Ignacio Velez-Pareja

Which cost of debt should be used in forecasting cash flows

?Que costo de deuda debe ser usado para pronosticar los flujos de caja? Con frecuencia analistas y profesores utilizan la tasa de interes efectiva para estimar el costo de la deuda para pronosticar y descontar los flujos de caja. Otros estiman los pagos de interes basados en el promedio de la deuda calculado con el saldo inicial y final. Otros mas utilizan la convencion de final de periodo y calculan el interes multiplicando el saldo inicial de la deuda por su costo contractual. El uso de uno u otro metodo es critico para el calculo de los ahorros en impuestos. Se ilustran estos enfoques con ejemplos y se muestran las diferencias al usarlos. Se presenta una propuesta simple para solucionar el problema.Frequently analysts and teachers use the capitalized rate of interest for the cost of debt when forecasting and discounting cash flows. On the other hand, some authors (and analysts) estimate the interest payments when forecasting annual financial statements or cash flows based on the average of debt calculated with the beginning balance and the end of year balance. This makes some sense because usually firms repay debt in a monthly or quarterly basis and calculating interest payments might not reflect reality. Others use the end of year convention that calculates the yearly interest multiplying the beginning balance times the contractual cost of debt.In this teaching note we show the differences when we use those different approaches and make a simple proposal to solve the problem.

Prospective Analysis: Guidelines for Forecasting Financial Statements

We discuss some ideas useful when forecasting financial statements that are based on historical data.The chapter is organized as follows: First we discuss the relevance of prospective analysis for non traded firms. In a second section we a basic reviews of subjects that will be needed for forecasting financial statements. We discuss the use of plugs for financial forecasting. We show an alternate approach to avoid such popular practice. The approach we propose follows the Double Entry Principle. This principle guarantees consistent and error free financial statements. We show with a simple example how the plug works and its limitations and problems that arise when using it.Next, the reader will find what information is needed for the forecasting of financial statements and where and how to find it. We present the procedure to identify policies that govern the ongoing of a firm such as accounts receivable and payable, inventories, dividend payout, and identify price increases and other basic variables. We also deal with the real life problem of a firm with multiple products and/or services.We start with historical financial statements, We include inflation rates, real increases in prices and volume and policies in order to construct intermediate tables that make very easy the construction of the pro forma financial statements. We use a detailed example to illustrate the method.We derive the cash flows that will be used in the book to value a firm. This type of models might be used by non traded firm for a permanent assessment of the value creation.Finally we show some tools to perform sensitivity analysis for financial management and analysis.