Question 1 (30 pts) Refer to the Excerpts from the 2019 Financial Statements of Merck. These are not attached to this document. You can find them on Canvas in the “Project 1” folder within FILES. (it’s a pdf file).
1. Assume that Free Cash Flow is Defined As
Cash from Operations + Cash From Investing (both as defined by GAAP).
• Calculate Free Cash Flow for Merck for the years 2017-2019 using this definition.
• In which year is Free Cash Flow the highest?
2. An Alternative Popular Way to Define Free Cash Flow is
FCF = Net Income (after tax) + (1-t) Interest + Depreciation – ∆ Working Capital – CAPEX
Let’s ignore the interest term and the CAPEX term (for now) and concentrate on the rest. To be clear, we’re concentrating on
Net Income (after tax) + Depreciation – ∆ Working Capital
This is intended reflect a “cash flow.”
• For each of 2017-2019 for Merck, what accruals does this definition miss? Be specific as to
the line items and magnitudes for each year.
• In total, how far “off” is this measure (in terms of capturing all accruals) for Merck in each of
the years 2017-2019?
3. What components of working capital underwent the biggest changes for Merck over the period 2017-2019?
4. Now let’s focus on the CAPEX term in this second definition of Free Cash Flow. What other investment activities (as classified in the cash flow statement) does this miss for Merck in 2017- 2019? Be specific, both in terms of type of investment and dollar amounts.
5. In the investing section of their cash flow statement, Merck lists large transactions associated with financial securities. If these cash flows are not considered part of the calculation of free cash flow, what do they represent? Where did they get the money to engage in these activities (or what did they do with the money they obtained from these activities)?
6. What were Merck’s largest financing activities (as defined by items in the financing section of the cash flow statement) over the period 2017-2019?
7. Would paying more dividends to shareholders impact Free Cash Flow under either of the definitions above?

Question 2 (20 pts): Refer to the Excerpts from the 2019 Financial Statements of GW, Inc. (not its real name). These excerpts are not attached. You can find them on Canvas in the “Project 1” folder within Files. (it’s an Excel Worksheet).
These are the actual financial statements (cash flow statements) for a company over the period 2017- 2019. Your job is to pretend that it is the beginning of 2017 and that these are FORECASTED financial statements (prepared according to GAAP). We’re going to be using these “forecasted” statements to calculate valuations.
1. Based on the Financing Section of the “forecasted” cash flow statements, what types of financial claims (financial liabilities and various claims on equity) does GW have? Give as complete a list as possible (e.g., common stock, … ). You don’t have to attach any numbers to the claims.
Financial claims include common stock, convertible, borrowings, collateralized lease repayments, convertible note hedges, warrants, investments by noncontrolling interests.
Initially, suppose Free Cash Flow (to all) is defined as Cash From Operations plus Cash from Investing, (both as defined by GAAP). Suppose that GW has a discount rate (weighted average cost of capital) of 8%.
2. What is the present value of the three “forecasted years” of Free Cash Flow? That is, suppose it is the end of 2016 (or beginning of 2017). All cash flows occur at the end of the year. Therefore, the 2017 cash flow is one year away, etc.
3. Now let’s work on adjusting the numbers. One of the most common adjustments is to move the after-tax cost of interest out of the Operating Cash Flow number.
• Do this for GW for each of the three years. Use a 20% tax rate.
• What evidence is there to suggest that interest might not be tax-deductible for GW?

4.Next, let’s adjust the cash flow statement numbers for GW to reflect the economic impact of non- cash investing and financing activities or non-cash operating and financing activities. Include your modification for interest cost from above as well.
a. Re-express the Statement of cash flows as follows (I don’t need every line item from the original cash flow statement)

b. Calculate the Present Value of the Modified Free Cash Flow Numbers
5. Of course, the valuation of GW would also include a “terminal value” or continuation value. Suppose that the terminal value is calculated by assuming the forecasted FCF for year 2020 continues as a perpetuity (with no growth).
• How big does FCF have to be in year 2020 (and each year onward) such that the Overall Enterprise Value of GW is 50 Billion dollars (as assessed at the beginning of 2017)?
Extra Credit: Who is this company? (their value is much bigger now)
Problem 3 (50 pts): Free Cash Flow Forecasts
Suppose we have a new venture that has already raised some debt and equity capital. A portion of their opening balance sheet is as follows. This includes only the operating assets and liabilities. Note that no information is provided about the amount of or types of debt vs equity claims. Obviously, in a complete balance sheet these would all be specified and the overall balance sheet would have to balance.
Required:
Our objective is to make financial projections for the next three years (the venture will hopefully persist beyond three years, but we won’t worry about projections beyond this time).
1. Project out the income statement for the next three years, then the balance sheet items. Note that you can’t get a complete balance sheet.
2. Then use these sets of statements to try to forecast the next three years of FREE CASH FLOW.
Be sure to indicate how you have defined free cash flow. Your choices for how to define it will be limited because of the limited amount of financial statement detail provided.
3. Some definitions of Free Cash flow focus solely on CAPEX in the investing category. If you wanted to do this, you’d obviously need to separate out CAPEX from the other types of investments. What else would you have to do differently in these projections? You don’t have to do (or re-do) any calculations here, just explain in words what (if anything) you’d do differently.
4. What advantages would there have been (if any) to forecasting out a complete set of financial statements relative to what you have here?