Question

1.The authors set forth a seven-step forecasting game plan for preparing pro forma financial statements. Discuss the seven steps necessary to prepare the three principal financial statements.

2.Sales numbers are determined by both a volume component and price component. Projecting prices depends on factors specific to the firm and its industry that might affect demand and price elasticity. Discuss whether it would be likely that the firm would be able to raise future prices for different types of business.

3.As an analyst it is important when projecting sales to make estimates about future changes in sales volume. Compare how you might make estimates about future sales value for a company in different stage of life cycle.

4.Calculate the firm's cost of equity capital using the CAPM model.

5.Discuss the three components of CAPM model.

6.Why a firm’s dividend policy is irrelevant? Discuss the key assumption in the theory.

7.Explain “free” cash flows. Describe which types of cash flows are free and which are not.

8.Discuss under which scenario it is appropriate to use free cash flows for all debt and equity capital stakeholders.

Provide the rationale for using expected free cash flow in valuation. (CH12)

What three elements are needed to value a resource when using cash flows? (CH12)

Answer 1

1. Financial Statements are the statement of accounts showing the financial aspects of an organisation. There are mainly three financial statements for any organisation:-

• Profit or loss account (Income Statement) for the financial year
• Balance sheet showing financial position as on date.
• Cash flow statement.

Steps for preparing the financial statements are as follows:-

1. Record all the financial transactions – Journalise.
2. Post the transactions so journalised to respective ledger accounts – posting.
3. Classify the ledger accounts into Personal, Real and Nominal and according the same will be treated in Profit or loss account and /or balance sheet.
4. Balance the ledger accounts – balancing to find out the balances of ledger accounts month wise and finally at the year end.
5. Preparation of trial balances – tallying the accounting summary from the ledger balances.
6. Treatment of any adjustments off the trial balances ie the transactions, events and other matters came to notice after preparation of trial balance including any error of prior periods, clerical errors and such things will be made necessary adjustments.
7. Finally the preparation of financial statements.

2. The firm would be able to raise future prices for different types of business.

• Determination of price is purely based on certain factors – demand, market conditions, cost of production etc.
• In future the price of the product can be raised in comparison with the competitors based on the unqiue features and qualities it possessing. Eg: - Audi and Mercedes are the premium brands of cars and they are far above the rest in their product design and the same can be raised accordingly.
• Skimming pricing where the product will not be having competitors and accordingly the price of product can be raised.
• Product necessity another factor where the customers will buy even at any cost or stage .eg: basic necessities for day to day life such as food, items for bathing etc.
• In packaged pricing, the company can able to raise prices such as one plus one free.
• Prices can be raised based on certain geographical areas where the requirement is inevitable and hence the prices can be raised. Eg: - Sweater , jackets and coat in cool areas and place of rainy etc.

• Introduction Stage - product is newly introduced and the organisation will be incurring heavy expenses during this period. The organisation will be estimating less sales value as this is a period where the product is newly introduced and require to get into the market and captured.
• Growth Stage – Here the stage will be having captured market and high growth in sales as company starts the economics scale of production. Hence forth the highest estimate of sales value to be made.
• Maturity stage – During this stage the product is established and new competitors will enter. Here there should be minimal maintained estimate over and above the growth stage to be made so as to avoid the unwanted losses.
• Decline stage – The market starting to shrink for the product and the customers will be stitching to new or other products. Here the company should reduce the estimate at its very low level.

4. Firms cost of equity using CAPM model.

Cost of equity under CAPM (Capital Asset pricing Model ) = Risk free rate of return                        + Beta x (Market rate of return - Risk free rate of return)