4. (1 pt.) Briefly explain how you can dream the income statement and dream the balance sheet but then must derive the statement of cash flows.

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1 Valuation Quiz (25 points total) Name: ON BACK OF BACK PAGE 1. (2 pts.) Traditionally, net working capital refers to current assets minus current liabilities. Explain (a) why changes in net working capital are a part of the calculation of valuation cash flows; (b) why it may be better to alter the usual accounting definition to exclude some or all cash from the current assets portion of net working capital. (a) Changes in net working capital represent an investment that is not funded by current liabilities and therefore must be funded by long-term liabilities and/or equity. They are a use of cash. (b) Increases in surplus cash are not a required use of cash and, if foregone, would not directly harm the execution of the business plan. They are surplus and therefore reasonable to exclude from a required investment in current assets. 2. (1 pt.) Name three accounts/items in financial forecasts where one might check to make sure that the projections relating to cash are internally consistent. Ending cash balance in a cash budget, Cash balance on a projected balance sheet, ending cash balance (if included) on a projected statement of cash flows 3. (1 pt.) In what sense are equity free cash flow valuation methods permitting the valuation to be done as though there is a just in time (or equity credit line) source of funding? Surplus cash is treated as though repaid to the equity investors (or farmed out to an NPV zero investment) and then recaptured only when necessary to execute the business plan. It is as though the owners only raise as much equity capital as needed at any given time period. Free cash flow valuation only charges capital costs when the funds are employed in the conduct of the business plan. 4. (1 pt.) Briefly explain how you can dream the income statement and dream the balance sheet but then must derive the statement of cash flows. For our purposes, the statement of cash flows recaps the information projected in adjacent balance sheets. Therefore, we can make all of our projections assumptions in the income statements and balance sheets and then derive the statements of cash flow from those other statements. 5. (1 pt.) Why is it important to use a modest growth rate in a terminal value that is calculated using r-g? You can t grow faster than the economy forever and the r-g is a summary value for the infinite future cash flows.

2 6. (2 pts.) A firm predicts equity free cash flows per share at $50 annually at the end of the year starting one year from now. There is a planned sale at $1,050 including the final equity free cash flow at the end of the fifth year. You estimate that the proper discount rate is 50% per year for the next two years and then 20% per year for the last 3 years (years 3, 4 and 5). a. What is the present value of this security? (Show your formula, not just the answer.) 50 (1.5) (1.5) + (1.5) (1.20) + (1.5) (1.2) + (1.5) =$. (1.2) b. If you thought the last three years were more risky, would this current value be attractive to you? Discount rates are increasing in risk (other things being equal). Increasing the denominator decreases the estimated value, making the current value too high to pay (from your perspective). 7. (.5 pts.) Is an increase in accounts payable a source or a use of cash? Source 8. (.5 pts.) Your venture books all of its sales as Accounts Receivable. Draw the bucket diagram for Receipts = Sales Change in Accounts Receivable AR 0 -Receipts AR 1 + Sales

3 9. You operate a startup that produces and sells strombolis. Your raw materials supplier is willing to accept payment when the converted raw materials are sold, meaning that your accounts payable balance will always be equal to your inventory balance. Your inventory policy is to have exactly 20% of the cost of next year s sales in inventory at the end of the year. You must decide on the size of your factory, K. The larger the factory, the more strombolis you will be able to sell in years 2, 3 and 4; however, you also have to raise equity equal to the amount of the capital expenditure (all equity proceeds are used for the purchase of the factory). You expect sales to be level throughout the year, meaning 25% of the total sales volume is sold each quarter. You expect the subsidiary to have the following structure in its financials: Stromboli sales in units for Years 1, 2, 3 & 4: 100,000; K/2; K; 2K Revenue per stromboli $1.00 Cost per stromboli $.50 Miscellaneous expenses $2,000 per month Taxes (assume cash taxes treatment) 50% rate paid at the end of the year Initial time-zero (net) fixed assets K 200 Depreciation K/10 per year for years 1 through 10 Inventory at end of year based on 20 percent of next year s sales Accounts Receivable 90 days net (quarterly) Accounts Payable Equal to inventory balance Required Cash (project only one cash acct) 0 The venture organized earlier in Year 0 with $100,000 equity. There is an additional equity offering that takes place at the end of Year 0 to fund the purchase of fixed assets costing K (the use of the entire proceeds from the offering). The venture s first sales occur in Year 1. Complete the following financial statement projections. a) (2 pts.) Income Statements (in thousands): Year 1 Year 2 Year 3 Revenues 100 K/2 K - Cost of Goods Sold -50 -K/4 -K/2 - Other Expenses Depreciation -0.1K -0.1K -0.1K Profit Before Taxes K 0.15K K 24 - Taxes 0.05K K K + 12 Net Income -0.05K K K 12

4 b) (4 pts.) Construct the Balance sheets (in thousands): EOY 0 EOY 1 EOY 2 EOY 3 Cash K K K Inventories K 0.1K 0.2K Accounts Rec K 0.25K Current Assets K K K Gross Fixed Assets K K K K Acc. Depreciation 0 0.1K 0.2K 0.3K Net Fixed Assets K 0.9K 0.8K 0.7K Total Assets K K K K Accounts Payable K 0.1K 0.2K Total Liabilities K 0.1K 0.2K Par+APIC (post-money) K K K K Retained Earnings K K 0.225K 11 Total Owner s Equity K K K 1.225K + 89 Total Liab. and Equity K K K K c) (4 pts.) Construct the Statements of Cash Flow (in thousands): Year 0 Year 1 Year2 Year 3 NI K 0.075K K 12 +Depreciation 0 0.1K 0.1K 0.1K -Increase in AR (0.125K 25) K -Increase in Inventory -10 -(0.05K 10) -0.05K -0.1K +Increase in AP K K 0.1K -Capex -K Equity Issue K Change in Cash K K K Beginning Cash K K Ending Cash K K K

5 d) (1 pt.) Confirm that the depreciation for Year 2 as derived from CAPEX and the change in net fixed assets agrees with your Year 2 entry in the Income Statement. Give the derivation. From a bucket diagram Dep = CAPEX Change in NFA = 0 (-0.1K) = 0.1K e) (2 pts.) Construct the Equity Valuation Cash Flow for Years 0,1,2 and 3; Use the Pseudo Dividend Method s textbook formula (below) and the cash requirements stated in the problem. Year 0 Year 1 Year2 Year 3 NI K 0.075K K 12 +Depreciation 0 0.1K 0.1K 0.1K -Capex -K Increase in NOWC (0.125K 25) K Equity VCF (pre-money) -K K K K f) (1 pt.) Why are the Equity VCFs the same or different from the statement of cash flow s Change in Cash? g) (2 pts.) Select the better offer below to you as the owner. Assume a discount rate of 40% in the explicit period, stable growth of 5% and a discount rate of 15% after Year 3 and show your work. (Hint: The first cash flow is zero from a post-money perspective since the K is externally financed.) 1) K = $500 (thousands) and equity (of $K) issued for 25% of common stock. Your ownership is 75% (1.4) + (1.4) + (1.4) (1.4) =$ $ X 0.75 = $ (thousands) is your share of all-in DCF value at K=$500; However, the post-money offer values at $2,000 = $500/.25 implies a pre-money offer valuation of $2,000 - $500 = $1,500. Note pre-money NPV at K=$500 is negative at -$ ) K = $1,000 (thousands) and equity (of $K) issued for 60% of common stock. Your ownership is 40% (1.4) + (1.4) + (1.4) (1.4) =$ $ X 0.4 = $ is your share of all-in DCF value at K=$1,000. The post-money valuation $1,667 = $1,000/.6 implies a pre-money valuation of $1,667- $1,000 = $666,667. Note pre-money NPV at K=$1,000 is negative at -$ Moral of the story: When the funding level and investment are tied, you cannot just compare pre-money valuations inferred from offers. You need to look at your ownership in the post-money DCF value because (incremental) financing need not be NPV=0. Here, the additional $500 buys you $38.15 and the new investors $ That negative NPV additional $500 investment benefits you even though they should not invest the additional $500.