Question: The Quality of Forecasted Residual Operating Income and Free Cash Flow (Medium) A start-up begins operations in 2012 by investing $400 million in plant and equipment. It expects to increase investment by $40 million each year, indefinitely, depreciating it straight-line over two years. The investment program is expected to generate sales for the next five years, as follows (in millions of dollars):
a. Prepare a schedule of pro forma operating income, return on net operating assets (RNOA), residual operating income, and net operating assets for the years 2013 to 2017. Depreciation of the investment is the only operating expense. The firm has a 10 percent hurdle rate for its operations. Calculate the value of this film using residual operating income methods.
b. Forecast free cash flow for 2013 to 2017. Do you think that forecasted free cash flow is a good quality number on which to base a valuation? What features in the proforma explain why the pattern of free cash flows is different from that for residual operating income?