QUESTIONS

1. Prospective analysis is central to security valuation. All valuation models rely on forecasts of
earnings or cash flows that are, then, discounted back to the present to arrive at the estimated value
of the security. Prospective analysis is also useful to examine the viability of companies strategic
plans, that is, whether they will be able to generate sufficient cash flows from operations to finance
expected growth or whether they will be required to seek external financing. In addition,
prospective analysis is useful to examine whether announcing strategies will yield the benefits
expected by management. Finally, prospective analysis can be used by creditors to assess
companies ability to meet debt service requirements.
2. Prior to the forecasting process, financial statements can be recast to better portray economic
reality. Adjustments might include elimination of transitory items or reallocating them to past or
future years, capitalizing (expensing) items that have been expensed (capitalized) by management,
capitalizing operating leases and other forms of off-balance sheet financing, and so forth.
3. In addition to trend analysis, analysts frequently incorporate external (non-financial)
information into the prospective process. Some examples are the expected level of macroeconomic
activity, the degree to which the competitive landscape is changing, any strategic initiatives that
have been announced by management, and so forth.
4. The forecast horizon is the period for which specific estimates are made. It is usually 5-7 years.
Forecasts beyond the forecast horizon are of dubious value since estimates are uncertain.
5. Since all valuation models are infinite horizon models, analysts frequently assume a steady state
into perpetuity after the forecast horizon. A common assumption is that the company will grow at
the long-run rate of inflation, that is, remaining constant in real terms.
6. The projection process begins with an expected growth in sales. Gross profit and operating
expenses are, then, estimated as a percentage of forecasted sales using historical ratios and external
information. Depreciation expense is usually estimated as a percentage of beginning gross
depreciable assets under the assumption that depreciation policies will remain constant. Interest
expense is usually estimated at an average borrowing rate applied to the beginning balance of
interest bearing liabilities. Projections of expected interest rates are used for variable rate
indebtedness and new borrowings. Finally, tax expense is estimated using the effective tax rate on
pre-tax income.
7. In the first step, balance sheet items are projected using forecasted income sales (COGS) and
relevant turnover ratios. Long-term assets are projected using forecasted capital expenditures.
Long-term liabilities are projected from current maturities of longterm debt disclosed in the debt
footnote, and paid-in-capital is assumed to be constant in this stage. Retained earnings are
projected adding (subtracting) projected profits (losses) and subtracting projected dividends. Once
total liabilities and equities are forecasted, total assets is set equal to this amount and forecasted
cash is computed as the plug figure.

In the second step, long-term liabilities and equities are adjusted to yield the desired level of cash.
The analyst must be careful to maintain the historical leverage ratio and adjust liabilities and
equities proportionately.
8. The residual income model expresses stock price as the book value of stockholders equity plus
the present value of expected residual income (RI). Residual income can be expressed in ratio form
as,
RI = (ROEt k) * BVt-1
Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so long as
ROE k. In equilibrium, competitive forces will tend to drive rates of return (ROE) to cost (k) so
that abnormal profits are competed away. The estimation of stock price, then, amounts to the
projection of the reversion of ROE to its long-run value for a particular company and industry.
ROE is a value driver since it impacts our valuation of the stock price. Its components (asset
turnover and profit margin) are also value drivers
9. We can make two observations regarding the reversion of ROE:
a. ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition.
Furthermore, the reversion rate for the least profitable firms is greater than that for the most
profitable firms. And finally, reversion rates for the most extreme levels of ROE are greater than
those for firms at more moderate levels of ROE.
b. The reversion is incomplete. That is, there remains a difference of about 12% between the
highest and lowest ROE firms even after ten years. This may be the result of two factors:
differences in risk that are reflected in differences in their costs of capital (k); or, greater (lesser)
degrees of conservatism in accounting policies. The reversion of ROA and NPM are similar.
While some reversion of TAT is evident, it is much less than that of the other value drivers.
10. Short-term cash forecasts are key to assessments of short-term liquidity. An asset is called
"liquid" because it will or can be converted into cash within the current period. The analysis of
short-term cash forecasts will reveal whether an entity will be able to repay short-term loans as
planned. This also means such analysis is extremely important for a potential short-term credit
grantor. Short-term cash forecasts often are relatively realistic and accurate because of the
shortness of the time span covered.
11. A cash forecast, to be most meaningful, must be for a relatively short-term period of time.
There are many unpredictable variables involved in the preparation of a reliable forecast for a
highly liquid asset such as cash. Over a long period of time (that is, beyond the time span of one
year), the difference in the degree of liquidity among items in the current assets group is usually
insignificant. What is more important for long time spans are the projections of net income and
other sources and uses of funds. The focus should be shifted to working capital (and other accrual

measures), and away from cash flows, for longer forecast horizons of, say, thirty monthswhere
the time required to convert current assets into cash is insignificant.
12. Cash inflows and outflows are highly interrelated. These two flows are crucial to a companys
circulation system." A deficiency in any part of the system can affect the entire system. For
example, a reduction or cessation of sales affects the vital conversion of finished goods into
receivables or cash, which in turn leads to a drop in the cash reservoir. If the system is not
strengthened by "transfusion" (such as additional investment by owners or creditors), production
must be curtailed or discontinued. Lack of cash inflows also will reduce other expenses such as
advertising, promotion, and marketing expenses, which will further adversely affect sales. This
can yield a vicious cycle leading to business failure.
13. Most would agree with this assertion. Cash is the most liquid asset and when management
urgently needs to purchase assets or incur expenses, a cash exchange is the quickest and easiest
means to execute a transaction. Moreover, unless management has a credit line established with a
reliable outsider (such as a revolving account at a bank), lack of cash can mean a permanent loss
of profitable opportunities.
14. Ratio analysis is a static measurement tool. Ratios measure relations among financial statement
items as of a given moment and time. In contrast, funds flow analysis is a dynamic measure
covering a period of time. A dynamic model of funds flow analysis uses the present only as a
starting point and utilizes the best available estimates of future plans and conditions to forecast the
future availability and disposition of cash or working capital. Analyzing funds flow also
encompasses the projected operations of a company. Since one of the fundamental assumptions of
accounting is the going-concern concept, some assert that the dynamic model is more realistic and
is superior to static representations. However, care should be taken in placing too much reliance
on funds flow analysis as it is primarily based on estimates, and not on realized observations. 15.
Except for transactions involving the raising of money from external sources (such as through
loans or additional investments) and the investments of money in long-term assets, almost all
internally generated cash flows relate to and depend on sales. Accordingly, the usual first step in
preparing a cash forecast is to estimate sales for the period under consideration. The reliability of
any cash forecast depends on the accuracy of this forecast of sales. In arriving at the sales forecast,
the analyst should consider: (1) past trends of sales volume, (2) market share, (3) industry and
general economic conditions, (4) productive and financial capacity, and (5) competitive factors,
among other variables.