Financial accounting

A client explains that her firm’s value must be affected by the choice of explicit forecast horizon. Build a model to test her claim. NOPLAT, depreciation, and gross investment for year 1 have been forecasted to be $10.0, $2.5, and $13.61, respectively.

a. To evaluate your client’s claim, first assume a short horizon of three years.

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b. Compare the results of this three-year horizon to a five-year forecasted horizon. The company’s management team forecasted ROIC for years 1-3 to be 18 percent and 11 percent after that period. The company executives also forecasted NOPLAT to grow at 20 percent for years 1-3 and a decline to continuing growth rate of 7 percent thereafter. Depreciation in year t = 25% of NOPLAT in year t. Finally, the management team has estimated an initial WACC of 14 percent for years 1-3, and declining to 12 percent after the initial forecasted period.

c. Compare your computed value for both time horizons. Provide an explanation of your results. (Hint: Firm value using the 3-year horizon should equal the firm value using the 5-year horizon.)

· Gross investment for any year is NOPLAT × (g/ROIC) + Depreciation.

· The CV is the present value of the first year’s CV base free cash flow, NOPLAT× (1 – g/ROIC),discounted as a growing perpetuity: NOPLAT × (1 – g/ROIC)/(WACC – g) for years 4+ (or years 6+ for the five-year horizon). Remember to discount CV back to time zero to find the present value.

· FCF = NOPLAT + Depreciation – Gross Investment.

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