# Forecasted Income Statement

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```					Financial Statement Analysis (Spring 2004)
Solution to Exercise E16.3 in the Penman textbook.

Information given in E16.3 (p. 586) (in millions except price per share and other ratios):
2000          2001          2002       2003       2004       2005       2006       2007       2008       2009       2010       2011
Investment in PP&E (assume each year's investment occurs at year-end)                            600.00        700.00        800.00     900.00   1,000.00   1,000.00   1,000.00   1,000.00   1,000.00   1,000.00   1,000.00   1,000.00
Sales                                                                                                          250.00      1,530.00   3,540.00   4,295.00   4,305.00   4,410.00   4,500.00   4,500.00   4,500.00   4,500.00   4,500.00
Operating expenses (other than depreciation) as a % of sales                                                   70.00%        70.00%     70.00%     70.00%     70.00%     70.00%     70.00%     70.00%     70.00%     70.00%     70.00%
Effective tax rate *                                                                              0.00%         0.00%         0.00%      0.00%      0.00%      0.00%      0.00%      0.00%      0.00%      0.00%      0.00%      0.00%
Enterprise cost of capital (r)                                                                   10.00%        10.00%        10.00%     10.00%     10.00%     10.00%     10.00%     10.00%     10.00%     10.00%     10.00%     10.00%
* Note that since firms can choose different depreciation methods for book and tax purposes,
this exercise ignores tax effects.

Solution:
(a)
Assuming a 3-year useful life of PP&E:
Cost of year t-2 investments
Cost of year t-1 investments
Cost of year t investments
Gross investment in PP&E at year end

Depreciation schedule:
Depreciation of investments made at end of last year
Depreciation of investments made at end year t-2
Depreciation of investments made at end year t-3
Total depreciation expense

Proforma (forecasted) balance sheet:
Gross investment in PP&E
Accumulated depreciation
PP&E, net of accumulated depreciation (assume NOA=net PP&E)

Proforma (forecasted) income statement:
Sales revenue
Operating expenses other than depreciation
Depreciation expense
Pretax operating income
Tax expense
Operating income
Operating profit margin
Net operating asset turnover
RNOA

Assuming a 5-year useful life of PP&E:
Cost of year t-4 investments
Cost of year t-3 investments
Cost of year t-2 investments
Cost of year t-1 investments
Cost of year t investments
Gross investment in PP&E at year end

Depreciation schedule:
Depreciation of investments made at end of last year
Depreciation of investments made at end year t-2
Depreciation of investments made at end year t-3
Depreciation of investments made at end year t-4
Depreciation of investments made at end year t-5
Total depreciation expense

Proforma (forecasted) balance sheet:
Gross investment in PP&E
Accumulated depreciation
PP&E, net of accumulated depreciation (assume NOA=net PP&E)

Proforma (forecasted) income statement:
Sales revenue
Operating expenses other than depreciation
Depreciation expense
Pretax operating income
Tax expense
Operating income
Operating profit margin
Net operating asset turnover
RNOA

(b)

Note that the problem assumes that projections of sales and annual new investment in PP&E are both independent of
projections of useful lives of the PP&E. Taking annual new investment and sales as given and assuming operating
expenses other than depreciation are completely variable (at 70% of sales), the depreciation schedule is the only thing
that affects reported operating income and net operating assets. Once the firm reaches its steady state of \$1,000,000 in
new investment and \$1,000,000 in depreciation each year, operating income is the same under either useful life
assumption, but the shorter useful life assumption causes lower book value of net operating assets (i.e., it is more
conservative). Thus, when the firm reaches steady state RNOA is greater for the 3 -year versus the 5-year useful life
assumtion is 17.5%=\$350/\$2,000 versus only 11.67%=\$350/\$3,000. This has to be the case, since the value of the firm
is unaffected by the accounting. The book value of the net operating assets (and CSE) is smaller for the more
conservative 3-year life assumption, so the discounted present value of the forecasted residual operating income (and
RNOA) must be greater for the 3-year life assumption. Until the firm reaches steady state, the pattern of differences in
RNOA between the more conservative and more liberal accounting methods is difficult to predict. In this exercise, it
turns out that as of 12/31/04 (just before the planned IPO), RNOA is higher for the more liberal 5 -year useful life
assumption (i.e., 31.3%=\$688.50/\$2,200 versus 29.3%=\$488.50/\$1,666.67. This difference should have no affect on
astute investors, who should estimate the same value for the firm regardless of the book depreciation method, with no
cash flow implications [see computation of firm value in (c) below].
(c)
Projected value of the firm at 12/31/2004 (just before the IPO):
With 3-year useful life of PP&E assumption:
Projected NOA                                                                                         -
Projected ReOI                                                                                                         -   -   -   -   -   -   -
Projected PvReOI                                                                                      -                -   -   -   -   -   -   -
Projected value of the enterprise at 12/31/04                                                         -
With 5-year useful life of PP&E assumption:
Projected NOA                                                                                          -
Projected ReOI                                                                                                          -   -   -   -   -   -   -
Projected PvReOI                                                                                       -                -   -   -   -   -   -   -
Projected value of the enterprise at 12/31/04                                                          -
Check                                                                                                    -

(d)
Good financial statement analysis would find that the RNOA in 2004 is not indicative of the long-run RNOA for this
firm (see part (b)). But maybe the market does not see this. If an investment banker were pricing the IPO on the
basis of multiples of earnings from comparison firms, and did not adjust for depreciation methods, he or she might
price the earnings with five-year lives higher for the IPO. Would the market penetrate this illusion? The answer is
probably "yes". In any case, good managers spend their time adding value, not attempting to fool the market.

(e)

In 2009, profit is the same for both depreciation methods (and so, of course, is the value of the firm).
However, RNOA is higher with three-year life depreciation [see analysis in (b) above]. Would the market
interpret higher profitability (incorrectly) as requiring a higher price? If the officers of the firm believed that
the market could be "fooled," they might choose the three -year method to get a higher price for the shares
obtained from exercise of the options. However, as noted in (d) above, good managers spend their time
adding value, not attempting to fool the market. Good managers use the flexibility GAAP to provide more
informative financial reports. An important empirical question beginning to be addressed by academic
research is whether the market awards a lower cost of capital (and higher stock price) to firms with more
informative financial reports -- hopefully, we will find that this is indeed the case.

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