Hi, I'm Rick Lambert, Miller-Sherrerd Professor at the Wharton School. And welcome to lecture two of module four in our decision making and scenarios course. Here we're talking about a new product venture. In our second lecture we're going to talk more explicitly about the forecasting of the future cash flows. We're going to take our spreadsheet that we started to develop back in lecture one, and go into more detail about how that's going to play out, in terms of the forecasts of the future cash flows. So, open up the spreadsheet, and follow along. In forecasting out future financial statements, okay, and the time series, we usually start with trying to forecast out sales. Or sales growth. We're then going to take the projected sales figures to try to estimate the remaining income statement lines. These are often, as least partially, a function of the sales volume. We use the sales forecast to also construct a schedule for production, so when do we need to produce the product or the service? What are going to be the production volumes? What are going to be the inventory levels? Those kinds of things. Use the forecasted sales and production schedules to try to estimate the resources we're going to need to accomplish those plans. Those are assets and the timing of the resource acquisition and use. We're going to use the income statements and balance sheets that we project out to then construct the statement of cash flows. And again, remember, we're going to focus on the cash flows from the project itself and not worry about the specifics as to how the project is financed. So forecasting revenues. We're trying to assess what's the consumer demand for our product. This might involve looking at industry and market share, management estimates outside, analysts estimates about industry sales might be useful. Production and technology constraints, we can't sell more than we can make. So what's our production capacity? Demand also depends on sale's price. The higher you price your product the lower the sales volume is probably going to be. So you need to work in all of those things. For new ventures in particular, we need to worry about how long til we get to market? How long will high growth last? When will competitors come in with products that are going to eat away from the sales of our product? What will steady state look like? And what would the phase out period look like? Forecasting out the other income statement lines. Cost of good sold, what combinations of materials, labor and overhead are going to be required to put together our product or service? What those going to cost? What profit margin is expected? So our spreadsheet has a cell where we've got the projected profit margin. How much of cost are fixed versus variable? Some costs go up the more you sell. Some costs are independent of the sales volume. We want to lay out that in terms of our cost structure also. Selling general administrative expenses. How big are our marketing or advertising plans? How's that going to change over time? Again, how much of these costs go up when volume goes up versus stay flat? Looking at competitor financial statements or our own financial statements from products in the past might be helpful in terms of trying to forecast these things out. Depreciation expense. How big's that going to be? Well that depends on how much property plant and equipment we have? So this is going to tie into the balance sheet. How long is property plant and equipment going to last? What's the salvage value? We need to build these assumptions into our spreadsheet as well. Income tax expense, where's the income going to be? What's the tax jurisdiction? What's the rate? Accelerated versus straight line depreciation. In startups, there's often concerns about losses that you have and can you use those losses versus do you have to carry them forward? So that can get complicated. This is where having a tax professional can be very useful here. We're going to just assume that the tax rates are 40%. And that this project is part of a bigger company that's got taxable income. So, that if we have losses in the early period we can take advantage of those. In the disposal year, okay, we've got an other line in our income statement in the spreadsheet. There's going to be a gain on the sale of the property plant and equipment because we've depreciated it down to zero. But we actually sell it for more money than that and we've got other disposal costs of 2,000. This is a big one to think about that people often forget is, what are the costs of getting out of the project? So with all those assumptions we can forecast out what the income statement is going to look like. So this is our forecasts over the eight years of the projected income statements. Note that there's no sales growth during the operating phase by assumption, so we're going to change that later on. There's a big drop in sales at the very end, during the termination phase. There's a decline in income during the operating phase even though sales is constant. And that's because the tax benefits are changing over time because of the accelerated deprecation that's being used there. Okay, so this the lay out of our income statement. How about the balance sheet, our working capital accounts, accounts receivable? What's going to be our credit policy? How much of sales are for cash verses for credit? How quickly will we get paid? We have to work that into our spreadsheet. Inventory, what are our production plans? Do we produce in advance and have inventory on hand already? Or do we make it after we get an order? How long does production take? How much inventory do we want to hold? And then the payables. When do we pay for our inventory? When do we actually pay for the wages and the benefits? The timing is important here as well. We need to lay that out in our spread sheet. If there is any other working capital account so it's going to be relevant. Make sure you include those also. Then on the balance sheet, the long term assets. What are our production and capital expenditure plans? We've got an upfront investment in property plant equipment. Will we need to add capacity later? If we do, when and how much is that going to cost? At the end of the production life, what are the disposal costs or the resell value? Are there intangible assets in addition to tangible assets? Remember that intangible assets like R&D aren't put on the balance sheet, aren't capitalized. Again, what depreciation policy do we have? What amortization policy? What's on it for books? What's on it for tax purposes? This then, let's us lay out our forecasted balance sheets. Okay, so again, make sure on the balance sheet, assets equals liabilities plus owner's equity. Note that we've got a jump in working capital in year three. That's when production starts. That's when we start to have inventory. And receivables and things like that. This working capital is then released in year eight. Okay, that's when we collect on all of the remaining receivables, collect on inventory, pay off the remaining payables and those kinds of things. In between there, working capital isn't really changing over time. So even though we're making more sales on credit. We're also collecting on sales from the prior years so the receivables balances, the inventory balances aren't changing over time because we're in a constant state here. No growth is going on during that period and so there's no increase in working capital. Once we've got the forecasted income statement and the forecasted balance sheet, now we can forecast the cash flow statement. Okay, so again this is again what our ultimate focus is going to be. Operating cash flow is net income, plus the depreciation, because depreciation is in income, but it isn't cash outflow, minus the change in working capital. That's our investment in receivables, and inventory etc., that's in income that isn't cash. We're also going to have investing cash flows during the startup period, where we're going to be spending money on property, plant, and equipment, and investing cash flows during the disposal period where we're actually going to get money. So we need to make sure we include those into our spreadsheet as well. We can lay out our forecasted cash flows. Note the negative cash flows during the startup phase. This is where we're not bringing in any revenue, but we are spending money. The positive cash flows, during the operating phase. Note that cash lags behind income, because of the investment in working capital, in year three. That switches in year eight. In this case, our termination phase actually is a positive cash flow, mostly because of the release of the working capital. So we're bringing in money from collecting on the sales that had not been collected to that point. The last cash flow is not always a positive number. So, all of the work that we've done at this point should mostly be on the assumptions that went into the generation of the forecasted financial statements. Look at it again. Does it make any sense? Are the sales levels actually achievable? Is the production schedule achievable? Make sure you've included the cleanup costs or the disposal costs. A lot of people forget that one. So, at this point we've got the operating and investing cash flows, remember that that's what our focus is at this point. We're not looking at the financing cash flows. The discount rate is going to reflect whatever the opportunity cost of capital is. You'll see that we've got negative cash balances. If that worries you, just think about this as being part of a bigger company and the cash is coming from some other part of the company. What remains then, is to take those cash flows and to do a present value calculation. So in our next lecture, that's what we're going to focus on.
