm
Excel model
Interest: based on average debt/cash over year (Excel function =Average )
Depreciation
Value driver is net fixed assets (NFA)
Depreciation based on fixed assets at cost
Circularity?
Other models?
Depreciation: A circular argument?
FA at cost =
NFA + Depreciation
Accumulated Depreciation
Based on FA at cost
Net fixed assets
(Sales-driven)
FA at cost – depreciation
Click Cancel and then … File | Options | Formulas
Activate Circular references
Excel Circular formulas
Other circularities?
Profit after tax
Depends on Debt/Cash
Retained earnings
Accumulated
Income statement
Balance sheet
Summing up: Theoretical
Valuing firm: Build financial planning model
Excel model of firm
Value drivers
Project FCFs
Terminal value
Great discipline: Tie everything together!
Model variations
Change the plug
Cash? (This model)
Hard wired? (Good for debt capacity)
Plug—project finance?
Common stock?
Change Fixed Asset Model (see below)
Year-by-year value drivers?
Three fixed asset models
Net Fixed Assets = function of Sales
Appropriate when Depreciation has economic meaning
Fixed Assets at Cost = function of Sales
Depreciation has no economic meaning: Old assets perform as well as new assets
Net Fixed Assets = constant
Depreciation = Capital investment
Asset base, properly maintained, can support reasonable future levels of sales
PresentValue
discountedatWACC
Liabilities
Cash and marketable securities
Operating current assets
– Operating current liabilities
= Net working capital
Net fixed assets
Firm value
Firm value
THE ENTERPRISE VALUATION “BALANCE SHEET”
Enterprise value=
=PV(FCFs discounted
Liabilities
Operating current assets
Debt – cash & Mkt. securities
– Operating current liabilities
= Net debt
= Net working capital
Net fixed assets
Enterprise Value
Enterprise Value
Note that both variations on the enterprise valuation “balance sheet”
give the same equity value.
THE ENTERPRISE VALUATION “BALANCE SHEET”
A slight variation (cash netted out from debt)
Enterprise value =
=PV(FCFs discounted
Long-term FCF growth rate
Common choice: g = real growth + inflat
Discount onlyTerminal value
limited number of is PV of FCFs,
projected FCFsyears N+1, N+2,
FCFFCFTerminalValue
Enterprisevalue
WACCWACCWACC
14424431442443
Each FCF occurs approximate in mid-year
This is reflected in discount factor
Enterprisevalue
FCFTerminalValue
14444444244444443
ustment factor
for mid-year
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