Proformas and Valuation

Proformas for NPDBD

For this course, proformas should include income statements, balance sheets, and statements of cash flows for the new product for the next five years -- under pessimistic, likely, and optimistic scenarios. Key financial ratios (e.g. profit margin, days cash on hand, and debt ratio) for each year and scenario are also useful. A brief narrative with major assumptions and key outcomes should accompany each scenario proforma. Especially for valuation, the proformas should be for the new product alone, even if it will be part of an existing firm.

There can be flexibility concerning what type and depth of financial model is used to create the proformas, but it should include the following:

1) Figures should be consistent and linking among statements in the proforma, the valuation, and the rest of the business plan narrative.
2) Since variability in quantity produced generally has a large impact on financial performance, it should be clear how market size or share varies by scenario, how quantity is driven by market size and share, and how revenue is driven by price and quantity.
3) Especially if costs are not 100% variable with quantity, then the model should show how costs vary with volume.
4) The assumptions (e.g. days in accounts receivable and payable) used to adjust revenues and expenses to get cash inflows and outflows should be clearly shown.
5) Generally for this course one assumes that the product is funded completely by equity with no debt, but if there is any debt then financing details should be clear and operating cash flows without interest expense should be calculated for the valuation analysis.

Relating this to the handout "Financial Analysis and Planning: Valuation and Proformas," you may use this like a menu to pick different methods if you wish. For example, for the Income Statement, you could pick method 3,4,5,6, or 7 (1 and 2 are a bit simplistic). For the Cash Flow Statement you could pick method 1 or 2. For the Balance Sheet, you could pick method 1, 2, or 3. You do not have to follow any of these specific methods as long as you address the issues identified above.

Valuation for NPDBD

For this course, valuation should include NPV based on explicit model-estimated operating cash flows (without interest payments) for the project for the next five years, plus a lump sum present value for residual value thereafter, for pessimistic, likely, and optimistic scenarios. IRR can be calculated as well, but is optional. Operating cash flows without interest payments for the five years can be calculated from proforma figures. The present value of the residual value after year five may be estimated using the formula for a growing perpetuity and an assumption of constant cash flow growth. For additional information about valuation and the differences between accounting profits and cash flows, please see the hand-out "Valuation of Companies and Their Stocks."

The discount rate for valuation may be explicitly calculated using the Capital Asset Pricing Model (CAPM), the Weighted Average Cost of Capital (WACC), or a combination thereof. Sensitivity analysis should be done to see how NPV for the likely scenario is affected by changes in the discount rate. If it is too difficult to estimate a discount rate using CAPM or WACC, then a rough middle-range rate (15%) may be used for the pessimistic, likely, and optimistic scenarios and sensitivity analysis should be also done for the likely scenario using low (5%) and high (40%) discount rates.

Alternative approaches, quarterly results for early years, and other variations on proformas and valuation are possible, especially if requested by the sponsoring organization, but should be discussed in advance with course faculty. Both proformas and valuation should integrate with the final business plan.