FIN 9 Projecting Financial Statements

Welcome to module two of our corporate finance course. As you can see the title of the module, projecting financial statements. I just want to remind you, and this is a phrase I'll repeat over and over again, and I'm sure your professor will, when we're valuing something, it's the present value of future cash flows to figure out the value of a bond or any, another financial instrument, or when we're determining the value of a company, if we want to invest in the shares of a company, which finance people are interested in doing, it is all about present value of future cash flows. Well, a question that might occur to you is, well, future cash flows, right? We're, we're trying to figure out the money that's going to come in to a company or as a result of a financial instrument in the future, and so we use accounting information, but accounting information is all based on the past. We get financial statements for last year, we don't get financial statements for next year, and so something we have to do is take those past financial statements and project them forward. That's what module two is all about. And it's not as simple as it might seem. So if I take this balance sheet and I go, okay, let's just say next year, everything's going up by 20%, say, right? So last year my assets were 200. Well, if they go up by 20% this year, they're going to be 240, right? Just multiply that by 20%, you get 40 and then add it. Okay. It went up to 240 liabilities up 20%. So that's a one 50 plus 30 is a one 80 and equity up a 20%. So that's up by 10, right? 50 times 20% is 10. So that goes up to 60. And sure enough, our balance sheet bounces 240 on the asset side. Assets equals liabilities plus equity. Of course, 180 and 60 is 240. Yep. Our balance sheet balances. You might think, oh, good job by me, right? My balance sheet balanced. Okay. I've done the exercise, but what we learn in this chapter is it's actually more complicated than this. If we just do a, uh, uh, projection in this way, right. Where we just go plus 20% to everything all done, the financial statements break down because they depart from reality. So what are ways this financial statement might've departed reality? Well, the first one is the liabilities. What if we can't borrow any more money, right? We're at the top of our boring capacity. Well, that's a problem. And when we project forward, we have to say, oh, are we going to need to borrow new money? Can we get new money? And so this represents likely new borrowing. The fact that we go from one 50 to one 80. The other thing that breaks down is the equity, because of course equity involves the income statement. It links the income statement, the balance sheet through an account called retained earnings. And if you just project for 20%, well, it's going to depend on what happened on the income statement and how many dividends we wish to pay. And so it's not so simple as just to go everything plus 20%, everything plus 10%. And so what we'll learn this chapter is those complications, right? We want to figure out the present value of future cash flows, our accountant friends who prepare financial reports, give us past transactions. We've got to project them forward to figure out the present value of future cash flows. That's what chapter two is all about. I'm looking forward to getting into it. Thanks for watching. See you in the next video.