Question

we construct pro forma forecasts for two primary reasons, one is to estimate the "plug," but what's the other reason? That said, what exactly is the time value of money and/or discounted cash flow analysis? Finally, work with your peers to explore topics covered in this module's readings. What is a quantitative measure of "value-added" that we will use to accomplish this terms analytical goals?

Answer 1

We construct pro forma forecasts for two primary reasons, one is to estimate the "plug," but what's the other reason?

The other reason can be any of the following:

1. To assess the overall health of the company next year
2. To plan and budget for additional funding required, if any?
3. To assess the impact of an event that is planned or announced but yet to take place. We usually make pro forma statements to capture the impact of a recently announced merger, acquisition or restructuring transaction.

--------------------------

That said, what exactly is the time value of money and/or discounted cash flow analysis?

The cash flows need to be discounted because there is a time value of money. Cash flows which occur earlier are more valuable than cash flows which occur later. The time value of money is important for three reasons: inflation, uncertainty, and opportunity costs. The discount rate by which cash flows are discounted should be good enough to compensate an investor for all the three parameters.

Discounted cash flow analysis

• Involves discounting of all the cash inflows and outflows over the tenure of projected using a discount rate. It primarily uses the concept of time value of money.
• Focuses on the actual cash inflows and outflows from the project rather accrual accounting income
• Assumes that all cash flows occur at the end of the year. In some instances, a problem may say that a particular cash flow occurs at the beginning of a year. If that happens, we treat the cash flow occurring at the beginning of a year as though it occurs at the end of the previous year. This assumption is far from reality but probably the entire corporate finance world is willing to live with this error.
• Primarily used as a screening or elimination tool. It helps management reject few decisions and select some for further analysis, if required.

Under capital budgeting process, there are four methods of elimination or screening available. Three of them are based on discounted cash flow analysis while one of them is based on accounting income analysis.

• Methods of discounted cash flow analysis
  • Net present value (NPV)
  • Internal rate of return (IRR)
  • Discounted payback period (simple payback period involves cash flows but they are not discounted)

--------------------------------------

What is a quantitative measure of "value-added" that we will use to accomplish this terms analytical goals?

The quantitative measure of value added is reflected through the concept of EVA, economic value added.

EVA = True profit = Net operating profit after taxes after adjusting for the charge on the capital deployed to achieve that net profit.

While calculating the charge on the capital, all types of capital including the equity capital is considered along with its actual cost or opportunity cost.

The mathematical calculation of EVA is as follows:

EVA = NOPAT- WACC × CAPITAL EMPLOYED

Where NOPAT = Net operating profits after taxes = EBIT x (1 - tax rate) where EBIT is earnings before interest and taxes

WACC =Weighted average cost of all types of capital derived on the basis of actual cost or opportunity cost of each component / source of capital in the capital structure.

and Capital Employed = All the capital used by the company to derive the NOPAT