Ch10 Forecasting Free Cashflows.docx

CHAPTER 10 FORECASTING FREE CASH FLOWS LEARNING OBJECTIVES How to build a free cash flow valuation model. Why the assumptions that drive the valuation model must be reasonable and internally consistent. How to set assumptions for a valuation model. How to refine a valuation model. How to prepare a sensitivity analysis. TRUE/FALSE QUESTIONS Forecasting is more of an art than a science, and since it is subjective, it is difficult and prone to error. (moderate, L.O. 1, Introduction, true) Many acquisitions are failures simply because the buyer overpays for the target firm. (moderate, L.O. 1, Introduction, true) There are several “official” ways to forecast the line items included in the free cash flow forecast. (moderate, L.O. 2, Section 1, false) Reasonableness means the forecasted numbers are logical in relation to each other. (easy, L.O. 2, Section 1, false) Net revenues (sales) projections are often one of the most important variables affecting value. (moderate, L.O. 2, Section 1, true) Revenue in the first year of the forecast does not depend on actual revenue or an assumed growth rate. (moderate, L.O. 2, Section 1, false) The concepts of reasonableness and internal consistency require the analyst to build the model using cause-and-effect relationships. (moderate, L.O. 3, Section 2, true) Using the Gordon Growth Model, an analyst can forecast a finite number of periods explicitly and assume a regular pattern of cash flows after that point. (moderate, L.O. 3, Section 2, false) Once a firm has lost its competitive advantage, it will not be able to find positive net present value projects. (difficult, L.O. 3, Section 2, true) Historical relationships are not generally used for setting forecast assumptions. (moderate, L.O. 3, Section 2, false) A valuation model is a way to quantify the valuation implications of the assumptions an analyst makes about what the future holds for a firm. (difficult, L.O. 3, Section 2, true) A refinement in a valuation model, making it more accurate, will usually be worth the cost even if it has little impact on the forecast. (easy, L.O. 4, Section 3, false) Using several different ratios to model an element of the free cash flow forecast may improve the forecast’s accuracy. (moderate, L.O. 4, Section 3, true) Sensitivity analysis is not meaningful when the range of assumptions used covers the most extreme (both positive and negative) deviations from the base cash that could reasonably occur. (moderate, L.O. 5, Section 4, false) A combined sensitivity analysis gives the analyst a different picture than the single-assumption sensitivities because many of the assumptions in a free cash flow forecast may be interdependent. (moderate, L.O. 5, Section 4, true) MULTIPLE CHOICE QUESTIONS The forecasting and valuation process has four stages. The stage in which values are estimated for assumptions by considering historical relationships, trends, and expected changes in business is known as: a. modeling the free cash flows b. sensitivity analysis c. setting the model assumptions and computing the results d. refining the model (moderate, L.O. 1, Introduction, c) The first step in developing a free cash flow forecast is to model the components of free cash flow. The model is a set of equations, each of which: a. defines the value of a particular line item in the forecast b. defines the value of a particular line item in the forecast, given the values of other forecast items c. defines the value of a particular line item in the forecast, given the values of other forecast items and prior-year values d. defines the value of a particular line item in the forecast, given the values of other forecast items, prior-year values, and additional assumptions (easy, L.O. 2, Section 1, d) A free cash flow forecast must be both reasonable and internally consistent. One of the elements of reasonableness is that the forecasted numbers are: a. logical in relation to each other b. good estimates of the present values of line items on the firm’s financial statements c. good estimates of the future values of the forecasted items d. None of the above answers are correct. (moderate, L.O. 2, Section 1, c) The cost of sales is another key forecast component in a free cash flow forecast. For a forecast to be internally consistent, forecasted amounts are logical in relation to each other. The cost of sales forecast is internally consistent if: the cost of sales forecast depends on operating expenses computed as a percentage of revenues the cost of sales forecast depends on revenue the cost of sales is partially static None of the above answers are correct. (moderate, L.O. 2, Section 1, b) An internally inconsistent forecast occurs when: a parameter is changed in one equation and not the other equation operating expenses depend on revenue levels the cost of sales forecast must depend on revenue the cost of sales are entirely variable (moderate, L.O. 2, Section 1, a) In the forecast formula for the operating expenses cash flow variable, the net revenue projection for the firm: a. is multiplied by gross profit as a percentage of net revenue b. is multiplied by operating expenses as a percentage of net revenue c. is subtracted from operating expenses as a percentage of net revenue d. is added to the net revenue growth rate (difficult, L.O. 2, Section 1, b) Components from the free cash flow statement are used in the forecast formula for net operating profits after taxes (NOPAT). Which statement below regarding this formula is incorrect? a. The capital expenditures and changes in the working capital of the firm are included in NOPAT. b. Because it is not a cash flow, depreciation expense is an item that is reversed in NOPAT. c. Cash flows related to core operations are not included in NOPAT. d. Because it is not a cash flow, amortization is an item that is reversed in NOPAT. (difficult, L.O. 2, Section 1, a) Analysts assume that depreciation is a reasonable estimate of maintenance capital expenditures, which are required to maintain the existing level of productive capacity. Several key assumptions are made when we assume that depreciation is a reasonable estimate. Which key assumption about depreciation is incorrect? The firm uses an accurate estimate of the useful life to calculate depreciation. The asset will be replaced evenly over its life. The analyst assumes that the cost of a unit of productive capacity will change. All of the assumptions above are correct. (difficult, L.O. 2, Section 1, c) One key assumption regarding depreciation as a measure of maintenance capital expenditures is that firms, on average, will replace assets evenly over their lives. Firms often have large expenditures in some years and smaller expenditures in other years. The present value of such capital expenditures can be described as: lumpy smooth bumpy rough (moderate, L.O. 2, Section 1, a) When working with the free cash flow model, analysts are faced with the problem of forecasting free cash flow for an infinite number of periods. To solve the problem, analysts forecast a finite number of periods explicitly and then assume a regular pattern of cash flows after that point, which is called the: a. terminal value b. net present value of smooth cash flows c. perpetuity value d. Answers a and c are both correct. (easy, L.O. 3, Section 2, d) Using the free cash flow model, the problem of forecasting free cash flow for core operations is solved by: a. using a pattern of regular cash flows, the infinite series of cash flows can be valued without summing an infinite number of terms b. estimating only the net present value of free cash flows during the forecasting period c. estimating only the terminal value without using a constant growth rate d. separating the value of core operations into two parts, one of which represents the value of free cash flows during the forecasting period and the other part represents the terminal value (moderate, L.O. 3, Section 2, d) The question of the number of years to forecast explicitly before assuming a regular pattern of cash flows can be reasonably determined based on two principles. Which statement below is incorrect regarding these principles? a. The firm’s net present value projects have no bearing on the forecast horizon. b. The explicit forecast should be long enough for the analyst to expect a regular pattern of cash flows beginning at the point of terminal value. c. There is no right answer to the question of how many years the explicit forecast should be in length before assuming a regular pattern of cash flows. d. All of the answers above are correct. (moderate, L.O. 3, Section 2, a) In 1995 Congress enacted the Private Securities Litigation Reform Act which deals with “forward-looking” information. An example of such information would be the firm’s future expectations about: a. earnings b. prices c. capital expenditures d. All of the answers above are correct. (moderate, L.O. 3, Section 2, d) Historical relationships are considered a starting point for setting forecast assumptions. Which statement about historical relationships and forecasting is false? a. To forecast sales growth, an analyst might look at historical sales growth rates. b. A first step for setting forecast assumptions is to compute the historical values of all ratios used that will be used as assumptions. c. The free cash flow statement is used to calculate the historical values of the firm’s forecast ratios. d. There is no requirement that the forecast use historical values. (difficult, L.O. 3, Section 2, c) When an analyst prepares a business and financial statement analysis of a firm for use in a valuation, it is important to remember that all of the quantitative data compiled are just measurements of the business results. The analyst must concentrate on understanding the business using the numbers generated as a guide. The analyst can keep focused on the firm’s business issues by: a. using a log of business questions and issues uncovered during the analysis as a “reality check” when finalizing the firm’s forecast and valuation b. limiting the search for information about competitors of the firm c. not considering specific questions and issues about the firm during sensitivity analysis d. limiting the search for information about the industry in which the firm operates (moderate, L.O. 3, Section 2, a) After an initial free cash flow model has been built, the analyst may want to refine the model by doing more detailed analysis on one or more parts of the model. Assume that the analyst is considering whether to separate revenues and operating income forecasts by product line. In making such a decision, the analyst needs to consider if: a. a ratio should be separated into two or more parts b. different product lines will have different revenue growth rates or margin percentages c. the analysis should be separated into two or more business units using segment data d. linking the analysis to external or economy-wide forecasts will generate the desired information (moderate, L.O. 4, Section 3, b) After an initial free cash flow model has been built, the analyst may want to refine the model by doing more detailed analysis on one or more parts of the model. Assume that the analyst is considering whether to separate the analysis into two or more business units. To forecast by business unit, the analyst will want to: a. determine if different product lines will have different revenue growth rates or margin percentages b. study the firm’s historical results by business unit c. link the analysis to external or economy-wide forecasts to generate the desired information d. The analyst will not perform any of the above tasks in this situation. (moderate, L.O. 4, Section 3, b) SFAS No. 131 requires firms to disaggregate historical sales and margins by business unit. Firms subject to this GAAP standard must meet at least one “10% test.” Which statement below is correct regarding the “10% tests”? a. The segment’s assets are less than 10% of the combined assets of all operating segments. b. The absolute amount of the segment’s income or loss is less than 10% of the absolute amount of the combined profit of all segments reporting a profit. c. The segment’s revenue is at least 10% of the combined revenues of all operating segments. d. The absolute amount of the segment’s income or loss is less than 10% of the absolute amount of the combined loss of all segments reporting a profit. (moderate, L.O. 4, Section 3, c) An analyst may want to refine a free cash flow model by doing more detailed analysis on one or more parts of the model. Further analysis that is linked to external or economy-wide forecasts is generally useful: a. when the analysis is dividend into two or more business units b. when the analysis separates ratios into two or more parts c. for forecasting the firm’s sales d. for forecasting the firm’s net income growth over time (moderate, L.O. 4, Section 3, c) 35. Sensitivity analysis is a critical part of the valuation process. The analyst may calculate many sensitivities as part of the valuation. The type of sensitivity analysis in which the analyst determines the assumptions that would justify the current stock price for the firm and then base the investment decision on whether such assumptions are reasonable is known as: a. single-assumption sensitivity analysis b. reverse valuation c. scenario-based sensitivity analysis d. combined sensitivity analysis (moderate, L.O. 5, Section 4, b) 36. Sensitivity analysis is a critical part of the valuation process. An analyst finds out that a change in a firm’s advertising budget affects sales volume and operating expenses. The type of sensitivity analysis that would help the analyst in this situation is: a. single-assumption sensitivity analysis b. reverse valuation c. scenario-based sensitivity analysis d. combined sensitivity analysis (moderate, L.O. 5, Section 4, d) 37. An analyst calculates what would happen if revenues were higher or lower than that was projected in the base case forecast. This type of sensitivity analysis is called: a. single-assumption sensitivity analysis b. reverse valuation c. scenario-based sensitivity analysis d. combined sensitivity analysis (moderate, L.O. 5, Section 4, a) 38. Using sensitivity analysis, an analyst assesses how every assumption might change in the base case forecast given a different set of circumstances. This type of sensitivity analysis is called: a. single-assumption sensitivity analysis b. reverse valuation c. combined sensitivity analysis d. scenario-based sensitivity analysis (moderate, L.O. 5, Section 4, d) 39. Which type of sensitivity analysis lends itself to using matrices? a. single-assumption sensitivity analysis b. reverse valuation c. combined sensitivity analysis d. scenario-based sensitivity analysis (moderate, L.O. 5, Section 4, c) 40. Using sensitivity analysis, an analyst calculates a range of values given both optimistic and pessimistic values for an assumption. This type of sensitivity analysis is called: a. reverse valuation b. single-assumption sensitivity analysis c. combined sensitivity analysis d. scenario-based sensitivity analysis (moderate, L.O. 5, Section 4, b) ESSAYS 41. Discuss the steps in the free cash flow forecasting and valuation process. Suggested solution: The forecasting and valuation process has four stages: Model the free cash flows Set the model assumptions and compute the results Refine the model Perform sensitivity analysis In the first stage, the analyst must develop and create a set of equations to use in computing the forecasted value for each component of the free cash flow for each year of the forecast. Generally, ratios are used as assumptions for each equation. The analyst’s goal is to make the forecast both reasonable and internally consistent. The qualities of reasonableness and internal consistency require that the forecasting ratios are depicting the most direct cause-and-effect relationship possible. In the second stage, the analyst is responsible for estimating the model’s assumptions by considering historical relationships, trends, and expected changes in the business. Again, the analyst needs to pay attention to the qualities of reasonableness and internal consistency. The analyst must also establish a forecast horizon, by forecasting a finite number of periods explicitly, and then assume a regular pattern of cash flows after that point. The regular pattern of cash flows occurring after the finite period is known as the terminal or perpetuity value. Refining the model is the third stage of the process. Once the model is built and the assumptions have been set for a base case forecast, the analyst generally wants to refine it. Here the analyst may break down the forecast by product line, or sales growth could be analyzed in more depth by forecasting both price and volume changes. The analyst may also want to separate the analysis into two or more business units using segments or link the analysis to external or economy-wide forecasts. Any refinement has its costs and benefits, and the analyst needs to be aware that a particular refinement will not be worth the cost when it has little impact on the forecast. In general, if a refinement is worth its cost, the benefit derived from it will be a more accurate forecast. The final stage in the process is sensitivity analysis. Such analysis is critical to the valuation process. Sensitivity analysis allows the analyst to recalculate the forecast and the resulting valuation under many different assumptions. The assumptions can be varied so that the analyst has calculated a range of cases that may reasonably occur. In this way the analyst can gain a better understanding of the up- and downsides relative to the base case forecast. The analyst can use any of four common types of sensitivity analysis: single-assumption; combined sensitivity; scenario-based sensitivity; and/or reverse valuation. (moderate, L.O. 1, Section 1) 42. How would an analyst determine how much historical data is adequate in a free cash flow forecast? Suggested solution: One question an analyst must ask is how many years’ worth of historical information is adequate for a particular forecast. An analyst may use three, five, or ten or more years’ worth of information to help in projecting future values for the firm. Although there is no clear answer to this question, the analyst can use a few guidelines to help determine the best number of years to use for a firm’s forecast. The analyst should consider whether the history of a firm is indicative of its future. This requires the analyst to have some knowledge of the firm and the market and industry in which it operates to determine if the past may help in predicting the future for the firm. It is important to note that historical information is less useful for firms in the early stage of development. This is due in part to supernormal growth rates for a firm, and the fact that the firm may change direction since it is still in its infancy and seeking its path in a competitive environment. The firm may decide to change product lines or change a key distribution strategy in the early years of the firm. Such changes may make historical information less useful in future predictions about the firm. It may be far harder to predict the future for a firm that has been in existence for three years than a firm that has existed for 100 years. Historical information may be more useful for certain variables than others as well. This may be true in looking at future margins and reinvestment ratios, as the firm’s history may be more useful for these items than for an item such as the firm’s sales trends. (moderate, L.O. 3, Section 2) 43. Identify the four common types of sensitivity analysis and explain how an analyst might use each to expand a base case forecast. Suggested solution: The four common types of sensitivity analysis used by analysts are: Single-assumption Combined sensitivity Scenario-based Reverse valuation The single-assumption sensitivity analysis is usually done on a single assumption, such as a change in the firm’s revenues or operating margin. The analyst will generally calculate a range of values given both optimistic and pessimistic values for the assumption under analysis. The analyst will consider a very optimistic (best case) value as well as a very pessimistic (worst case) value under single-assumption sensitivity analysis. In combined sensitivity analysis, assumptions are altered for two or more variables simultaneously. This multiple-assumption approach provides a different picture for the analyst to examine because many of the assumptions made in a free cash flow forecast may be interdependent. This type of sensitivity analysis is suited to using a matrix to track sensitivities. An example where combined sensitivity analysis would be of value is when a new competitor of the firm can cause decreases in both the margin and revenues of the firm. When scenario-based sensitivity analysis is used, the analyst will change assumptions based on a specific event. An analyst might use this approach when the firm has a new entrant in the marketplace. In such a situation, the firm’s revenue growth and operating margin percentage might decline as the competitor takes market share and forces prices lower. As the scenario changes, the assumptions can be adjusted and the new information examined by the analyst. When the reverse valuation approach is used, the analyst “backs into” assumptions that would justify the current stock price of the firm and then the analyst would base any investment on whether such assumptions are reasonable. (moderate, L.O. 5, Section 4)