In this session, we discuss the process for projecting free cash flow for the company we are seeking the value. This is a critical step in the DCF modeling process. One that requires a firm grasp on the business and a keen understanding of what the key drivers are for the company, performance, cash flow, and financial position. Let's kick into the material. When we are projecting a company's free cash flow, we are focused on what is known as unlevered free cash flow. By unlevered, we are focused on cash flows of the business without regard for the capital structure of the company. In other words, it is focused on the cash flows of the company's core operations and excludes payments for interests and dividends. We do it this way because, as you will see later, we are focused on calculating the enterprise value of the business, not the equity value. We do it on a capital structure neutral basis. The core items we seek to project in this exercise are revenues, cash operating expenses, cash income taxes, which you will see is different than what is on the income statement, capital expenditures, and changes in working capital. This page shows the free cash flow formula at a high level. As you will see on the next page, we will project out the income statement for a five-year period based on the key drivers of the business. You will note, we take the income statement only to the EBIT line. Then adjust for taxes calculated at the marginal tax rate versus taking income tax expense off of the income statement. That is because income tax expense incorporates the impact of the tax shield due to the interest rate deduction. Whereas in the DCF analysis, we are calculating an income tax charge without regard to the capital structure. Netting the income tax is calculated in this manner from EBIT. We arrive at a term called earnings before interest, but after tax, which is also known as EBIAT. To be honest, this is the only time that I see this term used in the investment banking business, but it is consistently deployed in the DCF analysis. Another term for EBIAT is NOPAT, net operating profit after tax. NOPAT and EBIAT are interchangeable. From there, we adjust for the three following items. Number 1, add back of depreciation and amortization to adjust for non-cash operating charges flowing through the income statement. Number 2, deduction of capital expenditures to account for cash outlays for operating investments. Number 3, the change in net working capital, which reflects the amount of cash invested or generated from the change in balance sheet accounts. When projecting out the income statement, it is essential to have your arms around what the key drivers are behind the business. You should look at multiple years of historical results, and develop a perspective on how the business will grow or contract in future years. Typically, when projecting out revenue, you will determine what the appropriate growth rate is for each year, using a different rate for each year based on your insights about the business. From there, you will project cost of goods sold as a percentage of revenue. Again, taking into account your perspective about how the business will change over time. It is not atypical to see gross margins expand over time as the business scales. Similarly, we will project out SG&A as a percentage of revenue. We typically expect that percentage to decline as the business scales. The D&A projection is also generally estimated as a percentage of revenue, since the investment in capital and the related depreciation moves in a linear fashion with the growth of the business. One final comment on the income statement projection. It is very common and in fact important to build out separate cases. Generally, you will have an upside case, a base case, and a downside case. This is attributable to the fact that forecasting is an imperfect science, and it's hard to predict the future with certainty. In addition to projecting out the income statement, we will also project out changes in the balance sheet. Again, it is important to take a look at historical balances and the relationships with the business when determining how to project the balance sheet. Accounts receivable is projected based upon an analysis of days sales outstanding, and inventory is calculated based on an analysis of days inventory held. Accounts payable is projected based on days payable outstanding. The rest of the balance sheet, including CapEx, is generally projected based upon a percentage of revenue as there is typically a linear relationship between these items and revenue growth. Since the balance sheets capture point in time estimates of the business versus the income statement that reflects the business activity of the business over the year, the DCF analysis considers the change in current assets and current liabilities from year to year. Since we are focused on the company's operations and the cash flow related to it, we look at only changes in operating assets and liabilities. This means that we exclude cash and short-term debt from this analysis. The chart on this page shows an example of two sets of balance sheet line items. One as of the beginning of the year and one as of the end of the year. To assess the change in net working capital, we consider increases in assets as negative cash flow items, since we are investing cash to grow the line item. Whereas a decrease in assets results in an increase in cash. Changes in liability accounts are opposite of that for assets. Increases in liabilities are increases to cash, and decreases in liabilities are reductions. We then net the change in current assets and current liabilities to assess whether it is an increase in cash or decrease in cash. If the change in net working capital is positive, we deduct that amount from free cash flow. If the change in the net working capital is negative, we add that amount to free cash flow. This final page pulls it all together. You can see that we lay out the three years of historical periods to inform how we project out the next five years. Again, we project the income statement down to the EBIT line, reduce it for taxes at the marginal rate. Then adjust for the D&A, CapEx, and changes in net working capital.
